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 March 31, 2010




OR


 ̈
            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: 32,795,875 shares of common stock
outstanding as of May 6, 2010.





TABLE
OF CONTENTS





PagePART I.
      FINANCIAL INFORMATION
                  
                  3Item 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
                  
                  25Item 4T.
                  Controls
      and Procedures
                  
                  25PART
      II. OTHER INFORMATION
                  
                  25Item 1.
                  Legal
      Proceedings
                  
                  25Item 1A.
                  Risk
      Factors
                  
                  25Item 2.
                  Unregistered
      Sales of Equity Securities and Use of Proceeds
                  
                  25Item 3.
                  Defaults
      Upon Senior Securities
                  
                  25Item 5.
                  Other
      Information
                  
                  25Item 6.
                  Exhibits
                  
                  26SIGNATURES
                  
                  27








PART
I. FINANCIAL INFORMATION





Item
1. Financial Statements.





SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS





March 31, 2010 (Unaudited)
                    
                    
                    December 31, 2009ASSETSCURRENT
      ASSETSCash
      & cash equivalents
                    
                    $
                    42,079,522
                    
                    
                    $
                    48,967,992Restricted
      cash
                    
                    
                    1,326,313
                    
                    
                    
                    1,301,573Accounts
      receivable, net
                    
                    
                    22,687,065
                    
                    
                    
                    31,887,785Retentions
      receivable
                    
                    
                    720,340
                    
                    
                    
                    885,642Advances
      to suppliers
                    
                    
                    8,547,598
                    
                    
                    
                    7,657,791Other
      receivables, prepayments and deposits
                    
                    
                    3,974,543
                    
                    
                    
                    3,572,600Taxes
      receivable
                    
                    
                    1,122,365
                    
                    
                    
                    -Inventories
                    
                    
                    23,260,096
                    
                    
                    
                    11,259,273Notes
      receivable - bank acceptances
                    
                    
                    345,927
                    
                    
                    
                    397,248Total
      current assets
                    
                    
                    104,063,769
                    
                    
                    
                    105,929,904NON-CURRENT
      ASSETSRestricted
      cash
                    
                    
                    59,321
                    
                    
                    
                    48,361Accounts
      receivable, net
                    
                    
                    983,853
                    
                    
                    
                    237,384Retentions
      receivable
                    
                    
                    730,908
                    
                    
                    
                    349,931Intangible
      assets, net
                    
                    
                    4,059,989
                    
                    
                    
                    4,071,021Property
      and equipment, net
                    
                    
                    7,671,764
                    
                    
                    
                    7,739,609Total
      noncurrent assets
                    
                    
                    13,505,835
                    
                    
                    
                    12,446,306TOTAL
      ASSETS
                    
                    $
                    117,569,604
                    
                    
                    $
                    118,376,210LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIESAccounts
      payable
                    
                    $
                    1,507,115
                    
                    
                    $
                    3,493,196Unearned
      revenue
                    
                    
                    2,030,834
                    
                    
                    
                    2,130,637Taxes
      payable
                    
                    
                    -
                    
                    
                    
                    2,140,627Accrued
      liabilities and other payables
                    
                    
                    5,458,024
                    
                    
                    
                    3,685,272Notes
      payable - bank acceptances
                    
                    
                    1,723,165
                    
                    
                    
                    1,806,564Loans
      payable
                    
                    
                    4,394,767
                    
                    
                    
                    4,393,544Total
      current liabilities
                    
                    
                    15,113,905
                    
                    
                    
                    17,649,840DEFERRED
      TAX LIABILITY
                    
                    
                    944
                    
                    
                    
                    8,526COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITYCommon
      stock, $0.001 par value; 75,000,000
                      shares
      authorized,  32,794,875 shares issued
                      and
      outstanding at March 31, 2010 and
                      December
      31, 2009, respectively
                    
                    
                    32,795
                    
                    
                    
                    32,795Paid
      in capital
                    
                    
                    74,918,122
                    
                    
                    
                    74,917,370Statutory
      reserve
                    
                    
                    3,040,485
                    
                    
                    
                    2,872,006Accumulated
      other comprehensive income
                    
                    
                    1,009,133
                    
                    
                    
                    969,988Retained
      earnings
                    
                    
                    22,747,855
                    
                    
                    
                    21,231,484Total
      Company stockholders' equity
                    
                    
                    101,748,390
                    
                    
                    
                    100,023,643NONCONTROLLING
      INTEREST
                    
                    
                    706,365
                    
                    
                    
                    694,201TOTAL
      EQUITY
                    
                    
                    102,454,755
                    
                    
                    
                    100,717,844TOTAL
      LIABILITIES AND EQUITY
                    
                    $
                    117,569,604
                    
                    
                    $
                    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





THREE MONTHS ENDED MARCH 31,2010
                
                
                2009Net
      sales
                
                $
                9,368,836
                
                
                $
                6,207,503Cost
      of goods sold
                
                
                6,129,801
                
                
                
                3,900,947Gross
      profit
                
                
                3,239,035
                
                
                
                2,306,556Operating
      expensesSelling
      expenses
                
                
                644,923
                
                
                
                460,913General
      and administrative expenses
                
                
                776,996
                
                
                
                569,522Total
      operating expenses
                
                
                1,421,919
                
                
                
                1,030,435Income
      from operations
                
                
                1,817,116
                
                
                
                1,276,121Non-operating
      income (expenses)Interest
      income
                
                
                155,037
                
                
                
                16,681Interest
      expense
                
                
                (61,252
                )
                
                
                (52,852
                )Financial
      expense
                
                
                (4,313
                )
                
                
                (1,840
                )Other
      income
                
                
                66,735
                
                
                
                760Other
      expenses
                
                
                (240
                )
                
                
                -Total
      non-operating income (expenses), net
                
                
                155,967
                
                
                
                (37,251
                )Income
      before income tax
                
                
                1,973,083
                
                
                
                1,238,870Income
      tax expense
                
                
                269,520
                
                
                
                217,601Income
      from operations
                
                
                1,703,563
                
                
                
                1,021,269Less:
      Income attributable to noncontrolling interest
                
                
                (482
                )
                
                
                -Net
      income to SmartHeat Inc
                
                
                1,703,081
                
                
                
                1,021,269Other
      comprehensive itemForeign
      currency translation
                
                
                23,054
                
                
                
                1,710Comprehensive
      Income
                
                $
                1,726,135
                
                
                $
                1,022,979Basic
      weighted average shares outstanding
                
                
                32,794,875
                
                
                
                24,179,900Diluted
      weighted average shares outstanding
                
                
                32,864,453
                
                
                
                24,184,174Basic
      earnings per share
                
                $
                0.05
                
                
                $
                0.04Diluted
      earnings per share
                
                $
                0.05
                
                
                $
                0.04





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


4


SMARTHEAT
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS





THREE MONTHS ENDED MARCH 31,2010
                  
                  
                  2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Income
      including noncontrolling interest
                  
                  $
                  1,703,563
                  
                  
                  $
                  1,021,269Adjustments
      to reconcile income including noncontrollinginterest
      to net cash used in operating activities:Depreciation
      and amortization
                  
                  
                  228,614
                  
                  
                  
                  96,684Unearned
      interest on accounts receivable
                  
                  
                  39,574
                  
                  
                  
                  28,854Stock
      option compensation expense
                  
                  
                  752
                  
                  
                  
                  -Changes
      in deferred tax liability
                  
                  
                  (7,584
                  )
                  
                  
                  (122
                  )(Increase)
      decrease in current assets:Accounts
      receivable
                  
                  
                  8,273,722
                  
                  
                  
                  1,073,545Retentions
      receivable
                  
                  
                  (215,311
                  )
                  
                  
                  (575,657
                  )Advances
      to suppliers
                  
                  
                  (887,598
                  )
                  
                  
                  (838,551
                  )Other
      receivables, prepayments and deposits
                  
                  
                  (948,705
                  )
                  
                  
                  (608,803
                  )Inventory
                  
                  
                  (11,996,634
                  )
                  
                  
                  (2,044,149
                  )Increase
      (decrease) in current liabilities:Accounts
      payable
                  
                  
                  (2,070,772
                  )
                  
                  
                  1,596,204Unearned
      revenue
                  
                  
                  (100,387
                  )
                  
                  
                  238,745Taxes
      payable
                  
                  
                  (3,263,301
                  )
                  
                  
                  (1,164,537
                  )Accrued
      liabilities and other payables
                  
                  
                  2,498,738
                  
                  
                  
                  442,319Net
      cash used in operating activities
                  
                  
                  (6,745,329
                  )
                  
                  
                  (734,199
                  )CASH
      FLOWS FROM INVESTING ACTIVITIES:Change
      in restricted cash
                  
                  
                  (35,320
                  )
                  
                  
                  47,361Acquisition
      of property & equipment & intangible asset
                  
                  
                  (146,457
                  )
                  
                  
                  (10,474
                  )Notes
      receivable
                  
                  
                  51,427
                  
                  
                  
                  -Net
      cash used in (provided by) investing activities
                  
                  
                  (130,350
                  )
                  
                  
                  36,887EFFECT
      OF EXCHANGE RATE CHANGE ON CASH & CASH EQUIVALENTS
                  
                  
                  (12,791
                  )
                  
                  
                  (248
                  )NET
      DECREASE IN CASH & CASH EQUIVALENTS
                  
                  
                  (6,888,470
                  )
                  
                  
                  (697,560
                  )CASH
      & CASH EQUIVALENTS, BEGINNING OF PERIOD
                  
                  
                  48,967,992
                  
                  
                  
                  1,435,212CASH
      & CASH EQUIVALENTS, END OF PERIOD
                  
                  $
                  42,079,522
                  
                  
                  $
                  737,652Supplemental
      Cash flow data:Income
      tax paid
                  
                  $
                  648,603
                  
                  
                  $
                  777,627Interest
      paid
                  
                  $
                  61,252
                  
                  
                  $
                  60,316





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


5





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 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 in the amount 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 the 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 PRC, to purchase certain assets
consisting of the plant and equipment and certain land use rights
for 54,000,000 RMB, or United States Dollars (USD) 7,906,296. 
Taiyu then transferred all the assets acquired to SmartHeat Siping, the newly
incorporated subsidiary.  The purchase consideration was non-interest
bearing and was payable according to the following schedule:





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





At March
31, 2010, the Company paid approximately $3 million. The payment terms do not
include any default provision.  The Company paid approximately $1.8 million
in April 2010.





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 (US $1.46 million) for research, development, manufacturing , and sales
of plate heat exchangers in more regions of China.  Jinhui has not
commenced operations as of March 31, 2010. SmartHeat owns 52% of Jinhui and
invested approximately $765,000.





2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Principles
of Consolidation





The
accompanying consolidated financial statements include the accounts of
SmartHeat, Taiyu, SanDeKe, SmartHeat Siping, a newly incorporated subsidiary
in June 2009, and Jinhui, a joint venture formed in August 2009. The
"Company" refers collectively to SmartHeat, Taiyu, SanDeKe, SmartHeat Siping and
Jinhui. All significant inter-company accounts and transactions were eliminated
in consolidation.


6





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





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 March 31, 2010, the Company maintained restricted cash of
$1,385,634 in several bank accounts, $1,193,831 representing cash deposits from
customers for securing payment from customers that occurs no later than the
warranty period expires, and $191,803 representing the deposits the Company paid
to a commercial bank for the bank issuing the bank acceptance to its
vendors; of the total restricted cash, $1,326,313 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, $1,036,101 representing
cash deposits from customers for securing payment from customers that occurs no
later than the warranty period expires, and $313,833 representing the deposits
the Company paid to a commercial bank for the bank issuing the bank acceptance
to its vendors; of the total restricted cash, $1,301,573 will be released
to the Company within one year. Restricted cash is held in the 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 $1,128,734 and $1,128,420 at March 31,
2010 and December 31, 2009, respectively.





At March
31, 2010 and December 31, 2009, the Company had retentions receivable from
customers for product quality assurance of $1,451,248 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 $188,743 and $149,123 at March 31,
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, 5.575% at March 31, 2010, and
7.16% in December 31, 2009.





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.


7





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





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 a comparison of the
carrying amount of an asset to the estimated undiscounted future cash flows
expected to be generated by the asset. If the carrying amount of an asset
exceeds its estimated undiscounted future cash flows, an impairment charge is
recognized by the amount by which the carrying amount of the asset exceeds the
fair value of the assets. Fair value is generally determined using the asset’s
expected future discounted cash flows or market value, if readily determinable.
Based on its review, the Company believes that, as of March 31, 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 March 31, 2010 and December 31, 2009 are as
follows:





2010
                    
                    
                    2009Beginning
      balance
                    
                    $
                    675,562
                    
                    
                    $
                    -Provisions
      made
                    
                    
                    89,774
                    
                    
                    
                    675,562Actual
      costs incurred
                    
                    
                    (89,585
                    )
                    
                    
                    -Ending
      balance in current liabilities
                    
                    $
                    675,751
                    
                    
                    $
                    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 that were 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





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





The
Company adopted the provisions of the FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes (codified in FASB ASC Topic 740), on January 1,
2007. As a result of the implementation of FIN 48, the Company made a
comprehensive review of its portfolio of tax positions in accordance with
recognition standards established by FIN 48. As a result of the implementation
of Interpretation 48, the Company recognized no material adjustments to
liabilities or shareholders’ equity. When tax returns are filed, it is highly
certain that some positions taken would be sustained upon examination by the
taxing authorities, while others are subject to uncertainty about the merits of
the position taken or the amount of the position that would be ultimately
sustained. The benefit of a tax position is recognized in the financial
statements in the period during which, based on all available evidence,
management believes it is more likely than not that the position will be
sustained upon examination, including the resolution of appeals or litigation
processes, if any. Tax positions taken are not offset or aggregated with other
positions. Tax positions that meet the more-likely-than-not recognition
threshold are measured as the largest amount of tax benefit that is more than 50
percent likely of being realized upon settlement with the applicable taxing
authority. The portion of the benefits associated with tax positions taken that
exceeds the amount measured as described above is reflected as a liability for
unrecognized tax benefits in the accompanying balance sheets along with any
associated interest and penalties that would be payable to the taxing
authorities upon examination.





Interest
associated with unrecognized tax benefits is classified as interest expense and
penalties are classified as selling, general and administrative expense in the
statements of income. The adoption of FIN 48 did not have a material impact on
the Company’s financial statements. At March 31, 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 Chinese value-added
tax 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 three months ended March 31, 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 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 three months ended March 31, 2010 and
2009, revenue from after sales services after expiration of the warranty period
was approximately $17,390 and $1,700, respectively.


9





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





Cost
of Goods Sold





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





Concentration
of Credit Risk





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





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





Statement
of Cash Flows





In
accordance with SFAS No. 95, “Statement of Cash Flows,” 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 exclude the effect of conversion
from accounts payable to notes payable – bank acceptances of
$83,895.





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 for the three months ended March 31, 2010 and 2009:





2010
                      
                      
                      2009Net
      income
                      
                      $
                      1,703,081
                      
                      
                      $
                      1,021,269Weighted
      average shares outstanding - basic
                      
                      
                      32,794,875
                      
                      
                      
                      24,179,900Effect
      of dilutive securities:Unexercised
      warrants and options
                      
                      
                      69,578
                      
                      
                      
                      4,274Weighted
      average shares outstanding - diluted
                      
                      
                      32,864,453
                      
                      
                      
                      24,184,174Earnings
      per share - basic
                      
                      $
                      0.05
                      
                      
                      $
                      0.04Earnings
      per share - diluted
                      
                      $
                      0.05
                      
                      
                      $
                      0.04





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:


10





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





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





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





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





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





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





Foreign
Currency Translation and Comprehensive Income (Loss)





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





The
Company is required to file the Registration Statement with the SEC within 60
days of the closing of the private placement offering. The Registration
Statement must be declared effective by the SEC within 180 days of the final
closing of the offering. Subject to certain grace periods, the Registration
Statement must remain effective and available for use until the Investors can
sell all of the securities covered by the Registration Statement without
restriction pursuant to Rule 144. If the Company fails to meet the filing or
effectiveness requirements of the Registration Statement, the Company is
required to pay liquidated damages of 2% of the aggregate purchase price paid by
such Investor for any Registrable Securities then held by such Investor on the
date of such failure and on each anniversary of the date of such failure until
such failure is cured.  The last closing under the private placement
was 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 our investors as a result of
failure to declare the effectiveness of the Registration Statement within 180
days of the final closing of the offering.  The liquidated damages were
recorded as the Company’s G&A expense with charging corresponding account to
accrued liabilities.  The Registration Statement became effective June 23,
2009. The Company paid $63,004 for the liquidated damages and the remaining
$46,996 has been waived by investors.


11





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





Reclassifications





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





New
Accounting Pronouncements





On
February 25, 2010, the FASB issued Accounting Standards Update (“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. Early adoption is permitted. The adoption of this ASU will not
have a material impact on the Company’s consolidated financial
statements.





3.
INVENTORIES





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





2010
                      
                      
                      2009Raw
      materials
                      
                      $
                      16,364,889
                      
                      
                      $
                      8,627,624Work
      in process
                      
                      
                      2,685,198
                      
                      
                      
                      1,001,495Finished
      Goods
                      
                      
                      4,210,009
                      
                      
                      
                      1,630,154Total
                      
                      $
                      23,260,096
                      
                      
                      $
                      11,259,273





4.
NOTES RECEIVABLE – BANK ACCEPTANCES





The
Company sold goods to its customers and received Commercial Notes (Bank
Acceptance) from the customers in lieu of the 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 March 31, 2010 and December 31, 2009, the
Company had notes receivable of $345,927 and $397,248,
respectively.





5.
PROPERTY AND EQUIPMENT, NET





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





2010
                
                
                2009Building
                
                $
                4,420,545
                
                
                $
                4,419,315Production
      equipment
                
                
                2,999,879
                
                
                
                2,979,017Office
      equipment
                
                
                572,878
                
                
                
                545,789Vehicles
                
                
                646,013
                
                
                
                594,1688,639,315
                
                
                
                8,538,289Less:
      Accumulated depreciation
                
                
                (967,551
                )
                
                
                (798,680
                )$
                7,671,764
                
                
                $
                7,739,609


12





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





Depreciation
expense for the three months ended March 31, 2010 and 2009 was approximately
$168,900 and $55,000, respectively.





6.
OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS





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





2010
                      
                      
                      2009Cash
      advance to third parties
                      
                      $
                      2,850,246
                      
                      
                      $
                      1,332,787Deposit
      for public bids of sales contracts
                      
                      
                      505,986
                      
                      
                      
                      1,148,526Prepayment
      for freight and related insurance expenses
                      
                      
                      59,040
                      
                      
                      
                      74,412Deposits
                      
                      
                      7,662
                      
                      
                      
                      8,523Advance
      to employees
                      
                      
                      551,609
                      
                      
                      
                      432,144Due
      from officer
                      
                      
                      -
                      
                      
                      
                      576,208Total
                      
                      $
                      3,974,543
                      
                      
                      
                      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 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 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 March 31, 2010 and December 31, 2009,
respectively:





2010
                  
                  
                  2009Land
      use rights
                  
                  $
                  3,629,226
                  
                  
                  $
                  3,628,216Know-how
      technology
                  
                  
                  267,132
                  
                  
                  
                  267,058Customer
      list
                  
                  
                  191,885
                  
                  
                  
                  191,
      832Covenant
      not to compete
                  
                  
                  104,385
                  
                  
                  
                  104,356Software
                  
                  
                  244,091
                  
                  
                  
                  196,2184,436,719
                  
                  
                  
                  4,387,680Less:
      accumulated amortization
                  
                  
                  (376,730
                  )
                  
                  
                  (316,659
                  )$
                  4,059,989
                  
                  
                  $
                  4,071,021


13





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





Amortization
expense of intangible assets for the three months ended March 31, 2010 and 2009
was approximately $60,000 and $42,000, respectively.  Annual amortization
expense for the next five years from March 31, 2010, is expected to be:
$243,000, $242,000, $213,000, $129,000 and $85,000.





8.
TAXES PAYABLE (RECEIVABLE)





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





2010
                  
                  
                  2009Income
      tax payable
                  
                  $
                  79,976
                  
                  
                  $
                  1,202,058Value
      added tax payable (receivable)
                  
                  
                  (1,398,227
                  )
                  
                  
                  878,638Other
      taxes payable
                  
                  
                  195,886
                  
                  
                  
                  59,931$
                  (1,122,365
                  )
                  
                  $
                  2,140,627





9.
ACCRUED LIABILITIES AND OTHER PAYABLES





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





2010
                    
                    
                    2009Advance
      from third parties
                    
                    $
                    50,903
                    
                    
                    $
                    258,759Payable
      to Siping
                    
                    
                    4,631,898
                    
                    
                    
                    2,080,013Other
      payables
                    
                    
                    20,424
                    
                    
                    
                    91,329Warranty
      reserve
                    
                    
                    675,751
                    
                    
                    
                    675,562Accrued
      liabilities
                    
                    
                    77,741
                    
                    
                    
                    326,318Accrued
      salary
                    
                    
                    1,307
                    
                    
                    
                    104,168Total
                    
                    $
                    5,458,024
                    
                    
                    $
                    3,536,149





Advance
from third parties represented short term, non interest bearing advances from
third parties. Other payables consisted of payables for the Company’s
miscellaneous expenses including postage, business insurance, employee benefits,
bidding fee, etc. Accrued liabilities mainly consisted of accrued interest,
payroll, utility and liquidated damages for failure to declare the effectiveness
of the Registration Statement within 180 days of the final closing of the
offering.





10.
LOAN PAYABLE – INSTITUTIONAL INVESTOR





On July
3, 2009, the Company entered into a Senior Loan Agreement with an institutional
investor to obtain a loan of US $9,000,000.  Under the terms of the
Agreement, the Company agreed to interest of 10% payable quarterly beginning on
September 30, 2009. The principal amount and any unpaid interest accrued thereon
are due six (6) months from the date of the Agreement. This loan was repaid
during 2009.





11.
NOTES PAYABLE – BANK ACCEPTANCES





Notes
payable represented accounts payable to vendors that were converted to notes
payable accepted by the bank. The Company deposited a portion of the acceptance
amount into the bank. The bank charged certain percentage of the face value of
the note which is amortized over the term of the acceptance.





12.
LOANS PAYABLE - BANK





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





2010
                    
                    
                    2009From
      a commercial bank in the PRC for 30,000,000 RMB. Of which, 17,000,000 RMB
      is due on April 22, 2010. 13,000,000 RMB was entered into on June 12, 2009
      and is due on June 12, 2010. These loans currently bear interest at
      5.576%.  The Company pledged its building in the value of
      approximately RMB 12,430,950 or approximately $1,818,000 for this
      loan.
                    
                    $
                    4,394,767
                    
                    
                    $
                    4,393,544$
                    4,394,767
                    
                    
                    $
                    4,393,544


14





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





13.
DEFERRED TAX LIABILITY





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





14.
INCOME TAXES





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





SmartHeat
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 $1,945,000 and $1,775,000 at March 31, 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 is subject to the regular 25% income tax rate.





Foreign
pretax earnings were $2,144,260 and $1,352,956 for the three months ended March
31, 2010 and 209 respectively. Pretax earnings of a foreign subsidiary are
subject to U.S. taxation when effectively repatriated. The Company provides
income taxes on the undistributed earnings of non-U.S. subsidiaries except to
the extent those earnings are indefinitely invested outside the United States.
At March 31, 2010, $24.7 million of accumulated undistributed earnings of
non-U.S. subsidiaries was invested indefinitely. At the existing U.S. federal
income tax rate, additional taxes of $4.8 million would have to be provided if
such earnings were remitted currently.





The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the three months ended March 31, 2010 and 2009:





2010
                    
                    
                    2009US
      statutory rates
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %Tax
      rate difference
                    
                    
                    (9.8
                    )%
                    
                    
                    (15.7
                    )%Effect
      of tax holiday
                    
                    
                    (14.1
                    )%
                    
                    
                    (4.5
                    )%Other
                    
                    
                    0.6
                    %
                    
                    –
                    %Valuation
      allowance for U.S. NOL
                    
                    
                    2.9
                    %
                    
                    
                    4.2
                    %Tax
      per financial statements
                    
                    
                    13.6
                    %
                    
                    
                    18.0
                    %





15





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





15.
MAJOR CUSTOMERS AND VENDORS





Four
customers accounted for 61% and 50% of the Company’s net revenue for the three
months ended March 31, 2010 and 2009, respectively. For the three months ended
March 31, 2010, each customer accounted for approximately 17%, 17%, 14% and 13%
of the sales. For the three months ended March 31, 2009, each customer accounted
for approximately 18%, 16%, 12% and 5% of the sales. At March 31, 2010 and 2009,
the total receivable balance due from these customers was approximately
$3,500,000 and $3,319,000, respectively.





Two major
vendors provided 37% of the Company’s purchases of raw materials for the three
months ended March 31, 2010, and one major vendor provided 11% of the purchases
for the three months ended March 31, 2009. For the three months ended March 31,
2010, the two vendors accounted for approximately 19% and 18% of the purchases.
The Company had approximately $56,000 and $110,000 in accounts payable to its
major vendors at March 31, 2010 and 2009, respectively.





16.
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.





17.
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.





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 at a volatility of 15%, risk free interest rate of 2.76%,
and dividend yield of 0%. No estimate of forfeitures was made as the Company has
a short history of granting options.


16





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





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 one 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 shall vest on June 30, 2011;
25,000 shares shall vest on June 29, 2012. The options were valued at 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 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
                        
                        
                        
                        1.51GrantedExercisedForfeitedOutstanding
      at March 31, 2010
                        
                        
                        111,025
                        
                        
                        
                        6.00
                        
                        
                        
                        1.26Exercisable
      at March 31, 2010
                        
                        
                        111,025
                        
                        
                        
                        6.00
                        
                        
                        
                        1.26


17





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





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
                          
                          
                          20,000
                          
                          
                          $
                          4.60
                          
                          
                          
                          4.54GrantedExercisedForfeited
                          
                          
                          6,667Outstanding
      at December 31, 2009
                          
                          
                          13,333
                          
                          
                          $
                          4.60
                          
                          
                          
                          3.54Exercisable
      at December 31, 2009
                          
                          
                          13,333
                          
                          
                          $
                          4.60
                          
                          
                          
                          3.54Granted
                          
                          
                          50,000
                          
                          
                          $
                          11.85
                          
                          
                          
                          5.00ExercisedForfeitedOutstanding
      at March 31, 2010
                          
                          
                          63,333
                          
                          
                          $
                          10.32
                          
                          
                          
                          4.51Exercisable
      at March 31,2010
                          
                          
                          63,333
                          
                          
                          $
                          10.32
                          
                          
                          
                          4.51





There
were no options exercised during the three months ended March 31,
2010.





Stocks
issues 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 option in full at
closing. $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. In addition, the Company paid an
additional $4,499,820 advisory fee in connection with this public
offering.





18.
COMMITMENTS





Employment
Agreements





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





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





Consulting
Agreements





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.  The Company will compensate the consultant with an aggregate of
up to 4,000 restricted shares of the Company’s common stock, with 1,000 shares
to be granted on February 1, 2010, 1,000 shares to be granted on May 31, 2010,
1,000 shares to be granted on August 31, 2010, and 1,000 shares to be granted on
November 30, 2010.





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.  Total rental expense for the three months ended March 31, 2010
and 2009, was approximately $17,000 and $32,000, respectively.


18





SMARTHEAT
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


MARCH
31, 2010 (UNAUDITED) AND DECEMBER 31, 2009





19.
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.





Prior to
our acquisition of Taiyu, we were a development stage business with minimal
operations. We had no interest in any property, but had the right to conduct
exploration activities on 13 mineral title cells covering 27,027 hectares
(66,785 acres) in the Slocan Mining Division of southeastern British Columbia,
Canada. In connection with the acquisition of Taiyu, we transferred all of our
pre-closing assets and liabilities (other than the obligation to pay a $10,000
fee to the Company’s audit firm) to a wholly-owned subsidiary and sold all of
the outstanding capital stock of that subsidiary to our former director and
officer in exchange for the surrender of 2,500,000 shares of our common
stock held by the former director and officer.





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





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. Moreover, the PRC government has recently passed an economic stimulus
package and we believe that our sales will benefit from an increase in
government spending on infrastructure as provided in this package.


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, a newly incorporated subsidiary
in June 2009, and Jinhui, a new joint venture formed in August 2009. For
the purposes of this Report, "Company" refers collectively to SmartHeat, Taiyu,
SanDeKe, SmartHeat Siping and Jinhui. All significant inter-company accounts and
transactions have been eliminated in consolidation.





Use
of Estimates





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





Accounts
Receivable





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





Inventories





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





Property
and Equipment





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


21





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.





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 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
February 25, 2010, the FASB issued Accounting Standards Update (“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. Early adoption is permitted. The adoption of this ASU will not
have a material impact on the Company’s consolidated financial
statements.





Results
of Operations





Three
Months Ended March 31, 2010, Compared to the Three Months Ended March 31,
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
                      
                      
                      9,368,836
                      
                      
                      
                      
                      
                      
                      6,207,503Cost
      of sales
                      
                      
                      6,129,801
                      
                      
                      
                      65.4
                      %
                      
                      
                      3,900,947
                      
                      
                      
                      62.8
                      %Gross
      Profit
                      
                      
                      3,239,035
                      
                      
                      
                      34.6
                      %
                      
                      
                      2,306,556
                      
                      
                      
                      37.2
                      %Operating
      Expenses
                      
                      
                      1,421,919
                      
                      
                      
                      15.2
                      %
                      
                      
                      1,030,435
                      
                      
                      
                      16.6
                      %Income
      from Operations
                      
                      
                      1,817,116
                      
                      
                      
                      19.4
                      %
                      
                      
                      1,276,121
                      
                      
                      
                      20.6
                      %Other
      Income (Expenses), net
                      
                      
                      155,967
                      
                      
                      
                      1.7
                      %
                      
                      
                      (37,251
                      )
                      
                      
                      (0.6
                      )%Income
      tax expense
                      
                      
                      269,520
                      
                      
                      
                      2.9
                      %
                      
                      
                      217,601
                      
                      
                      
                      3.5
                      %Noncontrolling
      interest
                      
                      
                      (482
                      )
                      
                      
                      0
                      %
                      
                      
                      
                      
                      
                      
                      0
                      %Net
      Income to SmartHeat Inc.
                      
                      
                      1,703,081
                      
                      
                      
                      18.2
                      %
                      
                      
                      1,021,269
                      
                      
                      
                      16.5
                      %


22





Sales. Net sales during
the three months ended March 31, 2010, were $9.37 million, while our net sales
for the three months ended March 31, 2009, were $6.21 million, an
increase of $3.16 million, or 51%. The increase in sales was attributable
to an increase in our sales volume, with selling price determined based on our
standard profit margin rate. We have a strict review process for approving each
sales contract, especially with respect to the determination of 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. Our sales from the traditional heat-supply industry increased
approximately $0.71 or 11% compared with the same period in 2009.  We have
also developed new customers in other industries like chemical engineering,
electric power, metal smelting, etc., which increased approximately $1.52
million or 24% compared with same period in 2009.In addition, since July
2009, the new subsidiary SmartHeat Siping began operations and brought us $0.93
million sales or 15% of total sales in the first quarter of 2010. 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 March 31, 2010, was $6.13 million, while our
cost of sales for the three months ended March 31, 2009, was $3.90 million, an
increase of $2.23 million, or 57%.  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 first quarter of 2010. Cost of sales as a percentage of sales
was 65.4% for the three months ended March 31, 2010, and 62.8% for the same
period in 2009. The increase in cost of sales as a percentage of sales was
mainly due to decreased sales prices for certain customers in emerging markets
in the first quarter of 2010 to attract them as long term customers, while in
the first quarter of 2009, the sales price was relatively higher for these
customers.  We believe our cost of sales will remain stable as a result of
our current pricing strategy and the continued improvement in the efficiency of
our manufacturing facility.





Gross Profit.  Gross
profit was $3.24 million for the three months ended March 31, 2010, compared to
$2.31 million for the three months ended March 31, 2009, representing gross
margins of 34.6% and 37.2%, respectively.  The increase in our gross
profits was due mainly to increased sales activities. The decrease in gross
profit margin was due mainly to the regression of sales prices to a normal price
level for certain emerging industries customers as a result of our sales
strategy for business expansion while keeping the customers for the long
term.





Operating Expenses. 
Operating expenses consisting of selling, general and administrative expenses
totaled $1.42 million for the three months ended March 31, 2010, compared to
$1.03 million for the three months ended March 31, 2009, an increase of $0.41
million or 40%.  The increase in operating expenses resulted from increase
sales and expansion of our business.  Operating expenses as a percentage of
sales was 15.2% in the three months ended March 31, 2010, compared to 16.6% in
the same period of 2009. The decrease was attributable to our tight budgetary
control and cost effectiveness.





Net Income.  Our net
income for the three months ended March 31, 2010, was $ 1.70 million compared to
$1.02 million for the three months ended March 31, 2009, an increase of $ 0.68
million or 67%.  Net income as a percentage of sales is 18.2% and
16.5% in the three months ended March 31, 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.  Our management
believes that net income will continue to increase as we continue to increase
our sales, offer better quality products and control our manufacturing
costs.





Liquidity
and Capital Resources





Three
Months Ended March 31, 2010, Compared to the Three Months Ended March 31,
2009





As of
March 31, 2010, we had cash and cash equivalents of $42.08 million. Working
capital was $88.95 million at March 31, 2010. The ratio of current assets to
current liabilities was 6.89:1 at March 31, 2010.





The
following is a summary of cash provided by or used in each of the indicated
types of activities during the three months ended March 31, 2010 and
2009:





2010
                
                
                2009Cash
      provided by (used in):Operating
      Activities
                
                $
                (6,745,329
                )
                
                $
                (734,199
                )Investing
      Activities
                
                
                (130,350
                )
                
                
                36,887Financing
      Activities
                
                
                -
                
                
                
                -


23





Net cash
flow used in operating activities was $6.75 million in the three months ended
March 31, 2010, as compared to net cash flow used in operating activities of
$0.73 million in the same period of 2009. The increase in net cash flow used in
operating activities was mainly due to payments made for inventory, tax
payable and account payable despite a significant increase of net income and
more efficient collection of account receivables. The significant amount in
inventory was due to the rapid increase in our sales.





Net cash
flow used in investing activities was $0.13 million in the three months ended
March 31, 2010, compared to net cash generated in investing activities of $0.04
million in the same period of 2009.  The increase of net cash flow used in
investing activities was mainly due to purchase of fixed assets.





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 first quarter
of 2010, we had accounts receivable turnover of 2.83 on an annualized basis,
with days sales outstanding of 129 and inventory turnover of 3.1 on an
annualized basis.  For the first quarter of 2009, we had accounts
receivable turnover of 2.20 on an annualized basis, with days sales outstanding
of 163 and inventory turnover of 2.20 on an annualized basis.  The low
accounts receivable turnover and high days outstanding is due to the seasonality
of the Company’s sales. Approximately 70% of the Company’s revenue is generated
in the third and fourth quarters. In addition, customers usually do not pay on
due dates, which is normal in the heating manufacturing business in
China.





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





We
recognize the final 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 March 31,
2010 and December 31, 2009:





2010
                      
                      
                      2009From
      a commercial bank in the PRC for 30,000,000 RMB. Of which, 17,000,000 RMB
      was entered into on April 22, 2009 and is due on April 22, 2010.
      13,000,000 RMB was entered into on June 12, 2009 and is due on June 12,
      2010. These loans currently bear interest at 5.576%.  The Company
      pledged its building in the value of approximately RMB 12,430,950 or
      approximately $1,818,000 for this loan.
                      
                      $
                      4,394,767
                      
                      
                      $
                      4,393,544$
                      4,394,767
                      
                      
                      $
                      4,393,544


24





Item 3. Quantitative and Qualitative
Disclosures about Market Risk.





Not
required.





Item
4T. 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.





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.





All
information required to be reported in a report on Form 8-K during the period
covered by this Form 10-Q has been reported.


25





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


26




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.





SMARTHEATINC.(Registrant)Date:
      May 11, 2010
            By:
            /s/ Jun WangJun
      Wang
              Chief
      Executive Officer
              (Principal
      Executive Officer)


27