smartheat10q063012.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

 
FORM 10-Q
 


x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2012
OR
 
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 001-34246

SMARTHEAT INC.
(Exact name of registrant as specified in its charter)

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

A-1, 10, Street 7
Shenyang Economic and Technological Development Zone
Shenyang, China
 
110141
(Address of principal executive offices)
 
(Zip Code)

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

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the last 90 days.
YES  x    NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
YES  x    NO  ¨

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

Large accelerated filer ¨
Accelerated filer ¨
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  ¨   NO  x
3,955,774 shares of common stock outstanding as of August 17, 2012.
 
 
 


SmartHeat Inc.

Table of Contents
 
   Page
Note about Forward-Looking Statements  1
 
PART I. FINANCIAL INFORMATION
 
Item 1.   Financial Statements  3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations  28
Item 3. Quantitative and Qualitative Disclosures about Market Risk  28
Item 4.  Controls and Procedures  37
     
  PART II. OTHER INFORMATION  
Item 1.    Legal Proceedings  39
Item 1A. Risk Factors  39
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds  40
Item 3.  Defaults Upon Senior Securities  40
Item 4. Mine Safety Disclosures  40
Item 5.     Other Information  40
Item 6. Exhibits  40
     
  Signatures  41
     
  Exhibit Index  42
 
 
i

 
NOTE ABOUT FORWARD-LOOKING STATEMENTS AND OTHER INFORMATION

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, which include, but are not limited to, statements concerning our projected revenues, expenses, gross profit and income, mix of revenue, demand for our products, the benefits and potential applications for our products, the need for additional capital, our ability to obtain and successfully perform additional new contract awards and the related funding and profitability of such awards, the competitive nature of our business and markets and product qualification requirements of our customers. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,” “hopes,” “estimates,” “should,” “may,” “will,” “with a view to” and variations of these words or similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Such factors include, but are not limited to the following:

·  
our recent restructuring efforts;
·  
our new management’s ability to operate a public company;
·  
our goals and strategies;
·  
our expansion plans;
·  
our future business development, financial conditions and results of operations;
·  
the expected growth of the market for PHE products, heat meters and heat pumps in our target markets;
·  
our expectations regarding demand for our products;
·  
our expectations regarding keeping and strengthening our relationships with key customers;
·  
our ability to stay abreast of market trends and technological advances;
·  
our ability to protect our intellectual property rights effectively and not infringe on the intellectual property rights of others;
·  
our ability to attract and retain quality employees;
·  
our ability to pursue strategic acquisitions and alliances;
·  
competition in our industry in China;
·  
general economic and business conditions in the regions in which we sell our products;
·  
relevant government policies and regulations relating to our industry; and
·  
market acceptance of our products.

 
1

 
Additionally, this report contains statistical data that we obtained from various publicly available government publications and industry-specific third party reports. Statistical data in these publications also include projections based on a number of assumptions. The markets for PHEs, PHE Units, heat meters and heat pumps may not grow at the rates projected by market data, or at all. The failure of these markets to grow at the projected rates may have a material adverse effect on our business and the market price of our common stock. In addition, the changing nature of our customers’ industries results in uncertainties in any projections or estimates relating to the growth prospects or future condition of our markets. Furthermore, if any one or more of the assumptions underlying the market data is later found to be incorrect, actual results may differ from the projections based on these assumptions.

Unless otherwise indicated, information in this report concerning economic conditions and our industry is based on information from independent industry analysts and publications, as well as our estimates. Except where otherwise noted, our estimates are derived from publicly available information released by third party sources, as well as data from our internal research, and are based on such data and our knowledge of our industry, which we believe to be reasonable. None of the market data from independent industry publications cited in this report was prepared on our or our affiliates’ behalf.

Additional information on the various risks and uncertainties potentially affecting our operating results are discussed in this report and other documents we file with the Securities and Exchange Commission, or the SEC, or available upon written request to our corporate secretary at: A-1, 10, Street 7, Shenyang Economic and Technological Development Zone, Shenyang, China 110141. We undertake no obligation to revise or update publicly any forward-looking statements for any reason, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on these forward-looking statements.

As used in this report, “SmartHeat,” “Company,” “we,” “our” and similar terms refer to SmartHeat Inc. and its subsidiaries, unless the context indicates otherwise.

Our functional currency is the U.S. Dollar, or USD, while the functional currency of our subsidiaries in China are denominated in Chinese Yuan Renminbi, or RMB, the national currency of the People’s Republic of China, which we refer to as the PRC or China, and the functional currency of our subsidiary in Germany is denominated in Euros, or EUR. The functional currencies of our foreign operations are translated into USD for balance sheet accounts using the current exchange rates in effect as of the balance sheet date and for revenue and expense accounts using the average exchange rate during the fiscal year. See Note 2 of the consolidated financial statements included herein.

Effective February 7, 2012, we implemented a one-for-ten reverse stock split of our common stock. Unless otherwise indicated, all share amounts and per share prices in this report were retroactively adjusted to reflect the effect of this reverse stock split. See Note 1 of the consolidated financial statements included herein.
 
Since filing our Form 10-Q for the quarter ended March 31, 2012, we significantly restructured our Board of Directors (the “Board”) and management.  Two directors, Jun Wang and Arnold Staloff, resigned, and two new directors, Oliver Bialowons and Kenneth Scipta, were appointed to our Board.  To better focus his time and attention on our operations, Jun Wang resigned as Chairman and Chief Executive Officer of the parent company, but retained his positions as chief executive of all of our operating subsidiaries.   Mr. Wen Sha and Xudong Wang also refocused all of their time and attention to their roles with our operating subsidiaries by resigning from their respective positions with the parent company.  Oliver Bialowons assumed the duties of President of the parent company on May 25 and Michael Wilhelm assumed the duties of Chief Financial Officer and Treasurer on July 10, following the end of our second quarter. Since assuming their respective duties as President and Chief Financial Officer, our new management team has not yet had the opportunity to fully assess our internal controls and reporting systems. As a result, with respect to Item 4 (Controls and Procedures) and the certifications under Sections 302(a) and 906 of the Sarbanes Oxley Act of 2002, our current President and current Chief Financial Officer have relied upon the evaluation of the effectiveness of our disclosure controls and procedures implemented by our former Chief Executive Officer and Chief Financial Officer, and are qualified in their entirety by their knowledge as of the time of such certification.
 
 
2


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SMARTHEAT INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

   
June 30, 2012
   
December 31, 2011
 
   
(Unaudited)
       
ASSETS
           
             
CURRENT ASSETS
           
     Cash & equivalents
  $ 10,524,475     $ 12,419,922  
     Restricted cash
    2,014,879       2,688,691  
     Accounts receivable, net
    34,674,589       47,055,517  
     Retentions receivable
    3,804,683       3,583,898  
     Advances to suppliers
    7,736,041       17,603,984  
     Other receivables (net), prepayments and deposits
    6,966,372       6,663,330  
     Taxes receivable
    1,488,039       -  
     Inventories, net
    53,277,325       53,648,549  
     Notes receivable - bank acceptances
    714,636       1,916,320  
                 
        Total current assets
    121,201,039       145,580,211  
                 
NONCURRENT ASSETS
               
     Long term investment
    722,750       -  
     Restricted cash
    367,032       204,991  
     Retentions receivable
    357,790       670,291  
     Advance to supplier for equipment
    6,712,014       1,122,914  
     Construction in progress
    1,307,138       522,876  
     Property and equipment, net
    11,183,709       11,348,601  
     Intangible assets, net
    15,078,103       15,419,805  
     Goodwill
    2,037,892       2,098,332  
     Other noncurrent asset
    -       10,044  
                 
       Total noncurrent assets
    37,766,428       31,397,854  
                 
TOTAL ASSETS
  $ 158,967,467     $ 176,978,065  
                 
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
CURRENT LIABILITIES
               
     Accounts payable
  $ 8,622,034     $ 12,660,100  
     Advance from customers
    5,594,098       4,585,218  
     Taxes payable
    9,315       1,178,712  
     Accrued liabilities and other payables
    4,911,877       4,136,298  
     Notes payable - bank acceptances
    47,432       3,278,232  
     Loans payable
    16,442,948       10,633,402  
                 
         Total current liabilities
    35,627,704       36,471,962  
                 
DEFERRED TAX LIABILITY
    139,430       189,516  
                 
LONG-TERM PAYABLE
    2,055,368       2,281,023  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
STOCKHOLDERS' EQUITY
               
     Common stock, $0.001 par value; 75,000,000
        shares authorized, 3,955,774 shares issued and  outstanding
    3,956       3,956  
     Paid-in capital
    103,023,657       102,985,737  
     Statutory reserve
    5,396,014       5,396,014  
     Accumulated other comprehensive income
    10,495,262       11,119,887  
     Retained earnings
    1,260,570       17,445,733  
                 
         Total Company stockholders' equity
    120,179,459       136,951,327  
                 
         NONCONTROLLING INTEREST
    965,506       1,084,237  
                 
         TOTAL EQUITY
    121,144,965       138,035,564  
                 
TOTAL LIABILITIES AND EQUITY
  $ 158,967,467     $ 176,978,065  

The accompanying notes are an integral part of these consolidated financial statements.
 
 
3

 
SMARTHEAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)
 
   
SIX MONTHS ENDED JUNE 30,
   
THREE MONTHS ENDED JUNE 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(Unaudited)
   
(Unaudited)
 
                         
Net sales
  $ 11,728,846     $ 14,970,050     $ 4,982,448     $ 7,077,901  
Cost of goods sold
    9,736,416       9,762,240       4,535,323       4,432,011  
                                 
Gross profit
    1,992,430       5,207,810       447,125       2,645,890  
                                 
Operating expenses
                               
     Selling
    7,368,865       4,202,087       4,995,103       2,272,932  
     General and administrative
    5,480,510       6,819,012       929,452       3,740,566  
     Provision for bad debts
    5,880,728       5,805,672       3,384,837       3,736,818  
                                 
     Total operating expenses
    18,730,103       16,826,771       9,309,392       9,750,316  
                                 
Loss from operations
    (16,737,673 )     (11,618,961 )     (8,862,267 )     (7,104,426 )
                                 
Non-operating income (expenses)
                               
     Interest income
    110,611       132,494       62,472       57,160  
     Interest expense
    (628,049 )     (293,235 )     (345,469 )     (163,063 )
     Financial expense
    (83,015 )     (77,284 )     (31,884 )     (56,857 )
     Foreign exchange transaction gain (loss)
    20,322       (302,204 )     36,667       (177,104 )
     Other income (expenses)
    973,212       324,229       (189,752 )     291,524  
                                 
     Total non-operating income (expenses), net
    393,081       (216,000 )     (467,966 )     (48,340 )
                                 
Loss before income tax
    (16,344,592 )     (11,834,961 )     (9,330,233 )     (7,152,766 )
Income tax benefit
    (44,494 )     (1,328,059 )     (20,390 )     (647,160 )
                                 
Net loss before noncontrolling interest
    (16,300,098 )     (10,506,902 )     (9,309,843 )     (6,505,606 )
Less: loss attributable to noncontrolling interest
    (114,935 )     (134,724 )     (57,145 )     (87,230 )
                                 
Net loss to SmartHeat Inc.
    (16,185,163 )     (10,372,178 )     (9,252,698 )     (6,418,376 )
                                 
Other comprehensive item
                               
     Foreign currency translation gain (loss)
     attributable to SmartHeat Inc.
    (624,625 )     3,625,300       (894,662 )     1,832,070  
                                 
     Foreign currency translation loss
     attributable to noncontrolling interest
    (3,796 )     -       (4,813 )     -  
                                 
Comprehensive loss attributable to SmartHeat Inc.
  $ (16,809,788 )   $ (6,746,878 )   $ (10,147,360 )   $ (4,586,306 )
                                 
Comprehensive loss attributable to noncontrolling interest
  $ (118,731 )   $ (134,724 )   $ (61,958 )   $ (87,230 )
                                 
Basic weighted average shares outstanding
    3,955,774       3,857,238       3,955,774       3,859,260  
                                 
Diluted weighted average shares outstanding
    3,955,774       3,857,238       3,955,774       3,859,260  
                                 
Basic loss per share
  $ (4.09 )   $ (2.69 )   $ (2.34 )   $ (1.66 )
                                 
Diluted loss per share
  $ (4.09 )   $ (2.69 )   $ (2.34 )   $ (1.66 )
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
4

 
SMARTHEAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
   
SIX MONTHS ENDED JUNE 30,
 
   
2012
   
2011
 
   
(Unaudited)
 
             
CASH FLOWS FROM OPERATING ACTIVITIES:
           
            Loss including noncontrolling interest
  $ (16,300,098 )   $ (10,506,902 )
            Adjustments to reconcile net loss including noncontrolling
            interest to net cash provided by (used in) operating activities:
               
            Depreciation and amortization
    942,269       846,867  
            Provision for bad debts
    5,880,728       5,805,672  
            Provision for other receivables
    352,695       -  
            Provision for inventory impairment
    670,887       -  
            Unearned interest on accounts receivable
    (54,553 )     (51,955 )
            Stock option expense
    37,919       253,232  
            Changes in deferred tax
    (49,504 )     (1,344,853 )
                         (Increase) decrease in current assets:
               
                                   Accounts receivable
    6,414,799       (562,246 )
                                   Retentions receivable
    75,783       (465,697 )
                                   Advances to suppliers
    9,890,950       (10,382,745 )
                                   Other receivables, prepayments and deposits
    (682,631 )     1,412,427  
                                   Inventories
    (519,271 )     (9,186,101 )
                                   Taxes receivable
    (1,491,007 )     -  
                         Increase (decrease) in current liabilities:
               
                                   Accounts payable
    (3,997,057 )     2,280,976  
                                   Advance from customers
    748,702       717,616  
                                   Taxes payable
    (1,169,319 )     (2,823,643 )
                                   Accrued liabilities and other payables
    822,137       (940,503 )
                 
            Net cash provided by (used in) operating activities
    1,573,429       (24,947,855 )
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
                                   Change in restricted cash
    502,180       (418,844 )
                                   Acquisition of property & equipment
    (533,098 )     (2,135,598 )
                                   Acquisition of intangible assets
    (32,124 )     (97,420 )
                                   Cash paid for acquisition of subsidiaries
    -       (13,536,914 )
                                   Cash from acquisition of subsidiaries
    -       448,849  
                                   Notes receivable
    1,197,726       531,133  
                                   Advance for equipment purchase
    (5,608,880 )     -  
                                   Construction in progress
    (788,427 )     (432,405 )
                                   Equity method investee
    (721,439 )     -  
                 
            Net cash used in investing activities
    (5,984,062 )     (15,641,199 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
                                   Proceeds from short-term loans
    5,866,126       5,461,309  
                                   Cash contribution from noncontrolling interest
    -       749,303  
                                   Payment on notes payable
    (3,227,291 )     (2,051,360 )
                 
            Net cash provided by financing activities
    2,638,835       4,159,252  
                 
EFFECT OF EXCHANGE RATE CHANGE ON CASH & EQUIVALENTS
    (123,649 )     808,551  
                 
NET DECREASE IN CASH & EQUIVALENTS
    (1,895,447 )     (35,621,251 )
                 
CASH & EQUIVALENTS, BEGINNING OF PERIOD
    12,419,922       56,806,471  
                 
CASH & EQUIVALENTS, END OF PERIOD
  $ 10,524,475     $ 21,185,220  
                 
Supplemental cash flow data:
               
   Income tax paid
  $ 207,724     $ 135,449  
   Interest paid
  $ 723,113     $ 293,816  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
5

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
1. ORGANIZATION AND DESCRIPTION OF BUSINESS

SmartHeat Inc., formerly known as Pacific Goldrim Resources, Inc. (the “Company” or “SmartHeat”), was incorporated on August 4, 2006, in the State of Nevada. The Company, through its operating subsidiaries in China and Germany, designs, manufactures, sells and services plate heat exchangers (“PHEs”), PHE Units, which combine PHEs with various pumps, temperature sensors, valves and automated control systems, heat meters and heat pumps for use in commercial and residential buildings.

On April 14, 2008, the Company entered into a Share Exchange Agreement (the “Share Exchange Agreement”) to acquire Shenyang Taiyu Machinery and Electronic Equipment Co., Ltd., subsequently renamed SmartHeat Taiyu (Shenyang) Energy Technology Co., Ltd. (“Taiyu”), a privately held Sino-foreign joint venture company formed under the laws of the People’s Republic of China (“PRC”) on July 24, 2002, and engaged in the design, manufacture, sale and servicing of plate heat exchange products in China. The Share Exchange Agreement was entered into by SmartHeat, Taiyu and the shareholders of Taiyu. Pursuant to the Share Exchange Agreement, all of the equitable and legal rights, title and interests in and to Taiyu’s share capital of RMB 25,000,000 ($3.95 million) were exchanged for 1,850,000 shares of SmartHeat’s common stock (the “Share Exchange”). SmartHeat received PRC government approval on May 28, 2008, of its subscription for 71.6% of the registered capital of Taiyu, and approval on June 3, 2009, of the transfer of the remaining 28.4% ownership of Taiyu from the original joint venture shareholders who had received shares of SmartHeat common stock in the Share Exchange. Concurrent with the Share Exchange, one of SmartHeat’s shareholders cancelled 250,000 issued and outstanding shares of SmartHeat common stock pursuant to a split-off agreement dated April 14, 2008. As a result of the Share Exchange, Taiyu became a wholly foreign-owned enterprise of SmartHeat.

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

On September 25, 2008, the Company entered into a Share Exchange Agreement with Asialink (Far East) Limited to acquire all of the outstanding capital stock of SanDeKe Co., Ltd., a Shanghai-based manufacturer of PHEs (“SanDeKe”) for $741,516.

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

On June 16, 2009, Taiyu closed an asset purchase transaction with Siping Beifang Heat Exchanger Manufacture Co., Ltd. (“Siping Beifang”), a company organized under the laws of the PRC, to purchase certain assets consisting of the plant, equipment and certain land use rights for RMB 54,000,000 ($7.91 million). Taiyu then transferred all the acquired assets to SmartHeat Siping, the newly incorporated subsidiary. The Company paid RMB 7,250,000 ($1.06 million) on completion of inventory inspection, with the remaining consideration paid as of June 30, 2011.

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

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

On April 12, 2010, SmartHeat Investment formed SmartHeat (Shenyang) Energy Equipment Co., Ltd. (“SmartHeat Energy”), a wholly owned subsidiary in Shenyang with registered capital of $30 million, for the research, development, manufacturing and sales of energy products.
 
 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
On May 6, 2010, the Company formed SmartHeat (Shanghai) Trading Co., Ltd. (“SmartHeat Trading”) through a nominee to market and expand sales of the Company’s Taiyu-branded products. The Company made a capital contribution of $1.5 million and, from inception until November 9, 2011, controlled and was entitled to 100% of the profit or loss of SmartHeat Trading pursuant to an investment agreement dated February 1, 2010. Effective  November 9, 2011, the Company terminated the nominee-owner relationship and acquired direct control over SmartHeat Trading.
 
On January 7, 2011, the Company invested $771,658 for 51% of the equity interest in Hohhot Ruicheng Technology Co., Ltd. (“Ruicheng”), a joint venture formed on December 2, 2010, in Hohhot City, China, for the design and manufacture of heat meters.
 
On March 1, 2011, the Company entered into a purchase agreement with Shenyang Bingchuan Refrigerating Machine Limited Company, a Shenyang-based state-owned heat pump manufacturer and designer, which was renamed SmartHeat (Shenyang) Heat Pump Technology Co., Ltd. (“SmartHeat Pump”). The Company paid RMB 50 million ($7.6 million) to acquire 95% of the equity interest in SmartHeat Pump, with a local government entity retaining the remaining 5%.
 
On March 3, 2011, the Company completed the acquisition of Gustrower Warmepumpen GmbH, a designer and manufacturer of high efficiency heat pumps in Germany subsequently renamed SmartHeat Deutschland GmbH (“SmartHeat Germany”), from Conergy AG for EUR 4,248,082 ($5.90 million) paid at closing. This acquisition will extend the Company’s clean technology heating solutions into the rapidly growing heat pump markets in Europe and China, enabling its customers to purchase technologically advanced heat pumps at competitive prices.
 
In April 2012, the Company invested RMB 4,600,000 ($0.72 million) to establish a new joint venture named Urumchi XinRui Technology Limited Liability Company (“XinRui”). The Company owns 46% of XinRui. As of June 30, 2012, XinRui has not commenced operations.
 
Effective February 7, 2012, the Company implemented a one-for-ten reverse stock split of its common stock as approved by the Board of Directors on January 19, 2012. All share amounts and per share prices were retroactively adjusted to reflect the effect of this reverse stock split.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
 
The consolidated financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”).
 
The consolidated interim financial information as of June 30, 2012, and for the six and three months ended June 30, 2012 and 2011, were prepared without audit, pursuant to the rules and regulations of the SEC. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with U.S. GAAP are not included. The interim consolidated financial information should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011, previously filed with the SEC.
 
In the opinion of management, all adjustments (which include normal recurring adjustments) necessary to present a fair statement of the Company’s consolidated financial position as of June 30, 2012, its consolidated results of operations and cash flows for the six and three month periods ended June 30, 2012 and 2011, as applicable, were made. The interim results of operations are not necessarily indicative of the operating results for the full fiscal year or any future periods.
 
Principles of Consolidation
 
The accompanying consolidated financial statements include the accounts of SmartHeat’s U.S. parent, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Energy, SmartHeat Trading, Ruicheng, SmartHeat Germany and SmartHeat Pump, which are collectively referred to as the “Company.” All significant intercompany accounts and transactions were eliminated in consolidation.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Equity Method Accounting
 
In April 2012, the Company invested $722,750 to establish a new joint venture named Urumchi XinRui Technology Limited Liability Company (“XinRui”). The Company owns 46% of XinRui and accounted for this investment under the equity method of accounting (ASC 323-30). The Company recorded its investment at original cost. This balance will increase with income and decrease for dividends and losses from the subsidiary that accrue to the Company.
 
Noncontrolling Interest
 
The Company follows Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) Topic 810, “Consolidation,” which established new standards governing the accounting for and reporting of noncontrolling interests (“NCIs”) in partially owned consolidated subsidiaries and the loss of control of subsidiaries. Certain provisions of this standard indicate, among other things, that NCIs, previously referred to as minority interests, be treated as a separate component of equity, not as a liability, as was previously the case, that increases and decreases in the parent’s ownership interest that leave control intact be treated as equity transactions rather than as step acquisitions or dilution gains or losses and that losses of a partially owned consolidated subsidiary be allocated to the NCI even when such allocation might result in a deficit balance. This standard also required changes to certain presentation and disclosure requirements. Losses attributable to the NCI in a subsidiary may exceed the NCI’s interests in the subsidiary’s equity. The excess attributable to the NCI is attributed to those interests. The NCI shall continue to be attributed its share of losses even if that attribution results in a deficit NCI balance.
 
Use of Estimates
 
In preparing the financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Significant estimates, required by management, include the recoverability of long-lived assets, allowance for doubtful accounts and the reserve for obsolete and slow-moving inventories. Actual results could differ from those estimates.
 
Cash and Equivalents
 
For purposes of the statement of cash flows, the Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. As of June 30, 2012, the Company maintained restricted cash of $2.38 million in several bank accounts, of which $0.64 million was for cash deposits from customers  to secure payment from such customers no later than the expiration of the warranty period, $23,715 were deposits the Company paid to a commercial bank in exchange for the bank issuing bank acceptances to  vendors of the Company, $1.49 million were deposits made to earn interest income and $0.23 million was a deposit for a letter of credit. Of the total restricted cash at June 30, 2012, $2.01 million will be released to the Company within one year. As of December 31, 2011, the Company maintained restricted cash of $2.89 million in several bank accounts, of which $1.38 million was for cash deposits from customers to secure payment from such customers no later than the expiration of the warranty period; $1.48 million were deposits the Company paid to a commercial bank in exchange for the bank issuing bank acceptances to the Company’s vendors and $31,742 was a deposit for a letter of credit. Of the total restricted cash at December 31, 2011, $2.69 million will be released to the Company within one year.
 
The following table presents in U.S. dollars (“USD”) the amount of cash and equivalents held by the Company as of June 30, 2012 and December 31, 2011, based on the jurisdiction of deposit. The Company’s U.S. parent holds cash and equivalents in U.S. bank accounts denominated in USD.

 
As of June 30, 2012
 
United States
   
China
   
Germany
   
Total
 
Cash in bank
 
$
27,198
   
$
10,083,605
   
$
399,165
   
$
10,509,968
 
Cash on hand
   
-
     
14,507
     
-
     
14,507
 
Total cash
 
$
27,198
   
$
10,098,112
   
$
399,165
   
$
10,524,475
 

 
As of December 31, 2011
 
United States
   
China
   
Germany
   
Total
 
Cash in bank
 
$
282,359
   
$
10,555,706
   
$
1,570,632
   
$
12,408,697
 
Cash on hand
   
-
     
11,225
     
-
     
11,225
 
Total cash
 
$
282,359
   
$
10,566,931
   
$
1,570,632
   
$
12,419,922
 
 
 
8

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Accounts and Retentions Receivable

The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves. Based on historical collection activity, the Company had allowances of $16.41 million and $10.58 million at June 30, 2012, and December 31, 2011, respectively.
 
At June 30, 2012, and December 31, 2011, the Company had retentions receivable from customers for product quality assurance of $4.20 million and $4.30 million, respectively. The retention rate varies from 5% to 20% of the sales price with variable terms from 3 to 24 months depending on the shipping date, and for PHE Units, the customer acceptance date, of the products and the number of heating seasons that the warranty period covers.

Accounts receivable is net of unearned interest of $3,207 and $57,828 at June 30, 2012, and December 31, 2011, respectively. Unearned interest is imputed interest on accounts receivable with due dates over 1 year from the invoice date discounted at the Company’s borrowing rate of 6.00% at June 30, 2012, and December 31, 2011.

Bad Debt Allowance

The Company’s policy is to provide approximately 50% of accounts receivable aged over 180 days from the payment due date and 100% accounts receivable aged over 360 days from the payment due date as bad debt allowance.  Management of the Company’s subsidiaries further analyzes each individual customer for which they have taken a bad debt allowance to further assess the likelihood of collectability.  Customers who are either state-owned or have a history of support from the state, or larger companies with long operating histories, that management of the Company’s subsidiaries believe the chance of non-payment will be remote, are excluded for the purpose of calculating  bad debt allowance.

Advance to Suppliers

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

Inventories

Inventories are valued at the lower of cost or market, with cost determined on a moving weighted-average basis. The difference is recorded as a cost of sales, if the current market value is lower than their historical cost.  In addition, the Company makes an inventory impairment provision at each period end for inventory held over 360 days. Cost of work in progress and finished goods comprises direct material, direct labor and an allocated portion of production overheads.

Certain raw materials, such as stainless steel products, plates, shims, gaskets, and pump valves, require longer than normal procurement periods, or “lead times,” with some procurement periods running longer than six months.  In order to guarantee availability of raw materials for production and sales, the Company’s subsidiaries, based on historical sale patterns, estimate and purchase material for the upcoming period.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
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 years
Vehicles
5 years
Office equipment
5 years
Production 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 tangible assets, such as property, plant and equipment, goodwill and other intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable.
 
Recoverability of long-lived assets to be held and used is measured by comparing the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized based on the excess of the carrying amount over the fair value (“FV”) of the assets. FV generally is determined using the asset’s expected future discounted cash flows or market value, if readily determinable. The Company evaluates goodwill and intangible assets with indefinite lives for impairment annually using a two-step approach. Based on this valuation approach, the Company concluded that the goodwill balance of $6.06 million for SmartHeat Pump and $2.90 million for SmartHeat Germany was impaired as of December 31, 2011, as discussed under Goodwill below. Based on its review, the Company believes that, as of June 30, 2012, and December 31, 2011, there were no significant impairments of its other long-lived assets.
 
Warranties
 
The Company offers to all customers standard warranties on its products for one or two heating seasons depending on the terms negotiated. The Company accrues for warranty costs based on estimates of the costs that may be incurred under its warranty obligations. The warranty expense and related accrual is included in the Company’s selling expenses and other payables respectively, and is recorded when revenue is recognized. Factors that affect the Company’s warranty liability include the number of units sold, its estimates of anticipated rates of warranty claims, costs per claim and estimated support labor costs and the associated overhead. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.
 
Activity in the Company’s warranty reserve from January 1, 2011, to June 30, 2012, is as follows:
 
   
2012
   
2011
 
Beginning balance
 
$
515,812
   
$
 398,292
 
Provisions
   
449,662
     
 620,722
 
Actual costs incurred
   
(449,662
)
   
(503,202
Due to exchange rate
   
(1,957
   
-
 
Ending balance in current liabilities
 
$
513,855
   
$
515,812
 

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Research and Development Costs
 
Research and development (“R&D”) costs are expensed as incurred and included in general and administrative expenses. These costs primarily consist of cost of materials used, salaries paid for the Company’s development department and fees paid to third parties. R&D costs for the six months ended June 30, 2012 and 2011, were $114,890 and $512,867, respectively. R&D costs for the three months ended June 30, 2012 and 2011, were $63,956 and $383,885, respectively.
 
Income Taxes
 
The Company utilizes Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes” (codified in FASB ASC Topic 740), which requires recognition of deferred tax assets and liabilities for expected future tax consequences of events included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.
 
The Company follows the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (codified in FASB ASC Topic 740). When tax returns are filed, it is likely 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% 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. At June 30, 2012, the Company had not taken any significant uncertain tax position on its tax returns for 2011 or prior years, or in computing its tax provision for 2012.
 
Revenue Recognition
 
The Company’s revenue recognition policies are in compliance with SEC Staff Accounting Bulletin (“SAB”) 104 (codified in FASB ASC Topic 605). Sales revenue is recognized when PHEs, heat meters and heat pumps are delivered, and for PHE Units when customer acceptance occurs, the price is fixed or determinable, no other significant obligations of the Company exist and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition met are recorded as unearned revenue under “Advance from customers.”
 
The Company’s sales generally provide for 30% of the purchase price on placement of an order, 30% on delivery, 30% upon installation and acceptance of the equipment after customer testing and 10% no later than the termination of the standard warranty period, which ranges from 3 to 24 months from the acceptance date.
 
Due to the slowdown of the Chinese economy and tightened monetary policy, and in order to attract and retain customers, the Company’s subsidiaries have adjusted their contract and payment terms to permit for more flexible and longer payment terms.
 
Sales revenue is the invoiced value of goods, net of value-added tax (“VAT”). All of the Company’s products sold in the PRC are subject to a VAT of 17% of the gross sales price. This VAT may be offset by the VAT paid by the Company on raw materials and other materials purchased in China and included in the cost of producing the Company’s finished product. The Company recorded VAT payable and VAT receivable net of payments in the financial statements. The VAT tax return is filed offsetting the payables against the receivables. SmartHeat Germany, the Company’s German subsidiary, is subject to 19% VAT.
 
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.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Sales returns and allowances were $0 for the six and three months ended June 30, 2012 and 2011. The Company does not provide a right of return, price protection or any other concessions to its customers.
 
The Company provides a standard warranty to all customers, which is not considered an additional service; rather, an integral part of the product’s sale. The Company believes the existence of its standard product warranty in a sales contract does not constitute a deliverable in the arrangement and thus there is no need to apply the EITF 00-21 (codified in FASB ASC Topic 605-25) separation and allocation model for a multiple deliverable arrangement. SFAS 5 (codified in FASB ASC Topic 450) specifically addresses the accounting for standard warranties and neither SAB 104 nor EITF 00-21 supersedes SFAS 5. The Company believes that accounting for its standard warranty pursuant to SFAS 5 does not impact revenue recognition because the cost of honoring the warranty can be reliably estimated.
 
The Company charges for after-sales services provided after the expiration of the warranty period, with after-sales services mainly consisting of cleaning PHEs and repairing and exchanging parts. The Company recognizes such revenue when service is provided. For the six months ended June 30, 2012 and 2011, revenue from after-sales services after the expiration of the warranty period was $110,672 and $140,200, respectively. For the three months ended June 30, 2012 and 2011, revenue from after-sales services after the expiration of the warranty period was $(65,228) and $55,400, respectively, which was recorded in other income.
 
Cost of Goods Sold
 
Cost of goods sold consists primarily of material costs and direct labor and manufacturing overhead that are directly attributable to the products. Write-down of inventories to the lower of cost or market is also recorded in cost of goods sold.
 
Advance from Customers
 
The Company records payments received from customers in advance of their orders to advance account. These orders normally are delivered within a reasonable period of time based upon contract terms with the customers.
 
Concentration of Credit Risk
 
Cash includes cash on hand and demand deposits in accounts maintained within China. Balances at financial institutions within China are not covered by insurance. The Company has not experienced any losses in such accounts.
 
Certain other financial instruments, which subject the Company to concentration of credit risk, consist of accounts and other receivables. The Company does not require collateral or other security to support these receivables. The Company conducts periodic reviews of its customers’ financial condition and customer payment practices to minimize collection risk on accounts receivable.
 
The operations of the Company are located primarily in China. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environments in China, as well as by the general state of the PRC economy.
 
Goodwill
 
Goodwill is the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“Statement No. 142”), codified in ASC Topic 350, goodwill is not amortized but is tested for impairment, annually or when circumstances indicate a possible impairment may exist. Impairment testing is performed at a reporting unit level. An impairment loss generally would be recognized when the carrying amount of the reporting unit exceeds its FV, with the FV of the reporting unit determined using discounted cash flow (“DCF”) analysis. A number of significant assumptions and estimates are involved in the application of the DCF analysis to forecast operating cash flows, including the discount rate, the internal rate of return and projections of realizations and costs to produce. Management considers historical experience and all available information at the time the FVs of its reporting units are estimated.
 
The excess of the purchase price for SmartHeat Germany over the FV of the net assets acquired of $5.1 million (EUR 3.69 million at acquisition date) was recorded as goodwill. The excess of the purchase price for SmartHeat Pump over the FV of the net assets acquired of $5.60 million was recorded as goodwill.
 
 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
The Company performed an annual goodwill impairment assessment for SmartHeat Germany and SmartHeat Pump as of December 31, 2011. The goodwill balance prior to the impairment charge was $10.97 million, and was established primarily as a result of the acquisitions of SmartHeat Germany and SmartHeat Pump in 2011. The Company completed the step one analysis using DCF, which involved comparing the FV of the reporting unit with the unit’s book value. The DCF method uses revenue and expense projections and risk-adjusted discount rates. The process of determining FV is subjective and requires management to exercise judgment in determining future growth rates, discount and tax rates and other factors. The current economic environment has impacted the Company’s ability to forecast future demand and has in turn resulted in the use of higher discount rates, reflecting the risk and uncertainty in current markets. The results of the step one analysis indicated potential impairment in the SmartHeat Germany and SmartHeat Pump reporting units corroborated by a combination of factors including a decline in the market capitalization, which is below the book value, and the deteriorating macro environment, which has resulted in a decline in expected future demand. The Company therefore performed the second step of the goodwill impairment assessment to quantify the amount of impairment. This process involved calculating the implied FV of goodwill, determined in a manner similar to a purchase price allocation, and comparing the residual amount to the carrying amount of goodwill. This analysis incorporated the declining market capitalization in 2011 and the significant end market deterioration and economic uncertainties impacting expected future demand, including the continued tightened fiscal policy in China and difficulties in obtaining bank leasing loans that have contributed to a general slowdown in many sectors of China’s economy and caused the abandonment of certain projects by the Company’s customers, which in turn resulted in an unexpected cancelation of orders and delays in the performance of PHE Unit and PHE contracts. Based on this analysis, the Company concluded that the goodwill balance of $6.06 million for SmartHeat Pump and $2.90 million for SmartHeat Germany was impaired as of December 31, 2011. The goodwill impairment charge is non-cash in nature. The goodwill impairment charge is not deductible for income tax purposes and, therefore, the Company has not recorded a corresponding tax benefit in 2011.

Statement of Cash Flows

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

Basic and Diluted Earnings (Loss) per Share (EPS)

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

The following table presents a reconciliation of basic and diluted loss per share for the six months ended June 30, 2012 and 2011:
 
  
 
2012
   
2011
 
Net loss
 
$
(16,185,163
 
$
(10,372,178
)
                 
Weighted average shares outstanding - basic
   
3,955,774
     
3,857,238
 
Effect of dilutive securities:
               
Unexercised warrants and options
   
-
     
-
 
Weighted average shares outstanding - diluted
   
3,955,774
     
3,857,238
 
                 
Loss per share - basic
 
$
(4.09
)
 
$
(2.69
)
Loss per share - diluted
 
$
(4.09
)
 
$
(2.69
)
 
 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
The following table presents a reconciliation of basic and diluted earnings (loss) per share for the three months ended June 30, 2012 and 2011:

   
2012
   
2011
 
Net loss
 
$
(9,252,698
)
 
$
(6,418,376
                 
Weighted average shares outstanding - basic
   
3,955,774
     
3,859,260
 
Effect of dilutive securities:
               
Unexercised warrants and options
   
-
     
-
 
Weighted average shares outstanding - diluted
   
3,955,774
     
3,859,260
 
                 
Earnings (loss) per share - basic
 
$
(2.34
)
 
$
(1.66
Earnings (loss) per share - diluted
 
$
(2.34
)
 
$
(1.66

Basic and diluted loss per share are the same for the six and three months ended June 30, 2012 and 2011, because the common stock equivalent of the convertible securities outstanding, consisting of unexercised warrants issued to investors and options issued to the Company’s directors and an officer, are antidilutive and, accordingly, were excluded from the computation of diluted earnings (loss) per share. At June 30, 2012, and December 31, 2011, options to purchase 6,000 shares of common stock were outstanding, of which options to purchase 3,500 shares of common stock were exercisable, respectively, and warrants to purchase 0 shares of common stock were outstanding and exercisable.

Fair Value of Financial Instruments

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

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

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

 
Level 3 inputs to the valuation methodology are unobservable and significant to the FV measurement.

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

As of June 30, 2012, and December 31, 2011, the Company did not identify any assets and liabilities that are required to be presented on the balance sheet at FV.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Foreign Currency Translation and Comprehensive Income (Loss)

The accounts of the U.S. parent company are maintained in USD. The functional currency of the Company’s China subsidiaries is the Chinese Yuan Renminbi (“RMB”) and the functional currency of SmartHeat Germany, the Company’s subsidiary in Germany, is the Euro (“EUR”). The accounts of the China subsidiaries and German subsidiary were translated into USD in accordance with SFAS No. 52, “Foreign Currency Translation” (codified in FASB ASC Topic 830). According to SFAS No. 52, all assets and liabilities were translated at the exchange rate on the balance sheet date, stockholders’ equity was translated at the historical rates and statement of operations items were translated at the average exchange rate for the period. 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).

The RMB to USD exchange rates in effect as of June 30, 2012, and December 31, 2011, were RMB6.3249 = $1 and RMB6.3009 = $1, respectively. The weighted-average RMB to USD exchange rates in effect for the six months period ended June 30, 2012 and 2011, were RMB6.3074 = $1 and RMB6.5832 = $1, respectively. The exchange rates used in translation from RMB to USD were published by the People’s Bank of the People’s Republic of China.

The EUR to USD exchange rate in effect as of June 30, 2012, and December 31, 2011, were EUR0.7952 = $1 and EUR0.7723 =$1, respectively. The weighted-average EUR to USD exchange rate in effect for the six months ended June 30, 2012 and 2011, were EUR0.7706 = $1 and EUR 0.7126 = $1, respectively. The exchange rates used in translation from EUR to USD were published by OANDA Rates.

Stock-Based Compensation

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

Segment Reporting

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

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

The following table sets forth a summary of sales by product line for the six and three months ended June 30, 2012 and 2011:
 
   
For the six months
   
For the three months
 
   
2012
   
2011
   
2012
   
2011
 
    (in millions)  
PHEs
  $ 4.72     $ 7.29     $ 1.32     $ 1.27  
PHE Units
    4.49       4.43       1.66       3.98  
Heat meters
    1.74       1.28       1.71       0.36  
Heat pumps
    0.78       1.97       0.29       1.47  
    $ 11.73     $ 14.97     $ 4.98     $ 7.08  

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
New Accounting Pronouncements

On July 27, 2012, the FASB issued ASU 2012-02, Intangibles-Goodwill and Other (Topic 350) - Testing Indefinite-Lived Intangible Assets for Impairment.  The ASU provides entities with an option to first assess qualitative factors to determine whether events or circumstances indicate that it is more likely than not that the indefinite-lived intangible asset is impaired.  If an entity concludes that it is more than 50% likely that an indefinite-lived intangible asset is not impaired, no further analysis is required.  However, if an entity concludes otherwise, it would be required to determine the FV of the indefinite-lived intangible asset to measure the amount of actual impairment, if any, as currently required under US GAAP.  The ASU is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012.  Early adoption is permitted. The adoption of this pronouncement will not have a material impact on our financial statements.

As of June 30, 2012, there is no other recently issued accounting standards not yet adopted that would have a material effect on the Company’s consolidated financial statements.

3. INVENTORIES

Inventories at June 30, 2012, and December 31, 2011, were as follows:

   
2012
   
2011
 
Raw materials
 
$
39,503,460
   
$
39,280,141
 
Work in process
   
10,530,629
     
6,496,349
 
Finished goods
   
7,724,693
     
11,699,008
 
Total
   
57,758,782
     
57,475,498
 
Inventory allowance
   
(4,481,457
)
   
(3,826,949
)
Inventories, net
 
$
53,277,325
   
$
53,648,549
 

4. NOTES RECEIVABLE – BANK ACCEPTANCES

The Company sold goods to its customers and received commercial notes (bank acceptance) from them in lieu of payments for accounts receivable. The Company discounted the commercial notes with the bank or endorsed the commercial notes to vendors for payment of their own obligations or to get cash from third parties. Most of the commercial notes have a maturity of less than six months. As of June 30, 2012, the Company was contingently liable for notes endorsed to vendors of $1.34 million.

5. PROPERTY AND EQUIPMENT, NET

Property and equipment consisted of the following at June 30, 2012, and December 31, 2011:

   
2012
   
2011
 
Building
 
$
4,770,980
   
$
4,789,152
 
Production equipment
   
7,809,781
     
7,372,253
 
Office equipment
   
924,522
     
978,291
 
Vehicles
   
1,101,980
     
1,038,058
 
Total
   
14,607,263
     
14,177,754
 
Less: accumulated depreciation
   
(3,423,554
)
   
(2,829,153
)
Property & equipment, net
 
$
11,183,709
   
$
11,348,601
 

Depreciation expense for the six months ended June 30, 2012 and 2011, was $626,652 and $521,600, respectively. Depreciation expense for the three months ended June 30, 2012 and 2011, was $323,837 and $284,800, respectively.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
6. OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS

Other receivables, prepayments and deposits consisted of the following at June 30, 2012, and December 31, 2011, respectively:
 
   
2012
   
2011
 
Advance to third parties
 
$
4,014,227
   
$
4,473,539
 
Deposit for public bids of sales contracts
   
793,568
     
617,088
 
Prepayment for freight, related, insurance, advertisement and consulting expenses
   
657,973
     
238,855
 
Other deposits
   
64,678
     
91,988
 
Advance to employees
   
925,745
     
351,847
 
Other
   
861,901
     
890,013
 
Total
   
7,318,092
     
6,663,330
 
Less: bad debt allowance for other receivables
   
(351,720
)
   
-
 
Other receivables (net), prepayment & deposits
 
$
6,966,372
   
 $
6,663,330
 
 
Advance to third parties were short-term advances to unrelated parties with payment usually due within a year and includes an advance to Siping Beifang of RMB 22,000,000 ($3.48 million)  that is non-interest bearing and with due date extended to September 30, 2012. Deposits for public bidding represented the deposits for bidding on expected contracts, which will be returned to the Company after the bidding process is completed, usually within three to four months from the payment date. Prepayment for freight, related insurance expenses and advertisement represented prepaid shipping and freight insurance expenses for customers and is generally repaid upon customer receipt of products and prepaid advertising expense. Other deposits mainly consisted of deposits for rents, payroll expense and utilities. Advance to employees represented short-term loans to employees and advances for business trips and related expenses. Other receivables, prepayments and deposits are reimbursed or settled within 12 months.

7. INTANGIBLE ASSETS

Intangible assets consisted mainly of land use rights, trademarks, computer software, know-how technology, customer lists and covenants 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 RMB 3,549,682 ($0.44 million). In June 2009, the Company acquired land use rights for $3.1 million from Siping Beifang. In November 2010, the Company’s subsidiary, SmartHeat Energy, acquired land use rights for $10.10 million. The Company has the right to use the land for 50 years and is amortizing such rights on a straight-line basis for 50 years.

Intangible assets consisted of the following at June 30, 2012, and December 31, 2011, respectively:

 
Estimated Useful
Life (In years)
 
2012
   
2011
 
Land use rights
50
 
$
14,620,792
   
$
14,676,483
 
Know-how technology
5 – 10
   
878,568
     
881,915
 
Customer lists
5
   
207,096
     
207,885
 
Covenants not to compete
5
   
112,660
     
113,089
 
Software
5
   
541,966
     
517,474
 
Trademarks
7
   
287,787
     
288,883
 
Total
     
16,648,869
     
16,685,729
 
Less: accumulated amortization
     
(1,570,766
)
   
(1,265,924
)
Intangible assets, net
   
$
15,078,103
   
$
15,419,805
 

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Amortization expense of intangible assets for the six months ended June 30, 2012 and 2011, was $315,617 and $279,300, respectively. Amortization expense of intangible assets for the three months ended June 30, 2012 and 2011, was $150,599 and $173,800, respectively. Annual amortization expense for the next five years from June 30, 2012, is expected to be $594,000, $486,000, $449,000, $413,000 and $413,000, and $12,723,103 thereafter.

8. CONSTRUCTION IN PROGRESS

The Company had construction in progress of $1,307,138 at June 30, 2012, with three ongoing projects. SmartHeat Energy is building a factory with a total estimated cost of $9.00 million, of which the Company has paid $453,000 as of June 30, 2012. The Company temporarily halted construction on this factory because of the current economic and market conditions in China. SmartHeat Siping has a construction project of $52,000 for the laying of a foundation for its machinery installation. This foundation project will be completed in 2012, with remaining cost to complete of $12,000. Taiyu paid $0.80 million for equipment and its installation, which is expected to be completed in August 2012, with remaining cost to be paid of $0.54 million.

9. LONG TERM INVESTMENT

In April 2012, the Company invested $722,750 to establish a new Company named Urumchi XinRui Technology Limited Liability Company (“XinRui”). The Company owns 46% of XinRui and accounted this investment under the equity method.

10. MAJOR CUSTOMERS AND VENDORS

Below is the table indicating the Company’s major customers that account for over 10% of the Company’s total sales. At June 30, 2012, the total accounts receivable balance due from these two customers was $2,298,909. At December 31, 2011, the accounts receivable balance was $5,288,387.
 
   
Six months ended June 30,
   
Three months ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
China Precision Optical Machinery Imports & Exports Co., Ltd.
   
20
%
   
-
     
17
%
   
-
 
Hengli Petrifaction (Dalian) Co., Ltd.
   
15
%
   
-
     
-
     
-
 
Zhonglan International Chemical Industry Co., Ltd.
   
-
     
14
   
-
     
-
 

For the six and three months ended June 30, 2012 and 2011, no vendors accounted for over 10% of the Company’s total purchases.

11. TAXES RECEIVABLE AND PAYABLE

Taxes receivable consisted of the following at June 30, 2012:
 
Income tax receivable
 
$
83,409
 
Value-added tax receivable
   
1,404,630
 
Total
 
$
1,488,039
 

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Taxes payable consisted of the following at June 30, 2012, and December 31, 2011:
 
   
2012
   
2011
 
Income tax payable
 
$
-
   
$
182,560
 
Value-added tax payable
   
-
     
962,903
 
Other tax payable
   
9,315
     
33,249
 
Total
 
$
9,315
   
$
1,178,712
 

12. ACCRUED LIABILITIES AND OTHER PAYABLES

Accrued liabilities and other payables consisted of the following at June 30, 2012, and December 31, 2011:

   
2012
   
2011
 
Advance from third parties
 
$
1,093,287
   
$
981,658
 
Payable to Siping Beifang
   
1,540,995
     
1,377,060
 
Other payables
   
1,216,582
     
681,810
 
Warranty reserve (See Note 2)
   
513,855
     
515,812
 
Accrued expenses
   
547,158
     
579,958
 
Total
 
$
4,911,877
   
$
4,136,298
 

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

13. NOTES PAYABLE – BANK ACCEPTANCES

Notes payable represented the conversion of accounts payable into notes payable, which were issued by a bank. The Company deposited a portion of the acceptance amount into the bank as collateral. The terms of the notes range from 3-6 months and bear no interest. At June 30, 2012, and December 31, 2011, the Company deposited $23,715 and $1.48 million with the bank as restricted cash for the bank issuing the notes. The restricted cash is refundable when the notes are repaid.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
14. LOANS PAYABLE - BANK

Short-Term Loans

The Company was obligated for the following short-term loans as of June 30, 2012, and December 31, 2011:
 
   
2012
   
2011
 
From a commercial bank in the PRC for RMB 25,000,000 entered into on October 18, 2010. The loan currently bears interest at 7.22% with maturity on October 17, 2011, and was renewed until September 13, 2012. The loan was pledged by bank deposit.
 
3,952,632
   
3,967,687
 
From a commercial bank in the PRC for RMB 10,000,000 entered into on June 27, 2011. The loan currently bears interest at 7.57% with maturity on June 27, 2012. The loan was pledged by bank deposit. The loan was repaid in second quarter of 2012.
   
-
     
1,587,075
 
From a commercial bank in the PRC for RMB 3,000,000 entered into on June 30, 2011. The loan currently bears interest at 6.63% with maturity on June 29, 2012. The loan was guaranteed by a third party. The loan was repaid in second quarter of 2012.
   
-
     
476,122
 
From a commercial bank in the PRC for RMB 5,000,000 entered into on July 6, 2011. The loan currently bears interest at 6.63% with maturity on July 5, 2012. The loan was guaranteed by a third party. The loan was repaid in July 2012.
   
790,526
     
793,537
 
From a commercial bank in the PRC for RMB 3,000,000 entered into on July 15, 2011. The loan currently bears interest at 6.89% with maturity on July 14, 2012. The loan was guaranteed by a third party. The loan was repaid in July 2012.
   
474,316
     
476,122
 
From a commercial bank in the PRC for RMB 1,600,000 entered into on August 1, 2011. The loan currently bears interest at 6.89% with maturity on July 31, 2012. The loan was guaranteed by a third party. The loan was repaid in July 2012.
   
252,968
     
253,932
 
From a commercial bank in the PRC for RMB 3,300,000 entered into August 16, 2011. The loan currently bears interest at 6.89% with maturity on August 15, 2012.  The loan was guaranteed by a third party. The loan was repaid in August 2012.
   
521,747
     
523,737
 
From a commercial bank in the PRC for RMB 1,100,000 entered into on August 23, 2011. The loan currently bears interest at 6.89% with maturity on August 22, 2012. The loan was guaranteed by a third party.
   
173,916
     
174,578
 
From a commercial bank in the PRC for RMB 5,000,000 entered into on September 21, 2011. The loan currently bears interest at 7.22% with maturity on September 20, 2012. The loan was pledged by bank deposit.
   
790,526
     
793,537
 
From a commercial bank in the PRC for RMB 10,000,000 entered into on November 8, 2011. The loan currently bears interest at 7.872% with maturity on November 2, 2012. The loan was guaranteed by Taiyu.
   
1,581,053
     
1,587,075
 
From a commercial bank in the PRC for RMB 50,000,000 entered into on February 17, 2012.The loan currently bears interest at 7.872% with maturity on January 16, 2013. The loan was guaranteed by SanDeKe.
   
7,905,264
     
-
 
   
$
16,442,948
   
$
10,633,402
 

Of the loans listed above that are guaranteed by a third party, the guarantees were provided by the same third party company, the guarantee term is one year and the Company is not required to pay for this guarantee service as the Company provides the same guarantee service to loans of the third party company in return. As of June 30, 2012, and December 31, 2011, the Company has signed a contract to provide guarantees of up to RMB 30 million ($4.74 million) in loans for this third party company.

Long-Term Bank Loan

On December 12, 2011, the Company entered into a long-term loan agreement with a commercial bank for RMB 13,000,000 ($2.06 million), bearing interest of 6.65%, with a maturity date of October 26, 2013. The loan was pledged with building and land.
 
 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
15. DEFERRED TAX ASSET (LIABILITY)

Deferred tax asset (liability) represented differences between the tax bases and book bases of property and equipment and intangible assets arising from the acquisition of SanDeKe and SmartHeat Pump, and bad debt allowance and provision of inventory impairment booked by the Company which was not allowed per tax purpose. As of June 30, 2012, and December 31, 2011, deferred tax asset (liability) consisted of the following:
 
   
2012
   
2011
 
Deferred tax asset - current (bad debt allowance)
 
$
2,694,927
   
$
1,794,878
 
Deferred tax asset - current (inventory provision)
   
657,754
     
571,865
 
Less: valuation allowance
   
(3,352,681
)
   
(2,366,743
)
Deferred tax asset - current, net
   
-
     
-
 
Deferred tax liability - noncurrent (depreciation of fixed assets)
 
$
139,430
   
$
189,516
 

16. INCOME TAXES

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

SmartHeat, the parent company, was incorporated in the U.S. and has net operating losses (“NOL”) for income tax purposes, which can be carried forward for up to 20 years from the year the loss is incurred. SmartHeat has NOL carry forwards for income taxes of approximately $4.23 million at June 30, 2012, which may be available to reduce future years’ taxable income. Management believes the realization of benefits from these losses remains uncertain due to SmartHeat’s limited operating history and continuing losses. Accordingly, a 100% deferred tax asset valuation allowance has been provided.

Taiyu and SanDeKe are governed by the Income Tax Law of the PRC concerning privately-run enterprises, which are generally subject to tax at 25% on income reported in the statutory financial statements after appropriate tax adjustments. Under the 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 has been classified as a high-tech enterprise since 2009 and eligible for an income tax rate of 15% through 2012. The local PRC government reviews the high-tech status of such enterprises annually. The income tax rate for SanDeKe is 13% and 12% for 2012 and 2011, respectively, because of its foreign-invested enterprise status, and its income tax rate will increase to 25% starting from 2013.

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

The following table reconciles the U.S. statutory rates to the Company’s effective tax (benefit) rate for six months ended June 30, 2012 and 2011:

   
2012
   
2011
 
U.S. statutory rates
   
(34.0
)%
   
(34.0
)%
Tax rate difference
   
8.8
%
   
8.4
%
Effect of tax holiday
   
7.2
%
   
7.4
%
Others
   
-
%
   
(0.2
)%
Valuation allowance
   
17.7
%
   
7.2
%
Tax per financial statements
   
(0.3
)%
   
(11.2
)%

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
The following table reconciles the U.S. statutory rates to the Company’s effective tax (benefit) rate for three months ended June 30, 2012 and 2011:
 
   
2012
   
2011
 
U.S. statutory rates
   
(34.0
)%
   
(34.0
)%
Tax rate difference
   
8.8
%
   
8.4
%
Effect of tax holiday
   
8.2
%
   
7.5
%
Others
   
-
%
   
(1.2
)%
Valuation allowance
   
16.8
%
   
10.2
%
Tax per financial statements
   
(0.2
)%
   
(9.1
)%
 
The income tax (benefit) for the six months ended June 30, 2012 and 2011, consisted of the following:

   
2012
   
2011
 
Income tax expense (benefit) - current
 
$
763
   
$
(31,589
Income tax benefit - deferred
   
(45,257
)
   
(1,296,470
)
Total income tax benefit
 
$
(44,494
 
$
(1,328,059

The income tax (benefit) for the three months ended June 30, 2012 and 2011, consisted of the following:

   
2012
   
2011
 
Income tax expense (benefit) - current
 
$
107
   
$
(100,263
Income tax benefit - deferred
   
(20,497
)
   
(546,897
)
Total income tax benefit
 
$
(20,390
 
$
(647,160

17. STATUTORY RESERVES AND RESTRICTED NET ASSETS

The Company’s ability to pay dividends is primarily dependent on the Company receiving funds from its subsidiaries. Relevant PRC statutory laws and regulations permit payments of dividends by the Company’s PRC subsidiaries only out of the subsidiary’s retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. The results of operations reflected in the financial statements prepared in accordance with U.S. GAAP differ from those reflected in the statutory financial statements of the Company’s PRC subsidiaries.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
In accordance with the PRC Regulations on Enterprises with Foreign Investment and their articles of association, a foreign-invested enterprise (“FIE”) established in the PRC is required to provide certain statutory reserves, which are appropriated from net profit as reported in the FIE’s PRC statutory accounts. An FIE is required to allocate at least 10% of its annual after-tax profit to the surplus reserve until such reserve has reached 50% of its respective registered capital based on the FIE’s PRC statutory accounts. Appropriations to other funds are at the discretion of the board of directors for all FIEs. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. Additionally, shareholders of an FIE are required to contribute capital to satisfy the registered capital requirement of the FIE. Until such contribution of capital is satisfied, the FIE is not allowed to repatriate profits to its shareholders, unless otherwise approved by the State Administration of Foreign Exchange. Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment and Ruicheng were established as FIEs and therefore are subject to the above-mandated restrictions on distributable profits. As of June 30, 2012, the Company has met all registered capital requirements for its FIEs except for SmartHeat Investment, for which the Company is committed to contribute an additional $40.00 million in registered capital by April 2015 (see Note 19).

Additionally, in accordance with the Company Law of the PRC, a domestic enterprise is required to provide surplus reserve at least 10% of its annual after-tax profit until such reserve has reached 50% of its respective registered capital based on the enterprise’s PRC statutory accounts. A domestic enterprise is also required to provide discretionary surplus reserve, at the discretion of the board of directors, from the profits determined in accordance with the enterprise’s PRC statutory accounts. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. SmartHeat Energy, SmartHeat Trading and SmartHeat Pump were established as domestic enterprises and therefore are subject to the above-mentioned restrictions on distributable profits.

As a result of these PRC laws and regulations that require annual appropriations of 10% of after-tax income to be set aside prior to payment of dividends as general reserve fund, the Company’s PRC subsidiaries are restricted in their ability to transfer a portion of their net assets to the Company as a dividend.

18. STOCKHOLDERS’ EQUITY

Common Stock with Warrants Issued for Cash

In August 2008, the Company sold 163,000 units consisting of one share of the Company’s common stock and a 3-year warrant to purchase 15% of one share of the Company’s common stock for $60.00 per share, at $35.00 per unit, for approximately $5.7 million. The Company issued warrants to purchase 24,450 shares of its common stock. In connection with the private placement, the Company paid commissions of $340,000 and issued warrants to purchase 14,850 shares of its common stock to placement agents. The warrants are immediately exercisable and expire on the third anniversary of their issuance. The warrants require the Company to settle in its own shares. There is no provision for cash settlement, except in lieu of fractional shares. Net proceeds of $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 2010, warrants to purchase 1,425 shares were exercised at $60.00 per share for $85,500. All outstanding warrants expired unexercised on August 22, 2011, and no new warrants were issued during the six months ended June 30, 2012.
  
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 1,000 shares at an exercise price per share of $46.00, with a life of five years and vesting over three years as follows: 333 shares vest on July 17, 2009; 333 shares vest on July 17, 2010; and 334 shares vest on July 17, 2011, subject in each case to the director continuing to be associated with the Company as a director. The options were valued using a volatility of 15%, risk-free interest rate of 2.76%, and dividend yield of 0%. No estimate of forfeitures was made as the Company has a short history of granting options.

On February 1, 2010, the Company issued stock options to an employee. The terms of the options are 5,000 shares at an exercise price per share of $118.50, with a life of five years and vesting over two years as follows: 2,500 shares vest on June 30, 2011, and 2,500 shares vest on June 29, 2012. The options were valued using a volatility of 74%, risk free interest rate of 2.76%, and dividend yield of 0%. The grant-date FV of the options was $367,107.

Based on the FV method under SFAS No. 123 (Revised), “Share Based Payment” (“SFAS 123(R)”) (codified in FASB ASC Financial Instruments, Topic 718 & 505), the FV 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 U.S. 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 FV 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.
 
 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Following is a summary of the option activity:
 
   
Number of
Shares
   
Average
Exercise
Price per Share
   
Weighted
Average
Remaining
Contractual
Term in Years
 
Outstanding at December 31, 2011
   
6,000
     
106.40
     
2.83
 
Exercisable at December 31, 2011
   
3,500
     
97.80
     
2.65
 
Granted
   
-
     
-
     
-
 
Exercised
   
-
     
-
     
-
 
Forfeited
   
-
     
-
     
-
 
Outstanding at June 30, 2012
   
6,000
   
$
106.40
     
2.33
 
Exercisable at June 30, 2012
   
3,500
   
$
97.80
     
2.15
 

There were no options exercised during the six months ended June 30, 2012 and 2011. The Company recorded $78,366 and $102,731 as compensation expense for stock options during the six months ended June 30, 2012 and 2011, respectively. There were no options exercised during the three months ended June 30, 2012 and 2011. The Company recorded $59,198 and $51,646 as compensation expense for stock options during the three months ended June 30, 2012 and 2011, respectively.

On April 18, 2011, the Company issued 5,000 shares of stock to an employee as a bonus. On November 28, 2011, the Company issued 95,000 shares of stock to four employees as bonus. The Company recorded $559,000 as stock compensation expense during 2011.

19. COMMITMENTS

Executive Agreements

On July 10, 2012, SmartHeat entered into an agreement with Mr. Oliver Bialowons, the Company’s President, effective as of May 25, 2012 for a one-year term. Mr. Bialowons is compensated at $80,000 per year and eligible for an equity grant of 100,000 restricted shares of the Company’s common stock, at $0.05 per share. The shares will be issued if the Company, at the time of the issuance, remains a listed company on the NASDAQ Stock Market and shareholder approval is obtained.  The shares, upon their issuance, shall be restricted from being sold or transferred to more than aggregate of 10 persons or entities, until June 30, 2017. The Company shall have the option to repurchase the Shares for $0.20 per share until January 31, 2013, $0.40 per share until September 30, 2013, $0.60 per share until June 30, 2014, and $0.80 per share until January 31, 2016.

On July 10, 2012, the Company entered into an agreement with Mr. Michael Wilhelm, the Company’s Chief Financial Offer, for a one-year term with compensation of $36,000 per year. Mr. Wilhelm will be eligible for a discretionary annual cash bonus after SmartHeat's Form 10K for fiscal 2012 is filed with the SEC. Mr. Wilhelm's agreement contains customary provisions relating to termination, confidentiality, non-competition and indemnification.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
Lease Agreements

The Company leased offices for its sales representative in several different cities under various one-year, non-cancellable and renewable operating lease agreements. Rental expense for the six months ended June 30, 2012 and 2011, was approximately $275,000 and $252,350, respectively. Rental expense for the three months ended June 30, 2012 and 2011, was approximately $181,500 and $186,550, respectively.

Capital Contribution

The Company formed SmartHeat Investment on April 7, 2010, as an investment holding company with registered capital of $70 million to enable its establishment and investment in new businesses in China. Under PRC company law, registered capital must be used in the operations of the domestic company within its approved business scope. SmartHeat Investment was established as a separate subsidiary of the Company to allow for the allocation of capital to new businesses in China separate from its existing subsidiaries and operations. As a PRC investment holding company, the $70 million in approved registered capital of SmartHeat Investment is deemed a planned investment amount for the entity, not a traditional registered capital requirement under PRC corporate law. The Company contributed $30 million in capital to SmartHeat Investment on April 15, 2010, from proceeds of its public offering that closed on September 22, 2009. On April 12, 2010, SmartHeat Investment formed SmartHeat Energy, a wholly owned subsidiary in Shenyang with registered capital of $30 million, subsequently satisfied out of the registered capital of SmartHeat Investment, for the research, development, manufacturing and sale of energy products. As of June 30, 2012, the Company is committed to contribute the remaining  $40 million in registered capital to SmartHeat Investment by April 2015. The Company plans to satisfy this contribution through cash flow provided by operations and funds raised through offerings of its securities, if and when the Company determines such offerings are required, and at such time that the Company identifies a new acquisition, investment or business opportunity to be financed through SmartHeat Investment, although no specific investment candidate has been identified to date. If the Company is unable to make the required capital contribution to registered capital, the Company may apply to extend the payment period, typically granted for six months or more, or otherwise reduce the amount of registered capital to the amount already contributed. There is no penalty for failure to satisfy in full the approved registered capital of a PRC investment holding company.

Restructuring Agreement with a Consulting Firm

On April 23, 2012, the Company entered into an agreement (“Agreement”) with a consulting company named Nimbus Restructuring Manager LLC (“Nimbus”), for advice on raising capital and restructuring the Company to maximize value for the benefit of all of the stockholders of the Company. The term of the agreement is for a period not to exceed 270 days from April 23, 2012.

Upon execution of the Agreement, the Company paid a fee of $200,000. Additionally, the Company will pay the amount of $70,000 per month in advance on the first day of each month (commencing May 1, 2012), for the shorter of 6 months or until the purpose of this Agreement has been achieved. An additional $600,000 is required to be paid upon the completion of the Restructuring to the satisfaction of the Board. The amounts required to be paid to Nimbus in accordance with the terms of the Agreement shall be deemed to be fully earned and non-refundable immediately upon payment and following commencement of performance of the services specified.

The Company shall issue and sell to Nimbus an aggregate of 150,000 shares of the Company’s restricted common stock at the aggregate price of $7,500, or $0.05 per share, the Company has the right to repurchase such shares for $0.20 per share until 1/31/2013, $0.40 per share until 9/30/2012, $0.60 per share until 6/30/2014, $0.80 per share until 3/31/2015 and $1.00 per share until 1/31/2016.

The Company shall reimburse Nimbus and its affiliates for all reasonable and appropriate out-of-pocket expenses actually incurred in performance of the services specified in the Agreement. Upon execution of the Agreement, the Company is obligated to pay Nimbus an advance of $50,000 against any such future expenses, which amount is to be replenished monthly upon submission of adequate details regarding expenses or evidence for expenses incurred.

As of June 30, 2012, the Company paid $390,000 to Nimbus which included the $200,000 due upon the execution of the Agreement, $140,000 for the May and June monthly payment and $50,000 for the advance of expenses. $171,222 was recorded as an expense for the six and three months ended June 30, 2012, on a straight line method.
 
 
 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
20. CONTINGENCIES

Certain of the Company’s bank loans were guaranteed for repayment by a third party. The guarantee term is one year and the Company is not required to pay for this guarantee service as the Company provides the same guarantee service to loans of the third party company in return. As of June 30, 2012, and December 31, 2011, the Company has signed a contract to provide guarantees of up to RMB 30 million ($4.74 million) in loans for this third party company.

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 in China and foreign currency exchange. The Company’s results may be adversely affected by changes in PRC government policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad and rates and methods of taxation, among other things.

The Company’s sales, purchases and expense transactions in China are denominated in RMB and all of the Company’s assets and liabilities in China are also denominated in RMB. The RMB is not freely convertible into foreign currencies under the current PRC 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.
 
21. ACQUISITION AND UNAUDITED PRO FORMA INFORMATION

On March 3, 2011, the Company completed the acquisition of SmartHeat Germany, a designer and manufacturer of high efficiency heat pumps. This acquisition will extend the Company’s clean technology heating solutions into the rapidly growing heat pump markets in Europe and China, enabling its customers to purchase technologically advanced heat pumps at competitive prices. The purchase price was EUR 4,248,082 ($5.90 million), which was negotiated based on a two-times multiple of SmartHeat Germany’s projected net income over the three years following the acquisition, and was paid at closing. In the end of year 2011, SmartHeat transferred all of its ownership of SmartHeat Germany to SmartHeat Pump.

The following table summarizes the fair values of the assets acquired and liabilities assumed at the date of acquisition. The fair values of the assets acquired and liabilities assumed at the closing date were used for the purpose of purchase price allocation. The Company determined that little or no identifiable intangible assets, consisting of outstanding patents, technology and customer lists, were acquired with SmartHeat Germany based on the Company’s due diligence and discussions with the seller. Accordingly, the excess of the purchase price over the fair value of the net assets acquired of $5,134,627 was recorded as goodwill.
 
Cash
 
$
239,686
 
Accounts receivable
   
137,185
 
Other receivables
   
24,254
 
Inventory
   
667,412
 
Property and equipment
   
350,382
 
Goodwill
   
5,134,627
 
Accounts payable
   
(536,907
)
Other payables
   
(117,752
)
Purchase price
 
$
5,898,887
 

On March 1, 2011, the Company entered into a purchase agreement with SmartHeat Pump, a Shenyang-based state-owned heat pump manufacturer and designer. The Company paid RMB 50 million ($7.6 million) to acquire 95% of the equity interests in SmartHeat Pump, with a local government entity retaining the remaining 5% equity interest. The purchase price was negotiated based on a two-times multiple of the projected net income of SmartHeat Pump over the three years following the acquisition.

 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 (UNAUDITED) AND DECEMBER 31, 2011
 
The following table summarizes the preliminary fair values of the assets acquired and liabilities assumed at the date of the SmartHeat Pump acquisition. The fair values of the assets acquired and liabilities assumed at the closing date were used for the purpose of purchase price allocation. The Company determined that little or no identifiable intangible assets, consisting of outstanding patents, technology and customer lists, were acquired with SmartHeat Pump based on the Company’s due diligence and discussions with the seller. Accordingly, the excess of the purchase price over the FV of the net assets acquired of RMB 37,018,052 ($5.63 million) was recorded as goodwill.
 
Cash
 
$
189,438
 
Accounts receivable
   
920,463
 
Other receivable
   
263,220
 
Inventory
   
1,265,455
 
Property and equipment
   
759,341
 
Intangible assets
   
858,409
 
Goodwill
   
5,629,951
 
Accounts payable
   
(446,334
)
Other payable and accrued expenses
   
(686,195
)
Short-term loan
   
(760,433
)
Deferred tax liability
   
(285,069
)
Noncontrolling interest
   
(103,915
)
Purchase price
 
$
7,604,331
 
 
The amounts of revenue and earnings (loss) of SmartHeat Germany and SmartHeat Pump since their respective acquisition dates included in the consolidated income statement for 2011 are $1,975,332 and $(4,247,102) for SmartHeat Germany, and $2,570,280 and $(7,713,718) for SmartHeat Pump, respectively. The Company performed annual goodwill impairment assessment for SmartHeat Germany and SmartHeat Pump as of December 31, 2011, and concluded that the goodwill balance of $6.06 million for SmartHeat Pump and $2.90 million for SmartHeat Germany was impaired (see Note 2 - Goodwill).

22. SUBSEQUENT EVENTS

On July 27, 2012, the Company entered into a secured, revolving credit facility under the terms of a Secured Credit Agreement (the “Credit Facility” or the “Credit Agreement”) with Northtech Holdings Inc., a British Virgin Islands business corporation (“Northtech”), owned by certain members of the Company’s former management, James Wang, Rhett Wang and Wen Sha. Jane Ai, the Company’s Corporate Secretary is also a part owner of Northtech. The Credit Facility provides for borrowings of up to two million U.S. Dollars ($2,000,000) (the “Committed Amount”).  On July 31, 2012, we made an initial draw from the revolving line of credit of $500,000.

Borrowings under the Credit Facility are secured by the Company’s deposit accounts and general intangibles located in the United States, its trademarks in the People’s Republic of China  and 35% of its equity interests in each of its wholly-, directly owned subsidiaries.  An origination fee of 4% of the Committed Amount was due to Northtech upon the singing of the Credit Agreement. Borrowings will bear interest at a rate of 1.25% per month, payable monthly, and the Credit Facility will mature on April 30, 2013.  At the Company’s option, the maturity date of the Credit Facility may be extended for up to 4 successive 9 month periods in exchange for an extension fee of 4% of the Committed Amount for each extension. Generally, borrowings may be prepaid at any time without premium or penalty, provided however that if the Company prepays any amount due under the Credit Facility from the proceeds of another instrument or agreement of indebtedness, the Company shall pay a 10% prepayment fee.  All amounts due under the Credit Facility may, at the Company’s option, be paid in either cash or restricted shares of the Company’s common stock.  The Credit Agreement shall be submitted to the Company’s stockholders for approval at the Company’s next annual meeting. The Credit Agreement was filed as Exhibit 10.12 to the Company’s Current Report on Form 8K, filed with the SEC on August 1, 2012.
 
 
CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS

The comments made throughout this Quarterly Report should be read in conjunction with our consolidated financial statements and the notes thereto, and other financial information appearing elsewhere in this document. In addition to historical information, the following discussion and other parts of this document contain certain forward-looking information. When used in this discussion, the words, “believes,” “anticipates,” “expects” and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from projected results, due to a number of factors beyond our control. We do not undertake to publicly update or revise any of the forward-looking statements, even if experience or future changes show that the indicated results or events will not be realized. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Readers are also urged to carefully review and consider our discussions regarding the various factors that affect our business, which are described in this section and elsewhere in this report, and those listed in our other SEC filings.

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

Overview

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

We are a U.S. holding company with no material assets other than the ownership interests of our subsidiaries through which we design, manufacture and sell our clean technology PHEs and related systems. We were incorporated in the State of Nevada on August 4, 2006, under the name Pacific Goldrim Resources, Inc., as an exploration stage corporation with minimal operations to engage in the exploration for silver, lead and zinc. On April 14, 2008, we changed our name to SmartHeat Inc. and entered into a Share Exchange Agreement to acquire Shenyang Taiyu Machinery & Electronic Equipment Co., Ltd., subsequently renamed SmartHeat Taiyu (Shenyang) Energy Technology Co., Ltd., or Taiyu, a privately held Sino-foreign joint venture company formed under the laws of the PRC on July 24, 2002, and engaged in the design, manufacture, sale and servicing of plate heat exchange products in China. The Share Exchange Agreement was entered into by SmartHeat, Taiyu and the shareholders of Taiyu. We received PRC government approval on May 28, 2008, of our subscription for 71.6% of the registered capital of Taiyu, and approval on June 3, 2009, of the transfer of the remaining 28.4% ownership of Taiyu from the original joint venture shareholders who had received shares of our common stock in the Share Exchange. As a result of the Share Exchange Agreement and subsequent transactions contemplated thereby, and receipt of the above PRC government approvals, Taiyu became our wholly foreign-owned enterprise, or WFOE.
 
As an expansion of our business following our acquisition of Taiyu, we acquired and established subsidiaries in China and Germany. On September 25, 2008, we acquired SanDeKe Co., Ltd., or SanDeKe, a Shanghai-based manufacturer of PHEs. On June 16, 2009, we completed an asset purchase transaction with Siping Beifang Heat Exchanger Manufacture Co., Ltd., or Siping Beifang, to set up a new manufacturing facility under our newly incorporated subsidiary, SmartHeat Siping Beifang Energy Technology Co., Ltd., or SmartHeat Siping. On August 14, 2009, we formed Beijing SmartHeat Jinhui Energy Technology Co., Ltd., or Jinhui, a joint venture in Beijing of which we own 52%, to provide consulting services and expand our sales of PHEs into new industries and regions of China. On April 7, 2010, we formed SmartHeat (China) Investment Co., Ltd., or SmartHeat Investment, as an investment holding company in Shenyang for our investment in and establishment of new companies and businesses in China. On April 12, 2010, SmartHeat Investment formed SmartHeat Energy (Shenyang) Energy Equipment Co., Ltd., or SmartHeat Energy, as its wholly owned subsidiary for the research, development, manufacturing and sales of energy products. On May 6, 2010, we formed SmartHeat (Shanghai) Trading Co., Ltd., or SmartHeat Trading, through a nominee, Cleantech Holdings Inc., a British Virgin Islands company, or Cleantech Holdings, to market and expand sales of our branded products in China. Prior to November 9, 2011, we had no direct ownership interest in SmartHeat Trading; instead, we controlled and were entitled to 100% of the profit or loss of SmartHeat Trading under contractual arrangements. Effective as of November 9, 2011, we terminated the nominee-owner relationship and acquired direct control over SmartHeat Trading. On December 2, 2010, we formed Hohhot Ruicheng Technology Co., Ltd., or Ruicheng, a joint venture in Hohhot City, China, for the design and manufacture of heat meters, of which we acquired 51% of the equity interest on January 7, 2011. On March 1, 2011, we entered into a purchase agreement to acquire 95% of the equity interests in Shenyang Bingchuan Refrigerating Machine Limited Company, a Shenyang-based state-owned heat pump manufacturer and designer subsequently renamed SmartHeat (Shenyang) Heat Pump Technology Co., Ltd., or SmartHeat Pump. On March 3, 2011, we completed the acquisition of Gustrower Warmepumpen GmbH, subsequently renamed SmartHeat Deutschland GmbH, or SmartHeat Germany, a designer and manufacturer of high efficiency heat pumps in Germany, to extend our clean technology heating solutions into the rapidly growing heat pump markets in Europe and China.

Principal Factors Affecting Our Financial Performance

Our revenues are subject to fluctuations due to the timing of sales of high-value products, the impact of seasonal spending patterns, the timing and size of projects our customers perform, changes in overall spending levels in the industry, changes in PRC government fiscal policies, inflation in China and other unpredictable factors that may affect customer ordering patterns. Our revenues may fluctuate due to the seasonal nature of central heating services in the PRC because the equipment used in residential buildings must be delivered prior to the beginning of the heating season in late fall, which occurs during the third and fourth calendar quarters in China. We also anticipate decreased sales volume in the first calendar quarter compared to other quarters, as our customers generally install and test our products during this period, and in the process of budgeting their new projects. 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 decline in quarterly revenue.

 
In response to inflationary concerns, the PRC government tightened fiscal policies beginning in 2011 that contributed to a general slowdown in many sectors of China’s economy and restricted bank lending practices. China’s economy grew at its slowest pace in three years during the six months ended June 30, 2012, according to the National Bureau of Statistics of China. Historically, approximately 40% of our customers, representing the majority of our total sales, consist of state-owned enterprises in China. Many of these customers, the majority of which are real estate developers, encountered difficulties in 2011 in obtaining grants from the PRC government and faced an extended bank loan application process, both of which typically are used to finance the purchase of our products, and these conditions have continued into 2012. Accordingly, the continued deflationary policy of the PRC government affected the number of new sales of our PHEs and PHE Units as certain state-owned enterprises deferred bidding for new projects because of their working capital difficulties or abandoned existing projects. The decline in new projects among state-owned enterprises and increased peer competition contributed to a decline in sales of our PHEs and PHE Units in 2011 and the six months ended June 30, 2012. We also canceled contracts in 2011 with certain of these state-owned customers that were unable to make payments or that had requested adjustments to their payment terms in response to their financial difficulties. Although these events caused a decrease in our sales in 2011 and into 2012, a portion of the canceled PHE and PHE Unit orders were reinstated in the six months ended June 30, 2012, and we expect that additional orders and contracts that were canceled or partially delayed will be performed in late 2012, reducing the impact of the drop in our sales over the long term. Furthermore, the PRC government remains committed to the construction of affordable housing projects and emission-reduction and energy-saving policies, which we believe will continue to drive demand for our clean technology heat transfer products.
 
Our revenues also may fluctuate significantly due to material costs, which normally account for approximately 80% of our cost of sales. We experienced and anticipate continued fluctuation in raw material costs as a result of world economic conditions, such as the price of stainless steel used to produce plates for our PHEs and PHE Units. We monitor the commodities markets for pricing trends and changes, but we do not engage in hedging to protect against raw material fluctuations. Instead, we attempt to mitigate the short-term risks of price swings by purchasing raw materials in advance based on production needs and projected sales. We typically experience stronger sales during the second half of the year, which is the start of fall and winter in China, during which we historically generate the majority of our revenue. Accordingly, we increased our inventory and advances to suppliers during the first three quarters of 2011 in anticipation of our historical high season for production. Management believes our current levels of increased inventory resulting from the unexpected abandonment of projects and cancelation of orders by certain customers in 2011 will be consumed throughout 2012 as we fulfill new orders and delayed and reinstated contracts. Although we currently are able to obtain adequate supplies of raw materials, it is impossible to predict future availability or cost. Unfavorable fluctuations in the price, quality or availability of required raw materials could negatively affect our cash flows and ability to meet the demands of our customers, which could result in the loss of future sales.

Our profitability generally depends upon the margin between the cost to us of certain goods used in the manufacturing process, such as plates, pumps, water tanks, sensors, controlling systems and other raw materials, as well as our fabrication costs associated with converting such goods and raw materials compared to the selling price of our products, and the overall supply of raw materials. We intend to base the selling prices of our products upon the associated raw materials costs to us, which typically make up approximately 80% of total cost. We may not be able to pass all increases in raw material costs and ancillary acquisition costs associated with taking possession of raw materials through to our customers, however, and there may be a time lag as we bid on new projects and renegotiate pricing with our existing customers. Furthermore, to ease inflationary pressure on our costs, we implemented new controls over our purchasing process and raw material pricing by adopting a new budgetary control system to monitor our fixed costs and continued improvements to our manufacturing process to decrease labor cost and improve manufacturing efficiency.

The economic conditions our subsidiaries faced in 2011 and in the six months ended June 30, 2012, have made it difficult for our subsidiaries to pay dividends to our U.S. parent company, which is dependent upon such dividends to meet its financial obligations.  Relevant PRC statutory laws and regulations permit payments of dividends by the Company’s PRC subsidiaries only out of the subsidiary’s retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. Further, the Company’s PRC subsidiaries are required to take certain reserves as further detailed in Note 17 to our financial statements.  As of June 30, 2012, our U.S. parent company had $27,198 in cash. As a result, we sought alternative sources of capital for our U.S. parent company. On July 27, 2012, we entered into a secured, revolving credit facility under the terms of a Secured Credit Agreement with Northtech Holdings Inc., a British Virgin Islands business corporation owned by certain members of our former management, James Wang, Rhett Wang and Wen Sha.  Jane Ai, our Corporate Secretary, is also a part owner of Northtech.  The credit facility provides for borrowings of up to $2.0 million. Details regarding the credit facility were disclosed on a current report on Form 8K filed on August 1, 2012, to which the secured credit agreement was filed as Exhibit 10.12.  On July 31, 2012, we made an initial draw from the revolving line of credit of $500,000.  We believe the credit line will be sufficient to fund the expenses of our U.S. parent company for the next 12 months, during which time we hope to restore the profitability of our subsidiaries, put in place certain agreements between our U.S parent company and our subsidiaries to permit the up streaming of cash, and/or to find additional sources of financing for our U.S. parent company.

Significant Accounting Policies

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

Basis of Presentation

Our financial statements are prepared in accordance with generally accepted accounting principles in the U.S., or U.S. GAAP.

 
Principle of Consolidation

The accompanying consolidated financial statements include the accounts of SmartHeat’s U.S. parent and its subsidiaries, Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Energy, SmartHeat Trading, Ruicheng, SmartHeat Germany and SmartHeat Pump. All significant inter-company accounts and transactions were eliminated in consolidation.

Use of Estimates

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

Our policy is to maintain reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves. Accounts receivable are net of unearned interest. Unearned interest represents imputed interest on accounts receivable with due dates over one year from the invoice date discounted at our borrowing rate for the year. Based on historical collection activity, we reserved bad debt allowances of $16.41 million and $10.58 million at June 30, 2012, and December 31, 2011, respectively.

Impairment of Long-Lived Assets

We assess the impairment of long-lived assets, which include tangible assets, such as property, plant and equipment, goodwill and other intangible assets, whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. If such circumstances are determined to exist, an estimate of undiscounted future cash flows expected to be generated by the long-lived assets, or the appropriate grouping of assets, is compared to the carrying value to determine whether an impairment exists. If an asset is determined to be impaired, the loss is measured based on FV, generally determined using the asset’s expected future discounted cash flows or market value, if readily determinable. The following are indicators management considers in determining whether it is necessary to test assets for impairment in accordance with ASC 360-10-35-21:
 
·  
Significant decrease in the market price of a long-lived asset or asset group;
·  
Significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;
·  
Significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset or asset group, including an adverse action or assessment by a regulator;
·  
Accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset or asset group;
·  
Current-period operating or cash flow loss combined with a history of operating or cash flow losses, or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group; and
·  
Current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

We evaluate goodwill and intangible assets with indefinite lives for impairment annually using a two-step approach. Based on this valuation approach, we concluded that the goodwill balance of $6.06 million for SmartHeat Pump and $2.90 million for SmartHeat Germany was impaired as of December 31, 2011. Based on our review, we believe that, as of June 30, 2012, there were no significant impairments of our other long-lived assets.

Revenue Recognition

Our revenue recognition policies are in compliance with SEC Staff Accounting Bulletin (“SAB”) 104 (codified in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605). Sales revenue is recognized when PHEs, heat meters and heat pumps are delivered, and for PHE Units when customer acceptance occurs, the price is fixed or determinable, no other significant obligations of ours exist and collectibility is reasonably assured. Payments received before all of the relevant criteria for revenue recognition are recorded as unearned revenue under “Advance from customers.”
 
Our agreements with our customers generally provide that 30% of the purchase price is due upon placement of an order, 30% upon delivery and 30% upon installation and acceptance of the equipment after customer testing. As a common practice in the heating manufacturing business in China, payment of the final 10% of the purchase price is due no later than the termination date of the standard warranty period, which ranges from 3 to 24 months from the acceptance date.
 
 
Our standard warranty is provided to all customers and is not considered an additional service; rather, it is an integral part of the product sale. We believe the existence of the standard product warranty in a sales contract does not constitute a deliverable in the arrangement and thus there is no need to apply the EITF 00-21 (codified in FASB ASC Topic 605-25) separation and allocation model for a multiple deliverable arrangement. SFAS 5 (codified in FASB ASC Topic 450) specifically addresses the accounting for standard warranties and neither SAB 104 nor EITF 00-21 supersedes SFAS 5. We believe accounting for our standard warranty pursuant to SFAS 5 does not impact revenue recognition because the cost of honoring the warranty can be reliably estimated.

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

Foreign Currency Translation and Comprehensive Income (Loss)

The functional currency of our subsidiaries in China is RMB. The functional currency of SmartHeat Germany, our German subsidiary, is EUR. For financial reporting purposes, RMB and EUR were translated into USD as the reporting currency. Assets and liabilities are translated at the exchange rate in effect at the balance sheet date. Revenues and expenses are translated at the average rate of exchange prevailing during the reporting period. Translation adjustments arising from the use of different exchange rates from period to period are included as a component of stockholders’ equity as “Accumulated other comprehensive income.” Gains and losses resulting from foreign currency transactions are included in income. There was no significant fluctuation in exchange rate for the conversion of RMB to USD after the balance sheet date.

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

Recent Accounting Pronouncements

On July 27, 2012, the FASB issued ASU 2012-02, Intangibles-Goodwill and Other (Topic 350) - Testing Indefinite-Lived Intangible Assets for Impairment.  The ASU provides entities with an option to first assess qualitative factors to determine whether events or circumstances indicate it is more likely than not the indefinite-lived intangible asset is impaired.  If an entity concludes that it is more than 50% likely that an indefinite-lived intangible asset is not impaired, no further analysis is required.  However, if an entity concludes otherwise, it would be required to determine the fair value of the indefinite-lived intangible asset to measure the amount of actual impairment, if any, as currently required under US GAAP.  The ASU is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012.  Early adoption is permitted. The adoption of this pronouncement will not have a material impact on our financial statements.

Results of Operations

Six Months Ended June 30, 2012, Compared to the Six Months Ended June 30, 2011

The following table sets forth the results of our operations for the periods indicated as a percentage of net sales, certain columns may not add due to rounding.

   
2012
   
2011
 
   
$
   
% of Sales
   
$
   
% of Sales
 
Sales
 
$
11,728,846
         
$
14,970,050
       
Cost of sales
   
9,736,416
     
83
%
   
9,762,240
     
65
%
Gross profit
   
1,992,430
     
17
%
   
5,207,810
     
35
%
Operating expenses
   
18,730,103
     
160
%
   
16,826,771
     
112
%
Loss from operations
   
(16,737,673
)
   
(143
)%
   
(11,618,961
)
   
(78
)%
Other income (expenses), net
   
393,081
     
3
%
   
(216,000
)
   
(1
)%
Income tax benefit
   
(44,494
)
   
(0.4
)%
   
(1,328,059
)
   
(9
)%
Noncontrolling interest
   
(114,935
)
   
(1
)%
   
(134,724
   
(1
)%
Net loss to SmartHeat Inc.
 
$
(16,185,163
)
   
(138
)%
 
$
(10,372,178
)
   
(69
)%

 
Sales. Net sales in the six months ended June 30, 2012, were $11.73 million, consisting of $4.72 million for PHEs, $4.49 million for PHE Units, $1.74 million for heat meters and $0.78 million for heat pumps, while net sales in the six months ended June 30, 2011, were $14.97 million, consisting of $7.29 million for PHEs, $4.43 million for PHE Units, $1.28 million for heat meters and $1.97 million for heat pumps, an overall decrease of $3.24 million or 22%. The decrease in sales was due primarily to the decrease in sales volume in the six months ended June 30, 2012, compared to the 2011 period. Sales volume of PHEs, PHE Units, heat meters and heat pumps decreased 2.2%, 6.8%, 27.4% and 2.9%, respectively, in the six months ended June 30, 2012 compared to 2011. Sales volume is seasonal, with an expected decrease in sales volume during the first half of the year, when our customers generally are installing and testing our products and are in the process of budgeting for  new projects. The decrease in sales volume in the six months ended June 30, 2012 compared to 2011 resulted from the continued effects of a tightened fiscal policy in China, which has contributed to a general slowdown in many sectors of China’s economy, restricted bank lending practices and caused the abandonment of certain projects by our customers. China’s economy grew at its slowest pace in three years during the six months ended June 30, 2012. The PRC government remains committed to the construction of affordable housing projects and emission-reduction and energy-saving policies, however, which we believe will continue to drive demand for our clean technology heat transfer products. A smaller than expected portion of the PHE and PHE Unit orders canceled or delayed in 2011 were reinstated in the six months ended June 30, 2012, although we expect that additional orders and contracts that were canceled or partially delayed will be performed in late 2012, reducing the impact of our decreased sales over the long term.
 
We have a review process for approving each sales contract, especially with respect to sales price. Sales price is determined under each contract in proportion to our estimated cost in order to ensure our gross profit. Our sales price varies according to each sale depending mainly on each customer’s specific requirements and our negotiation of the contract amount and term. We believe our marketing policy remains successful and have maintained a comparable program to previous years, but we adjusted our pricing policy in 2011 in order to obtain more contracts. The approximately 5% increase in average selling price in the six months ended June 30, 2012 compared to the 2011 period, resulted from an increase of sales of higher selling-price products in the six months ended June 30, 2012 as compared to 2011 despite the decrease in sales volume.
 
Cost of Sales. Cost of sales was $9.74 million in the six months ended June 30, 2012, compared to $9.76 million in the six months ended June 30, 2011, a decrease of $0.02 million or 0.3%. Cost of sales mainly consisted of the cost of materials, factory overhead and labor. Materials cost was 68% of total cost, while factory overhead cost was 25% and labor 7%. Materials cost typically makes up approximately 80% of total cost, but with the decrease in production volume in the six months ended June 30, 2012, the proportion of factory overhead and manufacturing expense to total cost of sales increased significantly. The decrease in cost of sales is attributable to the decrease in sales. Cost of sales as a percentage of sales increased 18% to 83% in the six months ended June 30, 2012, compared to 65% in the 2011 period, which was mainly due to the significant decrease in sales and production volume. The overhead cost absorbed by individual products increased in the six months ended June 30, 2012, compared to the 2011 period, however, because of our decreased production volume. In order to ease inflationary pressures, we implemented new controls over our purchasing process and raw material pricing by adopting a new budgetary control system to monitor our fixed costs. We also continued improving our manufacturing process to decrease labor costs and improve efficiency.
 
We performed an inventory impairment assessment as of June 30, 2012, for the write-down of raw materials and finished goods in inventory. We stock inventory, consisting of raw materials and finished goods, according to projected sales and customer orders, with steel, plates and components for our products generally ordered two to three months in advance of anticipated production needs. As part of our impairment analysis, we performed an evaluation of raw materials stored over one year and not anticipated to be consumed, and an evaluation of potential impairment to the quality of these raw materials. If management anticipates that obsolete raw materials in inventory can be utilized and will be consumed within the next six months through new customer orders or substitute orders, no impairment is recorded. We collected information about delayed and canceled contracts and met with affected customers to discuss their financing situation and their projections of future orders. Finished goods manufactured for delayed and canceled contracts that we do not expect to be reinstated and contracts for which we have been unable to find substitute customers become impaired. We performed an evaluation of these finished goods stored over one year and recorded an impairment accordingly. A portion of the canceled orders from 2011 for PHEs and PHE Units were reinstated, and we believe that additional orders and contracts that were canceled or partially delayed will be performed in 2012, gradually consuming our increased levels of finished goods in inventory otherwise requiring impairment as we fulfill these delayed and reinstated contracts along with new orders. We also analyzed whether to take a reserve for conversion costs of finished goods in inventory for resale to substitute customers. Following the completion of our impairment analysis, we recorded provision of inventory impairment of $0.67 million for the six months ended June 30, 2012.
 
Gross Profit. Gross profit was $1.99 million in the six months ended June 30, 2012, compared to $5.21 million in the same period of 2011, or gross profit margins of 17% and 35%, respectively. The decreased gross profit was due primarily to our decreased sales and production volume.
 
Operating Expenses. Operating expenses consisting of selling, general and administrative expenses totaled $18.73 million in the six months ended June 30, 2012, compared to $16.83 million in the 2011 period, an increase of $1.90 million or 11%. Operating expenses as a percentage of sales were 160% in the six months ended June 30, 2012, compared to 112% in the six months ended June 30, 2011. The increase in operating expenses mainly resulted from: bad debt allowance for accounts receivables of $5.88 million for the six months ended June 30, 2012, compared with $5.81 million for the 2011 period, and an after-sales service expense of $2.05 million for the six months ended June 30, 2012, for equipment installation and modifications of products under warranty, as part of our continued process to improve product quality and introduce newly-developed technology to maintain existing customers and attract new contracts, compared with $0.17 million for the 2011 period.
 
We recorded a bad debt allowance of $5.88 million for the six months ended June 30, 2012, compared with $5.81 million for the 2011 period, primarily attributable to payment delays caused by the working capital difficulties of many of our state-owned customers. Due to the deflationary fiscal policy of the PRC government in 2011 that has continued into 2012, some of our state-owned customers encountered difficulties in obtaining grants from the government and loans from state-owned banks, both of which typically are used to finance the purchase of our products, which resulted in unexpected delays in paying our accounts receivable in a timely manner. Generally, we account for 50% of accounts receivable with aging over 180 days and 100% of accounts receivable with aging over 360 days as bad debt allowance. We do not expect a significant risk with respect to the overdue accounts receivable for which we took the bad debt allowance and hope that a substantial portion of the bad debt will be repaid as the PRC government restores grants and credit policies. We believe the stringent fiscal policy impacting our customers in China will be temporary and the expansion and training of our marketing team and other employees will increase sales and improve the efficiency of our operations.

 
We performed annual goodwill impairment assessment for SmartHeat Germany and SmartHeat Pump as of December 31, 2011. The goodwill balance prior to the impairment charge was $10.97 million and was established primarily as a result of the acquisition of SmartHeat Germany and SmartHeat Pump in 2011. We completed the step one analysis using discounted cash flow. The discounted cash flow method uses revenue and expense projections and risk-adjusted discount rates. The process of determining fair value is subjective and requires management to exercise a significant amount of judgment in determining future growth rates, discount and tax rates and other factors. The current economic environment has impacted our ability to forecast future demand and has in turn resulted in the use of higher discount rates, reflecting the risk and uncertainty in current markets. The results of the step one analysis indicated potential impairment in the SmartHeat Germany and SmartHeat Pump reporting units, corroborated by a combination of factors including a significant and sustained decline in the market capitalization, which is significantly below the book value, and the deteriorating macro environment, which resulted in a decline in expected future demand. We therefore performed the second step of the goodwill impairment assessment to quantify the amount of impairment. This process involved calculating the implied fair value of goodwill, determined in a manner similar to a purchase price allocation, and comparing the residual amount to the carrying amount of goodwill. Our analysis incorporated the declining market capitalization in 2011 and the significant end market deterioration and economic uncertainties impacting expected future demand, including the continued tightened fiscal policy in China and difficulties in obtaining bank leasing loans that have contributed to a general slowdown in many sectors of China’s economy and caused the abandonment of certain projects by our customers, which in turn resulted in an unexpected cancelation of orders and delays in the performance of PHE and PHE Unit contracts. We concluded that the goodwill balance of $6.06 million for SmartHeat Pump and $2.90 million for SmartHeat Germany was impaired as of December 31, 2011. The goodwill impairment charge is non-cash in nature and not deductible for income tax purposes. Although we wrote off goodwill in 2011 based on the current economic environments in China and Europe and our near-term assessment of the cash flows of these acquisitions, we anticipate growth in the heat pump markets in the future and are continuing their operations, viewing these acquisitions as providing value and increased sales over the long term.

Other income (expenses), net. Our other income for the six months ended June 30, 2012, was $393,081 compared to net other expense of $216,000 for the 2011 period, an increase of $609,081 or 282%. The increase was due mainly to the increased after-sales service revenue and technology service revenue of $0.56 million, and $0.38 million of government grant of enterprise tax refund for welfare, but partially offset by increased interest expense by $0.33 million. Also, one of our subsidiaries incurred a loss of $0.43 million related to the restructuring of its debt during the six months ended June 30, 2012.

Income tax expense (benefit). We had income tax benefit of $44,494 for the six months ended June 30, 2012, compared to $1.33 million for the 2011 period. The effective income tax rate for the six months ended June 30, 2012 was (0.3)% compared to (11.2)% for the 2011 period, with the difference mainly due to increased valuation allowance for deferred tax asset for bad debt allowance and inventory allowance resulting from our continued losses in the six months ended June 30, 2012.

Taiyu and SanDeKe are governed by the Income Tax Law of the PRC concerning privately-run enterprises, which are generally subject to tax at a statutory rate of 25% on income reported in the statutory financial statements after appropriated tax adjustments. Taiyu has been classified as a high-tech enterprise since 2009 and eligible for an income tax rate of 15% through 2012. The local PRC government reviews the high-tech status of such enterprises annually. The income tax rate for SanDeKe is 13% and 12% for 2012 and 2011, respectively, because of its foreign-invested enterprise status.

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

Net Income (Loss). Our net loss for the six months ended June 30, 2012, was $16.19 million compared to net loss of $10.37 million for the 2011 period, an increase of $5.81 million or 56%. Net loss as a percentage of sales was 138% in the six months ended June 30, 2012, and net loss as a percentage of sales was 69% in the comparable period of 2011. This increase in net loss was attributable to decreased net sales and increased bad debt allowance and inventory reserve.
 
Three Months Ended June 30, 2012, Compared to the Three Months Ended June 30, 2011
 
The following table sets forth the results of our operations for the periods indicated as a percentage of net sales, certain columns may not add due to rounding.
 
   
2012
   
2011
 
   
$
   
% of Sales
   
$
   
% of Sales
 
Sales
 
$
4,982,448
         
$
7,077,901
       
Cost of sales
   
4,535,323
     
91
%
   
4,432,011
     
63
%
Gross profit
   
447,125
     
9
%
   
2,645,890
     
37
%
Operating expenses
   
9,309,392
     
187
%
   
9,750,316
     
138
%
Loss from operations
   
(8,862,267
)
   
(178
)%
   
(7,104,426
)
   
(100
)%
Other income (expenses), net
   
(467,966)
     
(9)
%
   
(48,340
)
   
(1
)%
Income tax benefit
   
(20,390
)
   
(0.4
)%
   
(647,160
)
   
(9
)%
Noncontrolling interest
   
(57,145
)
   
(1
)%
   
(87,230
   
(1
)%
Net loss to SmartHeat Inc.
 
$
(9,252,698
)
   
(186
)%
 
$
(6,418,376
)
   
(91
)%

 
Sales. Net sales in the three months ended June 30, 2012, were $4.98 million, consisting of $1.32 million for PHEs, $1.66 million for PHE Units, $1.71 million for heat meters and $0.28 million for heat pumps, while net sales in the three months ended June 30, 2011, were $7.08 million, consisting of $1.27 million for PHEs, $3.98 million for PHE Units, $0.36 million for heat meters and $1.47 million for heat pumps, an overall decrease of $2.10 million or 30%. The decrease in sales was due primarily to the decrease in sales volume in the three months ended June 30, 2012, compared to the 2011 period. Sales volume of PHEs, PHE Units, heat meters and heat pumps increased 65%, 33%, 249% and 11%, respectively, in the second quarter of 2012 compared to 2011. Sales volume is seasonal, with an expected decrease in sales volume during the second quarter of each year when our customers generally are installing and testing our products and are in the process of budgeting for new projects. Increased sales volume was mainly due to increased sales of heat meters, but decrease in the value of the sales was due to the significantly lower selling price for our heat meters as compared to our other products. The PRC government remains committed to the construction of affordable housing projects and emission-reduction and energy-saving policies, however, which we believe will continue to drive demand for our clean technology heat transfer products. 
 
We have a review process for approving each sales contract, especially with respect to sales price. Sales price is determined under each contract in proportion to our estimated cost in order to ensure our gross profit. Our sales price varies according to each sale depending mainly on each customer’s specific requirements and our negotiation of the contract amount and term.
 
Cost of Sales. Cost of sales was $4.54 million in the three months ended June 30, 2012, compared to $4.43 million in the three months ended June 30, 2011, an increase of $0.10 million or 2%. Cost of sales mainly consisted of the cost of materials, factory overhead and labor. Materials cost was 73% of total cost, while factory overhead cost was 22% and labor 5%. Materials cost typically makes up approximately 80% of total cost, but with the decrease in production volume in the second quarters of 2012, the proportion of factory overhead and manufacturing expense to total cost of sales increased significantly.  Cost of sales as a percentage of sales increased 28% to 91% in the three months ended June 30, 2012, compared to 63% in the 2011 period, which was mainly due to the significant decrease in sales and production volume. The overhead cost absorbed by individual products increased in the three months ended June 30, 2012, compared to the 2011 period, however, because of the decreased production volume. In order to ease the pressure from inflation, we implemented new controls over our purchasing process and raw material pricing by adopting a new budgetary control system to monitor our fixed costs and continued improvements to our manufacturing process to decrease labor cost and improve manufacturing efficiency.
 
We performed an inventory impairment assessment as of June 30, 2012, for the write-down of raw materials and finished goods in inventory. Following the completion of our impairment analysis, we recorded provision of inventory impairment of $0.54 million for the three months ended June 30, 2012, and $0 for the three months ended June 30, 2011.
 
Gross Profit. Gross profit was $0.45 million in the three months ended June 30, 2012, compared to $2.65 million in the 2011 period, or gross profit margins of 9% and 37%, respectively. The decreased gross profit was due primarily to our decreased sales and production volume.
 
Operating Expenses. Operating expenses consisting of selling, general and administrative expenses totaled $9.31 million in the three months ended June 30, 2012, compared to $9.75 million in the 2011 period, a decrease of $0.44 million or 5%. Operating expenses as a percentage of sales were 187% in the three months ended June 30, 2012, compared to 138% in the three months ended June 30, 2011. The decrease in operating expenses mainly resulted from decreased G&A expense: bad debt provision for accounts receivables of $3.38 million for the three months ended June 30, 2012, compared with $3.74 million for the 2011 period; decreased R&D expense by $435,000; decreased salary and welfare expense by $131,000; decreased employees’ education and training expense by $83,000, decreased travelling and entertainment expense by 95,000; and general office expense of $125,000, offset by increased selling expense of $2.03 million for system upgrade installation and testing during the three month ended June 30, 2012.
 
We recorded a bad debt allowance of $3.38 million for the three months ended June 30, 2012, compared with $3.74 million for the 2011 period, primarily attributed to payment delays caused by the working capital difficulties of many of our state-owned customers. Due to the deflationary fiscal policy of the PRC government in 2011 that has continued into 2012, some of our state-owned customers encountered difficulties in obtaining grants from the government and loans from state-owned banks, both of which typically are used to finance the purchase of our products, which resulted in unexpected delays in paying our accounts receivable in a timely manner. Generally, we account for 50% of accounts receivable with aging over 180 days and 100% of accounts receivable with aging over 360 days as bad debt allowance. We do not expect a significant risk with respect to the overdue accounts receivable for which we took the bad debt allowance and believe that a substantial portion of the bad debt will be repaid as the PRC government restores grants and credit policies. We believe the stringent fiscal policy impacting our customers in China will be temporary and the expansion and training of our marketing team and other employees will increase sales and improve the efficiency of our operations. Nevertheless, we will institute a rigorous program of cost cutting to continue to tightly control our budget and implement additional cost control measures, including a review of the staffing levels of our employees in response to the decrease in revenue.
 
Other income (expenses), net. Our other expense for the three months ended June 30, 2012, was $467,966 compared to net other expense of $48,340 for the 2011 period, an increase of $419,626 or 868%. The increase was due mainly to the increased interest expense by $0.18 million and loss on debt restructuring of $0.43 million; but partially offset by the increased after-sales service revenue and technology service revenue of $0.10 million and $0.12 million of government grant of enterprise tax refund for welfare.
 
Income tax expense (benefit). We had income tax benefit of $20,390 for the three months ended June 30, 2012, compared to $647,160 for the 2011 period. The effective income tax rate for the three months ended June 30 of 2012 was (0.2)% compared to (9.1)% for the 2011 period, with the difference mainly due to increased valuation allowance for deferred tax asset for bad debt allowance and inventory allowance resulting from our continued losses during the three months ended June 30, 2012.

Net Income (Loss). Our net loss for the three months ended June 30, 2012, was $9.25 million compared to net loss of $6.42 million for the 2011 period, an increase of $2.83 million or 44%. Net loss as a percentage of sales was 186% in the three months ended June 30, 2012, and net loss as a percentage of sales was 91% in the comparable period of 2011. This increase in net loss was attributable to decreased net sales and increased bad debt allowance and inventory provision reserve.

 
Liquidity and Capital Resources

As of June 30, 2012, we had cash and equivalents of $10.52 million. Working capital was $85.57 million at June 30, 2012. The ratio of current assets to current liabilities was 3.40:1 at June 30, 2012.

As previously disclosed in the Company’s filings with the SEC, and set forth in Note 17, there are a number of issues with respect to the up streaming of cash from the Company’s subsidiaries in the PRC to the Company’s U.S. parent company.  See “Limitations on the ability of our operating subsidiaries to make payments to us could have a material adverse effect on our ability to conduct our business and fund our operations” disclosed under Risk Factors in the Company’s Annual Report on Form 10K for the fiscal year 2011.

Presently, the Company’s U.S. parent company is experiencing difficulty up streaming cash due to these issues. As a consequence, the Company obtained a revolving line of credit providing for borrowings of up to $2.0 million, to address the cash needs of the Company’s U.S. parent. On July 31, 2012, the Company made an initial draw from the revolving line of credit of $500,000.

See Note 22, Subsequent Events for further details regarding the line of credit.

The following is a summary of cash provided by or used in each of the indicated types of activities during the six months ended June 30, 2012 and 2011:

   
2012
   
2011
 
Cash provided by (used in):
           
Operating activities
 
$
1,573,430
   
$
(24,947,855
)
Investing activities
 
$
(5,984,062
)
 
$
(15,641,199
)
Financing activities
 
$
2,638,835
   
$
4,159,252

Net cash flow provided in o