**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**





**x**
            **QUARTERLY
                REPORT UNDER TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                OF
                1934****FOR
                THE QUARTERLY PERIOD ENDED JUNE 30, 2008****OR****o**
            **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.


**YES
      **x**
      NO
**o****





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





**Large
                accelerated filer o**
            **Accelerated
                filer****o****Non-accelerated
                filero**
            **Smaller
              reporting company x**(do
                not check if a smallerreporting
                company)





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


**YES
      o NO x**





State
      the
      number of shares outstanding of each of the issuer’s classes of common equity,
      as of the latest practicable date: 22,549,900 shares as of August 7,
      2008.










**TABLE
      OF CONTENTS**


PART
                I - FINANCIAL INFORMATION
              
              1Item
                  1.
              Financial
                  Statements
              
              1Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              15Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market Risk
              
              23Item
                  4.
              Controls
                  and Procedures
              
              23Item
                  1.
              Legal
                  Proceedings
              
              24Item
                  1A.
              Risk
                  Factors
              
              24Item
                  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
              
              35SIGNATURES
              
              36








**SMARTHEAT
      INC. AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**




**PART
      I - FINANCIAL INFORMATION**




**Item
      1.**  **Financial
      Statements**


AS
                  OF
                JUNE
                  30,
                2008
              
              AS
                  OF
                DECEMBER
                31,
                  2007(Unaudited)**ASSETS**CURRENT
                  ASSETSCash
                  & cash equivalents
              
              $
              207,495
              
              $
              393,147Restricted
                  cash
              
              
              807,709
              
              
              537,098Accounts
                  receivable, net
              
              
              7,954,078
              
              
              4,762,822Retentions
                  receivable
              
              
              26,552
              
              
              191,319Advances
                  to suppliers
              
              
              2,111,461
              
              
              158,750Other
                  receivables
              
              
              1,100,950
              
              
              766,231Inventories
              
              
              5,474,046
              
              
              7,928,408Due
                  from related party
              
              
              224,710
              
              
              118,560Total
                  current assets
              
              
              17,907,001
              
              
              14,856,335NON-CURRENT
                  ASSETSProperty
                  and equipment, net
              
              
              2,133,803
              
              
              2,040,809Construction
                  in progress
              
              
              40,696
              
              
              -Accounts
                  receivable, net
              
              
              -
              
              
              949,998Retentions
                  receivable
              
              
              -
              
              
              169,309Intangible
                  assets, net
              
              
              620,801
              
              
              534,208Total
                  noncurrent assets
              
              
              2,795,300
              
              
              3,694,324TOTAL
                  ASSETS
              
              **$**
              **20,702,301**
              
              **$**
              **18,550,659****LIABILITIES
                  AND STOCKHOLDERS' EQUITY**CURRENT
                  LIABILITIESAccounts
                  payable
              
              $
              4,724,904
              
              $
              3,128,585Unearned
                  revenue
              
              
              1,565,208
              
              
              3,125,406Tax
                  payable
              
              
              362,121
              
              
              503,010Other
                  payables
              
              
              1,294,697
              
              
              807,700Due
                  to related party
              
              
              526,772
              
              
              445,990Loans
                  payable
              
              
              4,693,917
              
              
              4,619,856Total
                  current liabilities
              
              
              13,167,619
              
              
              12,630,547COMMITMENTS
                  AND CONTINGENCIESMINORITY
                  INTEREST
              
              
              -
              
              
              -STOCKHOLDERS'
                  EQUITYCommon
                  stock, $0.001 par value; 75,000,000shares
                  authorized, 22,549,900 and 18,500,000shares
                  issued and outstanding at June 30, 2008and
                  December 31, 2007, respectively
              
              
              22,550
              
              
              18,500Paid
                  in capital
              
              
              3,098,082
              
              
              3,102,132Statutory
                  reserve
              
              
              627,722
              
              
              506,532Accumulated
                  other comprehensive income
              
              
              884,755
              
              
              473,859Retained
                  earnings
              
              
              2,901,573
              
              
              1,819,089Total
                  stockholders' equity
              
              
              7,534,682
              
              
              5,920,112TOTAL
                  LIABILITIES AND STOCKHOLDERS' EQUITY
              
              **$**
              **20,702,301**
              
              **$**
              **18,550,659**




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,****2008**
                
                **2007**
                
                **2008**
                
                **2007**Net
                    sales
                
                $
                8,637,283
                
                $
                2,457,967
                
                $
                5,558,232
                
                $
                1,159,098Cost
                    of goods sold
                
                
                6,228,156
                
                
                1,598,789
                
                
                4,115,200
                
                
                756,368Gross
                    profit
                
                
                2,409,127
                
                
                859,178
                
                
                1,443,032
                
                
                402,730Operating
                    expensesSelling
                    expenses
                
                
                608,028
                
                
                484,893
                
                
                410,607
                
                
                267,682General
                    and administrative expenses
                
                
                446,470
                
                
                298,842
                
                
                162,325
                
                
                141,397Total
                    operating expenses
                
                
                1,054,498
                
                
                783,735
                
                
                572,932
                
                
                409,079Income
                    (loss) from operations
                
                
                1,354,629
                
                
                75,443
                
                
                870,100
                
                
                (6,349
                )Non-operating
                    income (expenses)Interest
                    income
                
                
                260,683
                
                
                164,421
                
                
                113,545
                
                
                95,396Interest
                    expense
                
                
                (163,040
                )
                
                (87,966
                )
                
                (96,412
                )
                
                (57,854
                )Other
                    income
                
                
                8,290
                
                
                12,000
                
                
                6,116
                
                
                10,923Subsidy
                    income
                
                
                9,141
                
                
                51,830
                
                
                134
                
                
                272Total
                    non-operating income
                
                
                115,074
                
                
                140,285
                
                
                23,383
                
                
                48,737Income
                    before income tax
                
                
                1,469,703
                
                
                215,728
                
                
                893,483
                
                
                42,388Income
                    tax expense
                
                
                266,028
                
                
                52,486
                
                
                161,071
                
                
                39,178Income
                    after income tax
                
                
                1,203,675
                
                
                163,242
                
                
                732,412
                
                
                3,210Less:
                    minority interest
                
                
                -
                
                
                (1,846
                )
                
                -
                
                
                (9
                )Net
                    income
                
                
                1,203,675
                
                
                165,088
                
                
                732,412
                
                
                3,219Other
                    comprehensive itemForeign
                    currency translation
                
                
                410,896
                
                
                77,254
                
                
                168,802
                
                
                39,842Comprehensive
                    Income
                
                $
                1,614,571
                
                $
                242,342
                
                $
                901,214
                
                $
                43,061Basic
                    and diluted weighted average shares outstanding
                
                
                20,213,419
                
                
                18,500,000
                
                
                21,926,838
                
                
                18,500,000Basic
                    and diluted earnings per share
                
                $
                0.06
                
                $
                0.01
                
                $
                0.03
                
                $
                0.00




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,****2008**
              
              **2007**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  income
              
              $
              1,203,675
              
              $
              165,088Adjustments
                  to reconcile net income to net cashprovided
                  by operating activities:Depreciation
                  and amortization
              
              
              104,038
              
              
              46,166Unearned
                  interest on accounts receivable
              
              
              (22,366
              )
              
              (117,709
              )Minority
                  interest
              
              
              -
              
              
              (1,846
              )(Increase)
                  decrease in current assets:Accounts
                  receivable
              
              
              (1,803,120
              )
              
              3,199,540Retentions
                  receivable
              
              
              346,914
              
              
              (1,695,964
              )Advances
                  to suppliers
              
              
              (1,888,198
              )
              
              (317,223
              )Other
                  receivables
              
              
              (277,990
              )
              
              (146,098
              )Inventory
              
              
              2,874,481
              
              
              (1,066,714
              )Increase
                  (decrease) in current liabilities:Accounts
                  payable
              
              
              1,358,223
              
              
              579,464Unearned
                  revenue
              
              
              (1,709,100
              )
              
              339,079Tax
                  payable
              
              
              (167,960
              )
              
              (297,687
              )Other
                  payables
              
              
              423,418
              
              
              312,857Net
                  cash provided by provided by operating activities
              
              
              442,015
              
              
              998,953CASH
                  FLOWS FROM INVESTING ACTIVITIES:Restricted
                  cash
              
              
              (229,833
              )
              
              (787,349
              )Acquisition
                  of property & equipment
              
              
              (119,299
              )
              
              (20,517
              )Construction
                  in progress
              
              
              (39,549
              )
              
              (272,577
              )Net
                  cash used in investing activities
              
              
              (388,681
              )
              
              (1,080,443
              )CASH
                  FLOWS FROM FINANCING ACTIVITIES:Due
                  from / (to) shareholder
              
              
              (44,862
              )
              
              (58,055
              )Short
                  term loan
              
              
              (213,152
              )
              
              1,373,484Net
                  cash (used in) provided by financing activities
              
              
              (258,014
              )
              
              1,315,429EFFECT
                  OF EXCHANGE RATE CHANGE ON CASH & CASH EQUIVALENTS
              
              
              19,028
              
              
              22,221NET
                  INCREASE (DECREASE) IN CASH & CASH EQUIVALENTS
              
              
              (185,652
              )
              
              1,256,160CASH
                  & CASH EQUIVALENTS, BEGINNING OF PERIOD
              
              
              393,147
              
              
              202,295CASH
                  & CASH EQUIVALENTS, END OF PERIOD
              
              $
              207,495
              
              $
              1,458,455Supplemental
                  Cash flow data:Income
                  tax paid
              
              $
              197,756
              
              $
              86,544Interest
                  paid
              
              $
              87,887
              
              $
              53,909
  The
          accompanying notes are an integral part of these consolidated financial
          statements


3


**SMARTHEAT
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**JUNE
      30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


**1.
      ORGANIZATION AND DESCRIPTION OF BUSINESS**





SmartHeat
      Inc., formerly known as Pacific Goldrim Resources, Inc. (the “Company” or
“SmartHeat”), was incorporated on August 4, 2006 in the State of Nevada. The
      Company is engaged in the manufacturing and sale of plate heat exchangers and
      various packages, thermo meter testing devices and heat usage calculators
      through its wholly owned operating subsidiary in China.





On
      April
      14, 2008, the Company entered into a Share Exchange Agreement with Shenyang
      Taiyu Machinery and Electronic Equipment Co., Ltd. ("Taiyu") and the Taiyu
      Shareholders. The Company issued 18,500,000 shares of its common stock to the
      shareholder of Taiyu in exchange for all of the equitable and legal rights,
      title and interests in and to Taiyu's share capital in the amount of RMB
      25,000,000. Concurrent with the share exchange, one of SmartHeat’s shareholders
      cancelled 2,500,000 shares out of 6,549,900 of total issued and outstanding
      shares of SmartHeat pursuant to the Split-Off Agreement dated Aril 14, 2008.
      As
      a result of the share exchange and the cancellation of the 2,500,000 shares
      of
      the Company's common stock, there are 22,549,900 shares of the Company's common
      stock issued and outstanding, approximately 82.04% of which are held by the
      former Taiyu Shareholders.  The shareholders of the Company
      immediately prior to the completion of these transactions hold the remaining
      17.96% of the issued and outstanding share capital of SmartHeat. Taiyu became
      a
      wholly-owned subsidiary of SmartHeat.





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





Taiyu
      was
      incorporated in the Liaoning Province, People’s Republic of China (“PRC” or
      "China") in July, 2002. Taiyu is engaged in the manufacturing and sale of plate
      heat exchangers and various packages, thermo meter testing devices and heat
      usage calculators. The Company is an authorized dealer of the SONDEX brand;
      SONDEX is the second largest plate heat exchanger manufacturer in the
      world.





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 have been omitted pursuant to such rules and
      regulations. These financial statements should be read in conjunction with
      the 2007 audited financial statements and footnotes included in the
      Company’s audited financial statements.  The results for the six
      months ended June 30, 2008 are not necessarily indicative of the results to
      be
      expected for the full year ending December 31, 2008.





**2.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**




**Principles
      of Consolidation**





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





**Use
      of Estimates**





In
      preparing the financial statements in conformity with accounting principles
      generally accepted in the United States of America, management makes estimates
      and assumptions that affect the reported amounts of assets and liabilities
      and
      disclosures of contingent assets and liabilities at the dates of the financial
      statements, as well as the reported amounts of revenues and expenses during
      the
      reporting year. Significant estimates, required by management, include the
      recoverability of long-lived assets and the valuation of inventories. Actual
      results could differ from those estimates.




4


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


**Cash
      and Cash Equivalents**





For
      purposes of the statement of cash flows, the Company considers all highly liquid
      investments with an original maturity of three months or less to be cash
      equivalents. As of June 30, 2008 and December 31, 2007, the Company maintained
      restricted cash of $807,709 and $537,098, respectively, in several bank
      accounts, which was pledged for the guarantee of certain contracts execution
      and
      completion.





**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 $351,507 and $330,518 at June 30, 2008
      and December 31, 2007, respectively.





At
      June
      30, 2008 and December 31, 2007, the Company had retentions receivable from
      customers for product quality assurance in the amount of $26,552 and $360,628,
      respectively. The retention rate varies from 5% to 20% of the sales price with
      variable terms from 3 months to two years.





Accounts
      receivable is net of unearned interest of $134,831 and $148,421 at June 30,
      2008
      and December 31, 2007, respectively. Unearned interest represents imputed
      interest on accounts receivable with due dates over one year from the invoice
      date discounted at the Company's borrowing rate which was 7.04 % in 2008 and
      2007.





**Inventories**





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




**Property
      and Equipment**





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





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





**Land
      Use Right**




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




5


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


**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, 2008 and December
      31, 2007, there were no significant impairments of its long-lived
      assets.




**Income
      Taxes**





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





The
      Company does not have any significant deferred tax asset or liability that
      relates to tax jurisdictions not covered by the tax holiday.





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





Interest
      associated with unrecognized tax benefits is classified as interest expense
      and
      penalties are classified as selling, general and administrative expense in
      the
      statements of income. The adoption of FIN 48 did not have a material impact
      on
      the Company’s financial statements.





**Revenue
      Recognition**





The
      Company's revenue recognition policies are in compliance with SEC Staff
      Accounting Bulletin 104. Sales revenue is recognized at the date of shipment
      to
      customers when a formal arrangement exists, the price is fixed or determinable,
      the delivery is completed, 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.




6


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


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 and three months ended June
      30,
      2008 and 2007. The Company does not provide unconditional right of return,
      price
      protection or any other concessions to its customers. The Company provides
      free
      after-sale service for a period of one year. After-sale expense was $32,323
      and
      $46,997 for the six months ended June 30, 2008 and 2007 and $8,126 and $26,127
      for the three months ended June 30, 2008 and 2007, respectively.





**Cost
      of Goods Sold**




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





**Concentration
      of Credit Risk**





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





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





**Statement
      of Cash Flows**





In
      accordance with SFAS No. 95, “Statement of Cash Flows,” cash flows from the
      Company's operations is 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.





**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.





**Fair
      Value of Financial Instruments**





SFAS
      No.
      107, “Disclosures about Fair Value of Financial Instruments,” requires that 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.




7


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


**Foreign
      Currency Translation and Comprehensive Income (Loss)**




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





The
      Company uses SFAS No. 130, “Reporting Comprehensive Income.” Comprehensive
      income is comprised of net income and all changes to the statements of
      shareholders’ equity, except those due to investments by shareholders, changes
      in paid-in capital and distributions to shareholders.





**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.





**New
      Accounting Pronouncements**





**The
      Hierarchy of Generally Accepted Accounting Principles**





In
      May
      2008, the 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 will not have an 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 .” 
      SFAS 161 changes the disclosure requirements for derivative instruments and
      hedging activities. Entities are required to provide enhanced disclosures about
      (a) how and why an entity uses derivative instruments, (b) how derivative
      instruments and related hedged items are accounted for under Statement 133
      and
      its related interpretations, and (c) how derivative instruments and related
      hedged items affect an entity’s financial position, financial performance, and
      cash flows.  Based on current conditions, the Company does not expect the
      adoption of SFAS 161 to have a significant impact on its results of operations
      or financial position.




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





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




8


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


**Business
      Combinations**




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





·
            Acquisition
                costs will be generally expensed as
                incurred;




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




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




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




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




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





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





**Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans, an
      Amendment of FASB Statements No. 87, 88, 106, and 132R**




In
      September 2006, the FASB, issued SFAS, No. 158, “Employers’ Accounting for
      Defined Benefit Pension and Other Postretirement Plans, an Amendment of FASB
      Statements No. 87, 88, 106, and 132R,” which requires employers to recognize the
      underfunded or overfunded status of a defined benefit postretirement plan as
      an
      asset or liability in its statement of financial position and to recognize
      changes in the funded status in the year in which the changes occur through
      accumulated other comprehensive income. Additionally, SFAS 158 requires
      employers to measure the funded status of a plan as of the date of its year-end
      statement of financial position. The new reporting requirements and related
      new
      footnote disclosure rules of SFAS 158 are effective for fiscal years ending
      after December 15, 2006. The Company adopted the provisions of SFAS 158 for
      the
      year end 2006, and the effect of recognizing the funded status in accumulated
      other comprehensive income was not significant. The new measurement date
      requirement applies for fiscal years ending after December 15,
      2008.





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





In
      June
      2007, the 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.  Management is currently evaluating the effect of this
      pronouncement on our financial statements.




9





**3.
      INVENTORIES**





Inventories
      at June 30, 2008 and December 31, 2007 were as follows:





June
                30,
              2008
            
            December
                31,
              2007Raw
                materials
            
            $
            4,729,093
            
            $
            3,865,575Work
                in process
            
            
            486,057
            
            
            48,627Finished
                Goods
            
            
            258,896
            
            
            4,014,206Total
            
            $
            5,474,046
            
            $
            7,928,408




**4.
      PROPERTY AND EQUIPMENT, NET**





Property
      and equipment consisted of the following at June 30, 2008 and December 31,
      2007:





June
                30,
              2008
            
            December
                31,
              2007Building
            
            $
            1,727,829
            
            $
            1,624,651Production
                equipment
            
            
            324,360
            
            
            298,242Office
                equipment
            
            
            202,132
            
            
            156,368Vehicles
            
            
            143,280
            
            
            134,7242,397,601
            
            
            2,213,985Less:
                Accumulated depreciation
            
            
            (263,798
            )
            
            (173,176
            )$
            2,133,803
            
            $
            2,040,809





Depreciation
      expense for the six months ended June 30, 2008 and 2007 was $77,379 and $29,308;
      $39,420 and $15,039 for the three months ended June 30, 2008 and 2007,
      respectively.





**5.
      CONSTRUCTION IN PROGRESS**





The
      Company is in the process of constructing a warehouse for storage of the
      inventory. Total construction cost is about $48,000. At June 30, 2008, the
      Company had paid $40,696 for the construction.





**6.
      OTHER RECEIVABLES**





Other
      receivables consisted of cash advances to vendors, prepayment and deposits
      for
      freight insurance expense, guarantee deposits for public bidding, and cash
      advances to employees for normal business purposes such as travel expenses.




**7.
      RELATED PARTY TRANSACTIONS**




**Due
      from Related Party**





Due
      from
      related party consisted of purchase deposits and a short term advance to one
      of
      the Company’s shareholders of $224,710 and $118,560 at June 30, 2008 and
      December 31, 2007, respectively.





**Due
      to Related Party**





Due
      to
      related party represented an advance from the same shareholder with a variable
      interest rate tied to the bank interest rate (8.591% at June 30, 2008 and 6.903%
      per annum as of December 31, 2007); principal and interest are payable on
      demand. At June 30, 2008 and December 31, 2007, the amount due to this
      shareholder was $526,772 and $445,990, respectively. For the six months ended
      June 30, 2008 and 2007, respectively, the Company recorded interest expense
      to
      this shareholder of $5,903 and $28,167; and for the three months ended June,
      30,
      2008 and 2007, respectively, the Company recorded interest expense to this
      shareholder of $2,995 and $14,157.




10


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


**8.
      INTANGIBLE ASSETS**





Intangible
      assets mainly consisted of land use rights and computer software. All land
      in
      the PRC is government owned and cannot be sold to any individual or company.
      However, the government grants the user a “land use right” to use the land. The
      Company acquired land use rights during 2005 for $439,850 (RMB 3,549,682).
      The
      Company has the right to use the land for 50 years and is amortizing such rights
      on a straight-line basis for 50 years. Intangible assets consisted of following
      at June 30, 2008 and December 31, 2007:





June
                30,
              2008
            
            December
              31,
                2007Land
                use right
            
            $
            517,522
            
            $
            486,618Software
            
            
            175,696
            
            
            140,476693,218
            
            
            627,094Less:
                accumulated amortization
            
            
            (72,417
            )
            
            (92,886
            )$
            620,801
            
            $
            534,208




Amortization
      expense for the six months ended June 30, 2008 and 2007 were $26,320 and
      $10,896, $16,185 and $5,477 for the three months ended June 30, 2008 and 2007,
      respectively. Annual amortization expense for the next five years is expected
      to
      be as follows: $41,000, $41,000, $41,000, $11,000 and $11,000.





**9** . **MAJOR
      CUSTOMERS**  **AND
      VENDORS**





One
      major
      customer accounted for 19% and 28% of the Company’s net revenue for the six
      months ended June 30, 2008 and 2007, respectively. One major customer accounted
      for 12% and four major customers accounted for 53% of the Company’s revenue for
      the three months ended June 30, 2008 and 2007, respectively. At June 30, 2008,
      the total receivable balance due from this customer was $1,754,049.





Two
      major
      vendors provided 44% and one major vendor provided 20% of the Company’s
      purchases of raw materials for the six months ended June 30, 2008 and 2007,
      respectively. Two major vendors provided 27% and one major vendor provided
      68%
      of the Company’s purchases of raw materials for the three months ended June 30,
      2008 and 2007, respectively. For the six months ended June 30, 2008, each
      customer accounted for about 10% each of the total purchases. At June 30, 2008,
      total payable to these two major vendors was $690,395.





**10.
      TAX PAYABLE**





Tax
      payable consisted of the following at June 30, 2008 and December 31, 2007:





June
                30,
              2008
            
            December
                31,
              2007Income
                tax payable
            
            $
            149,995
            
            $
            74,981Value
                added tax payable
            
            
            227,569
            
            
            421,009Other
                taxes payable (receivable)
            
            
            (15,443
            )
            
            7,020$
            362,121
            
            $
            503,010





**11.
      OTHER PAYABLES**





Other
      payables mainly consisted of short term, non interest bearing advances from
      third parties and payables for the Company’s miscellaneous expenses.




11


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**


**12.
      LOANS PAYABLE - SHORT TERM**





The
      Company is obligated for the following short term loans payable as of June
      30,
      2008 and December 31, 2007:





Balance
                at
              June
                30,
              2008
            
            Balance
                at
              December
                31,
              2007Short
                term loan with a commercial bank in the PRC for 6,000,000 RMB, or
                $822,526. This loan was entered into on Apr 28, 2007 and is due on
                Apr 12,
                2008. This loan bears interest at 7.029% per annum. This loan was
                renewed
                on Apr 12, 2008 with new maturity date of June 13, 2009.
            
            $
            874,763
            
            $
            822,526Short
                term loan with a foreign commercial bank with branch in the PRC for
                10,200,000 RMB, or $1,398,295. This loan was entered into on Jun
                25, 2007
                and is due on Jun 24, 2008. This loan bears interest at 5.265% per
                annum.
                This loan was repaid in June 2008.
            
            
            —
            
            
            1,302,333The
                Company entered into a series of short term loans during 2006 and
                2007
                with a third party company in the PRC for total of 10,300,000 RMB
                or
                $1,412,003. Some of the loans will mature on various dates in year
                2008
                and some of the loans are payable on demand. These loans bear variable
                interest at 8.591% per annum for 2008 and 6.903% per annum for 2007.
            
            
            1,233,999
            
            
            1,412,003The
                Company entered into a series of short term loans during 2006 with
                another
                third party company in the PRC for total of 2,850,000 RMB, or $390,700.
                These loans are due on various dates in year 2008. These loans bear
                variable interest at 8.591% per annum for 2008 and 6.903% per annum
                for
                2007.
            
            
            414,834
            
            
            390,701The
                Company entered into a short term loan with another third party company
                in
                the PRC for 5,050,000 RMB or $625,759. This loan was entered into
                on Aug
                31, 2005 and was due on Aug 31, 2006. This loan bears no interest.
                Imputed
                interest on the loan was immaterial. This loan became payable on
                demand
                after Aug 31, 2006.
            
            
            736,259
            
            
            692,293The
                Company entered into a short term loan on June 30, 2008 with another
                third
                party company in the PRC for total of 10,000,000 RMB, or $1,458,000.
                This
                loan is due on Sept. 30, 2008 with interest rate of 10% per
                annum.
            
            
            1,434,062
            
            
            —$
            4,693,917
            
            $
            4,619,856





**13.
      MINORITY INTEREST**





Minority
      interest represented 45% interest in Yushi. At June 30, 2008 and December 31,
      2007, minority interest was zero as the minority’s share of cumulative losses
      exceeded its equity interest in Yushi. Minority’s share of loss for the six
      months ended June 30, 2008 and 2007 were limited to $0 and $1,846, respectively.





**14.
      INCOME TAXES**





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




12


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**
  The
      Company, as a manufacturing business, is subject to a 15% income tax rate.
      The
      Company was exempted from income tax for two years starting from the 1st
      profitable year since incorporation, and was entitled to a 50% discount on
      the
      15% income tax rate for 2005 through 2007. According to the new income tax
      law
      that became effective January 1, 2008, for those enterprises to which the 15%
      tax rate applicable previously, the applicable rates shall be gradually increase
      over a five-year period as follows:





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





For
      the
      six and three months ended June 30, 2008 and 2007, the Company’s effective
      income tax rate differs from US statutory rate due to the effect of tax
      holiday.





**15.
      STATUTORY RESERVES**





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





**Surplus
      Reserve Fund**





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





The
      surplus reserve fund is non-distributable other than during liquidation and
      can
      be used to fund previous years’ losses, if any, and may be utilized for business
      expansion or converted into


share
      capital by issuing new shares to existing shareholders in proportion to their
      shareholding or by increasing the par value of the shares currently held by
      them, provided that the remaining reserve balance after such issue is not less
      than 25% of the registered capital.





**Common
      Welfare Fund**





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





**16.
      COMMITMENTS**





The
      Company leased several offices for its sales representative in different cities
      under various one-year, non-cancellable, and renewable operating lease
      agreements.





Future
      minimum rental payments required under these operating leases are as
      follows:





Year
                Ending June 30,
            
            Amount2009
            
            $
            46,0002010
            
            
            21,000Total
            
            $
            67,000




13


**SMARTHEAT
        INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **JUNE
        30, 2008 (UNAUDITED) AND DECEMBER 31, 2007**
  Total
        rental expense for the six months ended June 30, 2008 and 2007 was approximately
        $32,000 and $19,000, and approximately $25,000 and $17,000 for the three
        months
        ended June 30, 2008 and 2007, respectively.





**17.
      CONTINGENCIES**




The
      Company’s operations in the PRC are subject to specific considerations and
      significant risks not typically associated with companies in the 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 expenses 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.
      SUBSEQUENT EVENTS**





On
      July
      7, 2008, the Company completed a closing of a private placement 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. 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 1,620,000
      million shares of common stock and warrants to purchase 243,000 shares of Common
      Stock. The warrants are immediately exercisable and expire on the third
      anniversary of their issuance. In connection with the private placement
      offering, the Company paid commissions and fees totaling $311,675 and issued
      warrants to purchase 147,500 shares of common stock.





In
      addition, the Company has agreed to file a registration statement with the
      SEC
      within 60 days of the final closing of this offering to permit resale of the
      shares and the common stock issuable upon the exercise of the warrants, make
      it
      effective within 180 days of the completion of the offering and to keep the
      registration statement effective subject to certain allowable grace periods
      as
      defined in the registration rights agreement. If the Company fails to file
      the
      registration statements by the date required or fails to keep the registration
      agreement effective, it will be obligated to pay liquidated damages equal to
      2%
      of the aggregate purchase price of the shares for each year.





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





14


**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
      are a
      leading provider of plate heat exchanger products to China's industrial,
      residential and commercial markets. We design, manufacture, sell, and service
      plate heat exchangers ("PHEs"), units which combine plate heat exchangers with
      various pumps, temperature sensors, valves, and automated control systems ("PHE
      Units"), and heat meters for a broad range of industries, including petroleum
      refining, petrochemicals, power generation, metallurgy, food & beverage and
      chemical processing. We sell PHEs under the Sondex brand and PHE Units designed
      by our engineers and assembled with Sondex plates under our Taiyu brand name.
      We
      are one of three authorized dealers of Sondex PHEs for the industrial and energy
      sectors in China. Our Sondex distribution territory is North China.




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.  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.  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.




**Recent
      Developments**




*Share
      Exchange and Related Transactions*




On
      April
      14, 2008, the Company entered into and consummated a series of agreements which
      resulted in the acquisition of all of share capital of Shenyang Taiyu Machinery
      & Electronic Equipment Co., Ltd, a plate heat exchange products company
      organized under the laws of the People's Republic of China ("Taiyu"), the
      divestiture of the Company's prior exploration business, and the change of
      the
      Company's name to SmartHeat Inc. The acquisition of Taiyu's share capital was
      accomplished pursuant to the terms of a Share Exchange Agreement dated April
      14,
      2008 (the "Share Exchange Agreement") by and among the Company's wholly owned
      subsidiary SmartHeat Inc., a Nevada corporation, Taiyu and all of the
      shareholders of Taiyu (the "Taiyu Shareholders").  At the closing
      under the Share Exchange Agreement all of the equitable and legal rights, title
      and interests in and to Taiyu's share capital in the amount of RMB25,000,000
      was
      exchanged for an aggregate of 18,500,000 shares of SmartHeat common stock (the
      "Share Exchange").  As a result of the Share Exchange, Taiyu became a
      wholly-owned subsidiary of SmartHeat. SmartHeat was thereafter immediately
      merged into the Company.




In
      addition, the following actions occurred under the terms of the Share Exchange
      Agreement:




·
            Immediately
                following the closing of the Share Exchange, the Company transferred
                all
                of its pre-closing assets and liabilities (other than the obligation
                to
                pay a $10,000 fee to the Company's audit firm) to a wholly owned
                subsidiary, PGR Holdings, Inc., a Nevada corporation ("SplitCo"),
                under
                the terms of an Agreement of Conveyance, Transfer and Assignment
                of Assets
                and Assumption of Obligations dated April 14, 2008.  The Company
                also sold all of the outstanding capital stock of SplitCo to Jason
                Schlombs (the former director and officer, and a major shareholder,
                of the
                Company) pursuant to a Stock Purchase Agreement dated April 14, 2008
                in
                exchange for the surrender of 2,500,000 shares of the Company's common
                stock held by Mr. Schlombs.




15


·
            As
                a condition to the closing of the Share Exchange, Mr. Jun Wang, the
                Chairman and Chief Executive Officer of Taiyu was appointed to the
                board
                of directors of the Company. Mr. Wang is the sole member of the board
                of
                directors as of the date hereof, Mr. Schlombs, having resigned effective
                as of the close of business on April 15,
                2008.




·
            Also
                as a condition to the closing of the Share Exchange, Mr. Schlombs
                resigned
                as the President, Chief Executive Officer, Secretary and Treasurer
                of the
                Company and Mr. Jun Wang was appointed as President and Chief Executive
                Officer, Ms. Zhijuan Guo was appointed as Chief Financial Officer
                and Ms.
                Huajun Ai was appointed as Corporate
                Secretary.




As
      a
      result of the Share Exchange and the cancellation of the 2,500,000 shares of
      the
      Company's common stock pursuant to the Split-Off Agreement, there are 22,549,900
      shares of the Company's common stock issued and outstanding, approximately
      82.04% of which are held by the former Taiyu Shareholders.  The
      shareholders of the Company immediately prior to the completion of these
      transactions hold the remaining 17.96% of the issued and outstanding share
      capital of SmartHeat.




*Change
      in Fiscal Year*




In
      connection with the consummation of the Share Exchange and related transactions
      discussed above, our fiscal year end was changed from October 31 to December
      31,
      effective as of April 14, 2008.




**Critical
      Accounting Policies**





Basis
      of Presentation





Our
      financial statements are prepared in accordance with GAAP and the requirements
      of Regulation S-X promulgated by the SEC.





Principle
      of Consolidation




The
      accompanying consolidated financial statements include the accounts of the
      Company and its direct and indirect subsidiaries. All significant inter-company
      accounts and transactions have been eliminated in consolidation.





Use
      of
      Estimates




In
      preparing the financial statements in conformity with accounting principles
      generally accepted in the United States of America, management makes estimates
      and assumptions that affect the reported amounts of assets and liabilities
      and
      disclosures of contingent assets and liabilities at the dates of the financial
      statements, as well as the reported amounts of revenues and expenses during
      the
      reporting year.  Significant estimates, required by management,
      include the recoverability of long-lived assets and the valuation of
      inventories.  Actual results could differ from those
      estimates.




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.




16




Accounts
      receivable is net of unearned interest.  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 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
                yearsVehicle
            
            
            5
                yearsOffice
                Equipment
            
            
            5
                yearsProduction
                Equipment
            
            
            5
                -
                10 years




Revenue
      Recognition




Our
      revenue recognition policies are in compliance with SEC Staff Accounting
      Bulletin No. 104.  Sales revenue is recognized at the date of shipment
      to customers when a formal arrangement exists, the price is fixed or
      determinable, the delivery is completed, 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.





**Foreign
      Currency Translation and Comprehensive Income (Loss)**




The
      Company’s functional currency is the 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 the exchange rate for the conversion of RMB to USD after the
      balance sheet date.




The
      Company uses SFAS 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.




17





**Results
      of Operations**




***Quarter
      Ended June 30, 2008 Compared to the Quarter Ended June 30,
      2007***




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


For
                  the Quarter Ended June 30,2008
              
              2007$
              
              %
                  of sales
              
              $
              
              %
                  of salesSales
              
              
              5,558,232
              
              
              
              
              
              1,159,098Cost
                  of Sales
              
              
              (4,115,200
              )
              
              74.0
              
              
              (756,368
              )
              
              65.0Gross
                  Profit
              
              
              1,443,032
              
              
              26.0
              
              
              402,730
              
              
              35.0Operating
                  Expenses
              
              
              (572,932
              )
              
              10.0
              
              
              (409,079
              )
              
              35.0Income
                  from Operations
              
              
              870,100
              
              
              16.0
              
              
              (6,349
              )
              
              (0.6
              )Other
                  Income (Expenses), net
              
              
              23,383
              
              
              0.4
              
              
              48,737
              
              
              4.0Net
                  Income
              
              
              732,412
              
              
              13.0
              
              
              3,219
              
              
              0.3







*Sales.* Our
      net sales for the three months ended June 30, 2008 were approximately $5.56
      million while our net sales in same period for 2007 were approximately $1.16
      million, an increase in revenues of $4.4 million, or about 380%.  The
      increase was primarily due to the expansion of our sales force, growth of our
      existing sales channels to develop new customers and the extension of our
      customer base into new regions in China. We believe that our sales will continue
      to grow as we strengthen our sales efforts by hiring more sales personnel,
      expanding sales channels, and improving the quality of our
      products.





*Cost
      of Sales.* Our
      cost of sales for the three months ended June 30, 2008 were approximately $4.12
      million while our cost of sales for the same period in 2007, were approximately
      $0.76 million, an increase of $3.36 million, or 444%.  The increase in
      cost of sales is attributed to increases in our production and sales during
      the
      period.  Cost of sales as a percentage of sales was approximately 74% for
      the
      second fiscal quarter of 2008 and
      65% for the same period in 2007. The increase in cost of sales as a percentage
      of sales for the second quarter of 2008 was mainly due to increases in the
      costs
      of new hired employees for our quality control, engineering and manufacturing
      departments, and increase in raw materials purchase price as a result of overall
      increases throughout China.





*Gross
      Profit* .  Gross
      profit was $1.44 million for the quarter ended June 30, 2008 as compared to
      $0.4
      million for the same period in 2007, representing gross margins of approximately
      26% and 35% for the second quarter of 2008 and 2007,
      respectively.  The increase in our gross profits was mainly due to the
      significant increase in our sales; while the decrease in our gross profit margin
      was mainly due to increased cost of manufacturing through increased cost of
      labor and depreciation expense for new acquired manufacturing equipment. In
      addition, we had more sales on (flat) plate heat exchanger than assembled heat
      exchanger unit during the quarter ended June 30, 2007. Assembled heat exchanger
      units have a relatively higher profit margin than (flat) plate heat exchangers
      as more profits can be added on to the parts that are used for the assembly
      of
      the whole unit. We believe our gross profit margin will increase due to the
      economies of scale as we continue to increase our production, improve efficiency
      on cost control and increase the sales on assembled heat exchanger
      unit.





*Operating
      Expenses* .  Operating
      expenses, consisting of selling, general and administrative expenses, totalled
      approximately $0.57 million for the three months ended June 30, 2008 as compared
      to $0.41 million for the same period in 2007, an increase of approximately
      $0.16
      million or 40%.  The increase in operating expenses was mainly due to
      proportional increases in after-sale service, payroll, insurance and travel
      expenses, coupled with our increased sales and production.





*Net
      Income* .  Our
      net income for the three month period ended June 30, 2008 was approximately
      $0.73 million as compared to $3,219 for the same period in 2007, an increase
      of
      $729,193 or 22753%.  This increase is attributable to economies of
      scale combined with rapid growth in revenue and efficiency of operations. Our
      management believes that net income will continue to increase as we continue
      to
      increase our sales, offer better quality products and control our manufacturing
      costs.




18





***Six
      Months Ended June 30, 2008 Compared to the Six Months Ended June 30,
      2007***




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


For
                  the Six Months
                Ended
                  June 30,2008
              
              2007$
              
              %
                  of Sales
              
              $
              
              %
                  of SalesSales
              
              
              8,637,283
              
              
              
              
              
              2,457,967Cost
                  of sales
              
              
              (6,228,156
              )
              
              72.0
              
              
              (1,598,789
              )
              
              65.0Gross
                  Profit
              
              
              2,409,127
              
              
              28.0
              
              
              859,178
              
              
              35.0Operating
                  Expenses
              
              
              (1,054,498
              )
              
              12.0
              
              
              (783,735
              )
              
              32.0Income
                  from Operation
              
              
              1,354,629
              
              
              16.0
              
              
              75,443
              
              
              3.0Other
                  Income (Expenses), net
              
              
              115,074
              
              
              1.3
              
              
              140,285
              
              
              6.0Net
                  Income
              
              
              1,203,675
              
              
              14.0
              
              
              165,088
              
              
              7.0




*Sales.* Our
      net sales for six months ended June 30, 2008 were approximately $8.64 million
      while our net sales for the same period in 2007, were approximately $2.46
      million, an increase in revenues of $6.18 million, or 251%.  The
      increase was due to growing demand for our product resulting from rapid increase
      in newly-build residential communities in Shenyang City and surrounding
      area.  We also increased the number of our sales representatives to
      develop new customers in more cities in China. 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.




*Cost
      of Sales.* Our
      cost of sales for six months ended June 30, 2008 were approximately $6.23
      million while our cost of sales for the same period in 2007 were approximately
      $1.6 million, an increase of $4.63 million, or 290%.  The increase in
      cost of sales is attributed to the increase of production and sales activities
      in 2008.  Cost of sales as a percentage of sales was approximately 72%
      for six months ended June 30, 2008 and 65% for the same period in
      2007.  The increase in cost of sales as a percentage of sales for six
      months ended June 30, 2008 was mainly due to increase in the
      costs
      of new hired employees for our quality control, engineering and manufacturing
      departments, and increase in raw materials purchase price as a result of overall
      increases throughout China.




*Gross
      Profit* .  Gross
      profit was $2.41 million for six months ended June 30, 2008 as compared to
      $0.86
      million for the same period in 2007, representing gross margins of approximately
      28% and 35% for six months ended June 30, 2008 and 2007,
      respectively.  The increase in our gross profits due to the increase
      of sales activities and decrease in gross profit margin was mainly due to the
      increase in manufacturing cost  discussed
      above. We believe our gross profit margin will increase due to the economy
      of
      scale as we will increase our production and improving our efficiency on cost
      control.





*Operating
      Expenses* .  Operating
      expenses consisted of selling, general and administrative expenses totalled
      approximately $1.05 million for six months ended June 30, 2008 as compared
      to
      $0.78 million for the same period in 2007, an increase of approximately $270,763
      or 35%.  The increased in operating expenses was mainly due to
      increase in rental expense as we leased new offices for our representatives
      in
      the major cities of China, after-sale service, payroll, insurance and travel
      expenses coupled with our increased sales and production.




*Net
      Income* .  Our
      net income for six months ended June 30, 2008 was $1.20 million as compared
      to
      approximately $165,088 for the same period in 2007, an increase of $1.04 million
      or 629%.  This increase is attributable to economy of scale combined
      with rapid growth in revenue and efficiency
      of operations. Our management believes that net income will continue to increase
      as we continue to increase our sales, offer better quality products and control
      our manufacturing costs.





**Liquidity
      and Capital Resources**




As
      of
      June 30, 2008, we had cash and cash equivalents of approximately $207,495.
      Working capital was approximately $4.74 million at June 30, 2008. The ratio
      of current assets to current liabilities was 1.36:1 at June 30, 2008.




19





The
      following is a summary of cash provided by or used in each of the indicated
      types of activities during the six months ended June 30, 2008 and
      2007:


For
                  the Six Months Ended June 30,2008
              
              2007Cash
                  provided by (used in):Operating
                  Activities
              
              $
              442,015
              
              $
              998,953Investing
                  Activities
              
              
              (388,681
              )
              
              (1,080,443
              )Financing
                  Activities
              
              
              (258,014
              )
              
              1,315,429




Net
      cash
      flow provided by operating activities was $442,015 for six month ended June
      30,
      2008, as compared to net cash flow provided by operating activities of $998,953
      for six month ended June 30,  2007.
      The
      decrease in net cash flow from operating activities for six month ended June
      30,
      2008 was mainly due to increase in advance to suppliers and other receivables,
      decrease in customer deposits.  In addition, our net income for six
      month ended June 30, 2008 has increased rapidly compared to the same period
      of  2007,
      bringing more cash in to the Company, while at the same time our accounts
      receivables have increased significantly, reducing our cash
      inflows.




Net
      cash
      flow used in investing activities was $388,681 for six month ended June 30,
      2008, as compared to net cash used in investing activities of $1,080,443 in
      the
      same period of 2007.  The decrease of net cash flow used in investing
      activities in six month ended June 30, 2008 was mainly due to the completion
      of
      construction in progress that was commenced in 2007 and a decrease in restricted
      cash that was pledged for the guarantee of certain contracts execution and
      completion.





Net
      cash
      flow used in financing activities was $258,014 for the six months ended June
      30,
      2008 as compared to net cash provided by financing activities of $1,315,429
      for
      the same period of 2007. The decrease of net cash inflow provided by financing
      activities for the six months ended June 30, 2008 was mainly due to decreased
      short term loans with banks and other third parties.





We
      believe we have sufficient cash to continue our current business
      through **** June
      30,
      2009 due to expected increased sales revenue and net income from operations.





We
      do not
      believe that inflation had a significant negative impact on our results of
      operations during the year ended June 30, 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.




20




**Contractual
      Obligations**




The
      Company is obligated for the following short term loans payable as of June
      30,
      2008:




Balance
                at June 30, 2008The
                Company entered into a short term loan with a commercial bank in
                the PRC
                for 6,000,000 RMB, or $822,526. This loan was entered into on April
                28,
                2007 and was due on April 12, 2008. This loan bears interest at 7.029%
                per
                annum. This loan was renewed on April 12, 2008 with new maturity
                date of
                June 13, 2009.
            
            $
            874,763The
                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
                or
                $1,412,003. Some of the loans will mature on various dates in year
                2008
                and some of the loans are payable on demand. These loans bear variable
                interest at 8.591% per annum for 2008 and 6.903% per annum for 2007.
            
            
            1,233,999The
                Company entered into a series of short term loans during 2006 with
                another
                third party company in the PRC for total of 2,850,000 RMB, or $390,700.
                These loans are due on various dates in year 2008. These loans bear
                variable interest at 8.591% per annum for 2008 and 6.903% per annum
                for
                2007.
            
            
            414,834The
                Company entered into a short term loan with another third party company
                in
                the PRC for 5,050,000 RMB or $625,759. This loan was entered into
                on Aug
                31, 2005 and was due on Aug 31, 2006. This loan bears no interest.
                Imputed
                interest on the loan was immaterial. This loan became payable on
                demand
                after Aug 31, 2006.
            
            
            736,259The
                Company entered into a short term loan on June 30, 2008 with another
                third
                party company in the PRC for total of 10,000,000 RMB, or $1,458,000.
                This
                loan is due on Sept. 30, 2008 with interest rate of 10% per
                annum.
            
            
            1,434,062$
            4,693,917





**Recent
      Accounting Pronouncements**




**The
      Hierarchy of Generally Accepted Accounting Principles**





In
      May
      2008, the 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 GAAP in the United States.  SFAS 162 will not
      have an 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 .” 
      SFAS 161 changes the disclosure requirements for derivative instruments and
      hedging activities. Entities are required to provide enhanced disclosures about
      (a) how and why an entity uses derivative instruments, (b) how derivative
      instruments and related hedged items are accounted for under Statement 133
      and
      its related interpretations, and (c) how derivative instruments and related
      hedged items affect an entity’s financial position, financial performance, and
      cash flows.  Based on current conditions, the Company does not expect the
      adoption of SFAS 161 to have a significant impact on its results of operations
      or financial position.




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





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




21





**Business
      Combinations**




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





·
            Acquisition
                costs will be generally expensed as
                incurred;




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




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




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




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




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





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





**Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans, an
      Amendment of FASB Statements No. 87, 88, 106, and 132R**




In
      September 2006, the FASB, issued SFAS, No. 158, “Employers’ Accounting for
      Defined Benefit Pension and Other Postretirement Plans, an Amendment of FASB
      Statements No. 87, 88, 106, and 132R,” which requires employers to recognize the
      underfunded or overfunded status of a defined benefit postretirement plan as
      an
      asset or liability in its statement of financial position and to recognize
      changes in the funded status in the year in which the changes occur through
      accumulated other comprehensive income. Additionally, SFAS 158 requires
      employers to measure the funded status of a plan as of the date of its year-end
      statement of financial position. The new reporting requirements and related
      new
      footnote disclosure rules of SFAS 158 are effective for fiscal years ending
      after December 15, 2006. The Company adopted the provisions of SFAS 158 for
      the
      year end 2006, and the effect of recognizing the funded status in accumulated
      other comprehensive income was not significant. The new measurement date
      requirement applies for fiscal years ending after December 15,
      2008.





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





In
      June
      2007, the 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.  Management is currently evaluating the effect of this
      pronouncement on our financial statements.




22





**Item
      3.**  **Quantitative
      and Qualitative Disclosures About Market Risk**




Not
      required




**Item
      4T. Controls and Procedures**




**Evaluation
      of Disclosure Controls and Procedures**




As
      of
      June 30, 2008, we carried out an evaluation of the effectiveness of the design
      and operation of our “disclosure controls and procedures” (as defined in the
      Exchange Act Rules 13a-15(e) and 15d-15(e)) under the supervision and with
      the
      participation of our management, including our Chief Executive Officer and
      our
      Chief Financial Officer. Based upon that evaluation, we concluded that our
      disclosure controls and procedures are effective.




Disclosure
      controls and procedures are controls and other procedures that are designed
      to
      ensure that information required to be disclosed in our reports filed or
      submitted under the Exchange Act are recorded, processed, summarized and
      reported, within the time periods specified in the SEC’s rules and forms.
      Disclosure controls and procedures include, without limitation, controls and
      procedures designed to ensure that information required to be disclosed in
      our
      reports filed under the Exchange Act is accumulated and communicated to
      management to allow timely decisions regarding required disclosure.




**Changes
      in Internal Controls Over Financial Reporting**




During
      the quarter ended June 30, 2008, there were no changes in our internal control
      over financial reporting that materially affected our internal control over
      financial reporting.




23


**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.




**Item
      1A.**  **Risk
      Factors**




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




**Risks
      Related to Our Business**




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




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




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




Demand
      for our products depends in large part upon the level of capital and maintenance
      expenditures of our customers and the end users. These expenditures have
      historically been cyclical in nature and vulnerable to economic downturns.
      Decreased capital and maintenance spending by our customers could have a
      material adverse effect on the demand for our products and our business,
      financial condition and results of operations. In addition, this historically
      cyclical nature of the demand for our products limits our ability to make
      accurate long-term predictions about our performance. Changing world economic
      and political conditions may also reduce the willingness of our customers and
      prospective customers to purchase our products and services. The seasonality
      of
      our business results in significant operational challenges to our production
      and
      inventory control functions.




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




Our
      five
      largest customers accounted for 48.5% of our revenues for the year ended
      December 31, 2007 and our ten largest customers accounted for 64.5% our revenues
      for the year ended December 31, 2007. Our largest customer accounted for 21%
      of
      our revenues in the year ended December 31, 2007. These customers may not
      maintain the same volume of business with us in the future. If we lose any
      of
      these customers or they reduce the amount of business they do with us, our
      revenues may be seriously affected.




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




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




24




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




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




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




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




·
            Substantially
                greater revenues and financial resources;




·
            Stronger
                brand names and consumer recognition;




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




·
            Pre-existing
                relationships with potential customers;




·
            More
                resources to make acquisitions;




·
            Lower
                labor and development costs; and




·
            Broader
                geographic presence.




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




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




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




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




25




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




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




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




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




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




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




26




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




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




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




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




***Our
      business could be subject to environmental
      liabilities***




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




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




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




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




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




27




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




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




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




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




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




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




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




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




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




·
            Governmental
                policies relating to foreign currency borrowings.




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




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




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




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




28




**Risks
      Related to Doing Business in China**




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




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




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




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




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




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




***Our
      bank accounts are not insured or protected against
      loss***




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




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




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




29




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




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




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




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




***We
      may face judicial corruption in China***




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




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




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




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




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




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




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




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




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




30




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




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




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




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




31




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




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




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




We
      may
      also decide to finance our subsidiaries by means of capital contributions.
      These
      capital contributions must be approved by the PRC Ministry of Commerce or its
      local counterpart. We cannot assure you that we will be able to obtain these
      government approvals on a timely basis, if at all, with respect to future
      capital contributions by us to our subsidiaries. If we fail to receive such
      approvals, our ability to use the proceeds of this offering and to capitalize
      our PRC operations may be negatively affected, which could adversely affect
      our
      liquidity and our ability to fund and expand our business




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




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




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




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




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




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




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




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




32


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




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




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




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




In
      addition, while we have developed substantial goodwill for our Taiyu brand
      in
      China, our application for the registration of that mark is still pending and
      there is no assurance that our application will be granted.




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




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




**Risks
      Related to Our Securities**




***Shares
      of our common stock lack a significant trading market***




Our
      shares are not eligible for trading on any national securities exchange. Prices
      for the shares of our common stock are quoted in the over-the-counter market
      on
      the OTC Bulletin Board, but there has been no meaningful volume in the trading
      of our shares and the market for our shares is highly illiquid. Although we
      have
      applied for the listing of our common stock on the NASDAQ Stock Market, there
      is
      no assurance that our application will be granted. There is no assurance that
      an
      active trading market in our common stock will ever develop, or, if such a
      market develops, that it will be sustained. In addition, there is a greater
      chance for market volatility for securities that quoted are on the OTC Bulletin
      Board as opposed to securities that trade on a national exchange. This
      volatility may be caused by a variety of factors, including the lack of readily
      available quotations, the absence of consistent administrative supervision
      of
      "bid" and "ask" quotations and generally lower trading volume. As a result,
      an
      investor may find it more difficult to dispose of, or to obtain accurate
      quotations as to the market value of, the common stock, or to obtain coverage
      for significant news events concerning us, and the common stock would become
      substantially less attractive for margin loans, for investment by financial
      institutions, as consideration in future capital raising transactions or other
      purposes.




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




Mr.
      Jun
      Wang, our director and Chief Executive Officer, owns of 50% of the equity in
      Beijing YSKN Machinery & Electronic Equipment Co., Ltd ("YSKN"), a company
      which is the record holder of 30.19% of our outstanding common stock. Mr. Wang
      has substantial influence over the actions of that substantial shareholder.
      As a
      result, Mr. Wang has significant influence over all corporate actions requiring
      shareholder approval, irrespective of how the Company's other shareholders
      may
      vote, including the following actions:




·
            electing
                or defeating the election of our directors;




33




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




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




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




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




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




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




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




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




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




Our
      articles of incorporation authorizes the issuance of up to 75,000,000 shares
      of
      common stock, par value $.001 per share. There are approximately 50,567,100
      authorized and unissued shares of our common stock which have not been reserved
      and are available for future issuance. Although we have no commitments as of
      the
      date of this offering to issue our securities, we may issue a substantial number
      of additional shares of our common stock, to complete a business combination
      or
      to raise capital. The issuance of additional shares of our common
      stock:




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




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




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




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




34




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




In
      connection with the consummation of share exchange, which is described in detail
      in Part I, Item 2. " Management’s
      Discussion and Analysis of Financial Condition and Results of Operations, *Recent
      Developments* "
      beginning on page __, on April 14, 2008, SmartHeat issued an aggregate of
      18,500000 shares to the former Taiyu Shareholders.




**Item
      3.****Defaults
      Upon Senior Securities**




None.




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




None.




**Item
      5.**  **Other
      Information**




*Subsequent
      Events*





On
      July
      7, 2008, the Company completed a closing of a private placement 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. 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 1,620,000
      million shares of common stock and warrants to purchase 243,000 shares of Common
      Stock. The warrants are immediately exercisable and expire on the third
      anniversary of their issuance. In connection with the private placement
      offering, the Company paid commissions and fees totaling $311,675 and issued
      warrants to purchase 147,500 shares of common stock.





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





**Item
      6.**  **Exhibits** ****




**Exhibit**
              **No.**
            
            **Document**
              **Description**31.1
            
            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).





35




**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)**August
                14, 2008
            By:
            /s/
              Jun
              WangJun
                Wang
              President
                and Chief Executive Officer




August
                14, 2008
            By:
            /s/
              Zhijuan GuoZhijuan
                Guo
              Chief
                Financial Officer




36




**EXHIBIT
      INDEX**





**Exhibit**
              **No.**
            
            **Document**
              **Description**31.1
            
            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