UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION


Washington, D.C.
20549




FORM 10-K


(Mark
One)





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


For
the fiscal year ended December 31, 2009




OR


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


For
the transition period from        
 to




Commission
file number 001-34246





SMARTHEAT
INC.


(Exact
Name of Registrant as Specified in Its Charter)




Nevada
                98
      -0514768(State
      or Other Jurisdiction of
                  Incorporation
      or Organization)
                (I.R.S.
      Employer
                  Identification
      No.)


A-1,
10, Street 7


Shenyang
Economic and Technological Development Zone


Shenyang,
China 110027


(Address
of Principal Executive Offices) (Zip Code)




Registrant’s
telephone number, including area code:


+86
(24) 2519-7699




Securities
registered pursuant to Section 12(b) of the Act:




Title
      of Each Class:
                Name
      of Each Exchange on Which
                  Registered:Common
      Stock, par value $0.001 per share
                NASDAQ
      Global Market





Securities
registered pursuant to Section 12(g) of the Act:


None




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes ̈  Noþ




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes  ̈  No þ




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, as
amended (“Exchange Act”) 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 þ  No  ̈





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the
best of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  ̈





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  ̈
            
            Smaller
      reporting companyþ(Do
      not check if a smaller reporting company)





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





The
aggregate market value of the registrant’s voting and non-voting common stock
held by non-affiliates of the registrant on June 30, 2009, the last business day
of the registrant’s most recently completed second fiscal quarter, was
approximately $72,293,530.00, based on the last closing sales price of the
registrant’s common stock as reported by the NASDAQ Global Market on that date.
For the purposes of the foregoing calculation only, all of the registrant’s
directors, executive officers and holders of ten percent or greater of the
registrant’s outstanding common stock have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate status is not a
determination for other purposes.




As of
March 30, 2010, there were 32,794,875shares of common stock
outstanding.





DOCUMENTS
INCORPORATED BY REFERENCE:




None







SMARTHEAT
INC.




ANNUAL REPORT ON
FORM 10-K


FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2009




TABLE
OF CONTENTS




PagePART
      IItem
      1.
                                    Business
                                    4Item
      1A.
                                    Risk
      Factors
                                    13Item
      1B.
                                    Unresolved
      Staff Comments
                                    25Item
      2.
                                    Properties
                                    25Item
      3.
                                    Legal
      Proceedings
                                    26PART IIItem
      4.
                                    Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                                    26Item
      5.
                                    Selected
      Financial Data
                                    28Item
      6.
                                    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                    28Item
      6A.
                                    Quantitative
      and Qualitative Disclosures About Market Risk
                                    36Item
      7.
                                    Financial
      Statements and Supplementary Data
                                    36Item
      8.
                                    Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                                    36Item
      8A(T).
                                    Controls
      and Procedures
                                    36Item
      8B.
                                    Other
      Information
                                    37PART IIIItem
      9
                                    Directors,
      Executive Officers and Corporate Governance
                                    38Item
      10
                                    Executive
      Compensation
                                    42Item
      11
                                    Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                                    44Item
      12
                                    Certain
      Relationships and Related Transactions, and Director
      Independence
                                    46Item
      13
                                    Principal
      Accountant Fees and Services
                                    47PART IVItem
      14.
                                    Exhibits
      and Financial Statement Schedules
                                    48Signatures
                                    
                                    49Exhibits
                                    
                                    50


2





SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS




In
this report, the terms “SmartHeat,” “Company,” “we,” “us” and “our” refer to
SmartHeat Inc. (“SmartHeat”) and its subsidiaries.




This
report contains forward-looking statements regarding SmartHeat which include,
but are not limited to, statements concerning our projected revenues, expenses,
gross profit and income, mix of revenue, demand for our products, the benefits
and potential applications for our products, the need for additional capital,
our ability to obtain and successfully perform additional new contract awards
and the related funding and profitability of such awards, the competitive nature
of our business and markets, and product qualification requirements of our
customers. These forward-looking statements are based on our current
expectations, estimates and projections about our industry, management’s
beliefs, and certain assumptions made by us. Words such as “anticipates,”
“expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,”
“hopes,” “estimates,” “should,” “may,” “will,” “with a view to” and variations
of these words or similar expressions are intended to identify forward-looking
statements. These statements are not guarantees of future performance and are
subject to risks, uncertainties and assumptions that are difficult to predict.
Therefore, our actual results could differ materially and adversely from those
expressed in any forward-looking statements as a result of various factors. Such
factors include, but are not limited to the following:




·
            our goals and
      strategies;





·
            our expansion
      plans;





·
            our future business development,
      financial conditions and results of
  operations;





·
            the expected growth of the market
      for PHE products and heat meters in
  China;





·
            our expectations regarding demand
      for our products;





·
            our expectations regarding
      keeping and strengthening our relationships with key
      customers;





·
            our ability to stay abreast of
      market trends and technological
advances;





·
            our ability to effectively
      protect our intellectual property rights and not infringe on the
      intellectual property rights of
others;





·
            our ability to attract and retain
      quality employees;





·
            our ability to pursue strategic
      acquisitions and alliances;





·
            competition in our industry in
      China;





·
            general economic and business
      conditions in the regions in which we sell our
      products;




·
            relevant government policies and
      regulations relating to our industry;
and





·
            market acceptance of our
      products.





Additionally,
this report contains statistical data that we obtained from various publicly
available government publications. Statistical data in these publications also
include projections based on a number of assumptions. The market for the PHEs,
PHE Units, and heat meters may not grow at the rate projected by market data, or
at all. The failure of this market to grow at the projected rate may have a
material adverse effect on our business and the market price of our securities.
In addition, the rapidly changing nature of our customers' industries results in
significant uncertainties in any projections or estimates relating to the growth
prospects or future condition of our market. Furthermore, if any one or more of
the assumptions underlying the market data is later found to be incorrect,
actual results may differ from the projections based on these assumptions. You
should not place undue reliance on these forward-looking
statements.


3





Unless
otherwise indicated, information in this report concerning economic conditions
and our industry is based on information from independent industry analysts and
publications, as well as our estimates. Except where otherwise noted, our
estimates are derived from publicly available information released by third
party sources, as well as data from our internal research, and are based on such
data and our knowledge of our industry, which we believe to be reasonable. None
of the independent industry publication market data cited in this report was
prepared on our or our affiliates’ behalf.





We do not
undertake any obligation to revise or update publicly any forward-looking
statements for any reason, except as required by law. Additional information on
the various risks and uncertainties potentially affecting our operating results
are discussed below and are contained in our publicly filed documents available
through the SEC’s website (www.sec.gov) or upon written request to our corporate
secretary at: A-1, 10, Street 7, Shenyang Economic and Technological Development
Zone, Shenyang, China 110027.




PART I


Item 1.   Business





General





We are a
leading designer, manufacturer and seller of clean technology plate heat
exchangers and related systems in China. Our products are used by our customers
in the industrial, residential and commercial markets in China to improve energy
utilization and efficiencies and reduce pollution by reducing the need for coal
fired boilers. We design, manufacture, sell and service plate heat exchangers
(“PHEs”), PHE Units, which combine PHEs with various pumps, temperature sensors,
valves and automated control systems (“PHE Units”), and heat meters for use in
commercial and residential buildings. Our products and systems are an
important element in providing a clean technology, mission-critical solution to
energy consumption and air pollution problems in China and are commonly used in
a wide variety of industrial processes where heat transfer is
required. Common applications include energy conversion for heating,
ventilation and air conditioning (“HVAC”) and industrial use in petroleum
refining, petrochemicals, metallurgy, food and beverage and chemical
processing. Our PHE Units are custom designed by our own in-house engineers
and sold under our own Taiyu brand name, while our PHEs are sold under both our
Taiyu brand as well as the Sondex brand name. We are an authorized dealer of
Sondex PHEs in China.




We were
incorporated in the State of Nevada on August 4, 2006 under the name
Pacific Goldrim Resources, Inc. as an exploration stage corporation to engage in
the exploration for silver, lead and zinc. On April 14, 2008 we changed our
name to SmartHeat Inc. and entered into a Share Exchange Agreement (the “Share
Exchange Agreement”) to acquire all of the equity interests in Shenyang Taiyu
Machinery & Electronic Equipment Co., Ltd. (“Taiyu”), a privately held
company formed under the laws of China engaged in the design, manufacture, sale
and servicing of plate heat exchange products in China. The Share Exchange
Agreement was entered by SmartHeat, Taiyu and the shareholders of Taiyu (the
“Taiyu Shareholders”). At the closing of the Share Exchange Agreement, all of
the equitable and legal rights, title and interests in and to Taiyu’s share
capital of Yuan 25,000,000 were exchanged for 18,500,000 shares of SmartHeat
common stock (the “Share Exchange”). As a result of the Share Exchange, Taiyu
became a wholly-owned subsidiary of SmartHeat. After the relevant PRC government
agency approved our subscription of 71.6% of the registered capital increase of
Taiyu on July 29, 2008, PRC approval of Taiyu becoming a wholly-owned
subsidiary of SmartHeat was obtained on June 3, 2009, when the transfer by
the three original owners of Taiyu of their remaining 28.4% ownership of Taiyu
to SmartHeat was officially recognized.




Prior to
our acquisition of Taiyu, we were a development stage business with minimal
operations. We had no interest in any property, but had the right to conduct
exploration activities on 13 mineral title cells covering 27,027 hectares
(66,785 acres) in the Slocan Mining Division of southeastern British Columbia,
Canada. In connection with the acquisition of Taiyu, the Company transferred all
of its pre-closing assets and liabilities (other than the obligation to pay a
$10,000 fee to the Company’s audit firm) to a wholly-owned subsidiary, PGR
Holdings, Inc., a Nevada corporation (“SplitCo”), under the terms of an
Agreement of Conveyance, Transfer and Assignment of Assets and Assumption of
Obligations dated April 14, 2008 (the “Transfer Agreement”). The Company
also sold all of the outstanding capital stock of SplitCo to Jason Schlombs (the
former director and officer, and a major shareholder, of the Company) pursuant
to a Stock Purchase Agreement dated April 14, 2008 (the “Split-Off
Agreement”) in exchange for the surrender of 2,500,000 shares of the Company’s
common stock held by Mr. Schlombs (the “Split-Off’).


4





Our
principal offices are located at A-1, 10, Street 7, Shenyang Economic and
Technological Development Zone, Shenyang, China 110027. Our telephone number is
+86 (24) 2519-7699.





Our
Products





We
design, manufacture, sell, and service the following products:




PHEs




A
      PHE is a device that transfers energy, usually in the form of heat, from
      one fluid to another across a solid surface. PHEs are constructed through
      the use of specifically manufactured stainless steel, titanium and nickel
      alloy plates that are sealed by gaskets and then bolted together in a
      large metal frame that holds the plates together. Plates come in a variety
      of sizes and wave patterns, have large heat transfer surfaces and have
      high thermal conductivity. The quantity and size of the plates used along
      with the total size of the PHE vary according to particular application
      requirements but generally do not exceed the size of a large refrigerator.
      PHEs are a replacement for the less efficient shell-and-tube heat
      exchangers. PHEs can be installed in new buildings and facilities as well
      as existing ones since they are smaller than traditional heat exchangers
      and can fit within existing installations. Additionally, because of the
      larger heat transfer surface area and despite its relatively small size,
      PHEs have a higher heat transfer coefficient than traditional
      shell-and-tube heat exchangers.
                      
                      Heat
      exchangers were first invented in the mid-1920’s to control pressure and
      temperature during industrial production. Later innovations in heat
      transfer technology, including the development of PHEs, led to higher heat
      recovery rates, lower fuel consumption and reduced related pollution. In a
      PHE, steam / hot water / fluid from an industrial process flows into the
      PHE from one location. Cool fluid from another source flows into the PHE
      from another location. As the hot and cold liquids move in opposite
      directions, the steam / hot water / fluid gets cooler as it transfers heat
      to the cool fluid, which absorbs the heat and gets warmer. In addition to
      more efficient heat transfer, PHEs offer a more compact design, ease of
      maintenance and the ability to adjust performance simply by adding or
      removing plates. This flexibility makes PHEs a preferred solution and
      translates into lower expenditures on installation and equipment
      purchases.
                    
                    PHE





We
currently focus exclusively on the Chinese market. In addition to manufacturing
our own PHEs, we import finished stainless steel plates from Sondex and assemble
customized PHEs and PHE Units based on our clients’ specifications. All
designs of our PHEs and PHE Units are done in-house by our engineers utilizing
advanced software and our proprietary in-house CAD software. In May 2009, we
acquired the production assets of Siping Beifang Heat Exchanger Manufacture Co.,
Ltd. (“Siping Beifang”), one of the major PHE manufacturers in China, and began
a program to vertically integrate our supply chain for our own PHE components
and, at the same time, supplement our Sondex relationship. As a result, we are
able to manufacture our own plates in-house and can design and manufacture PHEs
and PHE Units using either supply source. Our new plates provide solutions for a
market segment with strong demand for PHE products that are priced 10-15% lower
than PHE products with Sondex plates.




5




PHE
Units




We
      began designing, manufacturing and selling our branded PHE Units in May
      2003. PHE Units are built by integrating PHEs with various pumps,
      temperature sensors, valves and automated control systems to form a
      “unit.” While our PHE Units are used in a variety of industrial processes,
      we have developed an expertise in designing and integrating PHE Units for
      HVAC systems in residential and commercial buildings. Often our PHE Units
      are used along with other units to form a “PHE network” which is installed
      in a local district heating system. The production and sale of PHE Units
      have been central to our growth. PHE Units require a comparatively higher
      level of technical skill and knowledge of the applications in which they
      are used. As a result, PHE Units are generally sold at a higher selling
      price. Our PHE Units are designed in-house by our system engineers
      employing online customized CAD design software based on Solid Works
      software. Less than five years after entering the market, we believe we
      have emerged as a leading domestic producer of PHE Units, with a market
      share of approximately 8% in China in 2007 according to the China District
      Heating Association.
                    
                    PHE Unit




Heat
Meters





While
      heating companies in many Western countries have long used meters to
      measure customer heat usage and invoice customers, Chinese residents and
      commercial customers are largely billed based on the square footage of
      utilized space. Heat meters provide heat consumption information to users
      and measure the volume of heat used in commercial and residential
      facilities. As an important revenue gauge for utilities, the calibration
      of meters in many countries is regulated by government agencies and
      subject to local or national guidelines. In response to rising energy
      costs and the increased sensitivity to environmental issues, the Chinese
      government and local utility companies have made the use of heat meters
      compulsory in China. As of July 2003, heat meters were required nationally
      by law for new construction installed with central heating, and the law
      was extended in April 2008 by the Energy Conservation Law, Article 38, to
      existing buildings being retrofitted.
                      
                      Using
      our established relationships with provincial governments and utility
      companies throughout China, we introduced our patented heat meters to the
      market during the second quarter of 2006. Sales to date have been
      small relative to our other product lines but have been growing rapidly.
      Our sales of heat meters increased to $7.98 million or 1024% during 2009
      from $710,000 in 2008. However, we plan to work with various government
      entities to establish a national heating standard and become an active
      leader in China’s heat meter market in the coming
      years.
                    
                    Heat Meter




Market
Overview





Heat
transfer technology was introduced to China in the 1960’s from Russia, mainly
for applications in the petroleum industry. Foreign manufacturers began to
sell in China on a large commercial scale in the 1980’s and have since held
strong positions in the Chinese market. Domestic producers entered the
market in the late 1980’s and early 1990’s and began to establish meaningful
positions in the market due to reduced costs, faster delivery times and improved
service. The past decade has seen the rise of many domestic manufacturers,
along with joint ventures between local and international firms, to create a
market consisting of domestic firms, foreign joint ventures and direct imports.
Large international PHE producers include: Alfa Laval, Sondex, GEA, Tranter,
SWEP, Danfoss and Hisaka Works.





Today,
heat exchangers are used in a wide range of industrial processes. Common end
markets include energy (i.e., conventional and nuclear power plants), HVAC,
petroleum refining, petrochemicals, metallurgy, food and beverage and chemical
processing. Heat transfer equipment is also being employed in new energy
applications such as wind, solar, biomass and waste disposal. In 2009,
SmartHeat’s largest industry segments were petrochemicals, power plants, HVAC,
chemical and metallurgy.


6


Due to
the continuation of industrialization and urbanization in China, the China Heat
Association believes the domestic market for PHEs was approximately $2.4 billion
in 2007 and estimated the market will grow at an annual rate of about 30%
through 2010. The China Heat Association also believes that the domestic market
for PHE Units was approximately $139 million in 2007 and estimated the market
will grow at an annual rate of 70% through 2010.




Our Industry




Currently,
social, economic, environmental, regulatory and government stimulus-related
factors drive demand for environmentally-friendly solutions which reduce
pollution and advance energy efficiency, many of which utilize PHEs. These
include:




Environmental Conditions in China.According to the report entitled “International Energy Annual 2006—World
Energy Overview 1996-2006” published by the Energy Information Administration, a
subdivision of the United States Department of Energy, in 2006, the consumption
of coal was the world’s largest source of carbon dioxide emissions from the
consumption and flaring of fossil fuels, accounting for 41% of the world total.
China was the largest producer of carbon dioxide from the consumption of coal in
2006, accounting for 41% of the world total. According to a joint report by the
World Bank and Environmental Protection Administration, the economic burden of
premature mortality and morbidity associated with air pollution was $23 billion
in 2003, or 1.16% of GDP. PHEs and PHE Units help to alleviate this problem
through energy efficient technology that reduces coal consumption and CO2 emissions
traditionally associated with heat production.




Growing Demand for Heating Water.China currently provides households throughout 17 of its 34 northern
provinces with heating water. As new cities grow along with the emerging middle
class, so does the demand to expand this supply into new cities, industrial
parks and other provinces. Heating water in China is generated by local power
plants which pump emitted hot water from the power plant through a closed loop
system to a water heating company and then through a network of pipes up to a
distance of 50 kilometers. These systems of heating stations and sub-stations
utilize numerous PHEs and PHE Units, which provide a dual purpose: a cooling
system for the power plants and a heat source for residents and
factories.




Heightened Environmental
Awareness. In March 2006, China announced its 11th
Five-Year Plan that set new pollution reduction standards, targeting a 20%
reduction in energy consumption per unit of GDP and a 10% reduction in industry
expulsion of pollutant particles by 2010. The implementation of PHEs and PHE
Units in new construction facilities, and as replacements for legacy
shell-and-tube heat exchangers, can help meet these goals because of their
increased energy efficiency.




Urbanization. According to
the CIA World Factbook, 43% of China’s population lived in urban settings in
2008. Additionally, according to the National Bureau of Statistics of China, 15
cities near and around SmartHeat’s sales and service centers have a population
of more than five million and eight Chinese cities are among the world’s fastest
growing, increasing at an annual rate of 2.5% or more. China’s urbanization and
city population growth have lead to new infrastructure development and existing
infrastructure improvements that require ongoing investment in heating
solutions.




Government Stimulus. On
November 5th, 2008,
China’s State Council approved a $586 billion plan to invest in infrastructure
and social welfare. On March 6th, 2009,
China’s National Development and Reform Commission announced a revision of the
stimulus. The new revision includes $31 billion, a portion of which will be
allocated to energy-saving projects, and $59 billion to affordable housing.
These funds must be spent by the end of 2010.




Emerging Wealth.The rapidly
expanding middle class is demanding access to quality heating during the winter
months, and the source of such heating is often from hot water supplied from a
power station and district heating network utilizing a system of PHEs and PHE
Units.




Our
Competitive Strengths





We
believe we have the following competitive strengths:


7





Provider of Key Elements Used to
Improve Energy Efficiencies and Reduce Coal Pollution.We offer a full
line of PHEs, PHE Units and heat meters. The primary advantages of PHE
technology, compared to traditional shell and tube heat exchanger technology,
are efficiency, compact design and ease of customization. PHEs have larger heat
transfer surface areas and therefore greater thermal conductivity. As a result,
PHEs can transfer the same amount of heat as a traditional shell and tube heat
exchanger with a smaller size unit.





Established Leader and Brand Name in
the Growing China Heating Industry. We have a leading brand name in the
Chinese heating industry and seek to utilize this awareness to become the
leading Chinese supplier of PHEs, PHE Units and related products to the rapidly
growing Chinese market. We are a leading domestic producer of PHE Units under
the Taiyu brand, with a 2007 market share of approximately 8% in China according
to the China District Heating Association. We believe the Taiyu brand name is
recognized for quality and efficiency, which we can leverage to improve our
reputation as a leading seller of high quality PHE Units in China.





Quality Engineering, Research and
Development.We emphasize efficiency, durability and quality engineering
in all of our products. All of our products utilize the latest technologies, and
our designs are created using advanced software systems.  To maintain
our competitive edge in the marketplace and keep pace with new technologies, we
fund research and development on an on-going basis to find improved efficiencies
in design, cost and energy capture. Research and development costs for 2008 and
2009 were $1,020,000 and $1,360,000, respectively. We plan to continue to invest
in research and development to identify new industry applications for PHEs,
improve our product lines, develop multifunctional PHE Units and modify PHE
designs to meet the current market demand.





Strong Technical Support. The
selection of PHEs and PHE Units requires technical knowledge regarding the
operating temperature, pressure, corrosivity, viscosity and purity of the fluid
as well as the pressure loss within the system. Our unique design software
enables us to provide high quality and timely technical support to ensure our
customers receive the right equipment for each project. We also provide a
streamlined and error-free installation process to minimize project
complications.





Enterprise-Wide Design, Production
and Control Systems for Efficient Pricing and Streamlined Manufacturing.
Our technologically advanced CAD design systems are integrated with our
real-time enterprise resource planning (“ERP”) and finance systems. This
advanced, integrated platform allows our field salespeople to input orders,
obtain draft models, access quotes and confirm delivery dates within minutes.
The platform also enables inventory and production personnel to accurately
schedule and reduce lead production times to five days for PHEs and ten days for
PHE Units. We believe these lead times are some of the best in the industry and
create a differentiated level of customer service.





Focus on Quality.We have a
National Safety Certification for our PHE products, and are an ISO 9001
certified manufacturer.





First Rate Customer Service and
Reliable Product Delivery.We believe our employees provide first rate
customer service, technical expertise and product knowledge to streamline the
selection, design and installation processes. We provide after sale service
through our local service centers and deliver products on time to meet tight
project deadlines. Our focus on delivering premium service separates us from our
competitors and has been critical in helping us win a number of projects for
various multinational companies and local governments.





Diversified End Markets and
Customers. Our PHEs and PHE Units are broadly used across a variety of
industrial end markets including the energy (i.e., conventional and nuclear
power plants), HVAC, petroleum refining, petrochemicals, metallurgy, food and
beverage and chemical processing end markets. We also benefit from a diverse
customer mix. For the fiscal year ended December 31, 2009, our ten largest
customers accounted for 47% of sales and our largest customer accounted for 7%
of sales. This end market and customer diversification helps to insulate us from
sales volatility that would occur if we concentrated in specific industries. The
bulk of our customers are utilities, engineering and construction companies and
industrial companies.





Proven Ability to Identify and
Acquire Strategic Targets.We have completed two strategic acquisitions
that have accelerated our strategic plan by: (i) adding manufacturing capacity;
(ii) broadening our product offering to include multiple heat exchange systems;
(iii) facilitating access into new geographic regions throughout China; (iv)
improving our cost structure; (v) enhancing our engineering capabilities; or
(vi) helping us enter new and higher growth end markets.We have proven our
ability to complete successful acquisitions and believe there are additional
acquisition opportunities which we may potentially pursue.


8


Experienced Management Team.Our senior management team has extensive business and industry
experience. Mr. Jun Wang, our president and CEO, was the founder of Taiyu
in 2002. He was a sales manager for Honeywell International Inc. from 1996 to
1999 and was a sales manager for Alfa Laval from 1994 to 1996. Mr. Wang
obtained his Master’s degree in Engineering from Tsinghua University in 1989.
Ms. Zhijuan Guo, our CFO, has 14 years of finance and accounting experience
and has been with the Company since its inception in 2002.  Mr. Xudong
Wang, our VP of strategy and development has served as the VP of an
international financial firm. Mr. Wen Sha, our VP of marketing, has
extensive sales experience and industry contacts. He joined SmartHeat as a
Regional Sales Manager in 2005. Prior to that, he served as the General Manager
of Nanjing Hui Dun Ltd. and as sales director of APV Accessen in Shanghai, a
leading international PHE firm. Mr. Feng Chen, Ph.D., our CTO, joined
SmartHeat in 2008 as part of our SanDeKe acquisition. Prior to founding SanDeKe,
he served in a leading engineering position in China with Alfa
Laval.




Our Growth
Strategy




Our goal
is to further penetrate the many market segments throughout China for PHEs, PHE
Units and related accessories, expand our PHE Unit sales, promote the sale of
heat meters and execute strategic acquisitions that are accretive and
synergistic to our business.




Pursue High Growth Chinese End
Markets. We are targeting our sales efforts on a number of high growth
Chinese end markets such as power and petrochemical. We currently have a
presence in these segments but believe there are significant opportunities to
improve our market share by leveraging our premium product quality and high
quality service. Our solutions are commonly used in many of these industries and
customers continue to assess the cost savings and positive environmental
attributes of PHEs.




Capitalize upon Strong Industry
Dynamics in China. Continued economic growth in China, coupled with
evolving government policy and increasing environmental consciousness, present
us with significant future growth opportunities. The 11th
Five-Year Plan targeted a 20% reduction in energy consumption per unit of GDP
and a 10% reduction in industry expulsion of pollutant particles by 2010. We
believe this mandate will force whole industries to allocate major portions of
their infrastructure and energy investments into energy efficient, “green”
technologies such as PHEs and PHE Units. Management believes this growth will
accelerate as significant investments in district heating systems and
co-generation power plants come on-line in the next few years.




Continue Organic Growth Initiatives.We believe the current PHE market is fragmented and represents an
excellent opportunity for us to gain additional market share from our
competitors. We intend to open new sales offices, hire additional sales
personnel, expand into new distribution channels and improve the quality of our
products. We also intend to leverage our strong brand, quality customer service,
engineering and reliable product delivery to gain incremental business with our
existing clients. Finally, we believe that as we continue to grow, economies of
scale and improved cost control measures will drive stronger profitability
across all product lines.




Continue to Expand PHE Unit
Sales. The production and sale of PHE Units has been vital to our growth.
PHE Units require a high level of technical skill and knowledge of the
applications in which they are used, allowing for premium pricing and creating a
barrier to entry for competitors attempting to enter the market. Less than five
years after entering the market, we have emerged as a leading domestic producer
of PHE Units, with a 2007 market share of approximately 8% according to the
China District Heating Association. We are focused on continuing to pursue sales
of higher value-added PHE Units and, as a recognized brand, believe we are
well-positioned to capture incremental market share in a category that is
projected to grow 70% per year through 2010 by the China District Heating
Association.




Promote Heat Meters.In
response to rising energy costs and an increased focus on energy efficiency, the
Chinese government and local utility companies have made the use of heat meters
compulsory in China. As of July 2003, heat meters were required nationally by
law for new buildings installed with central heating and the law was extended in
April of 2008 by the Energy Conservation Law, Article 38, to buildings being
retrofitted. We plan to work with the various government entities to establish a
national heating standard and intend to leverage the Taiyu brand and our
superior quality to gain market share in this market.


9




Execute Strategic Acquisitions.We intend to continue to selectively acquire domestic targets that would
enable us to enter new customer segments or gain entry into new industries. For
instance, the recent acquisition of the plant and machinery and land use rights
from Siping Beifang provided us with an entrance into the petrochemical and high
pressure chemical end markets, which were previously immaterial segments for us.
Due to the high pressure and heat tolerance demands of the petrochemical
industry, we have also acquired valuable engineering expertise that may help us
address the nuclear energy segment in a meaningful way. We will continue to
identify and review targets that are accretive to our earnings, easily
integrated into our existing infrastructure and synergistic to our
operations





Production




Until
recently, we conducted all of our manufacturing activities at our Shenyang
plant. On September 25, 2008 we acquired SanDeKe Co., Ltd.
(“SanDeKe”), a PHE manufacturing company located in the Pudong district,
Shanghai. SanDeKe leases a manufacturing facility and business offices.
Additionally, on May 27, 2009, we acquired the plant, machinery and land
use rights of Siping Beifang, a major PHE manufacturer in China. Today, we
currently operate the following three manufacturing facilities:




Location
                
                PHEs/Day
                
                
                PHE Units/Day
                
                
                Heat Meters/DayShenyang
      (Taiyu)
                
                
                10
                
                
                
                7
                
                
                
                200Pudong
      (SanDeKe)
                
                
                4
                
                
                NA
                
                
                NASiping
      Beifang
                
                
                8
                
                
                
                1
                
                
                NATotal
                
                
                22
                
                
                
                8
                
                
                
                200




Location
                
                Square Feet
                
                Owned/LeasedShenyang
      (Taiyu)
                
                
                210,137
                
                OwnedPudong
      (SanDeKe)
                
                
                13,450
                
                LeasedSiping
      Beifang
                
                
                269,000
                
                OwnedTotal
                
                
                492,587





We
generally operate on an eight-hour shift, with the exception of the high season
from May to November, during which we may operate the plant for 11-12 hours per
day. Production is driven by orders from clients and is scheduled on a
just-in-time delivery basis. Our Shenyang facility currently has the
capacity to produce ten PHEs, seven PHE Units, and two hundred heat meters per
day, the SanDeKe facility has the capacity to produce four PHEs per day and our
Siping Beifang facility has the capacity to produce eight PHEs and one PHE Unit
per day.





Marketing




Since
initiating operations in May 2003, we developed the Taiyu brand, which is
recognized and associated with quality production and first-rate service. We
established positive relationships with local governments in Beijing, Shenyang,
Urumqi, Shandong, Jiangsu and Shanghai and we regularly appear in industry trade
shows, attending bi-annual HVAC trade fairs in Shanghai and Chinese
environmental protection forums. We also maintain positive relationships with
local utilities, oil refiners, steel producers and food and beverage companies.
Marketing costs are generally funded through working capital and expensed as
incurred.


10




Suppliers




Plates




Plates for
our PHEs and PHE Units are manufactured in our facilities and are also purchased
from Sondex under the terms of our Sondex authorized dealer
arrangement. While we are an authorized dealer, annual or quarterly
purchasing prices are not fixed and fluctuate according to Sondex’s most recent
pricing list. We generally order stainless steel plates two to three months
in advance based on production needs and projected sales. Plate purchases
from Sondex accounted for approximately 30% of our total annual raw material
purchases in the fiscal year ended 2008. In the fiscal year ended
December 31, 2009, plate purchases from Sondex accounted for approximately
12% of our total raw material purchases. As we further integrate Siping Beifang
into our operations, we believe our purchases of plates from Sondex will
decrease.




Components




Components
generally include pumps, valves, pipes and electronic meters purchased from a
number of premium international and domestic suppliers who have been certified
to meet our quality specifications. Representative component suppliers include
Siemens, Wilo A.G., Honeywell as well as others. Components are ordered on an as
needed basis.




Plates
and components together generally constituted approximately 98% of raw material
purchases in 2008 and 91% in 2009.





Customers




We sell
both directly through our sales force and through a network of 26 national
distributors located throughout China. All of our work is performed based
on written contracts with customers and there are no oral contracts. Our
customer base is diversified across a number of end markets and our ten largest
customers accounted for approximately 32% of our sales in fiscal 2008 and 47% of
our sales in fiscal 2009. Our largest customer accounted for approximately 6% of
fiscal 2008 sales and 7% of our sales in fiscal 2009.




Intellectual
Property




We use
the Taiyu brand name on most of our PHEs and all of our PHE Units and heat
meters. We registered and received approval from the China Trademark Bureau
for this trade name. We believe the Taiyu brand name is recognized in
China’s heating industry for quality and efficiency.We have eight
registered patents in China for PHE products and heat meters. We have two
patents for our plate heat exchangers, one for our heat transfer system for
space heating and domestic hot water, one for a heat meter cleaning pipe, two
for our heat meter testing system, one for an integrated heat transfer system
and one for an efficient-heat testing bench. Five of our patents expire in 2014,
one expires in 2016 and two expire in 2017.




Research
and Development





To
maintain our competitive edge in the marketplace and keep pace with new
technologies, we believe it is important to devote resources to ongoing research
and development to find improved efficiencies in design, cost and energy
capture. Research and development costs for 2008 and 2009 were $1,020,000 and
$1,360,000 respectively. We plan to continue to invest in research and
development to identify new industrial applications for PHEs, improve our heat
meters, design heat meters for industrial usage, develop multifunctional PHE
Units and modify PHE designs to meet current market demand. We also work with
several professors who are heat transfer experts on an individual consulting
basis.




Governmental and Environmental
Regulation





While our
PHEs and PHE Units are not subject to material regulation by the Chinese
government or other national agencies, we obtained National Safety Certification
for our PHE products and are an ISO 9001 certified manufacturer. The National
Safety Certification is not required for either the production or sale of PHE
products. However, obtaining this certification confirms our commitment to
safety and quality. For companies in industries utilizing high temperatures
or pressure in their production processes, the certification is of critical
importance in choosing a PHE provider.


11




Our heat
meters require a license for production and sale. We obtained this license
on August 12, 2005. The license is valid through March 11, 2012,
when we will need to submit a request to the Chinese government for renewal. The
Safety Bureau conducts site visits and inspections of documents on a periodic
basis to verify adherence to the standards. Additionally, due to rising energy
costs and the increased sensitivity to environmental issues, Chinese government
and local utility companies have made the use of heat meters compulsory in
China. As of July 2003, heat meters were required nationally by law for new
construction installed with central heating and. In April 2008, the law was
extended by the Energy Conservation Law, Article 38, to retrofitted
buildings.





Our
business and company registrations are in compliance with the laws and
regulations of the municipal governments of Shenyang and China. We are subject
to China’s National Environmental Protection Law as well as local laws regarding
pollutant discharge, air, water and noise pollution, with which we comply. The
cost of compliance with these regulations is not material.





Competition





The
Company competes exclusively in the domestic Chinese market. We believe our
competitive advantages lie in superior engineering and design skills, the
longevity and efficiency of the components we use, our ability to vertically
integrate our manufacturing process, our just-in-time delivery and the reliable
after sale service we provide through our local service centers. We also believe
our position as a China-based producer of PHEs and PHE Units in a marketplace
previously dominated by foreign manufacturers creates an advantage when seeking
new customers.




PHEs




According
to the China District Heating Association, Alfa Laval had the largest PHE market
share in 2007—30%—in mainland China. An assortment of other foreign
producers held an aggregate market share of 20% and the rest consisted of
multiple domestic producers. We believe the quality of our PHEs is equal to
Alfa Laval’s, as are our prices. In comparison with the other domestic
producers, our prices are approximately 15% higher, reflecting a premium we
believe is due to the quality of our products.




PHE
Units




According
to data from the China District Heating Association, we were the leading
producer and seller of PHE Units in China in 2007, representing 8% of the
market, followed by Danfoss and Accessen (a Sino-U.S. joint venture established
by Denmark’s Accessen and utilizing Alfa Laval plates as well as their own
plates in their PHE Units).We believe that Danfoss
competes directly with us for the local heat and power companies’ contracts in
larger cities, while Accessen targets the petrochemical, metallurgy and HVAC
sectors.




As the
majority of projects are awarded on a bid basis, prices among leading
competitors are difficult to assess. For certain projects, we do not bid,
rather we negotiate directly with customers. We have done prior projects
with some of the customers we negotiate with, including one of our largest
customers in 2008, Dalkia, a joint venture between Dalkia and the local
government in the Heilongjiang province. Dalkia is the leading provider of
energy services in Europe, active in multiple energy projects in China and is a
subsidiary of Veolia EDF.




Heat
Meters




The
market for heat meters is extremely fragmented with multiple overseas and
domestic producers and no established leader. Currently, the industry lacks
national product standards, which will be needed because of the legislation
requiring heat meters for all residential and commercial spaces. We seek to
become an integral player in the establishment of national heat meter standards
and a leading supplier of heat meters in China.


12


Seasonality





We
typically experience significantly stronger sales in the third and fourth
calendar quarters with up to 70% of our revenue generated during the winter
season in China. Our quarterly revenues may fluctuate significantly due to the
seasonal nature of central heating services in China, where the equipment used
in residential buildings must be delivered and installed prior to the beginning
of the heating season in late fall. We believe that as we expand our presence
into other industries and sectors, this seasonality will be partially
mitigated.





Employees




As of
December 31, 2009 we had approximately 570 full-time employees and
approximately 130 seasonal employees.





We
maintain strong ties with our employees and staff and retention is
stable. Our employee contracts adhere to both State and Provincial
employment regulations and all social security regulations. All
compensation, including social insurance, is paid in a timely manner to
authorities and employees. There have been no disputes to date and there
are no collective bargaining agreements.





Our sales
personnel are eligible to receive annual bonuses based on pre-established sales
targets. Production employees are also eligible for annual bonuses based on
product quality ratios, customer complaint ratios, new product invention and
product inventory.





Legal
Proceedings





SmartHeat
may occasionally become involved in various lawsuits and legal proceedings,
arising in the ordinary course of business. However, litigation is subject to
inherent uncertainties and an adverse result in these or other matters may arise
from time to time that may have an adverse affect on our business, financial
conditions, or operating results. SmartHeat is currently not aware of any such
legal proceedings or claims that will have, individually or in the aggregate, a
material adverse affect on our business, financial condition or operating
results.





Item 1A.Risk
Factors





Our
business and an investment in our securities are subject to a variety of
risks.  The following risk factors describe the most significant
events, facts or circumstances that could have a material adverse effect upon
our business, financial condition, results of operations, ability to implement
our business plan, and the market price for our securities.  Many of
these events are outside of our control. The risks described below are not the
only ones facing our company.  Additional risks not presently known to
us or that we currently believe are immaterial may also impair our business
operations.  If any of these risks actually occurs, our business,
financial condition or results of operation may be materially adversely
affected.  In such case, the trading price of our common stock could
decline and investors in our common stock could lose all or part of their
investment.





Risks Related to Our
Business




Our relationship with Sondex has
substantially contributed to our business and its growth.





We are an
authorized dealer of Sondex PHE plates in China.Sondex is one of the
world’s leading PHE and PHE plate manufacturers. We currently sell PHEs under
our own Taiyu brand or upon demand under the Sondex brand, and our PHE Units are
sold under our own Taiyu brand only. We believe our ability to provide
Sondex-branded PHEs has contributed to our reputation for high quality products.
Prior to our acquisition of Siping Beifang on May 27, 2009,  we
sourced all of our PHE plates, important raw elements used in both PHEs and PHE
Units, from Sondex. However, our recent acquisition of the plant, machinery and
land use rights of Siping Beifang, along with our internal R&D efforts, now
enable us to produce our own plates for our heat exchangers, which we believe
will significantly reduce our reliance on Sondex-supplied plates. We cannot
assure you our products will be as well received in the marketplace or that we
will be able to produce sufficient quantities to meet demand. If our
relationship with Sondex were to terminate, we would be required to either
manufacture plates ourselves and/or procure plates from other third-party
sources, of which we believe there are several alternate suppliers that meet our
volume and quality standards. Currently, we cannot guarantee our ability to
manufacture sufficient plates or that we will be able to secure supply of plates
from third-party sources on acceptable terms and in a timely fashion.
Accordingly, termination of our Sondex relationship may present risks to our
business, revenues and operations until we secure alternate and comparable
sources of supply.


13


The
markets we serve are subject to seasonality and cyclical demand, which could
harm our business and make it difficult to project long-term
performance.





Demand
for our products depends in large part upon the level of capital and maintenance
expenditures of our customers and the end users. These expenditures have
historically been cyclical in nature and vulnerable to economic downturns.
Decreased capital and maintenance spending by our customers could have a
material adverse effect on the demand for our products and our business,
financial condition and results of operations. In particular, an economic
slowdown in the domestic economy may result in reduced orders for PHEs from the
steel processing and petrochemical sectors and lower orders for PHE Units from
the HVAC sector. To date, the Company has not been adversely affected by
these trends and, given the current demand visibility, we do not currently
foresee weakening in the demand for our products in the next year. However,
the historically cyclical nature of the demand for our products limits our
ability to make accurate long-term predictions about our performance. Changing
world economic and political conditions may also reduce the willingness of our
customers and prospective customers to purchase our products and services. The
seasonality of our business results in significant operational challenges to our
production and inventory control functions.




We
derive a substantial part of our revenues from several major customers. If we
lose any of these customers or they reduce the amount of business they do with
us, our revenues may be seriously affected.





Our ten
largest customers accounted for 47% of our revenues for the fiscal year ended
December 31, 2009. Our largest customer accounted for 7% of our
revenues in the fiscal year ended December 31, 2009. These customers may
not maintain the same volume of business with us in the future. If we lose any
of these customers or they reduce the amount of business they do with us, our
revenues and profitability may be seriously affected.





Our
accounts receivables remain outstanding for a significant period of time, which
has a negative impact on our cash flow and liquidity.





Our
agreements with our customers generally provide that 30% of the purchase price
is due upon the placement of an order, 30% upon delivery and 30% upon
installation and acceptance of the equipment after customer testing. As a common
practice in the heating manufacturing business in China, payment of the final
10% of the purchase price is due no later than the termination date of the
standard warranty period, which ranges from 3 to 24 months from the acceptance
date. We may experience payment delays from time to time, which range from 1
month to 3 months from the due date. While these payment delays are very common
in the heating manufacturing industry in China and historically our collections
have been reasonably assured, such delays cause capital to be tied up in
inventories, which may result in pressure on our cash flows and liquidity. In
2008, we had accounts receivable turnover of 3.6, with days sales outstanding of
136 and inventory turnover of 3.1 on an annualized basis. In 2009, we had
accounts receivable turnover of 3.6 with days sales outstanding of 146 and
inventory turnover of 6.2 on an annualized basis.





We
acquire most of the components for the manufacture of our products from a
limited number of suppliers.





We
acquire most of the components for the manufacture of our products from a
limited number of suppliers. For us to have our products manufactured, these
components must be available when needed, at the right level of quality, and at
the right price. If we are unable to so obtain these components, we would
experience delays in manufacturing our products and our financial results could
be adversely affected. Suppliers of some of these components require us to place
orders with significant lead-time to assure supply in accordance with our
requirements. Certain of these suppliers are currently the sole source of one or
more components upon which we are dependent and alternative sources would not be
available for those components unless we were to redesign our products. Other
components could be obtained from alternate suppliers without redesign, but only
at higher prices than we currently pay or for delivery later than required by
our production schedule. We maintain a relatively small inventory of component
parts for resale and our parts services business would suffer if the supply of
replacement parts was reduced or terminated by our suppliers. If suppliers are
not able to provide these critical components on the dates and at the prices
scheduled, we may not be able to promptly and cost-effectively manufacture our
products to meet customer orders, which could harm our credibility and the
market acceptance and sales of our products. Increased costs associated with
supplied materials or components could increase our costs and reduce our
profitability if we are unable to pass these cost increases on to our
customers.


14




We
are a major purchaser of certain goods and raw materials that we use in the
manufacturing process of our products, and price changes for the commodities we
depend on may adversely affect our profitability.




Our
profitability generally depends upon the margin between the cost to us of
certain goods used in the manufacturing process, such as plates, pumps, water
tanks, sensors, controlling systems and other raw materials as well as our
fabrication costs associated with converting such goods and raw materials
compared to the selling price of our products, and the overall supply of raw
materials. It is our intention to base the selling prices of our products upon
the associated raw materials costs to us. However, we may not be able to pass
all increases in raw material costs and ancillary acquisition costs associated
with taking possession of the raw materials through to our customers. Although
we are currently able to obtain adequate supplies of raw materials, it is
impossible to predict future availability or cost. With the rapid growth of
China’s economy, the demand for certain raw materials is great while the supply
may be more limited. This may affect our ability to secure the necessary raw
materials in a cost-effective manner for production of our products at the
volume of purchase orders that we anticipate receiving. The inability to offset
price increases of raw materials by sufficient product price increases, and our
inability to obtain raw materials, would have a material adverse effect on our
consolidated financial condition, results of operations and cash
flows.




We
may experience material disruptions to our manufacturing
operations.




While we
seek to operate our facilities in compliance with applicable rules and
regulations and take measures to minimize the risks of disruption at our
facilities, a material disruption at one of our manufacturing facilities could
prevent us from meeting customer demand, reduce our sales and/or negatively
impact our financial results. Any of our manufacturing facilities, or any of our
machines within an otherwise operational facility, could cease operations
unexpectedly due to a number of events, including:




•
            prolonged
      power failures;




•
            equipment
      failures;




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




•
            fires,
      floods, earthquakes or other catastrophes;
and




•
            other
      operational problems.




We
cannot be certain that our product innovations and marketing successes will
continue.




We
believe our past performance has been based on, and our future success will
depend, in part, upon our ability to continue to improve our existing products
through product innovation and to develop, market and produce new products. We
cannot assure you we will be successful in introducing, marketing and producing
any new products or product innovations, or that we will develop and introduce
in a timely manner innovations to our existing products which satisfy customer
needs or achieve market acceptance. Our failure to develop new products and
introduce them successfully and in a timely manner could harm our ability to
grow our business and could have a material adverse effect on our business,
results of operations and financial condition.





Our
technology may not satisfy the changing needs of our customers.




With any
technology, including the technology of our current and proposed products, there
are risks that the technology may not successfully address all of our customers'
needs. While we have already established successful relationships with our
customers, their needs may change or vary. This may affect the ability of our
present or proposed products to address all of our customers' ultimate
technology needs in an economically feasible manner.


15


We
may not be able to keep pace with rapid technological changes and competition in
our industry.





While we
believe we have hired or engaged personnel and outside consultants who have the
experience and ability necessary to keep pace with advances in technology, and
while we continue to seek out and develop "next generation" technology through
our research and development efforts, there is no guarantee we will be able to
keep pace with technological developments and market demands in this evolving
industry and market. In addition, our industry is highly competitive. Although
we believe we have developed strategic relationships to best penetrate the China
market, we face competition from other manufacturers of products similar to our
products. Some of our competitors' advantages over us in the areas of products,
marketing and services include the following:




·
            Substantially greater revenues
      and financial resources;





·
            Stronger brand names and consumer
      recognition;





·
            The capacity to leverage
      marketing expenditures across a broader portfolio of
      products;





·
            Pre-existing relationships with
      potential customers;





·
            More resources to make
      acquisitions;





·
            Lower labor and development
      costs; and





·
            Broader geographic
      presence.





We will
face different market dynamics and competition if we expand our market to other
countries. In some international markets, our future competitors would have
greater brand recognition and broader distribution than we have. We may not be
as successful as our competitors in generating revenues in international markets
due to our inability to provide products that are attractive to the markets in
other countries, the lack of recognition of our brand, and other factors. As a
result, any international expansion efforts could be more costly and less
profitable than our efforts in the domestic market in China.




Our
products may contain defects, which could adversely affect our reputation and
cause us to incur significant costs.




Despite
testing, defects may be found in existing or new products. Any such defects
could cause us to incur significant return and exchange costs, re-engineering
costs, divert the attention of our engineering personnel from product
development efforts, and cause significant customer relations and business
reputation problems. Any such defects could force us to undertake a product
recall program, which could cause us to incur significant expenses and could
harm our reputation and that of our products. If we deliver products with
defects, our credibility and the market acceptance and sales of our products
could be harmed.




Due
to the nature of our business and products, we may be liable for damages based
on product liability and warranty claims.




Due to
the high pressures and temperatures at which many of our products are used, and
the fact that some of our products are relied upon by our customers or end users
in their facilities or operations, or are manufactured for relatively broad
consumer use, we face an inherent risk of exposure to claims in the event that
the failure, use or misuse of our products results, or is alleged to result, in
bodily injury, property damage or economic loss. We believe we meet or exceed
existing professional specification standards recognized or required in the
industries in which we operate. We have been subject to claims in the past, none
of which have had a material adverse effect on our financial condition or
results of operations, and we may be subject to claims in the future. Although
we currently maintain product liability coverage, which we believe is adequate
for the continued operation of our business, such insurance may become difficult
to obtain or may become unobtainable in the future on terms acceptable to us and
may not cover warranty claims. A successful product liability claim or series of
claims against us, including one or more consumer claims purporting to
constitute class actions, in excess of our insurance coverage or a significant
warranty claim or series of claims against us could materially decrease our
liquidity and impair our financial condition.





We
may experience delays in launching our products, which would negatively impact
our position in the marketplace.




We may
experience delays in bringing new products to market, due to design,
manufacturing or distribution problems. Such delays could adversely affect our
ability to compete effectively and may adversely affect our relationship with
our customers. Any such delays would adversely affect our revenues and our
ability to become profitable.


16


If
we are not able to manage our growth, we may not remain profitable.




Our
success will depend on our ability to expand and manage our operations and
facilities. There can be no assurance we will be able to manage our growth, meet
the staffing requirements for our business or for additional collaborative
relationships or successfully assimilate and train new employees. In addition,
to manage our growth effectively, we may be required to expand our management
base and enhance our operating and financial systems. If we continue to grow,
there can be no assurance that the management skills and systems currently in
place will be adequate or that we will be able to manage any additional growth
effectively. Failure to achieve any of these goals could have a material adverse
effect on our business, financial condition or results of
operations.





Our
business could be subject to environmental liabilities.





As is the
case with manufacturers of similar products, we use certain hazardous substances
in our operations. Currently, we do not anticipate any material adverse effect
on our business, revenues or results of operations, as a result of compliance
with Chinese environmental laws and regulations. However, the risk of
environmental liability and charges associated with maintaining compliance with
environmental laws is inherent in the nature of our business, and there is no
assurance that material environmental liabilities and compliance charges will
not arise in the future.




If
we lose our key personnel or are unable to attract and retain additional
qualified personnel, the quality of our services may decline and our business
may be adversely impacted.




We rely
heavily on the expertise, experience and continued services of our senior
management, including our president and chief executive officer. Loss of their
services could adversely impact our ability to achieve our business objectives.
We believe our future success will depend upon our ability to retain these key
employees and our ability to attract and retain other skilled personnel. The
rapid growth of the economy in China has caused intense competition for
qualified personnel. We cannot guarantee that any employee will remain employed
by us for any definite period of time or that we will be able to attract, train
or retain qualified personnel in the future and the loss of personnel could have
a material adverse effect on our business and company. Qualified employees
periodically are in great demand and may be unavailable in the time frame
required to satisfy our customers' requirements. We need to employ additional
personnel to expand our business. There is no assurance that we will be able to
attract and retain sufficient numbers of highly skilled employees in the future.
The loss of personnel or our inability to hire or retain sufficient personnel at
competitive rates could impair the growth of our business.




If
we fail to establish and maintain an effective system of internal control, we
may not be able to report our financial results accurately or to prevent fraud.
Any inability to report and file our financial results accurately and timely
could harm our business and adversely impact the trading price of our common
stock.





We are
required to establish and maintain internal controls over financial reporting,
disclosure controls, and to comply with other requirements of the Sarbanes-Oxley
Act and the rules promulgated by the SEC thereunder. Our management, including
our Chief Executive Officer and Chief Financial Officer, cannot guarantee our
internal controls and disclosure controls will prevent all possible errors or
all fraud. A control system, no matter how well conceived and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control system are met. In addition, the design of a control system must reflect
the fact that there are resource constraints and the benefit of controls must be
relative to their costs. Because of the inherent limitations in all control
systems, no system of controls can provide absolute assurance that all control
issues and instances of fraud, if any, within the Corporation have been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Further, controls can be circumvented by individual acts of
some persons, by collusion of two or more persons, or by management override of
the controls. The design of any system of controls also is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions. Over time, a control may become inadequate because
of changes in conditions or the degree of compliance with policies or procedures
may deteriorate. Because of inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and may not be
detected.


17





We
may need additional capital to execute our business plan and fund operations and
may not be able to obtain such capital on acceptable terms or at
all.




Capital
requirements are difficult to plan in our rapidly changing industry. Although we
currently expect to have sufficient funding for the next 12 months, we expect we
will need additional capital to fund our future growth.




Our
ability to obtain additional capital on acceptable terms or at all is subject to
a variety of uncertainties, including:




·
            Investors' perceptions of, and
      demand for, companies in our
industry;





·
            Investors' perceptions of, and
      demand for, companies operating in
China;





·
            Conditions of the U.S. and other
      capital markets in which we may seek to raise
  funds;





·
            Our future results of operations,
      financial condition and cash
flows;





·
            Governmental regulation of
      foreign investment in companies in particular
      countries;





·
            Economic, political and other
      conditions in the United States, China, and other countries;
      and





·
            Governmental policies relating to
      foreign currency borrowings.





We may be
required to pursue sources of additional capital through various means,
including joint venture projects and debt or equity financings. There is no
assurance we will be successful in locating a suitable financing transaction in
a timely fashion or at all. In addition, there is no assurance we will be
successful in obtaining the capital we require by any other means. Future
financings through equity investments are likely to be dilutive to our existing
stockholders. Also, the terms of securities we may issue in future capital
transactions may be more favorable for our new investors. Newly issued
securities may include preferences, superior voting rights, the issuance of
warrants or other derivative securities, and the issuances of incentive awards
under equity employee incentive plans, which may have additional dilutive
effects. Further, we may incur substantial costs in pursuing future capital
and/or financing, including investment banking fees, legal fees, accounting
fees, printing and distribution expenses and other costs. We may also be
required to recognize non-cash expenses in connection with certain securities we
may issue, such as convertible notes and warrants, which will adversely impact
our financial condition.




If we
cannot raise additional funds on favorable terms or at all, we may not be able
to carry out all or parts of our strategy to maintain our growth and
competitiveness or to fund our operations. If the amount of capital we are able
to raise from financing activities, together with our revenues from operations,
is not sufficient to satisfy our capital needs, even to the extent that we
reduce our operations accordingly, we may be required to cease
operations.




We
may be subject to claims that we have infringed the proprietary rights of
others, which could require us to obtain a license or change our
designs.





Although
we do not believe any of our products infringe the proprietary rights of others,
there is no assurance that infringement or invalidity claims (or claims for
indemnification resulting from infringement claims) will not be asserted or
prosecuted against us or that any such assertions or prosecutions will not
materially adversely affect our business. Regardless of whether any such claims
are valid or can be successfully asserted, defending against such claims could
cause us to incur significant costs and could divert resources away from our
other activities. In addition, assertion of infringement claims could result in
injunctions that prevent us from distributing our products. If any claims or
actions are asserted against us, we may seek to obtain a license to the
intellectual property rights that are in dispute. Such a license may not be
available on reasonable terms, or at all, which could force us to change our
designs.


18


Risks
Related to Doing Business in China





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





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




We
must comply with the Foreign Corrupt Practices Act.




We are
required to comply with the United States Foreign Corrupt Practices Act, which
prohibits U.S. companies from engaging in bribery or other prohibited payments
to foreign officials for the purpose of obtaining or retaining business. Foreign
companies, including some of our competitors, are not subject to these
prohibitions. Corruption, extortion, bribery, pay-offs, theft and other
fraudulent practices occur from time-to-time in mainland China. If our
competitors engage in these practices, they may receive preferential treatment
from personnel of some companies, giving our competitors an advantage in
securing business or from government officials who might give them priority in
obtaining new licenses, which would put us at a disadvantage. Although we inform
our personnel that such practices are illegal, we cannot assure you that our
employees or other agents will not engage in such conduct for which we might be
held responsible. If our employees or other agents are found to have engaged in
such practices, we could suffer severe penalties.




We
operate in the PRC through our Wholly Foreign Owned Enterprise (“WFOE”) status
initially approved by the local office of the PRC Ministry of Commerce
(“MOFCOM”). However, we cannot warrant that such approval procedures have been
completely satisfied due to a number of reasons, including changes in laws and
government interpretations. If we lose our WFOE status for any reason, our
business in China may be negatively impacted.





Our
operating entities in the PRC have received initial MOFCOM approval as WFOEs and
there may be conditions subsequent to complete and maintain such status. We
believe we have satisfied MOFCOM’s approval procedures for having obtained such
status. However, MOFCOM’s approval procedures or interpretations of its approval
procedures may be different from our understanding or may change. As a result,
if we lose our WFOE status for any reason, there may be a material adverse
effect on our business, financial condition, results of operations, reputation
and prospects, as well as the trading price of our shares.




If
we fail to satisfy an enlarged contribution of capital requirement at our PRC
subsidiaries, our business in China will be adversely affected.




We are
required to contribute RMB 53 million (US$ 7.8 million) as additional
contribution of capital to our PRC subsidiaries by July 2010. As of December 31,
2009 we have contributed a total of RMB 28 million to our PRC subsidiaries. We
expect the remaining RMB 25 million contribution will be completed by July 2010.
Under PRC laws, shareholders of a foreign-invested enterprise are required to
contribute capital to satisfy the registered capital requirement of the
foreign-invested enterprise within a period of not more than two years from the
date when the foreign-invested enterprise’s license to conduct business is
initially granted. The relevant PRC government agencies may grant an additional
three-month grace period. If the shareholders are unable to complete the capital
contribution within the grace period, the business license of the
foreign-invested enterprise may be revoked by the PRC government. Further, until
such contribution of capital is satisfied, the foreign-invested enterprise is
not allowed to repatriate profits to its shareholders, unless otherwise approved
by the State Administration for Foreign Exchange (“SAFE”).


19


We
are subject to economic and political risks in China over which we have little
or no control and may be unable to alter our business practice in time to avoid
the possibility of reduced revenues.





Our
business is conducted in China. Doing business outside the U.S., particularly in
China, subjects us to various risks, including changing economic and political
conditions, major work stoppages, exchange controls, currency fluctuations,
armed conflicts and unexpected changes in U.S. and foreign laws relating to
tariffs, trade restrictions, transportation regulations, foreign investments and
taxation. We have no control over most of these risks and may be unable to
anticipate changes in international economic and political conditions and,
therefore, unable to alter our business practice in time to avoid the
possibility of reduced revenues.




Substantially
all of our assets are located in China and all of our revenue is derived from
our operations in China. Accordingly, our results of operations and prospects
are subject, to a significant extent, to the economic, political and legal
developments in China.




While
China's economy has experienced significant growth in the past twenty years,
such growth has been uneven, both geographically and among various sectors of
the economy. The Chinese government has implemented various measures to
encourage economic growth and guide the allocation of resources. Some of these
measures benefit the overall economy of China, but they may also have a negative
effect on us. For example, our operating results and financial condition may be
adversely affected by the government control over capital investments or changes
in tax regulations. The economy of China has been changing from a planned
economy to a more market-oriented economy. In recent years China has implemented
measures emphasizing the utilization of market forces for economic reform and
the reduction of state ownership of productive assets, and the establishment of
corporate governance in business enterprises. However, a substantial portion of
productive assets in China are still owned by the government. In addition, the
government continues to play a significant role in regulating industry
development by imposing industrial policies. It also exercises significant
control over China's economic growth through the allocation of resources, the
control of payment of foreign currency-denominated obligations, the setting of
monetary policy and the provision of preferential treatment to particular
industries or companies.




We
may have difficulty establishing adequate management, legal and financial
controls in China.




China
historically has not adopted a Western style of management and financial
reporting concepts and practices, or modern banking, computer or other control
systems. We may have difficulty in hiring and retaining a sufficient number of
qualified employees to work in China. As a result of these factors, we may
experience difficulty in establishing management, legal and financial controls,
collecting financial data and preparing financial statements, books of account
and corporate records and instituting business practices that meet Western
standards.





Our
bank accounts are not insured or protected against loss.





We
maintain our cash with various banks and trust companies located in China. Our
cash accounts are not insured or otherwise protected. Should any bank or trust
company holding our cash deposits become insolvent, or if we are otherwise
unable to withdraw funds, we would lose the cash on deposit with that particular
bank or trust company.





As
we have limited business insurance coverage in China, any loss which we suffer
may not be insured or may be insured to only a limited extent.




The
insurance industry in China is still in an early stage of development and
insurance companies located in China offer limited business insurance products.
In the event of damage or loss to our properties, our insurance may not provide
as much coverage as if we were insured by insurance companies in the United
States .





Tax
laws and regulations in China are subject to substantial revision, some of which
may adversely affect our profitability.





The
Chinese tax system is in a state of flux, and it is anticipated that China's tax
regime will change in the coming years. Tax benefits we presently enjoy may not
be available in the wake of these changes, and we could incur tax obligations to
our government that are significantly higher than anticipated. These increased
tax obligations could negatively impact our financial condition and our
revenues, gross margins, profitability and results of operations may be
adversely affected as a result.


20


Certain
tax exemptions that we presently enjoy in China are scheduled to expire over the
next several years.





As a
substantial portion of our operations are located in a privileged economic zone,
we are entitled to certain tax benefits. When these exemptions expire, our
income tax expenses will increase, reducing our net income below what it would
be if we continued to enjoy these exemptions.





We
may face judicial corruption in China.




Another
obstacle to foreign investment in China is corruption. There is no assurance we
will be able to obtain recourse in any legal disputes with suppliers, customers
or other parties with whom we conduct business, if desired, through China's
poorly developed and sometimes corrupt judicial systems.




If
relations between the United States and China worsen, investors may be unwilling
to hold or buy our stock and our stock price may decrease.




At
various times during recent years, the U.S. and China have had significant
disagreements over political and economic issues. Controversies may arise in the
future between these two countries. Any political or trade controversies between
the U.S. and China, whether or not directly related to our business, could
reduce the price of our common stock.




China
could change its policies toward private enterprise or even nationalize or
expropriate private enterprises.




Our
business is subject to significant political and economic uncertainties and may
be affected by political, economic and social developments in China. Over the
past several years, the Chinese government has pursued economic reform policies
including the encouragement of private economic activity and greater economic
decentralization. The Chinese government may not continue to pursue these
policies or may significantly alter them to our detriment from time to time with
little, if any, prior notice.




Uncertainties
with respect to the Chinese legal system could limit legal protections available
to us.




Our
operating subsidiary, which conducts most of its operations in China, is
generally subject to laws and regulations applicable to foreign investment in
China. The Chinese legal system is based on written statutes, and prior court
decisions may be cited for reference but have no precedential value. Since 1979,
legislation and regulations have significantly enhanced the protections afforded
to various forms of foreign investments in China. However, since these laws and
regulations are relatively new and the legal system in China continues to
rapidly evolve, the interpretations of many laws, regulations and rules are not
always uniform and enforcement of these laws, regulations and rules involve
uncertainties, which may limit legal protections available to us. In addition,
any litigation in China may be protracted and result in substantial costs and
diversion of resources and management attention.




Limitations
on the ability of our operating subsidiary to make payments to us could have a
material adverse effect on our ability to conduct our business and fund our
operations.





We are a
holding company and conduct substantially all of our business through our
operating subsidiary in China. We will of necessity rely on dividends paid by
our subsidiaries for our cash needs, including the funds necessary to pay
dividends and other cash distributions to our shareholders, to service any debt
we may incur and to pay our operating expenses. The payment of dividends by
entities organized in China is subject to limitations. In particular,
regulations in China currently permit payment of dividends only out of
accumulated profits as determined in accordance with Chinese accounting
standards and regulations. Our Chinese subsidiary is also required to set aside
at least 10% of its after-tax profit based on Chinese accounting standards each
year to its general reserves until the accumulative amount of such reserves
reaches 50% of its registered capital. These reserves are not distributable as
cash dividends. In addition, it is required to allocate a portion of its
after-tax profit to its staff welfare and bonus fund at the discretion of its
board of directors. Moreover, if our subsidiary incurs debt on its own behalf in
the future, the instruments governing the debt may restrict its ability to pay
dividends or make other distributions to us. Any limitation on the ability of
our subsidiary to distribute dividends and other distributions to us could
materially and adversely limit our ability to make investments or acquisitions
that could be beneficial to our businesses, pay dividends or otherwise fund and
conduct our business.


21


Recent
Chinese regulations relating to the establishment of offshore special purpose
companies by Chinese residents and registration requirements for employee stock
ownership plans or share option plans may subject our China resident
shareholders to personal liability and limit our ability to acquire Chinese
companies or to inject capital into our operating subsidiaries in China, limit
our subsidiaries’ ability to distribute profits to us, or otherwise materially
and adversely affect us.




The State
Administration of Foreign Exchange ("SAFE") issued a public notice in
October 2005, requiring PRC residents, including both legal persons and natural
persons, to register with the competent local SAFE branch before establishing or
controlling any company outside of China, referred to as an “offshore special
purpose company,” for the purpose of acquiring any assets of or equity interest
in PRC companies and raising funds from overseas. In addition, any PRC resident
that is the shareholder of an offshore special purpose company is required to
amend his or her SAFE registration with the local SAFE branch, with respect to
that offshore special purpose company in connection with any increase or
decrease of capital, transfer of shares, merger, division, equity investment or
creation of any security interest over any assets located in China. To further
clarify the implementation of Circular 75, the SAFE issued Circular 124 and
Circular 106 on November 24, 2005 and May 29, 2007, respectively. Under Circular
106, PRC subsidiaries of an offshore special purpose company are required to
coordinate and supervise the filing of SAFE registrations by the offshore
holding company’s shareholders who are PRC residents in a timely manner. If
these shareholders fail to comply, the PRC subsidiaries are required to report
to the local SAFE authorities. If the PRC subsidiaries of the offshore parent
company do not report to the local SAFE authorities, they may be prohibited from
distributing their profits and proceeds from any reduction in capital, share
transfer or liquidation to their offshore parent company and the offshore parent
company may be restricted in its ability to contribute additional capital into
its PRC subsidiaries. Moreover, failure to comply with the above SAFE
registration requirements could result in liabilities under PRC laws for evasion
of foreign exchange restrictions. Some of our PRC resident beneficial owners
have not registered with the local SAFE branch as required under SAFE
regulations. The failure or inability of these PRC resident beneficial owners to
comply with the applicable SAFE registration requirements may subject these
beneficial owners or us to fines, legal sanctions and restrictions described
above.





On
March 28, 2007, SAFE released detailed registration procedures for employee
stock ownership plans or share option plans to be established by overseas listed
companies and for individual plan participants. Any failure to comply with the
relevant registration procedures may affect the effectiveness of our employee
stock ownership plans or share option plans and subject the plan participants,
the companies offering the plans or the relevant intermediaries, as the case may
be, to penalties under PRC foreign exchange regime. These penalties may subject
us to fines and legal sanctions, prevent us from being able to make
distributions or pay dividends, as a result of which our business operations and
our ability to distribute profits to you could be materially and adversely
affected.





In
addition, the National Development and Reform Commission ("NDRC") promulgated a
rule in October 2004 (the “NDRC Rule”), which requires NDRC approvals for
overseas investment projects made by PRC entities. The NDRC Rule also provides
that approval procedures for overseas investment projects of PRC individuals
must be implemented with reference to this rule. However, there exist extensive
uncertainties in terms of interpretation of the NDRC Rule with respect to its
application to a PRC individual’s overseas investment, and in practice, we are
not aware of any precedents that a PRC individual’s overseas investment has been
approved by the NDRC or challenged by the NDRC based on the absence of NDRC
approval. Our current beneficial owners who are PRC individuals did not apply
for NDRC approval for investment in us. We cannot predict how and to what extent
this will affect our business operations or future strategy. For example, the
failure of our shareholders who are PRC individuals to comply with the NDRC Rule
may subject these persons or our PRC subsidiary to certain liabilities under PRC
laws, which could adversely affect our business.





Regulation
of loans and direct investment by offshore holding companies to Chinese entities
may delay or prevent us from making loans or additional capital contributions to
our operating subsidiaries, which could materially and adversely affect our
liquidity and our ability to fund and expand our business.




As an
offshore holding company of our Chinese operating subsidiaries, we may need to
make loans to them, or we may need to make additional capital contributions to
them.




Any loans
to our operating subsidiaries are subject to Chinese regulations. For example,
loans by us to our subsidiaries in China, which are foreign-invested
enterprises, to finance their activities cannot exceed statutory limits and must
be registered with the SAFE.


22





We may
also decide to finance our subsidiaries by means of capital contributions. These
capital contributions must be approved by the PRC Ministry of Commerce or its
local counterpart. We cannot assure you that we will be able to obtain these
government approvals on a timely basis, if at all, with respect to future
capital contributions by us to our subsidiaries.




Restrictions
on currency exchange may limit our ability to receive and use our revenues
effectively.




The
Renminbi is currently convertible under the “current account,” which includes
dividends, trade and service-related foreign exchange transactions, but not
under the “capital account,” which includes foreign direct investment and loans.
Currently, our Chinese subsidiary may purchase foreign currencies for settlement
of current account transactions, including payments of dividends to us, without
the approval of SAFE. However, the relevant Chinese government authorities may
limit or eliminate their ability to purchase foreign currencies in the future.
Since a significant amount of our future revenues will be denominated in
Renminbi, any existing and future restrictions on currency exchange may limit
our ability to utilize revenues generated in Renminbi to fund our business
activities outside China that are denominated in foreign
currencies.




Foreign
exchange transactions by our Chinese subsidiaries under the capital account
continue to be subject to significant foreign exchange controls and require the
approval of or need to register with Chinese governmental authorities, including
SAFE. In particular, if our Chinese subsidiaries borrow foreign currency loans
from us or other foreign lenders, these loans must be registered with SAFE, and
if we finance our Chinese subsidiaries by means of additional capital
contributions, these capital contributions must be approved by certain
government authorities, including the NDRC, the Ministry of Commerce, or MOFCOM,
or their respective local counterparts. These limitations could affect the
ability of our Chinese subsidiaries to obtain foreign exchange through debt or
equity financing.





We
face risks associated with currency exchange rate fluctuations; any adverse
fluctuation may adversely affect our operating margins.





Almost
allof our
revenues are denominated in Renminbi. Conducting business in currencies other
than U.S. dollars subjects us to fluctuations in currency exchange rates that
could have a negative impact on our reported operating results. Fluctuations in
the value of the U.S. dollar relative to other currencies impact our revenues,
cost of revenues and operating margins and result in foreign currency
translation gains and losses. If the exchange rate of the Renminbi is affected
by lowering its value as against the U.S. dollar, our reported profitability
when stated in U.S. dollars will decrease. Historically, we have not engaged in
exchange rate hedging activities and have no current intention of doing
so.




We
may not be able to adequately protect our technology and other proprietary
rights.




Our
success will depend in part on our ability to obtain and protect our products,
methods, processes and other technologies, to preserve our trade secrets, and to
operate without infringing on the proprietary rights of third parties both
domestically and abroad. We have patents and patent applications pending in
China, and have worked and continue to work closely with Chinese patent
officials to preserve our intellectual property rights. Despite these efforts,
any of the following occurrences may reduce the value of our intellectual
property:





·
            Our applications for patents and
      trademarks relating to our business may not be granted and, if granted,
      may be challenged or
invalidated;





·
            Issued patents and trademarks may
      not provide us with any competitive
  advantages;





·
            Our efforts to protect our
      intellectual property rights may not be effective in preventing
      misappropriation of our
technology;





·
            Our efforts may not prevent the
      development and design by others of products or technologies similar to or
      competitive with, or superior to those we develop;
    or





·
            Another party may obtain a
      blocking patent and we would need to either obtain a license or design
      around the patent in order to continue to offer the contested feature or
      service in our products.


23





It
will be extremely difficult to acquire jurisdiction and enforce liabilities
against our officers, directors and assets based in China.




Our
executive officers and several of our directors, including the chairman of our
Board of Directors, are Chinese citizens. It may be difficult, if not
impossible, to acquire jurisdiction over these persons in the event a lawsuit is
initiated against us and/or our officers and directors by a stockholder or group
of stockholders in the United States. Also, because our operating subsidiaries
and assets are located in China, it may be extremely difficult or impossible for
you to access those assets to enforce judgments rendered against us or our
directors or executive offices by U.S. courts. In addition, the courts in China
may not permit the enforcement of judgments arising out of U.S. federal and
state corporate, securities or similar laws. Accordingly, United States
investors may not be able to enforce judgments against us for violation of U.S.
securities laws.




Risks
Related to Our Securities




The
market price for our common stock may be volatile.




The
trading price of our common stock may fluctuate widely in response to various
factors, some of which are beyond our control. These factors include, in
addition to the risk factors incorporated by reference herein, our quarterly
operating results or the operating results of other companies in our industry,
announcements by us or our competitors of acquisitions, new products, product
improvements, commercial relationships, intellectual property, legal, regulatory
or other business developments and changes in financial estimates or
recommendations by stock market analysts regarding us or our competitors. In
addition, the stock market in general, and the market for companies based in
China in particular, has experienced extreme price and volume fluctuations. This
volatility has had a significant effect on the market prices of securities
issued by many companies for reasons unrelated or disproportionate to their
operating performance. These broad market fluctuations may have a material
adverse effect on our stock price, regardless of our operating results. Further,
the market for our common stock is limited and we cannot assure you that a
larger market will ever be developed or maintained. Market fluctuations and
volatility, as well as general economic, market and political conditions, could
reduce our market price.




Our
quarterly results may be volatile.




Our
operating results have varied on a quarterly basis during our operating history
and are likely to fluctuate significantly in the future. Many factors, including
the risk factors incorporated by reference herein, could cause our revenues and
operating results to vary significantly in the future. Many of these factors are
outside of our control. Accordingly, we believe that quarter-to-quarter
comparisons of our operating results are not necessarily meaningful. Investors
should not rely on the results of one quarter as an indication of our future
performance. If our results of operations in any quarter do not meet analysts’
expectations, our stock price could materially decrease.




Future
sales of our stock could depress the market price of our common
stock.




Future
sales of shares of our common stock could adversely affect the prevailing market
price of our stock. If our significant stockholders sell a large number of
shares, or if we issue a large number of shares, the market price of our stock
could significantly decline. Moreover, the perception in the public market that
stockholders might sell shares of our stock could depress the market for our
shares.





Our principal
stockholder has the ability to exert significant control in matters requiring a
stockholder vote and could delay, deter or prevent a change of control in our
company.





As of
December 31, 2009, Mr. Jun Wang, our Chief Executive Officer and our
largest stockholder, beneficially owned 10.38% of our outstanding shares.
Mr. Wang possesses significant influence over us, giving him the ability,
among other things, to effectively control the election of all or a majority of
the Board of Directors and to approve significant corporate transactions. Such
stock ownership and control may also have the effect of delaying or preventing a
future change in control, impeding a merger, consolidation, takeover or other
business combination, or discouraging a potential acquirer from making a tender
offer or otherwise attempting to obtain control of our company. Without the
consent of Mr. Wang, we could be prevented from entering into potentially
beneficial transactions if they conflict with our major stockholder’s interests.
The interests of this stockholder may differ from the interests of our other
stockholders.


24




We
have provisions in our articles of incorporation that substantially eliminate
the personal liability of members of our board of directors for violations of
their fiduciary duty of care as a director and that allow us to indemnify our
officers and directors. This could make it very difficult for you to bring any
legal actions against our directors for such violations or could require us to
pay any amounts incurred by our directors in any such actions.




Pursuant
to our articles of incorporation, members of our board of directors will have no
liability for violations of their fiduciary duty of care as a director, except
in limited circumstances. This means that you may be unable to prevail in a
legal action against our directors even if you believe they have breached their
fiduciary duty of care. In addition, our certificate of incorporation allows us
to indemnify our directors from and against any and all expenses or liabilities
arising from or in connection with their serving in such capacities with us.
This means that if you were able to enforce an action against our directors or
officers, in all likelihood we would be required to pay any expenses they
incurred in defending the lawsuit and any judgment or settlement they otherwise
would be required to pay.





Because
we obtained our present operations by means of a "reverse acquisition," we may
not be able to attract the attention of major brokerage firms.




There may
be risks associated with our use of a "reverse acquisition" to obtain our
present operations. Securities analysts of major brokerage firms may not provide
coverage of us since there is no incentive to brokerage firms to recommend the
purchase of our common stock. No assurance can be given that brokerage firms
will, in the future, want to conduct any offerings on our behalf.




We
may issue additional shares of our capital stock or debt securities to raise
capital or complete acquisitions, which would reduce the equity interest of our
stockholders.




Our
articles of incorporation authorize the issuance of up to 75,000,000 shares of
common stock, par value $.001 per share. There are approximately 42,087,434authorized and unissued
shares of our common stock which have not been reserved and are available for
future issuance. Although we have no commitments as of the date of this report
to issue our securities, we may issue a substantial number of additional shares
of our common stock to complete a business combination or to raise capital. The
issuance of additional shares of our common stock:




·
            may significantly reduce the
      equity interest of our existing stockholders;
  and





·
            may adversely affect prevailing
      market prices for our common
stock.





We
have not paid dividends in the past and do not expect to pay dividends in the
future. Any return on investment may be limited to the value of our common
stock.




We have
never paid cash dividends on our common stock and do not anticipate doing so in
the foreseeable future. We presently do not intend to pay dividends in the
foreseeable future. Our management intends to follow a policy of retaining all
of our earnings to finance the development and execution of our strategy and the
expansion of our business. In addition, the payment of dividends is limited by
Chinese law. See "RISK FACTORS - Risks Relating to Doing Business in China
-Limitations on
the ability of our operating subsidiary to make payments to us could have a
material adverse effect on our ability to conduct our business and fund our
operations."




Item 1B. Unresolved Staff
Comments





Not
applicable.





Item 2.    Properties




Until
recently, we conducted all of our manufacturing activities at our Shenyang
plant.Our
headquarters and these manufacturing facilities are located in Shenyang's
Economic and Technological Development Zone, Shenyang City, Liaoning Province,
PRC.  We own two buildings, which include our office headquarters and
primary manufacturing facilities.  We have been granted the right to
use the land in Shenyang by the Municipal administration of state-owned land
through June 2055.




In
addition to the two buildings in Shenyang, we own 16 vehicles, 5 dual beam
cranes and other special equipment.


25




On
September 25, 2008 we acquired SanDeKe, a PHE manufacturing company located
in the Pudong district, Shanghai. SanDeKe leases a manufacturing facility and
business offices. Additionally, on May 27, 2009 we acquired the plant,
machinery and land use rights of Siping Beifang, a major PHE manufacturer in
China. Today, we currently operate the following three manufacturing
facilities:





Location
                
                Square Feet
                
                Owned/LeasedShenyang
      (Taiyu)
                
                
                210,137
                
                OwnedPudong
      (SanDeKe )
                
                
                13,450
                
                LeasedSiping
      Beifang
                
                
                269,000
                
                OwnedTotal
                
                
                492,587





We
believe our facilities are adequate for our current operations for fiscal
2010.





Item 3. Legal
Proceedings





From time
to time, we may become involved in various lawsuits and legal proceedings, which
arise in the ordinary course of business.  However, litigation is
subject to inherent uncertainties and an adverse result in these or other
matters may arise from time to time that may have an adverse affect on our
business, financial conditions, or operating results.  We are
currently not aware of any such legal proceedings or claims that will have,
individually or in the aggregate, a material adverse affect on our business,
financial condition or operating results.





PART II







Item
      4.
            Market for Registrant’s Common
      Equity, Related Stockholder Matters and Issuer Purchases of Equity
      Securities





On April
22, 2008, our common stock became eligible for quotation on the OTC
Bulletin Board under the symbol “SMHT.”  On January 29, 2009, our
common stock was listed on the NASDAQ Stock Market under the symbol “HEAT” and
was subsequently listed on the NASDAQ Global Market on March 10,
2009.  The following table sets forth the range of the high and low
sales prices of our common stock for each quarter (or portion thereof) beginning
on April 22, 2008 and ending on December 31, 2009 as reported by the OTC
Bulletin Board for the period beginning on April 22, 2008 to January 28, 2009
and as reported on the NASDAQ Stock Market from January 29, 2009 to March 9,
2009 and on the NASDAQ Global Market thereafter.





Fiscal 2008
                  
                  High
                  
                  
                  LowFirst
      Quarter  (through March 31, 2008)
                  
                  
                  N/A
                  
                  
                  
                  N/ASecond
      Quarter (April 22, 2008 - June 30, 2008)
                  
                  $
                  4.60
                  
                  
                  $
                  2.00Third
      Quarter  (through September 30, 2008)
                  
                  $
                  4.75
                  
                  
                  $
                  4.50Fourth
      Quarter  (through December 31, 2008)
                  
                  $
                  6.50
                  
                  
                  $
                  2.25




Fiscal 2009
                  
                  High
                  
                  
                  LowFirst
      Quarter (through March 31, 2009)
                  
                  $
                  6.20
                  
                  
                  $
                  5.50Second
      Quarter (through June 30, 2009)
                  
                  $
                  8.00
                  
                  
                  $
                  5.01Third
      Quarter  (through September 30, 2009)
                  
                  $
                  12.79
                  
                  
                  $
                  5.76Fourth
      Quarter  (through December 31, 2009)
                  
                  $
                  17.27
                  
                  
                  $
                  8.60


26





Holders
of Record





On March
30, 2010 there were approximately 43 stockholders of record based on information
provided by our transfer agent.Many of our shares of
common stock are held in street or nominee name by brokers and other
institutions on behalf of stockholders and we are unable to estimate the
total number of stockholders represented by these record holders.




Dividend
Policy




We have
not paid and do not expect to declare or pay any cash dividends on our common
stock in the foreseeable future, and we currently intend to retain future
earnings, if any, to finance the expansion of our business. The decision whether
to pay cash dividends on our common stock will be made by our board of
directors, in their discretion, and will depend on our financial condition,
operating results, capital requirements and other factors that the board of
directors considers significant.





Securities
authorized for issuance under equity compensation plans





During
the years ended December 31, 2009 and 2008 we did not have a formal equity
compensation plan in effect.  We granted two independent directors options
to purchase an aggregate of 20,000 shares of common stock during the year ended
December 31, 2008.  One of these directors forfeited his right to
unvested options to purchase an aggregate of 6,667 upon his resignation. We did
not grant any other equity based compensation awards during the years ended
December 31, 2009 and 2008.





The
following table provides aggregate information as of December 31, 2009 with
respect to all compensation plans (including individual compensation
arrangements) under which equity securities are authorized for
issuance.





Equity
Compensation Plan Information





Plan Category
                    
                    (a)
                      Number of
                      Securities to
                      be
                      Issued Upon
                      Exercise of
                      Outstanding
                      Options
                    
                    
                    (b)
                      Weighted-
                      Average
                      Exercise
                      Price
                      of
                      Outstanding
                      Options
                    
                    
                    (c)
                      Number of
                      Securities
                      Remaining
                      Available
                      for Future
                      Issuance
                      Under
                      Equity
                      Compensation
                      Plans
                      (excluding
                      securities
                      reflected
                      in column (a))Equity
      compensation plans approved by security holders
                    
                    
                    -0-
                    
                    
                    
                    N/A
                    
                    
                    
                    -0-Equity
      compensation plans not approved by security holders
                    
                    
                    13,333
                    
                    
                    $
                    4.60
                    
                    
                    
                    -0-Total
                    
                    
                    13,333
                    
                    
                    $
                    4.60
                    
                    
                    
                    -0-




Recent
Sales of Unregistered Securities





Previously
disclosed in filings with the SEC.





Purchases
of Equity Securities by the Issuer and Affiliated Purchasers





We did
not repurchase any of our common stock during 2009.


27


Item 5.    Selected
Financial Data





Not
applicable.





CAUTIONARY
STATEMENT FOR FORWARD-LOOKING STATEMENTS




This
Annual Report on Form 10-K includes forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended.  We have based
these forward-looking statements on our current expectations and projections
about future events.  These forward-looking statements are subject to
known and unknown risks, uncertainties and assumptions about us that may cause
our actual results, levels of activity, performance or achievements to be
materially different from any future results, levels of activity, performance or
achievements expressed or implied by such forward-looking
statements.  In some cases, you can identify forward-looking
statements by terminology such as “may,” “will,” “should,” “could,” “would,”
“expect,” “plan,” anticipate,” believe,” estimate,” continue,” or the negative
of such terms or other similar expressions.  Factors that might cause
or contribute to such a discrepancy include, but are not limited to, those
listed under the heading “Risk Factors” and those listed in our other
Securities and Exchange Commission filings.  The following discussion
should be read in conjunction with our Financial Statements and related
Notes thereto included elsewhere in this report. Throughout this Annual
Report we will refer to SmartHeat Inc. as "SmartHeat," the "Company," "we,"
"us," and "our."





Item 6.            Management’s
Discussion and Analysis of Financial Condition and Results of
Operations





Overview





We were
incorporated in the State of Nevada on August 4, 2006 under the name Pacific
Goldrim Resources, Inc. as an exploration stage corporation that intended to
engage in exploration for silver, lead and zinc. On April 14, 2008 we changed
our name to SmartHeat Inc. and acquired all of the equity interests in Shenyang
Taiyu Machinery & Electronic Equipment Co, Ltd. (“Taiyu”), a privately
held company formed under the laws of China engaged in the design, manufacture,
sale and servicing of plate heat exchange products in China (“PHE”). After the
relevant PRC government agency approved our subscription of 71.6% of the
registered capital increase of Taiyu on July 29, 2008, PRC approval of
Taiyu becoming a wholly-owned subsidiary of SmartHeat was obtained on
June 3, 2009, when the transfer by the three original owners of Taiyu of
their remaining 28.4% ownership of Taiyu to SmartHeat was officially
recognized.





Prior to
our acquisition of Taiyu, we were a development stage business with minimal
operations. We had no interest in any property, but had the right to conduct
exploration activities on 13 mineral title cells covering 27,027 hectares
(66,785 acres) in the Slocan Mining Division of southeastern British Columbia,
Canada. In connection with the acquisition of Taiyu, we transferred all of our
pre-closing assets and liabilities (other than the obligation to pay a $10,000
fee to the Company’s audit firm) to a wholly-owned subsidiary and sold all of
the outstanding capital stock of that subsidiary to our former director and
officer in exchange for the surrender of  2,500,000 shares of our
common stock held by the former director and officer.





Taiyu was
formed in July 2002 under the laws of China and is headquartered in Shenyang
City, Liaoning Province, China. As a result of our acquisition of Taiyu, we are
a leading provider of plate heat exchange products to China's industrial,
residential, and commercial markets, specializing in the manufacturing, sale,
research, and servicing of PHEs, PHE Units and heat meters for a broad range of
industries such as petroleum refinement, petrochemicals, power generation,
metallurgy, food & beverage, and chemical processing. We sell PHEs under
both our Taiyu brand as well as  Sondex brand name while our PHE Units
are custom designed by our own in house engineers and sold under our own Taiyu
brand name.





As an
expansion of our business, we acquired SanDeKe Co., Ltd. (“SanDeKe”), a
Shanghai-based manufacturer of PHEs on September 25, 2008, and closed an asset
purchase transaction with Siping Beifang Heat Exchanger Manufacture Co.,Ltd. on June 16, 2009 to
acquire plant and equipment and land use rights to set up a new
manufacturing facility under our newly incorporated subsidiary SmartHeat Siping
Beifang Energy Technology Co., Ltd. (“SmartHeat Siping”).  On August
14, 2009, we formed a joint venture with total registered capital of RMB 10
million (US $1.46 million) in Beijing, named Beijing SmartHeat Jinhui Energy
Technology Co., Ltd. (“Jinhui”), to expand our research, development,
manufacturing and sales of plate heat exchangers in more regions of
China.  We own 52% of the joint venture.


28





Our
revenue is subject to fluctuations due to the timing of sales of high-value
products, the impact of seasonal spending patterns, the timing and size of
projects our customers perform, changes in overall spending levels in the
industry and other unpredictable factors that may affect customer ordering
patterns. Our revenues may fluctuate significantly due to the seasonal nature of
central heating services in the People’s Republic of China (“PRC”), whereas, the
equipment used in residential buildings must be delivered and installed prior to
the beginning of the heating season in late fall.  Additionally,
any significant delays in the commercial launch or any lack or delay of
commercial acceptance of new products, unfavorable sales trends in existing
product lines, or impacts from the other factors mentioned above, could
adversely affect our revenue growth or cause a sequential decline in quarterly
revenue.   We have not been adversely affected by these trends or
weaker demand from steel processing, petrochemical and HVAC. Moreover, the PRC
government has recently passed an economic stimulus package and we believe that
our sales will benefit from an increase in government spending on infrastructure
as provided in this package.





While
our significant accounting policies are more fully described in Note 2 to our
consolidated financial statements, we believe  the following
accounting policies are the most critical to aid you in fully understanding and
evaluating this management discussion and analysis.





Basis of
Presentation




Our
financial statements are prepared in accordance with generally accepted
accounting principles in the United States of America (“US GAAP”).





Principle
of Consolidation





The
accompanying consolidated financial statements include the accounts of
SmartHeat, Taiyu, SanDeKe, SmartHeat Siping, a newly incorporated subsidiary
in June of 2009, and Jinhui, a new joint venture formed in August of 2009.
For purposes of this Report, "Company" refers collectively to SmartHeat, Taiyu,
SanDeKe, SmartHeat Siping and Jinhui. All significant inter-company accounts and
transactions have been eliminated in consolidation.





Use
of Estimates





In
preparing the financial statements in conformity with US GAAP, management makes
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the dates of
the financial statements, as well as the reported amounts of revenues and
expenses during the reporting year. Significant estimates, required by
management, include the recoverability of long-lived assets, allowance for
doubtful accounts, and the reserve for obsolete and slow-moving inventories.
Actual results could differ from those estimates.





Accounts
Receivable





Our
policy is to maintain reserves for potential credit losses on accounts
receivable. Management reviews the composition of accounts receivable and
analyzes historical bad debts, customer concentrations, customer credit
worthiness, current economic trends and changes in customer payment patterns to
evaluate the adequacy of these reserves. Accounts receivable are net of
unearned interest. Unearned interest represents imputed interest on accounts
receivable with due dates over one year from the invoice date discounted at our
borrowing rate for the year.





Inventories





Inventories
are valued at the lower of cost or market with cost determined on a moving
weighted average basis. Cost of work in progress and finished goods comprises
direct material, direct production cost and an allocated portion of production
overheads.


29





Property
and Equipment





Property
and equipment are stated at cost, net of accumulated depreciation. Expenditures
for maintenance and repairs are expensed as incurred; additions, renewals and
betterments are capitalized. When property and equipment are retired or
otherwise disposed of, the related cost and accumulated depreciation are removed
from the respective accounts, and any gain or loss is included in operations.
Depreciation of property and equipment is provided using the straight-line
method with a 10% salvage value and estimated lives as follows:




Building
              20
      yearsVehicles
              5
      yearsOffice
      Equipment
              5
      yearsProduction
      Equipment
              5 -
      10 years





Revenue
Recognition





Our
revenue recognition policies are in compliance with Securities and Exchange
Commission (“SEC”) Staff Accounting Bulletin (“SAB”) 104 (codified in Financial
Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”)
Topic 480). Sales revenue is recognized when products are delivered, for PHE and
heat meters, and for PHE units, when customer acceptance occurs, the price is
fixed or determinable, no other significant obligations of the Company exist and
collectibility is reasonably assured. Payments received before all of the
relevant criteria for revenue recognition are recorded as
unearned revenue.





Our
agreements with our customers generally provide that 30% of the purchase price
is due upon placement of an order, 30% is due upon delivery, 30% is due upon
installation and acceptance of the equipment after customer testing. As a common
practice in the heating manufacturing business in China,  payment of
the final 10%  of the purchase price is due no later than the
termination date of the standard warranty period which ranges from 3 to 24
months from the acceptance date.





Our
standard warranty is provided to all customers and is not considered an
additional service; rather it is integral part of the product sale. We believe
the existence of the standard product warranty in a sales contract does not
constitute a deliverable in the arrangement and thus there is no need to apply
the EITF 00-21 (codified in FASB ASC Topic 605-25) separation and
allocation model for a multiple deliverable arrangement. SFAS5(codified in
FASB ASC Topic 450) specifically address the accounting for standard
warranties and neither SAB 104 nor EITF 00-21 supersedes SFAS 5.
We believe accounting for our standard warranty pursuant to SFAS
5 does not impact revenue recognition because the cost of honoring the
warranty can be reliably estimated.





We
provide after sales services at a charge after expiration of the warranty
period, with after sales services mainly consisting of cleaning plate heat
exchangers and repairing and exchanging parts. We recognize such revenue when
service is provided.  The revenue earned from these services was not
material.





Foreign
Currency Translation and Comprehensive Income (Loss)





Our
functional currency is the Chinese yuan - renminbi (“RMB”). For financial
reporting purposes, RMB was translated into United States dollars ("USD") as the
reporting currency. Assets and liabilities are translated at the exchange rate
in effect at the balance sheet date. Revenues and expenses are translated at the
average rate of exchange prevailing during the reporting period. Translation
adjustments arising from the use of different exchange rates from period to
period are included as a component of shareholders' equity as "Accumulated other
comprehensive income." Gains and losses resulting from foreign currency
transactions are included in income. There has been no significant fluctuation
in exchange rate for the conversion of RMB to USD after the balance sheet
date.





We use
Statement of Financial Accounting Standards ("SFAS") No. 130, “Reporting
Comprehensive Income” (codified in FASB ASC Topic 220). Comprehensive income is
comprised of net income and all changes to the statements of shareholders’
equity, except those due to investments by shareholders, changes in paid-in
capital and distributions to shareholders.


30





Recent
Accounting Pronouncements





In
October 2009, the FASB issued an Accounting Standards Update (“ASU”) regarding
accounting for own-share lending arrangements in contemplation of convertible
debt issuance or other financing.  This ASU requires that at the date
of issuance of the shares in a share-lending arrangement entered into in
contemplation of a convertible debt offering or other financing, the shares
issued shall be measured at fair value and be recognized as an issuance cost,
with an offset to additional paid-in capital. Further, loaned shares are
excluded from basic and diluted earnings per share unless default of the
share-lending arrangement occurs, at which time the loaned shares would be
included in the basic and diluted earnings-per-share
calculation.  This ASU is effective for fiscal years beginning on or
after December 15, 2009, and interim periods within those fiscal years for
arrangements outstanding as of the beginning of those fiscal years.
The Company is currently evaluating the impact of this ASU on its consolidated
financial statements.




In August
2009, the FASB issued an ASU regarding measuring liabilities at fair value. This
ASU provides additional guidance clarifying the measurement of liabilities at
fair value in circumstances in which a quoted price in an active market for the
identical liability is not available; under those circumstances, a reporting
entity is required to measure fair value using one or more of valuation
techniques, as defined. This ASU is effective for the first reporting period,
including interim periods, beginning after the issuance of this ASU. The
adoption of this ASU did not have a material impact on the Company’s
consolidated financial statements.





On July
1, 2009, the Company adopted ASU No. 2009-01, “Topic 105 - Generally
Accepted Accounting Principles - amendments based on Statement of Financial
Accounting Standards No. 168 , “The FASB Accounting Standards CodificationTM and
the Hierarchy of Generally Accepted Accounting Principles” (“ASU No.
2009-01”).  ASU No. 2009-01 re-defines authoritative GAAP for
nongovernmental entities to be only comprised of the FASB Accounting Standards
CodificationTM (“Codification”) and, for SEC registrants, guidance issued by the
SEC.  The Codification is a reorganization and compilation of all
then-existing authoritative GAAP for nongovernmental entities, except for
guidance issued by the SEC.  The Codification is amended to effect
non-SEC changes to authoritative GAAP.  Adoption of ASU No. 2009-01
only changed the referencing convention of GAAP in Notes to the
Consolidated Financial Statements.





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





In June
2009, the FASB issued SFAS No. 166, “Accounting for Transfers of Financial
Assets — an amendment of FASB Statement No. 140” (“SFAS 166”), codified as FASB
Topic ASC 860, which requires entities to provide more information regarding
sales of securitized financial assets and similar transactions, particularly if
the entity has continuing exposure to the risks related to transferred financial
assets. SFAS 166 eliminates the concept of a “qualifying special-purpose
entity,” changes the requirements for derecognizing financial assets and
requires additional disclosures. SFAS 166 is effective for fiscal years
beginning after November 15, 2009. The Company does not believe the adoption of
SFAS 166 will have an impact on its financial condition, results of operations
or cash flows.





In May
2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS 165”) codified in
FASB ASC Topic 855-10-05, which provides guidance to establish general standards
of accounting for and disclosures of events that occur after the balance sheet
date but before financial statements are issued or are available to be issued.
SFAS 165 also requires entities to disclose the date through which subsequent
events were evaluated as well as the rationale for why that date was selected.
SFAS 165 is effective for interim and annual periods ending after June 15, 2009,
and accordingly, the Company adopted this pronouncement during the second
quarter of 2009. SFAS 165 requires public entities evaluate subsequent events
through the date that the financial statements are issued.


31





In April
2009, the FASB issued FSP No. SFAS 107-1 and APB 28-1, “Interim Disclosures
about Fair Value of Financial Instruments,” which is codified in FASB ASC Topic
825-10-50. This FSP essentially expands the disclosure about fair value of
financial instruments that were previously required only annually to also be
required for interim period reporting. In addition, the FSP requires certain
additional disclosures regarding the methods and significant assumptions used to
estimate the fair value of financial instruments. These additional disclosures
are required beginning with the quarter ending June 30, 2009. This FSP had no
material impact on the Company’s financial position, results of operations or
cash flows.





In
April 2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, “Recognition
and Presentation of Other-Than-Temporary Impairments,” which is codified in FASB
ASC Topic 320-10. This FSP modifies the requirements for recognizing
other-than-temporarily impaired debt securities and changes the existing
impairment model for such securities. The FSP also requires additional
disclosures for both annual and interim periods with respect to both debt and
equity securities. Under the FSP, impairment of debt securities will be
considered other-than-temporary if an entity (1) intends to sell the security,
(2) more likely than not will be required to sell the security before recovering
its cost, or (3) does not expect to recover the security’s entire amortized cost
basis (even if the entity does not intend to sell). The FSP further indicates
that, depending on which of the above factor(s) causes the impairment to be
considered other-than-temporary, (1) the entire shortfall of the security’s fair
value versus its amortized cost basis or (2) only the credit loss portion would
be recognized in earnings while the remaining shortfall (if any) would be
recorded in other comprehensive income. FSP 115-2 requires entities to initially
apply the provisions of the standard to previously other-than-temporarily
impaired debt securities existing as of the date of initial adoption by making a
cumulative-effect adjustment to the opening balance of retained earnings in the
period of adoption. The cumulative-effect adjustment potentially reclassifies
the noncredit portion of a previously other-than-temporarily impaired debt
security held as of the date of initial adoption from retained earnings to
accumulate other comprehensive income. The Company adopted FSP No. SFAS 115-2
and SFAS 124-2 beginning April 1, 2009. This FSP had no material impact on the
Company’s financial position, results of operations or cash flows.





In April
2009, the Financial Accounting Standards Board (“FASB”) issued FSP
No. SFAS 157-4, “Determining Fair Value When the Volume and Level of
Activity for the Asset or Liability Have Significantly Decreased and Identifying
Transactions That Are Not Orderly” (“FSP No. SFAS 157-4”). FSP
No. SFAS 157-4, which is codified in FASB ASC Topics 820-10-35-51 and
820-10-50-2, provides additional guidance for estimating fair value and
emphasizes that even if there has been a significant decrease in the volume and
level of activity for the asset or liability and regardless of the valuation
technique(s) used, the objective of a fair value measurement remains the same.
The Company adopted FSP No. SFAS 157-4 beginning April 1, 2009.
This FSP had no material impact on the Company’s financial position, results of
operations or cash flows.





Results
of Operations





Year
Ended December 31, 2009 Compared to the Year Ended December 31,
2008





The
following table sets forth the results of our operations for the years indicated
as a percentage of net sales:




2009
                          
                          
                          2008$
                          
                          
                          % of Sales
                          
                          
                          $
                          
                          
                          % of SalesSales
                          
                          
                          82,563,869
                          
                          
                          
                          
                          
                          
                          32,676,082Cost
      of sales
                          
                          
                          53,467,805
                          
                          
                          
                          64.8
                          %
                          
                          
                          21,717,735
                          
                          
                          
                          66.5
                          %Gross
      Profit
                          
                          
                          29,096,064
                          
                          
                          
                          35.2
                          %
                          
                          
                          10,958,347
                          
                          
                          
                          33.5
                          %Operating
      Expenses
                          
                          
                          10,920,865
                          
                          
                          
                          13.2
                          %
                          
                          
                          3,416,670
                          
                          
                          
                          10.5
                          %Income
      from Operations
                          
                          
                          18,175,199
                          
                          
                          
                          22.0
                          %
                          
                          
                          7,541,677
                          
                          
                          
                          23.0
                          %Other
      Income (Expenses), net
                          
                          
                          113,835
                          
                          
                          
                          (0.1
                          )%
                          
                          
                          93,289
                          
                          
                          
                          0.3
                          %Income
      tax expense
                          
                          
                          2,858,186
                          
                          
                          
                          3.5
                          %
                          
                          
                          1,293,660
                          
                          
                          
                          4.0
                          %Noncontrolling
      interest
                          
                          
                          (11,681
                          )
                          
                          
                          0
                          %
                          
                          
                          5,966
                          
                          
                          
                          0
                          %Net
      Income
                          
                          
                          15,442,529
                          
                          
                          
                          18.7
                          %
                          
                          
                          6,335,340
                          
                          
                          
                          19.4
                          %


32





Sales. Net sales during
the year ended December 31, 2009 were $82.56 million, while our net sales
for   2008 were $32.68 million, an increase of $49.89 million, or
153%. The increase in sales was attributable to an increase in our sales
volume, with selling price determined based on our standard profit margin rate.
We have a strict review process for approving each sales contract, especially
with respect to the determination of a selling price.  Sales price
under each contract is determined in proportion to our estimated cost in order
to ensure our gross profit.  Our selling price varies on each
sale, which depends mainly on each customer’s specific needs and our negotiation
of the contract amount and term. During the year ended December 31, 2009, we’ve
recognized $5.26 million of  revenue or 6.4% of the total from
contracts that we’ve previously signed. We have been continuously expanding the
heat-supply market in more regions as a result of the PRC government’s economic
stimulus plan stressing increasing domestic infrastructure construction. Our
sales from the traditional heat-supply industry was approximately $37.62 million
or 45.6% of the total sales.  We have also developed new customers in
other industries like chemical engineering, electric power, metal smelting, etc.
which accounted for $25.42 million or 30.7% of our total sales. Our sales of
heat meters have increased to $7.98 million, from approximately $710,000 in
2008, an increase of 1024%. Sales of heat meters accounted for 9.7% of the total
sales during 2009.In addition, since July
of 2009, the new subsidiary SmartHeat Siping began operations and brought us
additional sales of $6.28 million or 7.6% of total sales. We believe our sales
will continue to grow because we are strengthening our sales efforts by hiring
more sales personnel, increasing sales channels, and improving the quality of
our products.





Cost of
Sales.  Cost of sales for the year ended December 31, 2009 was
$53.47 million, while our cost of sales for 2008 was $21.72 million, an increase
of $31.75 million, or 146%.  Cost of sales mainly consisted of the
cost of materials and labor, as well as factory overhead costs. The
increase in cost of sales is attributed to the increase of production and sales
volume in 2009. Cost of sales as a percentage of sales was 64.8% for 2009
and 66.5% for 2008. The decrease in cost of sales as a percentage of sales was
mainly due to the stable raw material cost compared to the cost in 2008,
improved economies of scale on fixed costs as a result of increased production,
and our continuous improvement on control of the manufacturing costs. We believe
our cost of sales will remain stable as a result of our current pricing strategy
and the continued improvement in the efficiency of our manufacturing
facility.





Gross
Profit.  Gross profit was $29.10 million for the year ended
December 31, 2009, compared to $10.96 million for 2008, representing gross
margins of 35.2% and 33.5%, respectively.  The increase in our gross
profits and gross profit margin was mainly due to the decrease of cost of goods
sold as a percentage of sales while the Company’s sales activities
increased.





Operating
Expenses.  Operating expenses consisted of selling, general and
administrative expenses totaled $10.92 million for the year ended December 31,
2009, compared to $3.42 million for 2008, an increase of $7.50 million or
219%.  The increase in operating expenses was mainly due to a
proportional increase in payroll, insurance, and employee welfare and travel
expenses with our increased sales and production; as well as the increase in
audit, legal, consulting and filing expenses in connection with the Company
being public in the United States since April 2008.  In addition, a
one-time charge of approximately $110,000 occurred in the first quarter of
2009 as a result of failure to declare the effectiveness of the Registration
Statement within 180 days of the final closing of the offering.





Net Income.  Our
net income for the year ended December 31, 2009 was $ 15.44 million compared to
$6.34 million for 2008, an increase of $ 9.10 million or 144%.  Net
income as a percentage of sales is  18.7% in 2009 which is same as
2008. This increase in net income was attributable to economies of scale
combined with rapid growth in revenue and efficiency of operations, and lower
income tax rate of 15% for Taiyu effective January 1, 2009, down from 18% for
2008.  Our management believes that net income will continue to
increase as we continue to increase our sales, offer better quality products and
control our manufacturing costs.


33





Liquidity
and Capital Resources





Year
Ended December 31, 2009 Compared to the Year Ended December 31,
2008





As of
December 31, 2009, we had cash and cash equivalents of $48.97 million. Working
capital was $88.28 million at December 31, 2009. The ratio of current assets to
current liabilities was 6.00:1 at December 31, 2009.





The
following is a summary of cash provided by or used in each of the indicated
types of activities during the years ended December 31, 2009 and
2008:




2009
                
                
                2008Cash
      provided by (used in):Operating
      Activities
                
                $
                (19,584,349
                )
                
                $
                (761,033
                )Investing
      Activities
                
                
                (1,609,944
                )
                
                
                (507,110
                )Financing
      Activities
                
                
                68,775,920
                
                
                
                2,307,620





Net cash
flow used in operating activities was $19,584,349 million in 2009, as compared
to net cash flow used in operating activities of $761,033 in 2008. The increase
in net cash flow used in operating activities during 2009 was mainly due to
increases in accounts receivable, other receivable and retentions receivable
despite a significant increase of net income, the significant amount in accounts
receivable was due to the rapid increase in our sales with most of our accounts
receivables aging within one year from the sales recognition date. We’ve
also increased payment for advance to suppliers and inventory for being
readiness for the increased demand of our products.





Net cash
flow used in investing activities was $1,609,944 in 2009, compared to net cash
used in investing activities of $507,110 in 2008.  The increase of net
cash flow used in investing activities in the 2009 was mainly due to purchase of
fixed assets for SmartHeat Siping and increase in restricted cash which was
mainly the deposits from customers for securing payment from customers and the
deposits the Company paid to a commercial bank for the bank issuing the bank
acceptance to its vendors.





Net cash
flow provided by financing activities was $68,775,920 in 2009 as compared to net
cash provided by financing activities of $2,307,620 in 2008.  The
increase of cash inflow was mainly due to net proceeds of $65 million from
issuing new common stock through a public offering completed in September of
2009, proceeds from the bank loans of $4.55 million and repayment to bank loans
of $1.87 million, and cash contribution from noncontrolling interest of $0.71
million.





Our
agreements with our customers generally provide that 30% of the purchase price
is due upon the placement of an order, 30% is due upon delivery and 30% is due
upon installation and acceptance of the equipment after customer testing. As a
common practice in the heating manufacturing business in China, payment of the
final 10% of the purchase price is due no later than the termination date of the
standard warranty period which ranges from 3 to 24 months from the acceptance
date. Our receipts for payment on our products depend on the complexity of the
equipment ordered which impacts manufacturing, delivery, installation and
testing times and warranty periods. For example, PHEs are less complex than PHE
units and therefore have a shorter manufacturing, acceptance, warranty and
payment schedule. We may experience payment delays from time to time with a
range from 1 month to 3 months from the due date; however, we do not believe the
delays have significant negative impact on our liquidity as the payment delays
are very common in heating manufacturing industry in China, and the collection
of payment can be reasonably assured based on our historical collection
experience. Our accounts receivable turnover and inventory turnover are
relatively low, and days sales outstanding ratio relatively high. Consequently,
collection on our sales is rather slow and capital is tied up in inventories
which may result in pressure on cash flows. For 2009, we had accounts receivable
turnover of 3.63 on an annualized basis, with days sales outstanding of 146 and
inventory turnover of 6.16 on annualized basis. For 2008, we had accounts
receivable turnover of 3.58 on an annualized basis, with days sales outstanding
of 134 and inventory turnover of 3.09 on annualized basis. The low accounts
receivable turnover and high days outstanding is due to the seasonality of the
Company’s sales. Approximately 70% of the Company’s revenue is generated in the
third and 4th
quarters. In addition, customers usually do not pay on due dates which is normal
in the heating manufacturing business in China.





We are in
the manufacturing and processing business.  We purchase substantial
amounts of raw materials before the high season starts to meet production
needs.  There is no concern about inventory obsolescence since our
product can be sold for a profit without time limitation as long as there is
continued demand.  Additionally, we have increased our sales force for
developing new customers, which we believe will reduce on-hand inventory levels
and increase inventory turnover going forward.  Therefore, we believe
the potential risks and uncertainties associated with lower inventory turnover
are limited.


34





We
recognize the final 5-10% of the purchase price as a Retention Receivable which
is due no later than the termination of our warranty period.  The
deferral of the final payment is a common practice in the heating manufacturing
business in China.  Sometimes our customers are required to deposit
5%-10% of the sales price on high value products like an assembled heat
exchanger unit or the main part of a plate heat exchanger into designated bank
accounts as restricted cash for securing the payment after such period
expires.  Based on our historical experience, there have been no
defaults on such deferrals.  Therefore, we believe the potential risks
and uncertainty associated with defaults on such receivables are not
material.





Recent
Developments





Under the
terms of the Registration Rights Agreement for a private placement offering in
September of 2008, the Company was required to file a Registration Statement
registering the common stock and common stock underlying the warrants with the
Securities and Exchange Commission (the “SEC”) within 60 days of the closing of
the private placement offering. The Registration Statement must be declared
effective by the SEC within 180 days of the final closing of the offering or the
Company will be subject to penalties as described below. Subject to certain
grace periods, the Registration Statement must remain effective and available
for use until the investors can sell all of the securities covered by the
Registration Statement without restriction pursuant to Rule 144. If the Company
failed to meet the filing or effectiveness requirements of the Registration
Statement, it is required to pay liquidated damages of 2% of the aggregate
purchase price paid by such investor for any Registrable Securities then held by
such investor on the date of such failure and on each anniversary of the date of
such failure until such failure is cured.





Off-Balance
Sheet Arrangements





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





Contractual
Obligations





The
Company was obligated for the following short term loans payable as of December
31, 2009 and 2008:





2009
                          
                          
                          2008From
      a commercial bank in the PRC for 30,000,000 RMB. Of which, 17,000,000 RMB
      was entered into on April 22, 2009 and is due on April 22, 2010.
      13,000,000 RMB was entered into on June 12, 2009 and is due on June 12,
      2010. These loans currently bear interest at 5.576%.  The
      Company pledged its building in the value of approximately RMB 12,430,950
      or approximately $1,818,000 for this loan.
                          
                          $
                          4,393,544
                          
                          
                          $
                          -From
      a commercial bank in the PRC for 6,000,000 RMB. This loan was entered into
      on Apr 28, 2007 and was due on Apr 12, 2008. This loan was renewed on Apr
      12, 2008. The Company repaid loan in April of 2009.
                          
                          
                          -
                          
                          
                          
                          877,886Short
      term loans during 2006 and 2007 with a third party company in the PRC for
      total of 10,300,000 RMB. Some of the loans matured during 2008 and some of
      the loans are payable on demand. These loans bore variable interest at
      8.591% for 2009 and 2008.  The Company repaid RMB 2,600,000 in
      2008, RMB 2,700,000 in April of 2009, and RMB 5,000,000 in December of
      2009.
                          
                          
                          -
                          
                          
                          
                          1,126,621One
      year loan on July 1, 2008 with another third party company in the PRC for
      total of 3,000,000 RMB. This loan was renewed and due December
      31, 2009 with interest of 8.591%.  The Company repaid loan
      in December of 2009.
                          
                          
                          -
                          
                          
                          
                          438,943$
                          4,393,544
                          
                          
                          $
                          2,443,450


35





Item 6A. Quantitative and Qualitative
Disclosures About Market Risk





Not
applicable.




Item 7.    Financial Statements and
Supplementary Data





The
financial statements, together with the report thereon of SmartHeat Inc., appear
in a separate section of this report beginning on page F-1.




Item 8.    Changes in and Disagreements with
Accountants on Accounting and Financial Disclosure





None.





Item 8A(T). Controls and
Procedures.




Evaluation
of Disclosure Controls and Procedures




An
evaluation was conducted under the supervision and with the participation of the
Company’s management, including the Chief Executive Officer (“CEO”), its
principal executive officer, and Chief Financial Officer (“CFO”), its principal
financial officer, of the effectiveness of the design and operation of the
Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and
Rule 15d-15(e) of the Exchange Act) as of December 31, 2009. Based on that
evaluation, the CEO and CFO concluded the Company’s disclosure controls and
procedures were effective as of such date to ensure that information required to
be disclosed in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by the Company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the Company's management, including its principal executive and principal
financial officers, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure.




Management's
Annual Report on Internal Control over Financial Reporting




The
Company's management is responsible for establishing and maintaining adequate
internal control over financial reporting as defined in Rule 13a-15(f) of the
Exchange Act. The Company's internal control over financial reporting is a
process designed by, or under the supervision of, the Company's CEO and CFO, and
effected by the issuer's board of directors, management and other personnel, to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles and includes those policies and
procedures that:




•
              pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of the assets of the
      Company;•
              provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the Company
      are being made only in accordance with authorizations of management and
      directors of the Company;





•
            provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the Company's assets that
      could have a material effect on the financial
  statements.


36





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate. Therefore, internal control
over financial reporting determined to be effective provides only reasonable
assurance regarding the reliability of financial reporting and the preparations
of financial statements for external purposes in accordance with generally
accepted accounting principles.




The
Company carried out an evaluation of the effectiveness as of December 31, 2009,
of the design and operation of its internal control over financial reporting
pursuant to Rule 13a-15 of the Exchange Act, which was conducted under the
supervision and with the participation of the Company's CEO and CFO. This
evaluation was based on the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in the report entitled "Internal
Control—Integrated Framework". Based upon this evaluation, the Company's CEO and
CFO concluded that the Company's internal controls over financial reporting are
effective as of December 31, 2009.




This
Annual Report on Form 10-K does not, nor is required to, include an attestation
report of the Company’s independent registered public accounting firm regarding
internal control over financial reporting. Management’s report was not subject
to attestation by the Company’s independent registered public accounting firm
pursuant to temporary rules of the Securities and Exchange Commission that
permit the Company to provide only management’s report in this annual
report.




Changes
in Internal Control over Financial Reporting




There
were no changes in our internal control over financial reporting (as such term
is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during
the year ended December 31, 2009 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.




Item 8B. Other
Information




Submission
of Matters to a Vote of Security Holders





At the
Company’s 2009 Annual Meeting of Stockholders held on November 18, 2009, the
following actions were taken:





The
following directors were elected to serve until the 2010 Annual Meeting of
Stockholders and until their successors are elected and qualified:





Name
                
                Votes For
                
                
                Votes Withheld
                
                
                Votes AbstainedMr.
      Jun Wang
                
                
                21,455,001
                
                
                
                320,732
                
                
                
                52,957Mr.
      Arnold Staloff
                
                
                21,775,733
                
                
                
                0
                
                
                
                52,957Mr.
      Weiguo Wang
                
                
                21,775,733
                
                
                
                0
                
                
                
                52,957Mr.
      Wenbin Lin
                
                
                18,649,727
                
                
                
                3,126,006
                
                
                
                52,957Mr.
      Xin Li
                
                
                21,775,733
                
                
                
                0
                
                
                
                52,957





Proposal
2 to ratify the selection of Goldman Parks Kurland Mohidin, LLP as the Company’s
independent registered public accounting firm for the 2009 fiscal year was
approved by stockholders with 21,787,605 shares voting in favor of the proposal,
4,740 shares voting against the proposal and 36,345 shares
abstaining.





Stockholder
Proposals





Our 2010
Annual Meeting of Stockholders will be held on May 25, 2010 (China time) at our
corporate offices, A-1 10, Street 7, Shenyang Economic and Technological
Development, Shenyang, China commencing at 10:00 a.m. (China time). Stockholder
proposals must be received by our Corporate Secretary no later than April 13,
2010 (China time) in order to be included in our proxy statement. Our
determination of whether we will oppose inclusion of any proposal in our proxy
statement and proxy will be made on a case-by-case basis in accordance with our
judgment and the rules and regulations promulgated by the SEC. In addition, if a
stockholder wishes to present a proposal at the 2010 Annual Meeting that will
not be included in our proxy statement and the Company is not notified prior to
April 13, 2010 (China time), then the proxies solicited by our management for
the 2010 Annual Meeting will include discretionary authority to vote on the
proposal in the event that it is properly brought before the
meeting.


37





PART III




Item 9. Directors, Executive Officers and
Corporate Governance




Our
executive officers and directors, and their ages, positions and biographical
information, as of March 30, 2010, are as follows:





Name
                  
                  Age
                  
                  PositionJun
      Wang
                  
                  42
                  
                  Chairman
      of the Board of Directors, President & Chief Executive
      OfficerZhijuan
      Guo
                  
                  45
                  
                  Chief
      Financial Officer and TreasurerHuajun
      Ai
                  
                  39
                  
                  Corporate
      SecretaryXudong
      Wang
                  
                  36
                  
                  Vice
      President of Strategy and DevelopmentArnold
      Staloff
                  
                  65
                  
                  DirectorWeiguo
      Wang
                  
                  45
                  
                  DirectorWenbin
      Lin
                  
                  65
                  
                  DirectorXin
      Li
                  
                  38
                  
                  Director


Our
executive officers are elected annually by the board of directors and serve at
the discretion of the board.Our directors hold office
for one-year terms or until their successors have been elected and
qualified.  There are no family relationships between any of our
directors, executive officers or other key personnel and any other of our
directors, executive officers or key personnel.





Biographies




Jun
Wang, Chairman of the Board of Directors, President & CEO





Mr. Wang
was appointed as our Chairman of the Board of Directors, President and Chief
Executive Officer on April 14, 2008. Mr. Wang founded Taiyu and was appointed
Director, CEO and Chairman of Taiyu in 2002. Prior to that, Mr. Wang was the
Assistant General Manager of Beijing HotNet Company, a large PHE components
supplier in China. Mr. Wang gained substantial industry experience during his
tenure as the sales manager at Honeywell China between 1996 and 1999. He started
his professional career in 1994 as a Regional Sales Director at ALFA LAVAL, a
global leader in the PHE industry. Mr. Wang earned a Master's Degree in
Engineering from China's "MIT" - the renowned Tsinghua University. Mr. Wang is
fluent in English.





Zhijuan
Guo, CFO & Treasurer




Ms. Guo
was appointed as our Chief Financial Officer on April 14, 2008. Ms. Guo joined
Taiyu in 2002 as Chief Financial Officer. Prior to that time, she served as the
Production Planning Director of Shenyang Thermoelectric Co. Ltd. She obtained
her MBA in Finance from Shenyang North Eastern University and served as the
finance manager of a local Real Estate Development Firm from 1993 to 1999. From
March 1999 to November 2000, she also served as Auditing Director of Shenyang
Dongyu Group Corp.





Xudong
Wang, Vice President of Strategy and Development





Mr. Wang
joined SmartHeat on February 1, 2010 as our Vice President of Strategy and
Development. Prior to that time, Mr. Wang served as Vice President (Greater
China) for China US Bridge Capital Limited, an international financial firm.
From June 2007 to April 2009, Mr. Wang served as the Chief Financial Officer of
QKL Stores, Inc., a NASDAQ listed supermarket and department store chain in
Northeast China. From April 2006 to May 2007, Mr. Wang served as Chief Financial
Officer of ThyssenKrupp Presta Fawer Ltd., a Chinese subsidiary of a leading
German manufacturing group. From April 2005 to April 2006, Mr. Wang served as
the Financial Controller for Electronics, GmbH in Frankfurt, Germany. Mr. Wang
earned his Master of International Business Administration from the University
of Hamburg and his Bachelor of Accounting & Finance from the Shandong
University of Finance.


38





Huajun
Ai, Corporate Secretary




Ms. Ai
was appointed as our Corporate Secretary on April 14, 2008. Ms. Ai joined Taiyu
in 2002 as Corporate Secretary.  Prior to that time, from December
2000 to October 2002, she served as an accountant at Shenyang Dongyu
International Trade Co., Ltd.  From July 1994 to November 2000, Ms. Ai
served as an accountant at Northeast Jin Cheng Industrial Corp.  Ms.
Ai obtained her Bachelor's degree in Foreign Trade Accounting from Shenyang
North Eastern University in 1994.





Arnold
Staloff, Director





Mr.
Staloff has served as the Chairman of Audit Committee for each of Shiner
International, Inc. since 2007; AgFeed Industries, Inc. since 2007 and Deer
Consumer Products Inc. since 2009. From December 2005 to May 2007, Mr. Staloff
served as Chairman of the Board of SFB Market Systems, Inc., a New Jersey-based
company that provides technology solutions for the management and generation of
options series data. From March 2003 to December 2005, Mr. Staloff was an
independent consultant. From June 1990 to March 2003, Mr. Staloff served as
President and Chief Executive Officer of Bloom Staloff Corporation, an equity
and options market-making firm and foreign currency options floor broker.
Additionally, Mr. Staloff served on the Board of Directors of Lehman Brothers
Derivative Products Inc. from 1998 until 2008 and Lehman Brothers Financial
Products Inc. from 1994 until 2008. Mr. Staloff holds a Bachelor of Business
Administration from the University of Miami. Mr. Staloff has been appointed as
the Chairman of our Audit Committee and serves as a member of our Compensation
Committee and Nominating and Corporate Governance Committee. Mr. Staloff has
been a director of the Company since June 19, 2008.





Weiguo
Wang, Director




Dr. Wang
serves as Assistant Secretary General of the China Standardization Committee on
Boilers and Pressure Vessels, a position he has held since March 2005.
Additionally, Dr. Wang has served as a Director of the China Special Equipment
Inspection and Research Agency since January 2007 and Deputy General Manager of
Boilers Standard (Beijing) Technology Services Center Co., Ltd. since March
2004. From July 2001 to December 2003, Dr. Wang was a teacher at Tianjin
University, China. Mr. Wang holds a Bachelor’s degree in Mechanics, a Master’s
degree in Fluid Mechanics and a PhD in Fluid Mechanics, all from Beijing
University. Dr. Wang has been appointed as the
Chairman of our Compensation Committee and serves as a member of our Audit
Committee and Corporate Governance Committee.  Mr. Wang has been a
director of the Company since June 19, 2008.





Wenbin
Lin, Director




Mr. Lin
is one of the original founders of Taiyu in 2002. From December 2003 to October
2004, Mr. Lin served as Deputy Chairman and General Manager of Shenyang Huanggu
Thermoelectricity Heating Inc. From November 2002 to December 2003, Mr. Lin
served as Chairman and General Manager of Shenyang Heat Power Co. Ltd. From
September 1999 to May 2002, Mr. Lin served as Chairman of Shenyang
Thermoelectric Corp. From January 1991 to August 1999, Mr. Lin held a variety of
positions within the government of Shenyang City in the PRC, including Director
of the Economic Development & Reform Commission from February 1998 to August
1999, Director of Shenyang City’s Economics & Trade Commission from May 1995
to January 1998 and Deputy Director for the Economic Planning Commission from
January 1991 to April 1995. Mr. Lin holds a Bachelor’s degree in Press Machinery
from China's Anshan Steel Technical College. Mr. Lin has been appointed to each
of the Compensation Committee and Nominating and Corporate Governance Committee
of SmartHeat.  Mr. Lin has been a director of the Company since June
19, 2009.


39


Xin
Li, Director





Mr. Li
brings more than a decade of corporate governance and industrial operations
management experience to SmartHeat. He is a renowned management consultant in
China. He is currently the general manager of Beijing ShengGao Consulting Co.,
Ltd., a strategic advisory firm founded by him more than 10 years ago that
focuses on providing strategic guidance and management training to global
companies. He also serves as an independent director and chairs the audit and
various governance committees at several large Chinese domestic companies not
listed in the United States. Mr. Li is a prolific writer in strategies and
management issues. He has authored several books in the areas of management
science and strategic planning. Mr. Li is proficient in Mandarin Chinese and
English. He has a MBA and is a Research Fellow at the Management Science Center
of Beijing University. Mr. Li has been a director if the Company since July 29,
2009.





Legal
Proceedings





During
the past ten years, none of the Company’s directors or executive officers have
been:





·
            the
      subject of any bankruptcy petition filed by or against any business of
      which such person was a general partner or executive officer either at the
      time of the bankruptcy or within two years prior to that
    time;




·
            convicted
      in a criminal proceeding or is subject to a pending criminal proceeding
      (excluding traffic violations and other minor
  offenses);




·
            subject
      to any order, judgment or decree, not subsequently reversed, suspended or
      vacated, of any court of competent jurisdiction, permanently or
      temporarily enjoining, barring, suspending or otherwise limiting his
      involvement in any type of business, securities or banking
      activities;




·
            found
      by a court of competent jurisdiction (in a civil action), the SEC or the
      Commodity Futures Trading Commission to have violated a federal or state
      securities or commodities law, that has not been reversed, suspended, or
      vacated;




·
            subject
      of, or a party to, any order, judgment, decree or finding, not
      subsequently reversed, suspended or vacated, relating to an alleged
      violation of a federal or state securities or commodities law or
      regulation, law or regulation respecting financial institutions or
      insurance companies, law or regulation prohibiting mail or wire fraud or
      fraud in connection with any business entity;
or




·
            subject
      of, or a party to, any sanction or order, not subsequently reversed,
      suspended or vacated, of any self-regulatory organization, any registered
      entity or any equivalent exchange, association, entity or organization
      that has disciplinary authority over its members or persons associated
      with a member.




Corporate
Governance





Board
Leadership Structure and Role in Risk Oversight




Mr. Wang
has served as our Chairman of the Board of Directors, Chief Executive Officer,
and President since April 14, 2008. We continue to believe that our leadership
structure is appropriate because Mr. Wang takes an active role in board
functions and was one of the original founders of Taiyu in 2002, which is now a
wholly-owned subsidiary of the Company. Under Mr. Wang’s leadership, our
management team has executed a strategy that has significantly improved our
earnings growth, cash flow stability, and competitiveness in the domestic
Chinese market. We do not currently have a lead independent
director.





Our board
of directors delegates risk oversight to our Audit Committee, which considers
and addresses risk management issues and concerns.





Audit
Committee





We
established our Audit Committee in June 2008. The Audit Committee consists of
Messrs. Staloff and Li and Dr. Wang, each of whom is an independent director.
Mr. Staloff, Chairman of the Audit Committee, is an “audit committee financial
expert” as defined under Item 407(d) of Regulation S-K. The purpose of the Audit
Committee is to represent and assist our board of directors in its general
oversight of our accounting and financial reporting processes, audits of the
financial statements and internal control and audit functions.


40





As more
fully described in its charter, the functions of the Audit Committee include the
following:




·
            appointment
      of independent auditors, determination of their compensation and oversight
      of their work;





·
            review
      the arrangements for and scope of the audit by independent
      auditors;





·
            review
      the independence of the independent
auditors;





·
            consider
      the adequacy and effectiveness of the internal controls over financial
      reporting;





·
            pre-approve
      audit and non-audit services;





·
            establish
      procedures regarding complaints relating to accounting, internal
      accounting controls, or auditing
matters;





·
            review
      and approve any related party
transactions;





·
            discuss
      with management our major financial risk exposures and our risk assessment
      and risk management policies; and





·
            discuss
      with management and the independent auditors our draft quarterly interim
      and annual financial statements and key accounting and reporting
      matters.





The board
of directors has adopted a written charter for the Audit Committee. A copy of
the Audit Committee Charter is posted on our website atwww.smartheatinc.com.




Compensation
Committee




We
established our Compensation Committee in June 2008. The Compensation Committee
consists of Messrs. Staloff and Li and Dr. Wang, each of whom is an independent
director, and Mr. Lin. Dr. Wang is the Chairman of the Compensation Committee.
The Compensation Committee is responsible for the design, review, recommendation
and approval of compensation arrangements for our directors, executive officers
and key employees, and for the administration of our equity incentive plans,
including the approval of grants under such plans to our employees, consultants
and directors. The Compensation Committee also reviews and determines
compensation of our executive officers, including our Chief Executive Officer.
The board of directors has adopted a written charter for the Compensation
Committee. A current copy of the Compensation Committee Charter is posted on our
website atwww.smartheatinc.com.





Nominating
and Corporate Governance Committee




We
established our Nominating and Corporate Governance Committee in June 2008. The
Nominating and Corporate Governance Committee consists of Messrs. Staloff and Li
and Dr. Wang, each of whom is an independent director, and Mr.
Lin.  Mr. Li is the Chairman of the Nominating and Corporate
Governance Committee. The Nominating and Corporate Governance Committee assists
in the selection of director nominees, approves director nominations to be
presented for shareholder approval at our annual general meeting and fills any
vacancies on our board of directors, considers any nominations of director
candidates validly made by shareholders, and reviews and considers developments
in corporate governance practices. The board of directors has adopted a written
charter for the Nominating and Corporate Governance Committee. A current copy of
the Nominating and Corporate Governance Committee Charter is posted on our
website atwww.smartheatinc.com.


41





Procedures
for Shareholder Recommendations of Nominees to the Boards of
Directors





During
the year ended 2009, there were no material changes to the procedures described
in Company’s Proxy Statement relating to the 2009 Annual Meetings of
Stockholders by which security holders may recommend nominees to the Company’s
Boards of Directors.





Code
of Ethics




Our board
of directors has adopted a Code of Conduct, which applies to all directors,
officers and employees, including our principal executive officer, our principal
financial and accounting officer, and all members of our finance department
performing similar functions. The purpose of the Code of Conduct is to promote
honest and ethical conduct. The full text of the Code of Conduct is posted on
our website located atwww.smartheatinc.com,
and is available in print, without charge, upon written request to SmartHeat at
A-1, 10, Street 7, Shenyang Economic and Technological Development Zone,
Shenyang, China 110027, Att. Corporate Secretary. We intend to post promptly any
amendments to or waivers of the Code on our website.





Section 16(a)
Beneficial Ownership Reporting Compliance





Section
16(a) of the Exchange Act requires our executive officers and directors and
persons who own more than 10% of our common stock to file reports regarding
ownership of, and transactions in, our securities with the Commission and to
provide us with copies of those filings. Based solely on our review of the
copies received by us and on the written representations of certain reporting
persons, we believe that during fiscal year ended December 31, 2009, the
following reporting persons have failed to file such reports on a timely
basis:





Name and principal position
                      
                      Number of
                        late reports
                      
                      
                      Transactions not
                        timely reported
                      
                      
                      Known failures to
                        file a required formXin
      Li, Director
                      
                      1
                      
                      
                      0
                      
                      
                      0





Item 10.  Executive
Compensation





As a
“Smaller Reporting Company,” we have elected to follow scaled disclosure
requirements for smaller reporting companies with respect to the disclosure
required by Item 402 of Regulation S-K. Under the scaled disclosure obligations,
the Company is not required to provide a Compensation Discussion and Analysis,
Compensation Committee Report and certain other tabular and narrative
disclosures relating to executive compensation.




The
following table sets forth information concerning the compensation for the years
ended December 31, 2009, 2008 and 2007 of certain of our executive officers. A
discussion of each of the principal elements comprising this executive
compensation follows this table.




Summary Compensation Table – 2009Fiscal
                                  
                                  Salary
                                  
                                  
                                  Bonus
                                  
                                  
                                  Stock
                                    Awards
                                  
                                  
                                  Option
                                    Awards
                                  
                                  
                                  TotalName and principal position
                                  
                                  Year
                                  
                                  ($)
                                  
                                  
                                  ($)
                                  
                                  
                                  ($)
                                  
                                  
                                  ($)
                                  
                                  
                                  ($)Jun
      Wang
                                  
                                  2007
                                  
                                  
                                  18,000
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  18,000President
      and Chief Executive Officer
                                  
                                  2008
                                  
                                  
                                  18,000
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  18,0002009
                                  
                                  
                                  18,000
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  18,000Zhijuan
      Guo
                                  
                                  2007
                                  
                                  
                                  10,684
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  10,684Chief
      Financial Officer
                                  
                                  2008
                                  
                                  
                                  10,684
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  10,6842009
                                  
                                  
                                  18,000
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  18,000


42


Narrative
Disclosure to Summary Compensation Table.





Employment
Agreements





On
January 1, 2008, Taiyu entered into a three-year employment agreement with Mr.
Jun Wang, which agreement may be renewed at the end of the initial term upon
mutual agreement between Mr. Jun Wang and Taiyu.  Either party shall
give written notice to the other party of its intention not to renew the
agreement at least 30 days prior to the end of the initial
term.  Pursuant to the terms of the employment agreement, Mr. Jun Wang
shall receive a salary in an amount that is not less than the lowest minimum
wage per month paid in Shenyang and shall be based on the uniform wage and
incentive system in Shenyang. In addition, Mr. Jun Wang shall be entitled to
overtime pay in accordance with the applicable law.




On
January 1, 2008, Taiyu entered into a three year employment agreement with Ms.
Zhijuan Guo, at terms identical to the terms of the employment agreement with
Mr. Jun Wang.





Change-In-Control
Agreements





We do not
have any existing arrangements providing for payments or benefits in connection
with the resignation, severance, retirement or other termination of any of our
named executive officers, changes in their compensation or a change in
control.





Stock
Incentive Plans




We had no
stock incentive plan during 2008 or 2009.





Outstanding
Equity Awards at Fiscal Year-End




As of
December 31, 2009, there were no outstanding equity awards held by executive
officers of our company.





Compensation
of Directors





Director Compensation Table – 2009Fees Earned or
                  Paid in Cash
                
                
                Stock
                  Awards
                
                
                Option
                  Awards
                
                
                TotalName and principal position
                
                ($)
                
                
                ($)
                
                
                ($)
                
                
                ($)Jun
      Wang, Chairman
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Wenbin
      Lin
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Frederic
      Rittereiser (1)
                
                
                20,000
                
                
                
                —
                
                
                
                —
                
                
                
                20,000Arnold
      Staloff (2)
                
                
                50,000
                
                
                
                —
                
                
                
                —
                
                
                
                50,000Weiguo
      Wang
                
                
                12,000
                
                
                
                —
                
                
                
                —
                
                
                
                12,000Xin
      Li
                
                
                17,500
                
                
                
                —
                
                
                
                —
                
                
                
                17,500




(1) On
July 17, 2008, Mr. Rittereiser was awarded options to purchase 10,000 shares of
our common stock, expiring on July 17, 2013, at an exercise price of
$4.60 per share, with a three-year vesting schedule. As Mr. Rittereiser
voluntarily retired as director of the Company on July 31, 2009, he forfeited
his unvested options. As of December 31, 2009, Mr. Rittereiser holds 3,333
options to purchase the Company’s common stock.  Mr. Ritteresier was
not awarded any options in 2009.





(2) On
July 17, 2008, Mr. Staloff was awarded options to purchase 10,000 shares of our
common stock, expiring on July 17, 2013, at an exercise price of $4.60
per share, with a three-year vesting schedule. As of December 31, 2009, Mr.
Staloff  holds 3,333 options to purchase the Company’s common stock.
The remaining 6,667 options will vest equally on each of the second and third
anniversaries of the grant date. Mr. Staloff was not awarded any options in
2009.


43


Narrative
Disclosure to Director Compensation Table.





On June
19, 2008, Messrs. Rittereiser and Staloff and Dr. Wang joined the board of
directors as independent directors, satisfying the definition of “independence”
as defined in Rule 5605 of the NASDAQ Listing Rules. Additionally, Mr. Lin
joined the board of directors on June 19, 2008. Mr. Lin is not an "independent"
director. Mr. Li was appointed as a member of the board of directors on July 29,
2009. Mr. Li is an “independent” director. Mr. Rittereiser voluntarily retired
as a director of the Company on July 31, 2009.   We agreed to pay
the following annual compensation to our independent directors. Mr. Staloff is
entitled to receive $50,000 in cash per year, paid in equal quarterly
installments. This fee includes $10,000 for serving as Chairman of the Audit
Committee.  Mr. Rittereiser was entitled to receive $40,000 in cash per
year, paid in equal quarterly installments. Dr. Wang and Mr. Li are each
entitled to receive $12,000 in cash per year, paid in equal quarterly
installments. In addition, on July 17, 2008, each of Messrs. Staloff and
Rittereiser were awarded options to purchase 10,000 shares of our common stock,
expiring on July 17, 2013, at an exercise price of $4.60 per share,
with a three-year vesting schedule. Mr. Rittereiser forfeited his unvested
options upon his voluntary retirement as a director of the Company on July 31,
2009.





We have
not compensated, and will not compensate, our non-independent directors, such as
Messrs. Wang and  Lin, for serving as our directors, although they are
entitled to reimbursements for reasonable expenses incurred in connection with
attending our board meetings.





The
directors may determine remuneration to be paid to the directors with interested
members of the board refraining from voting. The Compensation Committee will
assist the directors in reviewing and approving the compensation structure for
the directors.





We do not maintain a
medical, dental or retirement benefits plan for the directors.





Impact
of Accounting and Tax Treatment of Compensation




Section 162(m)
of the Internal Revenue Code disallows a tax deduction to publicly held
companies for compensation paid to the principal executive officer and to each
of the three other most highly compensated officers (other than the principal
financial officer) to the extent that such compensation exceeds
$1.0 million per covered officer in any fiscal year. The limitation applies
only to compensation that is not considered to be performance-based.
Non-performance-based compensation paid to our executive officers during fiscal
2008 did not exceed the $1.0 million limit per officer, and we do not
expect the non-performance-based compensation to be paid to our executive
officers during fiscal 2010 to exceed that limit. Because it is unlikely that
the cash compensation payable to any of our executive officers in the
foreseeable future will approach the $1.0 million limit, we do not expect
to take any action to limit or restructure the elements of cash compensation
payable to our executive officers so as to qualify that compensation as
performance-based compensation under Section 162(m). We will reconsider
this decision should the individual cash compensation of any executive officer
ever approach the $1.0 million level.




Item 11.   Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters




The
following table provides information concerning beneficial ownership of our
common stock as of December 31, 2009, by (i) each person that we know
beneficially owns more than 5% of our outstanding common stock, (ii) each of our
named executive officers, (iii) each of our directors and (iv) all of our named
executive officers and directors as a group.





The
amounts and percentages of common stock beneficially owned are reported on the
basis of regulations of the SEC governing the determination of beneficial
ownership of securities. Under the rules of the SEC, a person is deemed to be a
“beneficial owner” of a security if that person has or shares “voting power,”
which includes the power to vote or to direct the voting of such security, or
“investment power,” which includes the power to dispose of or to direct the
disposition of such security. A person is also deemed to be a beneficial owner
of any securities of which that person has the right to acquire beneficial
ownership within 60 days of December 31, 2009. Under these rules, more than one
person may be deemed a beneficial owner of the same securities and a person may
be deemed to be a beneficial owner of securities as to which such person has no
economic interest. As of December 31, 2009, there were 32,794,875 shares of
our common stock issued and outstanding.


44





Unless
otherwise indicated, each of the shareholders named in the table below, or his
or her family members, has sole voting and investment power with respect to such
shares of common stock.  Except as otherwise indicated, the address of
each of the shareholders listed below is: c/o SmartHeat Inc., A-1, 10, Street 7,
Shenyang Economic and Technological Development Zone, Shenyang, China
110027.




Name of Beneficial Owner
                          
                          Number of
                            Shares
                            Beneficially
                            Owned
                          
                          
                          Percentage
                            Beneficially
                            Owned5%
      Shareholders:Beijing
      YSKN Machinery & Electronic Equipment Co., Ltd (1)
                            Rm
      1106, Huapu International Plaza No.19,
                            Chaowai
      Street, Chaoyang District
                            Beijing,
      China
                          
                          
                          6,808,000
                          
                          
                          
                          20.76
                          %Yang
      In Cheol (2)
                            #630-5,
      Namchon-Dong
                            Namdong-Yu
                            Incheon,
      South Korea 302-405
                          
                          
                          3,848,000
                          
                          
                          
                          11.73
                          %ShenYang
      ZhiCe Investment Co., Ltd (3)
                            No.
      1 Yuebin Street
                            Shenhe
      District
                            Shenyang,
      China 110027
                          
                          
                          2,960,000
                          
                          
                          
                          9.03
                          %FMR
      LLC (4)
                            82
      Devonshire Street
                            Boston,
      MA 02109
                          
                          
                          4,003,489
                          
                          
                          
                          12.21
                          %Directors
      and Named Executive OfficersJun
      Wang, Chairman of the Board, President and CEO (1)
                          
                          
                          3,404,000
                          
                          
                          
                          10.38
                          %Zhijuan
      Guo, CFO
                          
                          
                          0
                          
                          
                          
                          —Arnold
      Staloff, Director
                          
                          
                          15,033
                          (5)
                          
                          
                          *Weiguo
      Wang, Director
                          
                          
                          0
                          
                          
                          
                          —Wenbin
      Lin, Director
                          
                          
                          473,600
                          (6)
                          
                          
                          1.44
                          %Xin
      Li, Director
                          
                          
                          0
                          
                          
                          
                          —All
      Directors and named Executive Officers as a group
      (6 persons)
                          
                          
                          3,892,633
                          
                          
                          
                          11.87
                          %





*
            Less
      than 1% of shares outstanding.





(1)           The
information for YSKN and Mr. Jun Wang is derived from Amendment No. 1 to
Schedule 13D, dated June 30, 2008, which was filed with the SEC to report
the shares beneficially owned by such persons as of May 7, 2008. The
Schedule 13D states that YSKN has sole power to vote and dispose of
6,808,000 shares owned by YSKN and that Messrs. Jun Wang and Fang Li each
hold 50% of the equitable and legal rights, title and interests in and to the
share capital of YSKN and, as a result of such ownership each of Messrs. Wang
and Li has shared power to vote and dispose of the shares owned directly by
YSKN.


45





(2)          The
information for Yang In Cheol is derived from a Schedule 13G, dated April
25, 2008, which was filed with the SEC to report the shares beneficially owned
by him as of April 14, 2008. The Schedule 13G states that Yang In Cheol has
sole power to vote and dispose of 3,848,000 shares owned by
him.





(3)          The
information for ShenYang ZhiCe Investment Co., Ltd is derived from a
Schedule 13G, dated April 25, 2008, which was filed with the SEC to report
the shares beneficially owned by it as of April 14, 2008. The Schedule 13G
states that ShenYang ZhiCe Investment Co., Ltd has sole power to vote and
dispose of 2,960,000 shares owned by it.  ShenYang ZhiCe
Investment Co. is owned by Ms. Huiqin Wang, Ms. Dongmei Li and Mr. Zhaohui Lin,
with each of them having a voice in the voting and disposition of the shares
held by ShenYang ZhiCe Investment Co.  Ms. Li and Mr. Lin are adult
children of Wenbin Lin, a director of SmartHeat.  Neither Mr. Wenbin
Lin nor SmartHeat have any interest in, or other relationship with, ShenYang
ZhiCe Investment Co., Ltd.





(4)          The
information for FMR LLC is derived from Amendment No. 1 to Schedule 13G, dated
February 16, 2010, which was filed with the SEC to report the shares
beneficially owned by it as of December 31, 2009. The Schedule 13G states that
FMR LLC, an investment advisor, has sole power to dispose or to direct the
disposition of 4,003,408 shares owned by it.





(5)           Includes
options to purchase 3,333 shares of common stock that are presently exercisable,
warrants to purchase 1,500 shares of common stock that are presently exercisable
and 100 shares beneficially owned by Mr. Staloff’s spouse.





(6)        
  Includes 473,600 shares beneficially owned by Mr. Lin's spouse
through her ownership of 16% equity interest in ShenYang ZhiCe Investment Co.,
Ltd., which holds an aggregate of 2,960,000 shares of common stock of SmartHeat.
Mr. Lin disclaims beneficial ownership of these shares.




We are
not aware of any arrangements that could result in a change in control of the
Company.





The
disclosure of securities authorized for issuance under equity compensation plans
required by Item 201(d) of Regulation S-K is set forth in Item 4
herein.





Item 12.              Certain
Relationships and Related Transactions and Director
Independence





Certain
Relationships and Related Transactions





There
were no transactions with any related persons (as that term is defined in Item
404 in Regulation S-K) during the fiscal year ended 2009, or any currently
proposed transaction, in which we were or are to be a participant and the amount
involved was in excess of $120,000 and in which any related person had a direct
or indirect material interest.





We have
adopted a written policy in connection with related party transactions involving
our company. The policy requires the prior approval by our Audit Committee for
any transaction, arrangement or relationship in which (i) the aggregate amount
involved will or may be expected to reach $50,000 in any calendar year, (ii) we
are a participant and (iii) any related person has or will have an interest.
Related persons include our executive officers, directors, greater than 5%
stockholders or immediate family members of any of the foregoing. Pursuant to
the policy, the Audit Committee, among other factors, is required to take into
account whether the transaction is on terms no less favorable than terms
generally available to an unaffiliated third party under the same or similar
circumstances. In addition, the Chairman of the Audit Committee has the
authority to approve or ratify any interested transaction with a related person
in which the aggregate amount involved is expected to be less than
$25,000.


46


Director
Independence





Subject
to certain exceptions, under the listing standards of NASDAQ, a listed company’s
board of directors must consist of a majority of independent directors.
Currently, our board of directors has determined that each of Messrs. Arnold
Staloff, Xin Li and Weiguo Wang is an “independent” director as defined by the
listing standards of NASDAQ currently in effect and approved by the SEC and all
applicable rules and regulations of the SEC. We have established the following
standing committees of the board: Audit, Compensation and Nominating and
Corporate Governance. All members of the Audit Committee and a majority of the
members of the Compensation and Nominating and Corporate Governance Committees
satisfy the “independence” standards applicable to members of each such
committee. The board of directors made this affirmative determination regarding
these directors’ independence based on discussion with the directors and on its
review of the directors’ responses to a standard questionnaire regarding
employment and compensation history; affiliations, family and other
relationships; and transactions with the Company. The board of directors
considered relationships and transactions between each director or any member of
his immediate family and the Company and its subsidiaries and affiliates. The
purpose of the board of director’s review with respect to each director was to
determine whether any such relationships or transactions were inconsistent with
a determination that the director is independent under the NASDAQ rules. Mr.
Wenbin Lin is not deemed an independent director within the meaning of
applicable NASDAQ and SEC rules; however, the Board of Directors has determined
that, in light of the relative newness of SmartHeat as a public company and the
unique circumstances relating to conducting our operations in China, it is
advisable and in the best interests of SmartHeat and its shareholders that Mr.
Lin be appointed to each of the Compensation Committee and Nominating and
Corporate Governance Committee of SmartHeat.





Item 13.             Principal
Accountant Fees and Services




The firm
of Goldman Parks Kurland Mohidin LLP (“GPKM”) has been selected by the audit
committee of our board as the independent registered certified public accounting
firm to audit the books and accounts of our company and its subsidiaries for the
fiscal year ending December 31, 2009. This firm has served as independent public
accountants for our company since April 14, 2008.  Prior to April 14,
2008, we engaged Dale Matheson Carr Hilton Labonte LLP ("DMCHL") as our
independent accountants.





Audit
Fees





The
aggregate fees billed for each of the last two fiscal years for professional
services rendered by the principal accountant for our audit of annual financial
statements and review of financial statements included in our Quarterly Reports
on Form 10-Q or services that are normally provided by the accountant in
connection with statutory and regulatory filings or engagements for those fiscal
years were:





Year
                
                Fees
                
                Name2009
                
                $
                145,000
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                133,000
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                2,000
                
                Dale
      Matheson Carr Hilton Labonte
LLP




Audit-Related
Fees





The
aggregate fees billed in each of the last two fiscal years for assurance and
related services by the principal accountants that are reasonably related to the
performance of the audit or review of our financial statements and are not
reported in the preceding paragraph were:





Year
                
                Fees
                
                Name2009
                
                $
                0
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                0
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                0
                
                Dale
      Matheson Carr Hilton Labonte,
LLP





Tax
Fees





The
aggregate fees billed in each of the last two fiscal years for professional
services rendered by the principal accountants for tax compliance, tax advice
and tax planning were:





Year
                
                Fees
                
                Name2009
                
                $
                0
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                0
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                0
                
                Dale
      Matheson Carr Hilton Labonte,
LLP


47





All
Other Fees





The
aggregate fees billed in each of the last two fiscal years for products and
services provided by the principal accountants, other than the services reported
in the preceding paragraphs of this Item 13 were:





Year
                
                Fees
                
                Name2009
                
                $
                0
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                0
                
                Goldman
      Parks Kurland Mohidin, LLP2008
                
                $
                0
                
                Dale
      Matheson Carr Hilton Labonte,
LLP





Audit Committee’s
Pre-Approval Policy





The Audit
Committee pre-approves all audit and permissible non-audit services provided by
the independent auditors. These services may include audit services,
audit-related services, tax services and other services. The Audit Committee has
adopted a policy for the pre-approval of services provided by the independent
auditors. Under this policy, pre-approval is generally provided for up to one
year and any pre-approval is detailed as to the particular service or category
of services and is subject to a specific budget. In addition, the Audit
Committee may also pre-approve particular services on a case-by-case basis. For
each proposed service, the independent auditor is required to provide detailed
back-up documentation at the time of approval. The Audit Committee may delegate
pre-approval authority to one or more of its members. Such a member must report
any decisions to the Audit Committee at the next scheduled meeting.





PART IV




Item
      14.
            Exhibits
      and Financial Statement Schedules




Financial
Statements




See Index
to Consolidated Financial Statements on page F-1 of this
Form 10-K.





Financial
Statement Schedules:




Not
applicable.




Exhibits




48


SMARTHEAT
INC.




Consolidated
Financial Statements


For
the Years Ended December 31, 2009 and 2008




Page
                NumberReport
      of Independent Registered Public Accounting Firm
              F-2Financial
      StatementsConsolidated
      Balance Sheets as of December 31, 2009 and 2008
              F-3Consolidated
      Statements of Income and Other Comprehensive Income
                for
      the years ended December 31, 2009 and 2008
              F-4Consolidated
      Statement of Stockholders’ Equity
                for
      the years ended December 31, 2009 and 2008
              F-5Consolidated
      Statements of Cash Flows
                for
      the years ended December 31, 2009 and 2008
              F-6Notes
      to Consolidated Financial Statements
              F-7


F-1


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
shareholders of SmartHeat, Inc and Subsidiaries


fka
(Shenyang Taiyu Machinery & Electronic Equipment Co., Ltd.)





We have
audited the consolidated balance sheets of SmartHeat, Inc, fka (Shenyang Taiyu
Machinery & Electronic Equipment Co., Ltd.) and Subsidiaries (the “Company”)
as of December 31, 2009 and 2008 and the related consolidated statements of
income and other comprehensive income,  shareholders’ equity and cash
flows for each of the two years ended on December 31, 2009 and
2008.  These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation.  We
believe that our audits provide a reasonable basis for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of the Company as of
December 31, 2009 and 2008, and the consolidated results of its operations and
its cash flows for the years ended December 31, 2009 and 2008 in conformity with
U.S. generally accepted accounting principles.





Goldman
Parks Kurland Mohidin LLP


Encino,
California


March 29,
2010


F-2




SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


AS
OF DECEMBER 31, 2009 AND 2008




2009
                        
                        
                        2008ASSETSCURRENT
      ASSETSCash
      & cash equivalents
                        
                        $
                        48,967,992
                        
                        
                        $
                        1,435,212Restricted
      cash
                        
                        
                        1,301,573
                        
                        
                        
                        462,048Accounts
      receivable, net
                        
                        
                        31,887,785
                        
                        
                        
                        11,390,169Retentions
      receivable
                        
                        
                        885,642
                        
                        
                        
                        290,852Advances
      to suppliers
                        
                        
                        7,657,791
                        
                        
                        
                        412,524Other
      receivables, prepayments and deposits
                        
                        
                        3,572,600
                        
                        
                        
                        698,834Inventories
                        
                        
                        11,259,273
                        
                        
                        
                        6,107,583Notes
      receivable - bank acceptances
                        
                        
                        397,248
                        
                        
                        
                        14,631Total
      current assets
                        
                        
                        105,929,904
                        
                        
                        
                        20,811,853NON-CURRENT
      ASSETSRestricted
      cash
                        
                        
                        48,361
                        
                        
                        
                        219,472Accounts
      receivable, net
                        
                        
                        237,384
                        
                        
                        
                        310,810Retentions
      receivable
                        
                        
                        349,931
                        
                        
                        
                        166,912Intangible
      assets, net
                        
                        
                        4,071,021
                        
                        
                        
                        1,155,131Property
      and equipment, net
                        
                        
                        7,739,609
                        
                        
                        
                        2,436,553Total
      noncurrent assets
                        
                        
                        12,446,306
                        
                        
                        
                        4,288,878TOTAL
      ASSETS
                        
                        $
                        118,376,210
                        
                        
                        $
                        25,100,731LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIESAccounts
      payable
                        
                        $
                        3,493,196
                        
                        
                        $
                        1,210,906Unearned
      revenue
                        
                        
                        2,130,637
                        
                        
                        
                        850,408Taxes
      payable
                        
                        
                        2,140,627
                        
                        
                        
                        1,327,775Accrued
      liabilities and other payables
                        
                        
                        3,685,272
                        
                        
                        
                        1,330,812Due
      to minority shareholder
                        
                        
                        -
                        
                        
                        
                        5,303Notes
      payable - bank acceptances
                        
                        
                        1,806,564
                        
                        
                        
                        -Loans
      payable
                        
                        
                        4,393,544
                        
                        
                        
                        2,443,450Total
      current liabilities
                        
                        
                        17,649,840
                        
                        
                        
                        7,168,654DEFERRED
      TAX LIABILITY
                        
                        
                        8,526
                        
                        
                        
                        38,854COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITYCommon
      stock, $0.001 par value; 75,000,000 shares authorized, 32,794,875 and
      24,179,900 shares issued and outstanding at December 31, 2009 and 2008,
      respectively
                        
                        
                        32,795
                        
                        
                        
                        24,180Paid
      in capital
                        
                        
                        74,917,370
                        
                        
                        
                        8,223,453Statutory
      reserve
                        
                        
                        2,872,006
                        
                        
                        
                        1,150,542Accumulated
      other comprehensive income
                        
                        
                        969,988
                        
                        
                        
                        984,629Retained
      earnings
                        
                        
                        21,231,484
                        
                        
                        
                        7,510,419Total
      Company stockholders' equity
                        
                        
                        100,023,643
                        
                        
                        
                        17,893,223NONCONTROLLING
      INTEREST
                        
                        
                        694,201
                        
                        
                        
                        -TOTAL
      EQUITY
                        
                        
                        100,717,844
                        
                        
                        
                        17,893,223TOTAL
      LIABILITIES AND EQUITY
                        
                        $
                        118,376,210
                        
                        
                        $
                        25,100,731




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


F-3


SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




YEARS ENDED DECEMBER 31,2009
                
                
                2008Net
      sales
                
                $
                82,563,869
                
                
                $
                32,676,082Cost
      of goods sold
                
                
                53,467,805
                
                
                
                21,717,735Gross
      profit
                
                
                29,096,064
                
                
                
                10,958,347Operating
      expensesSelling
      expenses
                
                
                3,934,749
                
                
                
                1,564,977General
      and administrative expenses
                
                
                6,986,116
                
                
                
                1,851,693Total
      operating expenses
                
                
                10,920,865
                
                
                
                3,416,670Income
      from operations
                
                
                18,175,199
                
                
                
                7,541,677Non-operating
      income (expenses)Interest
      income
                
                
                409,221
                
                
                
                405,266Interest
      expense
                
                
                (518,382
                )
                
                
                (314,192
                )Financial
      expense
                
                
                (30,304
                )
                
                
                -Other
      income
                
                
                116,795
                
                
                
                11,738Other
      expenses
                
                
                (2,838
                )
                
                
                (13,709
                )Exchange
      loss
                
                
                (26,255
                )
                
                
                (12,044
                )Subsidy
      income
                
                
                165,598
                
                
                
                16,230Total
      non-operating income, net
                
                
                113,835
                
                
                
                93,289Income
      before income tax
                
                
                18,289,034
                
                
                
                7,634,966Income
      tax expense
                
                
                2,858,186
                
                
                
                1,293,660Income
      from operations
                
                
                15,430,848
                
                
                
                6,341,306Less:
      Income (loss) attributable to noncontrolling interest
                
                
                (11,681
                )
                
                
                5,966Net
      income to SmartHeat Inc
                
                
                15,442,529
                
                
                
                6,335,340Other
      comprehensive itemForeign
      currency translation
                
                
                (14,641
                )
                
                
                510,770Comprehensive
      Income
                
                $
                15,427,888
                
                
                $
                6,846,110Basic
      weighted average shares outstanding
                
                
                26,535,502
                
                
                
                22,176,322Diluted
      weighted average shares outstanding
                
                
                26,592,066
                
                
                
                22,176,432Basic
      earnings per share
                
                $
                0.58
                
                
                $
                0.29Diluted
      earnings per share
                
                $
                0.58
                
                
                $
                0.29




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


F-4




SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENT OF STOCKHOLDERS' EQUITY


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




Common stock
                  
                  
                  
                  
                  
                  
                  
                  
                  Other comprehensiveShares
                  
                  
                  Amount
                  
                  
                  Paid in capital
                  
                  
                  Statutory reserves
                  
                  
                  income
                  
                  
                  Retained earnings
                  
                  
                  TotalBalance
      at January 1, 2008
                  
                  
                  18,500,000
                  
                  
                  $
                  18,500
                  
                  
                  $
                  3,102,132
                  
                  
                  $
                  506,532
                  
                  
                  $
                  473,859
                  
                  
                  $
                  1,819,089
                  
                  
                  $
                  5,920,112Recapitalization
      on reverse acquisition
                  
                  
                  4,049,900
                  
                  
                  
                  4,050
                  
                  
                  
                  -4,050
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Shares
      issued
                  
                  
                  1,630,000
                  
                  
                  
                  1,630
                  
                  
                  
                  5,119,758
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  5,121,388Net
      income for the year
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  6,335,340
                  
                  
                  
                  6,335,340Stock
      compensation expense related to stock options
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  5,613
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  5,613Transfer
      to statutory  reserves
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  644,010
                  
                  
                  
                  -
                  
                  
                  
                  -644,010
                  
                  
                  
                  -Foreign
      currency translation gain
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  510,770
                  
                  
                  
                  -
                  
                  
                  
                  510,770Balance
      at December 31, 2008
                  
                  
                  24,179,900
                  
                  
                  
                  24,180
                  
                  
                  
                  8,223,453
                  
                  
                  
                  1,150,542
                  
                  
                  
                  984,629
                  
                  
                  
                  7,510,419
                  
                  
                  
                  17,893,223Shares
      issued
                  
                  
                  8,333,000
                  
                  
                  
                  8,333
                  
                  
                  
                  64,999,057
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  65,007,390Warrants
      exercised
                  
                  
                  281,975
                  
                  
                  
                  282
                  
                  
                  
                  1,691,568
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  0
                  
                  
                  
                  1,691,850Net
      income for the year
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  15,442,529
                  
                  
                  
                  15,442,529Stock
      compensation expense related to stock options
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  3,292
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  3,292Transfer
      to statutory  reserves
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,721,464
                  
                  
                  
                  -
                  
                  
                  
                  -1,721,464
                  
                  
                  
                  -Foreign
      currency translation gain
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -14,641
                  
                  
                  
                  -
                  
                  
                  
                  -14,641Balance
      at December 31, 2009
                  
                  
                  32,794,875
                  
                  
                  $
                  32,795
                  
                  
                  $
                  74,917,370
                  
                  
                  $
                  2,872,006
                  
                  
                  $
                  969,988
                  
                  
                  $
                  21,231,484
                  
                  
                  $
                  100,023,643





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


F-5




SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008




YEARS
      ENDED DECEMBER 31,2009
                
                
                2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Income
      including noncontrolling interest
                
                $
                15,430,848
                
                
                $
                6,341,306Adjustments
      to reconcile income including noncontrolling interest to net cash used in
      operating activities:Depreciation
      and amortization
                
                
                635,368
                
                
                
                252,598Unearned
      interest on accounts receivable
                
                
                120,522
                
                
                
                (127,819
                )Stock
      option compensation expense
                
                
                3,292
                
                
                
                5,613Changes
      in deferred tax liability
                
                
                (30,353
                )
                
                
                (163
                )(Increase)
      decrease in current assets:Accounts
      receivable
                
                
                (20,724,401
                )
                
                
                (4,943,868
                )Retentions
      receivable
                
                
                (777,062
                )
                
                
                (74,797
                )Advances
      to suppliers
                
                
                (7,233,127
                )
                
                
                62,759Other
      receivables, prepayments and deposits
                
                
                (2,230,595
                )
                
                
                182,577Inventory
                
                
                (5,143,857
                )
                
                
                2,405,678Increase
      (decrease) in current liabilities:Accounts
      payable
                
                
                4,051,684
                
                
                
                (2,389,649
                )Unearned
      revenue
                
                
                1,278,907
                
                
                
                (2,993,636
                )Taxes
      payable
                
                
                811,275
                
                
                
                779,408Accrued
      liabilities and other payables
                
                
                (5,776,850
                )
                
                
                (261,040
                )Net
      cash used in operating activities
                
                
                (19,584,349
                )
                
                
                (761,033
                )CASH
      FLOWS FROM INVESTING ACTIVITIES:Increase
      in restricted cash
                
                
                (667,502
                )
                
                
                (108,040
                )Cash
      purchased at acquisition
                
                
                -
                
                
                
                55,426Acquisition
      of property & equipment
                
                
                (942,442
                )
                
                
                (439,861
                )Notes
      receivable
                
                
                -
                
                
                
                (14,635
                )Net
      cash used in investing activities
                
                
                (1,609,944
                )
                
                
                (507,110
                )CASH
      FLOWS FROM FINANCING ACTIVITIES:Cash
      contribution from noncontrolling interest
                
                
                705,882
                
                
                
                -Change
      in due to minority shareholders
                
                
                -
                
                
                
                (663
                )Repayment
      to shareholder
                
                
                -
                
                
                
                (343,913
                )Proceeds
      from short term loans
                
                
                4,552,774
                
                
                
                5,136,069Repayment
      on short term loans
                
                
                (1,870,976
                )
                
                
                (7,583,873
                )Warrants
      exercised
                
                
                380,850
                
                
                
                -Shares
      issued
                
                
                65,007,390
                
                
                
                5,100,000Net
      cash provided by financing activities
                
                
                68,775,920
                
                
                
                2,307,620EFFECT
      OF EXCHANGE RATE CHANGE ON CASH & CASH EQUIVALENTS
                
                
                (48,847
                )
                
                
                2,588NET
      INCREASE IN CASH & CASH EQUIVALENTS
                
                
                47,532,780
                
                
                
                1,042,065CASH
      & CASH EQUIVALENTS, BEGINNING OF YEAR
                
                
                1,435,212
                
                
                
                393,147CASH
      & CASH EQUIVALENTS, END OF YEAR
                
                $
                48,967,992
                
                
                $
                1,435,212Supplemental
      Cash flow data:Income
      tax paid
                
                $
                1,500,415
                
                
                $
                660,127Interest
      paid
                
                $
                338,513
                
                
                $
                274,969




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


F-6




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


1.
ORGANIZATION AND DESCRIPTION OF BUSINESS





SmartHeat
Inc., formerly known as Pacific Goldrim Resources, Inc. (the “Company” or
“SmartHeat”), was incorporated August 4, 2006 in the State of Nevada. The
Company designs, manufactures, sells,  and services plate heat
exchangers  (“PHE”), PHE Units, and heat meters through its wholly
owned operating subsidiaries in China.





On April
14, 2008, the Company entered into a Share Exchange Agreement (the “Share
Exchange Agreement”) with Shenyang Taiyu Machinery and Electronic Equipment Co.,
Ltd. ("Taiyu") and the Taiyu Shareholders. At the closing under the Share
Exchange Agreement, all of the equitable and legal rights, title and interests
in and to Taiyu’s share capital in the amount of Yuan 25,000,000 were exchanged
for an aggregate of 18,5000,000 shares of SmartHeat common stock (the “Share
Exchange”). Concurrent with the share exchange, one of SmartHeat’s shareholders
cancelled 2,500,000 shares of 6,549,900 of issued and outstanding shares of
SmartHeat pursuant to the Split-Off Agreement dated April 14, 2008. As a result
of the Share Exchange, Taiyu became a wholly-owned subsidiary of
SmartHeat.





Prior to
the acquisition of Taiyu, the Company was a non-operating public shell. Pursuant
to Securities and Exchange Commission ("SEC") rules, the merger or acquisition
of a private operating company into a non-operating public shell with nominal
net assets is considered a capital transaction, rather than a business
combination. Accordingly, for accounting purposes, the transaction was treated
as a reverse acquisition and recapitalization, and pro-forma information is not
presented. Transaction costs incurred in the reverse acquisition were
expensed.





Taiyu was
incorporated in the Liaoning Province, China in July, 2002. Taiyu manufactures
and sells PHEs, PHE Units, and heat meters. . The Company is an authorized
dealer of the SONDEX brand; SONDEX is the second largest plate heat exchanger
manufacturer in the world.





On
September 25, 2008, the Company entered into a Share Exchange Agreement (the
"Agreement") with Asialink (Far East) Limited ("Asialink") to acquire all
outstanding capital stock of SanDeKe Co., Ltd., a Shanghai based manufacturer of
heat plate exchangers ("SanDeKe"). The purchase price for SanDeKe was $741,516.
Under the terms of the Agreement, two shareholders of SanDeKe agreed not to
compete with the business of SanDeKe for four years after the
purchase.





On June
12, 2009, the Company incorporated a new subsidiary SmartHeat Siping Beifang
Energy Technology Co., Ltd (“SmartHeat Siping”) to manufacture heat
exchangers.





On June
16, 2009, Taiyu closed an asset purchase transaction with Siping Beifang Heat
Exchanger Manufacture Co.,Ltd. (“Siping”), a
company organized under the laws of the PRC, to purchase certain assets
consisting of the plant and equipment and certain land use rights
for 54,000,000 RMB, or United States Dollars (USD)
7,906,296.  Taiyu then transferred all the assets acquired to
SmartHeat Siping, the newly incorporated subsidiary.  The purchase
consideration was non-interest bearing and was payable according to the
following schedule:




Payment in RMB
                  
                  Payment in USD
                  
                  Payment DateRMB
      3,000,000
                  
                  $
                  439,239
                  
                  May
      27, 2009RMB
      10,250,000
                  
                  $
                  1,500,732
                  
                  June
      30, 2009RMB 13,000,000
                  
                  $
                  1,903,367
                  
                  September
      30, 2009RMB
      12,300,000
                  
                  $
                  1,800,878
                  
                  March
      1, 2010RMB
      8,200,000
                  
                  $
                  1,200,586
                  
                  September
      30, 2010





At
December 31, 2009, the Company paid approximately $3 million. The payment terms
do not include any default provision.





On August
14, 2009, the Company formed a Joint Venture (JV) with registered capital of RMB
10 million (US $1.46 million), Beijing SmartHeat Jinhui Energy Technology Co.,
Ltd (“Jinhui”) for research, development, manufacturing , and sales of plate
heat exchangers.  The JV did not commence operations as of December
31, 2009. SmartHeat owns 52% of the JV and invested approximately
$765,000.


F-7


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 and 2008





2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Principles
of Consolidation





The
accompanying consolidated financial statements include the accounts of
SmartHeat, Taiyu, SanDeKe, SmartHeat Siping, a newly incorporated subsidiary
in June of 2009 and Jinhui, a joint venture formed in August of 2009. The
"Company" refers collectively to SmartHeat, Taiyu, SanDeKe, SmartHeat Siping and
Jinhui. All significant inter-company accounts and transactions were eliminated
in consolidation.





Non-Controlling
Interest





Effective
January 1, 2009, the Company adopted Financial Accounting Standards Board’s
(“FASB”) Accounting Standards Codification (“ASC”) Topic 810, “Consolidation,”
which established new standards governing the accounting for and reporting of
noncontrolling interests (NCIs) in partially owned consolidated subsidiaries and
the loss of control of subsidiaries. Certain provisions of this standard
indicate, among other things, that NCIs (previously referred to as minority
interests) be treated as a separate component of equity, not as a liability (as
was previously the case), that increases and decreases in the parent’s ownership
interest that leave control intact be treated as equity transactions rather than
as step acquisitions or dilution gains or losses, and that losses of a partially
owned consolidated subsidiary be allocated to the NCI even when such allocation
might result in a deficit balance. This standard also required changes to
certain presentation and disclosure requirements. Losses attributable to the NCI
in a subsidiary may exceed the NCI’s interests in the subsidiary’s equity. The
excess attributable to the NCI is attributed to those interests. The NCI shall
continue to be attributed its share of losses even if that attribution results
in a deficit NCI balance.





Use
of Estimates





In
preparing the financial statements in conformity with US generally accepted
accounting principle (“US GAAP”), management makes estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the dates of the financial statements, as
well as the reported amounts of revenues and expenses during the reporting year.
Significant estimates, required by management, include the recoverability of
long-lived assets, allowance for doubtful accounts, and the reserve for obsolete
and slow-moving inventories. Actual results could differ from those
estimates.





Cash
and Cash Equivalents





For
purposes of the statement of cash flows, the Company considers all highly liquid
investments with an original maturity of three months or less to be cash
equivalents. As of December 31, 2009, the Company maintained restricted cash of
$1,349,934 in several bank accounts, $1,036,101 representing cash deposits from
customers for securing payment from customers that occurs no later than the
warranty period expires, and $313,833 representing the deposits the Company paid
to a commercial bank for the bank issuing the bank acceptance to its
vendors; of the total restricted cash, $1,301,573 will be released to the
Company within one year. As of December 31, 2008, the Company maintained
restricted cash of $681,520, of which, $462,048 was released to the Company
within one year. Restricted cash is held in the interest bearing bank
accounts.





Accounts
and Retentions Receivable





The
Company’s policy is to maintain reserves for potential credit losses on accounts
receivable. Management reviews the composition of accounts receivable and
analyzes historical bad debts, customer concentrations, customer credit
worthiness, current economic trends and changes in customer payment patterns to
evaluate the adequacy of these reserves. Based on historical collection
activity, the Company had allowances of $1,128,420 and $629,687 at December 31,
2009 and December 31, 2008, respectively.





F-8




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


At
December 31, 2009 and 2008, the Company had retentions receivable from customers
for product quality assurance of $1,235,573 and $457,764, respectively. The
retention rate varies from 5% to 20% of the sales price with variable terms from
three months to two years depending on the shipping date of the products and the
number of heating seasons that the warranty period covers.





Accounts
receivable is net of unearned interest of $149,123 and $28,526 at December 31,
2009 and 2008, respectively. Unearned interest represents imputed interest on
accounts receivable with due dates over one year from the invoice date
discounted at the Company's borrowing rate, 7.16% at December 31, 2009 and
7.04% in 2008.





Inventories





Inventories
are valued at the lower of cost or market with cost determined on a moving
weighted average basis. Cost of work in progress and finished goods comprises
direct material, direct production cost and an allocated portion of production
overheads.





Property
and Equipment





Property
and equipment are stated at cost, net of accumulated depreciation. Expenditures
for maintenance and repairs are expensed as incurred; additions, renewals and
betterments are capitalized. When property and equipment are retired or
otherwise disposed of, the related cost and accumulated depreciation are removed
from the respective accounts, and any gain or loss is included in operations.
Depreciation of property and equipment is provided using the straight-line
method with a 10% salvage value and estimated lives ranging from 5 to 20 years
as follows:





Building
              20
      yearsVehicles
              5
      yearsOffice
      Equipment
              5
      yearsProduction
      Equipment
              5-10
      years





Land
Use Rights





Right to
use land is stated at cost less accumulated amortization. Amortization is
provided using the straight-line method over 50 years.





Impairment
of Long-Lived Assets





Long-lived
assets, which include property, plant and equipment and intangible assets, are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.





Recoverability
of long-lived assets to be held and used is measured by a comparison of the
carrying amount of an asset to the estimated undiscounted future cash flows
expected to be generated by the asset. If the carrying amount of an asset
exceeds its estimated undiscounted future cash flows, an impairment charge is
recognized by the amount by which the carrying amount of the asset exceeds the
fair value of the assets. Fair value is generally determined using the asset’s
expected future discounted cash flows or market value, if readily determinable.
Based on its review, the Company believes that, as of December 31, 2009 and
2008, there were no significant impairments of its long-lived
assets.





F-9
 
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


Warranties





The
Company offers standard warranties to all customers on its products for one or
two heating seasons depending on the terms negotiated with the customers. The
Company accrues for warranty costs based on estimates of the costs that may be
incurred under its warranty obligations. The warranty expense and related
accrual is included in the Company's selling expenses and other payable
respectively, and is recorded at the time revenue is recognized. Factors that
affect the Company's warranty liability include the number of sold units, its
estimates of anticipated rates of warranty claims, costs per claim and estimated
support labor costs and the associated overhead.  The Company
periodically assesses the adequacy of its recorded warranty liabilities and
adjusts the amounts as necessary.





The
Company's warranty reserve activity for 2009 and 2008 was as
follows:





2009
                        
                        
                        2008Beginning
      balance
                        
                        $
                        -
                        
                        
                        $
                        -Provisions
      made
                        
                        
                        675,562
                        
                        
                        
                        95,000Actual
      costs incurred
                        
                        
                        -
                        
                        
                        
                        (95,000
                        )Ending
      balance in current liabilities
                        
                        $
                        675,562
                        
                        
                        $
                        -





Income
Taxes





The
Company utilizes Statement of Financial Accounting Standards ("SFAS") No. 109,
“Accounting for Income Taxes,” (codified in FASB ASC Topic 740), which requires
recognition of deferred tax assets and liabilities for expected future tax
consequences of events that were included in the financial statements or tax
returns. Under this method, deferred income taxes are recognized for the tax
consequences in future years of differences between the tax bases of assets and
liabilities and their financial reporting amounts at each period end based on
enacted tax laws and statutory tax rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established, when necessary, to reduce deferred tax assets to the amount
expected to be realized.





The
Company adopted the provisions of the Financial Accounting Standards Board's
("FASB") Interpretation No. 48, Accounting for Uncertainty in Income Taxes,
(codified in FASB ASC Topic 740) on January 1, 2007. As a result of the
implementation of FIN 48, the Company made a comprehensive review of its
portfolio of tax positions in accordance with recognition standards established
by FIN 48. As a result of the implementation of Interpretation 48,
the Company recognized no material adjustments to liabilities or
shareholders’ equity. When tax returns are filed, it is highly certain that some
positions taken would be sustained upon examination by the taxing authorities,
while others are subject to uncertainty about the merits of the position taken
or the amount of the position that would be ultimately sustained. The benefit of
a tax position is recognized in the financial statements in the period during
which, based on all available evidence, management believes it is more likely
than not that the position will be sustained upon examination, including the
resolution of appeals or litigation processes, if any. Tax positions taken are
not offset or aggregated with other positions. Tax positions that meet
the more-likely-than-not recognition threshold are measured as the largest
amount of tax benefit that is more than 50 percent likely of being realized upon
settlement with the applicable taxing authority. The portion of the benefits
associated with tax positions taken that exceeds the amount measured as
described above is reflected as a liability for unrecognized tax benefits in the
accompanying balance sheets along with any associated interest and penalties
that would be payable to the taxing authorities
upon examination.





Interest
associated with unrecognized tax benefits is classified as interest expense and
penalties are classified as selling, general and administrative expense in the
statements of income. The adoption of FIN 48 did not have a material impact on
the Company’s financial statements. At December 31, 2009 and 2008, the Company
had not taken any significant uncertain tax position on its tax return for 2008
and prior years or in computing its tax provision for 2009.





Revenue
Recognition





The
Company's revenue recognition policies are in compliance with SEC Staff
Accounting Bulletin (“SAB”) 104 (codified in FASB ASC Topic 480). Sales revenue
is recognized when PHE and heat meters are delivered and for PHE units, when
customer acceptance occurs, the price is fixed or determinable, no other
significant obligations of the Company exist and collectibility is reasonably
assured. Payments received before all of the relevant criteria for revenue
recognition met are recorded as unearned revenue.




F-10




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


The
Company’s sales generally provide for 30% of the purchase price on placement of
an order, 30% on delivery, 30% upon installation and acceptance of the equipment
after customer testing, and 10% of the purchase price no later than the
termination of the standard warranty period.





Sales
revenue represents the invoiced value of goods, net of value-added tax ("VAT").
All of the Company’s products sold in the PRC are subject to Chinese value-added
tax of 17% of gross sales price. This VAT may be offset by VAT paid by the
Company on raw materials and other materials included in the cost of producing
their finished product. The Company recorded VAT payable and VAT receivable net
of payments in the financial statements. The VAT tax return is filed offsetting
the payables against the receivables.





Sales and
purchases are recorded net of VAT collected and paid as the Company acts as an
agent for the government. VAT taxes are not affected by the income tax
holiday.





Sales
returns and allowances were $0 for both 2009 and 2008. The Company does not
provide right of return, price protection or any other concessions to its
customers.





The
Company provides standard warranty to all customers, which is not considered an
additional service; rather it is an integral part of the product’s sale. The
Company believes the existence of its standard product warranty in a sales
contract does not constitute a deliverable in the arrangement and thus there is
no need to apply EITF 00-21 (codified in Financial Accounting Standards Board
(“FASB”) Accounting Standards Codification (“ASC”) Topic 605-25) separation and
allocation model for a multiple deliverable arrangement. SFAS 5 (codified in
FASB ASC Topic 450) specifically address the accounting for standard warranties
and neither SAB 104 nor EITF 00-21 supersedes SFAS 5. The Company believes that
accounting for its standard warranty pursuant to SFAS 5 (codified in FASB ASC
Topic 450) does not impact revenue recognition because the cost of honoring the
warranty can be reliably estimated.





The
Company provides after sales services at a charge after expiration of the
warranty period, with after sales services mainly consisting of cleaning plate
heat exchangers and repairing and exchanging parts. The Company recognizes such
revenue when service is provided. For the years ended December 31, 2009 and
2008, revenue from after sales services after expiration of the warranty period
was approximately $471,900 and $49,800, respectively.





Cost
of Goods Sold





Cost of
goods sold consists primarily of material costs, direct labor, and manufacturing
overhead which are directly attributable to the products.  Write-down of
inventories to lower of cost or market is also recorded in cost of goods
sold.





Concentration
of Credit Risk





Financial
instruments that potentially subject the Company to credit risk consist
primarily of accounts receivable and other receivables. The Company does not
require collateral or other security to support these receivables. The Company
conducts periodic reviews of its clients' financial condition and customer
payment practices to minimize collection risk on accounts
receivable.





The
operations of the Company are located in the PRC. Accordingly, the Company's
business, financial condition, and results of operations may be influenced by
the political, economic, and legal environments in the PRC, as well as by the
general state of the PRC economy.





F-11
 
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


Statement
of Cash Flows





In
accordance with SFAS No. 95, “Statement of Cash Flows,” codified in FASB ASC
Topic 230, cash flows from the Company's operations are calculated based upon
the local currencies. As a result, amounts related to assets and liabilities
reported on the statement of cash flows may not necessarily agree with changes
in the corresponding balances on the balance sheet.  The cash flows
from operating, investing and financing activities exclude the effect of
conversion from accounts payable to notes payable – bank acceptances of
$1,805,823, conversion from accounts receivable to notes receivable – bank
acceptances of $382,446, and assets purchased from Siping of $7,906,296 during
2009. Cash from financing activity and operating activity excludes (1) $1.3
million proceeds from the exercise of warrants, the proceeds of which were
deposited in a bank account in the name of the Chief Financial Officer but was
controlled by the Company pursuant to a Bank Account Control Agreement and (2)
$734,792 paid from that account to an independent third party as repayment of a
loan due from the Company.





Basic
and Diluted Earnings per Share (EPS)





Basic EPS
is computed by dividing income available to common shareholders by the weighted
average number of common shares outstanding for the period. Diluted EPS is
similarly computed, except that the denominator is increased to include the
number of additional common shares that would have been outstanding if the
potential common shares had been issued and if the additional common shares were
dilutive. Diluted net earnings per share are based on the assumption that all
dilutive convertible shares and stock options were converted or exercised.
Dilution is computed by applying the treasury stock method. Under this method,
options and warrants are assumed to have been exercised at the beginning of the
period (or at the time of issuance, if later), and as if funds obtained
thereby were used to purchase common stock at the average market price during
the period.





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





2009
                        
                        
                        2008Net
      income
                        
                        $
                        15,442,529
                        
                        
                        $
                        6,335,340Weighted
      average shares outstanding - basic
                        
                        
                        26,535,502
                        
                        
                        
                        22,176,322Effect
      of dilutive securities:Unexercised
      warrants and options
                        
                        
                        56,564
                        
                        
                        
                        110Weighted
      average shares outstanding - diluted
                        
                        
                        26,592,066
                        
                        
                        
                        22,176,432Earnings
      per share - basic
                        
                        $
                        0.58
                        
                        
                        $
                        0.29Earnings
      per share - diluted
                        
                        $
                        0.58
                        
                        
                        $
                        0.29





Fair
Value of Financial Instruments





For
certain of the Company’s financial instruments, including cash and cash
equivalents, restricted cash, accounts receivable, accounts payable, accrued
liabilities and short-term debt, the carrying amounts approximate their fair
values due to their short maturities.  ASC Topic
820, “Fair Value Measurements and Disclosures,” requires disclosure of the fair
value of financial instruments held by the Company. ASC Topic 825, “Financial
Instruments,” defines fair value, and establishes a three-level valuation
hierarchy for disclosures of fair value measurement that enhances disclosure
requirements for fair value measures.  The carrying amounts reported in the
consolidated balance sheets for receivables and current liabilities each qualify
as financial instruments and are a reasonable estimate of their fair values
because of the short period of time between the origination of such instruments
and their expected realization and their current market rate of interest. The
three levels of valuation hierarchy are defined as follows:





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





Level 2
inputs to the valuation methodology include quoted prices for similar assets and
liabilities in active markets, and inputs that are observable for the asset or
liability, either directly or indirectly, for substantially the full term of the
financial instrument.





F-12


SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008




Level 3
inputs to the valuation methodology are unobservable and significant to the fair
value measurement.




The
Company analyzes all financial instruments with features of both liabilities and
equity under ASC 480, “Distinguishing Liabilities from Equity,” and ASC
815.




As
of December 31, 2009, the Company did not identify any assets and liabilities
that are required to be presented on the balance sheet at fair
value.




Foreign
Currency Translation and Comprehensive Income (Loss)





The
accounts of the Company’s Chinese subsidiaries are maintained in the Chinese
Yuan Renminbi (RMB) and the accounts of the U.S. parent company are maintained
in the U.S. Dollar (USD). The accounts of the Chinese subsidiaries were
translated into USD in accordance with SFAS No. 52, "Foreign Currency
Translation," (codified in FASB Accounting Standards Codification (“ASC”) Topic
830), with the RMB as the functional currency for the Chinese subsidiaries.
According to the Statement, all assets and liabilities were translated at the
exchange rate on the balance sheet date, stockholders’ equity are translated at
the historical rates and statement of operations items are translated at the
weighted average exchange rate for the year. The resulting translation
adjustments are reported under other comprehensive income in accordance with
SFAS No. 130, "Reporting Comprehensive Income” (codified in FASB ASC Topic
220).





Stock-Based
Compensation




The
Company accounts for its stock-based compensation in accordance with SFAS No.
123R, “Share-Based Payment, an Amendment of FASB Statement No.
123” (codified in FASB ASC Topics 718 & 505). The Company recognizes in
the income statement the grant-date fair value of stock options and other
equity-based compensation issued to employees and non-employees.





Segment
Reporting





SFAS No.
131, "Disclosures about Segments of an Enterprise and Related Information"
(codified in FASB ASC Topic 280) requires use of the “management approach” model
for segment reporting. The management approach model is based on the way a
company's management organizes segments within the company for making operating
decisions and assessing performance. Reportable segments are based on products
and services, geography, legal structure, management structure, or any other
manner in which management disaggregates a company.





SFAS 131
has no effect on the Company's financial statements as substantially all of the
Company's operations are conducted in one industry segment. All of the Company's
assets are located in the PRC.





Registration
Rights Agreement





The
Company accounts for payment arrangements under registration rights agreement in
accordance with FASB Staff Position EITF 00-19-2, (codified in FASB ASC Topic
815), which requires the contingent obligation to make future payments or
otherwise transfer consideration under a registration payment arrangement,
whether issued as a separate agreement or included as a provision of a financial
instrument or other agreement, be separately recognized and measured in
accordance with FASB Statement No. 5, Accounting for Contingencies (codified in
FASB ASC Topic 450).





F-13


SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008




The
Company is required to file the Registration Statement with the SEC within 60
days of the closing of the private placement offering. The Registration
Statement must be declared effective by the SEC within 180 days of the final
closing of the offering. Subject to certain grace periods, the Registration
Statement must remain effective and available for use until the Investors can
sell all of the securities covered by the Registration Statement without
restriction pursuant to Rule 144. If the Company fails to meet the filing or
effectiveness requirements of the Registration Statement, the Company is
required to pay liquidated damages of 2% of the aggregate purchase price paid by
such Investor for any Registrable Securities then held by such Investor on the
date of such failure and on each anniversary of the date of such failure until
such failure is cured.  The last closing under the private
placement was September 24, 2008 and the 180 day period for effectiveness of the
registration statement under the Registration Rights Agreement ended on March
23, 2009.  At March 31, 2009, the Company became liable to pay
approximately $110,000 liquidated damages to our investors as a result of
failure to declare the effectiveness of the Registration Statement within 180
days of the final closing of the offering.  The liquidated damage was
recorded as the Company’s G&A expense with charging corresponding account to
accrued liabilities.  The Registration Statement became effective June
23, 2009. The Company paid $63,004 for the liquidated damage in
2009.





New
Accounting Pronouncements





In
October 2009, the FASB issued an Accounting Standards Update (“ASU”) regarding
accounting for own-share lending arrangements in contemplation of convertible
debt issuance or other financing.  This ASU requires that at the date
of issuance of the shares in a share-lending arrangement entered into in
contemplation of a convertible debt offering or other financing, the shares
issued shall be measured at fair value and be recognized as an issuance cost,
with an offset to additional paid-in capital. Further, loaned shares are
excluded from basic and diluted earnings per share unless default of the
share-lending arrangement occurs, at which time the loaned shares would be
included in the basic and diluted earnings-per-share
calculation.  This ASU is effective for fiscal years beginning on or
after December 15, 2009, and interim periods within those fiscal years for
arrangements outstanding as of the beginning of those fiscal years.
The Company is currently evaluating the impact of this ASU on its consolidated
financial statements.




In August
2009, the FASB issued an ASU regarding measuring liabilities at fair value. This
ASU provides additional guidance clarifying the measurement of liabilities at
fair value in circumstances in which a quoted price in an active market for the
identical liability is not available; under those circumstances, a reporting
entity is required to measure fair value using one or more of valuation
techniques, as defined. This ASU is effective for the first reporting period,
including interim periods, beginning after the issuance of this ASU. The
adoption of this ASU did not have a material impact on the Company’s
consolidated financial statements.





On July
1, 2009, the Company adopted ASUNo. 2009-01, “Topic 105 - Generally
Accepted Accounting Principles - amendments based on Statement of Financial
Accounting Standards No. 168, “The FASB Accounting Standards CodificationTM and
the Hierarchy of Generally Accepted Accounting Principles” (“ASU No.
2009-01”).  ASU No. 2009-01 re-defines authoritative GAAP for
nongovernmental entities to be only comprised of the FASB Accounting Standards
CodificationTM (“Codification”) and, for SEC registrants, guidance issued by the
SEC.  The Codification is a reorganization and compilation of all
then-existing authoritative GAAP for nongovernmental entities, except for
guidance issued by the SEC.  The Codification is amended to effect
non-SEC changes to authoritative GAAP.  Adoption of ASU No. 2009-01
only changed the referencing convention of GAAP in Notes to the
Consolidated Financial Statements.





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





F-14




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


In June
2009, the FASB issued SFAS No. 166, “Accounting for Transfers of Financial
Assets — an amendment of FASB Statement No. 140” (“SFAS 166”), codified as FASB
Topic ASC 860, which requires entities to provide more information regarding
sales of securitized financial assets and similar transactions, particularly if
the entity has continuing exposure to the risks related to transferred financial
assets. SFAS 166 eliminates the concept of a “qualifying special-purpose
entity,” changes the requirements for derecognizing financial assets and
requires additional disclosures. SFAS 166 is effective for fiscal years
beginning after November 15, 2009. The Company does not believe the adoption of
SFAS 166 will have an impact on its financial condition, results of operations
or cash flows.




In May
2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS 165”) codified in
FASB ASC Topic 855-10-05, which provides guidance to establish general standards
of accounting for and disclosures of events that occur after the balance sheet
date but before financial statements are issued or are available to be issued.
SFAS 165 also requires entities to disclose the date through which subsequent
events were evaluated as well as the rationale for why that date was selected.
SFAS 165 is effective for interim and annual periods ending after June 15, 2009,
and accordingly, the Company adopted this pronouncement during the second
quarter of 2009. ASC Topic 855-requires that public entities evaluate subsequent
events through the date that the financial statements are issued.





In April
2009, the FASB issued FSP No. SFAS 107-1 and APB 28-1, “Interim Disclosures
about Fair Value of Financial Instruments,” which is codified in FASB ASC Topic
825-10-50. This FSP essentially expands the disclosure about fair value of
financial instruments that were previously required only annually to also be
required for interim period reporting. In addition, the FSP requires certain
additional disclosures regarding the methods and significant assumptions used to
estimate the fair value of financial instruments. These additional disclosures
are required beginning with the quarter ending June 30, 2009. This FSP had no
material impact on the Company’s financial position, results of operations or
cash flows.





In
April 2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, “Recognition
and Presentation of Other-Than-Temporary Impairments,” which is codified in FASB
ASC Topic 320-10. This FSP modifies the requirements for recognizing
other-than-temporarily impaired debt securities and changes the existing
impairment model for such securities. The FSP also requires additional
disclosures for both annual and interim periods with respect to both debt and
equity securities. Under the FSP, impairment of debt securities will be
considered other-than-temporary if an entity (1) intends to sell the security,
(2) more likely than not will be required to sell the security before recovering
its cost, or (3) does not expect to recover the security’s entire amortized cost
basis (even if the entity does not intend to sell). The FSP further indicates
that, depending on which of the above factor(s) causes the impairment to be
considered other-than-temporary, (1) the entire shortfall of the security’s fair
value versus its amortized cost basis or (2) only the credit loss portion would
be recognized in earnings while the remaining shortfall (if any) would be
recorded in other comprehensive income. FSP 115-2 requires entities to initially
apply the provisions of the standard to previously other-than-temporarily
impaired debt securities existing as of the date of initial adoption by making a
cumulative-effect adjustment to the opening balance of retained earnings in the
period of adoption. The cumulative-effect adjustment potentially reclassifies
the noncredit portion of a previously other-than-temporarily impaired debt
security held as of the date of initial adoption from retained earnings to
accumulate other comprehensive income. The Company adopted FSP No. SFAS 115-2
and SFAS 124-2 beginning April 1, 2009. This FSP had no material impact on the
Company’s financial position, results of operations or cash flows.





In April
2009, the FASB issued FSP No. SFAS 157-4, “Determining Fair Value When
the Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly” (“FSP
No. SFAS 157-4”). FSP No. SFAS 157-4, which is codified in
FASB ASC Topics 820-10-35-51 and 820-10-50-2, provides additional guidance for
estimating fair value and emphasizes that even if there has been a significant
decrease in the volume and level of activity for the asset or liability and
regardless of the valuation technique(s) used, the objective of a fair value
measurement remains the same. The Company adopted FSP No. SFAS 157-4
beginning April 1, 2009. This FSP had no material impact on the Company’s
financial position, results of operations or cash flows.





F-15
 
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


3.
INVENTORIES





Inventories
at December 31, 2009 and 2008 were as follows:





2009
                          
                          
                          2008Raw
      materials
                          
                          $
                          8,627,624
                          
                          
                          $
                          4,411,298Work
      in process
                          
                          
                          1,001,495
                          
                          
                          
                          652,472Finished
      Goods
                          
                          
                          1,630,154
                          
                          
                          
                          1,043,813Total
                          
                          $
                          11,259,273
                          
                          
                          $
                          6,107,583





4.
NOTES RECEIVABLE – BANK ACCEPTANCES





The
Company sold goods to its customers and received Commercial Notes (Bank
Acceptance) from the customers in lieu of the payments for accounts
receivable.  The Company discounted the Notes with the bank or
endorsed the Notes to vendors, which could be for payment of their own
obligations or get cash from the third parties.  Most of the
Commercial Notes have maturity of less than six months.  At December
31, 2009 and 2008, the Company had notes receivable of $397,248 and $14,631,
respectively.





5.
PROPERTY AND EQUIPMENT, NET





Property
and equipment consisted of the following at December 31, 2009 and
2008:





2009
                    
                    
                    2008Building
                    
                    $
                    4,419,315
                    
                    
                    $
                    1,818,827Production
      equipment
                    
                    
                    2,979,017
                    
                    
                    
                    441,065Office
      equipment
                    
                    
                    545,789
                    
                    
                    
                    231,975Vehicles
                    
                    
                    594,168
                    
                    
                    
                    300,9568,538,289
                    
                    
                    
                    2,792,823Less:
      Accumulated depreciation
                    
                    
                    (798,680
                    )
                    
                    
                    (356,270
                    )$
                    7,739,609
                    
                    
                    $
                    2,436,553




Depreciation
expense for 2009 and 2008 was approximately $442,400 and $168,000,
respectively.





6.
OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS




Other
receivables, prepayments and deposits consisted of the following at December 31,
2009 and 2008, respectively:





2009
                    
                    
                    2008Cash
      advance to third parties
                    
                    $
                    1,332,787
                    
                    
                    $
                    89,628Deposit
      for public bids of sales contracts
                    
                    
                    1,148,526
                    
                    
                    
                    353,399Prepayment
      for freight and related insurance expenses
                    
                    
                    74,412
                    
                    
                    
                    95,888Deposits
                    
                    
                    8,523
                    
                    
                    
                    42,783Advance
      to employees
                    
                    
                    432,144
                    
                    
                    
                    117,136Due
      from officer
                    
                    
                    576,208
                    
                    
                    
                    -Total
                    
                    $
                    3,572,600
                    
                    
                    
                    698,834





Cash
advance to third parties was short term cash advances to customers and vendors
with repayment usually within three to six months.  Deposits for
public bidding represented the deposits for bidding expected contracts, which
will be returned to the Company after the bidding process is completed unusually
within three to four months from the payment date.  Prepayment for
freight and /or related insurance expenses represented prepaid shipping and
freight insurance expenses for customers and is generally repaid upon customer
receipt of products.  Deposits mainly consisted of deposits for rents
and utilities. Cash advance to employees represented short term loan to
employees and advance to employees for business trip and related expenses. Other
receivables, prepayments and deposits are reimbursed or settled within
12 months.





F-16


SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008




Other
receivables, prepayments and deposits include remaining proceeds of $576,210 at
December 31, 2009 from the exercise of warrants credited to a bank account in
the  name of the Chief Financial Officer which was controlled by the
Company pursuant to a Bank Account Control Agreement between the Company and the
Chief Financial Officer. The Company has exclusive right to direct the use of
all funds in the account solely for its benefit or the benefit of its
subsidiaries pursuant to the Bank Account Control Agreement.  The
Chief Financial Officer was  prohibited from using the funds in the
account for her personal use.  The $576,210 deposit was transferred to
the Company’s bank account on March 18, 2010.





7.
INTANGIBLE ASSETS





Intangible
assets mainly consisted of land use rights, computer software, know-how
technology, customer list and covenant not to compete. All land in the PRC is
government owned and cannot be sold to any individual or company. However, the
government grants the user a “land use right” to use the land. The Company
acquired land use right during 2005 for approximately $440,000 (RMB 3,549,682).
In June of 2009, the Company acquired land use rights for $3,108,000 from
Siping. The Company has the right to use the land for 50 years and is amortizing
such rights on a straight-line basis for 50 years.





Intangible
assets consisted of the following at December 31, 2009 and 2008,
respectively:





2009
                      
                      
                      2008Land
      use rights
                      
                      $
                      3,628,216
                      
                      
                      $
                      519,369Know-how
      technology
                      
                      
                      267,058
                      
                      
                      
                      266,808Customer
      list
                      
                      
                      191,
      832
                      
                      
                      
                      191,652Covenant
      not to compete
                      
                      
                      104,356
                      
                      
                      
                      104,258Software
                      
                      
                      196,218
                      
                      
                      
                      190,1664,387,680
                      
                      
                      
                      1,272,253Less:
      accumulated amortization
                      
                      
                      (316,659
                      )
                      
                      
                      (117,122
                      )$
                      4,071,021
                      
                      
                      $
                      1,155,131





Amortization
expense of intangible assets for 2009 and 2008 was approximately $199,500 and
$63,000, respectively.  Annual amortization expense for the next five
years from December 31, 2009 is expected to be: $233,000, $233,000, $215,000,
$146,000 and $77,000.




8.
TAXES PAYABLE




Taxes
payable consisted of the following at December 31, 2009 and 2008:




2009
                    
                    
                    2008Income
      tax payable
                    
                    $
                    1,202,058
                    
                    
                    $
                    723,958Value
      added tax payable
                    
                    
                    878,638
                    
                    
                    
                    597,676Other
      taxes payable
                    
                    
                    59,931
                    
                    
                    
                    6,141$
                    2,140,627
                    
                    
                    $
                    1,327,775




F-17


SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008




9.
ACCRUED LIABILITIES AND OTHER PAYABLES





Accrued
liabilities and other payables consisted of the following at December 31, 2009
and 2008:




2009
                    
                    
                    2008Advance
      from third parties
                    
                    $
                    258,759
                    
                    
                    $
                    453,625Payable
      for purchase of SanDeKe
                    
                    
                    -
                    
                    
                    
                    741,516Payable
      to Siping – current portion
                    
                    
                    2,080,013
                    
                    
                    
                    -Other
      payables
                    
                    
                    91,329
                    
                    
                    
                    99,418Warranty
      reserve
                    
                    
                    675,562
                    
                    
                    
                    -Accrued
      liabilities
                    
                    
                    475,441
                    
                    
                    
                    36,253Accrued
      salary
                    
                    
                    104,168
                    
                    
                    
                    -Total
                    
                    $
                    3,685,272
                    
                    
                    $
                    1,330,812





Advance
from third parties represented short term, non interest bearing advances from
third parties. Other payables consisted of payables for the Company’s
miscellaneous expenses including postage, business insurance, employee benefits,
bidding fee, etc. Accrued liabilities mainly consisted of accrued interest,
payroll, utility, and liquidated damages for failure to declare the
effectiveness of the Registration Statement within 180 days of the final closing
of the offering.





10.
LOAN PAYABLE – INSTITUTIONAL INVESTOR




On
July 3, 2009, the Company entered into a Senior Loan Agreement with an
institutional investor to obtain a loan of US $9,000,000.  Under the
terms of the Agreement, the Company agreed to interest of 10% payable quarterly
beginning on September 30, 2009. The principal amount and any unpaid interest
accrued thereon are due six (6) months from the date of the Agreement. This loan
was repaid during the quarter from the proceeds of a public
offering.





11.
NOTES PAYABLE – BANK ACCEPTANCES





Notes
payable represented accounts payable to vendors that were converted to notes
payable accepted by the bank. The Company deposited a portion of the acceptance
amount into the bank. The bank charged certain percentage of the face value of
the note which is amortized over the term of the acceptance.





12.
LOANS PAYABLE - BANK





The
Company was obligated for the following short term loans payable as of December
31, 2009 and 2008:




2009
                    
                    
                    2008From
      a commercial bank in the PRC for 30,000,000 RMB. Of which, 17,000,000 RMB
      is due on April 22, 2010. 13,000,000 RMB was entered into on June 12, 2009
      and is due on June 12, 2010. These loans currently bear interest at
      5.576%.  The Company pledged its building in the value of
      approximately RMB 12,430,950 or approximately $1,818,000 for this
      loan.
                    
                    $
                    4,393,544
                    
                    
                    $
                    -Bank
      in the PRC for 6,000,000 RMB. This loan was entered into on Apr 28, 2007
      and was due on Apr 12, 2008. This loan was renewed on Apr 12, 2008. The
      Company repaid loan in April of 2009.
                    
                    
                    -
                    
                    
                    
                    877,886Loans
      during 2006 and 2007 with a third party in the PRC for total of 10,
      300,000 RMB.  These loans bore variable interest at 8.591% for
      2009 and 2008.  The Company repaid RMB 2,600,000 in 2008, RMB
      2,700,000 in April of 2009, and RMB 5,000,000 in December of
      2009.
                    
                    
                    -
                    
                    
                    
                    1,126,621One
      year loan on July 1, 2008 with another third party company in the PRC for
      3,000,000 RMB. This loan has renewed and due on December 31, 2009
      with interest of 8.591%.  The Company repaid loan in December of
      2009.
                    
                    
                    -
                    
                    
                    
                    438,943$
                    4,393,544
                    
                    
                    $
                    2,443,450




F-18




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008




13.
DEFERRED TAX LIABILITY





Deferred
tax liability represented differences between the tax bases and book bases of
property and equipment and intangible assets arising from the acquisition of
SanDeKe.





14.
INCOME TAXES





The
Company is subject to income taxes by entity on income arising in or derived
from the tax jurisdiction in which each entity is domiciled.





SmartHeat
was incorporated in the US and has net operating losses (NOL) for income tax
purposes.  SmartHeat has net operating loss carry forwards for income
taxes of approximately $1,775,000 at December 31, 2009 which may be available
to reduce future years’ taxable income as NOL; NOL can be carried forward
up to 20 years from the year the loss is incurred. Management believes the
realization of benefits from these losses uncertain due to the Company’s limited
operating history and continuing losses. Accordingly, a 100% deferred
tax asset valuation allowance has been provided.





Taiyu and
SanDeKe are governed by the Income Tax Law of the PRC concerning privately-run
enterprises, which are generally subject to tax at a statutory rate of 25% on
income reported in the statutory financial statements after appropriated tax
adjustments.





Taiyu, as
a manufacturing business, is subject to 18% income tax rate for 2008 and 20%
income tax rate for 2009. According to the new income tax law that became
effective January 1, 2008, new high-tech enterprises that government gives
special support are subject to income tax rate of 15%.  Taiyu was
recognized as a new high-tech enterprise and registered the status with tax
bureau, therefore, enjoys the income tax rate of 15% from 2009 through
2010.





SanDeKe
is subject to an 18% income tax rate after 7% reduction in federal income tax
rate given by federal government. SanDeKe, is also exempt from income tax for
two years starting from the 1st profitable year, and is entitled to a 50%
discount on the 18% income tax rate for 2010 through 2012.





The
Company's net income for the year ended December 31, 2009 would be lower by
approximately $2,319,000 or $0.09  earnings per common share, had
Taiyu not enjoyed lower income tax rate and SanDeKe not been exempted from
income tax for the year  ended December 31, 2009.





Foreign
pretax earnings approximated $19,957,433 and $7,746,800 for the years ended
December 31, 2009 and 2008 respectively. Pretax earnings of a foreign subsidiary
are subject to U.S. taxation when effectively repatriated. The Company provides
income taxes on the undistributed earnings of non-U.S. subsidiaries except to
the extent those earnings are indefinitely invested outside the United States.
At December 31, 2009, $23,011,781 of accumulated undistributed earnings of
non-U.S. subsidiaries was indefinitely invested. At the existing U.S. federal
income tax rate, additional taxes of $4,758,600 would have to be provided if
such earnings were remitted currently.





F-19




SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008




The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the years ended December 31, 2009 and 2008:





2009
                    
                    
                    2008US
      statutory rates
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %Tax
      rate difference
                    
                    
                    (15.3
                    )%
                    
                    
                    (16.4
                    )%Effect
      of tax holiday
                    
                    
                    (7.2
                    )%
                    
                    
                    (1.2
                    )%Other
                    
                    
                    1.0
                    %
                    
                    
                    -
                    %Valuation
      allowance for US NOL
                    
                    
                    3.1
                    %
                    
                    
                    0.5
                    %Tax
      per financial statements
                    
                    
                    15.6
                    %
                    
                    
                    16.9
                    %





15.
STATUTORY RESERVES





Pursuant
to the corporate law of the PRC effective January 1, 2006, the Company is now
only required to maintain one statutory reserve by appropriating from its
after-tax profit before declaration or payment of dividends. The statutory
reserve represents restricted retained earnings.





Surplus
Reserve Fund





The
Company is now only required to transfer 10% of its net income, as determined
under PRC accounting rules and regulations, to a statutory surplus reserve fund
until such reserve balance reaches 50% of the Company’s registered
capital.





The
surplus reserve fund is non-distributable other than during liquidation and can
be used to fund previous years’ losses, if any, and may be utilized for business
expansion or converted into share capital by issuing new shares to existing
shareholders in proportion to their shareholding or by increasing the par value
of the shares currently held by them, provided that the remaining reserve
balance after such issue is not less than 25% of the registered
capital.





Common
Welfare Fund





The
common welfare fund is a voluntary fund that provides that the Company can elect
to transfer 5% to 10% of its net income to this fund. This fund can only be
utilized on capital items for the collective benefit of the Company’s employees,
such as construction of dormitories, cafeteria facilities, and other staff
welfare facilities. This fund is non-distributable other than upon
liquidation.





16.
STOCKHOLDERS’ EQUITY





Common
Stock with Warrants Issued for Cash





In August
2008, SmartHeat sold 1,630,000 Units at $3.50 per Unit for gross proceeds of
approximately $5.7 million. Each "Unit" consisted of one share of SmartHeat
common stock and a three year warrant to purchase 15% of one share of common
stock at $6.00 per share. The Units sold represent 1,630,000 million shares of
common stock and warrants to purchase 244,500 shares of Common Stock. In
connection with the private placement offering, the Company paid commission of
approximately $340,000 and issued warrants to purchase 148,500 shares of common
stock to its placement agents. The warrants are immediately exercisable and
expire on the third anniversary of their issuance. The warrants require the
Company to settle in its own shares.  There is no provision for cash
settlement, except in lieu of fractional shares.  Net proceeds of
approximately $5.1 million were received by the Company. The value of warrants
was determined by using the Black-Scholes pricing model with the following
assumptions:  discount rate– 2.76%; dividend
yield– 0%;
expected volatility– 15% and term of 3
years.  The value of the Warrants was $70,246.  During 2009,
281,975 shares of warrants were exercised at $6 per share for the aggregate
amount of $1,691,850.




F-20




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


Stock Options to Independent
Directors





On July
17, 2008, the Company granted non-statutory stock options to each of its two
independent US directors. The terms of each option are: 10,000 shares at an
exercise price per share of $4.60, with a life of five years and vesting over
three years as follows: 3,333 shares vest on July 17, 2009; 3,333 shares vest on
July 17, 2010; and 3,334 shares vest on July 17, 2011, subject in each case to
the director continuing to be associated with the Company as a
director.





On July
31, 2009, one of the Company’s independent US directors voltuntarily
retired.  As such, he forefeited his right to his unvested options to
purchase 6,667 shares.





Based on
the fair value method under SFAS No. 123 (Revised) “Share Based Payment” (“SFAS
123(R)”), (codified in FASB ASC Financial Instruments, Topic 718 & 505) the
fair value of each stock option granted is estimated on the date of the grant
using the Black-Scholes option pricing model. The Black-Scholes option pricing
model has assumptions for risk free interest rates, dividends, stock volatility
and expected life of an option grant. The risk free interest rate is based upon
market yields for United States Treasury debt securities at a maturity near the
term remaining on the option. Dividend rates are based on the Company’s dividend
history. The stock volatility factor is based on the historical volatility of
the Company’s stock price. The expected life of an option grant is based on
management’s estimate. The fair value of each option grant to independent
directors is calculated by the Black-Scholes method and is recognized as
compensation expense over the vesting period of each stock option award. For
stock options issued, the fair value was estimated at the date of grant using
the following range of assumptions:





The
options vest over three years and have a life of 5 years, volatility of 15%,
risk free interest rate of 2.76%, and dividend yield of 0%. No estimate of
forfeitures was made as the Company has a short history of granting options.
There were no options exercised during the year ended December 31,
2009.





Following
is a summary of the warrant activity:




Number of
                      Shares
                    
                    
                    Average
                      Exercise
                      Price per Share
                    
                    
                    Weighed
                      Average
                      Remaining
                      Contractual
                      Term in YearsOutstanding
      at December 31, 2007
                    
                    
                    -Exercisable
      at December 31, 2007
                    
                    
                    -Granted
                    
                    
                    393,000
                    
                    
                    $
                    6.00
                    
                    
                    
                    3.00ExercisedForfeitedOutstanding
      at December 31, 2008
                    
                    
                    393,000
                    
                    
                    
                    6.00
                    
                    
                    
                    2.51Exercisable
      at December 31, 2008
                    
                    
                    393,000
                    
                    
                    
                    6.00
                    
                    
                    
                    2.51GrantedExercised
                    
                    
                    (281,975
                    )ForfeitedOutstanding
      at December 31, 2009
                    
                    
                    111,025
                    
                    
                    $
                    6.00
                    
                    
                    
                    1.51Exercisable
      at December 31, 2009
                    
                    
                    111,025
                    
                    
                    $
                    6.00
                    
                    
                    
                    1.51




F-21




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008
 Following
is a summary of the option activity:




Number of
                    Shares
                  
                  
                  Average
                    Exercise
                    Price per Share
                  
                  
                  Weighed
                    Average
                    Remaining
                    Contractual
                    Term in YearsOutstanding
      at December 31, 2007
                  
                  
                  -Exercisable
      at December 31, 2007
                  
                  
                  -Granted
                  
                  
                  20,000
                  
                  
                  $
                  4.60
                  
                  
                  
                  5.00ExercisedForfeitedOutstanding
      at December 31, 2008
                  
                  
                  20,000
                  
                  
                  
                  4.60
                  
                  
                  
                  4.54Exercisable
      at December 31, 2008
                  
                  
                  20,000
                  
                  
                  
                  4.60
                  
                  
                  
                  4.54GrantedExercisedForfeited
                  
                  
                  6,667Outstanding
      at December 31, 2009
                  
                  
                  13,333
                  
                  
                  $
                  4.60
                  
                  
                  
                  3.54Exercisable
      at December 31, 2009
                  
                  
                  13,333
                  
                  
                  $
                  4.60
                  
                  
                  
                  3.54





Stocks
issues for public offering




On
September 22, 2009, the Company closed its public offering of 8,333,000 shares
of its common stock, at $9 per share, which includes 1,086,913 shares sold as a
result of the underwriters' exercise of their over-allotment option in full at
closing. A total gross proceeds of $74,997,000 was received from this offering.
After underwriting discounts and commissions and offering expenses, the Company
received net proceeds of US $65,007,390.  The Company paid $5,249,790
to the underwriters as commission for this public offering. In addition, the
Company paid an additional $4,499,820 advisory fee in connection with this
public offering.




17.
COMMITMENTS





Employment
Agreements





On
January 1, 2008, the Company entered into a three-year employment agreement with
Mr. Jun Wang, which agreement may be renewed at the end of the initial term upon
mutual agreement between Mr. Jun Wang and the Company.  Either party
shall give written notice to the other party of its intention not to renew
the agreement at least 30 days prior to the end of the initial
term.  Pursuant to the terms of the employment agreement, Mr. Jun Wang
shall receive a salary in an amount that is not less than the lowest minimum
wage per month paid in Shenyang and shall be based on the uniform wage and
incentive system in Shenyang, currently $18,000 per annum. In addition, Mr. Jun
Wang shall be entitled to overtime pay in accordance with the applicable
law.





On
January 1, 2008, the Company entered into a three year employment agreement with
Ms. Zhijuan Guo, at terms identical to the terms of the employment agreement
with Mr. Jun Wang with current salary of $18,000 per annum.





Lease
agreements





The
Company leased several offices for its sales representative in different cities
under various one-year, non-cancellable, and renewable operating lease
agreements.   Total rental expense for the years ended December 31,
2009 and 2008 was approximately $128,000 and $87,000, respectively.





18.
CONTINGENCIES





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





F-22


SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008
 The
Company’s sales, purchases and expense transactions are denominated in RMB and
all of the Company’s assets and liabilities are also denominated in RMB. The RMB
is not freely convertible into foreign currencies under the current law. In
China, foreign exchange transactions are required by law to be transacted only
by authorized financial institutions. Remittances in currencies other than RMB
may require certain supporting documentation in order to affect the
remittance.





19.
ACQUISITION OF SANDEKE CO., LTD.





On
September 25, 2008, the Company entered into an Agreement for the acquisition of
all the outstanding capital stock of SanDeKe. The purchase price for the SanDeKe
shares was $741,516. Under the terms of the Agreement, two of the shareholders
of SanDeKe have agreed not to compete with the business of SanDeKe for a period
of four years after the completion of the purchase.  At June 30, 2009,
the Company paid the purchase consideration for SanDeKe.





For
convenience of reporting the acquisition for accounting purposes, September 1,
2008 was designated as the acquisition date.





The
following table summarizes the fair values of the assets acquired and
liabilities assumed at the date of acquisition.   The fair value of
the net assets acquired exceeded the total consideration for the acquisition by
approximately $117,000 (RMB 800,000). The excess (negative goodwill) was
allocated on a pro rata basis to long-lived assets.





Cash
                
                $
                59,245Accounts
      receivable
                
                
                489,527Advance
      to suppliers
                
                
                329,951Other
      receivables
                
                
                128,646Inventory
                
                
                92,370Property
      and equipment
                
                
                73,324Intangible
      assets
                
                
                563,567Accounts
      payable
                
                
                (332,276
                )Advance
      from customers
                
                
                (557,216
                )Deferred
      tax liability
                
                
                (39,076
                )Other
      current liabilities
                
                
                (66,546
                )Purchase
      price
                
                $
                741,516





The
intangible asset consisted of know-how technology is amortized over 5 years, the
customer list over 5 years and covenants not to compete, over 4
years.





The
following unaudited pro forma consolidated results of operations of the Company
for the year ended December 31, 2008 presents the operations of the Company and
SanDeKe as if the acquisition of SanDeKe occurred on January 1,
2008.  The pro forma results are not necessarily indicative of the
actual results that would have occurred had the acquisitions been completed as
of the beginning of the periods presented, nor are they necessarily indicative
of future consolidated results.





F-23




SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 and 2008


For the year ended
                      December 31, 2008
                    
                    Pro forma
                      ConsolidatedNet
      revenue
                    
                    $
                    34,811,919Cost
      of revenue
                    
                    
                    23,470,686Gross
      profit
                    
                    
                    11,341,233Selling
      expense
                    
                    
                    1,564,370General
      & administrative expense
                    
                    
                    2,215,839Total
      operating expenses
                    
                    
                    3,780,209Income
      from operations
                    
                    
                    7,561,024Non-operating
      income net
                    
                    
                    92,887Income
      before income tax
                    
                    
                    7,653,337Income
      tax
                    
                    
                    1,293,823Minority
      interest
                    
                    
                    5,966Net
      income
                    
                    $
                    6,353,548


F-24


SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act
of 1934, the Registrant has duly caused this report on Form 10-K to be signed on
its behalf by the undersigned, thereunto duly authorized.




SMARTHEAT
      INCDate:
      March 31, 2010
              By:
              /s/
      Jun WangJun
      WangChief
      Executive Officer (Principal
                Executive
      Officer)




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report on
Form 10K has been signed below by the following persons on behalf of
the Registrant and in the capacities and on the dates indicated:




Signature
                          
                          Title
                          
                          Date/s/
      Jun Wang
                          
                          Chairman
      of the Board, President & Chief
                            Executive
      Officer
                          
                          March
      31, 2010Jun
      Wang
                          
                          (Principle
      Executive Officer)/s/
      Zhijuan Guo
                          
                          Chief
      Financial Officer and Treasurer
                          
                          March
      31, 2010Zhijuan
      Guo
                          
                          (Principal
      Financial Officer and Principal
                            Accounting
      Officer)/s/
      Xin Li
                          
                          Director
                          
                          March
      31, 2010Xin
      Li/s/
      Arnold Staloff
                          
                          Director
                          
                          March
      31, 2010Arnold
      Staloff/s/
      Weiguo Wang
                          
                          Director
                          
                          March
      31, 2010Weiguo
      Wang/s/
      Wenbin Lin
                          
                          Director
                          
                          March  31,
      2010Wenbin
      Lin




49




EXHIBIT
INDEX





2.1
            Share
      Exchange Agreement and Plan of Reorganization by and among SmartHeat Inc.
      ("SmartHeat"), Shenyang Taiyu Electronic & Machinery Co., Ltd.
      ("Taiyu") and all of the shareholders of Taiyu (the "Taiyu Shareholders")
      dated April 14, 2008 (Incorporated herein by reference to Exhibit 2.1 to
      the Current Report on Form 8-K filed on April 18, 2008)2.2
            Articles
      of Exchange between Taiyu and SmartHeat, dated April 14, 2008
      (Incorporated herein by reference to Exhibit 2.2 to the Current Report on
      Form 8-K filed on April 18, 2008)2.3
            Articles
      of Merger between Pacific Goldrim Resources, Inc. and SmartHeat, dated
      April 14, 2008 (Incorporated herein by reference to Exhibit 2.3 to the
      Current Report on Form 8-K filed on April 18, 2008)3.1
            Articles
      of Incorporation (Incorporated herein by reference to Exhibit 3.1 to the
      Company's Form SB-2 filed on December 22, 2006)3.2
            Amended
      and Restated By-Laws adopted April 15, 2008 (Incorporated herein by
      reference to Exhibit 3(ii) to the Current Report on Form 8-K filed
      on October 16, 2008)4.1
            Specimen
      Stock Certificate (Incorporated herein by reference to Exhibit 4.1 of
      Amendment No. 2 to SmartHeat’s Registration Statement on Form S-1/A filed
      on February 4, 20094.2
            Form
      of Common Stock Purchase Warrant forming part of Units sold, and also
      issued as compensation to selected dealers in our private placement
      offering that had a final closing in August 2008. (Incorporated herein by
      reference to Exhibit 10.13 to the Current Report on Form 8-K filed on July
      11, 2008)10.1
            English
      Translation of Employment Agreement between Taiyu and Jun Wang, dated
      January 1, 2008 (Incorporated herein by reference to Exhibit 10.1 to the
      Current Report on Form 8-K filed on April 18, 2008)10.2
            English
      Translation of Employment Agreement between Taiyu and Zhijuan Guo, dated
      January 1, 2008 (Incorporated herein by reference to Exhibit 10.2 to the
      Current Report on Form 8-K filed on April 18,
  2008)





10.3
            Certificate
      of Appointment by Sondex A/S of Taiyu as Authorized Dealer in China, dated
      March 2006 and letter naming Taiyu as  Dealer of North China,
      dated May 5, 2006 (Incorporated herein by reference to Exhibit 10.4 to the
      Current Report on Form 8-K filed on April 18, 2008)10.4
            Form
      of Purchase Order for with Sondex A/S (Incorporated herein by reference to
      Exhibit 10.5 to the Current Report on Form 8-K filed on April 18,
      2008)10.5
            English
      Translation of Sales Contract between Taiyu and Dalkia (Jiamusi) Urban
      Heating Company Ltd, dated June 18, 2007 (Incorporated herein by reference
      to Exhibit 10.6 to the Current Report on Form 8-K filed on April 18,
      2008)10.6
            Form
      of Purchase Order (Incorporated herein by reference to Exhibit 10.9 to the
      Current Report on Form 8-K filed on April 18, 2008)10.7
            English
      Translation of Loan Agreement with Citibank (China) Co., Ltd., dated June
      25, 2007 (Incorporated herein by reference to Exhibit 10.7 to the Current
      Report on Form 8-K filed on April 18, 2008)10.8
            English
      Translation of Loan Agreement with China CITIC Bank, dated April 17, 2007
      (Incorporated herein by reference to Exhibit 10.8 to the Current Report on
      Form 8-K filed on April 18, 2008)




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10.9
            Resignation
      Letter from Jason Schlombs, dated April 15, 2008 (Incorporated herein by
      reference to Exhibit 10.10 to the Current Report on Form 8-K filed on
      April 18, 2008)10.10
            Agreement
      of Conveyance, Transfer and Assignment of Assets and Assumption of
      Obligations between SmartHeat and Goldrim Holding, Inc., dated April 14,
      2008 (Incorporated herein by reference to Exhibit 10.11 to the Current
      Report on Form 8-K filed on April 18, 2008)10.11
            Stock
      Purchase Agreement between Jason Schlombs and SmartHeat, dated April 14,
      2008 (Incorporated herein by reference to Exhibit 10.12 to the Current
      Report on Form 8-K filed on April 18, 2008)10.12
            Form
      of Registration Rights Agreement in connection with Units sold in our
      private placement offering completed in August 2008 (Incorporated herein
      by reference to Exhibit 10.14 to the Current Report on Form 8-K filed on
      July 11, 2008)10.13
            English
      Translation of Share Exchange Agreement dated September 25, 2008 between
      the Company and Asialink (Far East) Limited (incorporated by reference to
      Exhibit 10.13 of Amendment No. 1 to SmartHeat's Registration Statement on
      Form S-1/A filed on December 12, 2008)10.14
            English
      Translation of the Asset Acquisition Agreement, dated May 27, 2009 by and
      between Taiyu Machinery and Electrical Equipment Co., Ltd and Siping
      Beifang the Heat Exchanger Manufacture Co., Ltd. (Incorporated herein by
      reference to Exhibit 10.14 to the Current Report on Form 8-K filed on May
      29, 2009)10.15
            English
      Translation of the Amended and Restated Asset Purchase Agreement, dated
      June 16, 2009 by and between Taiyu Machinery and Electrical Equipment Co.,
      Ltd and Siping Beifang the Heat Exchanger Manufacture Co., Ltd.
      (Incorporated herein by reference to Exhibit 10.15 to the Current Report
      on Form 8-K/A filed on June 16, 2009)10.16
            Senior
      Loan Agreement with Strong Growth Capital, Ltd., dated July 3, 2009
      (Incorporated herein by reference to Exhibit 10.16 to the Current Report
      on Form 8-K filed on July 7, 2009)10.17
            10%
      Senior Promissory Note dated July 3, 2009, (Incorporated herein by
      reference to Exhibit 10.17 to the Current Report on Form 8-K filed on July
      7, 2009)16.1
            Letter
      from Dale Matheson Carr Hilton Labonte LLP, dated April 18, 2009
      (Incorporated herein by reference to Exhibit 16.1 to the Current Report on
      Form 8-K filed on April 18, 2008)21
            List
      of subsidiaries of the Company




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31.1
            Certification
      of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and
      15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      200231.2
            Certification
      of Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a) and
      15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      200232.1
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002, as signed by  the Chief
      Executive Officer32.2
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002, as signed by the Chief Financial
      Officer




52