UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 WASHINGTON, D.C. 20549

 

FORM 10-Q/A

 

Amendment No. 1

 

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

 

For the quarterly period ended June 30, 2011

 

OR

 

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

 

For the transition period from                      to                     

 

Commission File No. 000-12536

 

China Recycling Energy Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

Nevada	90-0093373
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
12/F, Tower A Chang An International Building No. 88 Nan Guan Zheng Jie Xi’an City, Shaanxi Province, China
(Address of Principal Executive Offices, Zip Code)

 

Registrant’s Telephone Number, Including Area Code: + 86-29-8769-1097

 

Indicate by check mark 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 past 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” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ¨  Accelerated filer   ¨   Non-accelerated filer  ¨  Smaller reporting company  x

 

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

 

Yes  ¨    No  x

 

The number of shares outstanding of the registrant’s Common Stock, as of August 10, 2011 was 43,533,174.

 

 

INDEX

 

Explanatory Note

			Page No.
PART I - FINANCIAL INFORMATION
Item 1.		Financial Statements	4
		Consolidated Balance Sheets as of June 30, 2011 (Unaudited) and December 31, 2010	4
		Consolidated Statements of Income (Unaudited) – Three and Six Months Ended June 30, 2011 and June 30, 2010	5
		Consolidated Statements of Cash Flows (Unaudited) – Six Months Ended June 30, 2011 and June 30, 2011	6
		Notes to Consolidated Financial Statements (Unaudited)	7
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations	32
Item 3.		Quantitative and Qualitative Disclosures About Market Risk	47
Item 4.		Controls and Procedures	47
PART II - OTHER INFORMATION
Item 1.		Legal Proceedings	48
Item 1A.		Risk Factors	48
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds	48
Item 3.		Defaults Upon Senior Securities	48
Item 4.		[Removed and Reserved]	48
Item 5.		Other Information	48
Item 6.		Exhibits	48

 

 

Explanatory Note

 

In response to a comment letter received from the Securities and Exchange Commission (the “SEC”), dated December 14, 2012, China Recycling Energy Corporation (the “Company,” “we,” “us” or “our”) is filing this Amendment No. 1 on Form 10-Q/A to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2011, originally filed with the SEC on August 15, 2011 (the “Original Form 10-Q”) for the following purposes: (i) revise disclosures relating to the treatment of settlement shares issued to Xueyi Dong pursuant to that certain Biomass Power Generation Asset Transfer Agreement, dated June 29, 2010 between Mr. Dong and the Company; (ii) revise tables (three and six months) comparing our results of operations as a percentage of net sales and revise our discussions relating to non-operating income (expenses), income tax expense and net income in the Results of Operations section of our MD&A; (iii) revise our disclosures relating to basic and diluted earnings per share in Note 2 (to our consolidated financial statements); (iv) revise Note 12 (to our consolidated financial statements); (v) restate the fair value of certain settlement shares issued to Xueyi Dong in Note 16 (to our consolidated financial statements); and (vi) include a new Note 21 (to our consolidated financial statements) to describe the purpose and underlying reasons of this restatement and present the effect of this restatement on our financial statements.

 

This Form 10-Q/A should be read in conjunction with the Company’s periodic filings made with the SEC subsequent to the filing date of the Original Form 10-Q, including any amendments to those filings, as well as any Current Reports, filed on Form 8-K subsequent to the date of the Original Form 10-Q. In addition, in accordance with applicable rules and regulations promulgated by the SEC, the Company’s Chief Executive Officer and Chief Financial Officer are providing currently dated certifications in connection with this Form 10-Q/A. The certifications are filed as Exhibits 31.1, 31.2 and 32.1. Because this Form 10-Q/A sets forth the Original Form 10-Q in its entirety, it includes both items that have been changed as a result of the amended disclosures and items that are unchanged from the Original Form 10-Q. Other than the revision of the disclosures as discussed above, this Form 10-Q/A speaks as of the original filing date of the Original Form 10-Q and has not been updated to reflect other events occurring subsequent to the original filing date. This includes forward-looking statements and all other sections of this Form 10-Q/A that were not directly impacted by this amendment, which should be read in their historical context. The following items have been amended as a result of the amended disclosures:

 

Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Part IV Financial Statements and Accompanying Notes

 

 

PART I – FINANCIAL INFORMATION

 

Item 1.       Financial Statements

 

CHINA RECYCLING ENERGY CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

AS OF JUNE 30, 2011 AND DECEMBER 31, 2010

 

		2011 Restated				2010
		(UNAUDITED)				Restated
ASSETS
CURRENT ASSETS
Cash & equivalents		$	10,560,586			$	11,072,250
Restricted cash			-				2,151,690
Current portion of investment in sales type leases, net			8,360,756				7,624,637
Interest receivable on sales type leases			2,364,448				554,930
Prepaid expenses			5,316				33,274
Other receivables			1,787,839				393,015
Total current assets			23,078,945				21,829,796
NON-CURRENT ASSETS
Prepaid interest			792,694				774,609
Investment in sales type leases, net			127,917,588				117,586,131
Property and equipment, net			138,084				159,968
Construction in progress			32,915,400				25,377,983
Total non-current assets			161,763,766				143,898,691
TOTAL ASSETS		$	184,842,711			$	165,728,487
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable		$	2,030,075			$	5,012,640
Notes payable - bank acceptances			-				2,868,921
Taxes payable			1,444,647				1,631,900
Interest payable on Trust loans			2,728,275				380,524
Accrued liabilities and other payables			3,093,645				3,160,950
Advance from related parties			1,397,657				1,365,877
Convertible notes - current			3,000,000				4,403,078
Accrued interest on convertible notes - current			48,000				191,828
Deferred tax liability - current			1,269,564				1,188,504
Bank loans payable - current			3,708,511				1,811,950
Trust loans payable - current			5,199,642				5,081,010
Total current liabilities			23,920,016				27,097,182
NONCURRENT LIABILITIES
Shares to be issued			10,941,175				8,970,587
Deferred tax liability, net			7,140,042				6,429,139
Long term liability			293,590				-
Convertible notes, net of discount due to beneficial conversion feature			4,348,321				4,095,356
Conversion liability			6,766,560				6,438,035
Accrued interest on long term convertible notes			314,908				419,922
Bank loans payable			3,708,511				2,264,937
Trust loans payable			33,762,903				32,992,586
Total noncurrent liabilities			67,276,010				61,610,562
Total liabilities			91,196,026				88,707,744
CONTINGENCIES AND COMMITMENTS			-				-
STOCKHOLDERS' EQUITY
Common stock, $0.001 par value; 100,000,000 shares authorized, 39,198,982 shares issued and outstanding as of June 30, 2011 and December 31, 2010, respectively			39,200				39,200
Additional paid in capital			46,884,219				44,666,824
Statutory reserve			6,134,619				5,203,605
Accumulated other comprehensive income			8,434,876				6,083,840
Retained earnings			27,978,880				17,622,514
Total Company stockholders' equity			89,471,794				73,615,983
Noncontrolling interest			4,174,891				3,404,760
Total equity			93,646,685				77,020,743
TOTAL LIABILITIES AND EQUITY		$	184,842,711			$	165,728,487

 

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

 

 

CHINA RECYCLING ENERGY CORPORATION

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(UNAUDITED)

 

		SIX MONTHS ENDED JUNE 30,								THREE MONTHS ENDED JUNE 30,
		2011 (Restated)				2010 (Restated)				2011 (Restated)				2010 (Restated)
Revenue
Sales of systems		$	11,343,798			$	31,921,309			$	72,544			$	21,795,873
Contingent rental income			585,023				742,638				293,128				742,638
Total revenue			11,928,821				32,663,947				365,672				22,538,511
Cost of sales
Cost of systems			8,524,672				24,600,160				68,640				16,801,915
Total cost of sales			8,524,672				24,600,160				68,640				16,801,915
Gross profit			3,404,149				8,063,787				297,032				5,736,596
Interest income on sales-type leases			10,626,804				6,418,263				5,488,501				3,323,695
Total operating income			14,030,953				14,482,050				5,785,533				9,060,291
Operating expenses
General and administrative			3,446,457				2,746,173				1,678,768				1,386,476
Income from operations			10,584,496				11,735,877				4,106,765				7,673,815
Non-operating income (expenses)
Interest income			58,643				21,434				23,862				(37,705	)
Interest expense			(5,611,459	)			(1,188,449	)			(3,085,498	)			(737,075	)
Changes in conversion liability fair value			6,132,906				-				3,599,312				-
Changes in fair value of the liability			3,029,411				751,061				1,970,588				751,061
Other income (expenses)			(41,751	)			(3,568	)			(708	)			92,691
Financial expense			(1,938	)			-				(871	)			-
Total non-operating income (expenses), net			3,565,812				(419,522	)			2,506,685				68,972	)
Income before income tax			14,150,308				11,316,355				6,613,450				7,742,787
Income tax expense			2,179,631				2,898,043				783,701				1,861,277
Income before noncontrolling interest			11,970,677				8,418,312				5,829,749				5,881,510
Less: Income attributable to noncontrolling interest			683,298				486,573				164,160				92,132
Net income attributable to China Recycling Energy Corp			11,287,379				7,931,739				5,665,589				5,789,378
Other comprehensive items
Foreign currency translation gain attributable to China Recycling Energy Corp			2,351,036				343,948				1,369,164				385,866
Foreign currency translation gain attributable to noncontrolling interest			86,833				10,550				50,281				20,795
Comprehensive income attributable to China Recycling Energy Corp		$	13,638,415			$	8,275,687			$	7,034,753			$	6,175,244
Comprehensive income attributable to noncontrolling interest		$	770,131			$	497,123			$	214,441			$	112,927
Basic weighted average shares outstanding			40,707,568				38,778,035				42,199,576				38,778,035
Diluted weighted average shares outstanding *			58,025,792				48,919,003				58,388,599				48,819,250
Basic earnings per share		$	0.28			$	0.20			$	0.13			$	0.15
Diluted earnings per share *		$	0.21			$	0.17			$	0.10			$	0.12

 

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

 

*   Interest expense on convertible notes is added back to net income for the computation of diluted EPS.

 

 

CHINA RECYCLING ENERGY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

		SIX MONTHS ENDED JUNE 30,
		2011 (Restated)				2010 (Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Income including noncontrolling interest		$	11,970,677			$	8,418,312
Adjustments to reconcile income including noncontrolling interest to net cash used in operating activities:
Changes in sales type leases receivables			(11,343,798	)			(19,953,281	)
Changes in fair value of the liability			(3,029,411	)			(751,061	)
Depreciation and amortization			29,418				25,323
Amortization of discount related to conversion feature of convertible note			3,345,398				880,466
Interest expense from changes in conversion liability			(6,132,906	)			-
Stock options and warrants expenses			1,445,327				1,407,547
Changes in deferred tax			607,580				1,832,221
(Increase) decrease in current assets:
Interest receivable on sales type lease			(1,777,472	)			(55,993	)
Collection of principal on sales type leases			3,286,197				1,587,602
Prepaid expenses			28,430				279,184
Other receivables			(1,370,926	)			(1,232,323	)
Construction in progress			(6,871,097	)			(11,030,396	)
Increase (decrease) in current liabilities:
Accounts payable			(3,066,667	)			2,593,038
Taxes payable			(222,960	)			412,624
Interest payable			2,314,017				1,356,732
Long term liability			290,471				-
Accrued liabilities and other payables			(123,975	)			(166,058	)
Accrued interest on convertible notes			(237,064	)			(3,639	)
Net cash used in operating activities			(10,858,761	)			(14,399,702	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Restricted cash			2,178,533				(200,653	)
Acquisition of property & equipment			(4,071	)			(131,547	)
Net cash provided by (used in) investing activities			2,174,462				(332,200	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of convertible notes			7,583,801				-
Cash contribution from noncontrolling interest			-				908,279
Notes payable - bank acceptances			(2,904,710	)			-
Proceeds from loans			4,127,746				15,757,780
Repayment of loans			(917,277	)			-
Advance from related parties			-				2,022,535
Net cash provided by financing activities			7,889,560				18,688,594
EFFECT OF EXCHANGE RATE CHANGE ON CASH & EQUIVALENTS			283,075				21,065
NET INCREASE (DECREASE) IN CASH & EQUIVALENTS			(511,664	)			3,977,757
CASH & EQUIVALENTS, BEGINNING OF PERIOD			11,072,250				1,111,943
CASH & EQUIVALENTS, END OF PERIOD		$	10,560,586			$	5,089,700
Supplemental Cash flow data:
Income tax paid		$	1,395,651			$	945,165
Interest paid		$	1,163,756			$	201,635

 

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

 

 

CHINA RECYCLING ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011 (UNAUDITED) AND DECEMBER 31, 2010

 

1. ORGANIZATION AND DESCRIPTION OF BUSINESS

 

China Recycling Energy Corporation (the “Company” or “CREG”) (formerly China Digital Wireless, Inc.) was incorporated on May 8, 1980, under the laws of the State of Colorado. On September 6, 2001, the Company re-domiciled its state of incorporation from Colorado to Nevada. The Company, through its subsidiary, Shanghai TCH Energy Technology Co., Ltd (“Shanghai TCH”), sells and leases energy saving systems and equipment.  On March 8, 2007, the Company changed its name to “China Recycling Energy Corporation.”

 

On February 1, 2007, the Company’s subsidiary, Shanghai TCH, conditionally entered into two top gas recovery turbine systems (“TRT”) projects, each evidenced by a joint-operation agreement, with Xi’an Yingfeng Science and Technology Co., Ltd. (“Yingfeng”) which were approved and made effective by our Board of Directors on April 8, 2007. TRT is an electricity generating system that utilizes the exhaust pressure and heat produced in the blast furnace of a steel mill to generate electricity. Yingfeng is a joint stock company registered in Xi’an, Shaanxi Province, Peoples Republic of China (the “PRC”), and engages in designing, installing, and operating TRT systems and sales of other renewable energy products. 

 

Under the Joint-Operation Agreement, Shanghai TCH and Yingfeng jointly pursued a top gas recovery turbine project ("TRT Project") which was to design, construct, install and operate a TRT Project for Zhangzhi Iron and Steel Holdings Ltd. ("Zhangzhi"). This TRT Project was initiated by a Contract to Design and Construct TRT System (“Project Contract”) entered by Yingfeng and Zhangzhi in 2006. Due to Yingfeng’s lack of capital in pursuing this Project alone, Yingfeng sought Shanghai TCH’s cooperation. Shanghai TCH provided various investments and properties into this TRT Project including cash, hardware, software, equipment, major components and devices. In return, Shanghai TCH obtained all the rights, titles, benefits and interests that Yingfeng originally had under this Project Contract, including but not limited to the regular cash payments made by Zhangzhi and other property rights and interests. This project was completed and put into operation in February 2007.

 

Under another Joint-Operation Agreement, Shanghai TCH and Yingfeng jointly pursued another TRT project to design, construct, install and operate a TRT Project for Xingtai Iron and Steel Company, Ltd. (“Xingtai”). This Project was initiated by a Contract to Design and Construct TRT Project (“Project Contract”) entered by Yingfeng and Xingtai on September 26, 2006. Due to Yingfeng’s lack of capital in pursuing this Project alone, Yingfeng sought Shanghai TCH’s cooperation. Shanghai TCH agreed to pursue this project with Yingfeng as a joint venture. Under the terms of the Joint-Operation Agreement, Shanghai TCH provided various investments and properties into the Project including cash, hardware, software, equipment, major components and devices. In return, Shanghai TCH obtained all the rights, titles, benefits and interests that Yingfeng originally had under this Project Contract, including but not limited to the regular cash payments made by Xingtai and other property rights and interests. This project was completed and put into operation in August 2007.

 

On October 31, 2007, Shanghai TCH entered an asset-transfer agreement with Yingfeng to transfer from Yingfeng to Shanghai TCH all electricity-generating related assets owned by Yingfeng. As the result, the contractual relationships between Shanghai TCH and Yingfeng under the TRT Project Joint-Operation Agreement on April 8, 2007 were terminated.

 

In November 2007, Shanghai TCH signed a cooperative agreement with Shengwei Group to build two sets of 12MW pure low temperature cement waste heat power generator systems (“CHPG”) for Shengwei’s two 2,500-tons-per-day cement manufacturing lines in Jin Yang and for a 5,000-tons-per-day cement manufacturing line in Tong Chuan.  Total investment in these projects was $12,593,000 (RMB 93,000,000).  At the end of 2008, construction of the CHPG in Tong Chuan was completed at a cost of $6,191,000 (RMB 43,000,000) and put into operation.  Under the original agreement, the ownership of the power generator system would belong to Shengwei from the date the system was put into service.  Shanghai TCH is responsible for the daily maintenance and repair of the system, and charges Shengwei a monthly electricity fee based on the actual power generated by the system at 0.4116 RMB per KWH for an operating period of five years with the assurance from Shengwei of a properly functioning 5,000-tons-per-day cement manufacturing line and not less than 7,440 heat hours per year for the electricity generator system.  Shengwei Group collateralized the cement manufacturing line in Tong Chuan to guarantee its obligations to provide the minimum electricity income from the power generator system under the agreement during the operating period. At the end of the five year operating period, Shanghai TCH will have no further obligations under the cooperative agreement.  On May 20, 2009, Shanghai TCH entered into a supplementary agreement with Shengwei Group to amend the timing for title transfer to the end of the lease term. In addition, the supplementary agreement provided that Shanghai TCH will charge Shengwei based on actual power usage subject to a minimum of  $0.31 million (RMB 2.1 million) per month during the operating period. 

 

 

On June 29, 2009, construction of the CHPG in Jin Yang was completed at a cost of $7,318,000 (RMB 50,000,000) and put into operation. Shanghai TCH charges Shengwei a technical service fee of $336,600 (RMB 2,300,000) monthly for the sixty months of the lease term. Shengwei has the right to purchase the CHPG systems for $29,000 (RMB 200,000) at the end of the lease term. Shengwei is required to provide assurance of properly functioning 5,000-tons-per-day cement manufacturing lines and not less than 7,440 heat hours per year for the CHPG. Shengwei Group collateralized the cement manufacturing lines in Jin Yang to guarantee its obligations to provide the minimum electricity income from the power generator system under the agreement during the operating period. Effective July 1, 2009, Shanghai TCH outsourced the operation and maintenance of the CHPG systems in Tong Chuan and JinYang to a third party for $732,000 (RMB 5,000,000) per year.

 

On April 14, 2009, the Company incorporated a joint venture (“JV”) with Erdos Metallurgy Co., Ltd. (“Erdos”) to recycle waste heat from Erdos’ metal refining plants to generate power and steam, which will then be sold back to Erdos. The name of the JV is Inner Mongolia Erdos TCH Energy Saving Development Co., Ltd (“Erdos TCH”) with a term of 20 years, and registered capital of $2,635,000 (RMB 18,000,000). On September 30, 2009, Xi’an TCH Energy Technology Co., Ltd. (“Xi’an TCH”) injected additional capital of $4.03 million (RMB 27,500,000). In November 2009, Xi’an TCH injected further capital of $5.05 million (RMB 34,500,000). As of June 30, 2011, total registered capital was raised to $17.55 million (RMB 120 million), of which, $16.37 million (RMB112 million) was contributed by Xi’an TCH and $1.18 million (RMB 8 million) was from Erdos.  Total investment for the project is estimated at approximately $74 million (RMB 500 million) with an initial investment of $17.55 million (RMB 120,000,000). As of June 30, 2011, Erdos contributed 7% of the total investment of the project, and Xi’an TCH contributed 93%. According to Xi’an TCH and Erdos’ agreement on profit distribution, Xi’an TCH and Erdos will receive 80% and 20% of the profit from the JV, respectively, until Xi’an TCH receives complete return on its investment. Xi’an TCH and Erdos will then receive 60% and 40% of the profit from the JV, respectively. The profits to be distributed will be computed based on Chinese generally accepted accounting principles. The main difference between US GAAP (Generally Accepted Accounting Principles) and Chinese GAAP with regards to Erdos is that Erdos is treated as a sales-type lease under US GAAP and as an operating lease under Chinese GAAP. When the term of the JV expires, Xi’an TCH will transfer its equity in the JV to Erdos at no additional cost.

 

On April 18, 2009, Erdos TCH signed a Cooperation Agreement with Erdos to recycle heat from groups of furnaces of Erdos Metallurgy’s metal refining plants to generate power and steam, which will then be sold back to Erdos Metallurgy. According to the contract, Erdos TCH will install a group of power generation projects with a total of 70MW power capacity, which may expand up to 120MW, and 30-ton steam per hour, with an estimated total investment in excess of $75 million (RMB 500 million).  The construction of the projects was split into three phases, two power generation systems in Phase I with a total of 18MW power capacity, three power generation systems in Phase II with a total of 27MW power capacity and one power generation system in Phase III with 25MW power capacity.

 

At the end of 2009, Erdos TCH completed the first 9MW power station of Phase I of the project and put it into operation.  Phase I includes two 9MW units for a combined 18MW power capacity. In March of 2010, the Company completed the second 9MW capacity power station and put it into operation. Pursuant to the Co-operation Agreement and the supplement agreements signed between Erdos and Erdos TCH, Erdos shall purchase all the electricity and steam to be generated from the JV’s power generation projects. Erdos TCH leased the two 9 MW units to Erdos and will be responsible for the operation and maintenance of the units.

 

For each phase of the project, the lease term is 20 years starting from the date of completion of the phase. Erdos agreed to pay a fixed minimum of $0.22 million (RMB 1.5 million) per month for each 9MW capacity power generation unit. In addition Erdos will pay the actual amount if the sale of the electricity generated by each unit is more than $0.22 million (RMB 1.5 million) monthly.

 

On December 10, 2010, Erdos TCH entered into a supplementary agreement with Xi’an Huaxin Energy Tech Co., Ltd (the contractor for construction) for changing Erdos Phase II project of four 9MW waste heat generation systems to three 9MW systems, and moved the fourth 9MW waste heat generation system into Phase III of the project; and accordingly, the construction cost decreased from $37.4 million (RMB248 million) to $28.1 million (RMB186 million) for the Phase II.  In the first quarter of 2011, the Company completed all three 9MW power stations of Phase II and put them into operation. Erdos TCH also outsourced to an independent third party the operation and maintenance of these three 9 MW power generation systems for an annual charge $947,000 (RMB 6.27 million) for each system. After 20 years, the systems will be transferred to Erdos without charge.

 

 

On September 30, 2009, Xi’an TCH delivered to Shenmu County Jiujiang Trading Co., Ltd. (“Shenmu”) three 6 MW capacity Waste Gas Power Generation (“WGPG”) power generating systems pursuant to a Cooperative Contract on Coke-oven Gas Power Generation Project (including its Supplementary Agreement) and a Gas Supply Contract for Coke-oven Gas Power Generation Project.  The terms of these contracts are for 10 years, and they provide that Xi’an TCH will recycle coke furnace gas from the coke-oven plant of Shenmu to generate power, which will be supplied back to Shenmu.  Shenmu agrees to supply Xi’an TCH the coke-oven gas free of charge.  Shenmu will pay the Company an annual “energy-saving service fee” of approximately $5.6 million in equal monthly installments for the life of the contracts, as well as such additional amount as may result from the supply of power to Shenmu in excess of 10.8 million kilowatt hours per month.  The Company is responsible for operating the systems and will do so through an unrelated third party. Shenmu guarantees that monthly gas supply will not be less than 21.6 million standard cubic meters. If gas supply is less, Shenmu agrees to pay Xi’an TCH an energy-saving service fee described above or up to 10.8 million kilowatt-hours per month. Xi’an TCH maintains the ownership of the project for the term of the contracts, including the already completed investment, design, equipment, construction and installation as well as the operation and maintenance of the project.  At the end of the 10-year term, ownership of the systems transfers to Shenmu at no charge.  Shenmu gave a lien on its production line to guarantee its performance under the contracts.  Shenmu’s three major shareholders provide an unlimited joint liability guarantee to Xi’an TCH for Shenmu’s performance under the contracts and the Yulin Huiyuan Group, an independent third party, provides a guarantee to Xi’an TCH for Shenmu’s performance under the contracts.

 

On January 20, 2010, Xi’an TCH entered into a Technical Reconstruction Letter of Intent with Xueyi Dong (“Dong”) a natural person with Chinese citizenship for Xi’an TCH reconstructing and transforming a Thermal Power Generation System owned by Dong into a 12MW Biomass Power Generation Systems (“Biomass Systems” or “BMPG”) for approximately RMB 15 million ( $2.2 million), of which, RMB 7 million (  $1.03 million) was payable to Dong, and RMB 8 million ( $1.18 million) was payable to one of the Company’s shareholders, who had previously paid that amount to Dong on behalf of the Company.   After the successful transformation of the system, Xi’an TCH entered into a Biomass Power Generation Asset Transfer Agreement (the “Transfer Agreement”) with Dong on June 29, 2010.  Under the Transfer Agreement, Dong transferred the Biomass Systems to Xi’an TCH, and Xi’an TCH will pay Dong RMB 100,000,000 ($14,705,900) for the systems, including RMB 20,000,000 in cash and RMB 80,000,000 in shares of the Company’s common stock. The stock price will be the same as the Company’s public offering price in the first public offering which occurs in 2010 or 2011 but in no circumstance less than $4 per share.  The exchange rate between U.S. Dollar and Chinese RMB in connection with the stock issuance is 1:6.8.  As of June 30, 2011, the Company had paid the cash portion in full and had shares to be issued of $5.94 million (the fair value at June 30, 2011) in connection with this transaction.

 

On June 29, 2010, Xi’an TCH entered into a Biomass Power Generation Project Lease Agreement with PuCheng XinHengYuan Biomass Power Generation Co., Ltd., (“XHY”).  Under this lease agreement, Xi’an TCH leased this same set of 12MW biomass power generation systems to XHY at minimum RMB 1,900,000 per month ($279,400) for 15 years.  The leasing fee will increase proportionately with the biomass generated electricity fee in China during the term of this lease agreement. 

 

On September 30, 2010, Xi’an TCH delivered to Zhongbao Binhai Nickel Co., Ltd. (“Zhongbao”) a 7 MW capacity Waste Heat Power Generation (“WHPG”) system, an integral part of the facilities designed to produce 80,000 tons of nickel-alloy per year according to the recovery and power generation of waste heat agreement with Zhongbao, a nickel-alloy manufacturing joint venture between Zhonggang and Shanghai Baoshan Steel Group established in June 2009.  Total investment in this project was approximately $7.8 million (RMB 55 million). The waste heat agreement with Zhongbao has a term of nine years and provides that Xi’an TCH will recycle waste heat from the nickel-alloy rotary kilns of Zhongbao to generate power and steam, which will be supplied back to Zhongbao, and help reduce over 20,000 tons of carbon dioxide emissions every year. At the end of the term, the WHPG system will be transferred to Zhongbao for RMB 1. Pursuant to the agreement, Zhongbao will pay Xi’an TCH a monthly “energy-saving service fee” based on the volume of electricity and steam generated the previous month at a pre-agreed price, but no less than a minimum monthly payment of $224,000 (RMB 1.5 million). Zhongbao will supply Xi’an TCH certain gas, water and compressed air from the nickel-alloy rotary kilns free of charge. Zhongbao also guarantees to continuously supply not less than 6800 heat hours per year for the WHPG, or the operating term will be extended accordingly. Xi’an TCH outsourced the operation and maintenance of the WHPG for the whole operation period to a third party for an annual fee of RMB 2.4 million ($366,000).  In addition, Xi’an TCH is responsible for applying for the Clean Development Mechanism (“CDM”) under the Kyoto Protocol.  Net proceeds from any CDM credit will be distributed between Zhongbao and Xi’an TCH at 60% and 40%, respectively.  Xi’an TCH had not commenced the CDM application process as of June 30, 2011.

 

On March 15, 2011, the Company incorporated a new wholly owned subsidiary Pingshan County Shengda Energy Technology Co., Ltd (“Shengda”). Xi’an TCH contributed cash of $4,559,271 (RMB 30,000,000) into Shengda as initial capital. Shengda was set up in order to undertake waste energy recycling projects from a steel and chemical company in Pingshan county as to a Recycling Economy Projects Cooperative Framework Agreement that has been developed by the parties. The final terms for the projects have not been reached and entered, and Shengda is not currently operational.

 

 

The unaudited financial statements included herein were prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  The information furnished herein reflects all adjustments (consisting of normal recurring accruals and adjustments) that are, in the opinion of management, necessary to fairly present the operating results for the respective periods. Certain information and footnote disclosures normally present in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) have been omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with the audited financial statements and footnotes included in the Company’s 2010 audited financial statements included in the Company’s Annual Report on Form 10-K.  The results for the six and three months ended June 30, 2011 are not necessarily indicative of the results to be expected for the full year ending December 31, 2011. 

 

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

These accompanying consolidated financial statements have been prepared in accordance with US GAAP and pursuant to the rules and regulations of the SEC for annual financial statements. 

 

Basis of Consolidation  

 

The consolidated financial statements include the accounts of CREG and, its subsidiary, Sifang Holdings, its wholly owned subsidiaries, Huahong New Energy Technology Co., Ltd. ("Huahong") and Shanghai TCH, Shanghai TCH’s subsidiaries Xi’an TCH Energy Tech Co., Ltd. (“Xi’an TCH”) and Xingtai Huaxin Energy Tech Co., Ltd. (“Huaxin”), and Xi’an TCH’s subsidiary, Pingshan Xian Shengda Energy Technology Ltd Co. (“Shengda”) and Erdos TCH Energy Saving Development Co., Ltd (“Erdos TCH”), in which 93% of the investment is from Xi’an TCH.  Substantially all of the Company’s revenues are derived from the operations of Shanghai TCH and its subsidiaries, which represent substantially all of the Company’s consolidated assets and liabilities as of June 30, 2011 and December 31, 2010, respectively. All significant inter-company accounts and transactions were eliminated in consolidation.  

 

Use of Estimates

  

In preparing these consolidated financial statements in accordance with US GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheets and revenues and expenses during the period reported. Actual results may differ from these estimates.  

 

Revenue Recognition

 

Sales-type Leasing and Related Revenue Recognition

 

We construct and lease waste energy recycling power generating projects to our customers. We usually transfer ownership of the waste energy recycling power generating projects to our customers at the end of the lease term.  Our investment in these projects is recorded as investment in sales-type leases in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 13, “Accounting for Leases” (codified in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 840) and its various amendments and interpretations. We finance construction of waste energy recycling power generating projects and our customers for the price of the projects.  The sales and cost of sales are recognized at the inception of lease. The investment in sales-type leases consists of the sum of the total minimum lease payments receivable less unearned interest income and estimated executory cost. Minimum lease payments are part of the lease agreement between the Company (lessor) and the customer (lessee).  The discount rate implicit in the sales type lease is used to calculate the present value of minimum lease payments.  The minimum lease payment consists of the gross lease payments net of executory costs and contingent rentals, if any. Unearned interest income is amortized to income over the lease term to produce a constant periodic rate of return on net investment in the lease.  While revenue is recognized at the inception of the lease, the cash flow from the sales-type lease occurs over the course of the lease which results in interest income and reduction of receivables. Revenue is recognized net of Sales Tax.

 

Contingent Rental Income

 

The Company records income from actual electricity usage in addition to minimum lease payments of each project as contingent rental income in the period contingent rental income is earned.  Contingent rent is not part of minimum lease payments.

 

Cash and Equivalents  

 

Cash and equivalents includes cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments.  

 

  

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

 

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 over the estimated lives as follows:  

 

Building			20 years
Vehicle			2 - 5 years
Office and Other Equipment			2 - 5 years
Software			2 - 3 years

 

Impairment of Long-life Assets

 

In accordance with SFAS 144 (codified in FASB ASC Topic 360), the Company reviews its long-lived assets, including property, plant and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be fully recoverable. If the total of the expected undiscounted future net cash flows is less than the carrying amount of the asset, a loss is recognized for the difference between the fair value and carrying amount of the asset. There was no impairment as of June 30, 2011 and December 31, 2010. 

 

Cost of Sales  

 

Cost of sales consists primarily of the direct material of the power generating system and expenses incurred directly for project construction for sales-type leasing; and rental expenses for two pieces of power generation equipment for the operating lease.  

 

Income Taxes  

 

The Company utilizes SFAS No. 109, “Accounting for Income Taxes,” (codified in FASB ASC Topic 740), which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

 

The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (“FIN 48”), 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 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination.  Interest associated with unrecognized tax benefits are classified as interest expense and penalties are classified in selling, general and administrative expenses in the statements of income. The adoption of FIN 48 did not have a material impact on the Company’s financial statements.   As of June 30, 2011 and December 31, 2010, the Company had not taken any uncertain positions that would necessitate recording of tax related liability. 

 

 

Non-Controlling Interest

 

The Company follows FASB 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.

 

The net income (loss) attributed to the NCI was separately designated in the accompanying statements of income and other comprehensive income. 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.

 

Statement of Cash Flows

  

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

 

 Fair Value of Financial Instruments

 

For certain of the Company’s financial instruments, including cash and equivalents, restricted cash, accounts receivable, other receivables, accounts payable, accrued liabilities and short-term debt, the carrying amounts approximate their fair values due to their short maturities. Receivables on sales-type leases are based on interest rates implicit in the lease.

 

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

 

·

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

 

·

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

 

·

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

 

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, 2011 and December 31, 2010, the Company did not identify any assets and liabilities that are required to be presented on the balance sheet at fair value.

 

 

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 Topic 718 and 505).  The Company recognizes in its statement of operations the grant-date fair value of stock options and other equity-based compensation issued to employees and non-employees. 

 

Basic and Diluted Earnings per Share  

 

The Company presents net income (loss) per share (“EPS”) in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share” (codified in FASB ASC Topic 740).  Accordingly, basic income (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted average number of shares outstanding, without consideration for common stock equivalents.  Diluted net income per share is computed by dividing the net income by the weighted-average number of common shares outstanding as well as common share equivalents outstanding for the period determined using the treasury-stock method for stock options and warrants and the if-converted method for convertible notes.  The Company has made an accounting policy election to use the if-converted method for convertible securities that are eligible to receive common stock dividends, if declared.  Diluted earnings per share reflect the potential dilution that could occur based on the exercise of stock options or warrants or conversion of convertible securities using the if-converted method. The following table presents a reconciliation of basic and diluted earnings per share: 

 

The following table presents a reconciliation of basic and diluted earnings per share for six and three months ended: 

 

		Six Months Ended								Three Months Ended
		2011				2010				2011				2010
Net income for common shares		$	11,287,379			$	7,931,739			$	5,665,589			$	5,789,378
Interest expense on convertible notes*			694,001				246,361				327,401				123,861
Net income  for diluted shares		$	11,981,380			$	8,178,100			$	5,992,990			$	5,913,239
Weighted average shares outstanding – basic			40,707,568				38,778,035				42,199,576				38,778,035
Effect of dilutive securities:
Convertible notes**			15,385,662				7,658,468				14,412,151				7,660,795
Options granted			1,912,122				2,357,500				1,760,488				2,264,454
Warrants granted			20,440				125,000				16,384				115,966
Weighted average shares outstanding – diluted			58,025,792				48,919,003				58,388,599				48,819,250
Earnings (loss) per share – basic***		$	0.28			$	0.20			$	0.13			$	0.15
Earnings (loss) per share – diluted		$	0.21			$	0.17			$	0.10			$	0.12

 

 

	*	Interest expense on convertible notes was added back to net income for the computation of diluted earnings per share.
	**	The Investors decided to convert $5,000,000 convertible note into 4,334,192 shares effective on April 29, 2011; however, the shares were issued after the period covered by this quarterly report (June 30, 2011).

***

Basic earnings per share included shares to be issued of 4,334,192 shares from April 29, 2011.

 

Foreign Currency Translation and Comprehensive Income (Loss)

 

The Company’s functional currency is the Renminbi (“RMB”). For financial reporting purposes, RMB were translated into United States Dollars (“USD”) as the reporting currency. Assets and liabilities are translated at the exchange rate in effect at the balance sheet date. Revenues and expenses are translated at the average rate of exchange prevailing during the reporting period. Translation adjustments arising from the use of different exchange rates from period to period are included as a component of 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 the exchange rate for the conversion of RMB to USD after the balance sheet date. 

 

The Company uses SFAS 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 stockholders, changes in paid-in capital and distributions to stockholders.  

 

 

Segment Reporting  

 

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (codified in FASB ASC Topic 280) requires use of the “management approach” model for segment reporting. The management approach model is based on the way a company’s management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregates a company. SFAS 131 has no effect on the Company’s financial statements as substantially all of the Company’s operations are conducted in one industry segment. All of the Company’s assets are located in the PRC. 

 

Registration Rights Agreement

 

The Company accounts for payment arrangements under a registration rights agreement in accordance with ASC Topic 825, “Financial Instruments,” which requires the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, be separately recognized and measured in accordance with ASC Topic 450, “Contingencies,” (see Note 14, Registration Rights Agreement for Convertible Note).

 

Reclassifications  

 

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

 

New Accounting Pronouncements  

 

In May 2011, FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (ASC Topic 820), to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between GAAP and International Financial Reporting Standards. ASU 2011-04 changes certain fair value measurement principles and enhances the disclosure requirements. The provisions of this new guidance are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The guidance is not expected to have a material impact on our consolidated financial statements.

 

In June 2011, FASB issued ASU 2011-05, Comprehensive Income (ASC Topic 220):  Presentation of Comprehensive Income.  Under the amendments in this update, an entity has the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. In addition, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented.  The amendments in this update should be applied retrospectively and are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is currently assessing the effect that the adoption of this pronouncement will have on its financial statements.

 

3. NET INVESTMENT IN SALES-TYPE LEASES  

 

Under sales-type leases, Shanghai TCH leased TRT systems to Xingtai and Zhangzhi with terms of five and thirteen years, respectively and leased CHPG systems to Tong Chuan Shengwei and Jin Yang Shengwei respectively for five years, WGPG systems to Shenmu for ten years, BMPG systems to Pucheng for fifteen years, and a power and steam generating system from waste heat from metal refining to Erdos for twenty years. The components of the net investment in sales-type leases as of June 30, 2011 and December 31, 2010 are as follows:  

 

 

		2011				2010
Total future minimum lease payments receivable		$	417,247,218			$	379,641,671
Less: executory cost			(111,838,528	)			(99,866,170	)
Less: unearned interest income			(169,130,346	)			(154,564,733	)
Net investment in sales - type leases			136,278,344				125,210,768
Current portion			8,360,756				7,624,637
Noncurrent portion		$	127,917,588			$	117,586,131

 

As of June 30, 2011, the future minimum rentals to be received on non-cancelable sales-type leases by years are as follows: 

 

2012		$	37,201,181
2013			35,680,199
2014			33,883,835
2015			27,549,931
2016			27,519,027
Thereafter			255,413,045
Total		$	417,247,218

 

4. RESTRICTED CASH, NOTES PAYABLE – BANK ACCEPTANCES

 

Restricted cash as of June 30, 2011 and December 31, 2010 was $0 and $2,151,690, respectively, held by the bank as collateral to issue bank acceptances. The Company endorses bank acceptances to vendors as payment of their own obligations.  Most of the bank acceptances have maturities of less than six months. As of June 30, 2011 and December 31, 2010, the Company had bank acceptances of $0 and $2,868,921, respectively.   

 

5. PREPAID EXPENSES  

 

Prepaid expenses mainly consisted of prepayment for supplies, office rental, parking space, insurance and legal fees.   

 

6. CONSTRUCTION IN PROGRESS

 

“Construction in progress” is the amount paid for constructing power generation systems. During the first quarter of 2011, Erdos power generation system Phase II, the third 9MW Capacity Electricity power generation system was completed and put into operation. At June 30, 2011, the Company had paid approximately $18.89 million for Phase III of the Erdos TCH power generation system projects, and $12.36 million for Shannxi Datong Coal Group Power Generation project (See Note 19). The Company was committed to pay additional $0.9 million for Phase III projects excluding quality deposits of $120,000 in 2011, and $15.45 million for Shannxi Datong Coal Group Power Generation project.

 

In June 2011, ShenQiu YuNeng Thermal Power Generation project commenced and the total estimated project cost is for  RMB 22.5 million ( $3.5 million). As of June 30, 2011, the Company had paid $1.74 million and was committed to pay an additional $1.76 million for the project.

 

7. TAXES PAYABLE

 

“Taxes payable” consisted of the following at June 30, 2011 and December 31, 2010: 

 

		2011				2010
Income tax		$	967,808			$	1,237,823
Business tax			425,623				347,654
Other taxes			51,216				46,423
		$	1,444,647			$	1,631,900

 

 

8. ACCRUED LIABILITIES AND OTHER PAYABLES

 

“Accrued liabilities and other payables” consisted of the following as of June 30, 2011 and December 31, 2010: 

 

		2011				2010
Employee training, labor union expenditure and social insurance payable		$	250,740			$	245,019
Consulting and legal expenses			827,544				541,638
Payable to Yingfeng			1,658,053				1,730,451
Payable to Pucheng			-				286,892
Accrued payroll and welfare			269,425				259,120
Accrued system maintenance expense			74,100				72,409
Other			13,783				25,421
Total		$	3,093,645			$	3,160,950

 

 “Payable to Yingfeng” is the cost of obtaining the ownership of two TRT projects (Zhangzhi and Xingtai) that were previously owned by Yingfeng. This amount is non-interest bearing and is payable on demand. “Payable to Pucheng” is the deposit for rental payments by Pucheng.

 

9.  RELATED PARTY TRANSACTIONS

 

As of June 30, 2011, advances from related parties totaled $1,397,657, including $1,359,787 from Erdos (the minority shareholder of Erdos TCH), as an advance for the capital needs of Erdos TCH, and a $37,870 advance from management of the Company, with no interest, payable on demand. As of December 31, 2010, advances from related parties totaled $1,365,877, including $1,328,763 from Erdos (the minority shareholder of Erdos TCH) as an advance for the capital needs of Erdos TCH and a $37,114 payment by the Company’s management for paying certain operating expenses on behalf of the Company.

 

Erdos TCH sold all power generation stations through sales type leases to Erdos Metallurgy Co., Ltd., the non-controlling interest.  Total sales and interest income for this non-controlling interest was $11.5 million and $3.25 million for the six months ended June 30, 2011, and $10.1 million and $0.9 million for the same period of 2010; $0.2 million and $1.85 for three months ended June 30, 2011, and  $0 and  $0.6 million for the same period of 2010, respectively.

 

10. NONCONTROLLING INTEREST

 

“Non-controlling interest” was a 7% equity interest of Erdos JV owned by Erdos Metallurgy Co., Ltd.  According to Xi’an TCH and Erdos’ agreement on profit distribution, Xi’an TCH and Erdos will receive 80% and 20% of the profit from the JV, respectively, until Xi’an TCH has received a complete return on its investment. Xi’an TCH and Erdos will then receive 60% and 40% of the profit from the JV, respectively. 

 

As of June 30, 2011, the total registered capital of Erdos JV is RMB 120,000,000 ($17.55 million), of which, $16.37 million (RMB112 million) was contributed by Xi’an TCH and $1.18 million (RMB 8 million) was from Erdos. Erdos TCH engages in a business similar to that of Xi’an TCH. 

 

Erdos TCH allocates its income to Xi’an TCH and Erdos at a proportion of 80% and 20% based on net income calculated under Chinese GAAP.  The main difference between US GAAP and Chinese GAAP with respect to Erdos is that the Erdos agreement is treated as a sales-type lease under US GAAP and as an operating lease under Chinese GAAP.  The following is the profit and loss statement of Erdos TCH, prepared under Chinese GAAP for the six months ended June 30, 2011:

 

Net Revenue		$	6,387,265
Cost of Revenue			(3,663,910	)
Gross Profit			2,724,355
Operating expenses			10,907
Income from operations			2,713,448
Non-operating income			4,477
Income tax expense			(679,481	)
Net Income		$	2,038,444

 

 

The following is a reconciliation of net income per Chinese GAAP to net income per US GAAP:

 

Net income per Chinese GAAP		$	2,038,444
Adjustments under US GAAP
Revenue per sales-type lease			5,125,394
Cost of revenue			(5,072,460	)
Income from operation			2,091,378
Interest income			1,785,208
Income before income tax			3,876,586
Deferred income tax expense			(460,095	)
Net income per US GAAP		$	3,416,491

 

The following is the balance sheet of Erdos TCH, prepared under Chinese GAAP at June 30, 2011:

 

Assets
Cash and equivalents		$	690,282
Other current assets			5,052,782
Property and equipment			49,053,058
Construction in process			20,276,276
Total Assets		$	75,072,398
Liabilities
Accounts payable		$	1,879,366
Other current liabilities			4,641,470
Long term loan			46,356,388
Total liabilities			52,877,224
Equity
Paid in capital			17,573,578
Statutory reserve			153,147
Other comprehensive income			1,060,856
Retained earnings			3,407,593
Total stockholders’ equity			22,195,174
Total liabilities and stockholders’ equity		$	75,072,398

 

11. DEFERRED TAX

 

Deferred tax asset was a result of the accrued maintenance cost on power generation systems that can be deducted for tax purposes in the future; and difference between tax and accounting basis of cost of fixed assets which was capitalized for tax purposes and expensed as part of cost of systems in the book.   Deferred tax liability arose from the difference between tax and accounting basis of net investment in sales-type leases. 

 

As of June 30, 2011 and December 31, 2010, deferred tax asset (liability) consisted of the following:

 

		2011				2010
Deferred tax asset — noncurrent (accrual of system maintenance cost)		$	369,849			$	23,161
Deferred tax asset — noncurrent (depreciation of fixed assets)			24,420,546				22,571,649
Deferred tax liability — noncurrent (net investment in sales-type leases)			(31,930,437	)			(29,023,949	)
Deferred tax liability, net of deferred tax asset – noncurrent		$	(7,140,042	)		$	(6,429,139	)
Deferred tax liability — current (net investment in sales-type leases)		$	(1,269,564	)		$	(1,188,504	)

  

 

12. INCOME TAX

 

Effective January 1, 2008, the PRC government implemented a new corporate income tax law with a maximum rate of 25%. The Company is governed by the Income Tax Law of the PRC concerning privately-run enterprises, which are generally subject to tax at 25% (33% prior to 2008) on income reported in the statutory financial statements after appropriate tax adjustments.  Under the 2008 Chinese tax law, the tax treatment of finance and sales-type leases is similar to US GAAP.  However, the local tax bureau continues to treat CREG sales-type leases as operating leases.  Accordingly, the Company recorded deferred income taxes. 

 

The Company’s subsidiaries generate all of their net income from their PRC operations. Shanghai TCH’s effective income tax rates for 2011 and 2010 are 24% and 22%, respectively. Xi’an TCH’s effective income tax rate for 2011 and 2010 is 15% as a result of its high tech enterprise status that was approved by the taxing authority. Xingtai Huaxin’s effective income tax rate for 2011 and 2010 is 25%.  Huahong and Erdos TCH’s effective income tax rate for 2011 and 2010 is 25%.  Pingshan Shengda’s effective income tax rate for 2011 is 25%. Shanghai TCH, Xi’an TCH, Xingtai Huaxin, Huahong, Pingshan Shengda and Erdos TCH file separate income tax returns. If Xi’an TCH had not been granted high tech enterprise status, income tax expense for the three months ended June 30, 2011, would have been increased by $693,370 and earnings per share would have been reduced by $0.02.

 

Shanghai TCH, as a business in a Development Zone, was subject to a 15% income tax rate. According to the new income tax law that became effective January 1, 2008, for those enterprises to which the 15% tax rate was applicable previously, the applicable rates shall increase as follows: 

 

Year		Tax Rate
2010			22	%
2011			24	%
2012			25	%

 

There is no income tax for companies domiciled in the Cayman Islands. Accordingly, the Company’s consolidated financial statements do not present any income tax provisions related to Cayman Islands tax jurisdiction where Sifang Holding is domiciled. 

 

The parent company, China Recycling Energy Corporation, is taxed in the U.S. and has net operating loss carry forwards for income taxes of $6.72 million at June 30, 2011, which may be available to reduce future years’ taxable income as NOLs can be carried forward up to 20 years from the year the loss is incurred. Management believes the realization of benefits from these losses appears uncertain due to the Company’s limited operating history and continuing losses. Accordingly, a 100% deferred tax asset valuation allowance was provided. 

 

The following table reconciles the U.S. statutory rates to the Company’s effective tax rate for the six and three months ended June 30, 2011 and 2010, respectively: 

 

		For the Six Months								For the Three Months
		2011				2010				2011				2010
U.S. statutory rates			34.0	%			34.0	%			34.0	%			34.0	%
Tax rate difference – current provision			(7.4	)%			(11.0	)%			(5.9	)%			(10.1	)%
Effective tax holiday			(4.9	)%			(9.3	)%			(5.1	)%			(10.5	)%
Non tax-deductible expenses (non-taxable income), net			(0.3	)%			0.4	%			(0.5	)%			(1.4	)%
Other			(0.2	)%			4.4	%			0.2	%			6.7	%
Valuation allowance on NOL (utilization of NOL)			(5.8	)%			7.1	%			(10.8	)%			5.3	%
Tax per financial statements			15.4	%			25.6	%			11.9	%			24.0	%

 

The provision for income tax expenses for the six and three months ended June 30, 2011 and 2010 consisted of the following:

 

		For the Six Months								For the Three Months
		2011				2010				2011				2010
Income tax expense - current		$	1,572,051			$	1,065,821			$	809,195			$	573,873
Income tax benefit - deferred			607,580				1,832,222				(25,494	)			1,287,404
Total income tax expenses		$	2,179,631			$	2,898,043			$	783,701			$	1,861,277

 

 

13. LOANS PAYABLE

 

Collective Capital Trust Plan

 

On December 3, 2009, the Company and Beijing International Trust Co., Ltd. (“Beijing Trust”) formed a Low Carbon Fortune-Energy Recycling No. 1 Collective Capital Trust Plan (“Plan”). Under the Plan, Beijing Trust raised RMB 181,880,000 ($26.75 million) through sale of 181,880,000 trust units at RMB 1 per unit. All amounts raised under the Plan were loaned to Erdos TCH in connection with its waste heat power generation projects Phase II and Phase III construction and operation.

 

The Plan included 145,500,000 category A preferred trust units ($21.4 million), consisting of category A1 preferred trust 12,450,000 units ($1.8 million), category A2 preferred trust 15,000,000 units ($2.2 million), category A3 preferred trust 118,050,000 units ($17.4 million); and 36,380,000 category B secondary trust units ($5.35 million), consisting of category B1 secondary trust 9,100,000 units ($1.34 million) and category B2 secondary trust 27,280,000 units ($4.01 million). The B1 units were purchased by members of management of Erdos TCH and the B2 units were purchased by Xi’an TCH. Under the Agreement, the annual base interest rate is 9.94% for A1 preferred trust fund units with a term of two years, 11% for A2 preferred trust fund units with a term of three years, 12.05% for A3 preferred trust fund units and 8.35% for the category B secondary trust fund units, each with a term of four years.

 

Erdos TCH provided a lien on its equipment, assets and accounts receivable to guarantee the loans under the Agreement. Xi’an TCH and Mr. Guohua Ku (the Company’s CEO) also provided unconditional and irrevocable joint liability guarantees to Beijing Trust for Erdos TCH’s performance under the Agreement. Erdos (the minority shareholder and customer of Erdos TCH) provided a commitment letter on minimum power purchase from Erdos TCH. 

 

On December 18, 2009, an additional RMB 25,000,000 ($3.7 million) was raised to support the Company’s Erdos Power Generation Projects. The Company sold 25,000,000 trust units at RMB 1 per unit which included 20,000,000 category A1 preferred trust units ($ 2.9 million) and 5,000,000 category B2 secondary trust units ($ 0.7 million). The B2 units were purchased by Xi’an TCH.

 

During December 2009, the Plan sold  206,880,000 units for RMB 206,880,000 ($30.3 million), of which, 9,100,000 units ($1.3 million) were purchased by the management of Erdos TCH; the 32,280,000 units purchased by Xi’an TCH, the amount of $4.7 million was considered as investment by Xi’an TCH into Erdos TCH and, accordingly, was eliminated in the consolidated financial statements. The net long term loan payable under this trust plan was $25.6 million at December 31, 2009. 

 

On April 15, 2010, Beijing Trust completed the second expansion of the Plan. The second expansion raised RMB 93,120,000 ($13.7 million) through the sale of 93,120,000 trust units at RMB 1 per unit.  All amounts raised under the Second Expansion were loaned to Erdos TCH.  The second expansion included 2,800,000 category A1 preferred trust units ($0.4 million), 5,000,000 category A2 preferred trust units ($0.7 million), 66,700,000 category A3 preferred trust units ($9.8 million), 4,650,000 category B1 preferred trust units ($0.7 million), and 13,970,000 category B2 secondary trust units ($2.1 million).  The B1 units were purchased by members of management of Erdos TCH and the B2 units were purchased by Xi’an TCH. 

 

With the completion of the second expansion, the Low Carbon Fortune-Energy Recycling No. 1 Collective Capital Trust Plan reached RMB 300,000,000 ($44.1 million) and completed all its trust plan raising work, of which, 13,750,000 units ($2.0 million) were purchased by the management of Erdos TCH; 47,850,000 units were purchased by Xi’an TCH, of which, 46,250,000 ($6.8 million) was B2 units and 1,600,000 ($235,600) units was A1 units, the amount was considered as investment by Xi’an TCH into Erdos TCH and, accordingly, was eliminated in the consolidated financial statements. The net long term loan payable under this trust plan was RMB 252,150,000 ($38.5 million) at June 30, 2011.  Interest expense accrued on this trust loan was $5.9 million and $4.5 million at June 30, 2011 and December 31, 2010, respectively.

 

In addition to the above, under the Loan Agreement, Erdos TCH must pay a management incentive benefit to Beijing Trust upon maturity of the category A3 and category B trust units in December 2013 if the ratio of Erdos TCH’s profit to its registered capital exceeds a base amount. If this criterion is met, the amount of the management incentive benefit is calculated based on a formula tied to Erdos TCH’s net profit and the average registered capital for the 2012 fiscal year. Under this formula the management incentive benefit could range between 0% and 100% of the net profit of Erdos TCH in the 2012 fiscal year.

 

 

The management incentive benefit was structured to provide an incentive to management to make the joint venture profitable. Under the Plan, Beijing Trust will distribute the entire amount of the management incentive benefit it receives to the holders of the category B trust units. As previously disclosed, the holders of the category B trust units are the management of Erdos TCH and Xi’an TCH. Category B trust units receive a lower base interest rate than the category A trust units but the economic return to the holders of category B trust units will be enhanced by any management incentive benefit.

 

Erdos TCH also will share the benefits from Clean Development Mechanism ("CDM") under the Kyoto Protocol equally with Beijing Trust during the term of the loan. Any benefit received from CDM will be paid to Erdos Metallurgy first.  Under the agreement with Xi’an TCH, Erdos Metallurgy agrees to deliver to Xi’an TCH 50% of the benefit Erdos Metallurgy receives. Xi’an TCH agrees to share 50% of the benefit it receives from Erdos Metallurgy with Erdos TCH. Under the Capital Trust Loan Agreement between Erdos TCH and Beijing Trust, Erdos TCH agrees that 50% of any benefit it receives will be delivered to Beijing Trust. Pursuant to the Plan, Beijing Trust will distribute 70% of the CDM benefit it receives to the holders of the category B trust units. The receipt of any CDM benefit is subject to a process of evaluation and certification of the project by the CDM Executive Board and is under the guidance of the Conference of the Parties of the United Nations Framework Convention on Climate Change. The first stages of the certification process have been completed successfully.

 

Bank Long Term Loans - Industrial Bank

 

The Company entered a loan agreement with Industrial Bank Co., Ltd., Xi’an Branch (the “Lender”) for a loan designed for energy saving and emission reduction projects, whereby the Lender agreed to loan RMB 30,000,000 ($4,635,639) to Xi’an TCH for three years from April 6, 2010 to April 6, 2013. The proceeds of the loan are required to be used in payment for equipment for Xi’an TCH’s energy saving and emission reduction projects. The Loan Agreement has a floating interest rate that resets at the beginning of each quarter at 110% of the national base interest rate for the same term and same level loan (currently 7.015%).  Under the loan, Xi’an TCH is required to make quarterly interest payments and, beginning six months after the date of the release of the funds, to make minimum quarterly principal payments of RMB 3,000,000 ($463,564) each quarter. The Loan Agreement contains standard representations, warranties and covenants, and the loan is guaranteed by Xi’an TCH, Shaanxi Shengwei Construction Material Group and Mr. Guohua Ku. At June 30, 2011, $927,128 of the principal was repaid and $1,854,256 will be repaid within one year which was classified as current liability.

 

The loan has the following covenants during the loan period: (i) maintain the current assets and net assets not less than RMB500million ($78 million); (ii) assets to liability ratio not less than 80%; and (iii) the current ratio not less than 2.5. The borrower was Xi’an TCH. As of June 30, 2011, the amount of net assets and the current ratio of Xi’an TCH were not in compliance with the covenants; however, the Company received a waiver letter from the Lender.

 

The Company entered another loan agreement with the same Industrial Bank for energy saving and emission reduction projects, whereby the Lender agreed to loan RMB 30,000,000 ($4,635,639) to Xi’an TCH for three years  to March 30, 2014. As of June 30, 2011, the Company received RMB 27,000,000 ($4,172,075) of the loan. The proceeds of the loan are required to be used in payment for construction and equipment purchase for Xi’an TCH’s energy saving and emission reduction projects. The Loan Agreement has a floating interest rate that resets at the beginning of each quarter at 115% of the national base interest rate for the same term and same level loan (currently 7.015%).  Under the loan, Xi’an TCH is required to make quarterly interest payments and, beginning six months after the date of the release of the funds, to make minimum quarterly principal payments of RMB 3,000,000 ($463,564) each quarter. The Loan Agreement contains standard representations, warranties and covenants, and the loan is guaranteed by Xi’an TCH, Mr. Guohua Ku and Ms Chaoying Zhang. At June 30, 2011, $463,564 of the principal was repaid and $1,854,256 will be repaid within one year which was classified as current liability.

 

The loan was originally pledged with the system and revenue of the project ZhongBao. In June 2011, the system of the project ZhongBao was sold to and leased back from Cinda Financial Leasing Co., Ltd. (the “Cinda Financial”) (see Note 19, Commitment), the Company engaged a third party bonding company as the guarantor for the loan, which was approved by the Industrial Bank in July 1, 2011.

 

The loan has the following covenants during the loan period: (i) maintain the current assets and net assets not less than RMB500 million ($78 million); (ii) assets to liability ratio not less than 80%; and (iii) the current ratio not less than 1. The borrower was Xi’an TCH. As of June 30, 2011, the amount of net assets of Xi’an TCH was not in compliance with the covenants; however, the Company received a waiver letter from the Lender.

 

 

14. CONVERTIBLE NOTES PAYABLE

 

Convertible Notes from Carlyle

 

On November 16, 2007, the Company entered into a Stock and Notes Purchase Agreement (“Purchase Agreement”) with Carlyle Asia Growth Partners III, L.P. (“CAGP”) and CAGP III Co. Investment, L.P. (together with CAGP, the “Investors”). Under the terms of the Purchase Agreement, the Company sold the Investors a 10% Secured Convertible Promissory Note of $5,000,000 (the “First Note”). Additionally, the Purchase Agreement provides for two subsequent transactions to be effected by the Company and the Investors, which include (i) the issuance by the Company of and subscription by the Investors for 4,066,706 shares of common stock of Company, at $1.23 per share for $5,000,000, and (ii) the issuance and sale by the Company to the Investors of a 5% Secured Convertible Promissory Note of $15,000,000 (the foregoing transactions, together with sale and purchase of the First Note, are hereinafter referred to as the “Offering”). The subsequent transactions are contingent upon the satisfaction of certain conditions specified in the Purchase Agreement, including entry into specified energy and recycling project contracts and the purchase of certain energy recycling systems. 

 

The First Note bore interest at 10% and was due November 16, 2009. The principal amount of the First Note, together with any interest thereon, converted, at the option of the holders at any time on or prior to maturity, into shares of the Company’s common stock at an initial conversion price of $1.23 per share (subject to anti-dilution adjustments). The First Note was subject to mandatory conversion upon the consummation of the aforementioned issuance and subscription of shares of the Company’s common stock under the Purchase Agreement. The obligations of the Company under the First Note ranked senior to all other debt of the Company. 

 

As collateral for the First Note, the President and a major shareholder of the Company pledged 9,653,471 shares of the Company’s common stock held by him to secure the First Note. This pledge was released during the fiscal quarter ended June 30, 2011 and is of no further force or effect.

 

The First Note was considered to have a beneficial conversion feature (“BCF”) because the conversion price was less than the quoted market price at the time of issuance. Accordingly, the beneficial conversion feature of $5,000,000 was recorded separately as unamortized beneficial conversion feature based on the intrinsic value method. As the BCF was greater than the face value of the note, all of the proceeds were allocated to the BCF. No value was assigned to the note option or the equity option (two subsequent transactions discussed above). The First Note was recorded in the balance sheet at face value less the unamortized beneficial conversion feature. The terms for the First Note were amended on April 29, 2008 and the First Note was repaid in full on June 25, 2008, as described below. 

 

On April 29, 2008, the Company entered into an Amendment to the Purchase Agreement with the Investors. Under the terms of the Amendment, (i) the Company issued and the Investors subscribed for 4,066,706 shares of common stock of the Company, at $1.23 per share for $5,002,048, as originally contemplated under the Agreement; (ii) the Investors converted the principal under the First Note (and waived any accrued interest thereon) into 4,065,040 shares of common stock of the Company at $1.23, pursuant to the terms and conditions of the First Note issued under the Agreement; (iii) the Company issued and sold to the Investors a new 5% Secured Convertible Promissory Note of $5,000,000 (the “Second Note” and collectively with the First Note, the “Notes”); and (iv) the Company granted to the Investors an option to purchase a 5% Secured Convertible Promissory Note of $10,000,000, exercisable by the Investors at any time within nine (9) months following the date of the closing of the transactions contemplated by the Amendment (the “Option Note”).

 

The Second Note bore interest at 5% and matured on April 29, 2011. The principal face amount of the Second Note, together with any interest thereon, was convertible, at the option of the holders at any time on or after March 30, 2010 (or such earlier date if the audited consolidated financial statements of the Company for the fiscal year ending December 31, 2009 are available prior to March 30, 2010) and prior to maturity, into shares of the Company’s common stock at an initial conversion price that is tied to the after-tax net profits of the Company for the year ending December 31, 2009, as described in the Second Note. As more fully described in the Second Note, the obligations of the Company under the Second Note are senior to all other debt of the Company. 

 

The Second Note and the 8% Note described below are both secured by a security interest granted to the Investors pursuant to the Share Pledge Agreement. 

 

 

On June 25, 2008, the Company and investors entered into a Rescission and Subscription Agreement to rescind the conversion of the First Note and the issuance of conversion shares of Common Stock at the Second Closing pursuant to Amendment to Stock and Notes Purchase Agreement dated April 29, 2008. The Company and the Investors rescinded the conversion of the principal amount ($5,000,000) under the First Note into 4,065,040 shares of Common Stock, and the Investors waived accrued interest on the First Note. Accordingly, the interest expense which had accrued on the note was recorded as a decrease in interest expense for the period. At the Rescission and Subscription Closing, the Company repaid in full the First Note and issued to the Investors, 4,065,040 shares of Common Stock at $1.23 per share for $5,000,000.  This was done through a cross receipt arrangement; the BCF was reversed to additional paid in stock.  The Company has now concluded that in substance the transaction resulted in the conversion of the first $5,000,000 note into common stock, and based on substance over form, the remaining BCF of $3,472,603 at the date of conversion was expensed. 

 

  On April 29, 2009, CREG issued an 8% Secured Convertible Promissory Note of $3 million to CAGP with a maturity of April 29, 2012. The note holder has the right to convert all or any part of the outstanding principal amount of this note, together with interest, if any, into shares of the Company’s common stock, at any time on or after March 30, 2010 (or such earlier date if the audited consolidated financial statements of the Company for the fiscal year ending December 31, 2009 are available on a date prior to March 30, 2010) and prior to the maturity date (or such later date on which this note is paid in full), at a conversion price per share of common stock equal to US $0.80.  The conversion feature of this note is not beneficial to the holder as the stock price on April 29, 2009 was $0.47. 

 

On April 29, 2009, CREG amended and restated the 5% secured convertible promissory note (the “Second Note”), which was issued as part of the amendment of the First Note on April 28, 2008. Accordingly, the Conversion Rights and Conversion Price were amended so that the holder of the Second Note has the right, but not the obligation, to convert all or any part of the aggregate outstanding principal amount of the Second Note, together with interest, into shares of the Company’s common stock, at any time on or after March 30, 2010 (or such earlier date if the audited consolidated financial statements of the Company for the fiscal year ending December 31, 2009 are available on a date prior to March 30, 2010) and prior to the maturity date (or such later date on which this Note is paid in full), at the following conversion price: (a) an amount equal to (i) the Company’s net profit, adjusted in accordance with the Second Note, multiplied by (ii) 5.5, and less (iii) the principal amount of the Second Note, together with accrued interest, divided by (b) the then total shares of the Company’s common stock outstanding on a fully-diluted basis. This note is considered to have a beneficial conversion feature starting from January 1, 2010 because the conversion price for this note was $1.154 as of April 29, 2011. Accordingly, the beneficial conversion feature of $3.15 million was recorded separately as unamortized beneficial conversion feature based on the intrinsic value method and the Second Note was recorded in the balance sheet at face value less the unamortized beneficial conversion feature. 

 

The interest on the convertible debts is payable annually, in arrears, provided the holder gives 30-day notice before each April 29 that it requires the interest payment.  Unpaid interest is due and payable at maturity.  At the holder’s election, at the time the holder elects to convert the debt into shares, shares can be issued as paid-in-kind interest to the extent that there is unpaid interest at the time of conversion.  To date, the Company has timely paid all interest payable, in cash.

 

In June 2011, the Investors converted the note into 4,334,192 shares of the Company’s common stock at a conversion price of $1.154 per share. The effective date of the conversion was April 29, 2011. As of June 30, 2011, the interest accrued on the second note was fully paid, and the 4,334,192 shares of common stock were recorded as shares to be issued in the accompanying financial statements, since such shares were not issued as of June 30, 2010. As disclosed on a Form 8-K filed July 22, 2011, the Company issued 4,334,192 shares of common stock to the Investors on July 21, 2011 (4,149,599 shares of common stock to CAGP; 184,593 shares of common stock to CAGP III Co. Investment, L.P.).  The unamortized portion BCF of $745,547 was fully amortized as of the conversion date. During the six months ended June 30, 2011, the Company amortized $1,368,988 BCF for the Second Note.

 

On April 29, 2009, the Company also agreed with the Investors to amend and restate the Registration Rights Agreement for the convertible notes to amend the rights for demand registration by the Investors and the applicable liquidated damages for the Company if it fails to timely comply with the demand for registration.

 

Registration Rights Agreement

 

Under the registration rights agreement, the Company must file the registration statement within 90 days of receipt of a demand notice to convert (the “Filing Date”), and the registration statement must have become effective within 120 days after filing (the “Effective Date”) or the Company must pay damages to the holders of the shares to be registered.  The Company must also pay damages if the registration statement ceases for any reason to remain continuously effective as to all Registrable Shares for which it is required to be effective, or the holders are not permitted to utilize the prospectus to resell shares for thirty (30) consecutive calendar days during any 12-month period.

 

 

The damages for failure to meet any of these requirements are equal to 1% of the sum of:

 

(x)

the purchase price of the unconverted notes;

 

(y)

the purchase price of shares of Company Common Stock purchased under a related agreement; and

 

(z)

the conversion price of shares of Common Stock received on conversion of notes, for each 30 days, or a pro rata portion of such 1% for a period less than 30 days.

 

The liquidated damages must be paid in cash; the registration rights agreement does not provide for any alternative payment arrangement.  The maximum potential amount of consideration, undiscounted, that the Company could be required to transfer under the registration payment arrangement cannot exceed 1% of the sum described above in any thirty (30) calendar day period.

 

Convertible Note Agreement with China Cinda

 

On August 18, 2010, the “Company and its wholly-owned subsidiaries Sifang, Shanghai TCH and Xi’an TCH entered into a Notes Purchase Agreement (the “Note Agreement”) with China Cinda (HK) Asset Management Co., Ltd, a company organized under the laws of the Hong Kong Special Administrative Region of China (“Cinda”).  Under the terms of the Note Agreement, the Company will issue  Cinda two tranches of convertible notes (the “Notes”), each having a principal amount equal to the US Dollar equivalent of RMB 50 million.  Also on August 18, 2010, Xi’an TCH and China Jingu International Trust Co. Ltd. (“Jingu”), an affiliate of Cinda also entered into a Capital Trust Loan Agreement (“Trust Loan Agreement”), in which Jingu will raise 100 million RMB under a Jingu CREG Recycling Economy No. 1 Collective Fund Trust Plan (“Trust Plan”) and lend such amount under the Trust Plan to Xi’an TCH (the “Loans”).  If the Loans under the Trust Loan Agreement do not occur, then under the Note Agreement the principal amount of the Notes to be issued in each tranche will be the US dollar equivalent of RMB 100 million.  All proceeds from the Notes and the Loans will be used to complete the Phases IV and V of the Erdos TCH Energy Saving Development Co., Ltd. (“Erdos TCH”) project, a joint venture between Xi’an TCH and Erdos Metallurgy Co., Ltd. to recycle waste heat from Erdos Metallurgy’s refining plants to generate power and steam and sell them back to Erdos Metallurgy, as well as other working capital needs. 

 

Under the Trust Loan Agreement and separate agreements entered by Jingu, Erdos TCH, Shanghai TCH, Xi’an TCH and Mr. Guohua Ku on August 18, 2010, Erdos TCH shall pledge the accounts receivable, equipment and assets of  its Phases IV and V projects to Jingu as a guarantee to the Loans, Xi’an TCH shall pledge its 80% equity in Erdos TCH to Jingu as a guarantee to the Loans, Shanghai TCH shall provide a joint liability guarantee to Jingu for the Loans, and Mr. Guohua Ku shall provide his personal joint liability to Jingu for the Loans.

 

Under the Note Agreement the Notes shall be issued before August 18, 2011.  The Notes have a three year maturity date from the date of the issuance of the first tranche.  The exchange rate between RMB and US Dollar for each issue of Notes is the middle rate published by the PBOC for the second business day prior to each issuance.  Each Note bears interest at a rate equal to that of PBOC base interest rate for the relevant interest period (the period commencing on and including January 1 of each year and ending on and including December 31 of such year) plus two percent (2%).  If Cinda does not convert or fully convert the Notes to shares prior to maturity, the Company will pay the difference between the interest rate described above and 18% on the outstanding amount.

 

The Loans have the following covenants: (i) maintain at all time a fixed charge coverage ratio of not less than 2.0:1.0; (ii) obtain consent from the lender prior to pay or declare any cash dividends or distributions on outstanding common stock; and (iii) maintain at all time a consolidated leverage ratio of not less than 65%. Pursuant to the terms and conditions of the Trust Loan Agreement, the Company is required to comply with these covenants annually on its consolidated financial statements audited under US GAAP.
 

Each Note has a conversion price at the lower of (i) US$2.46 per share or (ii) an amount equal to the Company’s earnings per share based upon the consolidated earnings of the Company for 2010 on a weighted average fully diluted basis, multiplied by 7.  In connection with the Trust Loan Agreement, the Company also entered into an Exchange Rights Agreement pursuant to which the Loans can be exchanged (on the same terms as the Notes can be converted) for shares of the Company’s common stock which can in turn be registered under the Registration Rights Agreement. The Notes will have a contingent beneficial conversion feature which will be recorded when the contingency is resolved.

 

As collateral for the Notes, Mr. Guohua Ku, the CEO and a major shareholder of the Company entered into a Share Pledge Agreement with Cinda, on August 18, 2010, to pledge 4,500,000 shares of the Company’s common stock held by him to secure the first Note.  The Agreement also calls for an additional 4,500,000 shares of the Company’s common stock held by Mr. Ku to secure the second Note before its issuance.

 

 

As of December 31, 2010, the Company received proceeds of RMB 50,000,000 ($7,533,391) from the first tranche of the Loans. As of January 30, 2011, the Company received proceeds of another RMB 50,000,000 ($7,533,391) from the first tranche convertible Note. Under ASC 815 – Derivatives and Hedging, the fair value of the conversion option is a derivative that has been bifurcated and treated as liability at the date of inception. Based on AU 560 - subsequent events, the conversion feature has been accounted for at June 30, 2011 and December 31, 2010 using the conversion price of $2.46. The conversion feature is akin to a call option, therefore, the Black-Scholes option pricing model was used by using the maximum conversion price of $2.46 as a the strike price. Since the conversion option is an embedded derivative and is bifurcated from the host contact, BCF analysis is not required. The fair value of the conversion feature was recorded as a liability and will be marked to market until the conversion rate is set. As the loan has a reset clause in the event the Company issues shares below the conversion price, it will be treated as a liability as long as the loan is outstanding. The unamortized discount due to conversion feature will continue to be amortized over the term of the loan; during the six and three months ended June 30, 2011, the Company amortized $1,976,410 and $1,074,956 from unamortized discount due to beneficial conversion feature.

 

For the first tranche of the Loans, the Company recorded the derivative liability of $3.44 million for conversion option at June 30, 2011, based on the Black-Scholes model by using the following assumptions: estimated life of three years, volatility of 100%, risk free interest rate of 1.07%, and dividend yield of 0%.  For the second tranche, the Company recorded the derivative liability of $3.33 million for conversion option at June 30, 2011 based on the Black-Scholes model by using the following assumptions: estimated life of three years, volatility of 100%, risk free interest rate of 0.96%, and dividend yield of 0%. 

 

15. STOCK-BASED COMPENSATION PLAN

 

Options to Employees

 

On November 13, 2007, the Company approved the 2007 Non-statutory Stock Option Plan, which was later amended and restated in August 2008 (the “2007 Plan”), and granted 3,000,000 options to acquire the Company’s common stock at $1.23 per share to twenty (20) managerial and non-managerial employees under the 2007 Plan. 

 

The vesting terms of options granted under the 2007 Plan are subject to the Non-Statutory Stock Option Agreements for managerial and non-managerial employees. For managerial employees, no more than 15% of the total stock options shall vest and become exercisable on the six month anniversary of the grant date. An additional 15% and 50% of the total stock options shall vest and become exercisable on the first and second year anniversary of the grant date, respectively. The remaining 20% of the total stock options shall vest and become exercisable on the third year anniversary of the grant date. For non-managerial employees, no more than 30% of the total stock options shall vest and become exercisable on the first year anniversary of the grant date. An additional 50% of the total stock options shall vest and become exercisable on the second year anniversary of the grant date. The remaining 20% of the total stock options shall vest and become exercisable on the third year anniversary of the grant date. Each stock option shall become vested and exercisable over a period of no longer than five years from the grant date. 

 

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

 

The options vest over three years and have a life of 5 years. The fair value of the options was calculated using the following assumptions, estimated life of five years, volatility of 100%, risk free interest rate of 3.76%, and dividend yield of 0%. No estimate of forfeitures was made as the Company has a short history of granting options.

 

Effective June 25, 2008, the Company cancelled all vested shares and accepted optionees’ forfeiture of any unvested shares underlying the currently outstanding options.

 

 

On August 4, 2008, the Company granted stock options to acquire 3,000,000 shares of the Company’s common stock, par value $0.001, at $0.80 per share to 17 employees under the 2007 Plan. The options vest over a period of three years and have a life of 5 years. The fair value of the options was calculated using the following assumptions, estimated life of five years, volatility of 100%, 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. The options were accounted for as a modification to the options that were cancelled on June 25, 2008. The grant date fair value of options was $5.04 million.

 

On November 9 and 11, 2009, the Company and three optionees agreed to cancel vested but unexercised options for 87,000 vested but not exercised shares and forfeit unvested options for 203,0000 unvested shares.  On November 11, 2009, the Company granted options to two other employees for 290,000 shares of the Company’s common stock at $2.35 per share. The options vest over three years and have a life of 5 years. The fair value of the options was calculated using the following assumptions, estimated life of five years, volatility of 100%, risk free interest rate of 3.84%, and dividend yield of 0%. The grant date fair value of options was $518,513.

 

On August 13, 2010, the Company granted 2,200,000 options to acquire the Company’s common stock at $3.05 per share to thirty six (36) managerial and non-managerial employees as new equity awards pursuant to the Corporation’s Amended and Restated 2007 plan.

 

According to the vesting terms, the options granted were divided into three tranches, (i) 1/3 (one third) of the total number of shares subject to the options shall vest and become exercisable if the Corporation meets its minimum revenue and earnings goals in the Corporation’s guidance for 2010 as delivered in its earnings releases and/or conference calls in the first quarter of 2010, such vesting to occur immediately upon completion of the annual audit confirming the financial results for 2010;  and (ii) an additional 1/3 (one third) of the total number of shares subject to the options shall vest and become exercisable if the Corporation meets certain financial goals of 2011 which will be set out and decided by the Compensation Committee, such vesting to occur immediately upon Compensation Committee’s determination that the Corporation has met such goals for 2011; and (iii) the remaining 1/3 (one third) of the total number of shares subject to the options shall vest and become exercisable if the Corporation meets certain financial goals of 2012 which will be set out and decided by the Compensation Committee, such vesting to occur immediately upon Compensation Committee’s determination that the Corporation has met such goals for 2012.  The Option may only be exercised to the extent that the Option has become vested and exercisable. The management used its estimates for determining the probability of achieving each year’s financial goals; these were 100%, 50% and 50% for 2010, 2011 and 2012, respectively.

 

The options have a life of 5 years. The fair value of the options was calculated using the following assumptions; estimated life of five years, volatility of 92%, risk free interest rate of 3.54%, and dividend yield of 0%. No estimate of forfeitures was made as the Company has a short history of granting options. Each tranche of the options was deemed independent of the others; therefore, the fair value of each tranche of the options will be fully expensed within each year.

 

The following table summarizes activity for employees in the Company’s Plan:

 

		Number of Shares				Average Exercise Price per Share				Weighed Average Remaining Contractual Term in Years
Outstanding at December 31, 2010			5,200,000				1.84				3.52
Exercisable at December 31, 2010			2,255,000			$	0.86				2.59
Granted			-				-				-
Exercised			-				-				-
Forfeited			-				-				-
Outstanding at June 30, 2011			5,200,000				1.84				3.02
Exercisable at June 30, 2011			2,988,333			$	1.40				2.62

 

The Company recorded $1,401,352 and $978,058 compensation expense for stock options to employees during the six months ended June 30, 2011 and 2010, respectively. For three months ended June 30, 2011, the Company recorded $332,272 and $471,932, respectively. There were no options exercised during the six months ended June 30, 2011.

 

 

Options to Independent Directors

 

On October 30, 2009, the Company granted stock options for 130,000 shares of the Company’s common stock, par value $0.001, at $1.85 per share to three independent directors. The options vested and became exercisable on the six-month anniversary of the grant date with a life of 5 years. The fair value of the options was calculated using the following assumptions: estimated life of five years, volatility of 100%, risk free interest rate of 3.54%, and dividend yield of 0%. The grant date fair value of options was $183,000.

 

On January 20, 2010, the Company granted stock options for 40,000 shares of the Company’s common stock, par value $0.001, at $4.68 per share to another independent director. The options vest and become exercisable on the six-month anniversary of the grant date with a life of 5 years. The fair value of the options was calculated using the following assumptions: estimated life of five years, volatility of 100%, risk free interest rate of 3.54%, and dividend yield of 0%. The grant date fair value of options was $142,000.

 

On October 7, 2010, the Board of Directors (“BOD”) of the Company approved the increase in its size from seven to nine members as a result of entering the Loan and Note agreements with Cinda on August 18, 2010 as described in Note 16 above. At the same time, the BOD appointed Mr. Yilin Ma and Mr. Chungui Shi as new members of the Board to fill the vacancies on the BOD until their successors have been duly elected and qualified. Mr. Shi is also appointed as a member of the Compensation Committee of the BOD. In connection with the appointment, the BOD of the Company has authorized the Company to provide Mr. Shi with (i) compensation of $2,000 per month and (ii) the grant of an option to purchase 40,000 shares of the Company's Common Stock, par value $0.001, at an exercise price equal to the closing price per share of the Company's Common Stock on October 7, 2010. The options vested and became exercisable on the six-month anniversary of the grant date with a life of 5 years. The fair value of the options was calculated using the following assumptions: estimated life of five years, volatility of 87%, risk free interest rate of 3.54%, and dividend yield of 0%. The grant date fair value of options was $83,000.

 

The following table summarizes option activity with respect to the independent directors:

 

		Number of Shares				Average Exercise Price per Share				Weighed Average Remaining Contractual Term in Years
Outstanding at December 31, 2010			210,000				2.60				4.05
Exercisable at December 31, 2010			170,000			$	2.52				3.89
Granted			-				-				-
Exercised			-				-				-
Forfeited			-				-				-
Outstanding at June 30, 2011			210,000				2.60				3.55
Exercisable at June 30, 2011			210,000			$	2.60				3.65

 

The Company recorded $43,975 and $247,991 compensation expense for stock options to independent directors during the six months ended June 30, 2011 and 2010, respectively. The Company recorded $2,962 and $101,466 during three months ended June 30, 2011 and 2010, respectively. No options were exercised during the six months ended June 30, 2011.

 

Warrants to Investor Relation Firms

 

On October 1, 2009, the Company granted warrants to acquire 200,000 shares of the Company’s common stock, par value $0.001, at $1.50 per share to certain investor relations firms. The warrants are exercisable, in whole or in part, at any time from July 1, 2010 (the “Vesting Date”) to October 1, 2014 (the “Expiration Date”). The Company accounted for warrants issued to investor relations firms based on ASC 505-50 at each balance sheet and expense recorded based on the period elapsed at each  balance sheet date, which is the date at which the counterparty’s performance is deemed to be completed for the period. The fair value of each warrant granted is estimated on the date of the grant using the Black-Scholes option pricing model under ASC 505-30-11 and is recognized as compensation expense over the service term of the investor relations agreement as it is a better matching of cost with services received. Under that Agreement, the issuance of the warrants was irrevocable and the Company agreed to take no action to cause the warrants to be void or revoked or their issuance to be otherwise terminated. The warrants are classified as equity instruments and are exercisable into a fixed number of common shares. There is no commitment or requirement to change the quantity or terms based on conditions to the counterparty’s performance or market conditions.  The fair value of the warrants was calculated using the following assumptions: estimated life of five years, volatility of 100%, risk free interest rate of 3.54%, and dividend yield of 0%.

 

 

The following table summarizes activity for the warrants to certain investor relations firms:

 

		Number of Shares				Average Exercise Price per Share				Weighed Average Remaining Contractual Term in Years
Outstanding at December 31, 2010			50,000				1.50				3.75
Exercisable at December 31, 2010			50,000			$	1.50				3.75
Granted			-				-				-
Exercised			-				-				-
Forfeited			-				-				-
Outstanding at June 30, 2011			50,000				1.50				3.25
Exercisable at June 30, 2011			50,000			$	1.50				3.25

 

The Company recorded $0 and $181,498 compensation expense for warrants to the IR during the six months ended June 30, 2011 and 2010, respectively. The Company recorded $0 and $90,749 during three months ended June 30, 2011 and 2010, respectively. There were no warrants exercised during the six months ended June 30, 2011.

 

16. SHAREHOLDERS’ EQUITY

 

On June 29, 2010, Xi’an TCH entered into a Biomass Power Generation Asset Transfer Agreement (the “Transfer Agreement”) with Dong, a natural person with Chinese citizenship.  Under the Transfer Agreement, Dong transferred the Biomass Systems to Xi’an TCH, and Xi’an TCH will pay Dong RMB 100,000,000 ($14,705,900) for the systems, including RMB 20,000,000 in cash and RMB 80,000,000 with equivalent shares of the Company’s common stock. The stock price will be the same price as the Company’s public offering price in the first public offering which occurs in 2010 or 2011 but in no circumstance less than $4 per share.  The exchange rate between U.S. Dollar and Chinese RMB in connection with the stock issuance is 1:6.8.  At June 30, 2011, the Company recorded shares to be issued of $5.94 million (the fair value at June 30, 2011) in connection with this transaction, and $5.0 million in connection with the conversion of the second convertible note of $5 million from Carlyle (Note 14).

 

 During the six months ended June 30, 2011 and 2010, the Company recorded a gain of $3.03 million and $0.75 million, respectively, which is the change of the fair value of 2,941,176 maximum numbers of shares to be issued to Dong. During the three months ended June 30, 2011 and 2010, the Company recorded a gain of $1.97 million and $0.75 million, respectively.

 

ARC Settlement

 

The Company and investment relationship company ARC China, Inc. (“ARC”) entered into a Share Purchase Binding Letter of Intent dated as of July 17, 2009 regarding ARC’s purchase of certain Preferred Stock Units of the Company (the “LOI”). Disputes arose between the Parties regarding the LOI, and a lawsuit was pending in federal court. On September 27, 2010, the Company approved the settlement of the lawsuit and the related disputes, claims or disagreements regarding the LOI and the Preferred Stock Units. Pursuant to the settlement, the Company will issue to ARC up to 520,000 shares of the Company's Common Stock at $1.23 per share. The Company issued 350,000 of these shares upon the execution of the settlement agreement. Upon satisfaction of certain conditions of the settlement agreement, the Company may issue to ARC or its affiliates up to an additional 170,000 shares at  $1.23 per share. ARC has agreed to provide consulting and investor relations services from November 1, 2010 to February 28, 2011. The Company received $430,500 from issuance of 350,000 shares in October 2010, which was recorded as subscription receivable as of September 30, 2010. The difference between the stock price at the settlement date and the issuance price for the 350,000 settlement shares was recorded as stock compensation expense for investor relations services in the amount of $602,000. A copy of the dismissal of the lawsuit with prejudice was filed by ARC China in Nevada federal court on November 10, 2010. The conditions for the issuance of the additional 170,000 shares were not met; consequently, 150,000 of those shares, which had been issued and delivered to an escrow agent, were returned to the Company and cancelled on March 29, 2011, and the other 20,000 shares were never issued.

 

 

17. STATUTORY RESERVES

 

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

 

Surplus Reserve Fund

 

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

 

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

 

Common Welfare Fund

 

The common welfare fund is a voluntary fund to which the Company can elect to transfer 5% to 10% of its net income. This fund can only be utilized on capital items for the collective benefit of the Company’s employees, such as construction of dormitories, cafeteria facilities, and other staff welfare facilities. This fund is non-distributable other than upon liquidation. The Company does not participate in this voluntary fund.

 

18. CONTINGENCIES

 

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

 

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

 

19. COMMITMENTS

 

Erdos Phase III of Power Generation Projects

 

In April 2009, Erdos TCH signed a contract with Erdos Metallurgy to recycle heat from groups of furnaces of Erdos Metallurgy’s metal refining plants to generate power and steam, to be sold back to Erdos Metallurgy. According to the contract, Erdos TCH will install a group of power generation projects with a total of 70MW power capacity, which may grow up to 120MW, and 30-ton steam per hour, with an estimated total investment in excess of $75 million (RMB 500 million). The Company split the construction of the projects into three phases, two units of power generation in Phase I with a total of 18MW power capacity, three units in Phase II with a total of 27MW power capacity and one unit in Phase III with 25MW power capacity.  For each phase of the project, the lease term is 20 years starting from the date of completion of the phase.  During the lease term, Erdos TCH will be responsible for operating the projects and charge Erdos Metallurgy for supply of electricity and steam.  Erdos Metallurgy agreed to pay a fixed minimum of $0.22 million (RMB 1.5 million) per month for each 9MW capacity power generation system.

 

During the first quarter of 2010, Erdos power generation system Phase I project was completed and put into operation.  During the fourth quarter of 2010 and first quarter of 2011, three 9MW power generation systems of Phase II were completed and put into operation. Erdos TCH outsourced to an independent third party the operation and maintenance of the power generation system for $922,000 (RMB 6.27 million) per year for each system.  After 20 years, the systems will be transferred to Erdos without any charge.

 

As of June 30, 2011 the projects of Erdos Phase III are under construction. At June 30, 2011, the Company has paid approximately $18.89 million for Phase III. The Company expects the completion of Phase III projects no later than the end of 2011.

 

 

Shannxi Datong Coal Group Power Generation Projects

 

In February 2011, Xi'an TCH signed a contract with Shannxi Datong Coal Group Steel Ltd Co (Shannxi Datong) to recycle gas and steam from groups of blast-furnaces and converter of Shannxi Datong's metal refining plants to generate power. According to the contract, the Company will install two 3MW TRT and one 15MW WGPG and two 1MW steam power generation systems, with a total of 23MW power capacity for an estimated total investment of $27.45 million (RMB 180 million). The lease term is 30 years. During the lease term, Shannxi Datong will be responsible for operating the projects and pay a service fee to the Company. The service fee is based on an average of 8,000 electricity-generating hours per year and RMB 0.33 per kilowatt hour ("Kwh") for the first 5 years from the completion of each power generation station. For each of the leases, at the 6th year, 11th year and 21st year thereafter, the rate will be RMB 0.3 Kwh, 0.27 Kwh and 0.25 Kwh, respectively. After 30 years, the units will be transferred to Shannxi Datong without any charge.

 

On February 28,2011, Xi’an TCH entered into an agreement with Xi’an Huaxin Energy Tech Co., Ltd (the contractor for construction) for Shannxi Datong Coal projects of two 3MW TRT and one 15 MW WGPG systems described above. The project is scheduled to complete in 12 months from construction commencement.

 

ShenQiu Thermal Power Generation Projects

 

On May 25, 2011, Xi’an TCH entered into a Letter of Intent with ShenQiu YuNeng Thermal Power Ltd Co., (“ShenQiu”) for Xi’an TCH reconstructing and transforming a Thermal Power Generation System owned by ShenQiu into a 75T/H Biomass Power Generation Systems for approximately RMB 22.5 million (approximately $3.5 million). The project commenced in June 2011 and will be completed in 90 days. Xi’an TCH will purchase the power station in 10 days after the completion of the transformation.

 

Financing Agreement- - Sale Lease-back transaction.

 

On June 28, 2011, Xi’an TCH”, entered into a Financing Agreement (the “Agreement”) with Cinda Financial Leasing Co., Ltd. (the “Cinda Financial”), an affiliate of China Cinda (HK) Asset Management Co., Ltd. (the “Cinda HK”).

 

Under the  Agreement, Xi’an TCH transferred its ownership of a set of 7MW steam turbine waste heat power generation system and four furnaces and  ancillary apparatus (the “Assets”) to Cinda Financial for  RMB 42.50 million ($6.64 million), and Cinda Financial in turn leased the Assets to Xi’an TCH for  5 years with an overall leasing fee of RMB 51.54 million ($8.05 million) based upon the transfer cost and the benchmark interest rate for five year loans by People’s Bank of China (“PBOC”) (presently 6.65%) plus 15% of that rate (which at present is 7.6475%).  The interest rate will increase if the five year benchmark interest rate of PBOC increases but will remain the same if the benchmark rate decreases in the future.  Xi’an TCH shall make pro rata quarterly payments to Cinda Financial for the leasing fees. Upon the completion of the leasing term and full payment of all leasing fees and other fees, Xi’an TCH can pay RMB 4,250 ($664) to reacquire the ownership of the Assets.

 

In addition to the leasing fees, Xi’an TCH shall pay a onetime non-refundable leasing service charge of RMB 2,550,000 ($398,438) and a refundable security deposit of RMB 2,125,000 ($332,031) to Cinda Financial.

 

In accordance with ASC 840-10-25-4, since CREG retains substantially all of the benefits and risks relating to the property, this transaction is a financing and will be recorded as such. The proceeds of this financing were not received prior to June 30, 2011; therefore, this transaction will be recorded in the third quarter of 2011.

 

20. SUBSEQUENT EVENTS

 

As disclosed under Note 14 (“Convertible Notes Payable”) and a Form 8-K filed, by the Company, on July 22, 2011, the Company, on July 21, 2011, issued 4,334,192 shares of common stock to the Investors (4,149,599 shares to CAGP; 184,593 shares to CAGP III Co. Investment, L.P.), pursuant to the Investors’ conversion of the Second Note, in June 2011, at a conversion price of $1.154 per share. The 4,334,192 shares of common stock issued subsequent to the period covered by this quarterly report  were recorded, by the Company, as shares to be issued in the accompanying financial statements, because such shares were not issued as of June 30, 2010.

 

 

21. RESTATEMENT OF FINANCIAL STATEMENTS

 

The financial statements for the periods ended June 30, 2011 and 2010 were restated to reflect the following:

 

According to FASB ASC 480-10-35-5, all other financial instruments recognized under the guidance in Section 480-10-25 shall be measured subsequently at fair value with changes in fair value recognized in earnings, unless either this subtopic or another subtopic specifies another measurement attribute.

 

Accordingly, the shares to be issued to Dong (with fixed obligation of RMB 80 million (US $11.78 million)) pursuant to Biomass Power Generation Asset Transfer Agreement entered on June 29, 2010 (“Note 16 - Shareholders’ Equity”) should be classified as a liability on the balance sheet and adjusted to fair value at each reporting period. Previously, the Company did not measure the changes in fair value of the liability at each reporting date.

 

The following table presents the effects of the restatement adjustment on the accompanying consolidated balance sheet at June 30, 2011:

 

Consolidated Balance Sheet		As Previously Reported				Restated				Net Adjustment
Shares to be issued		$	16,780,471			$	10,941,175			$	(5,839,296	)
Retained earnings		$	22,139,584			$	27,978,880			$	5,839,296

 

The following table presents the effects of the restatement adjustment on the accompanying consolidated statement of income and comprehensive income for the six months ended June 30, 2011:

 

Consolidated Statement of Income and Comprehensive Income		As Previously Reported				Restated				Net Adjustment
Changes in fair value of the liability		$	-			$	3,029,411			$	3,029,411
Total non-operating income (expense), net		$	536,401			$	3,565,812			$	3,029,411
Income before income taxes		$	11,120,897			$	14,150,308			$	3,029,411
Income before noncontrolling interest		$	8,941,266			$	11,970,677			$	3,029,411
Net income attributable to CREG		$	8,257,968			$	11,287,379			$	3,029,411
Comprehensive income attributable to CREG		$	10,609,004			$	13,638,415			$	3,029,411
Basic		$	0.20			$	0.28			$	0.08
Diluted		$	0.16			$	0.21			$	0.05

 

The following table presents the effects of the restatement adjustment on the accompanying consolidated statement of cash flows for the six months ended June 30, 2011:

 

		As Previously Reported				Restated				Net Adjustment
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	8,941,266			$	11,970,677			$	3,029,411
Changes in fair value of the liability		$	-			$	(3,029,411	)		$	(3,029,411	)

 

The following table presents the effects of the restatement adjustment on the accompanying consolidated statement of income and comprehensive income for the three months ended June 30, 2011:

 

Consolidated Statement of Income and Comprehensive Income		As Previously Reported				Restated				Net Adjustment
Changes in fair value of the liability		$	-			$	1,970,588			$	1,970,588
Total non-operating income (expense), net		$	536,097			$	2,506,685			$	1,970,588
Income before income taxes		$	4,642,862			$	6,613,450			$	1,970,588
Income before noncontrolling interest		$	3,859,161			$	5,829,749			$	1,970,588
Net income attributable to CREG		$	3,695,001			$	5,665,589			$	1,970,588
Comprehensive income attributable to CREG		$	5,064,165			$	7,034,753			$	1,970,588
Basic		$	0.09			$	0.13			$	0.04
Diluted		$	0.07			$	0.10			$	0.03

 

 

The following table presents the effects of the restatement adjustment on the accompanying consolidated statement of income and comprehensive income for the six months ended June 30, 2010:

 

Consolidated Statement of Income and Comprehensive Income		As Previously Reported				Restated				Net Adjustment
Changes in fair value of the liability		$	-			$	751,061			$	751,061
Total non-operating income (expense), net		$	(1,170,583	)		$	(419,522	)		$	751,061
Income before income taxes		$	10,565,294			$	11,316,355			$	751,061
Net Income		$	7,667,251			$	8,418,312			$	751,061
Net income attributable to CREG		$	7,180,678			$	7,931,739			$	751,061
Comprehensive income attributable to CREG		$	7,524,626			$	8,275,687			$	751,061
Basic		$	0.19			$	0.20			$	0.01
Diluted		$	0.15			$	0.17			$	0.02

 

The following table presents the effects of the restatement adjustment on the accompanying consolidated statement of cash flows for the six months ended June 30, 2010:

 

		As Previously Reported				Restated				Net Adjustment
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	7,667,251			$	8,418,312			$	751,061
Changes in fair value of the liability		$	-			$	(751,061	)		$	(751,061	)

 

The following table presents the effects of the restatement adjustment on the accompanying consolidated statement of income and comprehensive income for the three months ended June 30, 2010:

 

Consolidated Statement of Income and Comprehensive Income		As Previously Reported				Restated				Net Adjustment
Changes in fair value of the liability		$	-			$	751,061			$	751,061
Total non-operating income (expense), net		$	(682,089	)		$	68,972			$	751,061
Income before income taxes		$	6,991,726			$	7,742,787			$	751,061
Income before noncontrolling interest		$	5,130,449			$	5,881,510			$	751,061
Net income attributable to CREG		$	5,038,317			$	5,789,378			$	751,061
Comprehensive income attributable to CREG		$	5,424,183			$	6,175,244			$	751,061
Basic		$	0.13			$	0.15			$	0.02
Diluted		$	0.10			$	0.12			$	0.02

 

 

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

 

Note Regarding Forward-Looking Statements

 

This quarterly report on Form 10-Q and other reports filed by the Company from time to time with the SEC (collectively the “Filings”) contain or may contain forward-looking statements and information that are based upon beliefs of, and information currently available to, Company’s management as well as estimates and assumptions made by Company’s management. Readers are cautioned not to place undue reliance on these forward-looking statements, which are only predictions and speak only as of the date hereof. When used in the filings, the words “anticipate”, “believe”, “estimate”, “expect”, “future”, “intend”, “plan”, or the negative of these terms and similar expressions as they relate to Company or Company’s management identify forward-looking statements. Such statements reflect the current view of Company with respect to future events and are subject to risks, uncertainties, assumptions, and other factors (including the statements in the section “results of operations” below), and any businesses that Company may acquire. Should one or more of these risks or uncertainties materialize, or should the underlying assumptions prove incorrect, actual results may differ significantly from those anticipated, believed, estimated, expected, intended, or planned.

 

Although the Company believes that the expectations reflected in the forward-looking statements are based on reasonable assumptions, the Company cannot guarantee future results, levels of activity, performance, or achievements. Except as required by applicable law, including the securities laws of the United States, the Company does not intend to update any of the forward-looking statements to conform these statements to actual results. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this report, which attempts to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations, and prospects.

 

Our financial statements are prepared in US Dollars and in accordance with accounting principles generally accepted in the United States. See “Foreign Currency Translation and Comprehensive Income (Loss)” below for information concerning the exchange rates at which Renminbi (“RMB”) were translated into US Dollars (“USD”) at various pertinent dates and for pertinent periods.

 

OVERVIEW OF BUSINESS BACKGROUND

 

China Recycling Energy Corporation (the “Company” or “CREG”) (formerly China Digital Wireless, Inc.) was incorporated on May 8, 1980, under the laws of the State of Colorado. On September 6, 2001, the Company re-domiciled its state of incorporation from Colorado to Nevada. The Company, through its subsidiary Shanghai TCH Energy Technology Co., Ltd. (“Shanghai TCH”), is in the business of selling and leasing energy saving systems and equipment. On March 8, 2007, the Company changed its name to “China Recycling Energy Corporation”.

 

In September 2001, Boulder Brewing changed its state of incorporation from Colorado to Nevada and its name to Boulder Acquisitions, Inc., or Boulder Acquisitions. From the date of reincorporation until June 23, 2004, Boulder Acquisitions had no material operations or assets.

 

On June 23, 2004, we completed a stock exchange transaction with the stockholders of Sifang Holdings Co., Ltd. (“Sifang Holdings”). The exchange was consummated under Nevada and Cayman Islands law pursuant to the terms of a Securities Exchange Agreement, dated June 23, 2004 by and among Boulder Acquisitions, Sifang Holdings and the stockholders of Sifang Holdings. Pursuant to the Securities Exchange Agreement, we issued 13,782,636 shares of our common stock to the stockholders of Sifang Holdings, approximately 89.7% of our post-exchange issued and outstanding common stock, for 100% of the outstanding capital stock of Sifang Holdings.

 

Effective August 6, 2004, we changed our name from Boulder Acquisitions, Inc. to China Digital Wireless, Inc.  From August 2004 to December 2006, we primarily engaged in pager and mobile phone distribution and provided value added information services to the customers in the People’s Republic of China (“PRC”).  We phased out and scaled down most of the business of mobile phone distribution and provision of pager and mobile phone value-added information services, and on May 10, 2007, the Company approved and announced that it ceased and discontinued these businesses.

 

In December 2006, we began to conduct business in the energy saving and recycling industry, including purchasing certain equipment, devices, hardware and software for the construction and installation of TRT systems and other renewable energy products. TRT is an electricity generating system that utilizes the exhaust pressure and heat produced in the blast furnace of steel mills to generate electricity. It has commercial value for the steel mills by using waste heat and steam to produce electricity for the operation of the mills

 

 

Our current business is primarily conducted through our wholly-owned subsidiary, Sifang Holdings, its wholly-owned subsidiaries, Huahong New Energy Technology Co., Ltd. (“Huahong”) and Shanghai TCH, Shanghai TCH’s wholly-owned subsidiaries, Xi’an TCH Energy Technology Company, Ltd (“Xi’an TCH”) and Xingtai Huaxin Energy Tech Co., Ltd. (“Huaxin”), and Xi’an TCH’s subsidiary Erdos TCH Energy Saving Development Co., Ltd (“Erdos TCH”), in which 93% of the investment is from Xi’an TCH, a joint venture between Xi’an TCH and Erdos Metallurgy Co., Ltd.  Shanghai TCH was established as a foreign investment enterprise in Shanghai under the laws of the PRC on May 25, 2004, currently with registered capital of $29.80 million.  Xi’an TCH was incorporated in Xi’an, Shannxi Province under the laws of the PRC on November 8, 2007. Huaxin was incorporated in Xingtai, PRC in November 2007.  Erdos TCH was incorporated in April 2009.  Huahong was incorporated in February 2009.

 

On April 8, 2007, our Board of Directors approved and made effective a TRT Project Joint-Operation Agreement (“Joint-Operation Agreement”) which was conditionally entered into on February 1, 2007 between Shanghai TCH and Xi’an Yingfeng Science and Technology Co., Ltd. (“Yingfeng”). Yingfeng is a Chinese company located in Xi’an, Shaanxi Province, China, which designs, sells, installs, and operates TRT systems and other renewable energy products.  Due to Yingfeng’s lack of capital in pursuing this project alone, Yingfeng sought Shanghai TCH’s cooperation.  On October 31, 2007, Shanghai TCH entered an asset-transfer agreement with Yingfeng to transfer from Yingfeng to Shanghai TCH all electricity-generating related assets owned by Yingfeng. As a result, the contractual relationships between Shanghai TCH and Yingfeng under the TRT Project Joint-Operation Agreement entered on April 8, 2007 were terminated.

 

On April 14, 2009, the Company incorporated a joint venture (“JV”) between Xi’an TCH and Erdos Metallurgy Co., Ltd.  (“Erdos”) to recycle waste heat from Erdos’ metal refining plants to generate power and steam, which will then be sold back to Erdos.  The name of the JV is Inner Mongolia Erdos TCH Energy Saving Development Co., Ltd (“Erdos TCH”) with a term of 20 years.  As of December 31, 2010, Erdos contributed 7% of the total investment of the project, and Xi’an TCH contributed 93% of the total investment. Xi’an TCH and Erdos will receive 80% and 20% of the profit from the JV, respectively, until Xi’an TCH has received a complete return on its investment.  Xi’an TCH and Erdos will then receive 60% and 40% of the profit from the JV, respectively.

 

On March 15, 2011, the Company incorporated a new wholly owned subsidiary Pingshan Xi’an Shengda Energy Technology Ltd Co. (“Shengda”). Xi’an TCH contributed cash of $4,559,271(RMB 30,000,000) into Shengda as initial capital. Shengda was set up in order to undertake waste energy recycling projects from a steel and chemical company in Pingshan county as to a Recycling Economy Projects Cooperative Framework Agreement that has been developed by the parties but the final terms for the projects have not been reached and entered, and Shengda is not currently operational.

 

Hebei Xingtai Steel Group Project

 

On April 8, 2007, our Board of Directors approved and made effective a TRT Project Joint-Operation Agreement (“Joint-Operation Agreement”) which was conditionally entered into on February 1, 2007 between Shanghai TCH and Xi’an Yingfeng Science and Technology Co., Ltd. (“Yingfeng”). Under the Joint-Operation Agreement, Shanghai TCH and Yingfeng jointly pursued a project to design, construct, install and operate two TRT systems for Xingtai Iron and Steel Company, Ltd. (“Xingtai”). Shanghai TCH provided various forms of investments and properties into the project including cash, hardware, software, equipment, major components and devices. In return, Shanghai TCH obtained all the rights, titles, benefits and interests that Yingfeng originally had under the Project Contract, including but not limited to the regular cash payments made by Xingtai and other property rights and interests. On October 31, 2007, Shanghai TCH entered an asset-transfer agreement with Yingfeng to transfer from Yingfeng to Shanghai TCH all electricity-generating related assets owned by Yingfeng. According to the transferred contracts, Shanghai TCH installed and owns two TRT systems and leases them to Xingtai for five years, from January 25, 2007 to January 25, 2012.  During the lease, Xingtai will pay Shanghai TCH monthly rent of RMB 0.9 million ($0.13 million) to use the systems. Assuming all amounts due under the lease have been paid, Shanghai TCH will transfer the title of the systems to Xingtai free of charge.

 

 

Shanxi Zhangzhi Steel Group Project

 

Under the Joint-Operation Agreement discussed above, Shanghai TCH and Yingfeng also jointly pursued a project contract, which was entered into between Yingfeng and Zhangzhi Iron and Steel Company, Ltd. (“Zhangzhi”) on June 22, 2006, to design, construct, install and operate a TRT system for Zhangzhi Iron. Shanghai TCH provided various forms of investments and properties into the project including cash, hardware, software, equipment, major components and devices. In return, Shanghai TCH obtained all the rights, titles, benefits and interests that Yingfeng originally had under the Project Contract, including but not limited to the regular cash payments made by Xingtai and other property rights and interests. On October 31, 2007, Shanghai TCH acquired this contract as part of its asset-transfer agreement with Yingfeng as discussed above. According to the transferred contracts, Shanghai TCH installed and owns a TRT system and leases it to Zhangzhi for 13 years, from July 25, 2007 to July 25, 2020. During the lease term, Zhangzhi will pay Shanghai TCH a monthly rent of RMB 1.1 million ($0.16 million). After the term is over and all due rents are paid, Shanghai TCH will transfer the title of the system to Zhangzhi free of charge.

 

Shengwei Group – Tongchuan Project

 

In November 2007, Shanghai TCH signed a cooperative agreement with Shengwei Group to build two sets of 12MW cement low temperature heat power generation systems for Shengwei’s two 2,500-tons-per-day cement manufacturing lines in Jin Yang and for a 5,000-tons-per-day cement manufacturing line in Tong Chuan.  At the end of 2008, construction of the cement low temperature heat power generation in Tong Chuan was completed at a cost of $6,191,000 (RMB 43,000,000) and put into operation.  Under the original agreement, the ownership of the cement low temperature heat power generation systems would belong to Shengwei from the date the projects were put into service.  Shanghai TCH is responsible for the daily maintenance and repair of the projects, and charges Shengwei a monthly electricity fee based on the actual power generated by the projects at 0.4116 RMB per KWH for an operating period of five years with the assurance from Shengwei of a properly functioning 5,000-tons-per-day cement manufacturing line and not less than 7,440 heat hours per year for the electricity generator system.  Shengwei Group collateralized the cement manufacturing line in Tong Chuan to guarantee its obligations to provide the minimum electricity income from the power generator system under the agreement during the operating period. At the end of the five-year operating period, Shanghai TCH will have no further obligations under the cooperative agreement.  On May 20, 2009, Shanghai TCH entered into a supplementary agreement with Shengwei Group to amend the timing for title transfer to the end of the lease term. In addition, the supplementary agreement provided that Shanghai TCH will charge Shengwei based on actual power usage subject to a minimum of  $0.31 million (RMB 2.1 million) per month during the operating period.

 

Shengwei Group – Jinyang Project

 

On June 29, 2009, construction of the cement low temperature heat power generation system in Jin Yang was completed at a cost of $7,318,000 (RMB 50,000,000) and put into operation.  Shanghai TCH charges Shengwei a technical service fee of $336,600 (RMB 2,300,000) monthly for the sixty months of the lease term.  Shengwei has the right to purchase the ownership of the cement low temperature heat power generation system for $29,000 (RMB 200,000) at the end of lease term. Shengwei is required to provide assurance of properly functioning 5,000-tons-per-day cement manufacturing lines and not less than 7,440 heat hours per year for the cement low temperature heat power generation.  Shengwei Group collateralized the cement manufacturing lines in Jin Yang to guarantee its obligations to provide the minimum electricity income from the waste energy power generator system under the agreement during the operating period.  Effective July 1, 2009, Shanghai TCH outsourced the operation and maintenance of the cement low temperature heat power generation systems in Tong Chuan and JinYang to a third party for $732,000 (RMB 5,000,000) per year.

 

Shenmu Project

 

On September 30, 2009, Xi’an TCH delivered to Shenmu County Jiujiang Trading Co., Ltd. (“Shenmu”) a set of three 6 MW capacity waste gas power generation systems pursuant to a Cooperative Contract on Coke-oven Gas Power Generation Project (including its Supplementary Agreement) and a Gas Supply Contract for Coke-oven Gas Power Generation Project.  These contracts are for 10 years and provide  Xi’an TCH will recycle coke furnace gas from the coke-oven plant of Shenmu to generate power, which will be supplied back to Shenmu.  Shenmu agreed to supply Xi’an TCH the coke-oven gas free of charge.  Under the contracts, Shenmu will pay us an annual “energy-saving service fee” of approximately $5.6 million in equal monthly installments for the life of the contracts, as well as such additional amount as may result from the supply of power to Shenmu in excess of 10.8 million kilowatt hours per month. We are responsible for operating the projects and will do so through an unrelated third party. Shenmu guarantees that monthly gas supply will not be less than 21.6 million standard cubic meters. If gas supply is less, Shenmu agrees to pay Xi’an TCH the energy-saving service fee described above for up to 10.8 million kilowatt-hours per month. Xi’an TCH maintains the ownership of the project throughout the term of the contracts, including the already completed investment, design, equipment, construction and installation as well as the operation and maintenance of the project.  At the end of the 10-year term, ownership of the projects transfers to Shenmu at no charge.  Shenmu gave a lien on its production line to guarantee its performance under the Contracts. Shenmu’s three major stockholders provided an unlimited joint liability guarantee to Xi’an TCH for Shenmu’s performance under the Contracts and the Yulin Huiyuan Group, an independent third party, provides a guarantee to Xi’an TCH for Shenmu’s performance under the Contracts.

 

 

Erdos Projects

 

On April 14, 2009, the Company incorporated the JV between Xi’an TCH and Erdos Metallurgy Co., Ltd.  (“Erdos”) to recycle waste heat from Erdos' metal refining plants to generate power and steam, which will be sold back to Erdos.  The name of the JV is Inner Mongolia Erdos TCH Energy Saving Development Co., Ltd (“Erdos TCH”) with a term of 20 years, and initial registered capital of $2,635,000 (RMB 18,000,000). As of June 30, 2011, total registered capital was increased to $17.55 million (RMB 120 million), of which $16.37 million (RMB 112 million) was contributed by Xi’an TCH and $1.18 million (RMB 8 million) was from Erdos Metallurgy.  Total investment for the project is estimated at approximately $76 million (RMB 500 million) with an initial investment of $17.55 million (RMB 120,000,000). Erdos contributed 7% of the total investment of the project, and Xi’an TCH contributed 93% of the total investment. Xi’an TCH and Erdos will receive 80% and 20% of the profit from the JV, respectively, until Xi’an TCH has received a complete return on its investment.  Xi’an TCH and Erdos will then receive 60% and 40% of the profit from the JV, respectively. The profits to be distributed will be computed based on Chinese generally accepted accounting principles. The principal difference between US GAAP and Chinese GAAP with regards to the Erdos TCH project is that a sales-type lease under US GAAP is treated as an operating lease under Chinese GAAP.  When the term of the JV expires, Xi’an TCH will transfer its equity in the JV to Erdos at no additional cost.

 

At the end of 2009, Erdos TCH completed the first 9MW power station of Phase I of the project and put it into operation. At the end of March 2010, Erdos TCH completed the construction of Phase I through completion of the second 9MW power station and delivery of it for operation.  Phase I includes two 9MW systems for a combined 18MW power capacity. Pursuant to the Co-operation Agreement and the supplement agreements signed between Erdos and Erdos TCH, Erdos shall purchase all the electricity and steam to be generated from the JV’s power generation systems. Erdos TCH leased the two 9 MW systems to Erdos and is responsible for their operation and maintenance. For each phase of the project, the lease term is 20 years starting from the date of completion of the phase. Erdos agreed to pay a fixed minimum of $0.22 million (RMB 1.5 million) per month for each 9MW capacity power generation system. In addition Erdos will pay the actual amount if the actual sale of the electricity generated is more than $0.22 million (RMB 1.5 million) monthly per unit. Effective January 1, 2010 and April 2010 respectively, Erdos TCH outsourced to an independent third party the operation and maintenance of the two 9MW power generation projects for $922,000 (RMB 6.27 million) each per year. After 20 years, the units will be transferred to Erdos without any charge.

 

During the fourth quarter of 2010, Erdos power generation system Phase II two 9MW capacity electricity power generation systems were completed and put into operation. During the first quarter of 2011, Erdos power generation system Phase II the 3rd 9MW capacity electricity power generation system was completed and put into operation through sales type lease with terms similar to the Phase I project. At June 30, 2011, the Company paid approximately $18.19 million for Phase III of the Erdos TCH power generation system projects. The Company currently expects to complete Phase III in the third quarter of 2011.

 

Biomass Project

 

On January 20, 2010, Xi’an TCH entered into a Technical Reconstruction Letter of Intent with Xueyi Dong (“Dong”) a natural person with Chinese citizenship for Xi’an TCH reconstructing and transforming a Thermal Power Generation Systems owned by Dong into a 12MW Biomass Power Generation Systems (“Biomass Systems” or “BMPG”) for  RMB 15 million ( $2.2 million), of which, RMB 7 million ( $1.03 million) was payable to Dong, and RMB 8 million ( $1.18 million) was payable to one of the Company’s shareholders, who had previously paid that amount to Dong on behalf of the Company.

 

After the successful transformation of the systems, Xi’an TCH entered into a Biomass Power Generation Asset Transfer Agreement (the “Transfer Agreement”) with Dong on June 29, 2010.  Under the Transfer Agreement, Dong transferred the Biomass Systems to Xi’an TCH, and Xi’an TCH will pay Dong RMB 100,000,000 ( $14,705,900) for the systems, including RMB 20,000,000 in cash and RMB 80,000,000 in shares of the Company’s common stock. The stock price will be the same as in the Company’s first public offering, expected to occur later this year or in 2012, but in no circumstance will the stock price be less than $4 per share.  The exchange rate between U.S. Dollar and Chinese RMB in connection with the stock issuance is 1:6.8. As of June 30, 2011, the Company paid the cash portion in full; however, the shares to be issued in connection with this transaction, valued at $5.94 million (the fair value at June 30, 2011), have not been issued.

 

During the six months ended June 30, 2011 and 2010, the Company recorded a gain of $3.03 million and $0.75 million, respectively, which is the change of the fair value of 2,941,176 maximum numbers of shares to be issued to Dong.

 

 

On June 29, 2010, Xi’an TCH entered into a Biomass Power Generation Project Lease Agreement with PuCheng XinHengYuan Biomass Power Generation Co., Ltd., (“XHY”).  Under this lease agreement, Xi’an TCH leased this same set of 12MW biomass power generation systems to XHY at a minimum of RMB 1,900,000 per month ($279,400) for 15 years.  The leasing fee will increase proportionately with the biomass generated electricity fee in China during the term of this lease agreement.

 

Zhongbao Project

 

On September 30, 2010, Xi’an TCH delivered to Zhongbao Binhai Nickel Co., Ltd. (“Zhongbao”) a set of 7 megawatt capacity On September 30, 2010, Xi’an TCH delivered to Zhongbao Binhai Nickel Co., Ltd. (“Zhongbao”) a set of 7 megawatt capacity Waste Heat Power Generation (“WHPG”) systems, which are integral parts of the facilities designed to produce 80,000 tons of nickel-alloy per year according to the recovery and power generation of the waste heat agreement with Zhongbao, an agreement that was transferred from China Zhonggang Binhai Enterprise Ltd. (“Zhonggang”) in July 2009. Zhongbao is a nickel-alloy manufacturing joint venture between Zhonggang and Shanghai Baoshan Steel Group established in June 2009.  Total investment in this project was approximately $7.8 million (RMB 55 million). The Contract is for 9 years and provided that Xi’an TCH will recycle waste heat from the nickel-alloy rotary kilns of Zhongbao to generate power and steam, which will be supplied back to Zhongbao, and help to reduce over 20,000 tons of carbon dioxide emissions every year. By the end of the term, the system shall be transferred to Zhongbao at RMB 1. Under the Contracts, Zhongbao will pay the Company a monthly “energy-saving service fee” based on the volume of the electricity and steam generated from the WHPG system in the prior month within the first five days of each month at a pre-agreed price, but no less than the minimum monthly payment of $224,000 (RMB 1.5 million). Zhongbao agrees to supply Xi’an TCH the nickel-alloy rotary kilns gas, water and compressed air free of charge, except salty water at RMB 6.3 per ton. Zhongbao also guarantees to continuously supply not less than 6,800 heat hours per year for the WHPG, or the operating term will be extended accordingly. Xi’an TCH outsourced its operation and maintenance works to a third party for annual payments of RMB 2.4 million ($352,000) for the whole operation period. In addition, Xi’an TCH shall be responsible for applying the Clean Development Mechanism (“CDM”) and the net proceeds from CDM will be distributed between Zhonggang and Xi’an TCH at 60% and 40%, respectively.  The CDM work has not commenced as of June 30, 2011.

 

Shannxi Datong Coal Group Power Generation Projects

 

In February 2011, Xi’an TCH signed a contract with Shannxi Datong Coal Group Steel Ltd Co (Shannxi Datong) to recycle gas and steam from groups of blast-furnaces and converter of Shannxi Datong’s metal refining plants to generate power. According to the contract, the Company will install two 3MW TRT and one 15MW WGPG and two 1MW steam power generation systems, with a total of 23MW power capacity for an estimated total investment of $27.45 million (RMB 180 million). The lease term is 30 years. During the lease term, Shannxi Datong will be responsible for operating the projects and pay service fee to the Company. The service fee is based on an average of 8,000 electricity-generating hours per year and RMB 0.33 per kilowatt hour (“Kwh”) for the first 5 years from the completion of each power generation station. For each of the leases, at the 6th year, 11th year and 21st year thereafter, the rate will be RMB 0.3 Kwh, 0.27 Kwh and 0.25 Kwh, respectively. After 30 years, the units will be transferred to Shannxi Datong without any charge.

 

Shenqiu Yuneng Thermal Power Generation Projects

 

On May 25, 2011, Xi’an TCH entered into a Letter of Intent with ShenQiu YuNeng Thermal Power Ltd Co., (“ShenQiu”) for Xi’an TCH to reconstruct and transform a Thermal Power Generation System owned by ShenQiu into a 75T/H Biomass Power Generation System for approximately RMB 22.5 million (approximately $3.5 million). The project commenced in June 2011, and is expected to be completed in 90 days. Xi’an TCH will purchase the Biomass System from ShenQiu 10 days after completion of the transformation.

 

Related Party Transactions

 

Erdos TCH sold all power generation stations through sales type leases to Erdos Metallurgy Co., Ltd., the noncontrolling interest.  Total sales and interest income for this noncontrolling interest was $11.5 million and $3.25 million for the six months ended June 30, 2011, and $10.1 million and $0.9 million for the same period of 2010; $0.2 million and $1.85 for three months ended June 30, 2011, and  $0 and  $0.6 million for the same period of 2010, respectively.

 

 

Critical Accounting Policies and Estimates

 

Our management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which were prepared in accordance with accounting principles generally accepted in the United States (“US GAAP”). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported net sales and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

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

 

Basis of presentation

 

The accompanying consolidated financial statements were prepared in accordance with US GAAP and pursuant to the rules and regulations of the SEC for annual financial statements.

 

Basis of consolidation

 

The consolidated financial statements include the accounts of CREG and, its subsidiary, Sifang Holdings; Sifang Holdings’ wholly owned subsidiaries, Huahong and Shanghai TCH; Shanghai TCH’s subsidiaries Xi’an TCH and Huaxin; and Xi’an TCH’s subsidiary, Shengda and Erdos TCH, in which 93% of Erdos TCH’s investment is from Xi’an TCH.  Substantially all of the Company’s revenues are derived from the operations of Shanghai TCH and its subsidiaries, which represent substantially all of the Company’s consolidated assets and liabilities as of June 30, 2011 and December 31, 2010, respectively. All significant inter-company accounts and transactions were eliminated in the consolidation.

 

Use of estimates

 

In preparing these consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheets and revenues and expenses during the year reported. Actual results may differ from these estimates.

 

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

 

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 over estimated lives as follows:

 

Building	20 years
Vehicle	2 - 5 years
Office and Other Equipment	2 - 5 years
Software	2 - 3 years

 

 

Revenue Recognition

 

Sales-type Leasing and Related Revenue Recognition

 

The Company constructs and then leases waste energy recycling power generating projects to its customers. The Company usually transfers ownership of the waste energy recycling power generating projects to its customers at the end of each lease.  Investment in these projects is recorded as investment in sales-type leases in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 13, “Accounting for Leases” (codified in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 840) and its various amendments and interpretations. The Company manufactures and constructs the waste energy recycling power generating projects and finances its customers for the price of the projects.  The sales and cost of sales are recognized at the time of sale or inception of the lease. The investment in sales-type leases consists of the sum of the total minimum lease payments receivable less unearned interest income and estimated executory cost. Unearned interest income is amortized to income over the lease term so as to produce a constant periodic rate of return on the net investment in the lease.  While a portion of revenue is recognized at the inception of the lease, the cash flow from the sales-type lease occurs over the course of the lease. Revenue is net of Value Added Tax.

 

Contingent Rental Income

 

The Company records the income from actual electricity usage in addition to minimum lease payment of each project as contingent rental income in the period earned. Contingent rent is not part of minimum lease payments.

 

Foreign Currency Translation and Comprehensive Income (Loss)

 

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

 

The Company uses SFAS 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 stockholders, changes in paid-in capital and distributions to stockholders.

 

Recent Accounting Pronouncements

 

In June 2011, FASB issued ASU 2011-05, Comprehensive Income (ASC Topic 220):  Presentation of Comprehensive Income.  Under the amendments in this update, an entity has the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. In addition, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented.  The amendments in this update should be applied retrospectively and are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The guidance is not expected to have a material impact on our financial position or results of operations.

 

 

RESULTS OF OPERATIONS

 

Comparison of Three Months Ended June 30, 2011 and 2010

 

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

 

		2011								2010
		$				% of Sales				$				% of Sales
Sales		$	365,672				100	%		$	22,538,511				100	%
Sales of products			72,544				20	%			21,795,873				97	%
Contingent rental income			293,128				80	%			742,638				3	%
Cost of sales			(68,640	)			19	%			(16,801,915	)			75	%
Cost of products			(68,640	)			19	%			(16,801,915	)			75	%
Gross profit			297,032				81	%			5,736,596				25	%
Interest income on sales-type lease			5,488,501				1501	%			3,323,695				15	%
Total operating income			5,785,533				1582	%			9,060,291				40	%
Total operating expenses			(1,678,768	)			459	%			(1,386,476	)			6	%
Income from operations			4,106,765				1123	%			7,673,815				34	%
Total non-operating income (expenses), net			2,506,685				686	%			68,972				-	%
Income before income tax			6,613,450				1809	%			7,742,787				34	%
Income tax expense			783,701				214	%			1,861,277				8	%
Less: net income attributable to noncontrolling interest			164,160				45	%			92,132				0.4	%
Net income attributable to China Recycling Energy Corp		$	5,665,589				1550	%		$	5,789,378				26	%

 

SALES. Net sales of systems for the three months ended June 30, 2011 were $0.37 million while our net sales for the same period of 2010 were $22.54 million, a decrease of $22.17 million. The decrease was primarily due to the fact that there was no sale of system in the second quarter of 2011; in comparison, net sales for the same period in fiscal year 2010 reflected the completion and sale of Pucheng biomass power generation system. For the three months ended June 30, 2011, the Company received contingent rental income of $0.29 million, compared to $0.74 million for the same period in fiscal year 2010. The contingent rental income resulted from actual usage of the electricity in addition to the minimum lease payments received in the second quarter of 2011 from our Shengwei Group - Tongchuan Project, Erdos Project and Shenmu Project.  For the sales-type lease, sales and cost of sales are recorded at the time of leases; the interest income from the sales-type leases is our other major revenue source in addition to sales revenue.

 

COST OF SALES. Cost of sales for the second quarter of 2011 was $68,640 while our cost of sales for the comparable period of 2010 was $16.80 million, a decrease of $16.1 million. There was no system completed and sold during the second quarter of 2011, compared to the same period of 2010, when the Company executed the sales-type lease of Pucheng biomass power generation system with a cost of $16.80 million.

 

GROSS PROFIT. Gross profit was $0.3 million for the three months ended June 30, 2011 compared to $5.74 million for the same period of 2010, a gross margin of 81% and 25% for the comparable period of 2011 and 2010, respectively. Because no system was completed and sold during the second quarter of 2011, the gross profit was derived entirely from contingent rental income, while in the second quarter of 2010, it mainly resulted from the sale of the Pucheng biomass power generation system.

 

INTEREST INCOME ON SALES TYPE LEASES. Interest income on sales-type leases for the three months ended June 30, 2011 was $5.49 million, a $2.17 million increase from $3.32 million for the comparable period of 2010.  During the second quarter of 2011, interest income was derived from twelve systems:  two TRT systems, two CHPG systems, one WGPG system, two waste heat power generating systems associated with our Erdos Phase I project and two systems of Erdos Phase II project, the Pucheng biomass power generation system and Zhongbao WHPG system, and the 3rd 9MW waste heat power generating system of Erdos Phase II project. During the second quarter of 2010, interest income was generated from seven systems: two TRT systems, two CHPG systems, one WGPG system, and two waste heat power generating systems associated with our Erdos Phase I project.

 

OPERATING EXPENSES. Operating expenses consisted of selling, general and administrative expenses totaling $1.68 million for the second quarter of 2011 as compared to $1.39 million for the same period of 2010, an increase of $0.29 million or 21%. The increase was due to proportional increases in our payroll, welfare, business trip and marketing expenses as a result of continuous expansion of our business; in addition, we recorded $0.34 million in compensation expense for stock options during the second quarter of 2011, compared to $0.67 million for the same period of 2010.

 

 

NON-OPERATING INCOME (EXPENSES). Non-operating expenses consisted of non sales-type lease interest income, interest expense, bank charges and some miscellaneous expenses. For the three months ended June 30, 2011, net non-operating income was $2.51 million as compared to $68,972 for the comparable period of 2010. In the second quarter of 2011, we had $0.32 million interest expenses on loans, $1.82 million interest expense arising from the beneficial conversion feature of the convertible note from Carlyle and China Cinda, but offset by $3.60 million from changes in fair value of conversion feature liability of the convertible note from China Cinda, and $1.97 million from changes in fair value of the liability for shares to be issued to Dong; while in the same period of 2010, the interest expense was $0.44 million arising from beneficial conversion feature for the convertible note, and the income from changes in fair value of the liability for shares to be issued to Dong was $0.75 million.

 

INCOME TAX EXPENSE. The income tax expense was $0.78 million for the second quarter of 2011, a decrease of $1.08 million from $1.86 million for the comparable period of 2010. The decrease was mainly due to the decrease of income before income tax from $7.74 million for the second quarter of 2010 to $6.61 million for the same period of 2011. The consolidated effective income tax rate for the second quarter of 2011 and 2010 was 11.9% and 24.0%, respectively. The change in the consolidated effective tax rate was mainly due to tax rate change for future deferred tax items, effective tax holiday, valuation allowance on NOL, and permanent non-tax deductible interest expense resulting from amortization of a beneficial conversion feature for a convertible note, but offset with non-taxable income from changes in fair value of conversion feature liability and changes in fair value of the liability for shares to be issued to Dong, which accounted for net of (0.5)% of pretax income for the second quarter of 2011 compared to (1.4)% for the same quarter of 2010; non-tax deductible expenses were added back to taxable income for US income tax return purposes and non-taxable income were subtracted from taxable income. The income tax rate for Shanghai TCH was 24% and 22% for 2011 and 2010, respectively. Xi’an TCH’s effective income tax rate for 2011 and 2010 is 15% as a result of its high tech enterprise status that was approved by the taxing authority. Xingtai Huaxin’s effective income tax rate for 2011 and 2010 is 25%. Huahong, Erdos TCH and Shengda’s effective income tax rate for 2011 is 25%.

 

NET INCOME. Our net income for the three months ended June 30, 2011 was $5.67 million compared to $5.79 million for the same period of 2010, a decrease of $0.12 million. This decrease in net income was mainly due to the fact that no system was completed and sold during the quarter, despite increased interest income from lease payments for energy saving systems, and increased non-operating income compared with the second quarter of 2010.

 

Comparison of Six Months Ended June 30, 2011 and 2010

 

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

 

		2011								2010
		$				% of Sales				$				% of Sales
Sales		$	11,928,821				100	%		$	32,663,947				100	%
Sales of products			11,343,798				95	%			31,921,309				98	%
Contingent rental income			585,023				5	%			742,638				2	%
Cost of sales			(8,524,672	)			71	%			(24,600,160	)			75	%
Cost of products			(8,524,672	)			71	%			(24,600,160	)			75	%
Gross profit			3,404,149				29	%			8,063,787				25	%
Interest income on sales-type lease			10,626,804				89	%			6,418,263				19	%
Total operating income			14,030,953				118	%			14,482,050				44	%
Total operating expenses			(3,446,457	)			29	%			(2,746,173	)			8	%
Income from operations			10,584,496				89	%			11,735,877				36	%
Total non-operating income (expenses), net			3,565,812				30	%			(419,522	)			1	%
Income before income tax			14,150,308				119	%			11,316,355				35	%
Income tax expense			2,179,631				18	%			2,898,043				9	%
Less: net income attributable to noncontrolling interest			683,298				6	%			486,573				1	%
Net income attributable to China Recycling Energy Corp		$	11,287,379				95	%		$	7,931,739				25	%

 

 

SALES. Net sales of systems for the six months ended June 30, 2011 were $11.93 million while our net sales for the same period of 2010 were $32.66 million, a decrease of $20.74 million. The decrease was primarily due to the completion and sale of the 3rd 9MW capacity power station of Erdos Phase II project through sales-type leasing arrangements and $0.59 million from contingent rental income in the six months ended June 30, 2011; in comparison, net sales for the same period in fiscal year 2010 reflected (i) the completion and sale of the second 9MW capacity power station of Erdos Phase I project through sales-type lease in the first quarter of 2010, which included two 9MW units, the first 9MW capacity power station was completed and sold in December of 2009; (ii) the completion of transformation and sale of Pucheng Biomass Power Generation System; and (iii) contingent rental income of $0.74 million from actual usage of the electricity in addition to the minimum lease payments from our Shengwei Group - Tongchuan Project, Erdos Project and Shenmu Project. For the sales-type lease, sales and cost of sales are recorded at the time of leases; the interest income from the sales-type leases is our other major revenue source in addition to sales revenue.

 

COST OF SALES. Cost of sales for the six months ended June 30, 2011 was $8.52 million while our cost of sales for the comparable period of 2010 was $24.60 million, a decrease of $16.08 million. The 3rd 9MW capacity power station of Erdos Phase II project was the only system completed and sold during the six months ended June 30, 2011,, compared to the same period of 2010 when cost of sales consisted of the second 9MW capacity power station of Erdos Phase I project and Pucheng biomass power generation system.

 

GROSS PROFIT. Gross profit was $3.4 million for the six months ended June 30, 2011 compared to $8.06 million for the same period of 2010, a  gross margin of 29% and 25% for the comparable period of 2011 and 2010, respectively.

 

INTEREST INCOME ON SALES TYPE LEASES. Interest income on sales-type leases for the six months ended June 30, 2011 was $10.63 million, a $4.21 million increase from $6.42 million for the comparable period of 2010.  During the six months ended June 30, 2011, the interest income was derived from twelve systems:  two TRT systems, two CHPG systems, one WGPG system, two waste heat power generating systems associated with our Erdos Phase I project and two systems of Erdos Phase II project, the Pucheng biomass power generation system and Zhongbao WHPG system, and the 3rd 9MW waste heat power generating system of Erdos Phase II project. During the six months ended June 30, 2010, interest income was generated from seven systems: two TRT systems, two CHPG systems, one WGPG system, and two waste heat power generating systems associated with our Erdos Phase I project.

 

OPERATING EXPENSES. Operating expenses consisted of selling, general and administrative expenses totaling $3.45 million for the six months ended June 30, 2011 as compared to $2.75 million for the same period of 2010, an increase of $0.7 million or 25%. The increase was due to proportional increases in our payroll, welfare, business trip and marketing expenses as a result of continuous expansion of our business; in addition, we recorded $1.45 million compensation expense for stock options during the six months ended June 30, 2011, compared to $1.41 million for the same period of 2010.

 

NON-OPERATING INCOME (EXPENSES). Non-operating expenses consisted of non sales-type lease interest income, interest expense, bank charges and some miscellaneous expenses. For the six months ended June 30, 2011, net non-operating income was $3,565,812 as compared to net non-operating expense of $419,522 for the comparable period of 2010. In the six months ended June 30, 2011, we had $1.32 million interest expense on loans and $3.34 million interest expense arising from the beneficial conversion feature of the convertible note from Carlyle and China Cinda, but offset by $6.13 million from changes in fair value of conversion feature liability of the convertible note from China Cinda, and $3.03 million from changes in fair value of the liability for shares to be issued to Dong; while in the same period of 2010, the interest expense was $1 million arising from the beneficial conversion feature for the convertible note, and the income from changes in fair value of the liability for shares to be issued to Dong was $0.75 million.

 

INCOME TAX EXPENSE. Income tax expense was $2.18 million for the six months ended June 30, 2011, a decrease of $0.72 million from $2.9 million for the comparable period of 2010. The decrease was mainly due to non taxable interest income related to conversion feature liability and changes in fair value of the shares to Dong, but partially offset by non taxable interest expense. The consolidated effective income tax rate for the six months ended June 30, 2011 and 2010 was 15.4% and 25.6%, respectively. The change in the consolidated effective tax rate was mainly due to tax rate change for future deferred tax items, effective tax holiday, valuation allowance on NOL, and permanent non-tax deductible interest expense resulting from amortization of a beneficial conversion feature for a convertible note, but offset with non-taxable income from changes in fair value of conversion feature liability and changes in fair value to the liability for shares to be issued to Dong, which accounted for net of (0.3)% of pretax income for the six months ended June 30, 2011 compared to 0.4% for the same period of 2010; non-tax deductible expenses were added back to taxable income for US income tax return purposes and non-taxable income were subtracted from taxable income. The income tax rate for Shanghai TCH was 24% and 22% for 2011 and 2010, respectively. Xi’an TCH’s effective income tax rate for 2011 and 2010 is 15% as a result of its high tech enterprise status that was approved by the taxing authority. Xingtai Huaxin’s effective income tax rate for 2011 and 2010 is 25%.  Huahong, Erdos TCH and Shengda’s effective income tax rate for 2011 is 25%.

 

 

NET INCOME. Our net income for the six months ended June 30, 2011 was $11.29 million compared to $7.93 million for the same period of 2010, an increase of $3.36 million. This increase in net income was mainly due to the increased interest income from lease payments for energy saving systems, and the income from changes in fair value of the liability for shares to be issued to Dong, compared with the same period of 2010.

 

Liquidity and Capital Resources

 

Comparison of Six Months Ended June 30June 30, 2011 and 2010

 

As of June 30, 2011, the Company had cash and cash equivalents of $10.56 million, other current assets were $12.52 million and current liabilities were $23.92 million.  Working capital was a negative $0.84 million. The debt-to-equity ratio was 0.64:1 at June 30, 2011.

 

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, 2011 and 2010:

 

		2011				2010
Cash provided by (used in):
Operating Activities		$	(10,858,761	)		$	(14,399,702	)
Investing Activities			2,174,462				(332,200	)
Financing Activities			7,890,419				18,688,594

 

Net cash used in operating activities was $10,858,761 during the six months ended June 30, 2011, as compared to $14,399,702 used in the comparable period of 2010. The decrease in net cash outflow was mainly from the sale of our third 9MW recycling waste heat power generation system of the Erdos Phase II project through sales-type lease for $11.34 million. This project commenced construction in 2010 and was completed in the first quarter of 2011, which resulted in cash inflow of $7.07 million from construction in progress in 2011, but was offset by payments of $12.23 million for construction related to the Shannxi Datong Coal Group Power Generation Projects and $1.72 million for the ShenQiu YuNeng Thermal Power Generation project. The construction was considered an operating activity due to the similar nature of producing inventory for sale. Cash received from collection of principal on sales type leases was $3.29 million in the six months ended June 30, 2011 compared with $1.59 million in the same period of 2010, an increase of $1.7 million.

 

Net cash provided by investing activities was $2.17 million in the six months ended June 30, 2011, compared to $0.33 million used in the comparable period of 2010. The increase of net cash provided by investing activities was mainly due to the release of restricted cash of $2.18 million from the bank which we previously deposited in the bank as collateral for the bank acceptances. In the same period of 2010 we deposited into bank $0.20 million as restricted cash and purchased equipment for $0.13 million.

 

Net cash provided by financing activities was $7.89 million for the six months ended June 30, 2011 compared to net cash provided by financing activities of $18.69 million for the comparable period in 2010. The cash inflow in the six months ended June 30, 2011 included $7.58 million in proceeds from convertible notes from China Cinda, $4.1 million in proceeds from a bank loan, offset by repayment on notes payable (bank acceptances) of $2.90 million and repayment of bank loan for $0.92 million.

 

On June 29, 2010, Xi’an TCH entered into a Biomass Power Generation Asset Transfer Agreement (the “Transfer Agreement”) with Dong, a natural person with Chinese citizenship.  Under the Transfer Agreement, Dong transferred the Biomass Systems to Xi’an TCH, and Xi’an TCH will pay Dong RMB 100,000,000 ($14,705,900) for the systems, including RMB 20,000,000 in cash and RMB 80,000,000 with equivalent shares of the Company’s common stock. The stock price will be the same price as the Company’s public offering price in the first public offering which occurs in 2010 or 2011 but in no circumstance less than $4 per share.  The exchange rate between U.S. Dollar and Chinese RMB in connection with the stock issuance is 1:6.8.  As of June 30, 2011, the Company recorded shares to be issued of $5.94 million (the fair value at June 30, 2011) in connection with this transaction, although the shares have not yet been issued.

 

We believe we have sufficient cash to continue our current business through 2011 due to stable recurring receipts from  sales-type leases in place. As of June 30, 2011, we have two TRT systems, two CHPG systems, one WGPG system, five recycling waste heat power generating systems from the Erdos projects, one BMPG and one WHPG of Zhongbao, currently generating net cash inflow. In addition, we have access to bank loans in case of an immediate need for working capital. We believe we have sufficient cash resources to cover our anticipated capital expenditures in 2011.

 

 

On May 25, 2011, the Company filed a Registration Statement on Form S-3 with the SEC to register an indeterminate number of shares of common stock with an aggregate initial offering price not to exceed $200,000,000. The registration statement has not gone effective, and the Company has not yet determined the size or timing of any potential future offering. We intend to use the net proceeds we receive from the sale of the shares of our common stock that may be offered for general corporate purposes, which may include, among other things, repayment of debt, repurchases of common stock, capital expenditures, the financing of possible acquisitions or business expansions, increasing our working capital and the financing of ongoing operating expenses and overhead.

 

We do not believe inflation has had a significant negative impact on our results of operations during 2011.

 

Off-Balance Sheet Arrangements

 

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

 

Contractual Obligations

 

Convertible Notes Payable - Carlyle

 

On April 29, 2008, we issued and sold to Carlyle Asia Growth Partners III, L.P. (“CAGP”) and CAGP III Co. Investment, L.P. (together with CAGP, the “Investors”) a 5% Secured Convertible Promissory Note in the principal amount of $5,000,000.  The terms for the note were amended and restated on April 29, 2009.

 

This note bore interest at 5% and matured on April 29, 2011. The principal amount of the note, together with any interest thereon, was convertible, at the option of the holders at any time on or after March 16, 2010 and prior to maturity, into shares of the Company’s common stock at an initial conversion price tied to the after-tax net profits of the Company for the fiscal year ending December 31, 2009.  The obligation of the Company under this note is ranked senior to all other debt of the Company. The note is secured by a security interest granted to the investors pursuant to a share pledge agreement.  This pledge was released during the six months ended June 30, 2011 and is of no further force or effect.

 

In June 2011, the Investors converted the note into 4,334,192 shares of the Company’s common stock at a conversion price of $1.154 per share. The effective date of the conversion was April 29, 2011. As of June 30, 2011, the interest accrued on the second note was fully paid, and the 4,334,192 shares of common stock were recorded as shares to be issued in the accompanying financial statements, since such shares were not issued as of June 30, 2010. As disclosed on a Form 8-K filed July 22, 2011, the Company issued 4,334,192 shares of common stock to the Investors on July 21, 2011 (4,149,599 shares of common stock to CAGP; 184,593 shares of common stock to CAGP III Co. Investment, L.P.).  The unamortized portion BCF of $745,547 was fully amortized as of the conversion date. During the six months ended June 30, 2011, the Company amortized $1,368,988 BCF for the note.

 

On April 29, 2009, we issued an 8% Secured Convertible Promissory Note of $3 million to Carlyle Asia Growth Partners III, L.P. with a maturity date of April 29, 2012. The note holder has the right to convert all or any part of the aggregate outstanding principal amount of this note, together with interest, if any, into shares of our common stock, at any time on or after March 16, 2010 and prior to the maturity date (or such later date on which this note is paid in full), at a conversion price per share of common stock equal to $0.80, and this note was convertible in full into 3,750,000 shares of our common stock as of June 30, 2011. These conversion shares rank pari-passu with those issuable under the 5% Secured Convertible Promissory Note

 

Loan Payable – Collective Capital Trust Plan

 

On December 3, 2009, Beijing International Trust Co., Ltd. (“Beijing Trust”) formed a Low Carbon Fortune-Energy Recycling No. 1 Collective Capital Trust Plan (“Plan”), pursuant to the Capital Trust Loan Agreement entered into by Erdos TCH Energy Saving Development Co., Ltd and Beijing Trust dated November 19, 2009. Under the Plan, Beijing Trust raised RMB 181,880,000 ($26.75 million) through the sale of 181,880,000 total trust units at RMB 1 per unit. All amounts raised under the Plan are loaned to Erdos TCH in connection with the construction and operation of Phases II and III of the Erdos Power Generation Projects. These projects, when completed, will recycle waste heat from Erdos Metallurgy’s metal refining plants to generate electric power and steam, which will then be sold back to Erdos Metallurgy.

 

 

The Plan included 145,500,000 category A preferred trust units ($21.4 million), consisting of 12,450,000 category A1 preferred trust units ($1.8 million), 15,000,000 category A2 preferred trust units ($2.2 million), 118,050,000 category A3 preferred trust units ($17.4 million); and 36,380,000 category B secondary trust units ($5.35 million), consisting of 9,100,000 category B1 secondary trust units ($1.34 million) and 27,280,000 category B2 secondary trust units ($4.01 million). The B1 units were purchased by members of management of Erdos TCH and the B2 units were purchased by Xi’an TCH. Under the Agreement, the annual base interest rate is 9.94% for A1 preferred trust fund units with a term of two years, 11% for A2 preferred trust fund units with a term of three years, 12.05% for A3 preferred trust fund units and 8.35% for the category B secondary trust fund units, each with a term of four years.

 

Erdos TCH gave a lien on its equipment, assets and accounts receivable to guarantee the loans under the Agreement. Xi’an TCH and Mr. Guohua Ku, our CEO, also gave unconditional and irrevocable joint liability guarantees to Beijing Trust for Erdos TCH’s performance under the Agreement. Erdos (the minority stockholder and customer of Erdos TCH) provided a commitment letter on minimum power purchase from Erdos TCH.

 

On December 18, 2009, an additional RMB 25,000,000 ($3.68 million) was raised by Beijing Trust to support the Company’s Erdos Power Generation Projects. Beijing Trust sold 25,000,000 trust units at RMB 1 per unit which included 20,000,000 category A1 preferred trust units ($ 2.94 million) and 5,000,000 category B2 secondary trust units ($ 0.74 million). The B2 units were purchased by Xi’an TCH.

 

During December 2009, the Company sold aggregate 206,880,000 units for RMB 206,880,000 ($30.30 million), of which 9,100,000 units ($1.33 million) were purchased by the management of Erdos TCH; 32,280,000 units ($4.73 million) were purchased by Xi’an TCH; the amount of $4.73 million was considered as investment by Xi’an TCH into Erdos TCH and, accordingly, was eliminated in the Company’s consolidated financial statements.

 

On April 15, 2010, Beijing Trust completed the second expansion of the Plan. The second expansion of the Plan raised RMB 93,120,000 ($13.69 million) through the sale of 93,120,000 trust units at RMB 1 per unit.  All amounts raised under the Second Expansion of the Plan are to be loaned to Erdos TCH.  The second expansion of the Plan includes 2,800,000 category A1 preferred trust units ($0.41 million), 5,000,000 category A2 preferred trust units ($0.73 million), 66,700,000 category A3 preferred trust units ($9.81 million) and 4,650,000 category B1 preferred trust units ($0.68 million) and 13,970,000 category B2 secondary trust units ($2.05 million).  The B1 units were purchased by members of management of Erdos TCH and the B2 units have been purchased by Xi’an TCH.  With the completion of the second expansion of the Plan, the Low Carbon Fortune-Energy Recycling No. 1 Collective Capital Trust Plan has reached RMB 300,000,000 ($44.12 million) and completed its entire trust plan fund raising work.  The net long term loan payable under this trust plan was RMB 252,150,000 ($38.5 million) at June 30, 2011.  Interest expense accrued on this trust loan was $2.53 million and $4.5 million at June 30, 2011 and December 31, 2010, respectively.

 

In addition to the above, under the Loan Agreement, Erdos TCH must pay a management incentive benefit to Beijing Trust upon maturity of the category A3 and category B trust units in December 2013 if the ratio of Erdos TCH’s profit to its registered capital exceeds a base amount. If this criterion is met, the amount of the management incentive benefit is calculated based on a formula tied to Erdos TCH’s net profit and the average registered capital for the 2012 fiscal year. Under this formula the management incentive benefit could range between 0% and 100% of the net profit of Erdos TCH in the 2012 fiscal year.

 

The management incentive benefit was structured to provide an incentive to management to make the joint venture profitable. Under the Plan, Beijing Trust will distribute the entire amount of the management incentive benefit it receives to the holders of the category B trust units. As previously disclosed, the holders of the category B trust units are the management of Erdos TCH and Xi’an TCH. Category B trust units receive a lower base interest rate than the category A trust units but the economic return to the holders of category B trust units will be enhanced by any management incentive benefit.

 

Erdos TCH also agrees to share the benefits from the Clean Development Mechanism ("CDM") under the Kyoto Protocol equally with Beijing Trust during the term of the loan. Any benefit received from the CDM will be paid to Erdos Metallurgy first. Under the agreement with Xi’an TCH, Erdos Metallurgy agrees to deliver to Xi’an TCH 50% of the benefit Erdos Metallurgy receives. Xi’an TCH agrees to share 50% of the benefit it receives from Erdos Metallurgy with Erdos TCH. Under the Capital Trust Loan Agreement between Erdos TCH and Beijing Trust, Erdos TCH agrees that 50% of any benefit it receives will be delivered to Beijing Trust. Pursuant to the Plan, Beijing Trust will distribute 70% of the CDM benefit it receives to the holders of the category B trust units. The receipt of any CDM benefit is subject to a process of evaluation and certification of the project by the CDM Executive Board and is under the guidance of the Conference of the Parties of the United Nations Framework Convention on Climate Change. The first stages of the certification process have been completed successfully.

 

 

Bank Long Term Loan

 

The Company entered a loan agreement with Industrial Bank Co., Ltd., Xi’an Branch (the “Lender”) for a loan designed for energy saving and emission reduction projects, whereby the Lender agreed to loan RMB 30,000,000 ($4,635,639) to Xi’an TCH for three years from April 6, 2010 to April 6, 2013. The proceeds of the loan are required to be used in payment for equipment for Xi’an TCH’s energy saving and emission reduction projects. The Loan Agreement has a floating interest rate that resets at the beginning of each quarter at 110% of the national base interest rate for the same term and same level loan (currently 7.015%).  Under the loan, Xi’an TCH is required to make quarterly interest payments and, beginning six months after the date of the release of the funds, to make minimum quarterly principal payments of RMB 3,000,000 ($463,564) each quarter. The Loan Agreement contains standard representations, warranties and covenants, and the loan is guaranteed by Xi’an TCH, Shaanxi Shengwei Construction Material Group and Mr. Guohua Ku. At June 30, 2011, $927,128 of the principal was repaid and $1,854,256 will be repaid within one year which was classified as a current liability.

 

The Company entered another loan agreement with the same Industrial Bank for energy saving and emission reduction projects, whereby the Lender agreed to loan RMB 30,000,000 ($4,635,639) to Xi’an TCH for three years from March 31, 2011 to March 30, 2014. As of June 30, 2011, the Company received RMB 27,000,000 ($4,172,075) of the loan. The proceeds of the loan are required to be used in payment for construction and equipment purchase for Xi’an TCH’s energy saving and emission reduction projects. The Loan Agreement has a floating interest rate that resets at the beginning of each quarter at 115% of the national base interest rate for the same term and same level loan (currently 7.015%).  Under the loan, Xi’an TCH is required to make quarterly interest payments and, beginning six months after the date of the release of the funds, to make minimum quarterly principal payments of RMB 3,000,000 ($463,564) each quarter. The Loan Agreement contains standard representations, warranties and covenants, and the loan is guaranteed by Xi’an TCH, Mr. Guohua Ku and Ms Chaoying Zhang. At June 30, 2011, $463,564 of the principal was repaid and $1,854,256 will be repaid within one year which was classified as current liability.

 

Convertible note agreement with China Cinda

 

On August 18, 2010, the Company and its wholly-owned subsidiaries Sifang, Shanghai TCH and Xi’an TCH entered into a Notes Purchase Agreement (the “Note Agreement”) with China Cinda (HK) Asset Management Co., Ltd, a company organized under the laws of the Hong Kong Special Administrative Region of China (“Cinda”).  Under the terms of the Note Agreement, the Company will issue to Cinda two tranches of convertible notes (the “Notes”), each having a principal amount equal to the US Dollar equivalent of RMB 50 million ($7.8 million). Also on August 18, 2010, Xi’an TCH and China Jingu International Trust Co. Ltd. (“Jingu”), an affiliate of Cinda entered into a Capital Trust Loan Agreement (“Trust Loan Agreement”), in which Jingu will raise 100 million RMB ($15.5 million) under a Jingu CREG Recycling Economy No. 1 Collective Fund Trust Plan (“Trust Plan”) and lend such amount under the Trust Plan to Xi’an TCH (the “Loans”).  If the Loans under the Trust Loan Agreement do not occur, then under the Note Agreement the principal amount of the Notes to be issued in each tranche will be the US dollar equivalent of RMB 100 million ($15.5 million). All proceeds from the Notes and the Loans will be used to complete Phases IV and V of the Erdos TCH Energy Saving Development Co., Ltd. (“Erdos TCH”) project, a joint venture between Xi’an TCH and Erdos Metallurgy Co., Ltd. to recycle waste heat from Erdos Metallurgy’s refining plants to generate power and steam and sell them back to Erdos Metallurgy, as well as other working capital needs.

 

The term of the Loans is for three years from the date of the first draw.  The interest rate for the Loans is the People’s Bank of China’s (“PBOC”) three year loan base interest rate plus two percent (2%).  If the Loans are not fully exchanged for shares of the Common Stock of the Company as described below prior to maturity, Xi’an TCH will pay the difference between the interest rate described above and 18% on the outstanding amount.  Under the Trust Loan Agreement and separate agreements entered by Jingu, Erdos TCH, Shanghai TCH, Xi’an TCH and Mr. Guohua Ku on August 18, 2010, Erdos TCH shall pledge the accounts receivable, equipment and assets of  its Phases IV and V projects to Jingu as a guarantee to the Loans, Xi’an TCH shall pledge its 80% equity in Erdos TCH to Jingu as a guarantee to the Loans, Shanghai TCH shall provide a joint liability guarantee to Jingu for the Loans, and Mr. Guohua Ku shall provide his personal joint liability to Jingu for the Loans.

 

Under the Note Agreement the Notes shall be issued before August 18, 2011.  The Notes have a three year maturity date from the date of the issuance of the first tranche.  The exchange rate between RMB and US Dollar for each issue of Notes is the middle rate published by the PBOC for the second business day prior to each issuance.  Each Note bears interest at a rate equal to that of PBOC base interest rate for the relevant interest period (the period commencing on and including January 1 of each year and ending on and including December 31 of such year) plus two percent (2%).  If Cinda does not convert or fully convert the Notes to shares prior to maturity, the Company will pay the difference between the interest rate described above and 18% on the outstanding amount.

 

 

As collateral for the Notes, Mr. Guohua Ku, the CEO and a major shareholder of the Company, entered into a Share Pledge Agreement with Cinda, on August 18, 2010, to pledge 4,500,000 shares of the Company’s common stock held by him to secure the first Note.  The Agreement also calls for an additional 4,500,000 shares of the Company’s common stock held by Mr. Ku to secure the second Note before its issuance. On December 30, 2010, the Company received proceeds of RMB50, 000,000 ($7,533,391) from the first tranche of the Loans. On January 30, 2011, the Company received proceeds of another RMB 50,000,000 ($7,533,391) from the first tranche convertible Note.

 

Commitments

 

Erdos Phase III of Power Generation Projects

 

In April 2009, Erdos TCH signed a contract with Erdos Metallurgy to recycle heat from groups of furnaces of Erdos Metallurgy’s metal refining plants to generate power and steam, to be sold back to Erdos Metallurgy. According to the contract, Erdos TCH will install a group of power generation projects with a total of 70MW power capacity, which may grow up to 120MW, and 30-ton steam per hour, with an estimated total investment in excess of $76 million (RMB 500 million). The Company split the construction of the projects into three phases, two units of power generation in Phase I with a total of 18MW power capacity, three units in Phase II with a total of 27MW power capacity and one unit in Phase III with 25MW power capacity.  For each phase of the project, the lease term is 20 years starting from the date of completion of the phase.  During the lease term, Erdos TCH will be responsible for operating the projects and charge Erdos Metallurgy for supply of electricity and steam.  Erdos Metallurgy agreed to pay a fixed minimum of $0.22 million (RMB 1.5 million) per month for each 9MW capacity power generation system.

 

During the first quarter of 2010, the Erdos power generation system Phase I project was completed and put into operation.  During the fourth quarter of 2010 and first quarter of 2011, three 9MW power generation systems of Phase II were completed and put into operation. Erdos TCH outsourced to an independent third party the operation and maintenance of the power generation system for $922,000 (RMB 6.27 million) per year for each system.  After 20 years, the systems will be transferred to Erdos without any charge.

 

As of June 30, 2011 the projects of Erdos Phase III are under construction. At June 30, 2011, the Company has paid  $18.19 million for Phase III. The Company expects the completion of Phase III projects no later than the end of 2011.

 

Shannxi Datong Coal Group Power Generation Projects

 

In February 2011, Xi'an TCH signed a contract with Shannxi Datong Coal Group Steel Ltd Co (Shannxi Datong) to recycle gas and steam from groups of blast-furnaces and converter of Shannxi Datong's metal refining plants to generate power. According to the contract, the Company will install two 3MW TRT and one 15MW WGPG and two 1MW steam power generation systems, with a total of 23MW power capacity for an estimated total investment of $27.45 million (RMB 180 million). The lease term is 30 years. During the lease term, Shannxi Datong will be responsible for operating the projects and pay a service fee to the Company. The service fee is based on an average of 8,000 electricity-generating hours per year and RMB 0.33 per kilowatt hour ("Kwh") for the first 5 years from the completion of each power generation station. For each of the leases, at the 6th year, 11th year and 21st year thereafter, the rate will be RMB 0.3 Kwh, 0.27 Kwh and 0.25 Kwh, respectively. After 30 years, the units will be transferred to Shannxi Datong without any charge.

 

On February 28,2011, Xi’an TCH entered into an agreement with Xi’an Huaxin Energy Tech Co., Ltd (the contractor for construction) for Shannxi Datong Coal projects of two 3MW TRT and one 15 MW WGPG systems described above. The project is scheduled to complete in 12 months from construction commencement.

 

ShenQiu Thermal Power Generation Projects

 

On May 25, 2011, Xi’an TCH entered into a Letter of Intent with ShenQiu YuNeng Thermal Power Ltd Co., (“ShenQiu”) for Xi’an TCH to reconstruct and transform a Thermal Power Generation System owned by ShenQiu into a 75T/H Biomass Power Generation Systems for approximately RMB 22.5 million (approximately $3.5 million). The project commenced in June 2011 and will be completed in 90 days. Xi’an TCH will purchase the power station within 10 days of the completion of the transformation.

 

 

Financial Leasing

Financing Agreement — Sale Lease-back transaction.

 

On June 28, 2011, Xi’an TCH, entered into a Financing Agreement (the “Agreement”) with Cinda Financial Leasing Co., Ltd. (the “Cinda Financial”), an affiliate of China Cinda (HK) Asset Management Co., Ltd. (the “Cinda HK”).

 

Under the Agreement, Xi’an TCH transferred its ownership of a set of 7MW steam turbine waste heat power generation system and four furnaces and  ancillary apparatus (the “Assets”) to Cinda Financial for  RMB 42.50 million ($6.64 million), and Cinda Financial in turn leased the Assets to Xi’an TCH for  5 years with an overall leasing fee of RMB 51.54 million ($8.05 million) based upon the transfer cost and the benchmark interest rate for five year loans by People’s Bank of China (“PBOC”) (presently 6.65%) plus 15% of that rate (which at present is 7.6475%).  The interest rate will increase if the five year benchmark interest rate of PBOC increases but will remain the same if the benchmark rate decreases in the future.  Xi’an TCH shall make pro rata quarterly payments to Cinda Financial for the leasing fees. Upon the completion of the leasing term and full payment of all leasing fees and other fees, Xi’an TCH can pay RMB 4,250 ($664) to reacquire the ownership of the Assets.

 

In addition to the leasing fees, Xi’an TCH shall pay a onetime non-refundable leasing service charge of RMB 2,550,000 ($398,438) and a refundable security deposit of RMB 2,125,000 ($332,031) to Cinda Financial.

 

In accordance with ASC 840-10-25-4, since CREG retains substantially all of the benefits and risks relating to the property, this transaction is  a financing and will be recorded as such. The proceeds of this financing were not received prior to June 30, 2011; therefore, this transaction will be recorded in the third quarter of 2011.

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk.

 

Exchange Rate Risk

 

Our operations are conducted mainly in the PRC. As such, our earnings are subject to movements in foreign currency exchange rates when transactions are denominated in RMB, which is our functional currency. Accordingly, our operating results are affected by changes in the exchange rate between the U.S. dollar and those currencies

 

Item 4.

Controls and Procedures.

 

Disclosure Controls and Procedures

 

The Company maintains disclosure controls and procedures which are designed to provide reasonable assurance that information required to be disclosed in the Company’s periodic SEC reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rules 13a – 15(e) and 15d – 15(e) of the Securities Exchange Act of 1934 (“Exchange Act”) at the end of the period covered by the report.

 

Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, at June 30, 2011, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that (i) the information required to be disclosed by us in this Report was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (ii) information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control Over Financial Reporting

 

With the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, the Company also conducted an evaluation of the Company’s internal control over financial reporting to determine whether any changes occurred during the Company’s fiscal quarter ended June 30, 2011, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.  Based on such evaluation, management concluded that, as of the end of the period covered by this report, there have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

PART II - OTHER INFORMATION

 

Item 1.

Legal Proceedings

 

The Company is not currently involved in any material pending legal proceedings.

 

Item 1A.

Risk Factors

 

There have been no material changes in our risk factors from those disclosed in Part I, Item 1A, of our Annual Report on Form 10-K as of and for the year ended December 31, 2010. An investment in our common stock involves various risks. When considering an investment in our company, you should consider carefully all of the risk factors described in our most recent Form 10-K. If any of those risks, incorporated by reference in this Form 10-Q, occur, the market price of our shares of common stock could decline and investors could lose all or part of their investment. These risks and uncertainties are not the only ones facing us and there may be additional matters that we are unaware of or that we currently consider immaterial. All of these could adversely affect our business, financial condition, results of operations and cash flows and, thus, the value of an investment in our company.

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

 

Item 3.

Defaults Upon Senior Securities

 

None.

 

Item 4.

Removed and Reserved.

 

None

 

Item 5.

Other Information

 

None

 

Item 6.

Exhibits

 

Exhibit
Number		Description
31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a).*
31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a).*
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350.*
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.*
101.INS		XBRL Instance Document.**
101.SCH		XBRL Taxonomy Extension Schema Document.**
101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document.**
101.LAB		XBRL Taxonomy Extension Label Linkbase Document.**
101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document.**
101.DEF		XBRL Taxonomy Definitions Linkbase Document.**

 

*

Filed herewith

**

Furnished with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2011

 

 

SIGNATURES

 

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

 

	CHINA RECYCLING ENERGY CORPORATION
	(Registrant)
Date: July 18, 2013	/s/ Guohua Ku
	Guohua Ku
	Chairman of the Board and Chief Executive Officer
Date: July 18, 2013	/s/ David Chong
	David Chong
	Secretary, Principal Financial Officer and Principal Accounting Officer

 

 

EXHIBIT INDEX

 

Exhibit
Number		Description
31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a).*
31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a).*
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350.*
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.*
101.INS		XBRL Instance Document.**
101.SCH		XBRL Taxonomy Extension Schema Document.**
101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document.**
101.LAB		XBRL Taxonomy Extension Label Linkbase Document.**
101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document.**
101.DEF		XBRL Taxonomy Definitions Linkbase Document.**

 

*

Filed herewith

**

Furnished with the Company’s Quarterly Report on Form 10-Q/A for the fiscal quarter ended June 30, 2011