UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





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





For the quarterly period ended June 30, 2011





OR





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





Commission file number: 001-34246





SMARTHEAT INC.


(Exact name of registrant as specified in its charter)





Nevada

98-0514768(State or other jurisdiction of incorporation

or organization)

(IRS Employer Identification No.)A-1, 10, Street 7

Shenyang Economic and Technological Development Zone

Shenyang, China

110141(Address of principal executive offices)

(Zip Code)





+86 (24) 2519-7699(Registrant’s telephone number, including area code)





Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the last 90 days.


YES  x    NO   ̈





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


YES   ̈    NO   ̈





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





Large accelerated filer  ̈
Accelerated filer xNon-accelerated filer  ̈
Smaller reporting company  ̈(do not check if a smaller reporting company)





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


YES   ̈   NO  x





Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 38,601,939 shares of common stock outstanding as of August 8, 2011.










SmartHeat Inc.





Table of Contents





PagePART I. FINANCIAL INFORMATIONItem 1.
Financial Statements
1Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
21Item 3.
Quantitative and Qualitative Disclosures about Market Risk
28Item 4.
Controls and Procedures
28PART II. OTHER INFORMATIONItem 1.
Legal Proceedings
29Item 1A.
Risk Factors
29Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
29Item 3.
Defaults Upon Senior Securities
29Item 5.
Other Information
29Item 6.
Exhibits
29Signatures
30Exhibit Index
31







PART I. FINANCIAL INFORMATION





Item 1. Financial Statements





SMARTHEAT INC. AND SUBSIDIARIES


CONSOLIDATED BALANCE SHEETS





June 30, 2011

(Unaudited)


December 31, 2010ASSETSCURRENT ASSETSCash & equivalents

$
21,185,220


$
56,806,471Restricted cash


2,807,193



1,949,742Accounts receivable, net


44,244,250



47,224,476Retentions receivable


3,574,673



2,548,401Advances to suppliers


19,040,093



8,351,579Other receivables, prepayments and deposits


4,778,925



6,301,772VAT receivable


1,214,614



-Inventories


38,475,589



26,585,362Deferred tax asset


1,310,393



380,232Notes receivable - bank acceptances


954,649



1,457,457Total current assets


137,585,599



151,605,492NON-CURRENT ASSETSRestricted cash


125,823



502,672Retentions receivable


590,481



1,062,167Construction in progress


520,149



81,204Property and equipment, net


11,296,956



8,381,019Intangible assets, net


15,264,541



14,243,734Goodwill


11,334,175



-Deferred tax asset


37,788



22,266Other non-current


19,559



-Total non-current assets


39,189,472



24,293,062TOTAL ASSETS

$
176,775,071


$
175,898,554LIABILITIES AND STOCKHOLDERS' EQUITYCURRENT LIABILITIESAccounts payable

$
8,002,064


$
4,490,333Advance from customers


1,882,200



1,131,193Income tax payable


8,845



2,000,456Accrued liabilities and other payables


2,499,011



3,039,701Notes payable - bank acceptances


185,426



2,207,280Loans payable


15,566,475



9,059,749Total current liabilities


28,144,021



21,928,712DEFERRED TAX LIABILITY


269,873



-LONG-TERM PAYABLE


11,919



-COMMITMENTS AND CONTINGENCIESSTOCKHOLDERS' EQUITYCommon stock, $0.001 par value; 75,000,000 shares authorized, 38,601,939 and 38,551,939 shares issued and outstanding at June 30, 2011, and December 31, 2010, respectively


38,602



38,552Paid-in capital


102,665,245



102,251,027Statutory reserve


3,535,997



5,301,918Accumulated other comprehensive income


7,877,561



4,252,261Retained earnings


32,893,758



41,500,015Total Company stockholders' equity


147,011,163



153,343,773NONCONTROLLING INTEREST


1,338,095



626,069TOTAL STOCKHOLDERS' EQUITY


148,349,258



153,969,842TOTAL LIABILITIES AND EQUITY

$
176,775,071


$
175,898,554





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




1


SMARTHEAT INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (LOSS)


(UNAUDITED)





SIX MONTHS ENDED JUNE 30,


THREE MONTHS ENDED JUNE 30,2011


2010


2011


2010Net sales

$
14,970,050


$
32,136,429


$
7,077,901


$
22,767,593Cost of goods sold


9,762,240



21,116,060



4,432,011



14,986,259Gross profit


5,207,810



11,020,369



2,645,890



7,781,334Operating expensesSelling


4,202,087



2,637,348



2,272,932



1,992,425General and administrativeR&D expense


512,867



290,573



383,885



-Provision for doubtful debts


5,805,672



322,828



3,736,818



-G&A expenses - other


6,306,145



1,947,614



3,356,681



1,784,019Total operating expenses


16,826,771



5,198,363



9,750,316



3,776,444Income (loss) from operations


(11,618,961
)


5,822,006



(7,104,426
)


4,004,890Non-operating income (expenses)Interest income


132,494



204,609



57,160



49,572Interest (expense) income


(293,235
)


-



(163,063
)


61,252Financial expense


(77,284
)


(19,003
)


(56,857
)


(14,690
)Foreign exchange transaction loss


(302,204
)


(43,671
)


(177,104
)


(43,671
)Other income


305,270



83,805



148,911



17,070Other expenses


18,959



(1,419
)


142,613



(1,179
)Total non-operating income (expenses), net


(216,000
)


224,321



(48,340
)


68,354Income (loss) before income tax


(11,834,961
)


6,046,327



(7,152,766
)


4,073,244Income tax expense (benefits)


(1,328,059
)


966,306



(647,160
)


696,786Income (loss) from operations


(10,506,902
)


5,080,021



(6,505,606
)


3,376,458Less: Income (loss) attributable to noncontrolling interest


(134,724
)


14,730



(87,230
)


14,248Net income (loss) to SmartHeat Inc.


(10,372,178
)


5,065,291



(6,418,376
)


3,362,210Other comprehensive itemForeign currency translation gain


3,625,300



512,851



1,832,070



489,797Comprehensive Income (Loss)

$
(6,746,878
)

$
5,578,142


$
(4,586,306
)

$
3,852,007Basic weighted average shares outstanding


38,572,381



32,800,818



38,592,598



32,806,048Diluted weighted average shares outstanding


38,572,381



32,854,058



38,592,598



32,832,633Basic earnings (loss) per share

$
(0.27
)

$
0.15


$
(0.17
)

$
0.10Diluted earnings (loss) per share

$
(0.27
)

$
0.15


$
(0.17
)

$
0.10





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




2


SMARTHEAT INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)





SIX MONTHS ENDED JUNE 30,2011


2010CASH FLOWS FROM OPERATING ACTIVITIES:Income (loss) including noncontrolling interest

$
(10,506,902
)

$
5,080,021Adjustments to reconcile income (loss) including noncontrollinginterest to net cash used in operating activities:Depreciation and amortization


846,867



470,404Unearned interest on accounts receivable


(51,955
)


(25,023
)Stock based compensation expense


253,232



73,064Changes in deferred tax


(1,344,853
)


(15,032
)(Increase) decrease in current assets:Accounts receivable, net


5,243,426



7,487,830Retentions receivable


(465,697
)


(1,096,277
)Advances to suppliers


(10,382,745
)


(6,104,038
)Other receivables, prepayments and deposits


1,412,427



1,406,764Inventories


(9,186,101
)


(11,009,976
)Increase (decrease) in current liabilities:Accounts payable


2,280,976



(71,654
)Advance from customers


717,616



1,327,817Taxes payable


(2,823,643
)


(843,313
)Accrued liabilities and other payables


(940,503
)


(3,283,123
)Net cash used in operating activities


(24,947,855
)


(6,602,536
)CASH FLOWS FROM INVESTING ACTIVITIES:Change in restricted cash


(418,844
)


595,152Deposit for equipment purchase


-



(5,370,066
)Acquisition of property & equipment


(2,135,598
)


(324,587
)Acquisition of intangible asset


(97,420
)


(102,666
)Notes receivable


531,133



-Cash acquired from acquisition


448,849



-Cash paid at acquisition


(13,536,914
)


-Construction in progress


(432,405
)


(32,850
)Net cash used in investing activities


(15,641,199
)


(5,235,017
)CASH FLOWS FROM FINANCING ACTIVITIES:Warrants exercised


-



85,500Proceeds from short-term loan


5,461,309



-Repayment to short-term loan


-



(4,248,960
)Cash contribution from noncontrolling interest


749,303



-Payment on notes payable


(2,051,360
)


(1,653,077
)Net cash provided by (used in) financing activities


4,159,252



(5,816,537
)EFFECT OF EXCHANGE RATE CHANGE ON CASH & EQUIVALENTS


808,551



133,320NET DECREASE IN CASH & EQUIVALENTS


(35,621,251
)


(17,520,770
)CASH & EQUIVALENTS, BEGINNING OF PERIOD


56,806,471



48,967,992CASH & EQUIVALENTS, END OF PERIOD

$
21,185,220


$
31,447,222Supplemental cash flow data:Income tax paid

$
135,449


$
1,441,940Interest paid

$
293,816


$
80,837





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




3


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





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, through its operating subsidiaries in China and Germany, designs, manufactures, sells and services plate heat exchangers (“PHEs”), PHE Units, which combine PHEs with various pumps, temperature sensors, valves and automated control systems, heat meters and heat pumps for use in commercial and residential buildings.





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





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





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





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





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





On June 16, 2009, Taiyu closed an asset purchase transaction with Siping Beifang Heat Exchanger Manufacture Co.,Ltd. (“Siping Beifang”), a company organized under the laws of the People’s Republic of China (“PRC”), to purchase certain assets consisting of the plant, equipment and certain land use rights for RMB 54,000,000 ($7,906,296). Taiyu then transferred all the acquired assets to SmartHeat Siping, the newly incorporated subsidiary. The Company paid RMB 7,250,000 ($1,061,500) upon the completion of inventory inspection. At June 30, 2011, the Company has paid in full the remaining purchase consideration.





On August 14, 2009, the Company formed Beijing SmartHeat Jinhui Energy Technology Co., Ltd. (“Jinhui”), a joint venture in Beijing with registered capital of RMB 10 million ($1.46 million), to provide consulting services and expand the Company’s sales of PHEs into new industries and regions of China. SmartHeat owns 52% of Jinhui and invested approximately $765,000.





On April 7, 2010, the Company formed SmartHeat (China) Investment Co., Ltd. (“SmartHeat Investment”), an investment holding company and wholly owned subsidiary in Shenyang with registered capital of $70 million.





On April 12, 2010, SmartHeat Investment formed SmartHeat (Shenyang) Energy Equipment Co., Ltd. (“SmartHeat Energy”), a wholly owned subsidiary in Shenyang with registered capital of $30 million, for the research, development, manufacturing and sales of energy products.





On May 6, 2010, SmartHeat formed SmartHeat (Shanghai) Trading Co., Ltd. (“SmartHeat Trading”) through a nominee to market and expand sales of the Company’s Taiyu-branded products. The Company made a capital contribution of $1.5 million and is entitled to 100% of the profit or loss of SmartHeat Trading.





In January 2011, the Company invested $771,658 for 51% of the equity interest in a newly formed joint venture, Hohhot Ruicheng Technology Co., Ltd. (“Ruicheng”), in Hohhot City, China for the design and manufacture of heat meters.





On March 3, 2011, the Company completed the acquisition of Gustrower Warmepumpen GmbH (“GWP”), a designer and manufacturer of high efficiency heat pumps in Germany, from Conergy AG. This acquisition will extend the Company’s clean technology heating solutions into the rapidly growing heat pump markets in Europe and China, enabling its customers to purchase technologically advanced heat pumps at competitive prices. The price was EUR 4,248,082 ($5,898,887) and was paid at closing.




4


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





On March 1, 2011, the Company entered into a purchase agreement with Shenyang Bingchuan Refrigerating Machine Limited Company (“Bingchuan”), a Shenyang-based state-owned heat pump manufacturer and designer. The Company paid RMB 50 million ($7.6 million) to acquire 95% of the equity interest in Bingchuan; the local government will retain the remaining 5% equity interest.





2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Principles of Consolidation





The accompanying consolidated financial statements include the accounts of SmartHeat’s U.S. parent, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Energy, SmartHeat Trading, Ruicheng, GWP and Bingchuan. The “Company” refers collectively to SmartHeat’s U.S. parent, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Energy, SmartHeat Trading, Ruicheng, GWP and Bingchuan. All significant intercompany accounts and transactions were eliminated in consolidation.





Noncontrolling Interest





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




Use of Estimates





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





Cash and 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 June 30, 2011, the Company maintained restricted cash of $2.9 million in several bank accounts, of which $1.25 million was cash deposits from customers for securing payment from such customers no later than the warranty period expiration and approximately $1.68 million was deposits the Company paid to a commercial bank for the bank issuing bank acceptances to the Company’s vendors. Of the total restricted cash at June 30, 2011, $2.8 million will be released to the Company within one year. As of December 31, 2010, the Company maintained restricted cash of $2.5 million in several bank accounts, of which $1.05 million was cash deposits from customers for securing payment from such customers no later than the warranty period expiration and approximately $1.40 million was deposits the Company paid to a commercial bank for the bank issuing bank acceptances to the Company’s vendors. Of the total restricted cash at December 31, 2010, $1.9 million will be released to the Company within one year.





Accounts and Retentions Receivable





The Company maintains 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 $8.6 million and $2.3 million at June 30, 2011, and December 31, 2010, respectively.




5


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





At June 30, 2011, and December 31, 2010, the Company had retentions receivable from customers for product quality assurance of $4.2 million and $3.6 million, respectively. The retention rate varies from 5% to 20% of the sales price with variable terms from 3 months to 2 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 $24,356 and $81,041 at June 30, 2011, and December 31, 2010, respectively. Unearned interest is imputed interest on accounts receivable with due dates over 1 year from the invoice date discounted at the Company’s borrowing rate, which was 6.31% at June 30, 2011, and December 31, 2010.





Advance to Suppliers





The Company makes advances to certain vendors to purchase its material and equipment. The advances are interest-free and unsecured.





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 labor 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 as follows:





Building

20 yearsVehicles

5 yearsOffice Equipment

5 yearsProduction Equipment

5-10 years





Land Use Rights





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





Impairment of Long-Lived Assets





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





Recoverability of long-lived assets to be held and used is measured by comparing 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 June 30, 2011, and December 31, 2010, there were no significant impairments of its long-lived assets.





Warranties





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




6


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





Activity in the Company’s warranty reserve during the periods ended June 30, 2011, and December 31, 2010, is as follows:





2011


2010Beginning balance

$
398,292


$
675,562Provisions made or adjusted


(135,403
)


(277,270
)Actual costs incurred


(168,187
)


-Ending balance in current liabilities

$
94,702


$
398,292





Research and Development Costs





Research and development costs are expensed as incurred and included in general and administrative expenses. These costs primarily consist of cost of materials used and salaries paid for the development department of the Company and fees paid to third parties. Research and development costs for the six months ended June 30, 2011 and 2010, were $512,867 and $290,573, respectively. Research and development costs for the three months ended June 30, 2011 and 2010, were $383,885 and $0, respectively.





Income Taxes





The Company utilizes Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes” (codified in FASB ASC Topic 740), which requires recognition of deferred tax assets and liabilities for expected future tax consequences of events 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 FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (codified in FASB ASC Topic 740). When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination.





Interest associated with unrecognized tax benefits is classified as interest expense and penalties are classified as selling, general and administrative expense in the statements of income. The adoption of FIN 48 did not have a material impact on the Company’s financial statements. At June 30, 2011, and December 31, 2010, the Company had not taken any significant uncertain tax position on its tax return for 2010 and prior years or in computing its tax provision for 2010.





Revenue Recognition





The Company’s revenue recognition policies are in compliance with SEC Staff Accounting Bulletin (“SAB”) 104 (codified in FASB ASC Topic 605). Sales revenue is recognized when PHEs and heat meters are delivered, and for PHE Units when customer acceptance occurs, the price is fixed or determinable, no other significant obligations of the Company exist and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition met are recorded as unearned revenue.





The Company’s sales generally provide for 30% of the purchase price on placement of an order, 30% on delivery, 30% upon installation and acceptance of the equipment after customer testing and 10% no later than the termination of the standard warranty period, which ranges from 3 to 24 months from the acceptance date.





Sales revenue is the invoiced value of goods, net of value-added tax (“VAT”). All of the Company’s products sold in the PRC are subject to a VAT of 17% of the gross sales price. This VAT may be offset by the VAT paid by the Company on raw materials and other materials included in the cost of producing the Company’s 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.




7


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





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.





We anticipate collecting our VAT receivable within one year. We do not experience credit losses with respect to our VAT receivables because they are owed to us by the PRC government. We classify our VAT receivable as a current asset because it is an asset that is reasonably expected to be realized (or sold or consumed) within one year or within our normal operating cycle.





Sales returns and allowances were $0 for the six months ended June 30, 2011 and 2010. Sales returns and allowances were $0 for the three months ended June 30, 2011 and 2010. The Company does not provide a right of return, price protection or any other concessions to its customers.





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





The Company charges for after-sales services provided after the expiration of the warranty period, with after-sales services mainly consisting of cleaning PHEs and repairing and exchanging parts. The Company recognizes such revenue when service is provided. For the six months ended June 30, 2011 and 2010, revenue from after-sales services after the expiration of the warranty period was $140,200 and $39,500, respectively. For the three months ended June 30, 2011 and 2010, revenue from after-sales services after the expiration of the warranty period was $55,400 and $22,100, respectively.





Cost of Goods Sold





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





Advance from Customers





The Company records payments received from customers in advance of their future orders to advance account. Those orders normally are delivered within a reasonable period of time based upon contract terms with the customers.





Concentration of Credit Risk





Cash includes cash on hand and demand deposits in accounts maintained within China. Balances at financial institutions within China are not covered by insurance. The Company has not experienced any losses in such accounts.





Certain other financial instruments, which subject the Company to concentration of credit risk, consist of accounts and other receivables. The Company does not require collateral or other security to support these receivables. The Company conducts periodic reviews of its customers’ 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.





Goodwill





Goodwill is the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“Statement No. 142”), codified in ASC Topic 350, goodwill is not amortized but is tested for impairment, annually or when circumstances indicate a possible impairment may exist. Impairment testing is performed at a reporting unit level. An impairment loss generally would be recognized when the carrying amount of the reporting unit exceeds its fair value, with the fair value of the reporting unit determined using discounted cash flow (“DCF”) analysis. A number of significant assumptions and estimates are involved in the application of the DCF analysis to forecast operating cash flows, including the discount rate, the internal rate of return and projections of realizations and costs to produce. Management considers historical experience and all available information at the time the fair values of its reporting units are estimated.




8


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





The excess of the purchase price over the fair value of the net assets acquired from GWP of $5.3 million was recorded as goodwill. The excess of the purchase price over the fair value of the net assets acquired from Bingchuan of $6.1 million was recorded as goodwill. As of June 30, 2011, the Company concluded there was no impairment of goodwill.





Statement of Cash Flows





In accordance with SFAS No. 95, “Statement of Cash Flows,” codified in FASB ASC Topic 230, cash flows from the Company’s operations are calculated based upon the local currencies. As a result, amounts shown on the statement of cash flows may not necessarily agree with changes in the corresponding asset and liability on the balance sheet.





Basic and Diluted Earnings (Loss) 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 computed similarly, 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 EPS are based on the assumption that all dilutive convertible shares and stock options were converted or exercised. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to have been exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.





The following table presents a reconciliation of basic and diluted earnings (loss) per share for the six months ended June 30, 2011 and 2010:





2011


2010Net income (loss)

$
(10,372,178
)

$
5,065,291Weighted average shares outstanding - basic


38,572,381



32,800,818Effect of dilutive securities:Unexercised warrants and options


-



53,240Weighted average shares outstanding - diluted


38,572,381



32,854,058Earnings (loss) per share - basic

$
(0.27
)

$
0.15Earnings (loss) per share - diluted

$
(0.27
)

$
0.15





The following table presents a reconciliation of basic and diluted earnings (loss) per share for the three months ended June 30, 2011 and 2010:





2011


2010Net income (loss)

$
(6,418,376
)

$
3,362,210Weighted average shares outstanding - basic


38,592,598



32,806,048Effect of dilutive securities:Unexercised warrants and options


-



26,585Weighted average shares outstanding - diluted


38,592,598



32,832,633Earnings (loss) per share - basic

$
(0.17
)

$
0.10Earnings (loss) per share - diluted

$
(0.17
)

$
0.10




9


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





Fair Value of Financial Instruments





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





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





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





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





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





As of June 30, 2011, and December 31, 2010, the Company did not identify any assets and liabilities that are required to be presented on the balance sheet at fair value.





Foreign Currency Translation and Comprehensive Income (Loss)





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





Stock-Based Compensation





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





Segment Reporting





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





SFAS No. 131 has no effect on the Company’s financial statements as substantially all of the Company’s operations are conducted in one industry segment.





Registration Rights Agreement





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




10


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





Under the terms of the registration rights agreement entered into between the Company and the investors in the Company’s private placement offering in 2008, the Company was required to file a registration statement (the “Registration Statement”) with the SEC within 60 days of the closing of the private placement and the Registration Statement must have been declared effective by the SEC within 180 days of the final closing of the private placement. Subject to certain grace periods, the Registration Statement must remain effective and available for use until the investors can sell all of the securities covered by the Registration Statement without restriction pursuant to Rule 144. If the Company fails to meet the filing or effectiveness requirements of the Registration Statement, the Company is required to pay liquidated damages of 2% of the purchase price paid by such investor for any registrable securities then held by such investor on the date of such failure and on each anniversary of the date of such failure until such failure is cured. The last closing under the private placement was on September 24, 2008, and the 180-day period for effectiveness of the Registration Statement under the registration rights agreement ended March 23, 2009. At March 31, 2009, the Company became liable to pay approximately $110,000 in liquidated damages to the investors because the Registration Statement had not been declared effective by the SEC within 180 days of the final closing of the offering. The liquidated damages were recorded as the Company’s general and administrative expense with charging corresponding account to accrued liabilities. The Registration Statement became effective on June 23, 2009, a post-effective amendment became effective on May 21, 2010, and another post-effective amendment became effective on April 20, 2011. The Company paid $63,004 for the liquidated damages and the remaining $46,996 was waived by investors.





Reclassifications





Certain prior year amounts were reclassified to conform to the manner of presentation in the current period.





New Accounting Pronouncements





In June 2011, FASB issued ASU 2011-05, Comprehensive Income (ASC Topic 220): Presentation of Comprehensive Income. Under the amendments in this update, an entity has the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. In addition, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The amendments in this update should be applied retrospectively and are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is currently assessing the effect that the adoption of this pronouncement will have on its financial statements.





3. INVENTORIES





Inventories at June 30, 2011, and December 31, 2010 were as follows:





2011


2010Raw materials

$
24,339,636


$
15,803,040Work in process


5,207,767



3,157,799Finished goods


8,928,186



7,624,523Total

$
38,475,589


$
26,585,362





4. NOTES RECEIVABLE – BANK ACCEPTANCES





The Company sold goods to its customers and received commercial notes (bank acceptance) from them in lieu of payments for accounts receivable. The Company discounted the commercial notes with the bank or endorsed the commercial notes to vendors for payment of their own obligations or to get cash from third parties. Most of the commercial notes have a maturity of less than six months. At June 30, 2011, and December 31, 2010, the Company had notes receivable of $954,649 and $1,457,457, respectively.




11


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





5. PROPERTY AND EQUIPMENT, NET





Property and equipment consisted of the following at June 30, 2011, and December 31, 2010:




2011


2010Building

$
4,662,830


$
4,556,445Production equipment


7,029,751



3,923,521Office equipment


870,818



794,816Vehicles


902,852



711,798Total


13,466,251



9,986,580Less: Accumulated depreciation


(2,169,295
)


(1,605,561
)Net

$
11,296,956


$
8,381,019





Depreciation for the six months ended June 30, 2011 and 2010, was $521,600 and $399,100, respectively. Depreciation for the three months ended June 30, 2011 and 2010, was $284,800 and $230,200, respectively.





6. OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS





Other receivables, prepayments and deposits consisted of the following at June 30, 2011, and December 31, 2010, respectively:





2011


2010Cash advanced to third parties

$
1,123,989


$
2,076,862Deposit for public bids of sales contracts


1,253,242



846,739Deposit for acquisition of Bingchuan


-



1,834,600Prepayment for freight and related insurance expenses


185,782



115,542Other deposits


203,967



53,289Advance to employees


487,697



600,427Others


1,524,248



774,313Total

$
4,778,925



6,301,772





Cash advanced to third parties was short-term cash advances to unrelated third parties with repayment usually within three to six months. Deposits for public bidding represented the deposits for bidding on expected contracts, which will be returned to the Company after the bidding process is completed, usually within three to four months from the payment date. Prepayment for freight and 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, payroll expense and utilities. Cash advance to employees represented short-term loans to employees and advances to employees for business trips and related expenses. Other receivables, prepayments and deposits are reimbursed or settled within 12 months.





7. INTANGIBLE ASSETS





Intangible assets consisted mainly of land use rights, trademark, 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). In June 2009, the Company acquired land use rights for $3.2 million from Siping Beifang. In November 2010, the Company’s subsidiary, SmartHeat Energy, acquired land use rights for $10.1 million. 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 June 30, 2011, and December 31, 2010, respectively:




12


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





2011


2010Land use rights

$
14,245,689


$
13,884,020Know-how technology


858,653



275,345Customer list


202,402



197,784Covenant not to compete


110,106



107,593Software


487,961



403,680Trademark


281,263



-Total


16,186,074



14,868,422Less: Accumulated amortization


(921,533
)


(624,688
)Net

$
15,264,541


$
14,243,734





Amortization of intangible assets for the six months ended June 30, 2011 and 2010, was $279,300 and $125,000, respectively. Amortization of intangible assets for the three months ended June 30, 2011 and 2010, was $173,800 and $65,000, respectively. Annual amortization expense for the next five years from June 30, 2011, is expected to be $588,000, $566,000, $436,000, $425,000 and $402,000.





8. CONSTRUCTION IN PROGRESS





The Company had construction in progress of $520,149 at June 30, 2011, with two ongoing projects. SmartHeat Energy is building a factory with a total estimated cost of $9 million, of which the Company has paid $458,000 as of June 30, 2011, and expects this construction to be completed by June 2012. SmartHeat Siping has a construction project of $62,000 for the laying of a foundation for its machinery installation. This foundation project will be completed in 2011, with remaining cost to complete of $25,000.





9. TAXES PAYABLE





Taxes payable consisted of the following at June 30, 2011, and December 31, 2010:





2011


2010Income tax payable

$
-


$
1,866,569Value-added tax payable


-



117,779Other taxes payable


8,845



16,108Total taxes payable

$
8,845


$
2,000,456





10. ACCRUED LIABILITIES AND OTHER PAYABLES





Accrued liabilities and other payables consisted of the following at June 30, 2011, and December 31, 2010:





2011


2010Advance from third parties

$
954,497


$
132,890Payable to Siping Beifang


-



1,238,166Other payables


1,067,821



952,593Warranty reserve


94,702



398,292Accrued expenses


381,991



317,840Total

$
2,499,011


$
3,039,701





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





11. NOTES PAYABLE – BANK ACCEPTANCES





Notes payable represented the conversion of accounts payable into notes payable, which were issued from the bank. The Company deposited a portion of the acceptance amount into the bank. The terms of the notes range from 3-6 months and bear no interest. At June 30, 2011, and December 31, 2010, the Company deposited $1.7 million and $1.4 million with the bank as restricted cash for the bank issuing the notes. The restricted cash is refundable when the notes are repaid.




13


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





12. LOANS PAYABLE - BANK





The Company was obligated for the following short-term loans as of June 30, 2011, and December 31, 2010:





2011


2010From a commercial bank in the PRC for RMB 3,000,000 entered into on June 30, 2011. The loan currently bears interest at 6.63% with maturity on June 29, 2012. The loan was guaranteed by a third party.

$
463,564


$
-From a commercial bank in the PRC for RMB 13,000,000 entered into on August 9, 2010. The loan currently bears interest at 5.31% with maturity on June 30, 2011. The Company pledged its building and land use rights for this loan. The loan was paid in full when it matured.


-



1,962,946From a commercial bank in the PRC for RMB 5,000,000 entered into on October 19, 2010. The loan currently bears interest at 5.84% with maturity on October 18, 2011. The loan was pledged by bank deposit.


772,606



754,979From a commercial bank in the PRC for RMB 17,000,000 entered into on June 1, 2010. The loan currently bears interest at 5.31% with maturity on June 30, 2011. The loan was guaranteed by a third party. The loan was paid in full when it matured.


-



2,566,929From a commercial bank in the PRC for RMB 25,000,000 entered into on October 18, 2010. The loan currently bears interest at 5.84% with maturity on October 17, 2011. The loan was pledged by bank deposit.


3,863,032



3,774,895From a commercial bank in the PRC for RMB 50,000,000 entered into on June 29, 2011. The loan currently bears interest at 6.94% with maturity on January 27, 2012. The loan was guaranteed by SanDeKe.


7,726,065



-From a commercial bank in the PRC for RMB 10,000,000 entered into on June 27, 2011. The loan currently bears interest at 7.57% with maturity on June 27, 2012. The loan was pledged by bank deposit.


1,545,213



-From a commercial bank in the PRC for RMB 3,200,000 entered into on March 15, 2011. The loan currently bears interest at 6.72% with maturity on July 14, 2011. The Company pledged saving deposit for this loan.


494,468



-From a commercial bank in the PRC for RMB 1,040,000 entered into on April 29, 2011. The loan currently bears interest at 7.02% with maturity on August 26, 2011. The Company pledged saving deposit for this loan.


160,702



-From a commercial bank in the PRC for RMB 3,500,000 entered into on June 2, 2011. The loan currently bears interest at 7.02% with maturity on September 29, 2011. The Company pledged saving deposit for this loan.


540,825



-$
15,566,475


$
9,059,749





13. DEFERRED TAX ASSET (LIABILITY)





Deferred tax asset (liability) represented differences between the tax bases and book bases of property and equipment and intangible assets arising from the acquisition of SanDeKe, GWP and Bingchuan, and bad debt allowance booked by the Company which was not allowed per tax purpose. As of June 30, 2011, deferred tax assets mainly resulted from allowance for bad debts and deferred tax liability related to the acquisition of Bingchuan.





14. INCOME TAXES





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





SmartHeat, the parent company, was incorporated in the U.S. and has net operating losses (NOL) for income tax purposes. SmartHeat has net operating loss carry forwards for income taxes of approximately $2.65 million at June 30, 2011, which may be available to reduce future years’ taxable income; NOL can be carried forward up to 20 years from the year the loss is incurred. Management believes the realization of benefits from these losses remains uncertain due to SmartHeat’s limited operating history and continuing losses. Accordingly, a 100% deferred tax asset valuation allowance has been provided.




14


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





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





According to the new income tax law that became effective January 1, 2008, new high-tech enterprises given special support by the PRC government are subject to an income tax rate of 15%. Taiyu was recognized as a new high-tech enterprise and, having registered its status with the tax bureau, therefore enjoyed the income tax rate of 15% from 2009 through 2010. Taiyu currently is in the process of renewing its high-tech enterprise status.





SanDeKe is exempt from income tax for two years starting from its first profitable year and is entitled to a 50% discount on the income tax rate from 2010 through 2012. The income tax rate for SanDeKe is 12% and 11% for 2011 and 2010, respectively.





SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Energy, Bingchuan, Ruicheng and SmartHeat Trading are subject to the regular 25% income tax rate. GWP is subject to a 15% corporate income tax in Germany.





The following table reconciles the U.S. statutory rates to the Company’s effective tax (benefit) rate for the six months ended June 30, 2011 and 2010:





2011


2010U.S. statutory rates


(34.0
)%


34.0
%Tax rate difference


8.4
%


(9.9
)%Effect of tax holiday


7.4
%


(11.6
)%Others


(0.2
)%


0.3
%Valuation allowance


7.2
%


3.1
%Tax (benefit) per financial statements


(11.2
)%


15.9
%





The following table reconciles the U.S. statutory rates to the Company’s effective tax (benefit) rate for the three months ended June 30, 2011 and 2010:





2011


2010U.S. statutory rates


(34.0
)%


34.0
%Tax rate difference


8.4
%


(9.6
)%Effect of tax holiday


7.5
%


(10.4
)%Others


(1.2
)%


(0.0
)%Valuation allowance


10.2
%


3.1
%Tax (benefit) per financial statements


(9.1
)%


17.1
%





The provision for income tax (benefit) for the six months ended June 30, 2011 and 2010, consisted of the following:





2011


2010Income tax expense - current

$
(31,589
)

$
981,338Income tax benefit - deferred


(1,296,470
)


(15,032
)Total income tax expense (benefit)

$
(1,328,059
)

$
966,306





The provision for income tax (benefit) for the three months ended June 30, 2011 and 2010, consisted of the following:





2011


2010Income tax expense - current

$
(100,263
)

$
704,234Income tax benefit - deferred


(546,897
)


(7,448
)Total income tax expense (benefit)

$
(647,160
)

$
696,786





15. STATUTORY RESERVES





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




15


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





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. As of June 30, 2011, and December 31, 2010, the Company has not made any reserve under the common welfare fund.





16. STOCKHOLDERS’ EQUITY





Common Stock with Warrants Issued for Cash





In August 2008, the Company sold 1,630,000 units consisting of one share of the Company’s common stock and a 3-year warrant to purchase 15% of one share of the Company’s common stock for $6.00 per share, at $3.50 per unit, for approximately $5.7 million. The Company issued warrants to purchase 244,500 shares of its common stock. In connection with the private placement, the Company paid commissions of $340,000 and issued warrants to purchase 148,500 shares of its common stock to placement agents. The warrants are immediately exercisable and expire on the third anniversary of their issuance. The warrants require the Company to settle in its own shares. There is no provision for cash settlement, except in lieu of fractional shares. Net proceeds of approximately $5.1 million were received by the Company. The value of warrants was determined by using the Black-Scholes pricing model with the following assumptions: discount rate– 2.76%; dividend yield– 0%; expected volatility– 15% and term of 3 years. The value of the warrants was $70,246. During 2009, warrants to purchase 281,975 shares were exercised at $6.00 per share for $1,691,850. During 2010, warrants to purchase 14,250 shares were exercised at $6.00 per share for $85,500.





Following is a summary of the warrant activity:





Number of

Shares


Average

Exercise

Price per Share


Weighted

Average

Remaining

Contractual

Term in YearsOutstanding at December 31, 2010


96,775


$
6.00



0.51Exercisable at December 31, 2010


96,775


$
6.00



0.51Granted


-



-



-Exercised


-



-



-Forfeited


-



-



-Outstanding at June 30, 2011


96,775


$
6.00



0.01Exercisable at June 30, 2011


96,775


$
6.00



0.01





Stock Options to Independent Directors and Employee





On July 17, 2008, the Company granted non-statutory stock options to each of its two independent U.S. 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 vested July 17, 2009; 3,333 shares vested July 17, 2010; and 3,334 shares vest on July 17, 2011, subject in each case to the director continuing to be associated with the Company as a director. The options were valued using a 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.




16


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





On July 31, 2009, one of the Company’s independent U.S. directors voluntarily retired. As such, he forfeited his right to his unvested options to purchase 6,667 shares.





On February 1, 2010, the Company issued stock options to an employee. The terms of the options are: 50,000 shares at an exercise price per share of $11.85, with a life of five years and vesting over two years as follows: 25,000 shares vest on June 30, 2011; 25,000 shares vest on June 29, 2012. The options were valued using a volatility of 74%, risk free interest rate of 2.76%, and dividend yield of 0%. The grant-date fair value of the options was $367,107.





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





Following is a summary of the option activity:





WeightedAverageAverage


RemainingNumber of


Exercise


ContractualShares


Price per Share


Term in YearsOutstanding at December 31, 2010


63,333


$
10.32



3.76Exercisable at December 31, 2010


10,000


$
4.60



2.54Granted


-



-



-Exercised


-



-



-Forfeited


-



-



-Outstanding at June 30, 2011


63,333


$
10.32



3.26Exercisable at June 30, 2011


35,000


$
4.60



3.15





There were no options exercised during the six months ended June 30, 2011 and 2010. The Company recorded $102,731 and $54,974 as compensation expense for stock options during the six months ended June 30, 2011 and 2010, respectively. There were no options exercised during the three months ended June 30, 2011 and 2010. The Company recorded $51,646 and $54,222 as compensation expense for stock options during the three months ended June 30, 2011 and 2010, respectively.





On April 18, 2011, the Company issued 50,000 shares of stock to an employee as bonus. The Company recorded $150,500 as stock compensation expenses during the three months ended June 30, 2011.





Stock Issued for Consulting Service





On January 1, 2010, the Company entered into a one-year service agreement with a consultant to provide business development assistance and engineering advice regarding the sales and marketing of the Company’s products. On July 16, 2010, the Company and consultant amended the compensation terms under the consulting agreement. The Company compensated the consultant on a quarterly basis at $6,250 and 500 restricted shares of the Company’s common stock in 2010. Starting from 2011, the Company will compensate the consultant on a quarterly basis at $6,250 only.




17


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





17. COMMITMENTS





Employment Agreements





On January 1, 2008, Taiyu entered into a 3-year employment agreement with Jun Wang, the Company’s Chief Executive Officer, which agreement was renewed on the same terms through December 31, 2013, upon mutual agreement between Mr. Wang and Taiyu. Pursuant to the terms of his employment agreement, Mr. Wang shall receive a salary 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. Effective on February 1, 2010, the Compensation Committee approved an increase in Mr. Wang’s annual compensation to a base salary of $150,000 per year.





On January 1, 2008, Taiyu entered into a 3-year employment agreement with Zhijuan Guo, the Company’s Chief Financial Officer, which agreement was renewed on the same terms through December 31, 2013, upon mutual agreement between Ms. Guo and Taiyu. Pursuant to the terms of her employment agreement, Ms. Guo shall receive a salary 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, Ms. Guo shall be entitled to overtime pay in accordance with the applicable law.





On February 1, 2010, SmartHeat entered into an employment agreement with Xudong Wang, the Company’s Vice President of Strategy and Development, for a term ending on June 30, 2013. Mr. Wang is compensated at RMB 70,000 ($10,648) per month and eligible for annual cash bonuses at the sole discretion of the Board of Directors.





Lease Agreements





The Company leased offices for its sales representative in several different cities under various one-year, non-cancellable and renewable operating lease agreements. Rental expense for the six months ended June 30, 2011 and 2010, was approximately $252,350 and $71,000, respectively. Rental expense for the three months ended June 30, 2011 and 2010, was approximately $186,550 and $54,000, respectively.





Capital Contribution





On April 7, 2010, the Company formed SmartHeat Investment, a wholly owned subsidiary in Shenyang, with registered capital of $70 million. As of June 30, 2011, the Company has contributed $30 million in capital, and was committed to contribute an additional $40 million within five years, which is permitted per PRC regulations.





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 in China are denominated in RMB and all of the Company’s assets and liabilities in China are also denominated in RMB. The RMB is not freely convertible into foreign currencies under the current law. In China, foreign exchange transactions are required by law to be transacted only by authorized financial institutions. Remittances in currencies other than RMB may require certain supporting documentation in order to affect the remittance.





19. ACQUISITION AND UNAUDITED PRO FORMA INFORMATION





On March 3, 2011, the Company completed the acquisition of GWP, a designer and manufacturer of high efficiency heat pumps. This acquisition will extend the Company’s clean technology heating solutions into the rapidly growing heat pump markets in Europe and China, enabling its customers to purchase technologically advanced heat pumps at competitive prices. The total purchase price was EUR 4,248,082 ($5,898,887) and was paid at closing.





The following table summarizes the preliminary fair values of the assets acquired and liabilities assumed at the date of acquisition. The fair values of the assets acquired and liabilities assumed at agreement date were used for the purpose of purchase price allocation. The excess of the purchase price over the fair value of the net assets acquired of $5,134,627 was recorded as goodwill.




18


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





Cash

$
239,686Accounts receivable


137,185Other receivables


24,254Inventory


667,412Property and equipment


350,382Goodwill


5,134,627Accounts payable


(536,907
)Other payables


(117,752
)Purchase price

$
5,898,887





On March 1, 2011, the Company entered into a purchase agreement with Bingchuan, a Shenyang-based state-owned heat pump manufacturer and designer. The Company paid RMB 50 million ($7.6 million) to acquire 95% of the equity interests in Bingchuan, with the local government retaining the remaining 5% equity interest.





The following table summarizes the preliminary fair values of the assets acquired and liabilities assumed at the date of the Bingchuan acquisition. The fair values of the assets acquired and liabilities assumed at the agreement date were used for the purpose of purchase price allocation. The excess of the purchase price over the fair value of the net assets acquired of $5,629,951 was recorded as goodwill.





Cash

$
189,438Accounts receivable


920,463Other receivable


263,220Inventory


1,265,455Property and equipment


759,341Intangible assets


858,409Goodwill


5,629,951Accounts payable


(446,334
)Other payable and accrued expenses


(686,195
)Short-term loan


(760,433
)Deferred tax liability


(285,069
)Noncontrolling interest


(103,915
)Purchase price

$
7,604,331





The following unaudited pro forma consolidated results of operations for SmartHeat for the six months ended June 30, 2011 and 2010, presents the operations of SmartHeat, GWP and Bingchuan as if the acquisitions occurred at January 1, 2011 and 2010, respectively. The pro forma results are not necessarily indicative of the actual results that would have occurred had the acquisitions been completed as of the beginning of the periods presented, nor are they necessarily indicative of future consolidated results.





2011Net revenue

$
15,367,545Cost of revenue


10,070,434Gross profit


5,297,111Total operating expenses


17,326,423Loss from operations


(12,029,312
)Total non-operating expenses


(243,961
)Loss before income tax


(12,273,273
)Income tax


(1,328,051
)Loss after income tax


(10,945,222
)Noncontrolling interest


145,110Loss to SmartHeat Inc.

$
(10,800,112
)Weighted average shares outstanding


38,572,381Loss per share

$
(0.28
)




19


SMARTHEAT INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30, 2011 (UNAUDITED) AND 2010





2010Net revenue

$
51,255,183Cost of revenue


36,065,259Gross profit


15,189,924Total operating expenses


11,473,852Income from operations


26,663,776Total non-operating income


3,326,736Income before income tax


29,990,512Income tax


(966,306
)Income after income tax


29,024,206Noncontrolling interest


(6,666
)Income to SmartHeat Inc.

$
29,017,540Weighted average shares outstanding


32,800,818Earnings per share

$
0.88




20


CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS





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





Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations





Overview





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





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





As an expansion of our business, we acquired SanDeKe Co., Ltd. (“SanDeKe”), a Shanghai-based manufacturer of PHEs, on September 25, 2008. On June 16, 2009, we completed an asset purchase transaction with Siping Beifang Heat Exchanger Manufacture Co., Ltd. (“Siping Beifang”) to set up a new manufacturing facility under our newly incorporated subsidiary, SmartHeat Siping Beifang Energy Technology Co., Ltd. (“SmartHeat Siping”). On August 14, 2009, we formed Beijing SmartHeat Jinhui Energy Technology Co., Ltd. (“Jinhui”), a joint venture in Beijing of which we own 52% with total registered capital of RMB 10 million ($1.46 million), to provide consulting services and expand our sales of PHEs into new industries and regions of China. On April 7, 2010, we formed SmartHeat (China) Investment Co., Ltd. (“SmartHeat Investment”), an investment holding company and wholly owned subsidiary in Shenyang with registered capital of $70 million. On April 12, 2010, SmartHeat Investment formed a wholly owned subsidiary in Shenyang named SmartHeat (Shenyang) Energy Equipment Co., Ltd. (“SmartHeat Energy”) with registered capital of $30 million for the research, development, manufacturing and sales of energy products. On May 6, 2010, we formed SmartHeat (Shanghai) Trading Co., Ltd. (“SmartHeat Trading”) to market and expand sales of our Taiyu-branded products. In January 2011, we invested $771,658 for 51% of the equity interest in a newly formed joint venture, Hohhot Ruicheng Technology Co., Ltd. (“Ruicheng”), in Hohhot City, China for the design and manufacture of heat meters. On March 3, 2011, we completed the acquisition of Gustrower Warmepumpen GmbH (“GWP”), a designer and manufacturer of high efficiency heat pumps in Germany. This acquisition will extend our clean technology heating solutions into the rapidly growing heat pump markets in Europe and China, enabling our customers to purchase technologically advanced heat pump technology at competitive prices. The total purchase price was EUR 4,248,082 ($5,898,887) and was paid at closing. On March 1, 2011, we entered into a purchase agreement with Shenyang Bingchuan Refrigerating Machine Limited Company (“Bingchuan”), a Shenyang-based state-owned heat pump manufacturer and designer. We paid RMB 50 million ($7.6 million) to acquire 95% of the equity interest in Bingchuan; the local government will retain the remaining 5% equity interest.




21


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, changes in PRC government fiscal policies, inflation in China and other unpredictable factors that may affect customer ordering patterns. Our revenues may fluctuate significantly due to the seasonal nature of central heating services in the PRC because the equipment used in residential buildings must be delivered and installed prior to the beginning of the heating season in late fall. Additionally, any significant delays in the commercial launch or any lack or delay of commercial acceptance of new products, unfavorable sales trends in existing product lines, or impacts from the other factors mentioned above, could adversely affect our revenue growth or cause a sequential decline in quarterly revenue. We have not been adversely affected by these trends or weaker demand from steel processing, petrochemical and HVAC industries.





Significant Accounting Policies





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





Basis of Presentation





Our financial statements are prepared in accordance with generally accepted accounting principles in the U.S. (“U.S. GAAP”).





Principle of Consolidation





The accompanying consolidated financial statements include the accounts of SmartHeat’s U.S. parent, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Energy, SmartHeat Trading, Ruicheng, GWP and Bingchuan. The “Company” refers collectively to SmartHeat’s U.S. parent, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Energy, SmartHeat Trading, Ruicheng, GWP and Bingchuan. All significant inter-company accounts and transactions were eliminated in consolidation.





Use of Estimates





In preparing the financial statements in conformity with U.S. 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 period. 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 labor 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 as follows:





Building

20 yearsVehicles

5 yearsOffice Equipment

5 yearsProduction Equipment

5 - 10 years




22


Revenue Recognition





Our revenue recognition policies are in compliance with SEC Staff Accounting Bulletin (“SAB”) 104 (codified in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605). Sales revenue is recognized when PHEs and heat meters are delivered, and for PHE Units when customer acceptance occurs, the price is fixed or determinable, no other significant obligations of ours exist and collectibility is reasonably assured. Payments received before all of the relevant criteria for revenue recognition are recorded as unearned revenue.





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





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





We charge for after-sales services provided after the expiration of the warranty period, with after-sales services mainly consisting of cleaning PHEs and repairing and exchanging parts. We recognize such revenue when service is provided. The revenue earned from these services was not material.





Foreign Currency Translation and Comprehensive Income (Loss)





The functional currency of our subsidiaries in China is the Chinese Yuan Renminbi (“RMB”). The functional currency of GWP, our German subsidiary, is the Euro (“EUR”). For financial reporting purposes, RMB and EUR were 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 stockholders’ equity as “Accumulated other comprehensive income.” Gains and losses resulting from foreign currency transactions are included in income. There has been no significant fluctuation in exchange rate for the conversion of RMB to USD after the balance sheet date.





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





Recent Accounting Pronouncements





In June 2011, FASB issued ASU 2011-05, Comprehensive Income (ASC Topic 220): Presentation of Comprehensive Income. Under the amendments in this update, an entity has the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. In addition, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The amendments in this update should be applied retrospectively and are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. We are currently assessing the effect that the adoption of this pronouncement will have on our financial statements.




23


Results of Operations





Six Months Ended June 30, 2011, Compared to the Six Months Ended June 30, 2010





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





2011


2010$


% of Sales


$


% of SalesSales

$
14,970,050





$
32,136,429Cost of sales


9,762,240



65.2
%


21,116,060



65.7
%Gross profit


5,207,810



34.8
%


11,020,369



34.3
%Operating expenses


16,826,771



112.4
%


5,198,363



16.2
%Income (loss) from operations


(11,618,961
)


(77.6
)%


5,822,006



18.1
%Other income (expenses), net


(216,000
)


(1.4
)%


224,321



0.7
%Income tax expense (benefit)


(1,328,059
)


(8.9
)%


966,306



3.0
%Noncontrolling interest


(134,724
)


(0.8
)%


14,730



0
%Net income (loss) to the Company

$
(10,372,178
)


(69.3
)%

$
5,065,291



15.8
%





Sales. Net sales in the six months ended June 30, 2011, were $14.97 million, consisting of $4.43 million for PHE Units, $7.29 million for PHEs, $1.28 million for heat meters and others of $1.97 million, while our net sales in the same period of 2010 were $32.14 million, consisting of $13.83 million for PHE Units, $17.21 million for PHEs and $1.10 million for heat meters, an overall decrease of $17.17 million or 53%. The decrease in sales was primarily due to tightened fiscal policy in China, which has contributed to a general slowdown in many sectors of the Chinese economy and caused a decrease in sales of our PHE Units and PHEs. Most of our customers are state-owned enterprises that encountered difficulties in obtaining grants from the PRC government and faced an extended bank loan application process, both of which typically are used to finance the purchase of our products, which resulted in an unexpected cancelation of orders and delays in the performance of PHE Unit and PHE contracts. Although these events caused a decrease in sales, we expect that a portion of the canceled PHE Unit and PHE orders will be reinstated and contracts that have been partially delayed will be performed within this fiscal year or 2012, reducing the impact of the drop in sales over the long term. We are taking steps to increase the sales of our PHE Units and PHEs by continuing our expansion into regional areas of China and are encouraged by our progress in establishing sales channels in North and South America, which we expect will meaningfully contribute to revenue in 2012.





Heat meter sales increased from the same period in 2010. Article 38 of China’s Energy Conservation Law issued in 2008 requires new apartments and retrofitted apartments to install heat meters; however, the implementation of this government-mandated process varies across regions and takes time, which may cause our heat meter growth rate to fluctuate. Nevertheless, we expect heat meter sales will experience significant growth in the following 2-3 years and believe we will benefit from this growth as we are one of the top heat meter manufacturers in China. We also have been expanding continuously into more regional heat-supply markets as a result of the PRC government’s economic stimulus plan that stresses increased domestic infrastructure construction and continuous research and development on new products.





We have a strict review process for approving each sales contract, especially with respect to the determination of a sales price. The sales price is determined under each contract in proportion to our estimated cost in order to ensure our gross profit. Our sales price varies according to each sale depending mainly on each customer’s specific requirements and our negotiation of the contract amount and term.





Cost of Sales.Cost of sales for the six months ended June 30, 2011, was $9.76 million, while our cost of sales for the same period of 2010 was $21.12 million, a decrease of $11.35 million or 54%. Cost of sales mainly consisted of the cost of materials and labor, as well as factory overhead. Materials cost is normally 80% of total cost, while factory overhead cost is about 15% and labor cost is about 5%. The decrease in cost of sales is attributable to the decrease in production and sales volume in the six months ended June 30, 2011. Cost of sales as a percentage of sales was 65.2% for the six months ended June 30, 2011, and 65.7% for the same period of 2010. The slight decrease in cost of sales as a percentage of sales was due to our effective control over inventory and raw material purchasing. We believe our cost of sales will remain stable as a result of stronger sales in new product areas, our research and development capability, our current pricing strategy and the continued improvement in the efficiency of our manufacturing facilities.





Gross Profit. Gross profit was $5.21 million for the six months ended June 30, 2011, compared to $11.02 million in the same period of 2010, or gross profit margins of 34.8% and 34.3%, respectively. The slight increase in our gross profit margin was due to the slight decrease in our production costs.




24


Operating Expenses. Operating expenses consisting of selling, general and administrative expenses totaled $16.83 million for the six months ended June 30, 2011, compared to $5.20 million for the same period of 2010, an increase of $11.63 million or 224%. Operating expenses as a percentage of sales were 112.4% in the six months ended June 30, 2011, compared to 16.2% in the same period of 2010. The increase in operating expenses mainly resulted from increased bad debt allowance of approximately $5.75 million and expansion of our business, which included additional costs of hiring more sales personnel, higher depreciation expense, training our marketing team and establishing new sales offices in more regions of China. Due to the stringent fiscal policy of the Chinese government, some of our state-owned customers encountered difficulties in obtaining grants from the government and loans from state-owned banks, both of which typically are used to finance the purchase of our products, which resulted in unexpected delays in paying our accounts receivable in a timely manner. As a result of these delays, we recorded $5.81 million bad debt allowance in the six months ended June 30, 2011. We do not expect a significant risk with respect to the overdue accounts receivable for which we took the bad debt allowance and believe that a substantial portion of the bad debt will be repaid as the Chinese government restores grants and credit policies. We believe the government’s stringent fiscal policy impacting our customers will be temporary and the expansion and training of our marketing team and other employees to date will increase sales and improve the efficiency of our operations. Nevertheless, we will institute a rigorous program of cost cutting to continue to tightly control our budget and implement additional cost control measures, including a review of the staffing levels of our employees in response to the decrease in revenue.





Net Income (Loss). Our net loss for the six months ended June 30, 2011, was $10.37 million compared to net income of $5.09 million for the same period of 2010, a decrease of $15.47 million or 304%. Net loss as a percentage of sales was 69.3% in the six months ended June 30, 2011, and net income as a percentage of sales was 15.9% in the 2010 period. This decrease in net income was attributable to the temporary decrease of net sales and increased bad debt allowance reserve.





Three Months Ended June 30, 2011, Compared to the Three Months Ended June 30, 2010





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





2011


2010$


% of Sales


$


% of SalesSales

$
7,077,901





$
22,767,593Cost of sales


4,432,011



62.6
%


14,986,259



65.8
%Gross profit


2,645,890



37.4
%


7,781,334



34.2
%Operating expenses


9,750,316



137.8
%


3,776,444



16.6
%Income (loss) from operations


(7,104,426
)


(100.4
)%


4,004,890



17.6
%Other income (expenses), net


(48,340
)


(0.7
)%


68,354



0.3
%Income tax expense (benefit)


(647,160
)


(9.1
)%


696,786



3.1
%Noncontrolling interest


(87,230
)


(1.2
)%


14,248



0.1
%Net income (loss)

$
(6,418,376
)


(90.7
)%

$
3,362,210



14.7
%





Sales. Net sales in the three months ended June 30, 2011, were $7.08 million, consisting of $3.98 million for PHE Units, $1.27 million for PHEs, $0.36 million for heat meters and others of $1.47 million, while our net sales in the same period of 2010 were $22.76 million, consisting of $9.51 million for PHE Units, $12.72 million for PHEs and $0.53 million for heat meters, an overall decrease of $15.69 million or 69%. The decrease in sales was primarily due to tightened fiscal policy in China, which has contributed to a general slowdown in many sectors of the Chinese economy and caused a decrease in sales of our PHE Units and PHEs. Most of our customers are state-owned enterprises that encountered difficulties in obtaining grants from the PRC government and faced an extended bank loan application process, both of which typically are used to finance the purchase of our products, which resulted in the unexpected cancelation of orders and delays in the performance of PHE Unit and PHE contracts. Although these events caused a decrease in sales, we expect that a portion of the canceled PHE Unit and PHE orders will be reinstated and contracts that have been partially delayed will be performed within this fiscal year or 2012, reducing the impact of the drop in sales over the long term. We are taking steps to increase the sales of our PHE Units and PHEs by continuing our expansion into regional areas of China and are encouraged by our progress in establishing sales channels in North and South America, which we expect will meaningfully contribute to revenue in 2012.





Heat meter sales increased from the same period in 2010. Article 38 of China’s Energy Conservation Law issued in 2008 requires new apartments and retrofitted apartments to install heat meters; however, the implementation of this government-mandated process varies across regions and takes time, which may cause our heat meter growth rate to fluctuate. Nevertheless, we expect heat meter sales will experience significant growth in the following 2-3 years and believe we will benefit from this growth as we are one of the top heat meter manufacturers in China. We also have been expanding continuously into more regional heat-supply markets as a result of the PRC government’s economic stimulus plan that stresses increased domestic infrastructure construction and continuous research and development on new products.





We have a strict review process for approving each sales contract, especially with respect to the determination of a sales price. The sales price is determined under each contract in proportion to our estimated cost in order to ensure our gross profit. Our sales price varies according to each sale depending mainly on each customer’s specific requirements and our negotiation of the contract amount and term.




25


Cost of Sales.Cost of sales for the three months ended June 30, 2011, was $4.43 million, while our cost of sales for the same period of 2010 was $14.99 million, a decrease of $10.55 million or 70%. Cost of sales mainly consisted of the cost of materials and labor, as well as factory overhead. Materials cost is normally 80% of total cost, while factory overhead cost is about 15% and labor cost is about 5%. The decrease in cost of sales is attributable to the decrease in production and sales volume in the three months ended June 30, 2011. Cost of sales as a percentage of sales was 62.6% for the three months ended June 30, 2011, and 65.8% for the same period of 2010. The decrease in cost of sales as a percentage of sales was due to our effective control over inventory and raw material purchasing. We believe our cost of sales will remain stable as a result of stronger sales in new product areas, our research and development capability, our current pricing strategy and the continued improvement in the efficiency of our manufacturing facilities.





Gross Profit. Gross profit was $2.65 million for the three months ended June 30, 2011, compared to $7.78 million in the same period of 2010, or gross profit margins of 37.4% and 34.2%, respectively. The increase in our gross profit margin was due to the decrease of cost of sales as a percentage of sales.





Operating Expenses. Operating expenses consisting of selling, general and administrative expenses totaled $9.75 million for the three months ended June 30, 2011, compared to $3.78 million for the same period of 2010, an increase of $5.97 million or 158%. Operating expenses as a percentage of sales were 137.8% in the three months ended June 30, 2011, compared to 16.6% in the same period of 2010. The increase in operating expenses mainly resulted from increased bad debt allowance of approximately $4.01 million and expansion of our business, which included additional costs of hiring more sales personnel, higher depreciation expense, training our marketing team and establishing new sales offices in more regions of China. Due to the stringent fiscal policy of the Chinese government, some of our state-owned customers encountered difficulties in obtaining grants from the government and loans from state-owned banks, both of which typically are used to finance the purchase of our products, which resulted in unexpected delays in paying our accounts receivable in a timely manner. As a result of these delays, we recorded $3.74 million bad debt allowance in the three months ended June 30, 2011. We do not expect a significant risk with respect to the overdue accounts receivable for which we took the bad debt allowance and believe that a substantial portion of the bad debt will be repaid as the Chinese government restores grants and credit policies. We believe the government’s stringent fiscal policy impacting our customers will be temporary and the expansion and training of our marketing team and other employees to date will increase sales and improve the efficiency of our operations. Nevertheless, we will institute a rigorous program of cost cutting to continue to tightly control our budget and implement additional cost control measures, including a review of the staffing levels of our employees in response to the decrease in revenue.





Net Income (Loss). Our net loss for the three months ended June 30, 2011, was $6.42 million compared to net income of $3.39 million for the same period of 2010, a decrease of $9.81 million or 289%. Net loss as a percentage of sales was 90.7% in the three months ended June 30, 2011, and net income as a percentage of sales was 14.9% in the 2010 period. This decrease in net income was attributable to the temporary decrease of net sales and increased bad debt allowance reserve.





Liquidity and Capital Resources





On November 23, 2010, we closed a public offering of 5,740,814 shares of our common stock at $5.00 per share, which includes 740,814 shares sold as a result of the underwriters exercising their over-allotment option. After underwriting discounts and commissions and related expenses, we received net proceeds of $27,040,741.





Six Months Ended June 30, 2011, Compared to the Six Months Ended June 30, 2010





As of June 30, 2011, we had cash and equivalents of $21.19 million. Working capital was $109.44 million at June 30, 2011. The ratio of current assets to current liabilities was 4.89:1 at June 30, 2011.





The following is a summary of cash provided by or used in each of the indicated types of activities during the six months ended June 30, 2011 and 2010:





2011


2010Cash provided by (used in):Operating activities

$
(24,947,855
)

$
(6,602,536
)Investing activities

$
(15,641,199
)

$
(5,235,017
)Financing activities

$
4,159,252


$
(5,816,537
)





Net cash flow used in operating activities was $24.95 million in the six months ended June 30, 2011, compared to net cash flow used in operating activities of $6.60 million in the same period of 2010. The increase in net cash outflow in operating activities was due mainly to decreased net income, increased payment of advance to suppliers and payment made for income tax and value-added tax (“VAT”).




26


Net cash flow used in investing activities was $15.64 million in the six months ended June 30, 2011, compared to net cash used in investing activities of $5.24 million in the same period of 2010. The increase of net cash flow used in investing activities was due mainly to the acquisition of Bingchuan and GWP for $13.54 million, purchase of property and equipment of $2.14 million, $0.42 million increase in restricted cash and $0.43 million on construction in progress, partially offset by cash acquired from acquisition for $0.45 million and proceeds from note receivables of $0.53 million.





Net cash flow provided by financing activities was $4.16 million in the six months ended June 30, 2011, compared to net cash used in financing activities of $5.82 million in the same period of 2010. The cash inflow was mainly from the proceeds from a short-term loan of $5.46 million and capital contribution from noncontrolling interest of $0.75 million, partially offset by payment on notes payable of $2.05 million, while in the 2010 period, we had $0.09 million cash inflow from warrants exercised, but repaid $4.25 million on short-term loans and $1.65 million on notes payable.





Our agreements with our customers generally provide that 30% of the purchase price is due upon the placement of an order, 30% upon delivery and 30% upon installation and acceptance of the equipment after customer testing. As a common practice in the heating manufacturing business in China, payment of the final 10% of the purchase price is due no later than the termination date of the standard warranty period, which ranges from 3 to 24 months from the acceptance date. Our receipts for payment on our products depend on the complexity of the equipment ordered, which impacts manufacturing, delivery, installation, testing times and warranty periods. For example, PHEs are less complex than PHE Units and therefore have a shorter manufacturing, acceptance, warranty and payment schedule. We may experience payment delays from time to time, which historically have been from 1 to 3 months from the due date, but given the temporary financial difficulties of some of our state-owned customers in China during the first half of 2011, we have experienced longer payment delays from these customers. Our accounts receivable and inventory turnover are relatively low and days sales outstanding ratio relatively high. Consequently, collection on our sales is slow and capital is tied up in inventories, which may result in pressure on cash flows. For the six months ended June 30, 2011, we had accounts receivable turnover of 2.37 on an annualized basis, with days sales outstanding of 154 and inventory turnover of 2.13 on an annualized basis. For the six months ended June 30, 2010, we had accounts receivable turnover of 2.76 on an annualized basis, with days sales outstanding of 132 and inventory turnover of 3.18 on an annualized basis. The low accounts receivable turnover and high days outstanding was due to the temporary financial difficulties of some of our state-owned customers that resulted in a delay in their making payments to us. The low inventory turnover rate was due to our decreased sales volume as a result of our state-owned customers’ temporary financial difficulty.





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





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 stockholders’ 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.




27


Contractual Obligations





We were obligated for the following short term loans payable as of June 30, 2011, and December 31, 2010:





2011


2010From a commercial bank in the PRC for RMB 3,000,000 entered into on June 30, 2011. The loan currently bears interest at 6.63% with maturity on June 29, 2012. The loan was guaranteed by a third party.

$
463,564


$
-From a commercial bank in the PRC for RMB 13,000,000 entered into on August 9, 2010. The loan currently bears interest at 5.31% with maturity on June 30, 2011. We pledged our building and land use rights for this loan. The loan was paid in full when it matured.


-



1,962,946From a commercial bank in the PRC for RMB 5,000,000 entered into on October 19, 2010. The loan currently bears interest at 5.84% with maturity on October 18, 2011. The loan was pledged by bank deposit.


772,606



754,979From a commercial bank in the PRC for RMB 17,000,000 entered into on June 1, 2010. The loan currently bears interest at 5.31% with maturity on June 30, 2011. The loan was guaranteed by a third party. The loan was paid in full when it matured.


-



2,566,929From a commercial bank in the PRC for RMB 25,000,000 entered into on October 18, 2010. The loan currently bears interest at 5.84% with maturity on October 17, 2011. The loan was pledged by bank deposit.


3,863,032



3,774,895From a commercial bank in the PRC for RMB 50,000,000 entered into on June 29, 2011. The loan currently bears interest at 6.94% with maturity on January 27, 2012. The loan was guaranteed by SanDeKe.


7,726,065



-From a commercial bank in the PRC for RMB 10,000,000 entered into on June 27, 2011. The loan currently bears interest at 7.57% with maturity on June 27, 2012. The loan was pledged by bank deposit.


1,545,213



-From a commercial bank in the PRC for RMB 3,200,000 entered into on March 15, 2011. The loan currently bears interest at 6.72% with maturity on July 14, 2011. We pledged saving deposit for this loan.


494,468



-From a commercial bank in the PRC for RMB 1,040,000 entered into on April 29, 2011. The loan currently bears interest at 7.02% with maturity on August 26, 2011. We pledged saving deposit for this loan.


160,702



-From a commercial bank in the PRC for RMB 3,500,000 entered into on June 2, 2011. The loan currently bears interest at 7.02% with maturity on September 29, 2011. We pledged saving deposit for this loan.


540,825



-$
15,566,475


$
9,059,749





Item 3. Quantitative and Qualitative Disclosures about Market Risk





We are exposed to market risks related to fluctuations in currency exchange rates and commodity prices for certain of our raw materials. We currently do not engage in forward foreign exchange agreements or other hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. We do not engage in hedging transactions to protect against raw material pricing fluctuations; instead, we attempt to mitigate the short-term risks of price swings by purchasing raw materials in advance.





Our Annual Report on Form 10-K for the year ended December 31, 2010, contains information about our exposure to market risks under “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.” There has been no material change in our exposure to market risks during the three months ended June 30, 2011.





Item 4. Controls and Procedures





Disclosure Controls and Procedures





As of the end of the period covered by this report, we conducted an evaluation under the supervision and with the participation of our management, including the Chief Executive Officer (“CEO”), our principal executive officer, and Chief Financial Officer (“CFO”), our principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act). Based on that evaluation, the CEO and CFO concluded that our disclosure controls and procedures were effective as of the date of that evaluation to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.





Changes in Internal Control over Financial Reporting





There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.





28


PART II. OTHER INFORMATION





Item 1. Legal Proceedings





We may become involved in various lawsuits and legal proceedings arising in the ordinary course of business. 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 effect 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 effect on our business, financial condition or operating results.





Item 1A. Risk Factors





You should consider carefully the factors discussed in the “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business. There have been no material changes to the risk factors described previously in that Annual Report.





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





None.





Item 3. Defaults Upon Senior Securities





None.





Item 5. Other Information





None.





Item 6. Exhibits





See the Exhibit Index following the signature page to this Quarterly Report on Form 10-Q for a list of exhibits filed or furnished with this report, which Exhibit Index is incorporated herein by reference.




29




SIGNATURES





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





SMARTHEAT INC.(Registrant)Date: August 9, 2011
By:
/s/ Jun WangJun WangChief Executive Officer(Principal Executive Officer)





30


EXHIBIT INDEX





Exhibit No.

Document Description31.1 †

Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2 †

Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1 ‡

Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, as signed by the Chief Executive Officer32.2 ‡

Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, as signed by the Chief Financial Officer101**

Interactive Data File (Quarterly Report on Form 10-Q, for the quarterly period ended June 30, 2011, furnished in XBRL (eXtensible Business Reporting Language))





† Filed herewith


‡ Furnished herewith


** To be filed by amendment as permitted by the 30-day grace period set forth in SEC Release No. 33-9002.




31