UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





x
                QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
                  
                  For
      the quarterly period ended September 30, 2010OR ̈
                TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





Commission
file number: 001-34246





SMARTHEATINC.


(Exact
name of registrant as specified in its charter)





Nevada
                  
                  98-0514768(State
      or other jurisdiction of incorporation
                    or
      organization)
                  
                  (IRS
      Employer Identification
No.)





A-1,
      10, Street 7
                    Shenyang
      Economic and Technological Development Zone
                    Shenyang,
      China
                  
                  110027(Address
      of principal executive offices)
                  
                  (Zip
      Code)





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





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





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





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





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





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date: 32,811,125 shares of common stock
outstanding as of November 8, 2010.









TABLE
OF CONTENTS





PagePART I.
      FINANCIAL INFORMATIONItem 1.
              Financial
      Statements
              
              3Item 2.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              
              20Item 3.
              Quantitative
      and Qualitative Disclosures About Market Risk
              
              26Item 4.
              Controls
      and Procedures
              
              26PART
      II. OTHER INFORMATIONItem 1.
              Legal
      Proceedings
              
              27Item 1A.
              Risk
      Factors
              
              27Item 2.
              Unregistered
      Sales of Equity Securities and Use of Proceeds
              
              27Item 3.
              Defaults
      Upon Senior Securities
              
              27Item 5.
              Other
      Information
              
              27Item 6.
              Exhibits
              
              27SIGNATURES
              
              28




2




PART I. FINANCIAL INFORMATION





Item
1. Financial Statements.





SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS





September 30, 2010 (Unaudited)
                            
                            
                            December 31, 2009ASSETSCURRENT
      ASSETSCash
      & cash equivalents
                            
                            $
                            14,724,091
                            
                            
                            $
                            48,967,992Restricted
      cash
                            
                            
                            1,296,318
                            
                            
                            
                            1,301,573Accounts
      receivable, net
                            
                            
                            50,052,608
                            
                            
                            
                            31,887,785Retentions
      receivable
                            
                            
                            2,096,943
                            
                            
                            
                            885,642Advances
      to suppliers
                            
                            
                            12,623,696
                            
                            
                            
                            7,657,791Other
      receivables, prepayments and deposits
                            
                            
                            5,352,081
                            
                            
                            
                            3,572,600Inventories
                            
                            
                            32,457,863
                            
                            
                            
                            11,259,273Notes
      receivable - bank acceptances
                            
                            
                            944,769
                            
                            
                            
                            397,248Total
      current assets
                            
                            
                            119,548,369
                            
                            
                            
                            105,929,904NON-CURRENT
      ASSETSDeferred
      tax asset
                            
                            
                            14,837
                            
                            
                            
                            -Restricted
      cash
                            
                            
                            92,013
                            
                            
                            
                            48,361Accounts
      receivable, net
                            
                            
                            219,725
                            
                            
                            
                            237,384Retentions
      receivable
                            
                            
                            734,238
                            
                            
                            
                            349,931Deposit
      for land use right
                            
                            
                            9,597,390
                            
                            
                            
                            -Intangible
      assets, net
                            
                            
                            4,127,767
                            
                            
                            
                            4,071,021Construction
      in progress
                            
                            
                            80,254
                            
                            
                            
                            -Property
      and equipment, net
                            
                            
                            8,044,911
                            
                            
                            
                            7,739,609Total
      noncurrent assets
                            
                            
                            22,911,135
                            
                            
                            
                            12,446,306TOTAL
      ASSETS
                            
                            $
                            142,459,504
                            
                            
                            $
                            118,376,210LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIESAccounts
      payable
                            
                            $
                            5,421,730
                            
                            
                            $
                            3,493,196Unearned
      revenue
                            
                            
                            4,283,004
                            
                            
                            
                            2,130,637Taxes
      payable
                            
                            
                            2,799,694
                            
                            
                            
                            2,140,627Accrued
      liabilities and other payables
                            
                            
                            4,887,566
                            
                            
                            
                            3,685,272Notes
      payable - bank acceptances
                            
                            
                            1,516,865
                            
                            
                            
                            1,806,564Loans
      payable
                            
                            
                            4,476,877
                            
                            
                            
                            4,393,544Total
      current liabilities
                            
                            
                            23,385,736
                            
                            
                            
                            17,649,840DEFERRED
      TAX LIABILITY
                            
                            
                            -
                            
                            
                            
                            8,526COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITYCommon
      stock, $0.001 par value; 75,000,000 shares
      authorized,  32,811,125 and 32,794,875 shares issued and
      outstanding at September 30, 2010 and December 31, 2009,
      respectively
                            
                            
                            32,811
                            
                            
                            
                            32,795Paid
      in capital
                            
                            
                            75,163,813
                            
                            
                            
                            74,917,370Statutory
      reserve
                            
                            
                            4,613,151
                            
                            
                            
                            2,872,006Accumulated
      other comprehensive income
                            
                            
                            2,901,709
                            
                            
                            
                            969,988Retained
      earnings
                            
                            
                            35,673,363
                            
                            
                            
                            21,231,484Total
      Company stockholders' equity
                            
                            
                            118,384,847
                            
                            
                            
                            100,023,643NONCONTROLLING
      INTEREST
                            
                            
                            688,921
                            
                            
                            
                            694,201TOTAL
      EQUITY
                            
                            
                            119,073,768
                            
                            
                            
                            100,717,844TOTAL
      LIABILITIES AND EQUITY
                            
                            $
                            142,459,504
                            
                            
                            $
                            118,376,210





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




3




SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF INCOME AND COMPREHENSIVE INCOME





NINE MONTHS ENDED SEPTEMBER 30,
                        
                        
                        THREE MONTHS ENDED SEPTEMBER 30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Net
      sales
                        
                        $
                        83,613,250
                        
                        
                        $
                        56,541,795
                        
                        
                        $
                        51,476,821
                        
                        
                        $
                        37,835,897Cost
      of goods sold
                        
                        
                        54,177,914
                        
                        
                        
                        36,562,363
                        
                        
                        
                        33,061,854
                        
                        
                        
                        24,687,460Gross
      profit
                        
                        
                        29,435,336
                        
                        
                        
                        19,979,432
                        
                        
                        
                        18,414,968
                        
                        
                        
                        13,148,438Operating
      expensesSelling
      expenses
                        
                        
                        5,972,651
                        
                        
                        
                        2,325,471
                        
                        
                        
                        3,335,303
                        
                        
                        
                        1,165,939General
      and administrative expenses
                        
                        
                        4,622,468
                        
                        
                        
                        2,626,775
                        
                        
                        
                        2,061,453
                        
                        
                        
                        1,286,643Total
      operating expenses
                        
                        
                        10,595,119
                        
                        
                        
                        4,952,245
                        
                        
                        
                        5,396,756
                        
                        
                        
                        2,452,582Income
      from operations
                        
                        
                        18,840,217
                        
                        
                        
                        15,027,187
                        
                        
                        
                        13,018,212
                        
                        
                        
                        10,695,856Non-operating
      income (expenses)Interest
      income
                        
                        
                        322,462
                        
                        
                        
                        145,839
                        
                        
                        
                        122,898
                        
                        
                        
                        65,418Interest
      expense
                        
                        
                        (41,871
                        )
                        
                        
                        (209,462
                        )
                        
                        
                        (46,916
                        )
                        
                        
                        (91,850
                        )Financial
      expense
                        
                        
                        (36,430
                        )
                        
                        
                        (222,625
                        )
                        
                        
                        (17,427
                        )
                        
                        
                        (222,625
                        )Exchange
      loss
                        
                        
                        24,652
                        
                        
                        
                        -
                        
                        
                        
                        68,323
                        
                        
                        
                        -Other
      income
                        
                        
                        135,715
                        
                        
                        
                        21,443
                        
                        
                        
                        51,910
                        
                        
                        
                        (14,866
                        )Other
      expenses
                        
                        
                        (1,269
                        )
                        
                        
                        61,644
                        
                        
                        
                        150
                        
                        
                        
                        72,843Total
      non-operating income (expenses), net
                        
                        
                        403,259
                        
                        
                        
                        (203,161
                        )
                        
                        
                        178,938
                        
                        
                        
                        (191,080
                        )Income
      before income tax
                        
                        
                        19,243,476
                        
                        
                        
                        14,824,026
                        
                        
                        
                        13,197,149
                        
                        
                        
                        10,504,776Income
      tax expense
                        
                        
                        3,059,182
                        
                        
                        
                        2,304,672
                        
                        
                        
                        2,092,876
                        
                        
                        
                        1,624,240Income
      from operations
                        
                        
                        16,184,294
                        
                        
                        
                        12,519,354
                        
                        
                        
                        11,104,273
                        
                        
                        
                        8,880,536Less:
      Income attributable to noncontrolling interest
                        
                        
                        16,962
                        
                        
                        
                        -
                        
                        
                        
                        2,232
                        
                        
                        
                        -Income
      to SmartHeat Inc.
                        
                        
                        16,201,256
                        
                        
                        
                        12,519,354
                        
                        
                        
                        11,106,505
                        
                        
                        
                        8,880,536Other
      comprehensive itemForeign
      currency translation
                        
                        
                        1,931,721
                        
                        
                        
                        270,399
                        
                        
                        
                        1,418,870
                        
                        
                        
                        257,256Comprehensive
      Income
                        
                        $
                        18,132,977
                        
                        
                        $
                        12,789,753
                        
                        
                        $
                        12,525,375
                        
                        
                        $
                        9,137,792Basic
      weighted average shares outstanding
                        
                        
                        32,804,292
                        
                        
                        
                        24,430,806
                        
                        
                        
                        32,811,125
                        
                        
                        
                        24,924,435Diluted
      weighted average shares outstanding
                        
                        
                        32,846,171
                        
                        
                        
                        24,513,092
                        
                        
                        
                        32,817,520
                        
                        
                        
                        25,010,735Basic
      earnings per share
                        
                        $
                        0.49
                        
                        
                        $
                        0.51
                        
                        
                        $
                        0.34
                        
                        
                        $
                        0.36Diluted
      earnings per share
                        
                        $
                        0.49
                        
                        
                        $
                        0.51
                        
                        
                        $
                        0.34
                        
                        
                        $
                        0.36





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




4




SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS





NINE MONTHS ENDED SEPTEMBER 30,2010
                
                
                2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Income
      including noncontrolling interest
                
                $
                16,184,294
                
                
                $
                12,519,354Adjustments
      to reconcile income including noncontrolling interest to net cash used in
      operating activities:Depreciation
      and amortization
                
                
                709,544
                
                
                
                409,371Allowance
      for accounts receivable
                
                
                15,744
                
                
                
                -Unearned
      interest on accounts receivable
                
                
                (74,520
                )
                
                
                195,901Stock
      option compensation expense
                
                
                142,869
                
                
                
                1,755Stock
      issued for consulting service
                
                
                18,090
                
                
                
                -Changes
      in deferred tax
                
                
                (23,160
                )
                
                
                (23,357
                )(Increase)
      decrease in current assets:Accounts
      receivable
                
                
                (17,807,291
                )
                
                
                (9,305,812
                )Retentions
      receivable
                
                
                (1,547,759
                )
                
                
                (2,403,726
                )Advances
      to suppliers
                
                
                (4,761,889
                )
                
                
                (3,051,902
                )Other
      receivables, prepayments and deposits
                
                
                1,995,914
                
                
                
                485,060Inventory
                
                
                (20,659,166
                )
                
                
                (8,277,813
                )Note
      receivables
                
                
                (404,449
                )
                
                
                (55,986
                )Increase
      (decrease) in current liabilities:Accounts
      payable
                
                
                3,635,847
                
                
                
                5,782,299Unearned
      revenue
                
                
                2,079,159
                
                
                
                1,232,371Taxes
      payable
                
                
                608,861
                
                
                
                818,141Accrued
      liabilities and other payables
                
                
                128,354
                
                
                
                (4,450,011
                )Net
      cash used in operating activities
                
                
                (19,759,558
                )
                
                
                (6,124,354
                )CASH
      FLOWS FROM INVESTING ACTIVITIES:Change
      in restricted cash
                
                
                (12,593
                )
                
                
                (380,457
                )Acquisition
      of property & equipment
                
                
                (3,277,320
                )
                
                
                (3,610,566
                )Acquisition
      of intangible asset
                
                
                (170,689
                )
                
                
                -Deposit
      for land use right
                
                
                (9,448,356
                )
                
                
                -Construction
      in progress
                
                
                (79,008
                )
                
                
                (60,203
                )Net
      cash used in investing activities
                
                
                (12,987,966
                )
                
                
                (4,051,226
                )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from short term loan
                
                
                4,407,357
                
                
                
                12,117,636Repayment
      to short term loan
                
                
                (4,407,357
                )
                
                
                (9,216,986
                )Payment
      on notes payable
                
                
                (1,812,243
                )
                
                
                -Issuance
      of common stock
                
                
                -
                
                
                
                66,138,390Warrants
      exercised
                
                
                85,500
                
                
                
                -Net
      cash provided by (used in) financing activities
                
                
                (1,726,743
                )
                
                
                69,039,040EFFECT
      OF EXCHANGE RATE CHANGE ON CASH & CASH EQUIVALENTS
                
                
                230,366
                
                
                
                (3,978
                )NET
      INCREASE (DECREASE) IN CASH & CASH EQUIVALENTS
                
                
                (34,243,901
                )
                
                
                58,859,482CASH
      & CASH EQUIVALENTS, BEGINNING OF PERIOD
                
                
                48,967,992
                
                
                
                1,435,213CASH
      & CASH EQUIVALENTS, END OF PERIOD
                
                $
                14,724,091
                
                
                $
                60,294,695Supplemental
      Cash flow data:Income
      tax paid
                
                $
                1,634,509
                
                
                $
                1,272,797Interest
      paid
                
                $
                137,787
                
                
                $
                219,061





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




5




SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2010 (UNAUDITED) AND DECEMBER 31, 2009





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 designs, manufactures, sells, and services plate heat exchangers
(“PHE”), PHE Units and heat meters through its wholly-owned operating
subsidiaries in China.





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





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





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





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





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





On June
16, 2009, Taiyu closed an asset purchase transaction with Siping Beifang Heat
Exchanger Manufacture Co.,Ltd. (“Siping”), a
company organized under the laws of the People’s Republic of China (“PRC”), to
purchase certain assets consisting of the plant and equipment and certain land
use rights for RMB 54,000,000, or United States Dollars (USD)
$7,906,296. Taiyu then transferred all the assets acquired to SmartHeat Siping,
the newly incorporated subsidiary. The Company paid RMB 7,250,000 ( $1,061,500)
upon the completion of inventory inspection. The remaining purchase
consideration was non-interest bearing and was payable according to the
following schedule:





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





At
September 30, 2010, the Company had paid approximately $6.70 million and had a
$1.2 million outstanding balance, which the Company expects to pay in December
2010 with the consent from the seller. The payment terms do not include any
default provision.





On August
14, 2009, the Company formed a joint venture in Beijing, named Beijing SmartHeat
Jinhui Energy Technology Co., Ltd (“Jinhui”), with registered capital of RMB 10
million ($1.46 million) for research, development, manufacturing and sales of
plate heat exchangers in China. Jinhui has not commenced operations as of
September 30, 2010. SmartHeat owns 52% of Jinhui and invested approximately
$765,000.





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




6




On April
12, 2010, HEAT Investment formed a wholly-owned subsidiary in Shenyang, named
SmartHeat (Shenyang) Energy Equipment Co., Ltd (“HEAT Energy”), with registered
capital of $30 million for research, development, manufacturing and sales of
energy products. HEAT Energy has not commenced operations as of September 30,
2010, except for a prepayment of $9.6 million for the purchase of a land use
right; the Company expects to complete the acquisition of the land use right by
the end of November 2010.





2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Principles
of Consolidation





The
accompanying consolidated financial statements include the accounts of
SmartHeat, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, HEAT Investment and HEAT
Energy. The "Company" refers collectively to SmartHeat, Taiyu, SanDeKe,
SmartHeat Siping, Jinhui, HEAT Investment and HEAT Energy. All significant
inter-company accounts and transactions were eliminated in
consolidation.





Non-Controlling
Interest





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





Use
of Estimates





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





Cash
and Cash Equivalents





For
purposes of the statement of cash flows, the Company considers all highly liquid
investments with an original maturity of three months or less to be cash
equivalents. As of September 30, 2010, the Company maintained restricted cash of
$1,388,331 in several bank accounts, of which $377,000 represented cash deposits
from customers for securing payment from such customers that occurs no later
than the warranty period expiration and approximately $1.01 million represented
deposits the Company paid to a commercial bank for the bank issuing bank
acceptances to the Company’s vendors; of the total restricted cash at
September 30, 2010, $1,296,318 will be released to the Company within one year.
As of December 31, 2009, the Company maintained restricted cash of $1,349,934 in
several bank accounts, of which approximately $1.03 million represented cash
deposits from customers for securing payment from such customers that occurs no
later than the warranty period expiration and $313,000 represented deposits the
Company paid to a commercial bank for the bank issuing bank acceptances to the
Company’s vendors; of the total restricted cash at December 31, 2009,
$1,301,573 will be released to the Company within one year. Restricted cash is
held in interest bearing bank accounts.





Accounts
and Retentions Receivable





The
Company’s policy is to maintain reserves for potential credit losses on accounts
receivable. Management reviews the composition of accounts receivable and
analyzes historical bad debts, customer concentrations, customer credit
worthiness, current economic trends and changes in customer payment patterns to
evaluate the adequacy of these reserves. Based on historical collection
activity, the Company had allowances of $1,165,814 and $1,128,420 at September
30, 2010 and December 31, 2009, respectively.





At
September 30, 2010 and December 31, 2009, the Company had retentions receivable
from customers for product quality assurance of $2,831,181 and $1,235,573,
respectively. The retention rate varies from 5% to 20% of the sales price with
variable terms from three months to two years depending on the shipping date of
the products and the number of heating seasons that the warranty period
covers.





Accounts
receivable is net of unearned interest of $91,127 and $149,123 at September 30,
2010 and December 31, 2009, 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 5.575% at September
30, 2010, and 7.16% at December 31, 2009.




7




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 as follows:





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





Land
Use Rights





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





Impairment
of Long-Lived Assets





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





Recoverability
of long-lived assets to be held and used is measured by comparing the carrying
amount of an asset to the estimated undiscounted future cash flows expected to
be generated by the asset. If the carrying amount of an asset exceeds its
estimated undiscounted future cash flows, an impairment charge is recognized by
the amount by which the carrying amount of the asset exceeds the fair value of
the assets. Fair value is generally determined using the asset’s expected future
discounted cash flows or market value, if readily determinable. Based on its
review, the Company believes that, as of September 30, 2010 and December 31,
2009, there were no significant impairments of its long-lived
assets.





Warranties





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





The
Company's warranty reserve at September 30, 2010 and December 31, 2009, are as
follows:





2010
                            
                            
                            2009Beginning
      balance
                            
                            $
                            675,562
                            
                            
                            $
                            -Provisions
      made
                            
                            
                            25,297
                            
                            
                            
                            675,562Actual
      costs incurred
                            
                            
                            -
                            
                            
                            
                            -Ending
      balance in current liabilities
                            
                            $
                            700,859
                            
                            
                            $
                            675,562





Income
Taxes





The
Company utilizes Statement of Financial Accounting Standards ("SFAS") No. 109,
“Accounting for Income Taxes” (codified in FASB ASC Topic 740), which requires
recognition of deferred tax assets and liabilities for expected future tax
consequences of events 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.




8




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





Interest
associated with unrecognized tax benefits is classified as interest expense and
penalties are classified as selling, general and administrative expense in the
statements of income. The adoption of FIN 48 did not have a material impact on
the Company’s financial statements. At September 30, 2010 and December 31, 2009,
the Company had not taken any significant uncertain tax position on its tax
return for 2009 and prior years or in computing its tax provision for
2009.





Revenue
Recognition





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





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





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





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





Sales
returns and allowances were $0 for both the nine and three months ended
September 30, 2010 and 2009. The Company does not provide right of return, price
protection or any other concessions to its customers.





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





The
Company provides after-sales services at a charge after the expiration of the
warranty period, with after-sales services mainly consisting of cleaning plate
heat exchangers and repairing and exchanging parts. The Company recognizes such
revenue when service is provided. For the nine months ended September 30, 2010
and 2009, revenue from after-sales services after the expiration of the warranty
period was $74,000 and $299,000, respectively. For the three months ended
September 30, 2010 and 2009, revenue from after-sales services after the
expiration of the warranty period was $34,500 and $295,000,
respectively.





Cost
of Goods Sold





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




9




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,” codified in FASB ASC
Topic 230, cash flows from the Company's operations are calculated based upon
the local currencies. As a result, amounts related to assets and liabilities
reported on the statement of cash flows may not necessarily agree with changes
in the corresponding balances on the balance sheet. The cash flows from
operating, investing and financing activities for the nine months ended
September 30, 2010, excluded the effect of issuance of notes payable (bank
acceptance) of $1.5 million as payments for accounts payable, and $2.9 million
notes receivable (bank acceptance) endorsed to vendors in lieu of
payment.





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





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





Nine Months
                  Ended September 30,
                  (Unaudited)
                
                
                Three Months
                  Ended September 30,
                  (Unaudited)2010
                
                
                2009
                
                
                2010
                
                
                2009Net
      income
                
                $
                16,201,256
                
                
                $
                12,519,354
                
                
                $
                11,106,505
                
                
                $
                8,880,536Weighted
      average shares outstanding - basic
                
                
                32,804,292
                
                
                
                24,430,806
                
                
                
                32,811,125
                
                
                
                24,924,435Effect
      of dilutive securities:Unexercised
      warrants and options
                
                
                41,879
                
                
                
                82,286
                
                
                
                6,395
                
                
                
                86,300Weighted
      average shares outstanding - diluted
                
                
                32,846,171
                
                
                
                24,513,092
                
                
                
                32,817,520
                
                
                
                25,010,735Earnings
      per share - basic
                
                $
                0.49
                
                
                $
                0.51
                
                
                $
                0.34
                
                
                $
                0.36Earnings
      per share - diluted
                
                $
                0.49
                
                
                $
                0.51
                
                
                $
                0.34
                
                
                $
                0.36





Fair
Value of Financial Instruments





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





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





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




10




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





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





As of
September 30, 2010 and December 31, 2009, the Company did not identify any
assets and liabilities that are required to be presented on the balance sheet at
fair value.





Foreign
Currency Translation and Comprehensive Income (Loss)





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





Stock-Based
Compensation





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





Segment
Reporting





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





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





Registration
Rights Agreement





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





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




11




Reclassifications





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





New
Accounting Pronouncements





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





On
February 25, 2010, the FASB issued ASU 2010-09 Subsequent Events Topic 855,
“Amendments to Certain Recognition and Disclosure Requirements,” effective
immediately. The amendments in the ASU remove the requirement for an SEC filer
to disclose a date through which subsequent events have been evaluated in both
issued and revised financial statements. Revised financial statements include
financial statements revised as a result of either correction of an error or
retrospective application of US GAAP. The FASB believes these amendments remove
potential conflicts with the SEC’s literature. The adoption of this ASU did not
have a material impact on the Company’s consolidated financial
statements.





On March
5, 2010, the FASB issued ASU No. 2010-11 Derivatives and Hedging Topic 815,
“Scope Exception Related to Embedded Credit Derivatives.” This ASU clarifies the
guidance within the derivative literature that exempts certain credit related
features from analysis as potential embedded derivatives requiring separate
accounting. The ASU specifies that an embedded credit derivative feature related
to the transfer of credit risk that is only in the form of subordination of one
financial instrument to another is not subject to bifurcation from a host
contract under ASC 815-15-25, Derivatives and Hedging – Embedded Derivatives –
Recognition. All other embedded credit derivative features should be analyzed to
determine whether their economic characteristics and risks are “clearly and
closely related” to the economic characteristics and risks of the host contract
and whether bifurcation is required. The ASU is effective for the Company on
July 1, 2010. The adoption of this ASU did not have a material impact on the
Company’s consolidated financial statements.





In April
2010, the FASB codified the consensus reached in Emerging Issues Task Force
Issue No. 08-09, “Milestone Method of Revenue Recognition.” FASB ASU
No. 2010-17 provides guidance on defining a milestone and determining when
it may be appropriate to apply the milestone method of revenue recognition for
research and development transactions. FASB ASU No. 2010-17 is
effective for fiscal years beginning on or after June 15, 2010, and is
effective on a prospective basis for milestones achieved after the adoption
date. The Company does not expect this ASU will have a material impact on
its financial position or results of operations when it adopts this update on
January 1, 2011.





3.
INVENTORIES





Inventories
at September 30, 2010 and December 31, 2009, were as follows:





2010
                    
                    
                    2009Raw
      materials
                    
                    $
                    16,023,547
                    
                    
                    $
                    8,627,624Work
      in process
                    
                    
                    3,801,792
                    
                    
                    
                    1,001,495Finished
      goods
                    
                    
                    12,632,524
                    
                    
                    
                    1,630,154Total
                    
                    $
                    32,457,863
                    
                    
                    $
                    11,259,273





4.
NOTES RECEIVABLE – BANK ACCEPTANCES





The
Company sold goods to its customers and received Commercial Notes (Bank
Acceptance) from them in lieu of payments for accounts receivable. The Company
discounted the Notes with the bank or endorsed the Notes to vendors, which could
be for payment of their own obligations or to get cash from the third parties.
Most of the Commercial Notes have a maturity of less than six months. At
September 30, 2010 and December 31, 2009, the Company had notes receivable of
$944,769 and $397,248, respectively.





5.
PROPERTY AND EQUIPMENT, NET





Property
and equipment consisted of the following at September 30, 2010 and December 31,
2009:




12




2010
                  
                  
                  2009Building
                  
                  $
                  4,503,137
                  
                  
                  $
                  4,419,315Production
      equipment
                  
                  
                  3,501,841
                  
                  
                  
                  2,979,017Office
      equipment
                  
                  
                  625,212
                  
                  
                  
                  545,789Vehicles
                  
                  
                  801,269
                  
                  
                  
                  594,168Total
                  
                  
                  9,431,459
                  
                  
                  
                  8,538,289Less:
      Accumulated depreciation
                  
                  
                  (1,386,548
                  )
                  
                  
                  (798,680
                  )Net
                  
                  $
                  8,044,911
                  
                  
                  $
                  7,739,609





Depreciation
expense for the nine months ended September 30, 2010 and 2009, was $518,703 and
$268,000, respectively. Depreciation expense for the three months ended
September 30, 2010 and 2009, was $119,603 and $157,000,
respectively.





6.
OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS





Other
receivables, prepayments and deposits consisted of the following at September
30, 2010 and December 31, 2009, respectively:





2010
                  
                  
                  2009Cash
      advance to third parties
                  
                  $
                  1,737,327
                  
                  
                  $
                  1,332,787Deposit
      for public bids of sales contracts
                  
                  
                  1,275,501
                  
                  
                  
                  1,148,526Prepayment
      for freight and related insurance expenses
                  
                  
                  57,923
                  
                  
                  
                  74,412Deposits
                  
                  
                  374,296
                  
                  
                  
                  8,523Advance
      to employees
                  
                  
                  896,809
                  
                  
                  
                  432,144Others
                  
                  
                  1,010,225
                  
                  
                  
                  -Due
      from officer
                  
                  
                  -
                  
                  
                  
                  576,208Total
                  
                  $
                  5,352,081
                  
                  
                  
                  3,572,600





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





Other
receivables, prepayments and deposits also included remaining proceeds of
$576,208 at December 31, 2009, from the exercise of warrants credited to a bank
account in the name of the Chief Financial Officer, which was controlled by
the Company pursuant to a Bank Account Control Agreement between the Company and
the Chief Financial Officer. The Company has the exclusive right to direct the
use of all funds in the account solely for its benefit or the benefit of its
subsidiaries pursuant to the Bank Account Control Agreement. The Chief Financial
Officer was prohibited from using the funds in the account for her personal
use. The $576,208 deposit was transferred to the Company’s bank account on March
18, 2010.





7.
INTANGIBLE ASSETS





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





Intangible
assets consisted of the following at September 30, 2010 and December 31, 2009,
respectively:





2010
                  
                  
                  2009Land
      use rights
                  
                  $
                  3,697,033
                  
                  
                  $
                  3,628,216Know-how
      technology
                  
                  
                  272,123
                  
                  
                  
                  267,058Customer
      list
                  
                  
                  195,470
                  
                  
                  
                  191,832Covenant
      not to compete
                  
                  
                  106,335
                  
                  
                  
                  104,356Software
                  
                  
                  373,320
                  
                  
                  
                  196,218Total
                  
                  
                  4,644,281
                  
                  
                  
                  4,387,680Less:
      Accumulated amortization
                  
                  
                  (516,514
                  )
                  
                  
                  (316,659
                  )Net
                  
                  $
                  4,127,767
                  
                  
                  $
                  4,071,021




13




Amortization
of intangible assets for the nine months ended September 30, 2010 and 2009 was
$191,000 and $141,000, respectively. Amortization of intangible assets for the
three months ended September 30, 2010 and 2009 was $67,000 and $58,000,
respectively. Annual amortization expense for the next five years from September
30, 2010, is expected to be: $255,000, $250,000, $209,000, $104,000 and
$92,000.





8.
TAXES PAYABLE





Taxes
payable consisted of the following at September 30, 2010 and December 31,
2009:





2010
                  
                  
                  2009Income
      tax
                  
                  $
                  2,354,163
                  
                  
                  $
                  1,202,058Value
      added tax
                  
                  
                  425,357
                  
                  
                  
                  878,638Other
      taxes
                  
                  
                  20,174
                  
                  
                  
                  59,931$
                  2,799,694
                  
                  
                  $
                  2,140,627





9.
ACCRUED LIABILITIES AND OTHER PAYABLES





Accrued
liabilities and other payables consisted of the following at September 30, 2010
and December 31, 2009:





2010
                      
                      
                      2009Advance
      from third parties
                      
                      $
                      -
                      
                      
                      $
                      258,759Payable
      to Siping (see Note 1)
                      
                      
                      1,223,680
                      
                      
                      
                      2,080,013Other
      payables
                      
                      
                      1,022,993
                      
                      
                      
                      91,329Warranty
      reserve
                      
                      
                      700,859
                      
                      
                      
                      675,562Accrued
      liabilities
                      
                      
                      1,940,034
                      
                      
                      
                      579,609Total
                      
                      $
                      4,887,566
                      
                      
                      $
                      3,685,272





Advance
from third parties represented short term, non interest bearing advances from
third parties. Other payables consisted of payables for the Company’s
miscellaneous expenses including postage, business insurance, employee benefits,
bidding fee, etc. Accrued liabilities mainly consisted of accrued purchase,
interest, utility, and liquidated damages for failure of the Registration
Statement to be declared effective by the SEC within 180 days of the final
closing of the private placement, which Registration Statement was subsequently
declared effective in June 2009 (See Note 2).





10.
NOTES PAYABLE – BANK ACCEPTANCES





Notes
payable represented the conversion of accounts payable into notes payable, which
were issued from the bank. The Company deposited a portion of the acceptance
amount into the bank. The bank charged a certain percentage of the face value of
the note, which is amortized over the term of the acceptance.





11.
LOANS PAYABLE - BANK





The
Company was obligated for the following short term loans payable as of September
30, 2010 and December 31, 2009:





2010
                      
                      
                      2009From
      a commercial bank in the PRC for RMB 30,000,000, of which RMB 17,000,000
      was entered into on April 22, 2009, and was due on April 22, 2010, and RMB
      13,000,000 was entered into on June 12, 2009, and was due on June 12,
      2010. These loans had an interest rate of 5.576%. The Company pledged its
      building in the value of approximately RMB 12,430,950 or approximately
      $1,818,000 for these loans. The Company paid the loans in full when they
      matured.
                      
                      $
                      -
                      
                      
                      $
                      4,393,544From
      a commercial bank in the PRC for RMB 17,000,000 entered into on July 1,
      2010. The loan currently bears interest at 5.31% with maturity on June 30,
      2011. The Company pledged its building and land use rights for this
      loan.
                      
                      
                      2,536,897
                      
                      
                      
                      -From
      a commercial bank in the PRC for RMB 13,000,000 entered into on August 9,
      2010. The loan currently bears interest at 5.31% with maturity on June 30,
      2011. The Company pledged its building and land use rights for this
      loan,.
                      
                      
                      1,939,980
                      
                      
                      
                      -$
                      4,476,877
                      
                      
                      $
                      4,393,544




14




12.
DEFERRED TAX ASSET (LIABILITY)





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





13.
INCOME TAXES





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





SmartHeat
was incorporated in the U.S. and has net operating losses (NOL) for income tax
purposes. SmartHeat has net operating loss carry forwards for income taxes of
approximately $2,381,000 and $1,775,000 at September 30, 2010 and December 31,
2009, respectively, which may be available to reduce future years’ taxable
income as NOL; NOL can be carried forward up to 20 years from the year the loss
is incurred. Management believes the realization of benefits from these losses
remains uncertain due to the Company’s limited operating history and continuing
losses. Accordingly, a 100% deferred tax asset valuation allowance has been
provided.





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





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





SanDeKe
is exempt from income tax for two years starting from its first profitable year,
and is entitled to a 50% discount on the income tax rate for 2010 through 2012.
The income tax rate for SanDeKe was 11% and 0% for 2010 and 2009,
respectively.





SmartHeat
Siping, Jinhui, HEAT Investment and HEAT Energy are subject to the regular 25%
income tax rate.





The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the nine and three months ended September 30, 2010 and
2009:





Nine Months
                      Ended September 30,
                    
                    
                    Three Months
                      Ended September 30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009US
      statutory rates
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %Tax
      rate difference
                    
                    
                    (9.4
                    )%
                    
                    
                    (14.0
                    )%
                    
                    
                    (9.2
                    )%
                    
                    
                    (14.0
                    )%Effect
      of tax holiday
                    
                    
                    (10.7
                    )%
                    
                    
                    (5.0
                    )%
                    
                    
                    (10.2
                    )%
                    
                    
                    (5.0
                    )%Others
                    
                    
                    0.3
                    %
                    
                    
                    (0.5
                    )%
                    
                    
                    0.2
                    %
                    
                    
                    -Valuation
      allowance
                    
                    
                    1.7
                    %
                    
                    
                    1.0
                    %
                    
                    
                    1.1
                    %
                    
                    
                    0.4
                    %Tax
      per financial statements
                    
                    
                    15.9
                    %
                    
                    
                    15.5
                    %
                    
                    
                    15.9
                    %
                    
                    
                    15.4
                    %





14.
MAJOR CUSTOMERS AND VENDORS





For the
nine months ended September 30, 2010 and 2009, no customer accounted for more
than 10% of sales. For the three months ended September 30, 2010, no customer
accounted for more than 10% of sales. For the three months ended September 30,
2009, one customer accounted for approximately 11% of sales. At September 30,
2010 and December 31, 2009, the total receivable balance due from these
customers was approximately $0 and $3,319,000, respectively.





No vendor
accounted for 10% of the Company’s purchases of raw materials for the nine
months ended September 30, 2010. One vendor accounted for 13% of the Company’s
purchases of raw materials for the nine months ended September 30, 2009. No
vendor provided 10% or more of the Company’s purchases of raw materials for the
three months ended September 30, 2010. One vendor accounted for 15% of the
Company’s purchases of raw materials for the three months ended September 30,
2009.




15




15.
STATUTORY RESERVES





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





Surplus
Reserve Fund





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





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





Common
Welfare Fund





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





16.
STOCKHOLDERS’ EQUITY





Common
Stock with Warrants Issued for Cash





In August
2008, SmartHeat sold 1,630,000 Units at $3.50 per Unit for approximately $5.7
million. Each "Unit" consisted of one share of SmartHeat common stock and a
three-year warrant to purchase 15% of one share of common stock at $6.00 per
share. The Units sold represent 1,630,000 million shares of common stock and
warrants to purchase 244,500 shares of Common Stock. In connection with the
private placement offering, the Company paid commissions of approximately
$340,000 and issued warrants to purchase 148,500 shares of common stock to its
placement agents. The warrants are immediately exercisable and expire on the
third anniversary of their issuance. The warrants require the Company to settle
in its own shares. There is no provision for cash settlement, except in lieu of
fractional shares. Net proceeds of approximately $5.1 million were received by
the Company. The value of warrants was determined by using the Black-Scholes
pricing model with the following assumptions: discount rate– 2.76%; dividend
yield– 0%;
expected volatility– 15% and term of 3
years. The value of the Warrants was $70,246. During 2009, 281,975 shares of
warrants were exercised at $6 per share for $1,691,850. During the nine months
ended September 30, 2010, 14,250 shares of warrants were exercised at $6 per
share for $85,500.





Following
is a summary of the warrant activity:





Number of
                    Shares
                  
                  
                  Average
                    Exercise
                    Price per Share
                  
                  
                  Weighted
                    Average
                    Remaining
                    Contractual
                    Term in YearsOutstanding
      at December 31, 2008
                  
                  
                  393,000
                  
                  
                  
                  6.00
                  
                  
                  
                  2.51Exercisable
      at December 31, 2008
                  
                  
                  393,000
                  
                  
                  
                  6.00
                  
                  
                  
                  2.51GrantedExercised
                  
                  
                  (281,975
                  )ForfeitedOutstanding
      at December 31, 2009
                  
                  
                  111,025
                  
                  
                  
                  6.00
                  
                  
                  
                  1.51Exercisable
      at December 31, 2009
                  
                  
                  111,025
                  
                  
                  
                  6.00
                  
                  
                  
                  1.51GrantedExercised
                  
                  
                  (14,250
                  )ForfeitedOutstanding
      at June 30, 2010
                  
                  
                  96,775
                  
                  
                  
                  6.00
                  
                  
                  
                  1.01Exercisable
      at June 30, 2010
                  
                  
                  96,775
                  
                  
                  
                  6.00
                  
                  
                  
                  1.01GrantedExercisedForfeitedOutstanding
      at September 30, 2010
                  
                  
                  96,775
                  
                  
                  
                  6.00
                  
                  
                  
                  0.76Exercisable
      at September 30, 2010
                  
                  
                  96,775
                  
                  
                  
                  6.00
                  
                  
                  
                  0.76




16






Stock
Options to Independent Directors and Employee





On July
17, 2008, the Company granted non-statutory stock options to each of its two
independent U.S. directors. The terms of each option are: 10,000 shares at an
exercise price per share of $4.60, with a life of five years and vesting over
three years as follows: 3,333 shares vest on July 17, 2009; 3,333 shares vest on
July 17, 2010; and 3,334 shares vest on July 17, 2011, subject in each case to
the director continuing to be associated with the Company as a director. The
options were valued using a volatility of 15%, risk free interest rate of 2.76%,
and dividend yield of 0%. No estimate of forfeitures was made as the Company has
a short history of granting options.





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





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





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





Following
is a summary of the option activity:





Number of
                                                    Shares
                                                  
                                                  
                                                  Average
                                                    Exercise
                                                    Price per Share
                                                  
                                                  
                                                  Weighted
                                                    Average
                                                    Remaining
                                                    Contractual
                                                    Term in YearsOutstanding
      at December 31, 2008
                                                  
                                                  
                                                  20,000
                                                  
                                                  
                                                  $
                                                  4.60
                                                  
                                                  
                                                  
                                                  4.54Exercisable
      at December 31, 2008
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -GrantedExercisedForfeited
                                                  
                                                  
                                                  6,667Outstanding
      at December 31, 2009
                                                  
                                                  
                                                  13,333
                                                  
                                                  
                                                  $
                                                  4.60
                                                  
                                                  
                                                  
                                                  3.54Exercisable
      at December 31, 2009
                                                  
                                                  
                                                  6,666
                                                  
                                                  
                                                  $
                                                  4.60
                                                  
                                                  
                                                  
                                                  3.54Granted
                                                  
                                                  
                                                  50,000
                                                  
                                                  
                                                  $
                                                  11.85
                                                  
                                                  
                                                  
                                                  5.00ExercisedForfeitedOutstanding
      at June 30, 2010
                                                  
                                                  
                                                  63,333
                                                  
                                                  
                                                  $
                                                  10.32
                                                  
                                                  
                                                  
                                                  4.26Exercisable
      at June 30, 2010
                                                  
                                                  
                                                  6,666
                                                  
                                                  
                                                  $
                                                  10.32
                                                  
                                                  
                                                  
                                                  4.26GrantedExercisedForfeitedOutstanding
      at September 30, 2010
                                                  
                                                  
                                                  63,333
                                                  
                                                  
                                                  $
                                                  10.32
                                                  
                                                  
                                                  
                                                  4.01Exercisable
      at September 30, 2010
                                                  
                                                  
                                                  9,999
                                                  
                                                  
                                                  $
                                                  10.32
                                                  
                                                  
                                                  
                                                  4.01




17




There
were no options exercised during the nine months ended September 30, 2010. The
Company recorded $142,869 and $1,755 as compensation expense for stock options
during the nine months ended September 30, 2010 and 2009, respectively. The
Company recorded $87,895 and $1,537 as compensation expense for stock options
during the three months ended September 30, 2010 and 2009,
respectively.





Stock
Issued for Public Offering





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





Stock
Issued for Consulting Service





On
January 1, 2010, the Company entered into a one-year consulting service
agreement with a consultant for providing business development assistance and
engineering advice regarding the sales and marketing of the products of the
Company.  On July 16, 2010, the Company and consultant amended the
compensation terms under the consulting service agreement. The Company will
compensate the consultant on a quarterly basis at $6,250 and 500 restricted
shares of the Company’s common stock; the Company granted the consultant 1,000
shares on April 9, 2010, under the terms of the original consulting agreement,
which the consultant accepted as payment in full for the first quarter of 2010.
The Company granted the consultant 1,000 shares on June 2, 2010, for the second
and third quarters of 2010, with the remaining 500 shares to be granted on or
about September 30, 2010.  For the nine months ended September 30,
2010, the Company recorded $18,090 stock compensation expense.





17.
COMMITMENTS





Employment
Agreements





On
January 1, 2008, the Company entered into a three-year employment agreement with
Mr. Jun Wang, the Company’s Chief Executive Officer, which agreement may be
renewed at the end of the initial term upon mutual agreement between Mr. Wang
and the Company. Either party shall give written notice to the other
party of its intention not to renew the agreement at least 30 days prior to
the end of the initial term. Pursuant to the terms of the employment agreement,
Mr. Wang shall receive a salary in an amount that is not less than the lowest
minimum wage per month paid in Shenyang and shall be based on the uniform
wage and incentive system in Shenyang. On February 1, 2010, the Company approved
an increase in the annual compensation for Mr. Wang to a base salary of $150,000
per annum, effective as of February 1, 2010. In addition, Mr. Wang shall be
entitled to overtime pay in accordance with the applicable law.





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





Lease
Agreements





The
Company leased several offices for its sales representative in different cities
under various one-year, non-cancellable, and renewable operating lease
agreements. Rental expense for the nine months ended September 30, 2010 and
2009, was approximately $142,000 and $135,000, respectively. Rental expense for
the three months ended September 30, 2010 and 2009, was approximately $71,000
and $56,000, respectively.





Capital
Contribution





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





Deposit
for Land Use Right





During
the three months ended September 30, 2010, HEAT Energy received a land use right
for building a plant to manufacture PHE, heat meters, PHE units, ground source
heat pump, pressure containers and nuclear power generation-related devices. The
charge for the land use right is RMB 64.31 million ($9.6
million).


18




18.
CONTINGENCIES





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





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




19




CAUTIONARY
STATEMENT FOR FORWARD-LOOKING STATEMENTS





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





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





Overview





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





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





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





On April
7, 2010, we formed a wholly-owned subsidiary in Shenyang, named Smartheat
(China) Investment Co., Ltd (“HEAT Investment”), with registered capital of $70
million. HEAT investment is an investment holding company.





On April
12, 2010, HEAT Investment formed a wholly-owned subsidiary in Shenyang, named
SmartHeat (Shenyang) Energy Equipment Co., Ltd (“HEAT Energy”), with registered
capital of $30 million for research, development, manufacturing and sales of
energy products. HEAT Energy has not commenced operations as of September 30,
2010.





Our
revenue is subject to fluctuations due to the timing of sales of high-value
products, the impact of seasonal spending patterns, the timing and size of
projects our customers perform, changes in overall spending levels in the
industry and other unpredictable factors that may affect customer ordering
patterns. Our revenues may fluctuate significantly due to the seasonal nature of
central heating services in the PRC, whereas, the equipment used in residential
buildings must be delivered and installed prior to the beginning of the heating
season in late fall. Additionally, any significant delays in the commercial
launch or any lack or delay of commercial acceptance of new products,
unfavorable sales trends in existing product lines, or impacts from the other
factors mentioned above, could adversely affect our revenue growth or cause a
sequential decline in quarterly revenue. We have not been adversely affected by
these trends or weaker demand from steel processing, petrochemical and
HVAC.




20




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





Basis
of Presentation





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





Principle
of Consolidation





The
accompanying consolidated financial statements include the accounts of
SmartHeat, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, HEAT Investment and HEAT
Energy. The "Company" refers collectively to SmartHeat, Taiyu, SanDeKe,
SmartHeat Siping, Jinhui, HEAT Investment and HEAT Energy. All significant
inter-company accounts and transactions were eliminated in
consolidation.





Use
of Estimates





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





Accounts
Receivable





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





Inventories





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





Property
and Equipment





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





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





Revenue
Recognition





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





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


21




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





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





Foreign
Currency Translation and Comprehensive Income (Loss)





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





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





Recent
Accounting Pronouncements





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





On
February 25, 2010, the FASB issued ASU 2010-09 Subsequent Events Topic 855,
“Amendments to Certain Recognition and Disclosure Requirements,” effective
immediately. The amendments in the ASU remove the requirement for an SEC filer
to disclose a date through which subsequent events have been evaluated in both
issued and revised financial statements. Revised financial statements include
financial statements revised as a result of either correction of an error or
retrospective application of US GAAP. The FASB believes these amendments remove
potential conflicts with the SEC’s literature. The adoption of this ASU did not
have a material impact on the Company’s consolidated financial
statements.





On March
5, 2010, the FASB issued ASU No. 2010-11 Derivatives and Hedging Topic 815,
“Scope Exception Related to Embedded Credit Derivatives.” This ASU clarifies the
guidance within the derivative literature that exempts certain credit related
features from analysis as potential embedded derivatives requiring separate
accounting. The ASU specifies that an embedded credit derivative feature related
to the transfer of credit risk that is only in the form of subordination of one
financial instrument to another is not subject to bifurcation from a host
contract under ASC 815-15-25, Derivatives and Hedging – Embedded Derivatives –
Recognition. All other embedded credit derivative features should be analyzed to
determine whether their economic characteristics and risks are “clearly and
closely related” to the economic characteristics and risks of the host contract
and whether bifurcation is required. The ASU is effective for the Company on
July 1, 2010. The adoption of this ASU did not have a material impact on the
Company’s consolidated financial statements.





In April
2010, the FASB codified the consensus reached in Emerging Issues Task Force
Issue No. 08-09, “Milestone Method of Revenue Recognition.” FASB ASU
No. 2010-17 provides guidance on defining a milestone and determining when
it may be appropriate to apply the milestone method of revenue recognition for
research and development transactions. FASB ASU No. 2010-17 is
effective for fiscal years beginning on or after June 15, 2010, and is
effective on a prospective basis for milestones achieved after the adoption
date. The Company does not expect this ASU will have a material impact on
its financial position or results of operations when it adopts this update on
January 1, 2011.


22




Results
of Operations





Nine
Months Ended September 30, 2010, Compared to the Nine Months Ended September 30,
2009





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





2010
                                
                                
                                2009$
                                
                                
                                % of Sales
                                
                                
                                $
                                
                                
                                % of SalesSales
                                
                                
                                83,613,250
                                
                                
                                
                                
                                
                                
                                56,541,795Cost
      of sales
                                
                                
                                54,177,914
                                
                                
                                
                                64.8
                                %
                                
                                
                                36,562,363
                                
                                
                                
                                64.7
                                %Gross
      profit
                                
                                
                                29,435,336
                                
                                
                                
                                35.2
                                %
                                
                                
                                19,979,432
                                
                                
                                
                                35.3
                                %Operating
      expenses
                                
                                
                                10,595,119
                                
                                
                                
                                12.7
                                %
                                
                                
                                4,952,245
                                
                                
                                
                                8.8
                                %Income
      from operations
                                
                                
                                18,840,217
                                
                                
                                
                                22.5
                                %
                                
                                
                                15,027,187
                                
                                
                                
                                26.6
                                %Other
      income (expenses), net
                                
                                
                                403,259
                                
                                
                                
                                0.5
                                %
                                
                                
                                (203,161
                                )
                                
                                
                                (0.4
                                )%Income
      tax expense
                                
                                
                                3,059,182
                                
                                
                                
                                3.6
                                %
                                
                                
                                2,304,672
                                
                                
                                
                                4.1
                                %Noncontrolling
      interest
                                
                                
                                16,962
                                
                                
                                
                                0
                                %
                                
                                
                                -
                                
                                
                                
                                0
                                %Net
      income to SmartHeat Inc.
                                
                                
                                16,201,256
                                
                                
                                
                                19.4
                                %
                                
                                
                                12,519,354
                                
                                
                                
                                22.1
                                %





Sales. Net sales during
the nine months ended September 30, 2010, were $83.61 million, consisting of
$33.81 million for PHE units, $40.89 million for PHEs, and $8.91 million for
heat meters, while our net sales for the nine months ended September 30, 2009,
were $56.54 million, consisting of $28.56 million for PHE units, $20.14 million
for PHEs, and $7.84 million for heat meters, an overall increase of $27.07
million or 48%. The increase in sales came primarily from two of the
Company’s product lines – PHEs and PHE units – and benefited from the continued
government stimulus in energy-saving industry, strong economic growth in China
and our successful market expansion. Our sales from our PHEs brought us
additional sales of $20.75million or 103% increase in sales during the nine
months ended September 30, 2010, compared with the same period of last year. Our
PHE unit sales increased by $5.24 million or 18% compared to the same period of
last year due to our continuous effort on market expansion. The heat meters
products also brought us an additional $1.08 million in sales or 14% increase in
sales compared with the same period of last year. According to Article 38 of
China’s Energy Conservation Law issued in 2007, new apartments and retrofitted
apartments must install heat meters, but the implementation of this
government-mandated process takes time and differs by region, which may cause
our growth rate to fluctuate; however, we expect heat meter sales generally will
witness significant growth in the coming 2-3 years and we believe we will
benefit from this growth as we are one of the top heat meter manufacturers. We
have a strict review process for approving each sales contract, especially with
respect to the determination of a selling price. Sales price under each contract
is determined in proportion to our estimated cost in order to ensure our gross
profit. Our selling price varies on each sale, which depends mainly on each
customer’s specific needs and our negotiation of the contract amount and term.
We have been continuously expanding the heat-supply market in more regions as a
result of the PRC government’s economic stimulus plan stressing increased
domestic infrastructure construction as well as continuous research and
development on new products. We believe our sales will continue to grow because
we are strengthening our sales efforts through the maturation of our sales force
and by increasing sales channels and improving the quality of our
products.





Cost of Sales.Cost of sales
for the nine months ended September 30, 2010, was $54.18 million, while our cost
of sales for the nine months ended September 30, 2009, was $36.56 million, an
increase of $17.62 million or 48%. Cost of sales mainly consisted of the cost of
materials and labor, as well as factory overhead costs. The increase in
cost of sales is attributed to the increase of production and sales volume in
the nine months ended September 30, 2010. Cost of sales as a percentage of
sales was 64.8% for the nine months ended September30, 2010, and 64.7% for the
same period in 2009. We believe our cost of sales will remain stable as a result
of stronger sales in new product areas, our current pricing strategy and the
continued improvement in the efficiency of our manufacturing
facility.





Gross Profit. Gross profit
was $29.44 million for the nine months ended September 30, 2010, compared to
$19.98 million for the nine months ended September 30, 2009, representing gross
margins of 35.2% and 35.3%, respectively. The increase in our gross profits was
due to increased sales activities. Gross profit margin remained consistent at
approximately 35%.





Operating Expenses. Operating
expenses consisting of selling, general and administrative expenses totaled
$10.60 million for the nine months ended September 30, 2010, compared to $4.95
million for the nine months ended September 30, 2009, an increase of $5.64
million or 114%. Operating expenses as a percentage of sales was 12.7% in the
nine months ended September 30, 2010, compared to 8.8% in the same period of
2009. The increase in operating expenses resulted from increased sales and
expansion of our business, including the hiring of more sales personnel, higher
depreciation expense, training the marketing team and establishing new sales
offices in more regions of China. We believe the expansion of our marketing team
and training of our marketing team and other employees will increase total sales
and improve the efficiency of our operation. We will continue our tight
budgetary control and cost effectiveness.




23




Net Income. Our net income
for the nine months ended September 30, 2010, was $16.20 million compared to
$12.52 million for the nine months ended September 30, 2009, an increase of
$3.68 million or 29%. Net income as a percentage of sales is 19.4% and
22.1% in the nine months ended September 30, 2010 and 2009, respectively. This
increase in net income was attributable to economies of scale combined with
rapid growth in revenue and efficiency of operations, while the decrease in net
income as a percentage to sales was attributable to increased operating expenses
as a result of the rapid expansion of our business. We believe net income will
continue to increase as we continue to increase our sales, offer better quality
products and control our manufacturing costs.





Quarter
Ended September 30, 2010, Compared to the Quarter Ended September 30,
2009





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





2010
                                
                                
                                2009$
                                
                                
                                % of Sales
                                
                                
                                $
                                
                                
                                % of SalesSales
                                
                                
                                51,476,821
                                
                                
                                
                                
                                
                                
                                37,835,897Cost
      of sales
                                
                                
                                33,061,854
                                
                                
                                
                                64.2
                                %
                                
                                
                                24,687,460
                                
                                
                                
                                65.2
                                %Gross
      profit
                                
                                
                                18,414,968
                                
                                
                                
                                35.8
                                %
                                
                                
                                13,148,438
                                
                                
                                
                                34.8
                                %Operating
      expenses
                                
                                
                                5,396,756
                                
                                
                                
                                10.5
                                %
                                
                                
                                2,452,582
                                
                                
                                
                                6.5
                                %Income
      from operations
                                
                                
                                13,018,212
                                
                                
                                
                                25.3
                                %
                                
                                
                                10,695,856
                                
                                
                                
                                28.3
                                %Other
      income (expenses), net
                                
                                
                                178,938
                                
                                
                                
                                0.3
                                %
                                
                                
                                (191,080)
                                
                                
                                
                                (0.5)
                                %Income
      tax expense
                                
                                
                                2,092,876
                                
                                
                                
                                4.0
                                %
                                
                                
                                1,624,240
                                
                                
                                
                                4.3
                                %Noncontrolling
      interest
                                
                                
                                2,232
                                
                                
                                
                                0
                                %
                                
                                
                                -
                                
                                
                                
                                0
                                %Net
      income to SmartHeat Inc.
                                
                                
                                11,106,505
                                
                                
                                
                                21.6
                                %
                                
                                
                                8,880,536
                                
                                
                                
                                23.5
                                %





Sales. Net sales during
the three months ended September 30, 2010, were $51.48 million, consisting of
$19.98 million for PHE units, $23.68 million for PHEs, and $7.82 for heat
meters, while our net sales for the three months ended September 30, 2009, were
$37.84 million, consisting of $16.70 million for PHE units, $13.73 million for
PHEs, and $7.41 million for heat meters, an overall increase of $13.64 million
or 36%. The increase in sales came from all three of the Company’s product
lines – PHEs  PHE units  and Heat Meters– and benefited from
the continued government stimulus in energy-saving industry, strong economic
growth in China and our successful market expansion. Our sales from our PHEs
increased due to the market’s acceptance of our products with well-developed
technology and reputation for high quality, while our sales of PHE units also
increased as a result of strong market demand and reputation of our Taiyu brand.
We have a strict review process for approving each sales contract, especially
with respect to the determination of a selling price. Sales price under each
contract is determined in proportion to our estimated cost in order to ensure
our gross profit. Our selling price varies on each sale, which depends
mainly on each customer’s specific needs and our negotiation of the contract
amount and term. We have been continuously expanding the heat-supply market in
more regions as a result of the PRC government’s economic stimulus plan
stressing increased domestic infrastructure construction. We believe our sales
will continue to grow because we are strengthening our sales efforts by hiring
more sales personnel, increasing sales channels and improving the quality of our
products.





Cost of Sales.Cost of sales
for the three months ended September 30, 2010, was $33.06 million, while our
cost of sales for the three months ended September 30, 2009, was $24.69 million,
an increase of $8.37 million or 34%. Cost of sales mainly consisted of the cost
of materials and labor, as well as factory overhead costs. The increase in
cost of sales is attributed to the increase of production and sales volume in
the three months ended September 30, 2010. Cost of sales as a percentage of
sales was 64.2% for the three months ended September 30, 2010, and 65.2% for the
same period in 2009. The decrease in cost of sales as a percentage of sales was
mainly due to increasing sales of high-margin products and significant sales
growth leading to reduction to unit cost.. We believe our cost of sales will
remain stable as a result of stronger sales in new product areas, our current
pricing strategy and the continued improvement in the efficiency of our
manufacturing facility.





Gross Profit. Gross profit
was $18.41 million for the three months ended September 30, 2010, compared to
$13.15 million for the three months ended September 30, 2009, representing gross
margins of 35.8% and 34.8%, respectively. The increase in our gross profits was
due to increased sales activities. The increase in gross profit margin was
mainly due to ibetter product mix and economic of scale.





Operating Expenses. Operating
expenses consisting of selling, general and administrative expenses totaled
$5.40 million for the three months ended September 30, 2010, compared to $2.45
million for the three months ended September 30, 2009, an increase of $2.94
million or 120%. Operating expenses as a percentage of sales was 10.5% in the
three months ended September 30, 2010, compared to 6.5% in the same period of
2009. The increase in operating expenses resulted from increased sales and
expansion of our business, including the hiring of more sales personnel, higher
depreciation expense, training the marketing team and establishing new sales
offices in more regions of China. We believe the expansion of our business
and training of our marketing team will increase total sales and improve
efficiency. We will continue our tight budgetary control and cost
effectiveness.




24




Net Income. Our net income
for the three months ended September 30, 2010, was $11.11 million compared to
$8.88 million for the three months ended September 30, 2009, an increase of
$2.23 million or 25%. Net income as a percentage of sales is 21.6% and
23.5% in the three months ended September 30, 2010 and 2009, respectively. This
increase in net income was attributable to economies of scale combined with
rapid growth in revenue and efficiency of operations, while the decrease in net
income as a percentage to sales was attributable to increased operating expenses
as a result of rapid expansion of our business by continuous establishing and
acquisition of new companies. We believe 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





Nine
Months Ended September 30, 2010, Compared to the Nine Months Ended September 30,
2009





As of
September 30, 2010, we had cash and cash equivalents of $14.72 million. Working
capital was $96.16 million at September 30, 2010. The ratio of current assets to
current liabilities was 5.11:1 at September 30, 2010.





The
following is a summary of cash provided by or used in each of the indicated
types of activities during the nine months ended September 30, 2010 and
2009:





2010
                
                
                2009Cash
      provided by (used in):Operating
      activities
                
                $
                (19,759,558
                )
                
                $
                (6,124,354
                )Investing
      activities
                
                
                (12,987,966
                )
                
                
                (4,051,226
                )Financing
      activities
                
                
                (1,726,743
                )
                
                
                69,039,040





Net cash
flow used in operating activities was $19.76 million in the nine months ended
September 30, 2010, as compared to net cash flow used in operating activities of
$6.12 million in the same period of 2009. The increase in net cash flow used in
operating activities was mainly due to increased accounts receivable
outstanding, increased payments made for inventory and advance to suppliers for
raw material despite a significant increase of net income. The significant
amount in inventory and advance to suppliers was due to the rapid increase in
our sales and readiness for the upcoming high season of production and
sales.





Net cash
flow used in investing activities was $12.99 million in the nine months ended
September 30, 2010, compared to net cash used in investing activities of $4.05
million in the same period of 2009. The increase of net cash flow used in
investing activities was mainly due to a deposit made for a land use right
purchase in the amount of $9.45 million, and purchase of fixed assets of $3.28
million.





Net cash
flow used in financing activities was $1.73 million in the nine months ended
September 30, 2010, compared to net cash provided by investing activities of
$69.04 million in the same period of 2009. The increase of net cash flow used in
financing activities was mainly due to repayment of notes payable, while in the
same period of 2009, we had $2.9 million proceeds from loan, net of repayment,
and $66 million from issuance of stock.





Our
agreements with our customers generally provide that 30% of the purchase price
is due upon the placement of an order, 30% is due upon delivery and 30% is due
upon installation and acceptance of the equipment after customer testing. As a
common practice in the heating manufacturing business in China, payment of the
final 10% of the purchase price is due no later than the termination date of the
standard warranty period, which ranges from 3 to 24 months from the acceptance
date. Our receipts for payment on our products depend on the complexity of the
equipment ordered, which impacts manufacturing, delivery, installation and
testing times and warranty periods. For example, PHEs are less complex than PHE
units and therefore have a shorter manufacturing, acceptance, warranty and
payment schedule. We may experience payment delays from time to time with a
range from 1 month to 3 months from the due date; however, we do not believe the
delays have a significant negative impact on our liquidity as the payment delays
are very common in the heating manufacturing industry in China, and the
collection of payment can be reasonably assured based on our historical
collection experience. Our accounts receivable turnover and inventory turnover
are relatively low, and days sales outstanding ratio relatively high.
Consequently, collection on our sales is rather slow and capital is tied up in
inventories, which may result in pressure on cash flows. For the nine months
ended September 30, 2010, we had accounts receivable turnover of 2.58 on an
estimated annualized basis, with days sales outstanding of 141 and inventory
turnover of 3.30 on an estimated annualized basis. For the nine months ended
September 30, 2009, we had accounts receivable turnover of 3.15 on an estimated
annualized basis, with days sales outstanding of 153 and inventory turnover of
3.57 on an estimated annualized basis. The low accounts receivable turnover and
high days outstanding is due to the seasonality of the Company’s sales and
postponement of payments from certain customers for projects collected in the
fourth quarter. The low inventory turnover for 2010 compared to 2009 was due to
increased inventory on hand for the readiness of the high production season with
an increased number of large orders in 2010. Approximately 70% of the Company’s
revenue is generated in the third and fourth quarters.




25




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





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





Off-Balance
Sheet Arrangements





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





Contractual
Obligations





The
Company was obligated for the following short term loans payable as of September
30, 2010 and December 31, 2009:





2010
                          
                          
                          2009Loans
      from a commercial bank in the PRC for RMB 30,000,000, of which RMB
      17,000,000 was entered into on April 22, 2009, and was due on April 22,
      2010, and RMB 13,000,000 was entered into on June 12, 2009, and was due on
      June 12, 2010. These loans had an interest rate of 5.576%. The Company
      pledged its building in the value of approximately RMB 12,430,950 or
      approximately $1,818,000 for these loans. The Company paid the loans in
      full when they matured.
                          
                          $
                          -
                          
                          
                          $
                          4,393,544Loan
      from a commercial bank in the PRC for RMB 17,000,000 entered into on July
      1, 2010. The loan currently bears interest at 5.31% with maturity on June
      30, 2011. The Company pledged its building and land use rights for this
      loan.
                          
                          
                          2,536,897Loan
      from a commercial bank in the PRC for RMB 13,000,000 entered into on
      August 9, 2010. The loan currently bears interest at 5.31% with maturity
      on June 30, 2011. The Company pledged its building and land use rights for
      this loan.
                          
                          
                          1,939,980$
                          4,476,877
                          
                          
                          $
                          4,393,544





Item 3. Quantitative and Qualitative
Disclosures about Market Risk.





Not
required.





Item
4. Controls and Procedures.





Disclosure
Controls and Procedures





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


26




Changes
in Internal Control over Financial Reporting





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





PART II. OTHER INFORMATION





Item 1. Legal Proceedings.





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





Item 1A. Risk Factors.





Not
required.





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





None.





Item 3. Defaults Upon Senior
Securities.





None.





Item 5. Other Information.





None.





Item 6. Exhibits.





Exhibit No.
                        
                        Document
      Description31.1
                        
                        Certification
      of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and
      15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      200231.2
                        
                        Certification
      of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and
      15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      200232.1
                        
                        Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002, as signed by the Chief Executive
      Officer32.2
                        
                        Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002, as signed by the Chief Financial
      Officer




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SIGNATURES





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





SMARTHEAT
      INC.(Registrant)Date:
      November 10, 2010
                By:
                /s/
      Jun WangJun
      WangChief
      Executive Officer(Principal
      Executive Officer)




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