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, 2008




OR


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


For the transition
period from        
 to




Commission
file number 000-53052




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 o     No þ


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 o     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 o




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. o




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




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




The
aggregate market value of the registrant’s common stock held beneficially by
non-affiliates of the registrant on June 30, 2008, the last business day of the
registrant’s most recently completed second fiscal quarter, was approximately
$41,095,480, based on the last closing sales price of the registrant’s common
stock as reported by the Over The Counter Bulletin Board 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 15, 2009, there were 24,179,900 shares of common stock
outstanding.




DOCUMENTS INCORPORATED BY
REFERENCE:




None










SMARTHEAT
INC.




ANNUAL
REPORT ON FORM 10-K


FOR THE FISCAL YEAR ENDED DECEMBER
31, 2008




TABLE OF
CONTENTS




PagePART
      IItem
      1.
                Business
                4Item
      1A.
                Risk
      Factors
                44Item
      1B.
                Unresolved
      Staff Comments
                22Item
      2.
                Properties
                22Item
      3.
                Legal
      Proceedings
                22Item
      4.
                Submission
      of Matters to a Vote of Security Holders
                22PART IIItem
      5.
                Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                22Item
      6.
                Selected
      Financial Data
                25Item
      7.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                25Item
      7A.
                Quantitative
      and Qualitative Disclosures About Market Risk
                32Item
      8.
                Financial
      Statements and Supplementary Data
                32Item
      9.
                Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                32Item
      9A(T).
                Controls
      and Procedures
                33Item
      9B.
                Other
      Information
                33PART IIIItem
      10
                Directors,
      Executive Officers and Corporate Governance
                34Item
      11
                Executive
      Compensation
                37Item
      12
                Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                40Item
      13
                Certain
      Relationships and Related Transactions, and Director
      Independence
                41Item
      14
                Principal
      Accountant Fees and Services
                42PART IVItem
      15.
                Exhibits
      and Financial Statement Schedules
                43Signatures
                
                46EX-23.1
                Consent
      of Independent Registered Public Accounting FirmEX-31.1
                Certification
      Pursuant to Section 302 of Jun WangEX-31.2
                Certification
      Pursuant to Section 302 of Zhijuan GuoEX-32
                Certificate
      of the Chief Executive Officer and Chief Financial Officer Pursuant to
      Section Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section
      906 of the Sarbanes-Oxley Act of 2002




Taiyu is
a trademark of the Company. Any other trademarks or trade names mentioned in
this report are the property of their respective owners.





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 provider of plate heat exchanger products to China's industrial,
residential and commercial markets. We design, manufacture, sell, and service
plate heat exchangers ("PHEs"), units which combine plate heat exchangers with
various pumps, temperature sensors, valves, and automated control systems ("PHE
Units"), and heat meters for a broad range of industries, including petroleum
refining, petrochemicals, power generation, metallurgy, food & beverage and
chemical processing. We sell PHEs under the Sondex brand and PHE Units designed
by our engineers and assembled with Sondex plates under our Taiyu brand name. We
are an authorized dealer of Sondex PHEs for the industrial and energy sectors in
China. Our Sondex distribution territory is northern and eastern
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 that intended to
engage in the exploration of 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 the People's Republic of China ("China")
engaged in the design, manufacture, sale, and servicing of plate heat exchange
products in China. The acquisition of Taiyu's equity interests was accomplished
pursuant to the terms of a Share Exchange Agreement dated April 14, 2008 (the
"Share Exchange Agreement") by and among SmartHeat, Taiyu and all of the
shareholders of Taiyu (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 18,500,000 shares of SmartHeat common stock (the "Share
Exchange"). As a result of the Share Exchange, Taiyu became a wholly-owned
subsidiary of SmartHeat.




Prior to
our acquisition of Taiyu, we were in the development stage and had minimal
business operations. We had no interest in any property, but had the right to
conduct exploration activities on thirteen (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





PHEs





A plate
heat exchanger (“PHE”) is a device which 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 plates welded together. Plates come in a variety of sizes and wave
patterns, have large heat transfer surfaces and high thermal conductivity. The
quantity and size of the plates used along with the total size of the PHE varies
according to particular application requirements but generally do not exceed the
size of a large refrigerator. Because of the larger heat transfer surface area
of the PHE and despite its relatively small size, PHEs have higher heat transfer
coefficient than the traditional shell-and-tube heat exchangers.





Heat
exchangers were first invented in the mid 1920s 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
leading to greater savings in fuel consumption and reductions in related
pollution. In the diagram, cold and hot fluids (red and blue arrows) enter heat
exchanger from opposite ends and flow in opposite directions through the plate
heat exchanger maximizing heat transfer from one fluid to the other. Plate heat
exchangers can be taken apart and plates can be added to increase heat transfer
area. This flexibility translates into lower expenditures on installation and
equipment purchases.





DIAGRAM
OF PLATE HEAT EXCHANGER











We are an
authorized dealer of Sondex PHEs for the industrial and energy sectors in
China.  Our Sondex distribution territory is northern and eastern
China. As an authorized
dealer of Sondex PHEs in China, we import finished stainless steel plates from
Sondex and assemble customized PHEs based on our clients'
specifications.  All design of our PHEs is done in-house by our
engineers utilizing a combination of software provided by Sondex and our
proprietary in-house designed software.  In the initial year of our
operations, the PHE was the cornerstone of our product line.  As an
authorized Sondex dealer, we have established a reputation as a high quality
provider of PHEs in China.  In May 2003, we began to sell customized
PHE Units containing Sondex plates.





5





PHE
Units




PHE Units
are mainly used in petroleum refining, chemicals and petrochemicals, energy
generation, HVAC, steel, medical, electronics, food & beverage processing
and other manufacturing sectors to reduce energy waste, improve temperature and
pressure controls and cool equipment. PHE Units are built by integrating PHEs
with various pumps, temperature sensors, valves, and automated control systems
to form a "unit" which is used along with other units to form a "PHE network"
installed in the local district heating systems. We specialize in making PHE
Units for HVAC systems in residential and commercial buildings.




We began
designing, manufacturing and selling our branded PHE Units in May
2003.  Our PHE Units are designed in-house by our system engineers
employing online customized CAD design software based on Solid Works software
which is integrated with our real-time enterprise resource planning system
databases.  This advanced design platform provides the following
benefits:




·
            We
      can provide accurate price quotes instantly;·
            Our
      purchasing function is immediately notified of any additional material
      orders needed; and·
            Our
      manufacturing operations are able to schedule production so that goods are
      delivered on a just-in-time basis.




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 application markets and this is reflected in the price.  In the
recent years, PHE Unit sales have contributed significantly to our revenue
growth and high margins.  Less than five years after entering the
market, we have emerged as a leading domestic producer of PHE Units, with a
market share of approximately 8% in China in 2007.





SMARTHEAT’S
PLATE HEAT EXCHANGER UNIT











6





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 their utilized
space.  Meters indicate heat in legal heat units and the calibration
of meters in many countries is regulated by government agencies and subject to
local or national guidelines.  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.  As of
January 2003, heat meters were required by law nationally for new construction
and the law was extended in April of 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
insignificant.  However, we plan to work with the various government
entities to establish a national heating standard and become an active
participant in China's heat meter market in the coming years.




SMARTHEAT’S
HEAT METERS











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
dominated the Chinese market.  As domestic producers sprang up in the
late 1980's and 1990's they began to take an increasingly larger share of the
market.  The past decade has seen the rise of many domestic
manufacturers along with joint venture operations between local and
international firms.  Today the market is split between domestic
firms, foreign JVs and direct imports.




Today,
heat exchangers are used in heat and power generation, HVAC and refrigeration,
chemicals & petrochemicals, steel & metallurgy, aeronautics, textiles,
food and beverage processing and various other manufacturing
industries.  Heat transfer equipment is also being employed in new
energy applications such as wind, solar, biomass and waste
disposal.




PHEs are
replacing the less efficient shell-and-tube heat exchanges. PHEs can be
installed in existing buildings and facilities as well as in new ones since they
are smaller than traditional heat exchangers and can fit within existing
installations.




PHEs are
used in a wide range of industries with the principal demand originating in the
petroleum refining, petrochemicals, power generation, metallurgy, food &
beverage, and chemical processing industries.





7





Within
the PHE industry, manufacturers are differentiated primarily based upon their
reputation and the technology, improved efficiency, and durability of their
products.  Given the growing importance of energy conservation and
waste reduction, PHEs are likely to play an increasingly important role in many
industries.




China
Heat Association believes that the domestic market for PHEs was approximately
$2.4 billion in 2007 and that it is expected to grow at an annual rate of about
30% until 2010 due to the continuation of industrialization and urbanization
trends in China. China Heat Association also believes that the domestic
market for PHE Units was approximately $139 million in 2007 and it is expected
to grow at an annual rate of 70% until 2010.





The
global market for heat transfer products and compact PHE Units in 2007 was
approximately $12 billion and $2.3 billion, respectively according to Alfa
Laval, a leading manufacturer in our industry.  Large international
PHE producers include: Alfa Laval, Sondex, GEA, Tranter SWEP, Danfoss, and
Hisaka Works.




New
environmental policies and regulations are also expected to have a positive
impact on the demand for PHE products.





Production




Until
recently, we conducted all of our manufacturing activities at our Shenyang
plant.  On September 25, 2008 we acquired SanDeKe, a PHE manufacturing
company located in Pudong district, Shanghai. SanDeKe leases a manufacturing
facility and business offices.




We
generally operate on an 8 hour shift, with the exception of the high season from
May to November, during which we may operate the plant for 11-12 hours a
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 10 PHEs, 3 PHE Units, and 50 heat meters per day and our
SanDeKe facility has the capacity to produce 17 PHEs per day.




Marketing




Since our
entry into the market for PHE Units in May 2003, the Taiyu brand name has been
promoted in conjunction with quality production and first-rate service by means
of our successful track record, industry trade fairs and establishing and
maintaining positive relationships with local governments in Beijing, Shenyang,
Urumqi, Shandong, Jiangsu and Shanghai.  We attend the bi-annual HVAC
trade fair in Shanghai and Chinese environmental protection forums and we visit
the local utilities companies, oil refiners, steel and food & beverage
companies.  Marketing costs are generally funded through working
capital and expensed as incurred.





Suppliers




Plates




Plates are
supplied by Sondex under the terms of our Sondex authorized dealer
arrangement.  We generally order stainless steel plates 2-3 months in
advance based on production needs and forecasted sales.  Plate
purchases generally constitute 40% of our total annual raw material
purchases.  While we are an authorized dealer, annual or quarterly
purchasing prices are not fixed and fluctuate according to Sondex's most recent
pricing list.




Components




Components
generally include pumps, valves, pipes, and electronic meters purchased from a
variety of international (Siemens, Wilo A.G., Honeywell) and domestic suppliers
who have been certified to meet Taiyu's quality
specifications.  Components are ordered on an as needed
basis.  Plates and components together constituted approximately 98%
of raw material purchases in 2007.




Customers




We sell
both directly through our sales force and through a network of 29 national
distributors located throughout China.  Our customer base consists
mainly of large companies with our 10 largest customers accounting for 32% of
our total sales of $32,676,082 in the fiscal year ended 2008.  Our 10
largest customers and their respective revenues during 2008 are as
follows:





8





Customer Name
                
                Sales
                
                
                % of Sales 2008Shanghai
      Guoshe Electromechanical Engineering CO., LTD
                
                $
                1,800,104
                
                
                
                6
                %Dalkai(
      Jiamusi ) City Heat CO., LTD
                
                
                1,787,756
                
                
                
                5
                %Shanghai
      Langu mechanical engineering CO., LTD
                
                
                1,085,753
                
                
                
                3
                %Eerduosi
      Dongsheng District House Property Bureau
                
                
                1,012,013
                
                
                
                3
                %Urumqu
      Heat Head Office
                
                
                939,388
                
                
                
                3
                %Dalkai
      Sunny( Harbin ) thermoelectricity Co., LTD
                
                
                828,572
                
                
                
                3
                %China
      Precision Machinery Import and Export CO., LTD
                
                
                789,433
                
                
                
                2
                %CPCC
      Shengli Oil Field
                
                
                753,611
                
                
                
                2
                %Jiangxi
      Saiwei LDK SolarEnergy Hightech Co., LTD
                
                
                748,237
                
                
                
                2
                %Wuhu
      Qiaohong International CO., LTD
                
                
                675,776
                
                
                
                2
                %Total
                
                $
                10,420,642
                
                
                
                32
                %





Each sale
can range from $2,500 to $500,000 and up depending on the client's
needs.  Contract implementation generally takes one to six
months.  Outstanding receivables are collected upon completion of work
with the exception of an approximate 10% warranty hold-back that remains unpaid
and outstanding for 3 - 24 months following delivery and contract
completion.   All of our work is performed based on written contracts
and there are no oral contracts.  Historically, the Company has not
had any uncollected warranty hold-backs.




Intellectual
Property




We use
the Taiyu brand name on all the PHE Units and heat meters we sell.  We
have registered and received approval from the China Trademark Bureau for this
trade name.  We believe that the Taiyu brand name is recognized in
China's heating industry for quality and efficiency.  We have six
registered patents in China for both PHE products and heat
meters.  Four of our patents expire in 2014, one expires in 2016 and
the last expires in 2017.




These
patents are integral to our ability to create and design PHEs and PHE
Units.  To the extent third parties utilize such patents in their
work, we do not receive royalties or licensing fees from any such third
parties.




Research
and Development




To
maintain our competitive edge in the marketplace and keep pace with new
technologies, constant research and development work is required to find
improved efficiencies in design, cost, and energy capture.  While the
core technology for plate production remains with Sondex, our competitive
advantage in the market stems from our engineering and system design
capabilities.




Research
and development costs are funded through working capital and expensed as
incurred.  Research and development costs for 2007 and 2008 were
$343,800 and $1,020,000, respectively. We plan to spend approximately $300,000
in 2009 on identifying new industry applications for PHEs, improving the
accuracy of heat meters, designing heat meters for industrial usage, developing
multifunctional PHE units and modifying PHE designs to meet the current market
demand.





While we
have no formal written alliances with the universities, we work with several
professors who are heat transfer experts on an individual consulting
basis.




Governmental
and Environmental Regulation




While our
PHE & PHE Units business and products are not subject to any material
regulation by the Chinese government or other national agency, we have obtained
National Safety Certification for our PHE products and we are an ISO 9000
certified manufacturer.  The National Safety Certification is not
required for either 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.  Of over 500 companies selling
PHEs in China, we believe that only 30 companies have obtained this
certification.





9





Our heat
meters require a license for production and sale.  We obtained this
license on August 12, 2005.  The license is valid through April 1,
2009.  We have applied for a renewal of this license.  We
currently anticipate that we will have a renewed license in place before April
1, 2009.  The Safety Bureau conducts site visits and inspections of
documents on a periodic basis to verify adherence to the standards.




Legislation
has been passed requiring the installation of heat meters.  As of
January 2003, heat meters were required by law nationally for new construction
and the law was extended in April of 2008 by the Energy Conservation Law,
Article 38, to existing buildings being retrofitted.




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 only in the domestic Chinese market.  We believe our
competitive advantages lie in our superior engineering and design skills, our
affiliation with Sondex, the longevity and efficiency of the Sondex plates we
use, our just-in-time delivery and the reliable after sale service we provide
through our local service centers.




PHEs




Alfa
Laval has the largest market share in mainland China.  An assortment
of other foreign producers hold an aggregate market share of 20%, and the rest
of the market is divided among multiple domestic producers.  We
believe the quality of our PHEs is considered on par with Alfa Laval's as are
our prices.  In comparison with the other domestic producers, our
prices are approximately 15% higher.




PHE
Units




According
to data from the China 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-US JV established by Denmark's Accessen and
utilizing Alfa Laval plates as well as their own plates in their PHE
Units).  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, but negotiate directly with the customers.  We have done prior
projects with some of the customers we negotiate with, including one of our
largest customers in 2008, Dalkia, a JV between Dalkia and the local government
in 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 leaders.  Currently, the
industry lacks National product standards which will be needed because of the
legislation requiring heat meters for all residential and commercial
spaces.  Two of our goals for the near future are to become an
integral player in the establishment of national heat meter standards and a
leading supplier of heat meters in China.





10





Seasonality




We
typically experience stronger sales in the third and fourth calendar quarters.
Our quarterly revenues may fluctuate significantly due to the seasonal nature of
central heating services in China , whereas, the equipment used in residential
buildings must be delivered and installed prior to the beginning of the heating
season in late fall.





Employees




As of
December 31, 2008, we had 210 full-time employees.




We
maintain strong ties with our employees and staff and retention is
stable.  Our employee contracts adhere to both State and Provincial
employment 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 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.






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.




Risks
Related to Our Business




Our
relationship with Sondex has substantially contributed to our business and its
growth. We could be adversely affected if that relationship
terminated




We are an
authorized dealer appointed by Sondex A/S for PHEs for the industrial and energy
sectors in China. Our territory is eastern and northern. Sondex is one of the
world's leading PHE manufacturers. Our sales of Sondex PHEs have contributed to
our reputation for the high quality of the products we manufacture and sell. If
our relationship with Sondex were to terminate, our business, revenues, and
results of operations could be adversely affected.




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.





11





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 10
largest customers accounted for 32% of our revenues for the fiscal year ended
December 31, 2008. Our largest customer accounted for 6%of our revenues in the
fiscal year ended December 31, 2008. 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 may be
seriously affected.





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




We
believe that 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 that 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.




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




While we
believe that 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 that 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 that we have developed strategic relationships to best
penetrate the China market, we face competition from other manufacturers of
product similar to our products. Some of our competitors' advantages over us in
both 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 market 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.





12





If
we are not as successful as our competitors in our target markets, our sales
could decline, our margins could be negatively impacted and we could lose market
share, any of which could materially harm our business




We depend
on a limited number of suppliers of components for our products and if we are
unable to obtain these components when needed, we would experience delays in
manufacturing our products and our financial results could be adversely
affected.




We
acquire most of the components for the manufacture of our products from a
limited number of suppliers. In order for us to have our products manufactured,
these components must be available at the right level of quality and at the
right price. 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 alternative suppliers without redesign, but
only at higher prices than we currently pay or for delivery later than required
by our production schedule. We rely on Sondex for parts for our PHE products and
PHE Units. If we were unable to obtain adequate supplies of parts from Sondex at
commercially reasonable prices, our operations could be interrupted. 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.





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 and 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. 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 material 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.




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.





13





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 that 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.





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 that 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.





14





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 that
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.





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
that 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 that we will be successful in locating a suitable financing
transaction in a timely fashion or at all. In addition, there is no assurance
that 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.





15





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 that 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.





Risks
Related to Doing Business in China




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 United States,
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 United States 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.




16




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 be altered in the coming years. Tax benefits that 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.




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
that 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 United States 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 United States 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.





17





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.





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.





18





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, or 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.




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. If we fail to receive such
approvals, our ability to use the proceeds of this offering and to capitalize
our PRC operations may be negatively affected, which could adversely affect our
liquidity and our ability to fund and expand our business.




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 the State Administration of Foreign Exchange, or 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.





19





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





Almost
all  of our
revenues are denominated in Renminbi. Conducting business in currencies other
than US 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 US 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 US dollar, our reported profitability when
stated in US 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.




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 United States courts. In addition, the courts
in China may not permit the enforcement of judgments arising out of United
States federal and state corporate, securities or similar laws. Accordingly,
United States investors may not be able to enforce judgments against us for
violation of United States securities laws.




Risks
Related to Our Securities




Our
director and Chief Executive Officer has a substantial ownership interest in one
of our major stockholders which gives him significant influence over certain
major decisions on which our stockholders may vote and may discourage an
acquisition of us




Mr. Jun
Wang, our director and Chief Executive Officer, owns 50% of the equity in
Beijing YSKN Machinery & Electronic Equipment Co., Ltd ("YSKN"), a company
which is the record holder of 28.16% of our outstanding common stock. Mr. Wang
has substantial influence over the actions of that substantial stockholder. As a
result, Mr. Wang has significant influence over all corporate actions requiring
stockholder approval, irrespective of how the Company's other stockholders may
vote, including the following actions:





20





·
            electing or defeating the
      election of our directors;




·
            amending or preventing amendment
      of our certificate of incorporation or
  bylaws;





·
            effecting or preventing a merger,
      sale of assets or other corporate transaction;
  and




·
            controlling the outcome of any
      other matter submitted to the shareholders for
  vote.




The
interests of Mr. Wang may differ from the interests of other stockholders. This
may discourage a potential acquirer from making a tender offer or otherwise
attempting to obtain control of the Company, which in turn could reduce our
stock price or prevent our stockholders from realizing a premium over our stock
price.




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 secondary offerings on our
behalf.




Future
sales of shares of our common stock by our stockholders could cause our stock
price to decline




We cannot
predict the effect, if any, that market sales of shares of our common stock or
the availability of shares of common stock for sale will have on the market
price prevailing from time to time. If our stockholders sell substantial amounts
of our common stock in the public market upon the effectiveness of a
registration statement, or upon the expiration of any holding period under Rule
144, such sales could create a circumstance commonly referred to as an
"overhang" and in anticipation of which the market price of our common stock
could fall. The existence of an overhang, whether or not sales have occurred or
are occurring, also could make more difficult our ability to raise additional
financing through the sale of equity or equity-related securities in the future
at a time and price that we deem reasonable or appropriate. The 18,500,000
shares of common stock we issued in the share exchange with the former
shareholders of Taiyu will be freely tradable upon the earlier of (i)
effectiveness of a registration statement covering such shares; and (ii) the
date on which such shares may be sold without registration pursuant to Rule 144
under the Securities Act of 1933, as amended (the "Securities Act"), and the
sale of such shares could have a negative impact on the price of our common
stock.




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 50,408,000
authorized 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 offering 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."




21




Item 1B. Unresolved Staff
Comments


Not
applicable.





Item 2.    Properties




Our
headquarters and 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 four vehicles, two dual beam
cranes and other special equipment.




SanDeKe
is located in Shanghai, Pudong District, PRC. SanDeKe leases a 1,500 square
meter manufacturing facility and 200 square meters of office space.





We
believe that our facilities are adequate for our current operations for fiscal
2009.





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.





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





None.





PART II




Item 5.
            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 Capital 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
bid prices per share of our common stock for each quarter (or portion thereof)
beginning on April 22, 2008 as reported by the OTC Bulletin
Board.  These quotations represent inter-dealer prices, without retail
mark-up, markdown, or commission and may not represent actual
transactions.





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





22





On March
9, 2009, there were approximately 450 stockholders of record based on
information provided by our transfer agent.




We have
never declared or paid cash dividends on our common stock and do not anticipate
paying any cash dividends on our common stock in the foreseeable
future.





We did
not repurchase any of our common stock during 2008.





Dividends





We have
never paid any dividends on the common stock.  We currently anticipate
that any future earnings will be retained for the development of our business
and do not anticipate paying any dividends on the common stock in the
foreseeable future.





Securities
authorized for issuance under equity compensation plans





During
the year ended December 31, 2008, we did not have a formal equity compensation
plan in effect.  We granted two independent directors options to
purchase 20,000 shares of common stock during the year ended December 31, 2008.
We did not grant any other equity based compensation awards during the year
ended December 31, 2008.





The
following table provides aggregate information as of December 31, 2008 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
                  
                  
                  20,000
                  
                  
                  $
                  4.60
                  
                  
                  
                  -0-Total
                  
                  
                  20,000
                  
                  
                  $
                  4.60
                  
                  
                  
                  -0-




Recent Sales of Unregistered
Securities





On August
8, 2006, we issued 2,500,000 shares of common stock to Mr. Jason Schlombs in
consideration of $ 0.001 per share for a total of $2,500 in a transaction exempt
from the registration requirements of the Securities Act pursuant to Regulation
S promulgated by the SEC thereunder.




On August
25, 2006, we issued 4,000,000 shares of common stock to 15 individuals for
consideration of $0.0075 per share for a total of $30,000 in a transaction
exempt from the registration requirements of the Securities Act pursuant to
Regulation S promulgated by the SEC thereunder.





23





On August
31, 2006, we issued 49,900 shares of common stock to 18 individuals in
consideration of $0.25 per share for a total of $12,475 in a transaction exempt
from the registration requirements of the Securities Act pursuant to Regulation
S promulgated by the SEC thereunder.





On April
14, 2008, pursuant to the terms of a Share Exchange Agreement dated April 14,
2008, by and among SmartHeat, Taiyu and the Taiyu Shareholders, each of whom is
a non-US person (as contemplated by Rule 902 under the Securities Act), all of
the equitable and legal rights, title and interests in and to Taiyu's share
capital in the amount of RMB25,000,000 (approximately $3,571,939 based on an
exchange rate of US$1.00 = RMB6.999) were exchanged for an aggregate of
18,500,000 shares of SmartHeat common stock. These issuances were exempt from
registration requirements under Regulation S under the Securities
Act.





On July
7, 2008, we sold an aggregate of 1,620,000 Units at an offering price of $3.50
per Unit for aggregate gross proceeds of approximately $5.67 million to each of
the following persons:





G
      & S I Fund LP
                  C.
      Robert Shearer
                  Nancy
      Palmero and Herman Palmero
                  Thomas
      Knox
                  Arnold
      Staloff
                  Domaco
      Venture Capital Fund Partnership
                  Marc
      Engelbert
                  Andrew
      Grossman Profit Sharing Plan, Pershing LLC as Custodian
                  Norton
      Hight & Joan Hight
                  Randall
      W. Hight
                  Maura
      Kelly
                  Wolfe
      F. Model
                  Anthony
      G. Polak
                  IRA
      FBO Anthony G. Polak, Pershing LLC as Custodian
                  IRA
      FBO Jack Polak, Pershing LLC as Custodian
                  Jonathan
      Rothschild
                  Elias
      Sayour Foundation Incorporated
                  Gary
      Stadtmauer
                  Rhea
      D. Stadtmauer and Janice Maiman
                  Teddy
      Chasanoff
                  Ross
      Pirasteh
                  Sandra
      G. Shapiro & Robert S. Shapiro
                  John
      Gross
                  Murray
      Stadtmauer & Clare Stadtmauer
                  IRA
      FBO Ronald M. Lazar Pershing As Custodian
                
                IRA
      FBO Kevin Clarke, Pershing LLC as Custodian
                  RL
      Capital Partners, LP
                  Geri
      Investments N.V.
                  IRA
      FBO Daniel Berkowitz Pershing LLC as Custodian
                  Harmon
      Corporation A.V.V.
                  Funcorp
      Associates Ltd.
                  La
      legetaz Private Foundation
                  Evie
      Falda & David Falda,
                  Ann
      V. Clemente
                  William
      H. Peterson Living Trust
                  Allied
      Diesel Service Inc. Employee Profit Sharing Plan #2
                  Florence
      E. Luvera
                  Kalman
      A. Barson (Roth IRA)
                  Steve
      Roman
                  Suellyn
      P. Tornay
                  Eximius
      bvba
                  IRA
      FBO David Swerdloff Pershing LLC as Custodian
                  Michael
      A. Berlinger
                  Sun
      Fun Investing Inc.
                  Strong
      Growth Capital Ltd
                  Yuzhen
      Hou
                  The
      USX China Fund
                  White
      Sand Investor Group, L.P.
                  Gibralt
      Capital Corporation





Each
"Unit" consisted of one share of our common stock and a three year warrant to
purchase 15% of one share of our common stock at an exercise price of $6.00 per
share (the "Warrants"). The Units sold represent an aggregate of 1,620,000
million shares of Common Stock and Warrants to purchase 243,000 shares of Common
Stock. The offering and sale of the Units was exempt from the registration
requirements of the Securities Act pursuant to Section 4(2) of the Securities
Act and Regulation D and Regulation S promulgated by the SEC thereunder. We
compensated three placement agents that assisted in the sale of the Units in
this private placement offering by (i) paying them cash equal to 6.5% of the
gross proceeds from the sales of Units placed and (ii) issuing them Warrants to
purchase that number of shares of Common Stock equal to 10% of the Units placed
as follows:




Placement Agent
                
                Cash
                
                WarrantsRodman
      & Renshaw, LLC
                
                $
                23,888
                
                56,500Maxim
      Group LLC
                
                $
                104,650
                
                —Four
      Tong Investments Ltd.
                
                $
                207,025
                
                91,000





24





The
Warrants granted to these placement agents had the same terms and conditions as
the Warrants granted in the offering.





On August
22, 2008, we sold an additional 10,000 Units at an offering price of $3.50 per
Unit for gross proceeds of approximately $35,000 to David L. Quinn and Tracy
Quinn. The offering and sale of the Units was exempt from the registration
requirements of the Securities Act pursuant to Section 4(2) of the Securities
Act and Regulation D promulgated by the SEC thereunder.  We paid Seaboard
Securities $2,275 and issued to Seaboard Securities Warrants to purchase 1,000
shares of our common stock in connection with this transaction.





Item 6.    Selected
Financial Data


Not
applicable.





Item 7.            
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations





Safe
Harbor Declaration




The
comments made throughout this prospectus should be read in conjunction with our
financial statements and the notes thereto, and other financial information
appearing elsewhere in this document. In addition to historical information, the
following discussion and other parts of this document contain certain
forward-looking information. When used in this discussion, the words,
"believes," "anticipates," "expects," and similar expressions are intended to
identify forward-looking statements. Such statements are subject to certain
risks and uncertainties, which could cause actual results to differ materially
from projected results, due to a number of factors beyond our control. SmartHeat
does not undertake to publicly update or revise any of its forward-looking
statements, even if experience or future changes show that the indicated results
or events will not be realized. Readers are cautioned not to place undue
reliance on these forward-looking statements, which speak only as of the date
hereof. Readers are also urged to carefully review and consider our discussions
regarding the various factors, which affect company business, included in this
section and elsewhere in this prospectus.




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 the exploration of silver, lead and zinc. On April 14, 2008 we changed
our name to SmartHeat Inc. and acquired all of the equity interests in
Taiyu.




Prior to
our acquisition of Taiyu, we were in the development stage and had minimal
business operations. We had no interest in any property, but had the right to
conduct exploration activities on thirteen (13) mineral title cells covering
270.27 hectares (667.85 acres) in the Slocan Mining Division of southeastern
British Columbia, Canada. In connection with the acquisition of Taiyu, we
transferred our prior assets and liabilities 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 2,500,000 shares of our common
stock.




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 the
Sondex brand and PHE Units that are designed by us and using PHEs that are
assembled with Sondex plates under our Taiyu brand name.




25




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 quarterly revenues may fluctuate significantly due to the seasonal
nature of central heating services in the PRC, whereas, the equipment used in
residential building s 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. In particular, our 2009 sales
may be affected by weaker demand from steel processing, petrochemical and HVAC
sectors.  To date, we have not been adversely affected by these
trends. 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.  However, due to the possibility of fluctuations in our
revenue and net income or loss, we believe that quarterly comparisons of our
operating results are not a good indication of future performance.





While
our significant accounting policies are more fully described in Note 2 to our
consolidated financial statements, we believe that 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.





Principle
of Consolidation




The
accompanying consolidated financial statements include the accounts of
SmartHeat, SanDeKe, Taiyu, Taiyu’s 55% owned subsidiary, Qingdao Yushi Heat
Power Equipment Co., Ltd ("Yushi") which also disposed by the Company in August,
2008. Yushi is engaged in manufacturing and selling of heat power equipment. For
purposes of this Annual Report, the "Company" refers collectively to SmartHeat,
SanDeKe, Taiyu and Yushi. All significant inter-company accounts and
transactions have been eliminated in consolidation.




Use
of Estimates




In
preparing the financial statements in conformity with accounting principles
generally accepted in the United States of America, 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.




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:





26





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




Revenue
Recognition




Our
revenue recognition policies are in compliance with SEC Staff Accounting
Bulletin (“SAB”) 104. Sales revenue is recognized when products are delivered
and customer acceptance is made when applicable, the price is fixed or
determinable, no other significant obligations of SmartHeat exist and
collectibility is reasonably assured. Payments received before all of the
relevant criteria for revenue recognition are met are recorded as unearned
revenue.





Foreign
Currency Translation and Comprehensive Income (Loss)




Our
functional currency is the Chinese yuan renminbi (“RMB”). For financial
reporting purposes, RMB has been 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.” 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.




Recent
Accounting Pronouncements




Accounting for Financial
Guarantee Insurance Contracts




In May
2008, FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance
Contracts, an interpretation of FASB Statement No. 60.”  The scope of this
Statement is limited to financial guarantee insurance (and reinsurance)
contracts, as described in this Statement, issued by enterprises included within
the scope of Statement 60. Accordingly, this Statement does not apply to
financial guarantee contracts issued by enterprises excluded from the scope of
Statement 60 or to some insurance contracts that seem similar to financial
guarantee insurance contracts issued by insurance enterprises (such as mortgage
guaranty insurance or credit insurance on trade receivables). This Statement
also does not apply to financial guarantee insurance contracts that are
derivative instruments included within the scope of FASB Statement No. 133,
“Accounting for Derivative Instruments and Hedging Activities.” This Statement
will not have an impact on the Company’s financial statements.





The Hierarchy of Generally
Accepted Accounting Principles





In May
2008, FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting
Principles.”  SFAS 162 identifies the sources of accounting principles and
the framework for selecting the principles to be used in the preparation of
financial statements of nongovernmental entities that are presented in
conformity with generally accepted accounting principles (GAAP) in the United
States (the GAAP hierarchy).  SFAS 162 adoption will not have an impact on
the Company’s financial statements.




Disclosures about Derivative
Instruments and Hedging Activities




In March
2008, FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and
Hedging Activities an amendment of FASB Statement No. 133.”  SFAS 161
changes the disclosure requirements for derivative instruments and hedging
activities. Entities are required to provide enhanced disclosures about (a) how
and why an entity uses derivative instruments, (b) how derivative instruments
and related hedged items are accounted for under Statement 133 and its related
interpretations, and (c) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash
flows.  Based on current conditions, the Company does not expect the
adoption of SFAS 161 to have a significant impact on its results of operations
or financial position.





27





Fair
value of measurements





On
January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements.”
SFAS 157 defines fair value, establishes a three-level valuation hierarchy for
disclosures of fair value measurement and enhances disclosures requirements for
fair value measures..  The three levels are defined as follow:





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




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




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




As of
December 31, 2008, the Company did not identify any assets and liabilities that
are required to be presented on the balance sheet at fair value.




Non-Controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No.
51





In
December 2007, FASB issued SFAS No. 160, "Non-controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No. 51." SFAS 160
establishes new accounting and reporting standards for the non-controlling
interest in a subsidiary and for the deconsolidation of a subsidiary.
Specifically, this statement requires the recognition of a non-controlling
interest (minority interest) as equity in the consolidated financial statements
and separate from the parent’s equity. The amount of net income attributable to
the non-controlling interest will be included in consolidated net income on the
face of the income statement. SFAS 160 clarifies that changes in a parent’s
ownership interest in a subsidiary that do not result in deconsolidation are
equity transactions if the parent retains its controlling financial interest. In
addition, this statement requires that a parent recognize a gain or loss in net
income when a subsidiary is deconsolidated. Such gain or loss will be measured
using the fair value of the non-controlling equity investment on the
deconsolidation date. SFAS 160 also includes expanded disclosure requirements
regarding the interests of the parent and its non-controlling interest. SFAS 160
are effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. The Company expects SFAS 160 will
have an impact on accounting for business combinations once adopted but the
effect is dependent upon acquisitions at that time.




Business
Combinations




In
December 2007, FASB issued SFAS No. 141 (Revised 2007), "Business
Combinations." SFAS 141R will significantly change the accounting for business
combinations. Under SFAS 141R, an acquiring entity will be required to recognize
all the assets acquired and liabilities assumed in a transaction at the
acquisition-date fair value with limited exceptions. SFAS 141R will change the
accounting treatment for certain specific items, including:





·
            Acquisition
      costs will be generally expensed as
incurred;





·
            Non-controlling
      interests (formerly known as “minority interests” - see SFAS 160
      discussion above) will be valued at fair value at the acquisition
      date;





·
            Acquired
      contingent liabilities will be recorded at fair value at the acquisition
      date and subsequently measured at either the higher of such amount or the
      amount determined under existing guidance for non-acquired
      contingencies;





28





·
            In-process
      research and development will be recorded at fair value as an
      indefinite-lived intangible asset at the acquisition
  date;





·
            Restructuring
      costs associated with a business combination will be generally expensed
      subsequent to the acquisition date;
and





·
            Changes in deferred tax asset
      valuation allowances and income tax uncertainties after the acquisition
      date generally will affect income tax
  expense.





SFAS 141R
also includes a substantial number of new disclosure requirements. SFAS 141R
applies prospectively to business combinations for which the acquisition date is
on or after the beginning of the first annual reporting period beginning on or
after December 15, 2008. Earlier adoption is prohibited. Accordingly, since
the Company is a calendar year-end company and will continue to record and
disclose business combinations following existing GAAP until January 1,
2009. The Company expects SFAS 141R will have an impact on accounting for
business combinations once adopted but the effect is dependent upon acquisitions
at that time.





Accounting for
Non-Refundable Advance Payments for Goods or Services Received for Use in Future
Research and Development Activities





In June
2007, FASB issued FASB Staff Position No. EITF 07-3, “Accounting for
Nonrefundable Advance Payments for Goods or Services Received for use in Future
Research and Development Activities,” which addresses whether non-refundable
advance payments for goods or services that used or rendered for research and
development activities should be expensed when the advance payment is made or
when the research and development activity has been performed. EITF 07-03
is effective for fiscal years beginning after December 15, 2008. Management
is currently evaluating the effect of this pronouncement on our financial
statements.





Results
of Operations




Year
Ended December 31, 2008 Compared to the Year Ended December 31,
2007




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




Years Ended December 312008
                          
                          
                          2007$
                          
                          
                          % of Sales
                          
                          
                          $
                          
                          
                          % of SalesSales
                          
                          
                          32,676,082
                          
                          
                          
                          
                          
                          
                          13,273,151Cost
      of sales
                          
                          
                          21,717,735
                          
                          
                          
                          66.0
                          %
                          
                          
                          8,667,353
                          
                          
                          
                          65.0
                          %Gross
      Profit
                          
                          
                          10,958,347
                          
                          
                          
                          34.0
                          %
                          
                          
                          4,605,798
                          
                          
                          
                          35.0
                          %Operating
      Expenses
                          
                          
                          3,416,670
                          
                          
                          
                          10.0
                          %
                          
                          
                          2,369,090
                          
                          
                          
                          18.0
                          %Income
      from Operation
                          
                          
                          7,541,677
                          
                          
                          
                          23.0
                          %
                          
                          
                          2,236,708
                          
                          
                          
                          17.0
                          %Other
      Income (Expenses), net
                          
                          
                          93,289
                          
                          
                          
                          0.3
                          %
                          
                          
                          24,957
                          
                          
                          
                          0.2
                          %Net
      Income
                          
                          
                          6,335,340
                          
                          
                          
                          19.0
                          %
                          
                          
                          2,087,891
                          
                          
                          
                          16.0
                          %





Sales.Net sales for 2008
were approximately $32.68 million, while our net sales in 2007 were
approximately $13.27 million, an increase in revenues of $19.40 million, or
146%. Approximately $14.76 million of the increase in sales was
attributable to an increase in our sales volume with selling price determined
based on our standard profit margin rate, of which, $10.57 million of increased
sales was from our existing customers and $4.19 million of increased sales was
from the new customers. We have a strict review process for approving each sales
contract, especially with respect to the determination of 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 mainly depends on each customer’s specific needs
and our negotiation of the contract amount and term. At September 23, 2008, we
acquired SanDeKe Co., Ltd (“SanDeKe”) which brought us additional $1.98 million
sales for 2008.  We have also increased the number of our branch
offices and sales representatives throughout China to develop new customers in
more regions. These new regions’ developments that occurred during 2008
accounted for approximately $2.07 million of the increase in our
revenues. In addition, we’ve increased our sales of heat meters by
approximately $0.52 million due to increased demand.  As we continue
to expand our customer base and increase our sales volume, we become less
dependent on these customers for revenue.  We believe that our sales
will continue to grow because we are strengthening our sales efforts by hiring
more sales personnel, increasing the sales channels, and improving the quality
of our products.





29





Cost of Sales.
  Cost of sales for 2008 was approximately $21.72 million, while our
cost of sales in 2007 was approximately $8.67 million, an increase of $13.05
million, or 151%.  Cost of sales mainly consisted of the cost of
materials and labor, as well as factory overhead costs, with material costs
accounting for 70% or more of our total cost of sales.  The increase
in cost of sales can be attributed to the increase of production and sales
volume in 2008.  Cost of sales as a percentage of sales was
approximately 66% for 2008 and 65% for 2007. The slight increase in cost of
sales was mainly due to relatively high cost of plate heat exchanger from
SanDeKe.  SanDeKe only produces plate heat exchanger which normally
has relatively higher cost of sales as a percentage of sales comparing with
assembled heat exchange unit and meter.  Even though raw materials are
major components in the determination of our cost of sales, a change in the
pricing of our raw materials would not adversely impact our
revenue.  We utilize a common pricing strategy in our industry,
adjusting the price of our product as the cost of raw materials
changes.  As a result, we generally increase our sales price when raw
material prices increase and decrease our sales price to remain competitive when
raw material prices decrease.  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 $10.96 million for 2008, as compared
to $4.61 million for 2007, representing gross margins of approximately 34% and
35% for 2008 and 2007, respectively.  The increase in our gross
profits but slight decrease in gross profit margin was mainly due to the
increase of cost of goods sold as percentage of sales while the company’s sales
activities increased.




Operating
Expenses.  Operating expenses consisted of selling, general and
administrative expenses totaled approximately $3.42 million for 2008, as
compared to $2.37 million for 2007, an increase of approximately $1.05 million
or 44%.  The increase in operating expenses was mainly due to a
proportional increase in payroll, insurance, 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 of
being public in US since April of 2008.





Net Income.  Our
net income for 2008 was $6.34 million as compared to approximately $2.09 million
for 2007, an increase of $4.25 million or 203%.  This increase is
attributable to economies of scale combined with rapid growth in revenue and
efficiency of operations. 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.





Liquidity
and Capital Resources




As of
December 31, 2008, we had cash and cash equivalents of approximately $1.44
million. Working capital was approximately $13.64 million at December 31,
2008. The ratio of current assets to current liabilities was 2.90:1 at December
31, 2008.





The
following is a summary of cash provided by or used in each of the indicated
types of activities during years ended December 31, 2008 and 2007:




For the Years Ended December 31,2008
                
                
                2007Cash
      provided by (used in):Operating
      Activities
                
                $
                (761,033
                )
                
                $
                (2,041
                )Investing
      Activities
                
                
                (507,110
                )
                
                
                (1,045,195
                )Financing
      Activities
                
                
                2,307,620
                
                
                
                1,216,723





30





Net cash
flow used in operating activities was $761,033 in 2008, as compared to net cash
flow used in operating activities of $2,041 in 2007. The increase in net cash
flow used in operating activities in 2008 was mainly due to $2.39 million cash
paid for accounts payable as we’ve increased our purchase due to increased
production, less unearned revenue received from customers for approximately
$2.99 million and increases in our accounts receivables and retention
receivables of approximately $5.02 million. Our net income has increased
rapidly compared to 2007 which brought more cash to the company, but at the same
time, our accounts receivable have increased which held back our cash inflows.
The significant increase 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.  Our inventory generally decreases in the
latter part of the year as a significant share of PHE Unit deliveries must be
completed by the beginning of heating season in late fall, which brought us
about $2.41 million cash inflow.





Net cash
flow used in investing activities was $507,110 in 2008, as compared to net cash
used in investing activities of $1,045,195 in 2007.  The decrease of
net cash flow used in investing activities in year 2008 was mainly due to less
cash spend for acquisition of manufacturing equipment, office equipment and
furniture during the year.




Net cash
flow provided by financing activities was $2,307,620 in 2008 as compared to net
cash provided by financing activities of $1,216,723 in 2007. The increase of net
cash flow provided by financing activities in 2008 was mainly due to net
proceeds of $5,100,000 from the shares issued despite repayments of $2.79 for
the loans from third parties and shareholders during the year.





Our
products are generally paid for within six months of delivery; 30% of the
purchase price is due upon the placement of an order, 30% is due on delivery and
30% is due on acceptance.  The final 10% of the purchase price may
remain outstanding for up to 24 months as a quality assurance and is accounted
for in our financial statements as Retentions Receivable. Indirect sales through
distributors are usually paid in full on delivery. 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 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.  For 2007, we had accounts receivable turnover of 2.8, with
days sales outstanding of 167 and inventory turnover of 1.09 on an annualized
basis.





We are in
the manufacturing and processing business.  We purchase substantial
amounts of raw materials before the high season (mid-April to mid-October)
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.





80-90% of
the purchase price for our products is collected within one year of sale;
however, it may take up to 24 months to receive payment of the remaining 10-20%
of the purchase price on each sale.  This is the normal practice in
the heating manufacturing business.  In addition, we sometimes request
our customers to deposit 5%-20% of the sales price on high value products like
assembled heat exchanger unit and main part of plate heat exchanger into
designated bank accounts as restricted cash for securing the payment after the
quality assurance (warranty) period expires.  Based on our historical
experience, default on payment from our customers is very
rare.  Therefore, we believe the potential risks and uncertainty
associated with high days outstanding of receivable are also very
limited.





Recent
Developments





There
have been no material trends, events or transactions that have arisen subsequent
to December 31, 2008 that have affected our financial condition and results of
operations.





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.





31





Contractual
Obligations





The
Company was obligated for the following short term loans payable as of December
31, 2008 and 2007:




2008
                
                
                2007Short
      term loan with a commercial bank in the PRC for 6,000,000 RMB. This loan
      was entered into on Apr 28, 2007 and is due on Apr 12, 2008. This loan was
      renewed on Apr 12, 2008 with new maturity date on June 13, 2009. This loan
      currently bears interest at 7.159% per annum.  The Company
      pledged its building in the value of approximately RMB 12,430,950 or
      approximately $1,818,000 for this loan.
                
                $
                877,886
                
                
                $
                822,526Short
      term loan with a foreign commercial bank with branch in the PRC for
      10,200,000 RMB. This loan was entered into on Jun 25, 2007 and was due on
      Jun 24, 2008. This loan born interest at 5.265% per annum. This loan was
      repaid in June, 2008.
                
                
                —
                
                
                
                1,302,333The
      Company entered into a series of short 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 will mature on various dates in year 2008 and some of the
      loans are payable on demand. These loans bear variable interest at 8.591%
      per annum for 2008 and 6.903% per annum for 2007.  The Company
      repaid RMB 2,600,000 in 2008 and had RMB 7,700,000 outstanding as of
      December 31, 2008.
                
                
                1,126,621
                
                
                
                1,412,003The
      Company entered into a series of short term loans during 2006 with another
      third party company in the PRC for total of 2,850,000 RMB. These loans
      were due on various dates in year 2008. These loans bore variable interest
      at 8.591% per annum for 2008 and 6.903% per annum for 2007.  The
      loans were paid in full at December 31, 2008.
                
                
                -
                
                
                
                390,701The
      Company entered into a short term loan with another third party company in
      the PRC for 5,050,000 RMB. This loan was entered into on Aug 31, 2005 and
      was due on Aug 31, 2006. This loan bears no interest. Imputed interest on
      the loan was immaterial. This loan became payable on demand after Aug 31,
      2006. This loan was paid in full at December 31, 2008.
                
                
                -
                
                
                
                692,293The
      Company entered into a one year loan on July 1, 2008 with another third
      party company in the PRC for total of 3,000,000 RMB. This loan is due on
      June 30, 2009 with interest rate of 8.591% per annum.
                
                
                438,943
                
                
                
                —$
                2,443,450
                
                
                $
                4,619,856




Item 7A. Quantitative and
Qualitative Disclosures About Market Risk
 Not
applicable.
  Item 8.    Financial
Statements and Supplementary Data
 The
financial statements, together with the report thereon of SmartHeat Inc., dated
March 11, 2009, as listed under Item 15 appear in a separate section of
this report beginning on page F-1.
  Item 9.    Changes in and
Disagreements with Accountants on Accounting and Financial
Disclosure
 None.





32





Item
9A (T).  Controls
and Procedures





a)
            Evaluation
      of disclosure controls and
procedures.





An
evaluation was performed, under the supervision and with the participation of
Company management, including the Chief Executive Officer (“CEO”) and the Chief
Financial Officer (“CFO”), of the effectiveness of the design and operation of
the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c)
and 15d-14(c) under the Exchange Act). Based on that evaluation, management,
including the CEO and CFO, has concluded that, as of December 31, 2008, the
Company’s disclosure controls and procedures were adequate to ensure that
information required to be disclosed in reports that the Company files or
submits under the Exchange Act has been recorded, processed, summarized and
reported in accordance with the rules and forms of the SEC.





(b)
              Report of
      Management on Internal Control over Financial
    Reporting


The following report shall not be
deemed to be filed for purposes of Section 18 of the Exchange Act or
otherwise subject to the liabilities of that section, unless we specifically
state that the report is to be considered “filed” under the Exchange Act or
incorporate it by reference into a filing under the Securities Act or the
Exchange Act.




Our management is responsible for
establishing and maintaining adequate internal control over financial reporting
as defined under Exchange Act Rules 13a-15(f). Internal control over
financial reporting is designed to provide reasonable assurance regarding the
reliability of our financial reporting and preparation of financial statements
for external purposes in accordance with U.S. GAAP. Internal control over
financial reporting includes maintaining records that in reasonable detail
accurately and fairly reflect our transactions; providing reasonable assurance
that transactions are recorded as necessary for preparation of our financial
statements in accordance with U.S. GAAP; providing reasonable assurance
that our receipts and expenditures are made in accordance with authorizations of
our management and directors; and providing reasonable assurance that
unauthorized acquisition, use or disposition of our assets that could have a
material effect on our financial statements would be prevented or detected on a
timely basis. Because of its inherent limitations, internal control over
financial reporting is not intended to provide absolute assurance that a
misstatement of our financial statements would be prevented or detected.
Furthermore, management does not expect that our disclosure controls and
procedures or our internal control over financial reporting will prevent or
detect all error and fraud. Any control system, no matter how well designed and
operated, is based upon certain assumptions and can provide only reasonable, not
absolute, assurance that its objectives will be met. Further, no evaluation of
controls can provide absolute assurance that misstatements due to error or fraud
will not occur or that all control issues and instances of fraud, if any, within
the Company have been detected.





An
evaluation was performed, under the supervision and with the participation of
Company management, including the CEO and the CFO, of the effectiveness of the
design and operation of the Company’s disclosure controls and procedures (as
defined in Rules 13a-14(c) and 15d-14(c) under the Exchange Act). Based on that
evaluation, management, including the CEO and CFO, has concluded that, as of
December 31, 2008, the Company’s disclosure controls and procedures were
adequate to ensure that information required to be disclosed in reports that the
Company files or submits under the Exchange Act has been recorded, processed,
summarized and reported in accordance with the rules and forms of the
SEC.





This
annual report on Form 10-K does not include an attestation report of our
independent registered public accounting firm regarding internal control over
financial reporting. Management’s report was not subject to attestation by our
independent registered public accounting firm pursuant to temporary rules of the
SEC that permit us to provide only management’s report in this annual
report.





(c)Changes in Internal Control over
Financial Reporting.





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





Item 9B. Other
Information


None.





33







PART III





Item 10.
              Directors,
      Executive Officers and Corporate
  Governance


Our
executive officers and directors, and their ages, positions and biographical
information, as of March 15, 2009, are as follows:





Name
              
              Age
              
              PositionJun
      Wang
              
              41
              
              Chairman
      of the Board of Directors, President & Chief Executive
      OfficerZhijuan
      Guo
              
              44
              
              Chief
      Financial Officer and TreasurerHuajun
      Ai
              
              38
              
              Corporate
      SecretaryFrederic
      Rittereiser
              
              72
              
              DirectorArnold
      Staloff
              
              64
              
              DirectorWeiguo
      Wang
              
              44
              
              DirectorWenbin
      Lin
              
              64
              
              Director





Our
directors hold office for one-year terms and until their successors have been
elected and qualified.  Our officers are elected annually by the board
of directors and serve at the discretion of the board. Messrs. Rittereiser,
Staloff, Wang and Lin were appointed as directors on June 19,
2008.





Biographies





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





Mr. Wang
is one of the original founders of Taiyu in 2002.  Prior to that, from
2000 to 2002, he was the Vice General Manager of Beijing HotNet
Company.  From 1996 to 1999, he was a sales manager for Honeywell
International Inc.  From 1994 to 1996, he was a sales manager for Alfa
Laval.  Mr. Wang obtained his Master's degree in Engineering from
Tsinghua University in 1989.





Zhijuan
Guo, CFO & Treasurer





Ms. Guo
was appointed Chief Financial Officer of Taiyu in 2002.  Prior to that
time, from December 2000 to June 2002, she served as the Production Planning
Director of Shenyang Thermoelectric Co. Ltd.  From March 1999 to
November 2000, she served as Auditing Director of Shenyang Dongyu Group
Corp.  From July 1993 to February 1999, Ms. Guo served as Finance
Manager of Shenyang Dongyu Real Estate Development Company.  Ms. Guo
obtained her MBA degree from Shenyang NorthEastern University in
2001.





Huajun
Ai, Corporate Secretary





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 Jincheng Industrial Corp.  Ms. Ai
obtained her Bachelor's degree in Foreign Trade Accounting from Shenyang North
Eastern University in 1994.





Frederic
Rittereiser, Director





Mr.
Rittereiser has served on the Board of Directors of AgFeed Industries, Inc.
since 2007. From October 1996 until retiring in 2002, Mr. Rittereiser served as
Chairman of the Board and Chief Executive Officer of Ashton Technology Group,
Inc., a company that develops and commercializes online transaction systems for
the financial industry. Mr. Rittereiser has been appointed to each of the Audit
Committee, Compensation Committee and Nominating and Corporate Governance
Committee of SmartHeat.


34


Arnold
Staloff, Director





Mr.
Staloff has served on the Boards of Directors of Exchange Lab Inc. since 2001,
AgFeed Industries, Inc. since 2007 and Shiner International Inc. since 2007.
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 to each of the Audit Committee, Compensation Committee and
Nominating and Corporate Governance Committee of SmartHeat.


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 to each of the Audit Committee,
Compensation Committee and Nominating and Corporate Governance Committee of
SmartHeat.





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.





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.





No
bankruptcy petition has been 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.  No director has been
convicted in a criminal proceeding and is not subject to a pending criminal
proceeding (excluding traffic violations and other minor
offenses).





No
director has been 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.





No
director has been 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.





Our Board
has implemented a process by which stockholders may send written communications
to the attention of the Board, any committee of the Board or any individual
Board member, care of our Secretary atA-1, 10, Street 7,
Shenyang Economic and Technological Development Zone, Shenyang, China 110027.
This centralized process will assist the Board in reviewing and responding to
stockholder communications in an appropriate manner. The name of any specific
intended Board recipient should be noted in the communication. Our Secretary,
with the assistance of our Assistant Secretary, will be primarily responsible
for collecting, organizing and monitoring communications from stockholders and,
where appropriate depending on the facts and circumstances outlined in the
communication, providing copies of such communications to the intended
recipients. Communications will be forwarded to directors if they relate to
appropriate and important substantive corporate or Board matters. Communications
that are of a commercial or frivolous nature or otherwise inappropriate for the
Board’s consideration will not be forwarded to the Board. Any communications not
forwarded to the Board will be made available to any of our independent
directors upon their request. There have been no material changes to these
procedures during the last fiscal year.


35


Corporate Governance, Board
Composition and Board Committees




Board Committees
and Meetings





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.
Rittereiser and Staloff and Dr. 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 Corporate
Governance and Nominating. 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. 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.




Audit
Committee




We
established our Audit Committee in June 2008. The Audit Committee consists of
Messrs. Rittereiser and Staloff 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. The Audit
Committee’s responsibilities include:





            The
      appointment, replacement, compensation, and oversight of work of the
      independent auditor, including resolution of disagreements between
      management and the independent auditor regarding financial reporting, for
      the purpose of preparing or issuing an audit report or performing other
      audit, review or attest services.





            Reviewing
      and discussing with management and the independent auditor various topics
      and events that may have significant financial impact on our company or
      that are the subject of discussions between management and the independent
      auditors.




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 at www.smartheatinc.com.




Compensation
Committee




We
established our Compensation Committee in June 2008. The Compensation Committee
consists of Messrs. Rittereiser and Staloff 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 at www.smartheatinc.com
..


36


Nominating
and Corporate Governance Committee




We
established our Nominating and Corporate Governance Committee in June 2008. The
Nominating and Corporate Governance Committee consists Messrs. Rittereiser and
Staloff and Dr. Wang, each of whom is an independent director, and Mr. Lin. Mr.
Rittereiser 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 at www.smartheatinc.com.





Code
of Conduct




Our board
of directors has adopted a Code of Conduct, which applies to all directors,
officers and employees, including its principal executive officer, its principal
financial and accounting officer, and all members of its 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 at www.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 or by . We intend to post promptly any
amendments to or waivers of the Code on our website.  The inclusion of
the Company’s website address in this report does not include or incorporate by
reference the information on the Company’s website into this
report.





Section 16(a)
Beneficial Ownership Reporting Compliance




Section 16(a)
of the Securities Exchange Act of 1934, which we refer to hereafter as the
Exchange Act, requires our officers and directors and persons who own more than
ten percent of a class of our equity securities registered under the Exchange
Act, to file with the SEC reports of ownership and changes in ownership of our
Common Stock and other equity securities. Officers, directors and greater than
ten percent stockholders are required by SEC regulations to furnish us with
copies of all Section 16(a) forms they file. Based solely on a review of
these forms, we believe that each of our executive officers, directors and
holders of ten percent or more of our Common Stock timely filed all reports
required to be filed pursuant to Section 16(a) of the Exchange Act during
fiscal 2008.





Item 11.  Executive
Compensation





As a
“Smaller Reporting Company,” the 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, 2008 and 2007 of the principal executive officer, principal
financial officer, in addition to our three most highly compensated officers
whose annual compensation exceeded $100,000, and up to two additional
individuals for whom disclosure would have been required but for the fact that
the individual was not serving as an executive officer of the registrant at the
end of the last fiscal year. A discussion of each of the principal elements
comprising this executive compensation follows this
table.


37




Summary
Compensation Table




Name and
                                Principal Position
                              
                              Year
                              
                              Salary ($)  
      (1)
                              
                              Other Annual
                                Compensation ($)
                              
                              Total ($)  
      (1)Jun
      Wang
                              
                              2008
                              
                              18,000
                              
                              
                              —
                              
                              18,000President
      and Chief Executive Officer
                              
                              2007
                              
                              18,000
                              
                              
                              —
                              
                              18,000Zhijuan
      Guo
                              
                              2008
                              
                              10,684
                              
                              
                              —
                              
                              10,684Treasurer
      and Chief Financial Officer
                              
                              2007
                              
                              10,684
                              
                              
                              —
                              
                              10,684




(1)
  based on an exchange rate of RMB7.3 = US$1.00





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.





Outstanding
Equity Awards at Fiscal Year-End




As of
December 31, 2008, there were no outstanding equity awards held by executive
officers of our company.




Stock
Incentive Plans




We had no
stock incentive plan during 2007 or 2008.





Compensation of
Directors





Director
Compensation





Name
                          
                          Fees Earned or
                            Paid in Cash ($)
                          
                          
                          Option Awards
                            ($) (1)
                          
                          
                          Total ($)Jun
      Wang
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Wenbin
      Lin
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Frederic
      Rittereiser
                          
                          
                          20,000
                          
                          
                          
                          2,806
                          (2)
                          
                          
                          22,806Arnold
      Staloff
                          
                          
                          25,000
                          
                          
                          
                          2,806
                          (3)
                          
                          
                          27,806Weiguo
      Wang
                          
                          
                          6,000
                          
                          
                          
                          -
                          
                          
                          
                          6,000




38




(1) The amounts
represented in the stock awards column reflect the compensation expense
recognized by the Company in fiscal
year 2008 determined pursuant to SFAS 123R, and no forfeitures are
assumed.




(2) 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.





(3) 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.





Narrative
Disclosure to Director Compensation Table.





On June
19, 2008, Messrs. Rittereiser, Staloff and Dr. Wang joined the board of
directors as independent directors, satisfying the definition of “independence”
as defined in Rule 4200 of the NASDAQ Rules.  Additionally, Mr. Lin joined
the board of directors on June 19, 2008. Mr. Lin is not an "independent"
director. 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 is entitled to receive $40,000 in
cash per year, paid in equal quarterly installments. Mr. Wang is 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.





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 2009 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.





Compensation
Committee Interlocks and Insider Participation





All
current members of the Compensation Committee are independent directors, and all
past members were independent directors at all times during their service on
such Committee. None of the past or present members of our Compensation
Committee are present or past employees or officers of ours or any of our
subsidiaries. No member of the Compensation Committee has had any relationship
with us requiring disclosure under Item 404 of Regulation S-K under the
Securities Exchange Act of 1934, as amended. None of our executive officers has
served on the Board or Compensation Committee (or other committee serving an
equivalent function) of any other entity, one of whose executive officers served
on our Board or Compensation Committee.


39


Item 12.              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, 2008, by:





•    each
stockholder, or group of affiliated stockholders, that we know beneficially owns
more than 5% of our outstanding common stock;




•    each
of our named executive officers;




•    each
of our directors; and




•    all
of our directors and executive officers as a group.





Unless
otherwise indicated, each of the shareholders named in the table below 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 Shenyang Taiyu Electronic & Machinery Co.,
Ltd., A-1, 10, Street 7, Shenyang Economic and Technological Development Zone,
Shenyang, China 110027.




Except as
otherwise noted, the individual or his or her family members had sole voting and
investment power with respect to such shares. The percentages of beneficial
ownership set forth below are based on 24,179,900 shares of our common stock
issued and outstanding as of December 31, 2008.





Name
      of Beneficial Owner
                    
                    Number of
                      Shares
                      Beneficially
                      Owned (1)
                    
                    
                    Percentage
                      Beneficially
                      Owned5%
      Shareholders:Beijing
      YSKN Machinery & Electronic Equipment Co., Ltd (2)
                      Rm
      1106, Huapu International Plaza No.19,
                      Chaowai
      Street, Chaoyang District
                      Beijing,
      China
                    
                    
                    6,808,000
                    
                    
                    
                    28.16
                    %Yang
      In Cheol (3)
                      #630-5,
      Namchon-Dong
                      Namdong-Yu
                      Incheon,
      South Korea 302-405
                    
                    
                    3,848,000
                    
                    
                    
                    15.9
                    %ShenYang
      ZhiCe Investment Co., Ltd (4)
                      No.
      1 Yuebin Street
                      Shenhe
      District
                      Shenyang,
      China 110027
                    
                    
                    2,960,000
                    
                    
                    
                    12.42
                    %Directors
      and Named Executive OfficersJun
      Wang, Chairman of the Board, President and CEO (2)
                    
                    
                    3,404,000
                    
                    
                    
                    14.08
                    %Zhijuan
      Guo, CFO
                    
                    
                    0
                    
                    
                    
                    —Frederic
      Rittereiser, Director
                    
                    
                    0
                    
                    
                    
                    —Arnold
      Staloff, Director
                    
                    
                    11,500
                    
                    
                    
                    *Weiguo
      Wang, Director
                    
                    
                    0
                    
                    
                    
                    —Wenbin
      Lin, Director
                    
                    
                    473,600
                    (5)
                    
                    
                    1.96
                    %All
      Directors and named Executive Officers as a group
      (6 persons)
                    
                    
                    3,889,100
                    
                    
                    
                    16.08
                    %





*
                  
                  Less
      than 1% of shares
outstanding.




40


(1)          The shares of our 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 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 a
right to acquire beneficial ownership within 60 days. Securities that can
be so acquired are deemed to be outstanding for purposes of computing such
person’s ownership percentage, but not for purposes of computing any other
person’s percentage. Under these rules, more than one person may be deemed
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.
Except as otherwise indicated in these footnotes, each of the beneficial owners
has, to our knowledge, sole voting and investment power with respect to the
indicated shares of common stock.





(2)          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. Wang and 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.





(3)          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.





(4)          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.





(5)          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.









Item 13.              Certain
Relationships and Related Transactions and Director
Independence





Beijing
YSKN Machinery & Electronic Equipment Co., Ltd ("YSKN") holds 6,808,000
shares, approximately 28.16%, of our common stock. YSKN was one of our sales
agents in 2006 and 2007 and one of our suppliers in 2006.  Sales
through YSKN amounted to $226,105 and $174,901 in 2006 and 2007,
respectively.  During 2006 we purchased raw material from YSKN in the
amount of $215,031. Our sales agency relationship with YSKN ceased on April 14,
2008. As of December 5, 2008, we do not owe any amounts to YSKN.  YSKN
is owned by Messrs. Jun Wang, our Chairman of the Board, President and CEO, and
Fang Li, each holding 50% of the equitable and legal rights, title and interests
in and to the share capital of YSKN.





Under
Item 404 of SEC Regulation S-K , a related person transaction is any
actual or proposed transaction, arrangement or relationship or series of similar
transactions, arrangements or relationships, including those involving
indebtedness not in the ordinary course of business, since the beginning of our
last fiscal year, to which we or our subsidiaries were or are a party, or in
which we or our subsidiaries were or are a participant, in which the amount
involved exceeded or exceeds $120,000 and in which any of our directors,
nominees for director, executive officers, beneficial owners of more than 5% of
any class of our voting securities, or any member of the immediate family of any
of the foregoing persons, had or will have a direct or indirect material
interest.


Pursuant
to its written charter, our Audit Committee is responsible for reviewing and
approving all related person transactions and potential conflict of interest
situations involving any of our directors, nominees for director, executive
officers, beneficial owners of more than 5% of any class of our voting
securities, or any member of the immediate family of any of the foregoing
persons.




41


Our Audit
Committee also has policies and procedures for related person transactions that
require the Audit Committee to review any proposed transaction with related
persons to determine if it rises to the level of a related person transaction
covered by Item 404 of Regulation S-K and, if it does, then such
related person transaction must be approved or ratified by the disinterested
members of the Audit Committee. Our management must disclose to the Audit
Committee all material information regarding actual and proposed related person
transactions known to them that involve our directors, nominees for director,
executive officers, persons known to be five percent or greater beneficial
owners of our stock, and any member of the immediate family of any of the
foregoing persons. A related person will not be deemed to have a material
interest in a transaction if the interest arises only: (a) from the
person’s position as a director of another corporation or organization that is a
party to the transaction; or (b) from the direct or indirect ownership by
such person and all other related persons, in the aggregate, of less than a ten
percent equity interest in another person or entity (other than a partnership)
which is a party to the transaction; or (c) from a combination of both
(a) and (b); or (d) from the person’s position as a limited partner in
a partnership in which the person and all other related persons, have an
interest of less than ten percent, and the person is not a general partner of
and does not hold another position in the partnership.





Our Audit
Committee has determined that the following categories of transactions shall be
deemed preapproved by the Audit Committee, notwithstanding the fact that they
are related person transactions:




•
              compensation
      to executive officers determined by our Compensation
      Committee;•
              compensation
      to directors determined by our Compensation Committee or our
      Board; and•
              transactions
      in which all security holders receive proportional
    benefits.




Item 14.                      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, 2008. 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:  GPKM
billed us an aggregate of $133,000 for professional services rendered for the
audit of our financial statements for the fiscal year ended December 31, 2008,
which we refer to as fiscal 2008 and for the reviews of the financial statements
included in our Quarterly Reports on Form 10-Q for the quarterly periods
beginning March 31, 2008 and for consents issued in connection with our
registration statements on Form S-1 in fiscal 2008.





DMCHL
billed us an aggregate of $8,000 for professional services rendered for the
fiscal year ended October 31, 2007, which we refer to as fiscal 2007, in
connection with the audit of the Company’s annual financial statements for
fiscal 2007 and for the reviews of the financial statements included in our
Quarterly Reports on Form 10-Q for fiscal 2007 and billed us $2,000 for the
Quarterly Report for the quarter ended January 31, 2008.




Audit-Related
Fees:  In fiscal 2008, neither GPKM nor DMCHL billed us for any
audit-related fees. In fiscal 2007, DMCHL did not bill us for any audit-related
fees.




Tax Fees:  We did
not engage GPKM to provide advice or assistance in tax compliance/preparation
and other tax services for either fiscal 2008.  DMCHL billed us an
aggregate of $1,000 for tax related fees in 2007.




All Other Fees:  We
did not engage either GPKM or DMCHL to provide any other services for fiscal
2008. We did not engage DMCHL to provide any other services for fiscal
2007.




Except
for the fees for services described under “Audit Fees” and “Tax Fees” above, we
did not pay GPKM or DMCHL any other fees or engage GPKM or DMCHL for any other
services during fiscal 2008 or fiscal 2007.


42


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 15.
            Exhibits
      and Financial Statement
Schedules




(a)(1)
                  Financial
      Statements


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





(2)
                Financial
      Statement
Schedules:




Not
applicable.





(3)
              Exhibits




The
following is a list of the exhibits encompassed in this
Form 10-K:





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(i)
              Certificate
      of Incorporation (Incorporated herein by reference to Exhibit 3.2 to the
      Company's Form SB-2 filed on December 22, 2006)3(ii)
              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 to the
      Company’s Form S-1/A filed on February 4, 2009).4.2
              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 (Commission File No. 000-53053) 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 (Commission File No. 000-53053) filed on April
      18, 2008)




43





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 10.3 to the
      Current Report on Form 8-K (Commission File No. 000-53053) filed on April
      18, 2008)10.4
                        Form
      of Purchase Order for with Sondex A/S (Incorporated herein by reference to
      Exhibit 10.4 to the Current Report on Form 8-K (Commission File No.
      000-53053) 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 10.5 to the Current Report on Form 8-K (Commission File No.
      000-53053) filed on April 18, 2008)10.6
                        Form
      of Purchase Order (Incorporated herein by reference to Exhibit 10.6 to the
      Current Report on Form 8-K (Commission File No. 000-53053) 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 (Commission File No. 000-53053) 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 (Commission File No. 000-53053) filed on April 18,
      2008)10.9
                        Resignation
      Letter from Jason Schlombs, dated April 15, 2008 (Incorporated herein by
      reference to Exhibit 10.9 to the Current Report on Form 8-K (Commission
      File No. 000-53053) 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 10.10 to the Current
      Report on Form 8-K (Commission File No. 000-53053) 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 10.11 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 10.13 to the Current Report on Form 8-K
      (Commission File No. 000-53053) 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 (Commission File No. 333-154415), filed with the SEC on
      December 12, 2008)21
                        List
      of subsidiaries of the Company (incorporated by reference to Exhibit 21 of
      SmartHeat's Registration Statement on Form S-1 (Commission File No.
      333-154415), filed with the SEC on October 17, 2008)23.1
                        Consent
      of Goldman Parks Kurland Mohidin LLP, the Company’s Independent Registered
      Accounting Firm.31.1
                        Certification
      of the Chief Executive Officer pursuant to Exchange Act
      Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 2002.31.2
                        Certification
      of the Chief Financial Officer pursuant to Exchange Act
      Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302
      of the Sarbanes-Oxley Act of 2002.  44
  32
                          Certifications
      of the Chief Executive Officer and Chief Financial Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906
      of the Sarbanes-Oxley Act of
2002.





(c)
              Financial
      Statement Schedules


Not
applicable.


45





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 17, 2009
                              
                              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
      17, 2009Jun
      Wang/s/
      Zhijuan Guo
                                          
                                          
                                          Chief
      Financial Officer and Treasurer
                                          
                                          March
      17, 2009Zhijuan
      Guo/s/
      Frederick Rittereiser
                                          
                                          
                                          Director
                                          
                                          March
      17, 2009Frederick
      Rittereiser/s/
      Arnold Staloff
                                          
                                          
                                          Director
                                          
                                          March
      17, 2009Arnold
      Staloff/s/
      Weiguo Wang
                                          
                                          
                                          Director
                                          
                                          March
      17, 2009Weiguo
      Wang/s/
      Wenbin Lin
                                          
                                          
                                          Director
                                          
                                          March
      17, 2009Wenbin
      Lin


46


SMARTHEAT
CORPORATION


Consolidated
Financial Statements


For
the Years Ended December 31, 2008, 2007







PageContentsReport
      of Independent Registered Public Accounting Firm
                  
                  
                  F-1Consolidated
      Balance Sheets
                  
                  
                  F-2Consolidated
      Statements of Operations
                  
                  
                  F-3Consolidated
      Statement of Stockholders’ Equity
    (Deficit)
                  
                  
                  F-4Consolidated
      Statements of Cash Flows
                  
                  
                  F-5Notes
      to Consolidated Financial Statements
                  
                  
                  F-6







REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
shareholders of SmatHeat, Inc.,


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 Subsidiary (the “Company”)
as of December 31, 2008 and 2007 and the related consolidated statements of
income and other comprehensive income,  shareholders’ equity and cash
flows for each of the two years ended December 31, 2008 and
2007.  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, 2008 and 2007, and the consolidated results of its operations and
its cash flows for the years ended December 31, 2008 and 2007 in conformity with
U.S. generally accepted accounting principles.





Goldman
Parks Kurland Mohidin LLP


Encino,
California


March 11,
2009





F-1





SMARTHEAT,
INC. AND SUBSIDIARY


CONSOLIDATED
BALANCE SHEETS





AS
      OF
                    DECEMBER
      31, 2008
                  
                  
                  AS
      OF
                    DECEMBER
      31, 2007ASSETSCURRENT
      ASSETSCash
      & cash equivalents
                  
                  $
                  1,435,212
                  
                  
                  $
                  393,147Restricted
      cash
                  
                  
                  462,048
                  
                  
                  
                  537,098Accounts
      receivable, net
                  
                  
                  11,390,169
                  
                  
                  
                  4,762,822Retentions
      receivable
                  
                  
                  290,852
                  
                  
                  
                  191,319Advances
      to suppliers
                  
                  
                  412,524
                  
                  
                  
                  158,750Other
      receivables, prepayments and deposits
                  
                  
                  698,834
                  
                  
                  
                  766,231Inventories
                  
                  
                  6,107,583
                  
                  
                  
                  7,928,408Due
      from related party
                  
                  
                  -
                  
                  
                  
                  118,560Note
      receivable
                  
                  
                  14,631
                  
                  
                  
                  -Total
      current assets
                  
                  
                  20,811,853
                  
                  
                  
                  14,856,335NON-CURRENT
      ASSETSRestricted
      cash
                  
                  
                  219,472
                  
                  
                  
                  -Accounts
      receivable, net
                  
                  
                  310,810
                  
                  
                  
                  949,998Retentions
      receivable
                  
                  
                  166,912
                  
                  
                  
                  169,309Intangible
      assets, net
                  
                  
                  1,155,131
                  
                  
                  
                  534,208Property
      and equipment, net
                  
                  
                  2,436,553
                  
                  
                  
                  2,040,809Total
      noncurrent assets
                  
                  
                  4,288,878
                  
                  
                  
                  3,694,324TOTAL
      ASSETS
                  
                  $
                  25,100,731
                  
                  
                  $
                  18,550,659LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIESAccounts
      payable
                  
                  $
                  1,210,906
                  
                  
                  $
                  3,128,585Unearned
      revenue
                  
                  
                  850,408
                  
                  
                  
                  3,125,406Taxes
      payable
                  
                  
                  1,327,775
                  
                  
                  
                  503,010Accrued
      liabilities and other payables
                  
                  
                  1,330,812
                  
                  
                  
                  807,700Due
      to related party
                  
                  
                  -
                  
                  
                  
                  445,990Due
      to minority shareholder
                  
                  
                  5,303
                  
                  
                  
                  -Loans
      payable
                  
                  
                  2,443,450
                  
                  
                  
                  4,619,856Total
      current liabilities
                  
                  
                  7,168,654
                  
                  
                  
                  12,630,547DEFERRED
      TAX LIABILITY
                  
                  
                  38,854
                  
                  
                  
                  -COMMITMENTS
      AND CONTINGENCIESMINORITY
      INTEREST
                  
                  
                  -
                  
                  
                  
                  -STOCKHOLDERS'
      EQUITYCommon
      stock, $0.001 par value; 75,000,000
                    shares
      authorized, 24,179,900 and 18,500,000
                    shares
      issued and outstanding at December 31,
                    2008
      and December 31, 2007, respectively
                  
                  
                  24,180
                  
                  
                  
                  18,500Paid
      in capital
                  
                  
                  8,223,453
                  
                  
                  
                  3,102,132Statutory
      reserve
                  
                  
                  1,150,542
                  
                  
                  
                  506,532Accumulated
      other comprehensive income
                  
                  
                  984,629
                  
                  
                  
                  473,859Retained
      earnings
                  
                  
                  7,510,419
                  
                  
                  
                  1,819,089Total
      stockholders' equity
                  
                  
                  17,893,223
                  
                  
                  
                  5,920,112TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                  
                  $
                  25,100,731
                  
                  
                  $
                  18,550,659





F-2





SMARTHEAT,
INC. AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME





FOR
      THE YEARS ENDED
                                              DECEMBER
      31,2008
                                            
                                            
                                            2007Net
      sales
                                            
                                            $
                                            32,676,082
                                            
                                            
                                            $
                                            13,273,151Cost
      of goods sold
                                            
                                            
                                            21,717,735
                                            
                                            
                                            
                                            8,667,353Gross
      profit
                                            
                                            
                                            10,958,347
                                            
                                            
                                            
                                            4,605,798Operating
      expensesSelling
      expenses
                                            
                                            
                                            1,564,977
                                            
                                            
                                            
                                            1,681,624General
      and administrative expenses
                                            
                                            
                                            1,851,693
                                            
                                            
                                            
                                            687,466Total
      operating expenses
                                            
                                            
                                            3,416,670
                                            
                                            
                                            
                                            2,369,090Income
      from operations
                                            
                                            
                                            7,541,677
                                            
                                            
                                            
                                            2,236,708Non-operating
      income (expenses)Interest
      income
                                            
                                            
                                            405,266
                                            
                                            
                                            
                                            175,084Interest
      expense
                                            
                                            
                                            (314,192
                                            )
                                            
                                            
                                            (230,905
                                            )Other
      income
                                            
                                            
                                            11,738
                                            
                                            
                                            
                                            45,126Other
      expenses
                                            
                                            
                                            (13,709
                                            )
                                            
                                            
                                            (16,939
                                            )Exchange
      loss
                                            
                                            
                                            (12,044
                                            )
                                            
                                            
                                            -Subsidy
      income
                                            
                                            
                                            16,230
                                            
                                            
                                            
                                            52,591Total
      non-operating income
                                            
                                            
                                            93,289
                                            
                                            
                                            
                                            24,957Income
      before income tax
                                            
                                            
                                            7,634,966
                                            
                                            
                                            
                                            2,261,665Income
      tax expense
                                            
                                            
                                            1,293,660
                                            
                                            
                                            
                                            175,647Income
      after income tax
                                            
                                            
                                            6,341,306
                                            
                                            
                                            
                                            2,086,018Less:
      minority interest
                                            
                                            
                                            5,966
                                            
                                            
                                            
                                            (1,873
                                            )Net
      income
                                            
                                            
                                            6,335,340
                                            
                                            
                                            
                                            2,087,891Other
      comprehensive itemForeign
      currency translation
                                            
                                            
                                            510,770
                                            
                                            
                                            
                                            333,449Comprehensive
      Income
                                            
                                            $
                                            6,846,110
                                            
                                            
                                            $
                                            2,421,340Basic
      weighted average shares outstanding
                                            
                                            
                                            22,176,322
                                            
                                            
                                            
                                            18,500,000Diluted
      weighted average shares outstanding
                                            
                                            
                                            22,176,432
                                            
                                            
                                            
                                            18,500,000Basic
      earnings per share
                                            
                                            $
                                            0.29
                                            
                                            
                                            $
                                            0.11Diluted
      earnings per share
                                            
                                            $
                                            0.29
                                            
                                            
                                            $
                                            0.11




F-3





SMARTHEAT
INC. AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





Common
      stock
                              
                              
                              Paid
      in
                              
                              
                              Statutory
                              
                              
                              Other
                                  comprehensive
                              
                              
                              RetainedShares
                              
                              
                              Amount
                              
                              
                              capital
                              
                              
                              reserves
                              
                              
                              income
                              
                              
                              earnings
                              
                              
                              TotalBalance
      at December 31, 2005
                              
                              
                              18,500,000
                              
                              
                              $
                              18,500
                              
                              
                              $
                              1,806,405
                              
                              
                              $
                              211,701
                              
                              
                              $
                              38,741
                              
                              
                              $
                              113,767
                              
                              
                              $
                              2,189,114Balance
      at December 31, 2006
                              
                              
                              18,500,000
                              
                              
                              $
                              18,500
                              
                              
                              $
                              2,181,782
                              
                              
                              $
                              296,364
                              
                              
                              $
                              140,410
                              
                              
                              $
                              861,716
                              
                              
                              $
                              3,498,772Stock
      dividend declared
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              920,350
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -920,350
                              
                              
                              
                              -Net
      income for the year
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              2,087,891
                              
                              
                              
                              2,087,891Transfer
      to statutory  reserves
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              210,168
                              
                              
                              
                              -
                              
                              
                              
                              -210,168
                              
                              
                              
                              -Foreign
      currency translation gain
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              333,449
                              
                              
                              
                              -
                              
                              
                              
                              333,449Balance
      at December 31, 2007
                              
                              
                              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 period
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              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
                              
                              
                              $
                              17,893,223




F-4





SMARTHEAT,
INC. AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CASH FLOWS





FOR
      THE YEARS ENDED DECEMBER 31,2008
                  
                  
                  2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                  
                  $
                  6,335,340
                  
                  
                  $
                  2,087,891Adjustments
      to reconcile net income to net cashused
      in operating activities:Depreciation
      and amortization
                  
                  
                  252,598
                  
                  
                  
                  104,055Unearned
      interest on accounts receivable
                  
                  
                  (127,819
                  )
                  
                  
                  (122,379
                  )Stock
      option compensation expense
                  
                  
                  5,613
                  
                  
                  
                  -Decrease
      in deferred tax liability
                  
                  
                  (163
                  )
                  
                  
                  -Minority
      interest
                  
                  
                  5,966
                  
                  
                  
                  (1,873
                  )(Increase)
      decrease in current assets:Accounts
      receivable
                  
                  
                  (4,943,868
                  )
                  
                  
                  (2,526,521
                  )Retentions
      receivable
                  
                  
                  (74,797
                  )
                  
                  
                  70,446Advances
      to suppliers
                  
                  
                  62,759
                  
                  
                  
                  (45,386
                  )Other
      receivables, prepayments and deposits
                  
                  
                  182,577
                  
                  
                  
                  (327,734
                  )Inventory
                  
                  
                  2,405,678
                  
                  
                  
                  (2,184,063
                  )Receivables
      from related party
                  
                  
                  -
                  
                  
                  
                  (86,242
                  )Increase
      (decrease) in current liabilities:Accounts
      payable
                  
                  
                  (2,389,649
                  )
                  
                  
                  979,881Unearned
      revenue
                  
                  
                  (2,993,636
                  )
                  
                  
                  1,265,085Taxes
      payable
                  
                  
                  779,408
                  
                  
                  
                  326,053Accrued
      liabilities and other payables
                  
                  
                  (261,040
                  )
                  
                  
                  513,507Payables
      to related party
                  
                  
                  -
                  
                  
                  
                  (54,761
                  )Net
      cash used in operating activities
                  
                  
                  (761,033
                  )
                  
                  
                  (2,041
                  )CASH
      FLOWS FROM INVESTING ACTIVITIES:Increase
      in restricted cash
                  
                  
                  (108,040
                  )
                  
                  
                  (135,915
                  )Cash
      purchased at acquisition
                  
                  
                  55,426
                  
                  
                  
                  -Acquisition
      of property & equipment
                  
                  
                  (439,861
                  )
                  
                  
                  (909,280
                  )Note
      receivable
                  
                  
                  (14,635
                  )
                  
                  
                  -Net
      cash used in investing activities
                  
                  
                  (507,110
                  )
                  
                  
                  (1,045,195
                  )CASH
      FLOWS FROM FINANCING ACTIVITIES:Change
      in due to minority shareholders
                  
                  
                  (663
                  )
                  
                  
                  -Change
      in due from / (to) shareholder
                  
                  
                  (343,913
                  )
                  
                  
                  (558,243
                  )Short
      term loans
                  
                  
                  (2,447,804
                  )
                  
                  
                  1,774,966Capital
      contribution
                  
                  
                  5,100,000
                  
                  
                  
                  -Net
      cash provided by financing activities
                  
                  
                  2,307,620
                  
                  
                  
                  1,216,723EFFECT
      OF EXCHANGE RATE CHANGE ON CASH & CASH EQUIVALENTS
                  
                  
                  2,588
                  
                  
                  
                  21,365NET
      INCREASE IN CASH & CASH EQUIVALENTS
                  
                  
                  1,042,065
                  
                  
                  
                  190,852CASH
      & CASH EQUIVALENTS, BEGINNING OF YEAR
                  
                  
                  393,147
                  
                  
                  
                  202,295CASH
      & CASH EQUIVALENTS, END OF YEAR
                  
                  $
                  1,435,212
                  
                  
                  $
                  393,147Supplemental
      Cash flow data:Income
      tax paid
                  
                  $
                  660,127
                  
                  
                  $
                  134,033Interest
      paid
                  
                  $
                  274,969
                  
                  
                  $
                  280,719




F-5


SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007
 1.
ORGANIZATION AND DESCRIPTION OF BUSINESS
 
 SmartHeat
Inc., formerly known as Pacific Goldrim Resources, Inc. (the “Company” or
“SmartHeat”), was incorporated on August 4, 2006 in the State of Nevada. The
Company is engaged in the manufacturing and sale of plate heat exchangers and
various packages, thermometer testing devices and heat usage calculators through
its wholly owned operating subsidiary in China.
 
 On April
14, 2008, the Company entered into a Share Exchange Agreement with Shenyang
Taiyu Machinery and Electronic Equipment Co., Ltd. ("Taiyu") and the Taiyu
Shareholders. The Company issued 18,500,000 shares of its common stock to the
shareholder of Taiyu in exchange for all of the equitable and legal rights,
title and interests in and to Taiyu's share capital in the amount of RMB
25,000,000. Concurrent with the share exchange, one of SmartHeat’s shareholders
cancelled 2,500,000 shares out of 6,549,900 of total issued and outstanding
shares of SmartHeat pursuant to the Split-Off Agreement dated April 14, 2008. As
a result of the share exchange and the cancellation of the 2,500,000 shares of
the Company's common stock, there are 22,549,900 shares of the Company's common
stock issued and outstanding, approximately 82.04% of which are held by the
former Taiyu Shareholders.  The shareholders of the Company
immediately prior to the completion of these transactions hold the remaining
17.96% of the issued and outstanding share capital of SmartHeat. 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 in substance, rather than a
business combination. Accordingly, for accounting purposes, the transaction was
treated as a reverse acquisition and a recapitalization, and pro-forma
information is not presented. Transaction costs incurred in the reverse
acquisition were charged to expense.
 
 Taiyu was
incorporated in the Liaoning Province, People’s Republic of China (“PRC” or
"China") in July, 2002. Taiyu is engaged in the manufacturing and sale of plate
heat exchangers and various packages, thermo meter testing devices and heat
usage calculators. 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") between Asialink (Far East) Limited ("Asialink") and the Company
providing for the acquisition by the Company from Asialink of all of the
outstanding capital stock of SanDeKe Co., Ltd., a Shanghai based manufacturer of
heat plate exchangers ("SanDeKe"). The purchase price for the SanDeKe shares was
$741,516, of which $222,455 was payable within 15 days after the signature date
of the Agreement, $370,758 is payable within 15 days after all necessary
documents have been filed with government agencies, and $148,303 of which is
payable within 15 days after the purchase has been approved and registered by
the government agencies. Under the terms of the Agreement, two of the
shareholders of SanDeKe agreed not to compete with the business of SanDeKe for a
period of four years after the completion of the purchase.
 
 Principles
of Consolidation
 
 The
accompanying consolidated financial statements include the accounts of
SmartHeat, SanDeKe, Taiyu, Taiyu’s 55% owned subsidiary, Qingdao Yushi Heat
Power Equipment Co., Ltd ("Yushi") which also disposed by the Company in August,
2008. Yushi is engaged in manufacturing and selling of heat power equipment. For
purposes of this Annual Report, the "Company" refers collectively to SmartHeat,
SanDeKe, Taiyu and Yushi. All significant inter-company accounts and
transactions have been eliminated in consolidation.
 
 Use
of Estimates
 
 In
preparing the financial statements in conformity with accounting principles
generally accepted in the United States of America (“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.




F-6




SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





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, 2008 the Company maintained total restricted
cash of $681,520 in several bank accounts, represented cash deposits from
customers for securing the payment from customers after the warranty period
expires while incentivizing the Company to fulfill its obligation during the
warranty period, of which, $462,048 was the cash that will be release to the
Company within one year. As of December 31, 2007, the Company maintained
restricted cash of $537,098 in several bank accounts, of which, approximately
$4,900 was collateralized for certain letters of credit that were issued by
several banks to the Company; and approximately $532,000 was cash deposits from
customers for securing the payment from customers after the warranty period
expires while incentivizing the Company to fulfill its obligation during the
warranty period.  Restricted cash was held in an interest bearing bank
account.




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 $629,687 and $330,518 at December 31,
2008 and 2007, respectively.





At
December 31, 2008 and 2007, the Company had retentions receivable from customers
for product quality assurance in the amount of $457,764 and $360,628,
respectively. The retention rate varies from 5% to 20% of the sales price with
variable terms from 3 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 $28,526 and $148,421 at December 31,
2008 and 2007, 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 which was 7.04% in 2008 and
2007.





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




F-7


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





Land
Use Right




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, 2008 and
2007, there were no significant impairments of its long-lived
assets.




Income
Taxes





The
Company utilizes Statement of Financial Accounting Standards ("SFAS") No. 109,
“Accounting for Income Taxes,” which requires the recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in the financial statements or tax returns. 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, 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.


F-8


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





Revenue
Recognition





The
Company's revenue recognition policies are in compliance with Securities and
Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) 104. Sales revenue
is recognized when products are delivered and customer acceptance is made, when
applicable, the price is fixed or determinable, no other significant obligations
of the Company exist and collectability is reasonably assured. Payments received
before all of the relevant criteria for revenue recognition are met are recorded
as unearned revenue.





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





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 2008 and 2007. The Company does not
provide unconditional right of return, price protection or any other concessions
to its customers. The Company provides free after-sale service for a period of
one year. After-sale expense was $95,638 and $383,177 for 2008 and 2007,
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 production of 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.





Statement
of Cash Flows





In
accordance with SFAS No. 95, “Statement of Cash Flows,” 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. Cash flows from operating, investing and financing
activities exclude the effect of the acquisition of SanDeKe.





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.


F-9


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





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





For the Years
                                                            Ended December 312008
                                                          
                                                          
                                                          2007Net
      income
                                                          
                                                          $
                                                          6,335,340
                                                          
                                                          
                                                          $
                                                          2,087,891Weighted
      average shares outstanding - basic
                                                          
                                                          
                                                          22,176,322
                                                          
                                                          
                                                          
                                                          18,500,000Effect
      of dilutive securities:Unexercised
      warrants and options
                                                          
                                                          
                                                          110
                                                          
                                                          
                                                          
                                                          —Weighted
      average shares outstanding - diluted
                                                          
                                                          
                                                          22,176,432
                                                          
                                                          
                                                          
                                                          18,500,000Earnings
      per share - basic
                                                          
                                                          $
                                                          0.29
                                                          
                                                          
                                                          $
                                                          0.11Earnings
      per share - diluted
                                                          
                                                          $
                                                          0.29
                                                          
                                                          
                                                          $
                                                          0.11





Fair
Value of Financial Instruments





SFAS No.
107, “Disclosures about Fair Value of Financial Instruments,” requires the
Company disclose estimated fair values of financial instruments. The carrying
amounts reported in the statements of financial position for current assets and
current liabilities qualifying as financial instruments are a reasonable
estimate of fair value.




Foreign
Currency Translation and Comprehensive Income (Loss)




The
Company’s functional currency is the RMB (RMB). For financial reporting
purposes, RMB has been 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.





The
Company uses SFAS No. 130, “Reporting Comprehensive Income.” 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.





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.”  The
Company recognizes in the statement of operations 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"
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.




F-10


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





Registration
Rights Agreement




The
Company accounts for payment arrangements under registration rights agreement in
accordance with FASB Staff Position EITF 00-19-2, which requires that 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.




New
Accounting Pronouncements




Accounting for Financial
Guarantee Insurance Contracts




In May
2008, FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance
Contracts, an interpretation of FASB Statement No. 60.”  The scope of this
Statement is limited to financial guarantee insurance (and reinsurance)
contracts, as described in this Statement, issued by enterprises included within
the scope of Statement 60. Accordingly, this Statement does not apply to
financial guarantee contracts issued by enterprises excluded from the scope of
Statement 60 or to some insurance contracts that seem similar to financial
guarantee insurance contracts issued by insurance enterprises (such as mortgage
guaranty insurance or credit insurance on trade receivables). This Statement
also does not apply to financial guarantee insurance contracts that are
derivative instruments included within the scope of FASB Statement No. 133,
“Accounting for Derivative Instruments and Hedging Activities.” This Statement
will not have an impact on the Company’s financial statements.





The Hierarchy of Generally
Accepted Accounting Principles





In May
2008, FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting
Principles.”  SFAS 162 identifies the sources of accounting principles and
the framework for selecting the principles to be used in the preparation of
financial statements of nongovernmental entities that are presented in
conformity with generally accepted accounting principles (GAAP) in the United
States (the GAAP hierarchy).  SFAS 162 adoption will not have an impact on
the Company’s financial statements.




Disclosures about Derivative
Instruments and Hedging Activities




In March
2008, FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and
Hedging Activities an amendment of FASB Statement No. 133.”  SFAS 161
changes the disclosure requirements for derivative instruments and hedging
activities. Entities are required to provide enhanced disclosures about (a) how
and why an entity uses derivative instruments, (b) how derivative instruments
and related hedged items are accounted for under Statement 133 and its related
interpretations, and (c) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash
flows.  Based on current conditions, the Company does not expect the
adoption of SFAS 161 to have a significant impact on its results of operations
or financial position.





Fair value of
measurements








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




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




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








F-11


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





Non-Controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No.
51





In
December 2007, FASB issued SFAS No. 160, "Non-controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No. 51." SFAS 160
establishes new accounting and reporting standards for the non-controlling
interest in a subsidiary and for the deconsolidation of a subsidiary.
Specifically, this statement requires the recognition of a non-controlling
interest (minority interest) as equity in the consolidated financial statements
and separate from the parent’s equity. The amount of net income attributable to
the non-controlling interest will be included in consolidated net income on the
face of the income statement. SFAS 160 clarifies that changes in a parent’s
ownership interest in a subsidiary that do not result in deconsolidation are
equity transactions if the parent retains its controlling financial interest. In
addition, this statement requires that a parent recognize a gain or loss in net
income when a subsidiary is deconsolidated. Such gain or loss will be measured
using the fair value of the non-controlling equity investment on the
deconsolidation date. SFAS 160 also includes expanded disclosure requirements
regarding the interests of the parent and its non-controlling interest. SFAS 160
are effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. The Company expects SFAS 160 will
have an impact on accounting for business combinations once adopted but the
effect is dependent upon acquisitions at that time.




Business
Combinations




In
December 2007, FASB issued SFAS No. 141 (Revised 2007), "Business
Combinations." SFAS 141R will significantly change the accounting for business
combinations. Under SFAS 141R, an acquiring entity will be required to recognize
all the assets acquired and liabilities assumed in a transaction at the
acquisition-date fair value with limited exceptions. SFAS 141R will change the
accounting treatment for certain specific items, including:





·
            Acquisition
      costs will be generally expensed as
incurred;





·
            Non-controlling
      interests (formerly known as “minority interests” - see SFAS 160
      discussion above) will be valued at fair value at the acquisition
      date;





·
            Acquired
      contingent liabilities will be recorded at fair value at the acquisition
      date and subsequently measured at either the higher of such amount or the
      amount determined under existing guidance for non-acquired
      contingencies;





·
            In-process
      research and development will be recorded at fair value as an
      indefinite-lived intangible asset at the acquisition
  date;





·
            Restructuring
      costs associated with a business combination will be generally expensed
      subsequent to the acquisition date;
and





·
            Changes in deferred tax asset
      valuation allowances and income tax uncertainties after the acquisition
      date generally will affect income tax
  expense.





SFAS 141R
also includes a substantial number of new disclosure requirements. SFAS 141R
applies prospectively to business combinations for which the acquisition date is
on or after the beginning of the first annual reporting period beginning on or
after December 15, 2008. Earlier adoption is prohibited. Accordingly, since
the Company is a calendar year-end company and will continue to record and
disclose business combinations following existing GAAP until January 1,
2009. The Company expects SFAS 141R will have an impact on accounting for
business combinations once adopted but the effect is dependent upon acquisitions
at that time.




Accounting for
Non-Refundable Advance Payments for Goods or Services Received for Use in Future
Research and Development Activities





In June
2007, FASB issued FASB Staff Position No. EITF 07-3, “Accounting for
Nonrefundable Advance Payments for Goods or Services Received for use in Future
Research and Development Activities,” which addresses whether non-refundable
advance payments for goods or services that used or rendered for research and
development activities should be expensed when the advance payment is made or
when the research and development activity has been performed. EITF 07-03
is effective for fiscal years beginning after December 15, 2008. Management
is currently evaluating the effect of this pronouncement on our financial
statements.


F-12


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





3.
INVENTORIES





Inventories
at December 31, 2008 and December 31, 2007 were as follows:





2008
                  
                  
                  2007Raw
      materials
                  
                  $
                  4,411,298
                  
                  
                  $
                  3,865,575Work
      in process
                  
                  
                  652,472
                  
                  
                  
                  48,627Finished
      Goods
                  
                  
                  1,043,813
                  
                  
                  
                  4,014,206Total
                  
                  $
                  6,107,583
                  
                  
                  $
                  7,928,408





4.
PROPERTY AND EQUIPMENT, NET





Property
and equipment consisted of the following at December 31, 2008 and
2007:





2008
                
                
                2007Building
                
                $
                1,818,827
                
                
                $
                1,624,651Production
      equipment
                
                
                441,065
                
                
                
                298,242Office
      equipment
                
                
                231,975
                
                
                
                156,368Vehicles
                
                
                300,956
                
                
                
                134,7242,792,823
                
                
                
                2,213,985Less:
      Accumulated depreciation
                
                
                (356,270
                )
                
                
                (173,176
                )$
                2,436,553
                
                
                $
                2,040,809





Depreciation
expense for 2008 and 2007 was approximately $168,000 and $45,000,
respectively.





5.
OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS





Other
receivables, prepayments and deposits consisted of the following at December 31,
2008 and December 31, 2007, respectively:





2008
                          
                          
                          2007Cash
      advance to third parties
                          
                          $
                          89,628
                          
                          
                          $
                          474,631Deposit
      for public bid
                          
                          
                          353,399
                          
                          
                          
                          130,724Prepayment
      for freight and related insurance expenses
                          
                          
                          95,888
                          
                          
                          
                          68,683Deposits
                          
                          
                          42,783
                          
                          
                          
                          15,346Advance
      to employees
                          
                          
                          117,136
                          
                          
                          
                          76,847Total
                          
                          $
                          698,834
                          
                          
                          $
                          766,231





Cash
advance to third parties was the short term cash advances to customers and
vendors with quick repayment usually within three to six
months.  Deposits for public bidding represented the deposits for
bidding the contracts, the deposit 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 mainly represented short term loan to
employees and advance to employees for business trip and related expenses. Other
receivables, prepayments and deposits are reimbursedor settled
within 12 months.


F-13


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





6.
RELATED PARTY TRANSACTIONS





Due
from Related Party





Due from
related party arose from sales to the shareholder of $118,560 at December 31,
2007.  Due from related party was paid in full in November
2008.





Due to Related Party





Due to
related party represented advance from the same shareholder with variable
interest rate tied to the bank interest rate, at 8.591% per annum for 2008 and
6.903% per annum as of December 31, 2007, principal and interest were payable on
demand, this advance was paid by September 30, 2008.





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 rights during 2005 for approximately $440,000 (RMB 3,549,682).
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, 2008 and 2007,
respectively:





2008
                
                
                2007Land
      use right
                
                $
                519,369
                
                
                $
                486,618Know-how
      technology
                
                
                266,808
                
                
                
                -Customer
      list
                
                
                191,652
                
                
                
                -Covenant
      not to compete
                
                
                104,258
                
                
                
                -Software
                
                
                190,166
                
                
                
                140,4761,272,253
                
                
                
                627,094Less:
      accumulated amortization
                
                
                (117,122
                )
                
                
                (92,886
                )$
                1,155,131
                
                
                $
                534,208




Amortization
expense of intangible assets for 2008 and 2007 was approximately $63,000 and
$52,000, respectively. Annual amortization expense for the next five years is
expected to be as follows: $180,000, $180,000, $180,000, $180,000 and
$140,000.





8. MAJOR CUSTOMERS AND VENDORS




Five
major customers accounted for 20% and 51% of the Company’s net revenue for 2008
and 2007, respectively.  For 2008, each customer accounted for about
6%, 5%, 3%, 3% and 3% of the sales.  For 2007, each customer accounted
for about 21%, 9%, 8%, 7% and 6% of the sales.   At December 31, 2008
and 2007, the total receivable balance due from these five customers was
approximately $5,073,000 and $2,824,000, respectively.




One major
vendor provided 7% and 22% of the Company’s purchases of raw materials for 2008
and 2007, respectively.  The Company had approximately $19,101 and $0
in accounts payable to this vendor at December 31, 2008 and 2007,
respectively.


F-14


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





9.
TAXES PAYABLE





Taxes
payable consisted of the following at December 31, 2008 and December 31,
2007:





2008
                
                
                2007Income
      tax payable
                
                $
                723,958
                
                
                $
                74,981Value
      added tax payable
                
                
                597,676
                
                
                
                421,009Other
      taxes payable
                
                
                6,141
                
                
                
                7,020$
                1,327,775
                
                
                $
                503,010





10.
ACCRUED LIABILITIES AND OTHER PAYABLES





Accrued
liabilities and other payables consisted of the following at December 31, 2008
and December 31, 2007:





2008
                          
                          
                          2007Advance
      from third parties
                          
                          $
                          453,625
                          
                          
                          $
                          139,945Payable
      for purchase consideration of SanDeKe
                          
                          
                          741,516
                          
                          
                          
                          -Other
      Payables
                          
                          
                          99,418
                          
                          
                          
                          667,755Accrued
      liabilities
                          
                          
                          36,253
                          
                          
                          
                          -Total
                          
                          $
                          1,330,812
                          
                          
                          $
                          807,700





Advance
from third parties represented short term, non interest bearing advances from
third parties. Other payables mainly consisted of payables for the Company’s
miscellaneous expenses including postage, business insurance, employee benefits,
etc. Accrued liabilities mainly consisted of accrued interest, payroll, and
utility.





11.
LOANS PAYABLE - SHORT TERM





The
Company is obligated for the following short term loans payable as of December
31, 2008 and December 31, 2007:





2008
                
                
                2007Short
      term loan with 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 with new maturity date on June 13, 2009. This
      loan currently bears interest at 7.159% per annum.  The Company
      pledged its building in the value of approximately RMB 12,430,950 or
      approximately $1,818,000 for this loan.
                
                $
                877,886
                
                
                $
                822,526Short
      term loan with a foreign commercial bank with branch in the PRC for
      10,200,000 RMB. This loan was entered into on Jun 25, 2007 and was due on
      Jun 24, 2008. This loan born interest at 5.265% per annum. This loan was
      repaid in June, 2008.
                
                
                —
                
                
                
                1,302,333The
      Company entered into a series of short 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 will mature on various dates in year 2008 and some of the
      loans are payable on demand. These loans bear variable interest at 8.591%
      per annum for 2008 and 6.903% per annum for 2007.  The Company
      repaid RMB 2,600,000 in 2008 and had RMB 7,700,000 outstanding as of
      December 31, 2008.
                
                
                1,126,621
                
                
                
                1,412,003The
      Company entered into a series of short term loans during 2006 with another
      third party company in the PRC for total of 2,850,000 RMB. These loans
      were due on various dates in year 2008. These loans bore variable interest
      at 8.591% per annum for 2008 and 6.903% per annum for 2007.  The
      loans were paid in full at December 31, 2008.
                
                
                -
                
                
                
                390,701The
      Company entered into a short term loan with another third party company in
      the PRC for 5,050,000 RMB. This loan was entered into on Aug 31, 2005 and
      was due on Aug 31, 2006. This loan bore no interest. Imputed interest on
      the loan was immaterial. This loan became payable on demand after Aug 31,
      2006. This loan was paid in full at December 31, 2008.
                
                
                -
                
                
                
                692,293The
      Company entered into a one year loan on July 1, 2008 with another third
      party company in the PRC for total of 3,000,000 RMB. This loan is due on
      June 30, 2009 with interest rate of 8.591% per annum.
                
                
                438,943
                
                
                
                —$
                2,443,450
                
                
                $
                4,619,856





F-15


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





12.
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.





13.
MINORITY INTEREST AND DUE TO MINORITY SHAREHOLDER





Minority
interest represented a 45% interest in Yushi. At August 31, 2008, the Company
liquidated Yushi and planned to distribute the remaining assets of $5,303 to its
minority shareholders. At August 31, 2008, minority interest was zero due to the
liquidation of Yushi; at December 31, 2007, minority interest was zero as
minority’s share of cumulative losses exceeded its equity interest in Yushi.
Minority’s share of income for 2008 was $5,966 as the forgiveness of the
accounts payable by Taiyu, minority’s share of loss for 2007 were limited to
$1,873.





14.
INCOME TAXES





The
Company is 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 a 15% income tax rate. Taiyu was
exempted from income tax for two years starting from the 1st profitable year
since incorporation, and was entitled to a 50% discount on the 15% income tax
rate for 2005 through 2007. According to the new income tax law that became
effective January 1, 2008, for those enterprises to which the 15% tax rate was
applicable previously, the applicable rates shall gradually increase over a
five-year period as follows:





Year
                  
                  Tax Rate2007
                  
                  
                  15
                  %2008
                  
                  
                  18
                  %2009
                  
                  
                  20
                  %2010
                  
                  
                  22
                  %2011
                  
                  
                  24
                  %2012
                  
                  
                  25
                  %




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 will be lower by approximately $91,000 or $0,004 earnings per share
had SanDeKe not been exempted from income tax for 2008. The Company's net income
would have been lower by approximately $175,000 or $0.01 earnings per share had
Taiyu not been subject to a 50% discount on the 15% income tax rate for
2007.




F-16





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the year ended December 31, 2008 and 2007:




2008
                    
                    
                    2007US
      statutory rates
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %Tax
      rate difference
                    
                    
                    (16.4
                    )%
                    
                    
                    (1
                    )%Effect
      of tax holiday
                    
                    
                    (1.2
                    )%
                    
                    
                    (25
                    )%Valuation
      allowance
                    
                    
                    0.5
                    %
                    
                    
                    -Tax
      per financial statements
                    
                    
                    16.9
                    %
                    
                    
                    8.0
                    %





15.
STATUTORY RESERVES





Pursuant
to the new 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, the Company closed a private placement offering of Units pursuant to which
SmartHeat sold an aggregate of 1,630,000 Units at an offering price of $3.50 per
Unit for aggregate gross proceeds of approximately $5.7 million. Each "Unit"
consists of one share of SmartHeat's common stock and a three year warrant to
purchase 15% of one share of common stock at an exercise price of $6.00 per
share. The Units sold represent an aggregate of 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 have been 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 warrant was $70,246. There were no warrants
exercised from the grant date to December 31, 2008.


F-17


SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008 AND 2007





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 shall vest on July 17, 2009; 3,333 shares
shall vest on July 17, 2010; and 3,334 shares shall vest on July 17, 2011,
subject in each case to the director continuing to be associated with the
Company as a director.





Based on
the fair value method under SFAS No. 123 (Revised) “Share Based Payment” (“SFAS
123(R)”), 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 a period of 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.





The
Company recorded $5,613 of compensation expense for stock options to its
independent directors for the year ended December 31, 2008. There were no
options exercised during 2008.





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
                                                            
                                                            
                                                            
                                                            6.00ExercisedForfeitedOutstanding
      at December 31, 2008
                                                            
                                                            
                                                            393,000
                                                            
                                                            
                                                            
                                                            6.00
                                                            
                                                            
                                                            
                                                            2.51Exercisable
      at December 31, 2008
                                                            
                                                            
                                                            393,000
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            2.51





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
                                                            
                                                            
                                                            
                                                            4.60ExercisedForfeitedOutstanding
      at December 31, 2008
                                                            
                                                            
                                                            20,000
                                                            
                                                            
                                                            
                                                            4.60
                                                            
                                                            
                                                            
                                                            4.54Exercisable
      at December 31, 2008
                                                            
                                                            
                                                            20,000
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            4.54




F-18




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




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 $10,684 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.





At
December 31, 2008, future minimum rental payments required under these operating
leases are as follows:





Year
      Ending December 31,
                  
                  Amount2009
                  
                  $
                  87,0002010
                  
                  
                  87,000Total
                  
                  $
                  174,000




Total
rental expense for the years ended December 31, 2008 and 2007 was approximately
$87,000 and $52,000, 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.




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.




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, SmartHeat 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.  Given the length of time it took the last
investor in the private placement to complete his paperwork, the Company
believes that the last closing under the private placement did not occur until
September 23rd or 24th and that the 180 day period for effectiveness of the
registration statement under the Registration Rights Agreement will not end
until March 23rd.  At March 10, 2009, the registration statement has
not declared effective yet.




F-19




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




19.
ACQUISITION OF SANDEKE CO., LTD.





On
September 25, 2008, the Company entered into a Share Exchange Agreement
("Agreement") for the acquisition by the Company of all of the outstanding
capital stock of SanDeKe. The purchase price for the SanDeKe shares was
$741,516, of which $222,455 was payable within 15 days after the signature date
of the Agreement, $370,758 is payable within 15 days after all necessary
documents have been filed with government agencies, and $148,303 of which is
payable within 15 days after the purchase has been approved and registered by
the government agencies. 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
March 10, 2009, the Company has not paid the purchase consideration
yet.





The
operating results of SanDeKe are included in the accompanying consolidated
statements of income from the acquisition date. For convenience of reporting the
acquisition for accounting purposes, September 1, 2008 has been 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 is amortized over 5 years and covenants not to compete, is
amortized over 4 years.





The pro
forma financial information of the consolidated operations of the Company as if
the acquisition of SanDeKe had occurred as of the beginning of the year is
presented below:




F-20




SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008 AND 2007




For the year ended
                                      December 31, 2008
                                    
                                    SmartHeat
                                      and
      subsidiaries
                                    
                                    
                                    SanDeKe
                                    
                                    
                                    Pro forma
                                      Adjustments
                                    
                                    
                                    Pro forma
                                      ConsolidatedNet
      revenue
                                    
                                    $
                                    32,676,082
                                    
                                    
                                    $
                                    2,135,837
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    34,811,919Cost
      of revenue
                                    
                                    
                                    21,717,735
                                    
                                    
                                    
                                    1,752,951
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    23,470,686Gross
      profit
                                    
                                    
                                    10,958,347
                                    
                                    
                                    
                                    382,886
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    11,341,233Selling
      expense
                                    
                                    
                                    1,564,977
                                    
                                    
                                    
                                    (607)
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,564,370General
      & administrative expense
                                    
                                    
                                    1,851,117
                                    
                                    
                                    
                                    286,591
                                    
                                    
                                    
                                    78,131
                                    
                                    
                                    
                                    2,215,839Total
      operating expenses
                                    
                                    
                                    3,416,094
                                    
                                    
                                    
                                    285,984
                                    
                                    
                                    
                                    78,131
                                    
                                    
                                    
                                    3,780,209Income
      (loss) from operations
                                    
                                    
                                    7,542,253
                                    
                                    
                                    
                                    96,902
                                    
                                    
                                    
                                    (78,131
                                    )
                                    
                                    
                                    7,561,024Non-operating
      income (expenses), net
                                    
                                    
                                    93,288
                                    
                                    
                                    
                                    (401
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    92,887Income
      (loss) before income tax
                                    
                                    
                                    7,634,966
                                    
                                    
                                    
                                    96,501
                                    
                                    
                                    
                                    (78,131
                                    )
                                    
                                    
                                    7,653,337Income
      tax
                                    
                                    
                                    1,293,660
                                    
                                    
                                    
                                    163
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,293,823Minority
      interest
                                    
                                    
                                    5,966
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    5,966Net
      income (loss)
                                    
                                    $
                                    6,335,340
                                    
                                    
                                    $
                                    96,339
                                    
                                    
                                    $
                                    (78,131
                                    )
                                    
                                    $
                                    6,353,548





a)
            Pro forma adjustment is to record
      additional amortization expense of $76,835 and depreciation expense of
      $1,296 for the increase in basis of the intangible assets and decrease in
      basis of the fixed assets as a result of the
    purchase.





For the year ended
                                                December 31, 2007
                                              
                                              Taiyu
                                              
                                              
                                              SanDeKe
                                              
                                              
                                              Pro forma
                                                Adjustments
                                              
                                              
                                              Pro forma
                                                ConsolidatedNet
      revenue
                                              
                                              $
                                              13,273,151
                                              
                                              
                                              $
                                              2,334,369
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              15,607,520Cost
      of revenue
                                              
                                              
                                              8,667,353
                                              
                                              
                                              
                                              2,059,235
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              10,726,588Gross
      profit
                                              
                                              
                                              4,605,798
                                              
                                              
                                              
                                              275,134
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,880,932Selling
      expense
                                              
                                              
                                              1,681,624
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              1,681,624General
      & administrative expense
                                              
                                              
                                              687,466
                                              
                                              
                                              
                                              283,689
                                              
                                              
                                              
                                              107,693
                                              
                                              
                                              
                                              1,078,848Total
      operating expenses
                                              
                                              
                                              2,369,090
                                              
                                              
                                              
                                              283,689
                                              
                                              
                                              
                                              107,693
                                              
                                              
                                              
                                              2,760,472Income
      from operations
                                              
                                              
                                              2,236,708
                                              
                                              
                                              
                                              (8,555
                                              )
                                              
                                              
                                              (107,693
                                              )
                                              
                                              
                                              2,120,460Non-operating
      income, net
                                              
                                              
                                              24,957
                                              
                                              
                                              
                                              (1,519
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              23,438Income
      before income tax
                                              
                                              
                                              2,261,665
                                              
                                              
                                              
                                              (10,074)
                                              
                                              
                                              
                                              (107,693
                                              )
                                              
                                              
                                              2,143,898Income
      tax
                                              
                                              
                                              175,647
                                              
                                              
                                              
                                              2,960
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              178,607Minority
      interest
                                              
                                              
                                              (1,873
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (1,873
                                              )Net
      income
                                              
                                              $
                                              2,087,891
                                              
                                              
                                              $
                                              (13,033
                                              )
                                              
                                              $
                                              (107,693
                                              )
                                              
                                              $
                                              1,967,165





a)
            Pro forma adjustment is to record
      additional amortization expense of $105,012 and depreciation expense of
      $2,681 for the increase in basis of the intangible assets and decrease in
      basis of the fixed assets as a result of the
    purchase.


F-21