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,
2009


OR





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





Commission
file number 000-53052





SMARTHEAT
INC.


(Exact
name of registrant as specified in its charter)





NEVADA
              98-0514768(State
      or other jurisdiction of
              (IRS
      Employerincorporation
      or organization)
              Identification
      No.)





A-1,
10, Street 7


Shenyang
Economic and Technological Development Zone


Shenyang,
China


110027


(Address
of principal executive offices, including zip code.)





+86
(24) 2519-7699


(telephone
number, including area code)





(Former
name or former address, if changed since last report)





Check
whether the issuer (1) filed all reports required to be filed by Section 13 or
15(d) of the Exchange Act during the past 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.  YESxNO ̈





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  ̈Non-accelerated filer  ̈
                      Smaller reporting company x(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 ̈NOx





State the
number of shares outstanding of each of the issuer’s classes of common equity,
as of the latest practicable date: 24,179,900 shares as of Aug 10,
2009.










TABLE
OF CONTENTS





PART I –
      FINANCIAL INFORMATION
                
                1Item 1.
                Financial
      Statements (Unaudited)
                
                1Item 2.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                24Item 3.
                Quantitative
      and Qualitative Disclosures About Market Risk
                
                34Item 4T.
                Controls
      and Procedures
                
                34Item 1.
                Legal
      Proceedings
                
                34Item 1A.
                Risk
      Factors
                
                35Item 2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                
                35Item 3.
                Defaults
      Upon Senior Securities
                
                35Item 4.
                Submission
      of Matters to a Vote of Security Holders
                
                35Item 5.
                Other
      Information
                
                35Item 6.
                Exhibits
                
                36SIGNATURES
                
                36





PART
I – FINANCIAL INFORMATION





Item 1.  Financial
Statements




SMARTHEAT,
INC. AND SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
 
 AS
      OF JUNE 30, 2009
                      
                      
                      AS
      OF DECEMBER 31, 2008(UNAUDITED)ASSETSCURRENT
      ASSETSCash
      & cash equivalents
                      
                      $
                      2,408,714
                      
                      
                      $
                      1,435,212Restricted
      cash
                      
                      
                      933,312
                      
                      
                      
                      462,048Accounts
      receivable, net
                      
                      
                      8,997,822
                      
                      
                      
                      11,390,169Retentions
      receivable
                      
                      
                      357,683
                      
                      
                      
                      290,852Advances
      to suppliers
                      
                      
                      2,909,069
                      
                      
                      
                      412,524Other
      receivables, prepayments and deposits
                      
                      
                      1,366,965
                      
                      
                      
                      698,834Inventories
                      
                      
                      8,220,181
                      
                      
                      
                      6,107,583Note
      receivable - bank acceptance
                      
                      
                      14,637
                      
                      
                      
                      14,631Total
      current assets
                      
                      
                      25,208,383
                      
                      
                      
                      20,811,853NON-CURRENT
      ASSETSRestricted
      cash
                      
                      
                      23,345
                      
                      
                      
                      219,472Accounts
      receivable, net
                      
                      
                      740,116
                      
                      
                      
                      310,810Retentions
      receivable
                      
                      
                      1,420,830
                      
                      
                      
                      166,912Intangible
      assets, net
                      
                      
                      4,179,143
                      
                      
                      
                      1,155,131Property
      and equipment, net
                      
                      
                      7,363,041
                      
                      
                      
                      2,436,553Total
      noncurrent assets
                      
                      
                      13,726,475
                      
                      
                      
                      4,288,878TOTAL
      ASSETS
                      
                      $
                      38,934,858
                      
                      
                      $
                      25,100,731LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIESAccounts
      payable
                      
                      $
                      1,620,935
                      
                      
                      $
                      1,210,906Unearned
      revenue
                      
                      
                      1,691,800
                      
                      
                      
                      850,408Notes
      payable - bank acceptance
                      
                      
                      762,710
                      
                      
                      
                      -Taxes
      payable
                      
                      
                      559,085
                      
                      
                      
                      1,327,775Accrued
      liabilities and other payables
                      
                      
                      5,968,709
                      
                      
                      
                      1,330,812Due
      to minority shareholder
                      
                      
                      -
                      
                      
                      
                      5,303Loans
      payable
                      
                      
                      5,562,142
                      
                      
                      
                      2,443,450Total
      current liabilities
                      
                      
                      16,165,381
                      
                      
                      
                      7,168,654OTHER
      PAYABLES - NONCURRENT
                      
                      
                      1,200,586
                      
                      
                      
                      -DEFERRED
      TAX LIABILITY
                      
                      
                      23,488
                      
                      
                      
                      38,854COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITYCommon
      stock, $0.001 par value; 75,000,000shares
      authorized, 24,179,900 shares issued andoutstanding
      at June 30, 2009 and December 31,2008,
      respectively
                      
                      
                      24,180
                      
                      
                      
                      24,180Paid
      in capital
                      
                      
                      8,223,671
                      
                      
                      
                      8,223,453Statutory
      reserve
                      
                      
                      1,530,781
                      
                      
                      
                      1,150,542Accumulated
      other comprehensive income
                      
                      
                      997,772
                      
                      
                      
                      984,629Retained
      earnings
                      
                      
                      10,768,999
                      
                      
                      
                      7,510,419Total
      stockholders' equity
                      
                      
                      21,545,403
                      
                      
                      
                      17,893,223TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                      
                      $
                      38,934,858
                      
                      
                      $
                      25,100,731
 
 The
accompanying notes are an integral part of these consolidated financial
statements
  1
 
 SMARTHEAT, INC. AND SUBSIDIARIES
 CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
 (UNAUDITED)
 
 FOR THE SIX MONTHS ENDED JUNE 30,
                              
                              
                              FOR THE THREE MONTHS ENDED JUNE 30,2009
                              
                              
                              2008
                              
                              
                              2009
                              
                              
                              2008Net
      sales
                              
                              $
                              18,705,898
                              
                              
                              $
                              8,637,283
                              
                              
                              $
                              12,498,395
                              
                              
                              $
                              5,558,232Cost
      of goods sold
                              
                              
                              11,874,903
                              
                              
                              
                              6,228,156
                              
                              
                              
                              7,973,956
                              
                              
                              
                              4,115,200Gross
      profit
                              
                              
                              6,830,995
                              
                              
                              
                              2,409,127
                              
                              
                              
                              4,524,439
                              
                              
                              
                              1,443,032Operating
      expensesSelling
      expenses
                              
                              
                              1,159,532
                              
                              
                              
                              608,028
                              
                              
                              
                              698,619
                              
                              
                              
                              410,607General
      and administrative expenses
                              
                              
                              1,340,132
                              
                              
                              
                              446,470
                              
                              
                              
                              770,610
                              
                              
                              
                              162,325Total
      operating expenses
                              
                              
                              2,499,664
                              
                              
                              
                              1,054,498
                              
                              
                              
                              1,469,229
                              
                              
                              
                              572,932Income
      from operations
                              
                              
                              4,331,331
                              
                              
                              
                              1,354,629
                              
                              
                              
                              3,055,210
                              
                              
                              
                              870,100Non-operating
      income (expenses)Interest
      income
                              
                              
                              80,421
                              
                              
                              
                              260,683
                              
                              
                              
                              63,740
                              
                              
                              
                              113,545Interest
      expense
                              
                              
                              (117,612
                              )
                              
                              
                              (163,040
                              )
                              
                              
                              (64,760
                              )
                              
                              
                              (96,412
                              )Subsidy
      income
                              
                              
                              35,340
                              
                              
                              
                              9,141
                              
                              
                              
                              35,340
                              
                              
                              
                              9,141Other
      expense
                              
                              
                              (11,199
                              )
                              
                              
                              -
                              
                              
                              
                              (10,119
                              )
                              
                              
                              (2,891
                              )Other
      income
                              
                              
                              969
                              
                              
                              
                              8,290
                              
                              
                              
                              969
                              
                              
                              
                              -Total
      non-operating income (expenses)
                              
                              
                              (12,081
                              )
                              
                              
                              115,074
                              
                              
                              
                              25,170
                              
                              
                              
                              23,383Income
      before income tax
                              
                              
                              4,319,250
                              
                              
                              
                              1,469,703
                              
                              
                              
                              3,080,380
                              
                              
                              
                              893,483Income
      tax expense
                              
                              
                              680,432
                              
                              
                              
                              266,028
                              
                              
                              
                              462,831
                              
                              
                              
                              161,071Net
      income
                              
                              
                              3,638,818
                              
                              
                              
                              1,203,675
                              
                              
                              
                              2,617,549
                              
                              
                              
                              732,412Other
      comprehensive itemForeign
      currency translation
                              
                              
                              13,143
                              
                              
                              
                              410,896
                              
                              
                              
                              11,433
                              
                              
                              
                              168,802Comprehensive
      Income
                              
                              $
                              3,651,961
                              
                              
                              
                              1,614,571
                              
                              
                              $
                              2,628,982
                              
                              
                              $
                              901,214Basic
      weighted average shares outstanding
                              
                              
                              24,179,900
                              
                              
                              
                              20,213,419
                              
                              
                              
                              24,179,900
                              
                              
                              
                              21,926,838Diluted
      weighted average shares outstanding
                              
                              
                              24,191,063
                              
                              
                              
                              20,213,419
                              
                              
                              
                              24,206,099
                              
                              
                              
                              21,926,838Basic
      earnings per share
                              
                              $
                              0.15
                              
                              
                              $
                              0.06
                              
                              
                              $
                              0.11
                              
                              
                              $
                              0.03Diluted
      earnings per share
                              
                              $
                              0.15
                              
                              
                              $
                              0.06
                              
                              
                              $
                              0.11
                              
                              
                              $
                              0.03
 
 The
accompanying notes are an integral part of these consolidated financial
statements
  2
 
 SMARTHEAT,
INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (UNAUDITED)
 
 FOR THE SIX MONTHS ENDED JUNE 30,2009
                        
                        
                        2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                        
                        $
                        3,638,818
                        
                        
                        $
                        1,203,675Adjustments
      to reconcile net income to net cash(used
      in) provided by operating activities:Depreciation
      and amortization
                        
                        
                        194,027
                        
                        
                        
                        104,038Unearned
      interest on accounts receivable
                        
                        
                        68,292
                        
                        
                        
                        (22,366
                        )Stock
      option compensation expense
                        
                        
                        218
                        
                        
                        
                        -Decrease
      in deferred tax liability
                        
                        
                        (15,380
                        )
                        
                        
                        -(Increase)
      decrease in current assets:Accounts
      receivable
                        
                        
                        1,349,607
                        
                        
                        
                        (1,803,120
                        )Retentions
      receivable
                        
                        
                        (1,320,413
                        )
                        
                        
                        346,914Advances
      to suppliers
                        
                        
                        (2,487,309
                        )
                        
                        
                        (1,888,198
                        )Other
      receivables, prepayments and deposits
                        
                        
                        (1,468,178
                        )
                        
                        
                        (277,990
                        )Inventories
                        
                        
                        (2,109,938
                        )
                        
                        
                        2,874,481Increase
      (decrease) in current liabilities:Accounts
      payable
                        
                        
                        1,721,658
                        
                        
                        
                        1,358,223Unearned
      revenue
                        
                        
                        840,957
                        
                        
                        
                        (1,709,100
                        )Taxes
      payable
                        
                        
                        (769,124
                        )
                        
                        
                        (167,960
                        )Accrued
      liabilities and other payables
                        
                        
                        226,202
                        
                        
                        
                        423,418Net
      cash (used in) provided by operating activities
                        
                        
                        (130,563
                        )
                        
                        
                        442,015CASH
      FLOWS FROM INVESTING ACTIVITIES:Restricted
      cash
                        
                        
                        (274,835
                        )
                        
                        
                        (229,833
                        )Construction
      in progress
                        
                        
                        -
                        
                        
                        
                        (39,549
                        )Acquisition
      of property & equipment
                        
                        
                        (239,005
                        )
                        
                        
                        (119,299
                        )Net
      cash used in investing activities
                        
                        
                        (513,840
                        )
                        
                        
                        (388,681
                        )CASH
      FLOWS FROM FINANCING ACTIVITIES:Payment
      of assets acquisition liability
                        
                        
                        (1,500,139
                        )
                        
                        
                        -Repayment
      to shareholder
                        
                        
                        -
                        
                        
                        
                        (44,862
                        )Proceeds
      from (Repayment to) short term loans
                        
                        
                        3,117,362
                        
                        
                        
                        (213,152
                        )Net
      cash provided by (used in) financing activities
                        
                        
                        1,617,223
                        
                        
                        
                        (258,014
                        )EFFECT
      OF EXCHANGE RATE CHANGE ON CASH & CASH EQUIVALENTS
                        
                        
                        682
                        
                        
                        
                        19,028NET
      INCREASE (DECREASE) IN CASH & CASH EQUIVALENTS
                        
                        
                        973,502
                        
                        
                        
                        (185,652
                        )CASH
      & CASH EQUIVALENTS, BEGINNING OF PERIOD
                        
                        
                        1,435,212
                        
                        
                        
                        393,147CASH
      & CASH EQUIVALENTS, END OF PERIOD
                        
                        $
                        2,408,714
                        
                        
                        $
                        207,495Supplemental
      Cash flow data:Income
      tax paid
                        
                        $
                        995,787
                        
                        
                        $
                        197,756Interest
      paid
                        
                        $
                        121,259
                        
                        
                        $
                        87,887
 
 The
accompanying notes are an integral part of these consolidated financial
statements
  3
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
  1.
ORGANIZATION AND DESCRIPTION OF BUSINESS
 
 SmartHeat
Inc., formerly known as Pacific Goldrim Resources, Inc. (the “Company” or
“SmartHeat”), was incorporated on August 4, 2006 in the State of Nevada. The
Company is engaged in the manufacturing and sale of plate heat exchangers and
various packages, thermometer testing devices and heat usage calculators through
its wholly owned operating subsidiaries in China.
 
 On April
14, 2008, the Company entered into a Share Exchange Agreement with Shenyang
Taiyu Machinery and Electronic Equipment Co., Ltd. ("Taiyu") and the Taiyu
Shareholders. The Company issued 18,500,000 shares of its common stock to the
shareholder of Taiyu in exchange for all of the equitable and legal rights,
title and interests in and to Taiyu's share capital of RMB 25,000,000.
Concurrent with the share exchange, one of SmartHeat’s shareholders cancelled
2,500,000 shares out of 6,549,900 of total issued and outstanding shares of
SmartHeat pursuant to the Split-Off Agreement dated April 14, 2008. As a result
of the share exchange and the cancellation of the 2,500,000 shares of the
Company's common stock, there were 22,549,900 shares of the Company's common
stock issued and outstanding, 82.04% of which was held by the former Taiyu
Shareholders.  The shareholders of the Company immediately prior to
the completion of these transactions held the remaining 17.96% of the issued and
outstanding share capital of SmartHeat. Taiyu became a wholly-owned subsidiary
of SmartHeat.
 
 Prior to
the acquisition of Taiyu, the Company was a non-operating public shell. Pursuant
to Securities and Exchange Commission ("SEC") rules, the merger or acquisition
of a private operating company into a non-operating public shell with nominal
net assets is considered a capital transaction, rather than a business
combination. Accordingly, for accounting purposes, the transaction was treated
as a reverse acquisition and a recapitalization, and pro-forma information is
not presented. Transaction costs incurred in the reverse acquisition were
charged to expense.
 
 Taiyu was
incorporated in the Liaoning Province, People’s Republic of China (“PRC” or
"China") in July, 2002. Taiyu is engaged in manufacturing and sale of plate heat
exchangers and various packages, thermo meter testing devices and heat usage
calculators. The Company is an authorized dealer of the SONDEX brand; SONDEX is
the second largest plate heat exchanger manufacturer in the world.
 
 On
September 25, 2008, the Company entered into a Share Exchange Agreement (the
"Agreement") between Asialink (Far East) Limited ("Asialink") and the Company
providing for the acquisition by the Company from Asialink of all of the
outstanding capital stock of SanDeKe Co., Ltd., a Shanghai based manufacturer of
heat plate exchangers ("SanDeKe"). The purchase price for the SanDeKe shares was
$741,516. Under the terms of the Agreement, two of the shareholders of SanDeKe
agreed not to compete with the business of SanDeKe for four years after the
completion of the purchase.
 
 On June
12, 2009, the Company incorporated a new subsidiary SmartHeat Siping Beifang
Energy Technology Co., Ltd (“SmartHeat Siping”) for the manufacturing of heat
exchangers.
  On June
16, 2009, Taiyu closed an asset purchase transaction with Siping Beifang Heat
Exchanger Manufacture Co.,Ltd (“Siping”), a
company organized under the laws of the PRC, to purchase certain assets
consisting of the plant and equipment and certain land use rights for a purchase
price of 54,000,000 RMB, or USD 7,906,296.  Taiyu then
transferred all the assets acquired to SmartHeat Siping, the newly incorporated
subsidiary.  The purchase consideration is non-interest bearing and
payable according to the following schedule:
  4
 SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 Payment
      in RMB
                  
                  Payment
      in USD
                  
                  Payment
      DateRMB
      3,000,000
                  
                  $
                  439,239
                  
                  May
      27, 2009RMB
      10,250,000
                  
                  $
                  1,500,732
                  
                  June
      30, 2009RMB 13,000,000
                  
                  $
                  1,903,367
                  
                  September
      30, 2009RMB
      12,300,000
                  
                  $
                  1,800,878
                  
                  March
      1, 2010RMB
      8,200,000
                  
                  $
                  1,200,586
                  
                  September
      30, 2010
  At June
30, 2009, the Company paid RMB 10,250,000 or $1,500,732. This payment includes
the first payment of RMB 3,000,000 or $439,239 and the balance of RMB 7,250,000
or $1,061,500 is applied towards the second payment. The Company recorded RMB
8,200,000 or $1,200,586 as part of other payable - non current. The payment
terms does not include any default provision.
 The
unaudited financial statements have been prepared by the Company,
pursuant to the rules and regulations of the SEC.  The information
furnished herein reflects all adjustments (consisting of normal recurring
accruals and adjustments) which are, in the opinion of management, necessary to
fairly present the operating results for the respective periods. Certain
information and footnote disclosures normally present in annual financial
statements prepared in accordance with accounting principles generally accepted
in the United States of America (“US GAAP”) have been omitted pursuant to such
rules and regulations. These financial statements should be read in
conjunction with the 2008 audited financial statements and footnotes
included in the Company’s audited financial statements.  The results
for the six months ended June 30, 2009 are not necessarily indicative of the
results to be expected for the full year ending December 31,
2009.
 
 2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Principles
of Consolidation
 
 The
accompanying consolidated financial statements include the accounts of
SmartHeat, Taiyu, SanDeKe and SmartHeat Siping, a newly incorporated subsidiary
in June, 2009. For purposes of this Quarterly Report, the "Company" refers
collectively to SmartHeat, Taiyu, SanDeKe and Siping. All significant
inter-company accounts and transactions have been eliminated in
consolidation.
 
 Use
of Estimates
 
 In
preparing the financial statements in conformity with US GAAP, management makes
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the dates of
the financial statements, as well as the reported amounts of revenues and
expenses during the reporting year. Significant estimates, required by
management, include the recoverability of long-lived assets, allowance for
doubtful accounts, and the reserve for obsolete and slow-moving inventories.
Actual results could differ from those estimates.
  Cash and Cash
Equivalents
  For
purposes of the statement of cash flows, the Company considers all highly liquid
investments with an original maturity of three months or less to be cash
equivalents. As of June 30, 2009, the Company maintained total restricted cash
of $956,657 in several bank accounts, $580,369 representing cash deposits from
customers for securing payment from customers that occurs no later than the
warranty period expires, and $376,288 representing the deposits the Company paid
to a commercial bank for the bank issuing the bank acceptance to its vendors
(see Note 10);  of the total restricted cash, $933,312 was cash that
will be released to the Company within one year. As of December 31, 2008, the
Company maintained total restricted cash of $681,520, of which, $462,048 was the
cash that will be released to the Company within one year. Restricted cash is
held in the interest bearing bank accounts.
   5
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 Accounts
and Retentions Receivable
  The
Company’s policy is to maintain reserves for potential credit losses on accounts
receivable. Management reviews the composition of accounts receivable and
analyzes historical bad debts, customer concentrations, customer credit
worthiness, current economic trends and changes in customer payment patterns to
evaluate the adequacy of these reserves. Based on historical collection
activity, the Company had allowances of $629,936 and $629,687 at June 30, 2009
and December 31, 2008, respectively.
 
 At June
30, 2009 and December 31, 2008, the Company had retentions receivable from
customers for product quality assurance of $1,778,513 and $457,764,
respectively. The retention rate varies from 5% to 20% of the sales price with
variable terms from three months to two years depending on the shipping date of
the products and the number of heating seasons that the warranty period
covers.
 
 Accounts
receivable is net of unearned interest of $96,838 and $28,526 at June 30, 2009
and December 31, 2008, respectively. Unearned interest represents imputed
interest on accounts receivable with due dates over one year from the invoice
date discounted at the Company's borrowing rate, currently 7.16%, and it was
7.04% in 2008.
 
 Inventories
 
 Inventories
are valued at the lower of cost or market with cost determined on a moving
weighted average basis. Cost of work in progress and finished goods comprises
direct material, direct production cost and an allocated portion of production
overheads.
  Property
and Equipment
 
 Property
and equipment are stated at cost, net of accumulated depreciation. Expenditures
for maintenance and repairs are expensed as incurred; additions, renewals and
betterments are capitalized. When property and equipment are retired or
otherwise disposed of, the related cost and accumulated depreciation are removed
from the respective accounts, and any gain or loss is included in operations.
Depreciation of property and equipment is provided using the straight-line
method with a 10% salvage value and estimated lives ranging from 5 to 20 years
as follows:
 
 Building
                20
      yearsVehicles
                5
      yearsOffice
      Equipment
                5
      yearsProduction
      Equipment
                5-10
      years
 
 Land
Use Rights
  Right to
use land is stated at cost less accumulated amortization. Amortization is
provided using the straight-line method over 50 years.
  Impairment
of Long-Lived Assets
  Long-lived
assets, which include property, plant and equipment and intangible assets, are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.
  Recoverability
of long-lived assets to be held and used is measured by a comparison of the
carrying amount of an asset to the estimated undiscounted future cash flows
expected to be generated by the asset. If the carrying amount of an asset
exceeds its estimated undiscounted future cash flows, an impairment charge is
recognized by the amount by which the carrying amount of the asset exceeds the
fair value of the assets. Fair value is generally determined using the asset’s
expected future discounted cash flows or market value, if readily determinable.
Based on its review, the Company believes that, as of June 30, 2009 and December
31, 2008, there were no significant impairments of its long-lived
assets.
  6
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 Warranties
 
 The
Company offers warranties to all customers on its products for one or two
heating seasons depending on the terms negotiated with the customers. The
Company accrues for warranty costs based on estimates of the costs that may be
incurred under its warranty obligations. The warranty expense and related
accrual is included in the Company's selling expenses and other payable
respectively, and is recorded at the time revenue is recognized. Factors that
affect the Company's warranty liability include the number of sold units, its
estimates of anticipated rates of warranty claims, costs per claim and estimated
support labor costs and the associated overhead.  The Company
periodically assesses the adequacy of its recorded warranty liabilities and
adjusts the amounts as necessary.
 
 The
Company's warranty reserve at June 30, 2009 and December 31, 2008 is as
follows:
 
 For the SixMonthsEndedJune 30, 2009
                      
                      
                      For the Year EndedDecember 31, 2008Beginning
      balance
                      
                      $
                      -
                      
                      
                      $
                      -Provisions
      made
                      
                      
                      219,893
                      
                      
                      
                      95,000Actual
      costs incurred
                      
                      
                      (31,743
                      )
                      
                      
                      (95,000
                      )Ending
      balance in current liabilities
                      
                      $
                      188,150
                      
                      
                      $
                      -
  Income
Taxes
 
 The
Company utilizes Statement of Financial Accounting Standards ("SFAS") No. 109,
“Accounting for Income Taxes,” which requires the recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in the financial statements or tax returns. Under this
method, deferred income taxes are recognized for the tax consequences in future
years of differences between the tax bases of assets and liabilities and their
financial reporting amounts at each period end based on enacted tax laws and
statutory tax rates applicable to the periods in which the differences are
expected to affect taxable income. Valuation allowances are established, when
necessary, to reduce deferred tax assets to the amount expected to be
realized.
 
 The
Company adopted the provisions of the Financial Accounting Standards Board's
("FASB") Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on
January 1, 2007. As a result of the implementation of FIN 48, the Company made a
comprehensive review of its portfolio of tax positions in accordance with
recognition standards established by FIN 48. As a result of the implementation
of Interpretation 48, the Company recognized no material adjustments to
liabilities or shareholders’ equity. When tax returns are filed, it is highly
certain that some positions taken would be sustained upon examination by the
taxing authorities, while others are subject to uncertainty about the merits of
the position taken or the amount of the position that would be ultimately
sustained. The benefit of a tax position is recognized in the financial
statements in the period during which, based on all available evidence,
management believes it is more likely than not that the position will be
sustained upon examination, including the resolution of appeals or litigation
processes, if any. Tax positions taken are not offset or aggregated with other
positions. Tax positions that meet the more-likely-than-not recognition
threshold are measured as the largest amount of tax benefit that is more than 50
percent likely of being realized upon settlement with the applicable taxing
authority. The portion of the benefits associated with tax positions taken that
exceeds the amount measured as described above is reflected as a liability for
unrecognized tax benefits in the accompanying balance sheets along with any
associated interest and penalties that would be payable to the taxing
authorities upon examination.
  7
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 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.
 
 Revenue
Recognition
 
 The
Company's revenue recognition policies are in compliance with SEC Staff
Accounting Bulletin (“SAB”) 104. Sales revenue is recognized when products are
delivered and for PHE and PHE units, when customer acceptance occurs, the price
is fixed or determinable, no other significant obligations of the Company exist
and collectibility is reasonably assured. Payments received before all of the
relevant criteria for revenue recognition are recorded as unearned
revenue.
 
 The
Company’s sales contracts with the customers generally provide that 30% of the
purchase price is due upon the placement of an order, 30% is due on delivery,
30% is due upon installation and acceptance of the equipment after customer
testing, the final 10% of the purchase price is due on a date that is no later
than the termination date of the standard warranty period.
 
 Sales
revenue represents the invoiced value of goods, net of value-added tax ("VAT").
All of the Company’s products that are sold in the PRC are subject to Chinese
value-added tax of 17% of the gross sales price. This VAT may be offset by VAT
paid by the Company on raw materials and other materials included in the cost of
producing their finished product. The Company recorded VAT payable and VAT
receivable net of payments in the financial statements. The VAT tax return is
filed offsetting the payables against the receivables.
  Sales and
purchases are recorded net of VAT collected and paid as the Company acts as an
agent for the government. VAT taxes are not affected by the income tax
holiday.
 
 Sales
returns and allowances were $0 for both the six months ended June 30, 2009 and
2008. The Company does not provide right of return, price protection or any
other concessions to its customers.
 
 The
standard warranty of the Company is provided to all customers and is not
considered an additional service; rather it is considered an integral part of
the product’s sale. The Company believes that 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 separation
and allocation model for a multiple deliverable arrangement. SFAS 5 specifically
address the accounting for standard warranties and neither SAB 104 nor EITF
00-21 supersedes SFAS 5. The Company believes that accounting for its standard
warranty pursuant to SFAS 5 does not impact revenue recognition because the cost
of honoring the warranty can be reliably estimated.
  The
Company provides after sales services at a charge after expiration of the
warranty period, with after sales services mainly consisting of cleaning plate
heat exchangers and repairing and exchanging parts. The Company recognizes such
revenue when service is provided. For the six months ended June 30, 2009 and
2008, revenue from after sales services after expiration of the warranty period
was approximately $3,700 and $21,000. For the three months ended June 30, 2009
and 2008, revenue from after sales services after expiration of the warranty
period was approximately $1,500 and $16,000, respectively.
  Cost
of Goods Sold
  Cost of
goods sold consists primarily of material costs, direct labor, and manufacturing
overhead which are directly attributable to the production of products. 
Write-down of inventories to lower of cost or market is also recorded in cost of
goods sold.
  8
 SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 Concentration
of Credit Risk
 
 Financial
instruments that potentially subject the Company to credit risk consist
primarily of accounts receivable and other receivables. The Company does not
require collateral or other security to support these receivables. The Company
conducts periodic reviews of its clients' financial condition and customer
payment practices to minimize collection risk on accounts
receivable.
 
 The
operations of the Company are located in the PRC. Accordingly, the Company's
business, financial condition, and results of operations may be influenced by
the political, economic, and legal environments in the PRC, as well as by the
general state of the PRC economy.
 
 Statement
of Cash Flows
 
 In
accordance with SFAS No. 95, “Statement of Cash Flows,” cash flows from the
Company's operations are calculated based upon the local currencies. As a
result, amounts related to assets and liabilities reported on the statement of
cash flows may not necessarily agree with changes in the corresponding balances
on the balance sheet.  The cash flows from operating, investing and
financing activities exclude the effect of conversion from accounts payable to
notes payable – bank acceptance in the amount of $762,621and assets purchased
from Siping Manufacture in the amount of $7,906,296 for the six months ended
June 30, 2009.
 
 Basic
and Diluted Earnings per Share (EPS)
  Basic EPS
is computed by dividing income available to common shareholders by the weighted
average number of common shares outstanding for the period. Diluted EPS is
similarly computed, except that the denominator is increased to include the
number of additional common shares that would have been outstanding if the
potential common shares had been issued and if the additional common shares were
dilutive. Diluted net earnings per share are based on the assumption that all
dilutive convertible shares and stock options were converted or exercised.
Dilution is computed by applying the treasury stock method. Under this method,
options and warrants are assumed to have been exercised at the beginning of the
period (or at the time of issuance, if later), and as if funds obtained
thereby were used to purchase common stock at the average market price during
the period.
 
 The
following table presents a reconciliation of basic and diluted earnings per
share:
 
 For the Six
                          Months Ended June 30,
                          (Unaudited)
                        
                        
                        For the Three Months
                          Ended June 30,
                          (Unaudited)2009
                        
                        
                        2008
                        
                        
                        2009
                        
                        
                        2008Net
      income
                        
                        $
                        3,638,818
                        
                        
                        $
                        1,203,675
                        
                        
                        $
                        2,617,549
                        
                        
                        $
                        732,412Weighted
      average shares outstanding - basic
                        
                        
                        24,179,900
                        
                        
                        
                        20,213,419
                        
                        
                        
                        24,179,900
                        
                        
                        
                        21,926,838Effect
      of dilutive securities:Unexercised
      warrants  and options
                        
                        
                        11,163
                        
                        
                        
                        —
                        
                        
                        
                        26,199
                        
                        
                        
                        —Weighted
      average shares outstanding - diluted
                        
                        
                        24,191,063
                        
                        
                        
                        20,213,419
                        
                        
                        
                        24,206,099
                        
                        
                        
                        21,926,838Earnings
      per share - basic
                        
                        $
                        0.15
                        
                        
                        $
                        0.06
                        
                        
                        $
                        0.11
                        
                        
                        $
                        0.03Earnings
      per share - diluted
                        
                        $
                        0.15
                        
                        
                        $
                        0.06
                        
                        
                        $
                        0.11
                        
                        
                        $
                        0.03
 
 Fair
Value of Financial Instruments
 
 SFAS No.
107, “Disclosures about Fair Value of Financial Instruments,” requires the
Company disclose estimated fair values of financial instruments. The carrying
amounts reported in the statements of financial position for current assets and
current liabilities qualifying as financial instruments are a reasonable
estimate of fair value.
  9
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 Foreign
Currency Translation and Comprehensive Income (Loss)
  The
accounts of the Company’s Chinese subsidiaries are maintained in the Chinese
Yuan Renminbi (RMB) and the accounts of the U.S. parent company are maintained
in the U.S. Dollar (USD). The accounts of the Chinese subsidiaries were
translated into USD in accordance with SFAS No. 52, "Foreign Currency
Translation," with the RMB as the functional currency for the Chinese
subsidiaries. According to the Statement, all assets and liabilities were
translated at the exchange rate on the balance sheet date, stockholders’ equity
are translated at the historical rates and statement of operations items are
translated at the weighted average exchange rate for the year. The resulting
translation adjustments are reported under other comprehensive income in
accordance with SFAS No. 130, "Reporting Comprehensive Income”.
  Stock-Based
Compensation
  The
Company accounts for its stock-based compensation in accordance with SFAS No.
123R, “Share-Based Payment, an Amendment of FASB Statement No. 123.”  The
Company recognizes in the 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"
requires use of the “management approach” model for segment reporting. The
management approach model is based on the way a company's management organizes
segments within the company for making operating decisions and assessing
performance. Reportable segments are based on products and services, geography,
legal structure, management structure, or any other manner in which management
disaggregates a company.
 
 SFAS 131 has no effect on
the Company's financial statements as substantially all of the Company's
operations are conducted in one industry segment. All of the Company's assets
are located in the PRC.
 
 Registration
Rights Agreement
  The
Company accounts for payment arrangements under registration rights agreement in
accordance with FASB Staff Position EITF 00-19-2, which requires that the
contingent obligation to make future payments or otherwise transfer
consideration under a registration payment arrangement, whether issued as a
separate agreement or included as a provision of a financial instrument or other
agreement, be separately recognized and measured in accordance with FASB
Statement No. 5, Accounting for Contingencies.
 
 The
Company is required to file the Registration Statement with the SEC within 60
days of the closing of the private placement offering. The Registration
Statement must be declared effective by the SEC within 180 days of the final
closing of the offering. Subject to certain grace periods, the Registration
Statement must remain effective and available for use until the Investors can
sell all of the securities covered by the Registration Statement without
restriction pursuant to Rule 144. If the Company fails to meet the filing or
effectiveness requirements of the Registration Statement, the Company is
required to pay liquidated damages of 2% of the aggregate purchase price paid by
such Investor for any Registrable Securities then held by such Investor on the
date of such failure and on each anniversary of the date of such failure until
such failure is cured.  The last closing under the private
placement occurred on September 24, 2008 and the 180 day period for
effectiveness of the registration statement under the Registration Rights
Agreement ended on March 23, 2009.  At March 31, 2009, the Company became
liable to pay approximately $110,000 liquidated damages to our investors as a
result of failure to declare the effectiveness of the Registration Statement
within 180 days of the final closing of the offering.  The liquidated
damage was recorded as the Company’s G&A expense with charging corresponding
account to accrued liabilities.  The Registration Statement became
effective on June 23, 2009.
  10
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 New
Accounting Pronouncements
 
 The FASB Accounting
Standards Codifications
 
 In June
2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting. SFAS 168 represents the last
numbered standard to be issued by FASB under the old (pre-Codification)
numbering system, and amends the GAAP hierarchy. On July 1, FASB will launch new
FASB’s Codification (full name: the FASB Accounting Standards Codification TM.)
The Codification will supersede existing GAAP for nongovernmental entities;
governmental entities will continue to follow standards issued by FASB's sister
organization, the Governmental Accounting Standards Board (GASB). This
pronouncement has no effect on the Company’s financial statements.
 
 Consolidation of Variable
Interest Entities
 
 In June
2009, the FASB issued SFAS No. 167, a revision to FASB Interpretation No. 46(R),
Consolidation of Variable Interest Entities, and will change how a company
determines when an entity that is insufficiently capitalized or is not
controlled through voting (or similar rights) should be consolidated. Under SFAS
No. 167, determining whether a company is required to consolidate an entity will
be based on, among other things, an entity's purpose and design and a company's
ability to direct the activities of the entity that most significantly impact
the entity's economic performance. SFAS 167 is effective at the start of a
company’s first fiscal year beginning after November 15, 2009, or January 1,
2010 for companies reporting earnings on a calendar-year basis.
 
 Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of
Liabilities
 
 In June
2009, the FASB issued SFAS No. 166, a revision to SFAS No. 140, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,
and will require more information about transferred of financial assets and
where companies have continuing exposure to the risks related to transferred
financial assets. SFAS 166 is effective at the start of a company’s first fiscal
year beginning after November 15, 2009, or January 1, 2010 for companies
reporting earnings on a calendar-year basis.
 
 Subsequent
Events
 
 In May
2009, the FASB issued SFAS No. 165, "Subsequent Events" ("SFAS 165"). SFAS 165
is intended to establish general standards of accounting for and disclosures of
events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. It requires the disclosure of the date
through which an entity has evaluated subsequent events and the basis for
selecting that date, that is, whether that date represents the date the
financial statements were issued or were available to be issued. SFAS 165 is
effective for interim or annual financial periods ending after June 15,
2009.
 
 The Hierarchy of Generally
Accepted Accounting Principles
 
 In May
2008, FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting
Principles.”  SFAS 162 identifies the sources of accounting principles and
the framework for selecting the principles to be used in the preparation of
financial statements of nongovernmental entities that are presented in
conformity with generally accepted accounting principles (GAAP) in the United
States (the GAAP hierarchy).  SFAS 162 adoption did not have an impact on
the Company’s financial statements.
  11
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 Determination of the Useful
Life of Intangible Assets
 
 In
April 2008, the FASB issued FASB Staff Position FAS 142-3, “Determination
of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends
the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”),
and requires additional disclosures. The objective of FSP FAS 142-3 is to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset under SFAS No. 141 (R), “Business Combinations” (“SFAS
141(R)”), and other accounting principles generally accepted in the USA. FSP FAS
142-3 applies to all intangible assets, whether acquired in a business
combination or otherwise and shall be effective for financial statements issued
for fiscal years beginning after December 15, 2008, and interim periods
within those fiscal years. The guidance for determining the useful life of
intangible assets shall be applied prospectively to intangible assets acquired
after the effective date. The disclosure requirements apply prospectively to all
intangible assets recognized as of, and subsequent to, the effective date.
Early adoption is prohibited. The adoption of FSP FAS 142-3 did not have a
material impact on the Company’s financial statements.
 
 Disclosures about Derivative
Instruments and Hedging Activities
 
 In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities an amendment of FASB Statement No. 133.”  This
Statement changes the disclosure requirements for derivative instruments and
hedging activities. Entities are required to provide enhanced disclosures about
(a) how and why an entity uses derivative instruments, (b) how
derivative instruments and related hedged items are accounted for under
Statement 133 and its related interpretations, and (c) how derivative
instruments and related hedged items affect an entity’s financial position,
financial performance, and cash flows. SFAS 161 is effective for fiscal
years, and interim periods within those fiscal years, beginning on or
after November 15, 2008. The adoption of SFAS 161 did not have a
material impact on the Company’s financial statements.
 
 Fair value of
measurements
  On
January 1, 2008, the Company adopted SFAS No. 157, “Fair Value
Measurements,” SFAS 157 defines fair value, establishes a three-level
valuation hierarchy for disclosures of fair value measurement and enhances
disclosures requirements for fair value measurements. The three levels are
defined as follow:
  ·
                Level 1 inputs to the valuation
      methodology are quoted prices (unadjusted) for identical assets or
      liabilities in active
markets.
 
 ·
                Level 2 inputs to the valuation
      methodology include quoted prices for similar assets and liabilities in
      active markets, and inputs that are observable for the asset or liability,
      either directly or indirectly, for substantially the full term of the
      financial instrument.
 
 ·
                Level 3 inputs to the valuation
      methodology are unobservable and significant to the fair value
      measurement.
  As of
June 30, 2009, the Company did not identify any assets and liabilities that are
required to be presented on the balance sheet at fair value.
 
 Non-Controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No. 51
 
 In
December 2007, FASB issued SFAS No. 160, "Non-controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No. 51." SFAS 160
establishes new accounting and reporting standards for the non-controlling
interest in a subsidiary and for the deconsolidation of a subsidiary.
Specifically, this statement requires the recognition of a non-controlling
interest (minority interest) as equity in the consolidated financial statements
and separate from the parent’s equity. The amount of net income attributable to
the non-controlling interest will be included in consolidated net income on the
face of the income statement. SFAS 160 clarifies that changes in a parent’s
ownership interest in a subsidiary that do not result in deconsolidation are
equity transactions if the parent retains its controlling financial interest. In
addition, this statement requires that a parent recognize a gain or loss in net
income when a subsidiary is deconsolidated. Such gain or loss will be measured
using the fair value of the non-controlling equity investment on the
deconsolidation date. SFAS 160 also includes expanded disclosure requirements
regarding the interests of the parent and its non-controlling interest. SFAS 160
is effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. The Company expects SFAS 160 will
have an impact on accounting for business combinations, but the effect is
dependent upon acquisitions at that time. The Company adopted the
provisions of SFAS 160 on January 1, 2009.
  12
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
  Business
Combinations
  SFAS 141
(Revised 2007), Business Combinations (SFAS 141(R)), is effective for the
Company for business combinations for which the acquisition date is on or after
January 1, 2009. SFAS 141(R) changes how the acquisition method is applied in
accordance with SFAS 141. The primary revisions to this Statement require an
acquirer in a business combination to measure assets acquired, liabilities
assumed, and any noncontrolling interest in the acquiree at the acquisition
date, at their fair values as of that date, with limited exceptions specified in
the Statement. This Statement also requires the acquirer in a business
combination achieved in stages to recognize the identifiable assets and
liabilities, as well as the noncontrolling interest in the acquiree, at the full
amounts of their fair values (or other amounts determined in accordance with the
Statement). Assets acquired and liabilities assumed arising from contractual
contingencies as of the acquisition date are to be measured at their
acquisition-date fair values, and assets or liabilities arising from all other
contingencies as of the acquisition date are to be measured at their
acquisition-date fair value, only if it is more likely than not that they meet
the definition of an asset or a liability in FASB Concepts Statement No. 6,
Elements of Financial Statements. This Statement significantly amends other
Statements and authoritative guidance, including FASB Interpretation No. 4,
Applicability of FASB Statement No. 2 to Business Combinations Accounted for by
the Purchase Method, and now requires the capitalization of research and
development assets acquired in a business combination at their acquisition-date
fair values, separately from goodwill. FASB Statement No. 109, Accounting for
Income Taxes, was also amended by this Statement to require the acquirer to
recognize changes in the amount of its deferred tax benefits that are
recognizable because of a business combination either in income from continuing
operations in the period of the combination or directly in contributed capital,
depending on the circumstances. The Company expects SFAS 141R will have a
significant impact on accounting for business combinations, but the effect is
dependent upon acquisitions at that time. The Company adopted the
provisions of SFAS 160 on January 1, 2009.
 
 Accounting for
Non-Refundable Advance Payments for Goods or Services Received for Use in Future
Research and Development Activities
 
 In June
2007, FASB issued FASB Staff Position No. EITF 07-3, “Accounting for
Nonrefundable Advance Payments for Goods or Services Received for use in Future
Research and Development Activities,” which addresses whether non-refundable
advance payments for goods or services that used or rendered for research and
development activities should be expensed when the advance payment is made or
when the research and development activity has been performed. EITF 07-03
is effective for fiscal years beginning after December 15, 2008.  The
adoption of EITF 07-03 did not have a significant impact on the Company’s
financial statements.
  13
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 3.
INVENTORIES
 
 Inventories
at June 30, 2009 and December 31, 2008 were as follows:
 
 June 30,
                    
                    
                    December 31,2009
                    
                    
                    2008Raw
      materials
                    
                    $
                    4,760,139
                    
                    
                    $
                    4,411,298Work
      in process
                    
                    
                    1,601,767
                    
                    
                    
                    652,472Finished
      Goods
                    
                    
                    1,858,275
                    
                    
                    
                    1,043,813Total
                    
                    $
                    8,220,181
                    
                    
                    $
                    6,107,583
  4.
PROPERTY AND EQUIPMENT, NET
 
 Property
and equipment consisted of the following at June 30, 2009 and December
31, 2008:
 
 June 30,
                      2009
                    
                    
                    December 31,
                      2008Building
                    
                    $
                    4,324,667
                    
                    
                    $
                    1,818,827Production
      equipment
                    
                    
                    2,666,584
                    
                    
                    
                    441,065Office
      equipment
                    
                    
                    306,717
                    
                    
                    
                    231,975Vehicles
                    
                    
                    577,368
                    
                    
                    
                    300,9567,875,336
                    
                    
                    
                    2,792,823Less:
      Accumulated depreciation
                    
                    
                    (512,296
                    )
                    
                    
                    (356,270
                    )$
                    7,363,041
                    
                    
                    $
                    2,436,553
 
 Depreciation
expense for the six months ended June 30, 2009 and 2008 was approximately
$111,000 and $77,000, respectively.  Depreciation expense for the
three months ended June 30, 2009 and 2008 was approximately $55,000 and $39,000,
respectively.
 
 5.
OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS
 
 Other
receivables, prepayments and deposits consisted of the following at June 30,
2009 and December 31, 2008, respectively:
 
 June 30,
                      2009
                    
                    
                    December 31,
                      2008Cash
      advance to third parties
                    
                    $
                    407,866
                    
                    
                    $
                    89,628Deposit
      for public bids of sales contracts
                    
                    
                    603,540
                    
                    
                    
                    353,399Prepayment
      for freight and related insurance expenses
                    
                    
                    102,082
                    
                    
                    
                    95,888Deposits
                    
                    
                    71,373
                    
                    
                    
                    42,783Advance
      to employees
                    
                    
                    182,104
                    
                    
                    
                    117,136Total
                    
                    $
                    1,366,965
                    
                    
                    $
                    698,834
 
 Cash
advance to third parties was the short term cash advances to customers and
vendors with repayment usually within three to six months.  Deposits
for public bidding represented the deposits for bidding expected contracts,
which will be returned to the Company after the bidding process is completed
unusually within three to four months from the payment
date.  Prepayment for freight and /or related insurance expenses
represented prepaid shipping and freight insurance expenses for customers and is
generally repaid upon customer receipt of products.  Deposits mainly
consisted of deposits for rents and utilities. Cash advance to employees
represented short term loan to employees and advance to employees for business
trip and related expenses. Other receivables, prepayments and deposits are
reimbursed or settled within 12 months.
  14
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 6.
INTANGIBLE ASSETS
 
 Intangible
assets mainly consisted of land use rights, computer software, know-how
technology, customer list and covenant not to compete. All land in the PRC is
government owned and cannot be sold to any individual or company. However, the
government grants the user a “land use right” to use the land. The Company
acquired land use right during 2005 for approximately $440,000 (RMB 3,549,682).
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.  The Company acquired
another land use right of $3,106,676 from Siping on June 16, 2009.
 
 Intangible
assets consisted of the following at June 30, 2009 and December 31, 2008,
respectively:
 
 June 30,
                      2009
                    
                    
                    December 31,
                      2008Land
      use rights
                    
                    $
                    3,626,252
                    
                    
                    $
                    519,369Know-how
      technology
                    
                    
                    266,913
                    
                    
                    
                    266,808Customer
      list
                    
                    
                    191,728
                    
                    
                    
                    191,652Covenant
      not to compete
                    
                    
                    104,299
                    
                    
                    
                    104,258Software
                    
                    
                    190,242
                    
                    
                    
                    190,1664,379,433
                    
                    
                    
                    1,272,253Less:
      accumulated amortization
                    
                    
                    (200,290
                    )
                    
                    
                    (117,122
                    )$
                    4,179,143
                    
                    
                    $
                    1,155,131
 
 Amortization
expense of intangible assets for the six months ended June 30, 2009 and 2008 was
approximately $83,000 and $26,000, respectively. Amortization expense for the
three months ended June 30, 2009 and 2008 was approximately $42,000 and $15,000,
respectively. Annual amortization expense for the next five years from June 30,
2009 is expected to be: $242,000, $242,000, $242,000, $242,000 and
$202,000.
 
 7.
MAJOR CUSTOMERS AND VENDORS
  Three
customers accounted for 21%, 14% and 10% of the Company’s net revenue for the
six months ended June 30, 2009 while one customer accounted for 19% of the
Company’s net revenue for the six months ended June 30, 2008. For the three
months ended June 30, 2009, three customers accounted for about 32%, 21%, and
15% of the sales.  For the three months ended June 30, 2008, one
customer accounted for about 12% of the sales. At June 30, 2009 the total
receivable balance due from these customers was approximately
$3,597,230.
  There is
no major vendor provided of the Company’s purchases of raw materials for the six
months and three months ended June 30, 2009 while two major vendors provided 44%
and 27% of the Company’s purchases of raw materials for the six months and three
months ended June 30, 2008, respectively.  The Company had
approximately $690,395 in accounts payable to these vendors at June 30,
2008.
 
 8.
TAXES PAYABLE
 
 Taxes
payable consisted of the following at June 30, 2009 and December 31,
2008:
 
 June 30,
                      2009
                    
                    
                    December 31,
                      2008Income
      tax payable
                    
                    $
                    424,234
                    
                    
                    $
                    723,958Value
      added tax payable
                    
                    
                    131,204
                    
                    
                    
                    597,676Other
      taxes payable
                    
                    
                    3,647
                    
                    
                    
                    6,141$
                    559,085
                    
                    
                    $
                    1,327,775
  15
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
   9.
ACCRUED LIABILITIES AND OTHER PAYABLES
  Accrued
liabilities and other payables consisted of the following at June 30, 2009 and
December 31, 2008:
  June 30,
                      2009
                    
                    
                    December 31,
                      2008Advance
      from third parties
                    
                    $
                    88,000
                    
                    
                    $
                    453,625Payable
      for purchase of SanDeKe
                    
                    
                    -
                    
                    
                    
                    741,516Payable
      for purchase of assets from SiPing – current portion
                    
                    
                    5,203,196
                    
                    
                    
                    -Other
      payables
                    
                    
                    322,020
                    
                    
                    
                    99,418Warranty
      reserve
                    
                    
                    188,151
                    
                    
                    
                    -Accrued
      liabilities
                    
                    
                    167,342
                    
                    
                    
                    36,253Total
                    
                    $
                    5,968,709
                    
                    
                    $
                    1,330,812
  Advance
from third parties represented short term, non interest bearing advances from
third parties. Other payables consisted of payables for the Company’s
miscellaneous expenses including postage, business insurance, employee benefits,
bidding fee, etc. Accrued liabilities mainly consisted of accrued interest,
payroll, utility, and liquidated damages for failure to declare the
effectiveness of the Registration Statement within 180 days of the final closing
of the offering.
 10.
NOTES PAYABLE – BANK ACCEPTANCE
  Notes
payable represented accounts payable to vendors that were converted to notes
payable accepted by the bank. The Company deposited a portion of the acceptance
amount into the bank. The bank charged 2.5% of the face value of the note which
is amortized over the term of the acceptance.
  16
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 11.
LOANS PAYABLE
 
 The
Company was obligated for the following short term loans payable as of June 30,
2009 and December 31, 2008:
  June
      30, 2009
                        
                        
                        December 31, 2008Loans
      from a commercial bank in the PRC for 30,000,000 RMB. Of which, 17,000,000
      RMB was entered into on April 22, 2009 and is due on April 22, 2010.
      13,000,000 RMB was entered into on June 12, 2009 and is due on June 12,
      2010. These loans currently bear interest at 5.576%.  The
      Company pledged its building in the value of approximately RMB 12,430,950
      or approximately $1,818,000 for this loan.
                        
                        $
                        4,391,165
                        
                        
                        $
                        -Loan
      from a commercial bank in the PRC for 6,000,000 RMB. This loan was entered
      into on Apr 28, 2007 and was due on Apr 12, 2008. This loan was renewed on
      Apr 12, 2008. The Company repaid loan in April, 2009.
                        
                        
                        -
                        
                        
                        
                        877,886The
      Company entered into a series of short term loans during 2006 and 2007
      with a third party company in the PRC for total of 10, 300,000 RMB. Some
      of the loans matured on various dates in 2008 and some of the loans are
      payable on demand. These loans bear variable interest at 8.591% for 2009
      and 2008.  The Company repaid RMB 2,600,000 in 2008, RMB
      2,700,000 in April, 2009, and had RMB 5,000,000 outstanding as of June 30,
      2009, due on December 31, 2009 with interest of 8.591%.
                        
                        
                        731,861
                        
                        
                        
                        1,126,621The
      Company entered into a one year loan on July 1, 2008 with another third
      party company in the PRC for total of 3,000,000 RMB. This loan is renewed
      and due on December 31, 2009 with interest of 8.591%.
                        
                        
                        439,116
                        
                        
                        
                        438,943$
                        5,562,142
                        
                        
                        $
                        2,443,450
  12.
DEFERRED TAX LIABILITY
 
 Deferred
tax liability represented differences between the tax bases and book bases of
property and equipment and intangible assets arising from the acquisition of
SanDeKe.
 
 13.
INCOME TAXES
 
 The
Company is subject to income taxes by entity on income arising in or derived
from the tax jurisdiction in which each entity is domiciled.
 
 SmartHeat
was incorporated in the United States and has incurred net operating loss for
income tax purposes.  SmartHeat has net operating loss carry forwards
for income taxes of approximately $230,000 at June 30, 2009 which may be
available to reduce future years’ taxable income as NOL can be carried
forward up to 20 years from the year the loss is incurred. Management believes
that the realization of the benefits from these losses appears uncertain due to
the Company’s limited operating history and continuing losses. Accordingly, a
100% deferred tax asset valuation allowance has been provided.
 
 Taiyu and
SanDeKe are governed by the Income Tax Law of the PRC concerning privately-run
enterprises, which are generally subject to tax at a statutory rate of 25% on
income reported in the statutory financial statements after appropriated tax
adjustments.
 
 Taiyu, as
a manufacturing business, is subject to 18% income tax rate for 2008 and 20%
income tax rate for 2009. According to the new income tax law that became
effective January 1, 2008, new high-tech enterprises that government gives
special support are subject to income tax rate of 15%.  Taiyu was
recognized as a new high-tech enterprise and registered the status with tax
bureau, therefore, enjoys the income tax rate of 15% from 2009 through
2010.
 
 SanDeKe
is subject to an 18% income tax rate after 7% reduction in federal income tax
rate given by federal government. SanDeKe, is also exempt from income tax for
two years starting from the 1st profitable year, and is entitled to a 50%
discount on the 18% income tax rate for 2010 through 2012.
  17
 SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 The
Company's net income for the six and three months ended June 30, 2009 would be
lower by approximately $191,000 or $0.01 earnings per common share, and $130,000
or $0.0053 earnings per common share had Taiyu not enjoyed lower income tax rate
and SanDeKe not been exempted from income tax for the six and three months ended
June 30, 2009.
  Foreign
pretax earnings approximated $4,436,000 and $1,469,000 for the six months ended
June 30, 2009 and 2008 respectively. Pretax earnings of a foreign subsidiary are
subject to U.S. taxation when effectively repatriated. The Company provides
income taxes on the undistributed earnings of non-U.S. subsidiaries except to
the extent that such earnings are indefinitely invested outside the United
States. At June 30, 2009, $10,998,000 of accumulated undistributed earnings of
non-U.S. subsidiaries was indefinitely invested. At the existing U.S. federal
income tax rate, additional taxes of $990,000 would have to be provided if such
earnings were remitted currently.
 
 The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the six and three months ended June 30, 2009 and 2008:
 
 For the Six Months EndedJune 30,
                          
                          
                          For the Three MonthsEnded June 30,2009
                          
                          
                          2008
                          
                          
                          2009
                          
                          
                          2008US
      statutory rates
                          
                          
                          34.0
                          %
                          
                          
                          34.0
                          %
                          
                          
                          34.0
                          %
                          
                          
                          34.0
                          %Tax
      rate difference
                          
                          
                          (14.0
                          )%
                          
                          
                          (16.0
                          )%
                          
                          
                          (14.0
                          )%
                          
                          
                          (16.0
                          )%Effect
      of tax holiday
                          
                          
                          (5.1
                          )%
                          
                          
                          -
                          
                          
                          
                          (5.0
                          )%
                          
                          
                          -Valuation
      allowance
                          
                          
                          0.9
                          %
                          
                          
                          -
                          
                          
                          
                          0.0
                          %
                          
                          
                          -Tax
      per financial statements
                          
                          
                          15.8
                          %
                          
                          
                          18.0
                          %
                          
                          
                          15.0
                          %
                          
                          
                          18.0
                          %
  14.
STATUTORY RESERVES
 
 Pursuant
to the new corporate law of the PRC effective January 1, 2006, the Company is
now only required to maintain one statutory reserve by appropriating from its
after-tax profit before declaration or payment of dividends. The statutory
reserve represents restricted retained earnings.
 
 Surplus
Reserve Fund
 
 The
Company is now only required to transfer 10% of its net income, as determined
under PRC accounting rules and regulations, to a statutory surplus reserve fund
until such reserve balance reaches 50% of the Company’s registered
capital.
 
 The
surplus reserve fund is non-distributable other than during liquidation and can
be used to fund previous years’ losses, if any, and may be utilized for business
expansion or converted into share capital by issuing new shares to existing
shareholders in proportion to their shareholding or by increasing the par value
of the shares currently held by them, provided that the remaining reserve
balance after such issue is not less than 25% of the registered
capital.
  Common
Welfare Fund
 
 The
common welfare fund is a voluntary fund that provides that the Company can elect
to transfer 5% to 10% of its net income to this fund. This fund can only be
utilized on capital items for the collective benefit of the Company’s employees,
such as construction of dormitories, cafeteria facilities, and other staff
welfare facilities. This fund is non-distributable other than upon
liquidation.
  18
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 15.
STOCKHOLDERS’ EQUITY
 
 Common
Stock with Warrants Issued for Cash
 
 In August
2008, the Company closed a private placement offering of Units pursuant to which
SmartHeat sold 1,630,000 Units at $3.50 per Unit for aggregate gross proceeds of
approximately $5.7 million. Each "Unit" consists of one share of SmartHeat
common stock and a three year warrant to purchase 15% of one share of common
stock at an exercise price of $6.00 per share. The Units sold represent an
aggregate of 1,630,000 million shares of common stock and warrants to purchase
244,500 shares of Common Stock. In connection with the private placement
offering, the Company paid commission of approximately $340,000 and issued
warrants to purchase 148,500 shares of common stock to its placement agents. The
warrants are immediately exercisable and expire on the third anniversary of
their issuance. The warrants require the Company to settle in its own
shares.  There is no provision for cash settlement, except in lieu of
fractional shares.  Net proceeds of approximately $5.1 million 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. There were no warrants
exercised from the grant date to June 30, 2009.
 
 Stock
Options to Independent Directors
 
 On July
17, 2008, the Company granted non-statutory stock options to each of its two
independent US directors. The terms of each option are: 10,000 shares at an
exercise price per share of $4.60, with a life of five years and vesting over
three years as follows: 3,333 shares vest on July 17, 2009; 3,333 shares vest on
July 17, 2010; and 3,334 shares vest on July 17, 2011, subject in each case to
the director continuing to be associated with the Company as a
director.
  Based on
the fair value method under SFAS No. 123 (Revised) “Share Based Payment” (“SFAS
123(R)”), the fair value of each stock option granted is estimated on the date
of the grant using the Black-Scholes option pricing model. The Black-Scholes
option pricing model has assumptions for risk free interest rates, dividends,
stock volatility and expected life of an option grant. The risk free interest
rate is based upon market yields for United States Treasury debt securities at a
maturity near the term remaining on the option. Dividend rates are based on the
Company’s dividend history. The stock volatility factor is based on the
historical volatility of the Company’s stock price. The expected life of an
option grant is based on management’s estimate. The fair value of each option
grant to independent directors is calculated by the Black-Scholes method and is
recognized as compensation expense over the vesting period of each stock option
award. For stock options issued, the fair value was estimated at the date of
grant using the following range of assumptions:
  The
options vest over three years and have a life of 5 years, volatility of 15%,
risk free interest rate of 2.76%, and dividend yield of 0%. No estimate of
forfeitures was made as the Company has a short history of granting options.
There were no options exercised during the six months ended June 30,
2009.
  Following is a summary of the warrant
activity:
 Number of
                      Shares
                    
                    
                    Average
                      Exercise
                      Price per Share
                    
                    
                    Weighed
                      Average
                      Remaining
                      Contractual
                      Term in YearsOutstanding
      at December 31, 2007
                    
                    
                    -Exercisable
      at December 31, 2007
                    
                    
                    -Granted
                    
                    
                    393,000
                    
                    
                    $
                    6.00
                    
                    
                    
                    3.00ExercisedForfeitedOutstanding
      at December 31, 2008
                    
                    
                    393,000
                    
                    
                    
                    6.00
                    
                    
                    
                    2.51Exercisable
      at December 31, 2008
                    
                    
                    393,000
                    
                    
                    
                    6.00
                    
                    
                    
                    2.51GrantedExercisedForfeitedOutstanding
      at June 30, 2009
                    
                    
                    393,000
                    
                    
                    $
                    6.00
                    
                    
                    
                    2.02Exercisable
      at June 30, 2009
                    
                    
                    393,000
                    
                    
                    $
                    6.00
                    
                    
                    
                    2.02
  19
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 Following
is a summary of the option activity:
 Number of
                      Shares
                    
                    
                    Average
                      Exercise
                      Price per Share
                    
                    
                    Weighed
                      Average
                      Remaining
                      Contractual
                      Term in YearsOutstanding
      at December 31, 2007
                    
                    
                    -Exercisable
      at December 31, 2007
                    
                    
                    -Granted
                    
                    
                    20,000
                    
                    
                    $
                    4.60
                    
                    
                    
                    5.00ExercisedForfeitedOutstanding
      at December 31, 2008
                    
                    
                    20,000
                    
                    
                    
                    4.60
                    
                    
                    
                    4.54Exercisable
      at December 31, 2008
                    
                    
                    20,000
                    
                    
                    
                    4.60
                    
                    
                    
                    4.54GrantedExercisedForfeitedOutstanding
      at June 30, 2009
                    
                    
                    20,000
                    
                    
                    $
                    4.60
                    
                    
                    
                    4.04Exercisable
      at June 30, 2009
                    
                    
                    20,000
                    
                    
                    $
                    4.60
                    
                    
                    
                    4.04
 
 16.
COMMITMENTS
 
 Employment
Agreements
  On
January 1, 2008, the Company entered into a three year employment agreement with
Mr. Jun Wang, which agreement may be renewed at the end of the initial term upon
mutual agreement between Mr. Jun Wang and the Company.  Either party
shall give written notice to the other party of its intention not to renew
the agreement at least 30 days prior to the end of the initial
term.  Pursuant to the terms of the employment agreement, Mr. Jun Wang
shall receive a salary in an amount that is not less than the lowest minimum
wage per month paid in Shenyang and shall be based on the uniform wage and
incentive system in Shenyang, currently $18,000 per annum. In addition, Mr. Jun
Wang shall be entitled to overtime pay in accordance with the applicable
law.
 
 On
January 1, 2008, The Company entered into a three year employment agreement with
Ms. Zhijuan Guo, at terms identical to the terms of the employment agreement
with Mr. Jun Wang with current salary of $10,684 per annum.
 
 Lease
agreements
 
 The
Company leased several offices for its sales representative in different cities
under various one-year, non-cancellable, and renewable operating lease
agreements.  At June 30, 2009, future minimum rental payments required
under these operating leases are as follows:
 
 Year
      Ending June 30,
                    
                    Amount2010
                    
                    $
                    87,0002011
                    
                    
                    87,000Total
                    
                    $
                    174,000
  20
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 17.
CONTINGENCIES
 
 The
Company sold goods to its customers and received Commercial Notes from the
customers in lieu of accounts receivable.  The Company discounts the
Notes with the bank or endorses the Notes to vendors, which could be for payment
of their own obligations or get cash from the third parties.  Most of
the Commercial Notes have maturity of less than six months.
 
 At June
30, 2009 and December 31, 2008, the Company is contingently liable to vendors
for endorsed notes receivable of $14,637 and $14,631, respectively.
 
 The
Company’s operations in the PRC are subject to specific considerations and
significant risks not typically associated with companies in North America and
Western Europe. These include risks associated with, among others, the
political, economic and legal environments and foreign currency exchange.
The Company’ s results may be adversely affected by changes in governmental
policies with respect to laws and regulations, anti-inflationary measures,
currency conversion and remittance abroad, and rates and methods of taxation,
among other things.
  The
Company’s sales, purchases and expense transactions are denominated in RMB and
all of the Company’s assets and liabilities are also denominated in RMB. The RMB
is not freely convertible into foreign currencies under the current law. In
China, foreign exchange transactions are required by law to be transacted only
by authorized financial institutions. Remittances in currencies other than RMB
may require certain supporting documentation in order to affect the
remittance.
  18.
ACQUISITION OF SANDEKE CO., LTD.
 
 On
September 25, 2008, the Company entered into an Agreement for the acquisition of
all the outstanding capital stock of SanDeKe. The purchase price for the SanDeKe
shares was $741,516. Under the terms of the Agreement, two of the shareholders
of SanDeKe have agreed not to compete with the business of SanDeKe for a period
of four years after the completion of the purchase.  At June 30, 2009,
the Company paid the purchase consideration for SanDeKe.
 
 For
convenience of reporting the acquisition for accounting purposes, September 1,
2008 was designated as the acquisition date.
 
 The
following table summarizes the fair values of the assets acquired and
liabilities assumed at the date of acquisition.   The fair value of
the net assets acquired exceeded the total consideration for the acquisition by
approximately $117,000 (RMB 800,000). The excess (negative goodwill) was
allocated on a pro rata basis to long-lived assets.
 
 Cash
                    
                    $
                    59,245Accounts
      receivable
                    
                    
                    489,527Advance
      to suppliers
                    
                    
                    329,951Other
      receivables
                    
                    
                    128,646Inventory
                    
                    
                    92,370Property
      and equipment
                    
                    
                    73,324Intangible
      assets
                    
                    
                    563,567Accounts
      payable
                    
                    
                    (332,276
                    )Advance
      from customers
                    
                    
                    (557,216
                    )Deferred
      tax liability
                    
                    
                    (39,076
                    )Other
      current liabilities
                    
                    
                    (66,546
                    )Purchase
      price
                    
                    $
                    741,516
  21
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 The
intangible asset consisted of know-how technology is amortized over 5 years, the
customer list is amortized over 5 years and covenants not to compete, is
amortized over 4 years.
 
 The
following unaudited pro forma consolidated results of operations of the Company
for the six months ended June 30, 2008 presents the operations of the Company
and SanDeKe as if the acquisition of SanDeKe occurred on January 1,
2008.  The pro forma results are not necessarily indicative of the
actual results that would have occurred had the acquisitions been completed as
of the beginning of the periods presented, nor are they necessarily indicative
of future consolidated results.
  Pro forma
                        ConsolidatedNet
      revenue
                      
                      $
                      9,980,244Cost
      of revenue
                      
                      
                      7,341,630Gross
      profit
                      
                      
                      2,638,614Selling
      expense
                      
                      
                      608,028General
      & administrative expense
                      
                      
                      759,989Total
      operating expenses
                      
                      
                      1,368,017Income
      from operations
                      
                      
                      1,270,597Non-operating
      income, net
                      
                      
                      113,572Income
      before income tax
                      
                      
                      1,384,169Income
      tax
                      
                      
                      266,028Net
      income
                      
                      $
                      1,118,141Basic
      and diluted weighted average shares outstanding
                      
                      
                      20,213,419Basic
      and diluted net earnings per share
                      
                      $
                      0.06
  19.  SUBSEQUENT
EVENTS
 
 On July
3, 2009, the “Company entered into a Senior Loan Agreement with an institutional
investor to obtain a loan of US $9,000,000.00.
 
 Under the
terms of the Agreement, the Company agreed to a simple interest rate of 10% per
annum payable quarterly beginning on September 30, 2009. The principal amount
and any unpaid interest accrued thereon are due six (6) months from the date of
the Agreement.
 
 The
Lender may demand payment of principal and interest three (3) months from the
date of the Note, in the event of a change of control or upon material organic
changes to the Company. The terms of any subsequent financing must meet with
Lender’s consent.
 
 Without
the prior written consent of the Lender, from the date hereof until the date the
Senior Note is repaid in full, the Company and its Subsidiary shall be
prohibited from
  (A)
Effecting or entering into an agreement or to affect any subsequent financing
which shall be senior to the Senior Notes, or any other financing;
  (B)
Selling, leasing, or otherwise disposing of their respective
assets;
  (C) Dissolving,
liquidating, or winding up their respective businesses;
  (D)
Conducting their respective businesses other than in their ordinary and usual
course;
  (E) Paying
any dividend or make any other distributions of cash or property;
  22
  SMARTHEAT
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 (UNAUDITED) AND DECEMBER 31, 2008
 (F) Merging
or consolidating with another entity;
  (G) Issuing
any shares of Company capital stock or Company debt securities.
  23




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 SEC 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., together with its
subsidiaries, as "SmartHeat," the "Company," "we," "us," and "our."





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




Overview
  We were
incorporated in the State of Nevada on August 4, 2006 under the name Pacific
Goldrim Resources, Inc. as an exploration stage corporation that intended to
engage in the exploration of silver, lead and zinc. On April 14, 2008 we changed
our name to SmartHeat Inc. and acquired all of the equity interests in
Taiyu.
  Prior to
our acquisition of Taiyu, we were in the development stage and had minimal
business operations. We had no interest in any property, but had the right to
conduct exploration activities on thirteen (13) mineral title cells covering
270.27 hectares (667.85 acres) in the Slocan Mining Division of southeastern
British Columbia, Canada. In connection with the acquisition of Taiyu, we
transferred our prior assets and liabilities to a wholly owned subsidiary and
sold all of the outstanding capital stock of that subsidiary to our former
director and officer in exchange for 2,500,000 shares of our common
stock.
  Taiyu was
formed in July 2002 under the laws of China and is headquartered in Shenyang
City, Liaoning Province, China. As a result of our acquisition of Taiyu, we are
a leading provider of plate heat exchange products to China's industrial,
residential, and commercial markets, specializing in the manufacturing, sale,
research, and servicing of PHEs, PHE Units and heat meters for a broad range of
industries such as petroleum refinement, petrochemicals, power generation,
metallurgy, food & beverage, and chemical processing. We sell PHEs under the
Sondex brand and PHE Units that are designed by us and using PHEs that are
assembled with Sondex plates under our Taiyu brand name.
 
 As
a  continuous expansion of our business, we acquired SanDeKe Co.,
Ltd., a Shanghai based manufacturer of heat plate exchangers on September 25,
2008, and closed an asset purchase transaction with Siping Beifang Heat
Exchanger Manufacture Co.,Ltd on June 16, 2009 in
order to acquire plant and equipment and land use rights to  set up a
new manufacturing facility under our newly incorporated subsidiary SmartHeat
Siping Beifang Energy Technology Co., Ltd (“SmartHeat Siping”).
  Our
revenue is subject to fluctuations due to the timing of sales of high-value
products, the impact of seasonal spending patterns, the timing and size of
projects our customers perform, changes in overall spending levels in the
industry and other unpredictable factors that may affect customer ordering
patterns. Our quarterly revenues may fluctuate significantly due to the seasonal
nature of central heating services in the PRC, whereas, the equipment used in
residential building s must be delivered and installed prior to the beginning of
the heating season in late fall.  Additionally, any significant
delays in the commercial launch or any lack or delay of commercial acceptance of
new products, unfavorable sales trends in existing product lines, or impacts
from the other factors mentioned above, could adversely affect our revenue
growth or cause a sequential decline in quarterly revenue. In particular, our
2009 sales may be affected by weaker demand from steel processing, petrochemical
and HVAC sectors.  To date, we have not been adversely affected by
these trends. Moreover, the PRC government has recently passed an economic
stimulus package and we believe that our sales will benefit from an increase in
government spending on infrastructure as provided in this
package.  However, due to the possibility of fluctuations in our
revenue and net income or loss, we believe that quarterly comparisons of our
operating results are not a good indication of future performance.
 
 While
our significant accounting policies are more fully described in Note 2 to our
consolidated financial statements, we believe that the following accounting
policies are the most critical to aid you in fully understanding and evaluating
this management discussion and analysis.
  Basis
of Presentation
  Our
financial statements are prepared in accordance with generally accepted
accounting principles in the United States of America.
 
 Principle
of Consolidation
  The
accompanying consolidated financial statements include the accounts of
SmartHeat, SmartHeat Siping, SanDeKe, and Taiyu. For purposes of this
Quarterly Statement, the "Company" refers collectively to SmartHeat, Siping,
SanDeKe and Taiyu. All significant inter-company accounts and transactions have
been eliminated in consolidation.
  24
  Use
of Estimates
  In
preparing the financial statements in conformity with accounting principles
generally accepted in the United States of America, management makes estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the dates of the financial
statements, as well as the reported amounts of revenues and expenses during the
reporting year. Significant estimates, required by management, include the
recoverability of long-lived assets, allowance for doubtful accounts, and the
reserve for obsolete and slow-moving inventories. Actual results could differ
from those estimates.
  Accounts
Receivable
  Our
policy is to maintain reserves for potential credit losses on accounts
receivable. Management reviews the composition of accounts receivable and
analyzes historical bad debts, customer concentrations, customer credit
worthiness, current economic trends and changes in customer payment patterns to
evaluate the adequacy of these reserves. Accounts receivable are net of
unearned interest. Unearned interest represents imputed interest on accounts
receivable with due dates over one year from the invoice date discounted at our
borrowing rate for the year.
  Inventories
  Inventories
are valued at the lower of cost or market with cost determined on a moving
weighted average basis. Cost of work in progress and finished goods comprises
direct material, direct production cost and an allocated portion of production
overheads.
  Property
and Equipment
  Property
and equipment are stated at cost, net of accumulated depreciation. Expenditures
for maintenance and repairs are expensed as incurred; additions, renewals and
betterments are capitalized. When property and equipment are retired or
otherwise disposed of, the related cost and accumulated depreciation are removed
from the respective accounts, and any gain or loss is included in operations.
Depreciation of property and equipment is provided using the straight-line
method with a 10% salvage value and estimated lives ranging from 5 to 20
years as follows:
  Building
                  20
      yearsVehicles
                  5
      yearsOffice
      Equipment
                  5
      yearsProduction
      Equipment
                  5 -
      10 years
  Revenue
Recognition
  Our
revenue recognition policies are in compliance with Securities and Exchange
Commission (SEC) Staff Accounting Bulletin (“SAB”) 104. Sales revenue is
recognized when products are delivered, and for PHE and PHE units, when customer
acceptance occurs, the price is fixed or determinable, no other significant
obligations of the Company exist and collectibility is reasonably assured.
Payments received before all of the relevant criteria for revenue recognition
are recorded as unearned revenue.
 
 Our sales
contracts with the customers generally provide that 30% of the purchase price is
due upon the placement of an order, 30% is due on delivery, 30% is due upon
installation and acceptance of the equipment after customer testing, the final
10% of the purchase price is due on a date that is no later than the termination
date of the standard warranty period.
 
 Our
standard warranty is provided to all customers and is not considered an
additional service; rather it is considered an integral part of the products
sale. We believe that 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 separation and allocation model for a
multiple deliverable arrangement. SFAS5 specifically
address the accounting for standard warranties and neither SAB 104 nor EITF
00-21 supersedes SFAS 5. We believe that 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.
  25
  We
provide after sales services at a charge after expiration of the warranty
period, with after sales services mainly consisting of cleaning plate heat
exchangers and repairing and exchanging parts. We recognize such revenue when
service is provided.  The revenue earned from these services was not
material.
 
 Foreign
Currency Translation and Comprehensive Income (Loss)
  Our
functional currency is the Chinese yuan - renminbi (“RMB”). For financial
reporting purposes, RMB has been translated into United States dollars ("USD")
as the reporting currency. Assets and liabilities are translated at the exchange
rate in effect at the balance sheet date. Revenues and expenses are translated
at the average rate of exchange prevailing during the reporting period.
Translation adjustments arising from the use of different exchange rates from
period to period are included as a component of shareholders' equity as
"Accumulated other comprehensive income." Gains and losses resulting from
foreign currency transactions are included in income. There has been no
significant fluctuation in exchange rate for the conversion of RMB to USD after
the balance sheet date.
  We use
Statement of Financial Accounting Standards ("SFAS") No. 130, “Reporting
Comprehensive Income.” Comprehensive income is comprised of net income and all
changes to the statements of shareholders’ equity, except those due to
investments by shareholders, changes in paid-in capital and distributions to
shareholders.
  Recent
Accounting Pronouncements
  The FASB Accounting
Standards Codifications
 
 In June
2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting. SFAS 168 represents the last
numbered standard to be issued by FASB under the old (pre-Codification)
numbering system, and amends the GAAP hierarchy. On July 1, FASB will launch
FASB’s new Codification (full name: the FASB Accounting Standards Codification
TM.) The new Codification will supersede existing GAAP for nongovernmental
entities; governmental entities will continue to follow standards issued by
FASB's sister organization, the Governmental Accounting Standards Board (GASB).
This pronouncement has no effect on Company’s financial statements.
 
 Consolidation of Variable
Interest Entities
 
 In June
2009, the FASB issued SFAS No. 167, a revision to FASB Interpretation No. 46(R),
Consolidation of Variable Interest Entities, and will change how a company
determines when an entity that is insufficiently capitalized or is not
controlled through voting (or similar rights) should be consolidated. Under SFAS
No. 167, determining whether a company is required to consolidate an entity will
be based on, among other things, an entity's purpose and design and a company's
ability to direct the activities of the entity that most significantly impact
the entity's economic performance. SFAS 167 is effective at the start of a
company’s first fiscal year beginning after November 15, 2009, or January 1,
2010 for companies reporting earnings on a calendar-year basis.
 
 Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of
Liabilities
 
 In June
2009, the FASB issued SFAS No. 166, a revision to SFAS No. 140, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,
which will require more information about the transfer  of financial
assets and identification of where companies have continuing exposure to the
risks related to transferred financial assets. SFAS 166 is effective at the
start of a company’s first fiscal year beginning after November 15, 2009, or
January 1, 2010 for companies reporting earnings on a calendar-year
basis.
  26
  Subsequent
Events
 
 In May
2009, the FASB issued SFAS No. 165, "Subsequent Events" ("SFAS 165"). SFAS 165
is intended to establish general standards of accounting for and disclosures of
events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. It requires the disclosure of the date
through which an entity has evaluated subsequent events and the basis for
selecting that date, that is, whether that date represents the date the
financial statements were issued or were available to be issued. SFAS 165 is
effective for interim or annual financial periods ending after June 15,
2009.
 
 The Hierarchy of Generally
Accepted Accounting Principles
 
 In May
2008, FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting
Principles.”  SFAS 162 identifies the sources of accounting principles and
the framework for selecting the principles to be used in the preparation of
financial statements of nongovernmental entities that are presented in
conformity with generally accepted accounting principles (GAAP) in the United
States (the GAAP hierarchy).  SFAS 162 adoption did not have an impact on
the Company’s financial statements.
  Determination of the Useful
Life of Intangible Assets
 
 In
April 2008, the FASB issued FASB Staff Position FAS 142-3, “Determination
of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends
the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”),
and requires additional disclosures. The objective of FSP FAS 142-3 is to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset under SFAS No. 141 (R), “Business Combinations” (“SFAS
141(R)”), and other accounting principles generally accepted in the USA. FSP FAS
142-3 applies to all intangible assets, whether acquired in a business
combination or otherwise and shall be effective for financial statements issued
for fiscal years beginning after December 15, 2008, and interim periods
within those fiscal years. The guidance for determining the useful life of
intangible assets shall be applied prospectively to intangible assets acquired
after the effective date. The disclosure requirements apply prospectively to all
intangible assets recognized as of, and subsequent to, the effective date. Early
adoption is prohibited. The adoption of FSP FAS 142-3 did not have a material
impact on the Company’s financial statements.
 
 Disclosures about Derivative
Instruments and Hedging Activities
 
 In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities an amendment of FASB Statement No. 133.”  This
Statement changes the disclosure requirements for derivative instruments and
hedging activities. Entities are required to provide enhanced disclosures about
(a) how and why an entity uses derivative instruments, (b) how
derivative instruments and related hedged items are accounted for under
Statement 133 and its related interpretations, and (c) how derivative
instruments and related hedged items affect an entity’s financial position,
financial performance, and cash flows. SFAS 161 is effective for fiscal
years, and interim periods within those fiscal years, beginning on or
after November 15, 2008. The adoption of SFAS 161 did not have a
material impact on the Company’s financial statements.
 
 Fair value of
measurements
  On
January 1, 2008, the Company adopted SFAS No. 157, “Fair Value
Measurements,” SFAS 157 defines fair value, establishes a three-level
valuation hierarchy for disclosures of fair value measurement and enhances
disclosures requirements for fair value measurements. The three levels are
defined as follow:
  ·
              Level 1 inputs to the valuation
      methodology are quoted prices (unadjusted) for identical assets or
      liabilities in active
markets.
 
 ·
              Level 2 inputs to the valuation
      methodology include quoted prices for similar assets and liabilities in
      active markets, and inputs that are observable for the asset or liability,
      either directly or indirectly, for substantially the full term of the
      financial instrument.
  27
  ·
              Level 3 inputs to the valuation
      methodology are unobservable and significant to the fair value
      measurement.
  As of
June 30, 2009, the Company did not identify any assets and liabilities that are
required to be presented on the balance sheet at fair value.
 
 Non-Controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No.
51
 
 In
December 2007, FASB issued SFAS No. 160, "Non-controlling Interests in
Consolidated Financial Statements - An Amendment of ARB No. 51." SFAS 160
establishes new accounting and reporting standards for the non-controlling
interest in a subsidiary and for the deconsolidation of a subsidiary.
Specifically, this statement requires the recognition of a non-controlling
interest (minority interest) as equity in the consolidated financial statements
and separate from the parent’s equity. The amount of net income attributable to
the non-controlling interest will be included in consolidated net income on the
face of the income statement. SFAS 160 clarifies that changes in a parent’s
ownership interest in a subsidiary that do not result in deconsolidation are
equity transactions if the parent retains its controlling financial interest. In
addition, this statement requires that a parent recognize a gain or loss in net
income when a subsidiary is deconsolidated. Such gain or loss will be measured
using the fair value of the non-controlling equity investment on the
deconsolidation date. SFAS 160 also includes expanded disclosure requirements
regarding the interests of the parent and its non-controlling interest. SFAS 160
is effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. The Company expects SFAS 160 will
have an impact on accounting for business combinations, but the effect is
dependent upon acquisitions at that time. The Company adopted the
provisions of SFAS 160 on January 1, 2009.
 
 Business
Combinations
  SFAS 141
(Revised 2007), Business Combinations (SFAS 141(R)), is effective for the
Company for business combinations for which the acquisition date is on or after
January 1, 2009. SFAS 141(R) changes how the acquisition method is applied in
accordance with SFAS 141. The primary revisions to this Statement require an
acquirer in a business combination to measure assets acquired, liabilities
assumed, and any noncontrolling interest in the acquiree at the acquisition
date, at their fair values as of that date, with limited exceptions specified in
the Statement. This Statement also requires the acquirer in a business
combination achieved in stages to recognize the identifiable assets and
liabilities, as well as the noncontrolling interest in the acquiree, at the full
amounts of their fair values (or other amounts determined in accordance with the
Statement). Assets acquired and liabilities assumed arising from contractual
contingencies as of the acquisition date are to be measured at their
acquisition-date fair values, and assets or liabilities arising from all other
contingencies as of the acquisition date are to be measured at their
acquisition-date fair value, only if it is more likely than not that they meet
the definition of an asset or a liability in FASB Concepts Statement No. 6,
Elements of Financial Statements. This Statement significantly amends other
Statements and authoritative guidance, including FASB Interpretation No. 4,
Applicability of FASB Statement No. 2 to Business Combinations Accounted for by
the Purchase Method, and now requires the capitalization of research and
development assets acquired in a business combination at their acquisition-date
fair values, separately from goodwill. FASB Statement No. 109, Accounting for
Income Taxes, was also amended by this Statement to require the acquirer to
recognize changes in the amount of its deferred tax benefits that are
recognizable because of a business combination either in income from continuing
operations in the period of the combination or directly in contributed capital,
depending on the circumstances. The Company expects SFAS 141R will have a
significant impact on accounting for business combinations, but the effect is
dependent upon acquisitions at that time. The Company adopted the
provisions of SFAS 160 on January 1, 2009.
  28
  Accounting for
Non-Refundable
Advance Payments for Goods or Services Received for Use in Future Research and
Development Activities
 
 In June
2007, FASB issued FASB Staff Position No. EITF 07-3, “Accounting for
Nonrefundable Advance Payments for Goods or Services Received for use in Future
Research and Development Activities,” which addresses whether non-refundable
advance payments for goods or services that used or rendered for research and
development activities should be expensed when the advance payment is made or
when the research and development activity has been performed. EITF 07-03
is effective for fiscal years beginning after December 15, 2008.  The
adoption of EITF 07-03 did not have a significant impact on the Company’s
financial statements.
 
 Results
of Operations
  Six
Months Ended June 30, 2009 Compared to the Six Months Ended June 30,
2008
  The
following table sets forth the results of our operations for the years indicated
as a percentage of net sales:
  For the Six Months Ended June 30,2009
                  
                  
                  2008$
                  
                  
                  % of Sales
                  
                  
                  $
                  
                  
                  % of SalesSales
                  
                  
                  18,705,898
                  
                  
                  
                  
                  
                  
                  8,637,283Cost
      of sales
                  
                  
                  11,874,903
                  
                  
                  
                  63.0
                  %
                  
                  
                  6,228,156
                  
                  
                  
                  72.0
                  %Gross
      Profit
                  
                  
                  6,830,995
                  
                  
                  
                  37.0
                  %
                  
                  
                  2,409,127
                  
                  
                  
                  28.0
                  %Operating
      Expenses
                  
                  
                  2,499,664
                  
                  
                  
                  13.0
                  %
                  
                  
                  1,054,498
                  
                  
                  
                  12.0
                  %Income
      from Operation
                  
                  
                  4,331,331
                  
                  
                  
                  23.0
                  %
                  
                  
                  1,354,629
                  
                  
                  
                  16.0
                  %Other
      Income (Expenses), net
                  
                  
                  (12,081
                  )
                  
                  
                  (0.1
                  )%
                  
                  
                  115,074
                  
                  
                  
                  1.0
                  %Net
      Income
                  
                  
                  3,638,818
                  
                  
                  
                  19.0
                  %
                  
                  
                  1,203,675
                  
                  
                  
                  14.0
                  %
  Sales. Net sales during
the six months ended June 30, 2009 were approximately $18.71 million, while our
net sales for the six months ended June 30, 2008 were approximately $8.64
million, an increase in revenues of $10.07 million, or 117%. The increase
in sales was attributable to an increase in our sales volume with selling price
determined based on our standard profit margin rate. We have a strict review
process for approving each sales contract, especially with respect to the
determination of selling price.  Sales price under each contract is
determined in proportion to our estimated cost in order to ensure our gross
profit.  Our selling price varies on each sale which mainly
depends on each customer’s specific needs and our negotiation of the contract
amount and term. During the six months ended June 30, 2009, we’ve recognized
$5.02 million revenue or 26% of the total revenue from the contracts that we’ve
previously signed; we have been continuously expanding the heat-supply market in
more regions as a result of the PRC government’s economy stimulus plan stressing
on increasing domestic infrastructure construction and our sales from the
traditional heat-supply industry was approximately $9.78 million or 51% of the
total sales.  We have also developed new customers in other industries
like chemical engineering, electric power, metal smelting, etc. which accounted
for $4.06 million or 21% of our total sales.   In addition, our sales on
heat meters have been increased to approximately $430,000 during the first six
months of 2009 from approximately $70,000 during the first six months of 2008.
  We believe that our sales will continue to grow because we are
strengthening our sales efforts by hiring more sales personnel, increasing the
sales channels, and improving the quality of our products.
  29
  Cost of
Sales.  Cost of sales for the six months ended June 30, 2009
was approximately $11.87 million, while our cost of sales for the same period in
2008 was approximately $6.23 million, an increase of $5.65 million, or
91%.  Cost of sales mainly consisted of the cost of materials and
labor, as well as factory overhead costs, with material costs accounting for 70%
or more of our total cost of sales.  The increase in cost of sales can
be attributed to the increase of production and sales volume in the first six
months of 2009.  Cost of sales as a percentage of sales was
approximately 63% for the first six months of 2009 and 72% for the same period
of 2008. The decrease in cost of sales as a percentage to the sales was mainly
due to decreased raw material cost, economy of scale on fixed costs as a result
of increased production, and our continuous improvement on control of the
manufacturing costs. We believe our cost of sales will remain stable as a result
of our current pricing strategy and the continued improvement in the efficiency
of our manufacturing facility.
  Gross
Profit.  Gross profit was $6.83 million for the six months
ended June 30, 2009, as compared to $2.41 million for the same period in 2008,
representing gross margins of approximately 37% and 28%,
respectively.  The increase in our gross profits and gross profit
margin was mainly due to the decrease of cost of goods sold as a percentage of
sales while the company’s sales activities increased.
  Operating
Expenses.  Operating expenses consisted of selling, general and
administrative expenses totaled approximately $2.50 million for the six months
ended June 30, 2009, as compared to $1.05 million for the six months ended June
30, 2008, an increase of approximately $1.45 million or 137%.  The
increase in operating expenses was mainly due to a proportional increase in
payroll, insurance, employee welfare and travel expenses with our increased
sales and production; as well as the increase in audit, legal, consulting and
filing expenses in connection with the Company of being public in US since April
of 2008.  In addition, a one-time charge of approximately
$110,000 occurred in the first quarter of 2009 as a result of failure to declare
the effectiveness of the Registration Statement within 180 days of the final
closing of the offering.
 
 Net Income.  Our
net income for the six months ended June 30, 2009 was $3.64 million as compared
to approximately $1.20 million for the same period in 2008, an increase of $2.44
million or 202%.  Net income as a percentage of sales increased from
14% in the first six months of 2008 to 19% in the same period of 2009. This
increase was attributable to economy of scale combined with rapid growth in
revenue and efficiency of operations, and lower income tax rate of 15% for Taiyu
effective January 1, 2009, down from 18% for 2008.  Our management
believes that net income will continue to increase as we continue to increase
our sales, offer better quality products and control our manufacturing
costs.
 
 Quarter
Ended June 30, 2009 Compared to the Quarter Ended June 30, 2008
  The
following table sets forth the results of our operations for the years indicated
as a percentage of net sales:
  For the Quarter Ended June 30,2009
                  
                  
                  2008$
                  
                  
                  % of Sales
                  
                  
                  $
                  
                  
                  % of SalesSales
                  
                  
                  12,498,395
                  
                  
                  
                  
                  
                  
                  5,558,232Cost
      of sales
                  
                  
                  7,973,956
                  
                  
                  
                  64.0
                  %
                  
                  
                  4,115,200
                  
                  
                  
                  74.0
                  %Gross
      Profit
                  
                  
                  4,524,439
                  
                  
                  
                  36.0
                  %
                  
                  
                  1,443,032
                  
                  
                  
                  26.0
                  %Operating
      Expenses
                  
                  
                  1,469,229
                  
                  
                  
                  12.0
                  %
                  
                  
                  572,932
                  
                  
                  
                  10.0
                  %Income
      from Operation
                  
                  
                  3,055,210
                  
                  
                  
                  24.0
                  %
                  
                  
                  870,100
                  
                  
                  
                  16.0
                  %Other
      Income (Expenses), net
                  
                  
                  25,170
                  
                  
                  
                  0.2
                  %
                  
                  
                  23,383
                  
                  
                  
                  0.4
                  %Net
      Income
                  
                  
                  2,617,549
                  
                  
                  
                  21.0
                  %
                  
                  
                  732,412
                  
                  
                  
                  13.0
                  %
  Sales. Net sales during
the three months ended June 30, 2009 were approximately $12.50 million, while
our net sales for the three months ended June 30, 2008 were approximately $5.56
million, an increase in revenues of $6.94 million, or 125%. The increase in
sales was attributable to an increase in our sales volume with selling price
determined based on our standard profit margin rate. We have a strict review
process for approving each sales contract, especially with respect to the
determination of selling price.  Sales price under each contract is
determined in proportion to our estimated cost in order to ensure our gross
profit. Our selling price varies on each sale which mainly depends on each
customer’s specific needs and our negotiation of the contract amount and
term.  The increase in our sales volume was mainly attributed to (1)
our continuous expansion in the heat-supply market in more regions as a
result of the PRC government’s economy stimulus plan stressing on increasing
domestic infrastructure construction, (2) development of new customers from
other industries like chemical engineering, electric power, metal smelting, etc.
(3) increase sales in heat meters. As we continue to expand our customer base
and increase our sales volume, we become less dependent on these customers for
revenue.  We believe that our sales will continue to grow because we
are strengthening our sales efforts by hiring more sales personnel, increasing
the sales channels, and improving the quality of our products.
  30
  Cost of
Sales.  Cost of sales for the three months ended June 30, 2009
was approximately $7.97 million  while our cost of sales for the same
period in 2008 was approximately $4.12 million, an increase of $3.86 million, or
94%.  Cost of sales mainly consisted of the cost of materials and
labor, as well as factory overhead costs, with material costs accounting for 70%
or more of our total cost of sales.  The increase in cost of sales can
be attributed to the increase of production and sales volume in the second
quarter of 2009.  Cost of sales as a percentage of sales was
approximately 64% for the second quarter of 2009 and 74% for the same period of
2008. The decrease in cost of sales as a percentage to the sales was mainly due
to decreased raw material cost, economy of scale on fixed costs as a result of
increased production, and our continuous improvement on control of the
manufacturing costs. We believe our cost of sales will remain stable as a result
of our current pricing strategy and the continued improvement in the efficiency
of our manufacturing facility.
  Gross
Profit.  Gross profit was $4.52 million for the three months
ended June 30, 2009, as compared to $1.44 million for the same period in 2008,
representing gross margins of approximately 36% and 26%,
respectively.  The increase in our gross profits and gross profit
margin was mainly due to the decrease of cost of goods sold as a percentage of
sales while the company’s sales activities increased.
  Operating
Expenses.  Operating expenses consisted of selling, general and
administrative expenses totaled approximately $1.47 million for the three months
ended June 30, 2009, as compared to $0.57 million for the three months ended
June 30, 2008, an increase of approximately $0.90 million or
156%.  The increase in operating expenses was mainly due to a
proportional increase in payroll, insurance, employee welfare and travel
expenses with our increased sales and production; as well as the increase in
audit, legal, consulting and filing expenses in connection with the Company of
being public in US since April of 2008.
  Net Income.  Our
net income for the three months ended June 30, 2009 was $2.62 million as
compared to approximately $0.73 million for the same period in 2008, an increase
of $1.89 million or 257%.  Net income as a percentage of sales
increased from 13% in the second quarter of 2008 to 21% in the same period of
2009. This increase was attributable to economy of scale combined with rapid
growth in revenue and efficiency of operations, and lower income tax rate of 15%
for Taiyu effective January 1, 2009, down from 18% for 2008.  Our
management believes that net income will continue to increase as we continue to
increase our sales, offer better quality products and control our manufacturing
costs.
 
 Liquidity
and Capital Resources
  Six
Months Ended June 30, 2009 Compared to the Six Months Ended June 30,
2008
 
 As of
June 30, 2009, we had cash and cash equivalents of approximately $2.41 million.
Working capital was approximately $7.84 million at June 30, 2009. The ratio
of current assets to current liabilities was 1.45:1 at June 30,
2009.
 
 The
following is a summary of cash provided by or used in each of the indicated
types of activities during the period ended June 30, 2009 and 2008:
  For the Six Months Ended June 30,2009
                  
                  
                  2008Cash
      provided by (used in):Operating
      Activities
                  
                  $
                  (130,563
                  )
                  
                  $
                  442,015Investing
      Activities
                  
                  
                  (513,840
                  )
                  
                  
                  (388,681
                  )Financing
      Activities
                  
                  
                  1,617,223
                  
                  
                  
                  (258,014
                  )
  Net cash
flow used in operating activities was $130,563 in the first six months of 2009,
as compared to net cash flow provided by operating activities of $442,015 in the
same period of 2008. The increase in net cash flow used in operating activities
during the first six months of 2009 was mainly due to increased payment in
advance to suppliers, other prepayments, deposits and purchase of inventory and
more income tax paid as our net income increased.  Our net income has
increased rapidly compared to the same period of 2008 along with the timely
collection of the accounts receivable, which brought about $1.35 million cash to
the Company, The significant amount in accounts receivable was due to the rapid
increase in our sales with most of our accounts receivables aging within one
year from the sales recognition date.
  31
  Net cash
flow used in investing activities was $513,840 in the first six months of 2009,
as compared to net cash used in investing activities of $388,681 in the same
period of 2008.  The increase of net cash flow used in investing
activities in the first six months of 2009 was mainly due to purchase of fixed
assets.
  Net cash
flow provided by financing activities was $1,617,223 in the first six months of
2009 as compared to net cash used in financing activities of $258,014 in the
same period of 2008.  The increase of cash inflow was mainly due to
proceeds from the new bank loans of $3.12 million less the partial payment $1.51
million made for the assets purchased from Siping Beifang Heat Exchanger
Manufacture Co.,Ltd in June of
2009.
  Our sales
contracts with our customers generally provide that 30% of the purchase price is
due upon the placement of an order, 30% is due on delivery and 30% is due upon
installation and acceptance of the equipment after customer testing. As a common
practice in the heating manufacturing business in China, payment is due on
the final 10% of the purchase price no later than the termination date of the
standard warranty period which ranges from 3 to 24 months from the acceptance
date of the products. Our receipts for payment on our products depend on the
complexity of the equipment ordered which impacts manufacturing, delivery,
installation and testing times and warranty periods.  For example,
PHEs are less complex than PHE units and therefore have a shorter manufacturing,
acceptance, warranty and payment schedule. We may experience payment delays from
time to time with a range from 1 month to 3 months from the due date; however,
we do not believe the delays have significant negative impact on our liquidity
as the payment delays are very common in heating manufacturing industry in
China, and the collection of payment can be reasonably assured based on our
historical collection experience.   Our accounts receivable
turnover and inventory turnover are relatively low, and days sales outstanding
ratio relatively high. Consequently, collection on our sales is rather slow and
capital is tied up in inventories which may result in pressure on cash flows.
For the first six months of 2009, we had accounts receivable turnover of 3.16 on
annualized basis, with days sales outstanding of 111 and inventory turnover of
3.31 on annualized basis.  For the first six months of 2008, we had
accounts receivable turnover of 2.46 on annualized basis, with days sales
outstanding of 168 and inventory turnover of 1.86 on annualized
basis. The low accounts receivable turnover and high days outstanding is
due to relatively longer terms for payment collection in the heating
manufacturing business in China.
  We are in
the manufacturing and processing business.  We purchase substantial
amounts of raw materials before the high season starts to meet production
needs.  There is no concern about inventory obsolescence since our
product can be sold for a profit without time limitation as long as there is
continued demand.  Additionally, we have increased our sales force for
developing new customers, which we believe will reduce on-hand inventory levels
and increase inventory turnover going forward.  Therefore, we believe
the potential risks and uncertainties associated with lower inventory turnover
are limited.
 
 We
recognize the final 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 assembled heat exchanger
unit and main part of plate heat exchanger into designated bank accounts as
restricted cash for securing the payment after such period
expires.  Based on our historical experience, there have been no
defaults on such deferrals.  Therefore, we believe the potential risks
and uncertainty associated with defaults on such receivables are not
material.
 
 Recent
Developments
 
 Under the
terms of the Registration Rights Agreement, the Company is required to file a
Registration Statement registering the common stock and common stock underlying
the warrants with the Securities and Exchange Commission (the “SEC”) within 60
days of the closing of the private placement offering. The Registration
Statement must be declared effective by the SEC within 180 days of the final
closing of the offering or the Company will be subject to penalties as described
below. Subject to certain grace periods, the Registration Statement must remain
effective and available for use until the investors can sell all of the
securities covered by the Registration Statement without restriction pursuant to
Rule 144. If the Company fails to meet the filing or effectiveness requirements
of the Registration Statement, it is required to pay liquidated damages of 2% of
the aggregate purchase price paid by such investor for any Registrable
Securities then held by such investor on the date of such failure and on each
anniversary of the date of such failure until such failure is
cured.
  32
  The
closing the private placement occurred on September 24, 2008. The Company was
obligated to cause the Registration Statement become effective on or before
March 23, 2009.  As a result of its failure to have a registration
statement effective on this date, the Company is liable to pay approximately
$110,000 liquidated damages to investors in the private placement. The
Company expects to pay liquidated damages from its working
capital.  The Registration Statement became effective on June 23,
2009.
  Off-Balance
Sheet Arrangements
 
 We have
not entered into any other financial guarantees or other commitments to
guarantee the payment obligations of any third parties.  We have not
entered into any derivative contracts that are indexed to our shares and
classified as shareholder’s equity or that are not reflected in our consolidated
financial statements.  Furthermore, we do not have any retained or
contingent interest in assets transferred to an unconsolidated entity that
serves as credit, liquidity or market risk support to such entity.  We
do not have any variable interest in any unconsolidated entity that provides
financing, liquidity, market risk or credit support to us or engages in leasing,
hedging or research and development services with us.
  Contractual
Obligations
 
 The
Company was obligated for the following short term loans payable as of June 30,
2009 and December 31, 2008:
 
 June 30, 2009
                      
                      
                      December 31, 2008Loans
      from a commercial bank in the PRC for 30,000,000 RMB. Of which, 17,000,000
      RMB was entered into on April 22, 2009 and is due on April 22, 2010.
      13,000,000 RMB was entered into on June 12, 2009 and is due on June 12,
      2010. These loans currently bear interest at 5.576%.  The
      Company pledged its building in the value of approximately RMB 12,430,950
      or approximately $1,818,000 for this loan.
                      
                      $
                      4,391,165
                      
                      
                      $
                      -Loan
      from a commercial bank in the PRC for 6,000,000 RMB. This loan was entered
      into on Apr 28, 2007 and was due on Apr 12, 2008. This loan was renewed on
      Apr 12, 2008 with new maturity date on June 13, 2009. This loan currently
      bears interest at 7.159%.  The Company pledged its building in
      the value of approximately RMB 12,430,950 or approximately $1,818,000 for
      this loan.  The Company repaid loan in April,
    2009.
                      
                      
                      -
                      
                      
                      
                      877,886The
      Company entered into a series of short term loans during 2006 and 2007
      with a third party company in the PRC for total of 10, 300,000 RMB. Some
      of the loans matured on various dates in 2008 and some of the loans are
      payable on demand. These loans bear variable interest at 8.591% for 2009
      and 2008.  The Company repaid RMB 2,600,000 in 2008, RMB
      2,700,000 in April, 2009, and had RMB 5,000,000 outstanding as of June 30,
      2009, due on December 31, 2009 with interest of 8.591%.
                      
                      
                      731,861
                      
                      
                      
                      1,126,621The
      Company entered into a one year loan on July 1, 2008 with another third
      party company in the PRC for total of 3,000,000 RMB. This loan is renewed
      anddue on December 31, 2009 with interest of
    8.591%.
                      
                      
                      439,116
                      
                      
                      
                      438,943$
                      5,562,142
                      
                      
                      $
                      2,443,450
  33




Item 3. Quantitative and Qualitative
Disclosures About Market Risk




Not
required




Item
4T. Controls and Procedures




Disclosure
Controls and Procedures




An
evaluation was conducted under the supervision and with the participation of the
Company’s management, including the Chief Executive Officer (“CEO”), its
principal executive officer, and Chief Financial Officer (“CFO”), its principal
financial officer, of the effectiveness of the design and operation of the
Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and
Rule 15d-15(e) of the Exchange Act) as of June 30, 2009. Based on that
evaluation, the CEO and CFO concluded that the Company’s disclosure controls and
procedures were effective as of such date to ensure that information required to
be disclosed in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission rules and forms.





Disclosure
controls and procedures include, without limitation, controls and procedures
designed to ensure that information required to be disclosed by the Company in
the reports that it files or submits under the Exchange Act is accumulated and
communicated to the Company's management, including its principal executive and
principal financial officers, or persons performing similar functions, as
appropriate to allow timely decisions regarding required
disclosure.




Changes
in Internal Controls Over Financial Reporting




There
were no changes in our internal control over financial reporting (as such term
is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during
the quarter ended June 30, 2009 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting.





Part II. OTHER INFORMATION




Item 1. Legal Proceedings




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


34


Item 1A. Risk Factors





Our
common stock price is subject to significant volatility, which could result in
substantial losses for investors.





During
the nine month period ended January 28, 2009, the high and low bid prices of our
common stock on the Over-The-Counter Bulletin Board ("OTCBB") were $6.50 per
share and $2.00 per share, respectively. We began trading on the Nasdaq Stock
Market on January 29, 2009 and were subsequently listed on the Nasdaq Global
Market on March 10, 2009. The high and low sales prices of our common stock were
$8.00 and $4.11, from January 29, 2009 to August 7, 2009.  Prices for
our shares are determined in the marketplace and may accordingly be influenced
by many factors, including, but not limited to:




·
              the
      depth and liquidity of the market for the
  shares;
  ·
              quarter-to-quarter
      variations in our operating
results;
 
 ·
              announcements
      about our performance as well as the announcements of our competitors
      about the performance of their
businesses;
 
 ·
              investors'
      evaluations of our future prospects and the food industry
      generally,
 
 ·
              changes
      in earnings estimates by, or failure to meet the expectations of,
      securities analysts;
 
 ·
              our
      dividend policy; and
 
 ·
              general
      economic and market
conditions.
  In
addition, the stock market often experiences significant price fluctuations that
are unrelated to the operating performance of the specific companies whose stock
is traded. These market fluctuations could adversely affect the trading price of
our shares.




The price
at which investors purchase shares of our common stock may not be indicative of
the price that will prevail in the trading market. Investors may be unable to
sell their shares of common stock at or above their purchase price, which may
result in substantial losses.







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




On July
7, 2008, the Company completed a closing of a private placement offering (the
"Offering") of Units pursuant to which SmartHeat sold an aggregate of 1,620,000
Units at an offering price of $3.50 per Unit for aggregate gross proceeds of
approximately $5.67 million. An additional 10,000 Units was sold in a second
closing of the Offering on August 12, 2008 for aggregate gross proceeds of
approximately $35,000. Each "Unit" consists of one share of SmartHeat's common
stock and a three year warrant to purchase 15% of one share of common stock at
an exercise price of $6.00 per share. The Units sold represent an aggregate of
1,630,000 million shares of common stock and warrants to purchase 244,500 shares
of Common Stock. The warrants are immediately exercisable and expire on the
third anniversary of their issuance. In connection with the Offering, the
Company paid commissions and fees approximately $340,000 and issued warrants to
purchase 148,500 shares of common stock. The proceeds from the sale of the Units
in the Offering were used for general corporate purposes.





Item 3. Defaults Upon Senior
Securities




None.




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




None.




Item 5. Other Information




None.


35


Item 6. Exhibits





Exhibit No.
            
            Document
      Description31.1
            
            Certification
      of Chief Executive Officer pursuant to Rule 13a-15(e) and 15d-15(e),
      promulgated under the Securities and Exchange Act of 1934, as
      amended.31.2
            
            Certification
      of Chief Financial Officer pursuant to Rule13a-15(e) and 15d-15(e),
      promulgated under the Securities and Exchange Act of 1934, as
      amended.32.1
            
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      theSarbanes-Oxley
      Act of 2002 (Chief Executive Officer).32.2
            
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      theSarbanes-Oxley
      Act of 2002 (Chief Financial
Officer).





SIGNATURES





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




SMARTHEAT
      INC.
                (Registrant)By:
              /s/ Jun
      WangAugust
      10, 2009
              
              Jun
      Wang
                President
      and Chief Executive Officer(Principle Executive
      Officer)By:
              /s/ Zhijuan
      GuoAugust
      10, 2009
              
              Zhijuan
      Guo
                Chief
      Financial Officer
                (Principal
      Financial and Accounting
Officer)




36





EXHIBIT
INDEX





Exhibit No.
              
              Document
      Description31.1
              
              Certification
      of Chief Executive Officer pursuant to Rule 13a-15(e) and 15d-15(e),
      promulgated under the Securities and Exchange Act of 1934, as
      amended.31.2
              
              Certification
      of Chief Financial Officer pursuant to Rule13a-15(e) and 15d-15(e),
      promulgated under the Securities and Exchange Act of 1934, as
      amended.32.1
              
              Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Executive
  Officer).32.2
              
              Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Financial
  Officer).


37