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

FORM 10-Q
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 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 Number: 000-53283

CHINA ENERGY RECOVERY, INC.
(Exact Name of Registrant as Specified in Its Charter)

Delaware
 
90-0459730
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification No.)

Building#26, No. 1388 Zhangdong Road,
   
Zhangjiang Hi-tech Park
   
Shanghai, China
 
201203
(Address of Principal Executive Offices)
 
(Zip Code)
 
+86 (0)21 2028-1866
(Registrant's Telephone Number, Including Area Code)
 
 
(Former Address)
 
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 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. (Check one):
 
Large accelerated filer
¨
Accelerated filer
¨
Non-accelerated filer
¨
Smaller reporting company  
x
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant 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 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 shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨    No x

Number of shares outstanding of the registrant's common stock as of October 31, 2011:
31,085,859 shares of Common Stock, $0.001 par value per share
 
 
 

 

TABLE OF CONTENTS

     
Page
Part I
 
Financial Information
  3
       
 
Item 1.
Unaudited Consolidated Financial Statements
3
       
   
Consolidated Balance Sheets as of December 31, 2010 and September 30, 2011
3
       
   
Consolidated Statements of Operations and Other Comprehensive Income (Loss) for the Three Months and Nine Months Ended September 30, 2010 and 2011
4
       
   
Consolidated Statements of Shareholders' Equity for the Year ended December 31, 2010 and Nine Months Ended September 30, 2011
5
       
   
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2011
6
       
   
Notes to the Consolidated Financial Statements
7
       
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
39
       
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
56
       
 
Item 4.
Controls and Procedures
56
       
Part II
 
Other Information
  57
       
 
Item 1.
Legal Proceedings
57
       
 
Item 1A.
Risk Factors
57
       
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
57
       
 
Item 3.
Defaults Upon Senior Securities
57
       
 
Item 4.
[Reserved]
57
       
 
Item 5.
Other Information
57
       
 
Item 6.
Exhibits
58

 
2

 

PART I
FINANCIAL INFORMATION

Item 1. Unaudited Consolidated Financial Statements
 
CHINA ENERGY RECOVERY, INC.  AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2010 AND SEPTEMBER 30, 2011
(UNAUDITED)
 
   
December 31,
   
September 30,
 
   
2010
   
2011
 
             
ASSETS
           
             
CURRENT ASSETS:
           
Cash
  $ 2,996,076     $ 6,802,619  
Restricted cash
    218,346       115,502  
Notes receivable
    1,341,359       1,554,467  
Accounts receivable, net of allowance for doubtful accounts - third parties
    7,059,935       7,658,742  
Accounts receivable -  related parties
    -       7,063,336  
Inventories
    8,661,800       13,861,479  
Other current assets and receivables
    1,185,032       502,829  
Deferred financing costs
    215,623       -  
Advances on purchases
    15,200,669       33,340,855  
Total current assets
    36,878,840       70,899,829  
                 
NON-CURRENT ASSETS:
               
Property, plant, and equipment, net
    10,101,755       26,240,267  
Deferred tax assets
    171,776       308,577  
Intangible assets
    2,477,959       4,982,462  
Long-term accounts receivable
    4,679,121       -  
Total non-current assets
    17,430,611       31,531,306  
Total assets
  $ 54,309,451     $ 102,431,135  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
                 
CURRENT LIABILITIES:
               
Accounts payable
  $ 4,557,848     $ 19,094,802  
Accrued expenses and other liabilities
    1,912,544       4,786,477  
Advances from customers-third parties
    27,530,065       50,596,455  
Taxes payable
    1,631,507       396,229  
Short-term bank loans
    4,333,700       11,875,453  
Short-term loans
    -       7,123,016  
Derivative liability, current
    374,846       26,825  
Long-term loan - current maturity
    3,177,973       543,778  
Total current liabilities
    43,518,483       94,443,035  
                 
NON-CURRENT LIABILITIES:
               
Warrant liability
    1,332,760       153,091  
Derivative liability, non-current
    48,461       -  
Convertible note
    4,691,582       -  
Long-term loan
    543,778       -  
Total  non-current liabilities
    6,616,581       153,091  
Total  liabilities
    50,135,064       94,596,126  
                 
SHAREHOLDERS' EQUITY:
               
Preferred stock ($0.001 par value; 50,000,000 shares authorized, 200,000 shares issued and outstanding as of both December 31, 2010 and September 30,  2011)
    189       189  
Common stock ($0.001 par value; 100,000,000  shares authorized, 30,906,266 and  31,085,859 shares issued and outstanding as of December 31, 2010 and September 30, 2011, respectively)
    30,906       31,085  
Additional paid-in-capital
    8,313,385       8,751,170  
Accumulated deficit
    (4,713,541 )     (1,428,142 )
Statutory reserves
    132,802       132,802  
Accumulated other comprehensive income
    410,646       347,905  
Total shareholders' equity
    4,174,387       7,835,009  
Total liabilities and shareholders' equity
  $ 54,309,451     $ 102,431,135  
 
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 
3

 

CHINA ENERGY RECOVERY, INC.  AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (LOSS)
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2011
(UNAUDITED)

   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2011
   
2010
   
2011
 
                         
REVENUES
                       
Third parties
  $ 6,147,651     $ 18,823,066     $ 17,447,570     $ 31,404,912  
Related  party
    -       10,563,392       -       23,631,431  
Total revenue
    6,147,651       29,386,458       17,447,570       55,036,343  
                                 
COST OF REVENUES
    (4,752,909 )     (24,298,399 )     (14,444,768 )     (45,567,195 )
                                 
GROSS PROFIT
    1,394,742       5,088,059       3,002,802       9,469,148  
                                 
SELLING, GENERAL & ADMINISTRATIVE EXPENSES
    (1,588,818 )     (2,490,222 )     (4,095,102 )     (6,366,370 )
                                 
(LOSS)/INCOME FROM  OPERATIONS
    (194,076 )     2,597,837       (1,092,300 )     3,102,778  
                                 
OTHER (EXPENSE)/INCOME, NET:
                               
Change in fair value of warrants
    (97,281 )     248,332       980,617       1,164,122  
Change in fair value of derivative liabilities
    28,920       72,764       847,825       396,482  
Non-operating income, net
    30,424       765,461       1,001,780       755,525  
Interest expenses, net
    (477,239 )     (370,400 )     (1,786,380 )     (1,345,664 )
Total other (expense)/income, net
    (515,176 )     716,157       1,043,842       970,465  
                                 
(LOSS)/INCOME BEFORE INCOME TAXES
    (709,252 )     3,313,994       (48,458 )     4,073,243  
                                 
PROVISION FOR INCOME TAXES
    (144,497 )     (709,391 )     (345,647 )     (787,844 )
                                 
NET (LOSS)/INCOME
    (853,749 )     2,604,603       (394,105 )     3,285,399  
                                 
OTHER COMPREHENSIVE INCOME/(LOSS)
                               
Foreign currency translation adjustment
    292,890       23,868       320,890       (62,741 )
                                 
COMPREHENSIVE (LOSS)/INCOME
  $ (560,859 )   $ 2,628,471     $ (73,215 )   $ 3,222,658  
(LOSS)/EARNINGS PER SHARE:
                               
Basic
  $ (0.03 )   $ 0.08     $ (0.01 )   $ 0.11  
Diluted
  $ (0.03 )   $ 0.08     $ (0.01 )   $ 0.11  
WEIGHTED AVERAGE SHARES OUTSTANDING:
                               
Basic
    30,883,916       31,085,859       30,834,537       31,015,385  
Diluted
    30,883,916       31,102,815       30,834,537       31,032,341  

The accompanying notes are an integral part of these unaudited consolidated financial statements.
 
 
4

 

CHINA ENERGY RECOVERY, INC.  AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(UNAUDITED)

    
Preferred Stock
   
Common stock
   
Additional
paid-in
   
Statutory
   
Accumulated
   
Accumulated
other
comprehensive
       
   
Shares
   
Amount
   
Shares
   
Amount
   
Capital
   
reserves
   
deficit
   
income/(loss)
   
Total
 
 
                                                     
BALANCE at January 1, 2010
    662,963     $ 626       30,638,720     $ 30,639     $ 8,163,224     $ 132,802     $ (1,194,158 )   $ (77,485 )   $ 7,055,648  
                                                                         
Conversion of preferred stock
    (462,963 )     (437 )     245,098       245       192       -       -       -       -  
Stock based compensation
    -       -       -       -       141,012       -       -       -       141,012  
Restricted common stock issued related to long-term loan
    -       -       22,448       22       8,957       -       -       -       8,979  
Net loss
    -       -       -       -       -       -       (3,519,383 )     -       (3,519,383 )
Foreign currency translation gain
    -       -       -       -       -       -       -       488,131       488,131  
 
                                                                       
BALANCE at December 31, 2010
    200,000       189       30,906,266       30,906       8,313,385       132,802       (4,713,541 )     410,646       4,174,387  
                                                                         
Common stock for consulting services
    -       -       50,385       50       40,258       -       -       -       40,308  
Restricted common stock issued related to long-term loan
    -       -       129,208       129       144,369       -       -       -       144,498  
Stock based compensation
    -       -       -       -       253,158       -       -       -       253,158  
Net income
    -       -       -       -       -       -       3,285,399       -       3,285,399  
Foreign currency translation loss
    -       -       -       -       -       -       -       (62,741 )     (62,741 )
 
                                                                       
BALANCE at September 30, 2011
    200,000     $ 189       31,085,859     $ 31,085     $ 8,751,170     $ 132,802     $ (1,428,142 )   $ 347,905     $ 7,835,009  

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

 
5

 

CHINA ENERGY RECOVERY, INC.  AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2011
(UNAUDITED)

   
Nine months ended September 30,
 
   
2010
   
2011
 
             
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net (Loss)/Income
  $ (394,105 )   $ 3,285,399  
Adjustments to reconcile net (loss)/income to net cash provided by operating activities:
               
Depreciation and amortization
    242,627       1,014,085  
Loss on disposal of PP&E
    -       52,732  
Recoveries of doubtful accounts credited to income
    (68,049 )     (37,624 )
Provision for inventories
    -       26,621  
Stock based compensation
    105,759       253,158  
Common stock issued for consulting services
    -       40,308  
Restricted common stock issued to settle exchange rate loss related to long-term loan
    -       144,498  
Accretion of interest on long-term loan
    33,980       81,870  
Amortization of deferred financing costs
    600,396       215,623  
Accretion of convertible notes
    697,253       116,714  
Capitalized interest expenses
    (114,329 )     (6,829 )
Cancellation of warrants
    -       (15,547 )
Change in fair value of warrants
    (980,617 )     (1,164,122 )
Change in fair value of derivative liabilities
    (847,825 )     (396,482 )
Deferred tax expense
    55,356       (136,801 )
Changes in operating assets and liabilities:
               
Notes receivable
    411,049       (213,108 )
Accounts receivable
    (1,317,802 )     (7,650,058 )
Inventories
    541,360       (5,230,423 )
Other receivables
    7,937       682,203  
Advances on purchases
    (2,821,431 )     (21,062,854 )
Long term accounts receivable - retainage
    1,725,146       4,679,121  
Accounts payable
    (453,572 )     9,344,972  
Other payables and accrued liabilities
    334,885       (902,707 )
Advances from customers – third parties
    2,633,332       23,066,390  
Taxes payable
    (647,792 )     (1,235,278 )
Effects of exchange rate changes on operations
    285,942       84,918  
Net cash provided by operating activities
    29,500       5,036,779  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Purchases of property, plant, and equipment
    (5,361,821 )     (9,011,203 )
Purchases of intangible assets
    (38,958 )     (2,465,073 )
Restricted cash
    -       112,040  
Proceeds from disposal of property, plant, and equipment
    -       24,863  
Net cash used in investing activities
    (5,400,779 )     (11,339,373 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Repayment of long term loans
    (360,823 )     (3,259,843 )
Cash proceeds from long term loans
    5,003,778       -  
Cash proceeds from short term loans
            2,314,720  
Cash proceeds from letter of credit
            3,304,560  
Cash proceeds from short term bank loans
    -       8,857,930  
Principal payments on short term bank loans
    (880,200 )     (1,162,700 )
Net cash provided by financing activities
    3,762,755       10,054,667  
                 
EFFECTS OF EXCHANGE RATE CHANGES ON CASH
    2,460       54,470  
                 
(DECREASE)/INCREASE IN CASH
    (1,606,064 )     3,806,543  
                 
CASH, beginning of period
  $ 2,386,573     $ 2,996,076  
                 
CASH, end of period
  $ 780,509     $ 6,802,619  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
               
Cash paid during the period for income taxes
  $ 53,446     $ 506,692  
Cash paid during the period for interest
  $ 451,303     $ 1,123,589  
                 
Supplemental schedule of non-cash investing and financing activities:
               
              -  
Accounts payable relating to purchase of plant and equipments
  $ 91,025     $ 5,191,982  
Common stock issued for consulting services
  $ -     $ 40,308  
Common stock issued related to long-term loan
  $ -     $ 144,498  

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

 
6

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Note 1 – Organization

China Energy Recovery, Inc. ("CER" or the "Company"), formerly known as MMA Media Inc. and Commerce Development Corporation Ltd., was incorporated under the laws of the State of Maryland in May, 1998. On February 5, 2008, the Company changed its name to China Energy Recovery, Inc. On January 24, 2008, the Company entered into a Share Exchange Agreement with Poise Profit International, Ltd. ("Poise Profit"), a company incorporated on November 23, 2007, under the laws of the British Virgin Islands, and the shareholders of Poise Profit. The share exchange transaction (the "Share Exchange") was consummated on April 15, 2008 and Poise Profit became a wholly-owned subsidiary of the Company. On April 16, 2008, the Company conducted a 1-for-2 reverse stock split pursuant to which each two shares of CER's common stock, issued and outstanding on the record date of April 15, 2008, converted into one share of CER's common stock. Pursuant to the Share Exchange Agreement, the Company agreed to acquire all of the issued and outstanding shares of Poise Profit's common stock in exchange for the issuance of 20,757,090 shares, or 81.5% of the Company's common stock on a post 1-for-2 reverse stock split basis, to the shareholders of Poise Profit.

Poise Profit is an off-shore holding company and has no operating business activities. Poise Profit owns 100% of HAIE Hi-tech Engineering (Hong Kong) Company, Limited ("Hi-tech") and CER (Hong Kong) Holdings Limited (“CER Hong Kong”), which were incorporated in Hong Kong on January 4, 2002 and August 13, 2008, respectively.

Effective on January 1, 2006, Hi-tech executed a series of contractual arrangements with Shanghai Hai Lu Kun Lun Hi-tech Engineering Co., Ltd ("Shanghai Engineering"), established in Shanghai in July 1999, and its shareholders, including a Consulting Services Agreement and an Operating Agreement, through which Hi-tech has the right to advise, consult, manage and operate Shanghai Engineering, and collect and own all of its net profits. Additionally, Shanghai Engineering's shareholders have assigned their voting rights over Shanghai Engineering to Hi-tech. In order to further reinforce Hi-tech's rights to control and operate Shanghai Engineering, Shanghai Engineering and its shareholders have granted Hi-tech the exclusive right and option to acquire all of their equity interests in Shanghai Engineering. Further, Shanghai Engineering shareholders have pledged all of their rights, titles and interests in Shanghai Engineering to Hi-tech.
 
Effective on May 23, 2007, Hi-tech executed a series of contractual arrangements with Shanghai Xin Ye Environmental Protection Engineering Technology Co., Ltd ("Shanghai Environmental"), incorporated in Shanghai in May, 2007 and Mr. Qinghuan Wu, the Company’s Chief Executive Officer, Shanghai Environmental’s sole shareholder, including a Consulting Services Agreement and an Operating Agreement, through which Hi-tech has the right to advise, consult, manage and operate Shanghai Environmental, and collect and own all of its net profits. Additionally, Mr. Wu assigned his voting rights over Shanghai Environmental to Hi-tech. In order to further reinforce Hi-tech's rights to control and operate Shanghai Environmental, Shanghai Environmental and Mr. Wu have granted Hi-tech the exclusive right and option to acquire all Mr. Wu’s equity interests in Shanghai Environmental. Further, Mr. Wu has pledged all of his rights, title and interest in Shanghai Environmental. Shanghai Environmental was dissolved in June, 2010 and the registered capital had been transferred to Shanghai Engineering accordingly.

 
7

 

All of Shanghai Engineering’s manufacturing activities were conducted through a Leasing and Operation Agreement, a form of cooperative manufacturing agreement, originally effective as of May 1, 2003 and subsequently renewed and amended with a state-owned enterprise, Shanghai Si Fang.  Pursuant to the agreement, Shanghai Si Fang leased a land use right, and certain buildings and fixed assets (lease elements) in one of its subsidiaries, Vessel Works Division, and provided management services and licensed the “Si Fang” brand and manufacturing license (non-lease elements) of Vessel Works Division to Shanghai Engineering.  Because the arrangement contains both the lease and non-lease elements, the quarterly payments were allocated between the lease and non-lease deliverables based on their respective fair values.  The lease elements were classified and accounted for as operating leases and the lease expense was recorded on a straight-line basis.  The non-lease elements were accounted for as prepayment for management and licensing fees and the payment was amortized on a straight-line basis over each contractual period. In April 2011, the contractual arrangement with Vessel Works Division was terminated.

Shanghai Engineering did not have a variable interest in Vessel Works Division through this agreement as the arrangement was established between Shanghai Engineering and Shanghai Si Fang.  Shanghai Engineering did not have any contractual or ownership interest in Vessel Works Division, and therefore, Shanghai Engineering did not have a variable interest in Vessel Works Division.

The arrangement, however, may have resulted in Shanghai Engineering having a variable interest in Shanghai Si Fang, but as Shanghai Si Fang is a state-owned enterprise that has substantive operations other than the Lease and Operation arrangement, Shanghai Engineering was not the primary beneficiary of Shanghai Si Fang.

In order to restructure the holding structure of the Company (the “Restructuring”), on December 2, 2008, 100% of the shares of CER Hong Kong were transferred to Poise Profit from Mr. Qinghuan Wu and his wife, Mrs. Zhou, and all the contracts between Hi-tech and Shanghai Engineering,  and between Hi-tech and Shanghai Environmental were transferred to CER Hong Kong.  Thereafter, CER Hong Kong, through its variable interest entities located in the People's Republic of China ("PRC"), designs, develops, manufactures and markets waste heat boilers and pressure vessels in the fields of chemical industry, petrochemical industry, oil refinery, fine chemicals, water and power conservancy, metallurgical, environmental protection, waste heat utilization and power generation from waste heat recovery.

On November 11, 2008, CER Energy Recovery (Shanghai) Co., Ltd. (“CER Shanghai”) was incorporated in Shanghai by CER Hong Kong. CER Shanghai’s registered capital is $5,000,000. As of December 31, 2010, CER Hong Kong has contributed all the registered capital. CER Shanghai is mainly engaged in the development of energy recovery and environmental protection technologies, and the design, installation and servicing of waste heat recovery systems.

 
8

 

CER Energy Recovery (Yangzhou) Co., Ltd. (“CER Yangzhou”) was incorporated on August 28, 2009 in Yangzhou, China by CER Hong Kong. CER Yangzhou’s registered capital is $20,000,000, all of which has been injected as of September 30, 2011. CER Yangzhou is mainly engaged in the development and manufacturing of waste heat recovery systems and other related energy efficiency equipment.

As all the above entities are under common control, the arrangements described above have been accounted for as a reorganization of entities and the financial statements have been prepared as if the reorganization had occurred retroactively. CER, Poise Profit, CER Hong Kong, Hi-tech, Shanghai Engineering, CER Shanghai, CER Yangzhou, and Shanghai Environmental, are collectively hereinafter referred to as the “Group”.

The accompanying financial statements have been prepared assuming the Company will continue as a going concern which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. Management intends to raise additional funds through additional bank financing to fund completion of Phase II of the Company’s new manufacturing facility. Although management continues to pursue these plans, there is no assurance that they will be successful. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
   
Note 2 – Summary of Significant Accounting Policies

The accompanying unaudited interim consolidated financial statements as of September 30, 2011 and for the three months and nine months ended September 30, 2011 and 2010 have been prepared by the Company, in accordance with generally accepted accounting principles, or GAAP, for interim financial reports and the instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under generally accepted accounting principles have been condensed or omitted pursuant to such regulations. In the opinion of the Company’s management, the unaudited interim consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the Company’s financial position, results of operations and cash flows. The results of operations for the three months and nine months ended September 30, 2011 are not necessarily indicative of the results of operations for the year ending December 31, 2011. The balance sheet at December 31, 2010 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

The principal accounting policies adopted in the preparation of these consolidated financial statements are set out below:

(a)
Principles of consolidation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“US GAAP”).  The consolidated financial statements include the financial statements of the Company, its wholly-owned subsidiaries Poise profit, CER Hong Kong, Hi-tech, CER Shanghai, CER Yangzhou, and its variable interest entities (“VIEs”) Shanghai Engineering and Shanghai Environmental. All significant inter-company transactions and balances among the Company, its subsidiaries and VIEs are eliminated upon consolidation.
 
 
9

 

In accordance with the Accounting Standard Codification (“ASC”) 810-10, variable interest entities (VIEs) are generally entities that lack sufficient equity to finance their activities without additional financial support from other parties or whose equity holders lack adequate decision making ability. All VIEs with which the Company is involved must be evaluated to determine the primary beneficiary of the risks and rewards of the VIE. The primary beneficiary is required to consolidate the VIE for financial reporting purposes.
 
The Company has concluded that Shanghai Engineering is, and Shanghai Environmental was (prior to its dissolution) a VIE and that the Company is the primary beneficiary. Under the requirements of US GAAP, the Company consolidates the financial statements of Shanghai Engineering and Shanghai Environmental.
 
Under the contractual arrangements with the VIEs, the Company has the power to direct activities of the VIEs, and can have assets transferred freely out of the VIEs without any restrictions. Therefore the Company concluded that there was no asset of a consolidated VIE that can be used only to settle obligations of the VIE, except for registered capital and PRC statutory reserves of the VIEs amounting to a total of $1.38 million as of September 30, 2011. As all the consolidated VIEs are incorporated as limited liability companies under the PRC Company Law, creditors of the VIEs do not have recourse to the general credit of the Company for any of the liabilities of the consolidated VIEs, which consisted of receipts in advance of $17.25 million, accounts payable of $8.96 million, accrued liabilities to suppliers and agents of $1.77 million, and other accrued liabilities of $0.54 million, totaling $28.53 million. Currently there is no contractual arrangement that could require the Company to provide additional financial support to the consolidated VIEs. As the Company is conducting certain business in the PRC mainly through the VIEs, the Company may provide such support on a discretionary basis in the future, which could expose the Company to a loss.

(b) Use of estimates

In preparing financial statements in conformity with US GAAP, management is required 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 and revenues and expenses during the reported periods. Significant estimates include useful lives of equipment, allowance for doubtful accounts, deferred tax assets and the completion percentage of the construction contracts. Actual results could differ from those estimates.

 
10

 

(c) Concentration of risk

The Company maintains cash balances at financial institutions within the U.S. Hong Kong and PRC. Balances at financial institutions or state owned banks within the PRC are not covered by insurance. Balances at financial institutions within the United States are covered by the Federal Deposit Insurance Corporation for $250,000 per depositor per institution. Balances at financial institutions within Hong Kong are fully covered by government provided insurance until the end of 2011.  The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risks on its cash in bank accounts.

For the three months ended September 30, 2010 and 2011, the Company’s five top customers accounted for 83% and 87% of the Company's sales, respectively. For the nine months ended September 30, 2010 and 2011, the Company’s five top customers accounted for 72% and 73% of the Company's sales, respectively. Receivables from these five top customers were 5% and 56% of total accounts receivable at September 30, 2010 and 2011, respectively. As of December 31, 2010, the top five customers accounted for 74% of total accounts receivable.

For the three months ended September 30, 2010 and 2011, the five top suppliers accounted for approximately 43% and 23% of the Company's purchases of raw materials, respectively. For the nine months ended September 30, 2010 and 2011, the five top suppliers accounted for approximately 36% and 25% of the Company's purchases of raw materials, respectively. Payables to these five suppliers were approximately 2% and 13% of total accounts payable at September 30, 2010 and 2011, respectively. As of December 31, 2010, the top five suppliers accounted for 26% of total accounts payable. 

The Company's operations are carried out 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 country, and by the general state of the country's economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies carrying out operations in the United States. 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.

(d) Foreign currency translations
 
The reporting currency of the Company is the U.S. dollar. Shanghai Engineering, CER Shanghai, CER Yangzhou, Hi-tech and CER Hong Kong use the Renminbi ("RMB") as their functional currency.  Results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the end of period exchange rates. Cash flows are also translated at average translation rates for the period, therefore, amounts reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheet. Translation adjustments resulting from this process are included in accumulated other comprehensive income (loss) in stockholders' equity. Transaction gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. For the three months ended September 30, 2010 and 2011, foreign currency translation gains amounted to $292,890 and $9,437, respectively. For the nine months ended September 30, 2010 and 2011, foreign currency translation gains amounted to $320,890 and losses amounted to $77,172, respectively.

 
11

 

The PRC government imposes significant exchange restrictions on fund transfers out of the PRC that are not related to business operations. These restrictions have not had a material impact on the Company because it has not engaged in any significant transactions that are subject to the restrictions.

Accumulated other comprehensive loss amounted to $410,646 and $333,474 as of December 31, 2010 and September 30, 2011, respectively. The balance sheet accounts with the exception of equity at December 31, 2010 and September 30, 2011 were translated at RMB6.83 to $1.00 and RMB6.35 to $1.00 respectively.

The average translation rates applied to income and cash flow statement amounts for the three months ended September 30, 2010 and 2011 were RMB6.80 to $1.00 and RMB6.40 to $1.00 respectively. For the nine months ended September 30, 2010 and 2011, the average translation rates were RMB6.80 to $1.00 and RMB6.49 to $1.00, respectively.

(e) Cash and restricted cash

Cash includes cash on hand and demand deposits with banks, which are unrestricted as to withdrawal and use, and which have original maturities less than three months.

Restricted cash represents a cash portion of the guaranty for the bids on contracts and is deposited in a separate bank account subject to withdrawal restrictions controlled by the customer to secure the Company’s performance of the project in process. The deposit cannot be drawn or transferred by the Company until the restriction period has expired. The Company also classified certain cash as restricted that is not available for use in its operations.

 (f) Notes receivable

Notes receivable represent trade accounts receivable due from various customers where the customers’ banks have guaranteed the payment of the receivables. The notes are non-interest bearing and normally paid within three to six months. The Company has the ability to submit a request for payment to the customer’s bank earlier than the scheduled payment date, but will incur an interest charge and a processing fee. 
 
(g) Receivables and allowance for doubtful accounts

Receivables include trade accounts due from the customers, and other receivables from cash advances to employees or third parties. Management regularly reviews aging of receivables and changes in payment trends by its customers, and records a reserve when they believe collection of amounts due are at risk. 

 
12

 

Allowance for doubtful accounts, December 31, 2009
  $ 589,048  
Addition
    152,960  
Write off
    (134,639 )
Translation adjustment
    17,645  
Allowance for doubtful accounts, December 31, 2010
  $ 625,014  
Reversal
    (37,624 )
Translation adjustment
    25,539  
Allowance for doubtful accounts, September 30, 2011
  $ 612,929  

Accounts receivable which are expected to be collected after twelve months are reclassified as long-term accounts receivable. The Company reserved a provision for accounts receivable balances based on the nature of the business and accounts receivable collection history (further discussed in Note 3).
 
(h) Inventories

Inventories comprised of raw materials, work in progress and finished goods and are stated at the lower of cost or market value. Costs of work in progress include direct labor, direct materials, and production overhead before the goods are ready for sale. Management reviews inventories for obsolescence or cost in excess of market value periodically. The obsolescence, if any, is recorded as a reserve against the inventory. The cost in excess of market value is written off and recorded as cost of revenues.

Provision for inventory, December 31, 2009
  $ 117,126  
Addition
    47,281  
Realized
    (74,090 )
Translation adjustment
    2,878  
Provision for inventory, December 31, 2010
  $ 93,195  
Addition
    26,621  
Realized
    (5,195 )
Translation adjustment
    4,124  
Provision for inventory, September 30, 2011
  $ 118,745  

(i) Advances on purchase

Advances on purchases are monies advanced to outside vendors for inventory purchases and property, plant and equipment purchases. This amount is refundable and bears no interest.

(j) Property, plant and equipment, net

Property, plant, and equipment is stated at cost. Depreciation is calculated principally by use of the straight-line method over the estimated useful lives of the related assets. Expenditures for maintenance and repairs which do not improve or extend the expected useful lives of assets are charged to operations as incurred, while renewals and betterments are capitalized.

Management established a 5% residual value for property, plant and equipment. The estimated useful lives for property, plant, and equipment are as follows:

 
13

 

Plants and Buildings
20-38 years
Transportation equipment
3-10 years
Machinery equipment
5-10 years
Office equipment
3-5 years

The gain or loss on disposal of property, plant, and equipment is the difference between the net sales proceeds and the carrying amount of the relevant assets; gains or losses, if any, are recognized in the consolidated statement of income and other comprehensive income. The Company disposed of machinery with a carrying value of $37,949 and two cars with carrying value of $39,646 during the three and nine months ended September 30, 2011, and recognized a combined disposal loss of $52,732 from the transactions.

(k) Impairment of assets

The Company assesses the carrying value of long-lived assets each reporting period, more often when factors indicating impairment are present, and reduces the carrying value of such assets by the amount of the impairment. The Company determines the existence of such impairment by measuring the expected future cash flows (undiscounted and without interest charges) and comparing such amount to the net asset carrying value. An impairment loss, if it exists, is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Fair value generally means based on either quoted market price, if available, or discounted cash flow analysis. There was no impairment of long lived assets recognized for the three and nine months ended September 30, 2010 and 2011.

 (l) Advances from customers

Advances from customers represent amounts advanced by customers on product or service orders. The product (service) normally is shipped (rendered) within one year after receipt of the advance payment, and the related sales are recognized in accordance with the Company’s revenue recognition policy.

(m) Income taxes

Income taxes are accounted for under the asset and liability method. Deferred income taxes are recognized for temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements, net operating loss carry forwards and credits, by applying enacted statutory tax rate in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Current income taxes are provided for in accordance with the laws of the relevant taxing authorities.

In assessing uncertain tax positions, the Company applies a more likely than not threshold and a two-step approach for the tax position measurement and financial statement recognition. For the two-step approach, the first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is greater than 50% likely to be realized upon settlement. As of September 30, 2011, the Company does not have any uncertain tax positions required to be recognized and measured under the accounting standard for income taxes.

 
14

 

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

(o) Operating leases

Leases where substantially all the rewards and risks of ownership of assets remain with the leasing company are accounted for as operating leases. Payments made under operating leases are charged to the statement of operation on a straight line basis over the lease periods.

(p) Stock based compensation

In accordance with ASC 718, Compensation-Stock Compensation, the Company measures the cost of employee services received in exchange for stock based compensation at the grant date fair value of the award.
 
The Group recognizes the stock based compensation costs, net of a forfeiture rate, on a straight-line basis over the requisite service period for each award.
 
ASC 718 requires forfeitures to be estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from those estimates.  There were no stock options granted in the three months ended September 30, 2010. Stock options to purchase 120,000 shares of common stock were granted to new directors in June 2011.
 
Cost of goods acquired or services received from non-employees is measured based on the fair value of the awards issued on the measurement date as defined in ASC 505. Awards granted to non-employees are remeasured at each reporting date using the fair value as at each period end. Changes in fair values between the interim reporting dates are attributed consistent with the method used in recognizing the original stock based compensation costs.

(q) Shipping and handling costs

Shipping and handling costs are included in selling, general and administrative expenses; they totaled $82,453 and $301,735 for the three months ended September 30, 2010 and 2011, respectively, and $192,369 and $410,108 for the nine months ended September 30, 2010 and 2011, respectively.

 
15

 

(r) Revenue recognition

The Company derives revenues principally from:

 
(a)
Provision of Engineering, Procurement and Construction ("EPC") services, which are essentially turnkey contracts where the Company provides all services in the whole construction process from design, development, engineering, manufacturing, procurement to installation;

 
(b)
Sales of energy recovery systems; and

 
(c)
Provision of design services.

Revenue by the above categories for three and nine months ended September 30, 2010 and 2011 are summarized as follows:

   
Three months ended September 30,
 
   
2010
   
2011
 
Revenue:
 
 
   
 
 
EPC contracts
  $ 3,079,689     $ 27,163,759  
Product
    3,067,962       2,222,699  
Totals
  $ 6,147,651     $ 29,386,458  

   
Nine months ended September 30,
 
   
2010
   
2011
 
Revenue:
 
 
   
 
 
EPC contracts
  $ 11,389,302     $ 46,896,711  
Product
    6,058,268       8,139,632  
Totals
  $ 17,447,570     $ 55,036,343  

In accordance with the accounting standard regarding performance of construction-type and certain production-type contracts, and long-term construction-type contracts, the Company adopted the percentage of completion method to recognize revenues and cost of sales for EPC contracts. EPC contracts are long-term, complex contracts involving multiple elements, such as design, manufacturing and installation, which all form one integral EPC project. The energy recovery system involved in an EPC project is highly customized to the specific customer's facilities and essentially not transferable to any other facilities without significant modification and cost. It would be difficult, if not impossible, to beneficially use a single element of a specific EPC project on a standalone basis other than in connection with the facilities for which it was intended. EPC contracts are by nature long-term construction-type contracts, usually lasting more than one accounting period, and the Company is able to reasonably estimate the progress toward completion, including contracts revenues and contracts costs. EPC contacts specify the customers' rights to the goods, the consideration to be paid and received, and the terms of payment. Specifically, the Company has the right to require a customer to make progress payments upon completion of determined stages of the project which serve as evidence of the customer's approval and acceptance of the work completed to date as complying with the terms of the particular EPC contract and upon which the company recognize the revenue.

 
16

 

Sales of the Company's energy recovery systems and related products are essentially product sales. The products consist mainly of waste heat boilers and other related equipment manufactured according to specific customers' specifications. Once manufactured, the Company ships the products to its customers in their entirety in one batch.  The Company’s service arrangement also includes a limited warranty to its customers pursuant to which the customers retain between 5% and 10% of the particular contract price as retainage during the limited warranty period (usually 12-18 months). The Company generally recognizes revenues including retainage from product sales when (i) persuasive evidence of an arrangement exists, which is generally represented by a contract between the Company and the customer; (ii) products are shipped; (iii) title and risk of ownership have passed to the customer, which generally occurs at the time of delivery; (iv) the customer accepts the products upon quality inspection performed by them; (v) the purchase price is agreed to between the Company and the customer; and (vi) collectability is reasonably assured. Net revenues represent the invoiced value of products, less returns and discounts, and net of value-added tax.

In providing design services, the Company designs energy recovery systems and other related systems based on a customer's requirements and the deliverable consists of engineering drawings. The customer may elect to engage the Company to manufacture the designed system or choose to present the Company's drawings to other manufacturers for manufacturing and installation. The Company recognizes revenues from design services when the services are provided, the design drawings are delivered, invoices are issued and collectability is reasonably assured. The Company generally delivers the drawings in one batch.

 (s) Fair value of financial instruments

The accounting standard regarding fair value of financial instruments and related fair value measurements defines financial instruments and requires fair value disclosures of those financial instruments. On January 1, 2008, the Company adopted accounting standard regarding fair value measurements, which defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosures requirements for fair value measures.  The carrying amounts reported in the accompanying consolidated balance sheets for current assets and current liabilities qualify as financial instruments. Management concluded the carrying values of these financial instruments are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and the current market rates 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. Fair valued assets and liabilities that are generally included in this category are assets comprised of cash, accounts and notes receivable, and liabilities comprised of bank loans, accounts payable, accrued liabilities and other payables. As of December 31, 2010 and September 30, 2011, the carrying values of these assets and liabilities approximated their fair values. 
     
¨
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 assets or liability, either directly or indirectly, for substantially the full term of the financial instruments. At December 31, 2010 and September 30, 2011, the Company did not have any fair value assets or liabilities classified as Level 2. 
 
 
17

 

¨
Level 3
Inputs to the valuation methodology are unobservable and significant to the fair value. Inputs reflected management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The following table presents information about the company’s financial liabilities classified as Level 3 as of September 30, 2011 and December 31, 2010.

         
Balance as of September 30, 2011
 
   
Carrying
   
Fair Value Measurements
 
   
Value
   
Using Fair Value Hierarchy
 
  
       
Level 1
   
Level 2
   
Level 3
 
                         
Derivative liability, current (Note 13)
  $ 26,825       -       -     $ 26,825  
Derivative liability, non-current (Note 13)
  $ -       -       -     $ -  
Warrant liability (Note 13)
  $ 153,091       -       -     $ 153,091  

         
Balance as of December 31, 2010
 
   
Carrying
   
Fair Value Measurements
 
   
Value
   
Using Fair Value Hierarchy
 
  
       
Level 1
   
Level 2
   
Level 3
 
Derivative liability, current (Note 13)
  $ 374,846       -       -     $ 374,846  
Derivative liability, non-current (Note 13)
  $ 48,461       -       -     $ 48,461  
Warrant liability (Note 13)
  $ 1,332,760       -       -     $ 1,332,760  

A summary of changes in Level 3 derivative and warrant liabilities for the years ended December 31, 2010 and for the nine months ended September 30, 2011 were as follows:

Balance at December 31, 2009
  $ 2,243,947  
Derivative liability of long term loan, current (Note 8)
    132,470  
Derivative liability of convertible notes (Note 9)
    48,461  
Change in fair value of warrant liability recognized in earnings
    (40,187 )
Change in fair value of derivative liability recognized in earnings
    (628,624 )
Balance at December 31, 2010
  $ 1,756,067  
Change in fair value of warrant liability recognized in earnings
    (1,164,122 )
Change in fair value of derivative liability recognized in earnings
    (396,482 )
Warrant cancellation (Note 13)
    (15,547 )
Balance at September 30, 2011
  $ 179,916  
 
 
18

 

(t) Segment reporting

The Group has adopted ASC 280, Segment Reporting, for its Segment reporting. The Group mainly operates in China and measures its business as a single segment.

(u) Recent accounting pronouncements

In April 2011, the FASB issued ASU 2011-02 which applies to all creditors, both public and nonpublic, that restructure receivables that fall within the scope of Subtopic 310-40, Receivables—Troubled Debt Restructurings by Creditors. In evaluating whether a restructuring constitute a trouble debt restructuring, Topic 310 clarifies the guidance on a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties. In addition, the amendments to Topic 310 clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables when evaluating whether a restructuring constitutes a troubled debt restructuring. The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. Early adoption is permitted. The Company has adopted the guidance and the adoption does not have a significant impact on its financial position or results of operations.

In 2011, the Financial Accounting Standards Board ("FASB") issued new accounting guidance that amends some fair value measurement principles and disclosure requirements. The new guidance states that the concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets and prohibits the grouping of financial instruments for purposes of determining their fair values when the unit of account is specified in other guidance. The Company will adopt this accounting standard upon its effective date for periods ending on or after December 15, 2011, and do not anticipate that this adoption will have a significant impact on its financial position or results of operations.

In 2011, the FASB issued new disclosure guidance related to the presentation of the Statement of Comprehensive Income. This guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. The Company will adopt this accounting standard upon its effective date for periods ending on or after December 15, 2011, and do not anticipate that this adoption will have any impact on its financial position or results of operations.

Note 3 – Accounts Receivable

(a)
Accounts Receivable

   
December 31,
   
September 30,
 
   
2010
   
2011
 
             
Current accounts receivable - third parties
  $ 7,059,935       7,658,742  
Current accounts receivable - related parties
    -       7,063,336  
Current accounts receivable
    7,059,935       14,722,078  
Subtract: Allowance for doubtful accounts
    -       -  
Current accounts receivable, net
  $ 7,059,935       14,722,078  
 
 
19

 
 
Current receivables include revenue recognized in excess of amounts billed for the EPC contracts recognized using the percentage of completion method.  As of December 31, 2010 and September 30, 2011, the revenue recognized in excess of amounts billed amounted to approximately $2,328,420 and $ 10,581,732, respectively.

(b)
Long-term Accounts Receivable

The Company classifies amounts which are to be collected after one year as long-term accounts receivable.

The following accounts receivable consisted of receivables related to revenue recognized in excess of amounts billed of approximately $4,679,121 and $1,995,866 as of December 31, 2010 and September 30, 2011, respectively. These receivables have original maturities of greater than 12 months. As of September 30, 2011, these balances include $1,995,866 that has been classified to current receivables due to a change in contractual term from March 2013 to March 2012.

   
December 31,
   
September 30,
 
   
2010
   
2011
 
Gross
  $ 6,242,969     $ 2,608,795  
Unearned Income
    (938,834 )     -  
Allowance for doubtful accounts
    (625,014 )     (612,929 )
Total, net
  $ 4,679,121     $ 1,995,866  
Less: Current portion
    -       (1,995,866 )
Total
  $ 4,679,121     $ -  

Contractual maturities of the long-term accounts receivable at September 30, 2011 are summarized as follows:

   
Amount
 
       
Twelve months ended September 30, 2012
    1,995,866  
Twelve months ended September 30, 2013
    612,929  
Total
    2,608,795  

Note 4 – Inventories

As of December 31, 2010 and September 30, 2011, inventories consist of the following:
 
   
December 31,
2010
   
September 30,
2011
 
         
 
 
Raw materials
  $ 1,589,194     $ 1,851,240  
Work in progress
    6,837,139       11,794,432  
Finished goods
    235,467       215,807  
Total inventories
  $ 8,661,800     $ 13,861,479  

 
20

 

For the three months ended September 30, 2010 and 2011, no accrual for inventory provision was required. For the nine months ended September 30, 2010 and 2011, management recorded inventory provisions of $0 and $26,621, respectively.

Note 5 –Property, Plant, and Equipment, Net

As of December 31, 2010 and September 30, 2011, property, plant and equipment consist of the following:

   
December 31,
2010
   
September 30,
2011
 
             
Plants & Buildings
  $ -     $ 22,257,414  
Machinery equipment
    666,335       4,275,516  
Transportation equipment
    395,582       363,154  
Office equipment
    502,625       809,506  
Accumulated depreciation
    (791,252 )     (1,661,048 )
Subtotal
    773,290       26,044,542  
Construction in progress
    9,328,465       195,725  
Property, plant and equipment, net
  $ 10,101,755     $ 26,240,267  

The Company exercised a purchase option on an office building in Shanghai Zhangjiang Integrated Circuit Industrial Zone in March 2011. The building was recorded at cost of RMB 48,526,172 (approximately $7,498,264) and is being depreciated over 38 years starting from July 2011 when the building was placed into service.

Depreciation expense for the three months ended September 30, 2010 and 2011 was $88,979 and $450,730, respectively. Depreciation expense for the nine months ended September 30, 2010 and 2011 was $191,786 and $949,145, respectively.

Note 6 – Intangible Assets

Intangible assets mainly represent the purchase of usage rights for a parcel of land in Yangzhou, China, where our manufacturing plant is located.  The Company obtained the usage title of the first land in December 2009.  The land use right was recorded at cost of $2,438,632 and is being amortized over the lease term of 50 years starting from November 2009 when it was acquired. In July 2011, the Company obtained the usage title of another parcel of land. The land use right was recorded at cost of $2,331,869 and is being amortized over the lease term of 50 years starting from July 2011. The amortization expense recorded for three months ended September 30, 2010 and 2011 amounted to $16,740 and $30,785 respectively. The amortization expense recorded for the nine months ended September 30, 2010 and 2011 amounted to $50,841 and $64,940, respectively. The remaining balance represents the net value of purchased software.

 
21

 
 
Note 7 – Short Term Bank Loans

On November 18, 2010, CER Shanghai borrowed RMB 8,400,000 (approximately $1,260,000) for working capital purpose from Shanghai Pudong Development Bank, Shanghai Branch. The term of the loan is one year. The loan agreement permitted the Company to draw down up to RMB 8,400,000 in principal amount before the end of 2010. The loan has been guaranteed by Qinghuan Wu, the Company’s Chief Executive Officer, and Jialing Zhou, a former director of the Company, and wife of Mr. Wu. The Company has also pledged the receivables from Sopo. The loan agreement provides for quarterly interest payments at an annual interest rate of 6.116%. On November, 2010, the Company drew down RMB 8,400,000, the full amount. On August 2011, CER paid the remaining outstanding principal due under the RMB 8,400,000 loan.

On December 9, 2010, CER Yangzhou entered into a three-year, loan facility with the Bank of China, Yizheng Branch.  The facility is RMB 30,000,000 (approximately $4,500,000).  The funds may be drawn down as a short term loan used for trade financing or similar purposes.  Any amounts due under the loan are repayable on November 24, 2013.  The loan has been guaranteed by Qinghuan Wu, the Company’s Chief Executive Officer; Jialing Zhou, a former director of the Company, and wife of Mr. Wu; one of the Group’s subsidiaries and one of the Group’s VIEs, CER Shanghai and Shanghai Engineering; and Yizheng Auto Industrial Park Investment and Development Co., Ltd. The Company has also pledged its land use right in Yizheng. By the end of 2010, the Company drew down RMB 21,000,000 (approximately $3,171,000) under the facility as a short-term loan, due in one year, which amount carries an annual interest rate of 5.838%. On June 20, 2011, the Company drew down RMB 9,152,782 (approximately $1,414,288) under the facility as a short-term loan, due in six months, which amount carries an annual interest rate of 5.56%. These funds were all used for working capital.

On August 17, 2011, CER Shanghai entered into a 90-day loan facility with the Industrial and Commercial Bank of China Limited, Zhangjiang Branch. On August 23, we drew down principal amount of $2,500,000 million. The loan is secured by a mortgage by a building in Shanghai, which is held by Jiangsu SOPO (Group) Company Limited. The loan carries an annual interest rate of 3.27% and the principle and interest will be repaid at maturity. The funds from the loan are used for working capital.On August 31, 2011, CER Shanghai borrowed RMB29,000,000 (approximately $4,500,000) for working capital purpose from Shanghai Pudong Development Bank, Luwan Branch. The loan is secured by a mortgage of CER’s new office building in Zhangjiang, Shanghai. The term of the loan is 9 months. The loan agreement provides for quarterly interest payments at an annual interest rate of 7.544% and the principal is due and payable at maturity in May 31, 2012.
 
While the currency of the primary economic environment in which the Company operates is the yuan renminbi and we translate to the U.S. dollar as the reporting currency, certain of the Company’s borrowings are denominated in yuan renminbi, and others in U.S. dollars, depending on our treasury strategy and operational needs.  The currency denomination of borrowings has a meaningful impact on the rate of interest charged given the different inflationary and economic factors of each of the two currencies.

Interest expense on short-term bank loans was $0 and $98,370 for the three months ended September 30, 2010 and 2011, respectively. Interest expense on short-term bank loans was $1,571 and $224,492 for the nine months ended September 30, 2010 and 2011, respectively.

 
22

 

Note 8 – Long Term Loans

On February 1, 2010, the Company, through its subsidiaries, CER Shanghai (“Borrower”) and CER Hong Kong (“Paying Agent”), entered into a series of agreements for a loan arrangement with two lenders (the “Loan Agreements”). The proceeds of this loan were used for construction of the new plant in China for the production of the Company’s products.

The aggregate principal amount of the loan under the two Loan Agreements is $4,000,000. The principal is due January 15, 2013, and bears interest at the annual rate of 15.1%.  The loan repayments are to be made three times a year starting May 15, 2010, and are fully amortizing, such that the principal and interest will be fully repaid at maturity. The Company is scheduled to pay the sum of $566,023 at the end of every four calendar months, commencing May 15, 2010.

On April 15, 2011, CER paid the remaining outstanding principal due under the $4 million long-term loan. The prepayment sum of $2,981,244 represented the principal amount due, the prepayment premium and the net interest due.

According to the loan agreement provisions, as an additional inducement to the Lender to make the Loan, CER will issue to the Lender or its designee, on each date that an amount of principal of the Loan is paid, shares of common stock of CER, on a restricted basis, without registration rights, as follows:  If the RMB exchange rate between the RMB and United States Dollar (“USD”) is less than RMB 6.8271(the agreed upon exchange rate on the date of the making of the Loan), such that the value of the RMB is greater than the USD, then the difference in the principal installment calculated at the rate of RMB and calculated at the rate of RMB to USD on such repayment date will be converted into a US dollar amount and divided by the closing price of one share of common stock of CER on the OTC or stock exchange, the result of which will represent that number of shares to be issued to the Lender as of such date, in restricted stock. The total number of shares due to the lenders under the terms of the Exchange Rate Differential Payment provisions of the Loan Agreement is 151,656, which were all issued as of May 2011. There are no derivative liabilities under the terms of the Exchange Rate Differential Payment provisions of the Loan Agreement as of September 30, 2011 as the amount has been fully paid in April 2011.

Contemporaneously with the funding of the Loan Agreements, on February 1, 2010, Mr. Qinghuan Wu, arranged for Haide Engineering (Hong Kong) Limited (“Haide”), a company controlled by Mr. Qinghuan Wu, to lend to the Company the sum of $1,000,000.  The proceeds of this loan will be forwarded to CER Yangzhou in the form of an investment which helped fund the Company’s new plant in Yangzhou, China.  The loan is an interest only loan, bearing interest at the annual rate of 9.5%, and is unsecured. The Company is scheduled to pay the sum of $23,750 at the end of every three calendar months. The principal is due in full on January 30, 2012; hence the remaining loan is classified as a current liability (long-term loan, current).  The loan is unsecured and there are no guarantees of the interest or principal. Shanghai Engineering has subordinated its loan to those under the Loan Agreements. The Company repaid principal of $460,000 in December 2010 and the balance as of September 30, 2011 was $543,778. The Company is scheduled to pay the sum of $12,915 at the end of every three calendar months thereafter.

 
23

 

Note 9 – Short Term Loans

On May 21, 2009, the Company entered into a term loan agreement (“Convertible Notes Agreement”) with an investment company (the “Lender”). Pursuant to the Convertible Notes Agreement, the lender provides term loan financing (“Convertible Notes”) to the Company in an amount of up to $5,000,000 within 6 months of the making, which may be drawn from time to time, in whole or in installments, upon notice, but once repaid shall not be subject to reborrowing. The proceeds from this Convertible Note were used for the construction of a new plant located in Yangzhou, China for the production of the products, including, but not limited to, the purchase of land for the plant, buildings, equipment and for the facilitating of financing loans from one or more in-China banks and other institutional lenders. Any amount borrowed will bear interest at 9.5%, payable every six months, calculated and compounded quarterly. Each draw is due twenty-four (24) months after the draw down date, together with any accrued and unpaid interest. The Company drew down $5,000,000 on September 29, 2009. For the three months ended September 30, 2010 and 2011, interest expense of $545,026 and $269,105, respectively, was incurred. For the nine months ended September 30, 2010 and 2011, interest expense of $1,656,936 and $817,082, respectively, was incurred. The Convertible Notes could be converted to 2,777,778 shares of common stock at the conversion price of $1.80. In addition, the Company has issued the Lender a five-year common stock purchase warrant (“Commitment Warrants”) to purchase up to 1,388,889 shares of the Company’s common stock, which is that number of shares of the Company’s common stock equal to 50% of the principal sum of this Convertible Note divided by the conversion price of $1.80. In connection with these Convertible Notes, the Company issued to the Lender one hundred shares of Series B preferred stock that provides for voting rights and the right to appoint directors to the Company’s Board in the event of defaults equal to or exceeding $1,000,000 in the aggregate amount.

The Lender may recall a Convertible Note after the first anniversary of the draw down at a redemption price equal to the outstanding principal plus any accrued and unpaid interest upon the closing by the Company of any debt and/or equity financing (except for debt financings with banks or institutional lenders in China), in an amount up to 50% of the amount financed.  Additionally, upon occurrence of certain events, the Lender can demand the entire outstanding principal, together with any accrued and unpaid interest to be immediately repaid in full or in part.  The Company can also prepay the Convertible Note at any time it desires with accrued interest and unpaid interest. On September 13, 2010, the Lender agreed not to exercise its right to request an early repayment prior to September 29, 2011.

The embedded conversion feature of the Convertible Notes is accounted for as a derivative liability separately in the balance sheet in accordance with ASC 815, Derivatives and Hedging, because the conversion price is denominated in US dollars, which is a currency other than the Company’s functional currency.  The conversion feature accounted as a derivative liability on the balance sheet is classified as a current liability based on the timing of the cash flows derived from the convertible notes. The Convertible Notes were recorded with a discount equal to the fair value of the conversion feature at the transaction date and were accreted to the redemption value of the Convertible Notes from the draw down date to the earliest redemption date using the interest method. The change in fair value of the conversion feature of $25,825 and $0 were recorded in the consolidated statements of operations for the three months ended September 30, 2010 and 2011, respectively. As of September 30, 2011, pursuant to the modifications described later in this footnote, the conversion feature expired; there is no conversion term on the modified loan going forward. The change in fair value of the conversion feature of $848,654 and $203,916 were recorded in the consolidated statements of operations for the nine months ended September 30, 2010 and 2011, respectively. The interest expense recognized for accretion to the redemption value of the Convertible Notes was $231,998 and $40,535 for the three months ended September 30, 2010 and 2011, respectively. The interest expense recognized for accretion to the redemption value of the Convertible Notes was $697,253 and $116,714 for the nine months ended September 30, 2010 and 2011, respectively.

 
24

 

The grant date value of the warrants issued in conjunction with the Convertible Notes was treated as a commitment fee for obtaining the Convertible Notes, and was recorded as deferred financing costs to be amortized over the period from grant date to the earliest redemption date of the Convertible Notes. For the three months ended September 30, 2010 and 2011, $191,458 and $66,919 of deferred financing costs were amortized and charged to interest expense, respectively. For the nine months ended September 30, 2010 and 2011, $600,396 and $215,623 of deferred financing costs were amortized and charged to interest expense, respectively. The Commitment Warrants were recorded as derivative liabilities in accordance with ASC 815, Derivatives and Hedging, because their exercise price is denominated in US dollars, which is a currency other than the Company’s functional currency, i.e., the RMB. Changes in fair value of the Commitment Warrants (Note 13) for the three and nine months ended September 30, 2010 and 2011 were recorded in the consolidated statements of operations.

On December 31, 2010, the Company entered into a loan agreement with the Lender to replace and continue the prior lending arrangement which was entered into on May 21, 2009, to extend the term until which the principal amount of $5,000,000 is due to September 29, 2012, and to change certain of the terms of the loan. The aggregate principal amount of the loan extension is $5,000,000, and bears interest at the annual rate of 15.1%, calculated on a monthly compounded basis.  The principal and accrued interest is due September 29, 2012; hence the modified loan is classified as a current liability (short-term loan) as of September 30, 2011. The loan may be prepaid by the Company, without penalty. The loan agreement provides for the typical events of default (which includes default in payment of any part of the principal of or interest, performance or compliance with the collateral agreement, assets attached or seized by any third person and or any part of the loan agreement being declared null and void or its enforceability being challenged), including a cross default clause, and the Company has made various representations and given various covenants to the lender, which includes the audit of the Company’s annual financial statements and review of the interim financial statements as well as the timely filing of such statements. In the event of a default, the lender would have the right to exercise its rights under the Class B Preferred Stock that was issued in connection with the issuance of Convertible Notes, which will continue with respect to the new loan. The Lender continues to have a right of first refusal with respect to future debt and equity fundings and a right to consent to certain debt and equity fundings by the Company and its subsidiaries and affiliates. As a guarantor of the payments under the loan extension, Mr. Wu, the Chief Executive Officer of the Company, pledged 8,000,006 of his shares in CER for the repayment of the principal due under the loan agreement.  The pledge will only take effect when the shares are released from its current pledge under the Long Term loan entered into by the Company on February 1, 2010.

 
25

 

The Company has accounted for the replacement and extension of the loan agreement as a modification as the changes are not substantial such that there has been no accounting extinguishment in accordance with ASC 470 Debt – Modifications and Extinguishments. Accordingly a new effective interest rate is determined based on the carrying amount of the original debt and the revised cash flow of the new loan.

Since the loan is fixed in United States dollars, the lender will receive compensation when the Renminbi exchange rate increases against the US dollar as compared to the rate fixed at the borrowing date. Accordingly, the Company has accounted for the feature as an embedded derivative and recognized derivative liability in the amount of $24,303 and $72,764 as of December 31, 2010 and September 30, 2011, respectively. The change in fair value of the derivative liability of $72,764 and $21,636 was recorded in the consolidated statements of operations for the three and nine months ended September 30, 2011, respectively.

On August 22, 2011, CER Shanghai borrowed $314,720 (RMB 2,000,000) from Shanghai Pudong Zhangjiang Micro-credit Co., Ltd. The loan carries an annual interest rate of 8% and the principal and interest will be repaid on November 22, 2011. The funds from the loan are used for working capital.

On September 30, 2011, CER entered into a term loan arrangement with Hold And Opt Investments Limited to borrow the aggregate sum of $ 2 million. The maturity date of the loan is October 30, 2011. The loan bears interest at the annual rate of 15.1% (monthly rate of 1.26%). The proceeds of this loan are intended for use as working capital.

Note 10 – Taxation

USA
The Company is subject to U.S. income tax at a rate of 34% on its assessable profits. No such tax has been incurred as the Group did not have any assessable income earned in or derived from the U.S. during the periods presented.

Hong Kong
CER Hong Kong subsidiaries were subject to Hong Kong profit tax at a rate of 16.5% on their assessable profits. No Hong Kong profit tax has been assessed as the Group did not have assessable profit that was earned in or derived from Hong Kong subsidiaries during the years presented.

PRC
The New Enterprise Income Tax ("EIT") law was effective January 1, 2008 and the standard EIT rate is 25%. Pursuant to the PRC tax law, net operating losses can be carried forward 5 years to offset future taxable income.

Pursuant to the PRC income tax laws, Shanghai Engineering is subject to enterprise income tax at a statutory rate of 15% as a high technology entity. Shanghai Environmental, CER Shanghai and CER Yangzhou are subject to enterprise income tax at a statutory rate of 25%.  

 
26

 
 
Deferred tax assets and liabilities without taking into consideration the offsetting of balances are as follows:

   
December 31,
   
September 30,
 
   
2010
   
2011
 
             
Deferred tax assets, non-current:
           
Tax loss carry forwards
    3,299,721       3,949,224  
-Allowance for doubtful accounts and provision for inventory
    120,839       125,573  
Valuation allowance
    (3,116,086 )     (3,701,041 )
      304,474       373,756  
Total deferred tax assets
    304,474       373,756  
                 
Deferred tax liabilities, non-current:
               
Taxable temporary difference related to derivative liabilities
    (132,698 )     (65,179 )
Total deferred tax liabilities
    (132,698 )     (65,179 )

The net balances of deferred tax assets and liabilities after offsetting are as follows:

   
December 31,
   
September 30,
 
   
2010
   
2011
 
Deferred tax assets, current, net
    -       -  
Deferred tax assets, non-current net
    171,776       308,577  
Deferred tax liabilities, net
    -       -  

On February 22, 2008, the Ministry of Finance (“MOF”) and the State Administration of Taxation (“SAT”) jointly issued Cai Shui [2008] Circular 1 (“Circular 1”). According to Article 4 of Circular 1, distributions of accumulated profits earned by a foreign investment enterprise (“FIE”) prior to January 1, 2008 to foreign investor(s) in 2008 or after will be exempt from withholding tax (“WHT”) while distribution of the profit earned by an FIE after January 1, 2008 to its foreign investor(s) shall be subject to WHT at a rate up to 10% (a lower rate is available under the protection of tax treaties). Since the Company intends to indefinitely reinvest its earnings to further expand the businesses in mainland China, the foreign invested enterprises do not intend to declare dividends to their immediate foreign holding companies in the foreseeable future. As a result, if any dividends are declared out of the cumulative retained earnings as of December 31, 2007, they should be exempt from WHT. Accumulated losses of non-US subsidiaries as of December 31, 2010 and September 30, 2011 were approximately $498,756 (RMB2,643,099),and $2,217,907 (RMB14,981,546), respectively, and they are considered to be indefinitely reinvested.  Accordingly, no provision has been made.  No dividend was declared as of December 31, 2010 and September 30, 2011.

No provision for taxation has been made for Hi-tech, CER Hong Kong, and CER Yangzhou for the three and nine months ended September 30, 2010 and 2011, as those subsidiaries did not generate any taxable profits during the periods.

 
27

 
 
   
Three months ended September 30,
 
   
2010
   
2011
 
US income tax expense
  $ -     $ -  
HK income tax expense
    -       -  
PRC income tax expense
    144,497       709,391  
Total  provision for income taxes
  $ 144,497     $ 709,391  

   
Nine months ended September 30,
 
   
2010
   
2011
 
US income tax benefit
  $ -     $ -  
HK income tax expense
    -       -  
PRC income tax expense
    345,647       787,844  
Total  provision for income taxes
  $ 345,647     $ 787,844  

The Company is incorporated in the U.S. and incurred a net operating loss for income tax purposes for each of the nine month periods ended September 30, 2010 and 2011. The net operating loss carryforwards for U.S. income tax purposes were approximately $6,615,870 and $8,165,571 for the nine months ended September 30, 2010 and 2011, respectively, and may be used to reduce future years' taxable income. These carryforwards will expire, if not utilized, in 20 years. Management believes that the realization of the benefits arising from this loss are uncertain due to Company's limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has recorded $3,299,721 and $3,949,224 of deferred tax assets as of December 31, 2010 and September 30, 2011, respectively for these loss carryforwards. 

The valuation allowance as of December 31, 2010 and September 30, 2011 was as follows:

   
Amount
 
Balance of December 31, 2009
  $ 1,822,225  
Increase
    1,293,861  
Balance of December 31, 2010
    3,116,086  
Increase
    584,955  
Balance of September 30, 2011
  $ 3,701,041  

Note 11 –Earnings per Share

The Company reports earnings per share in accordance with the provisions of ASC 260, “Earnings Per Share”. This standard requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings/(losses) per share excludes dilution and is computed by dividing net income (loss) available to common stockholders by the weighted average common shares outstanding during the period under the two-class method. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. In computing the dilutive effect of convertible securities, the number of shares is adjusted for the additional common stock to be issued as if the convertible securities are converted at the beginning of the period (or at the time of issuance, if later). In computing the dilutive effect of options and warrants, the treasury method is used. Under this method, options and warrants are assumed to be exercised at the beginning of the period and as if funds obtained thereby were used to purchase common stock at the average market price during the period. 

 
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The following is a reconciliation of the basic and diluted earnings per share computations for the three and nine months ended September 30, 2010 and 2011:

   
Three months ended September 30,
 
   
2010
   
2011
 
Numerator:
 
 
       
Net (loss)/income
    (853,749 )     2,604,603  
Amount allocated to preferred stockholders
    -       (8,853 )
Net income available to common stock holders
– Basic and diluted
    (853,749 )     2,595,750  
                 
Denominator:
               
Denominator for basic earnings per share -
Weighted average common stock outstanding
    30,883,916       31,085,859  
Weighted average stock options
    -       16,956  
Denominator for diluted earnings per share
    30,883,916       31,102,815  
Basic earnings per share
  $ (0.03 )   $ 0.08  
Diluted earnings per share
  $ (0.03 )   $ 0.08  

   
Nine months ended September 30,
 
   
2010
   
2011
 
             
Numerator:
           
Net income
    (394,105 )     3,285,399  
Amount allocated to preferred stockholders
    -       (11,192 )
Net income available to common stock holders
– Basic and diluted
    (394,105 )     3,274,207  
Denominator:
               
Denominator for basic earnings per share -
Weighted average common stock outstanding
    30,834,537       31,015,385  
Weighted average stock options
    -       16,956  
Denominator for diluted earnings per share
    30,834,537       31,032,341  
Basic earnings per share
  $ (0.01 )   $ 0.11  
Diluted earnings per share
  $ (0.01 )   $ 0.11  

For the three and nine months ended September 30, 2010, warrants to purchase 3,357,450 shares of the Company’s common stock and options to purchase 560,000 shares of its common stock were not included in the calculation of diluted earnings per share because of their anti-dilutive effect.

For the three months and nine months ended September 30, 2011, warrants to purchase 3,241,709 shares of the Company’s common stock and options to purchase 180,000 shares were excluded from the diluted earnings per share calculation because of their anti-dilutive effect.
 
 
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Note 12 – Convertible Preferred Stock

Series A Convertible Preferred Stock

On April 15, 2008 and as a condition to closing of the Share Exchange, CER entered into Securities Purchase Agreements with 25 accredited investors pursuant to which CER issued and sold an aggregate of 7,874,241 units at a unit price of $1.08 (the "Financing"). Each unit consisted of one share of CER's Series A convertible preferred stock, par value of $0.001, and one warrant to purchase one-half of one share of CER's common stock at an exercise price of $1.29 per share. After the 1-for-2 reverse stock split conducted on April 16, 2008, the 7,874,241 shares of the Company’s Series A convertible preferred stock are convertible into 3,937,121 shares of common stock and the warrants are exercisable into 1,968,561 shares of the Company's common stock at an exercise price of $2.58 per share. The issuance costs of $1,859,902, including commissions, legal fees and transaction expenses were taken from the proceeds. The net proceeds were allocated between the Series A convertible preferred stock and warrants based on their relative fair values. As of the closing date, the fair value of Series A convertible preferred stock was estimated at $1.68 where as the fair value of the warrants was estimated at $0.85.  As a result, an aggregate amount of $5,307,539 was allocated to Series A convertible preferred stock and $1,336,739 was allocated to the warrants. The fair value of the warrants was initially valued using the binomial model with assumptions such as, stock price, volatility, expected term, dividend, risk-free interest rate, etc.
 
The rights, preferences and privileges with respect to the Series A convertible preferred stock are as follows:
 
Voting
 
Holders of Series A convertible preferred stock are entitled to the number of votes equal to the number of shares of common stock into which such shares of preferred stock could be converted and to vote as a single class.
 
Dividends
 
Holders of Series A convertible preferred stock are entitled to dividends when dividends are declared for common stockholders.  There have been no dividends declared to date.
 
Liquidation
 
In the event of any liquidation, dissolution or winding up of the Company, the holders of Series A convertible preferred stock shall be entitled to receive the amount of the original issue price per share (as adjusted for the 1-for-2 reverse stock split) for each share of Series A convertible preferred stock, plus all declared and unpaid dividends.

 
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Conversion
 
Each share of Series A convertible preferred stock is convertible into common stock on a one-for-one basis, anytime at the option of the holder. The current conversion price is $2.16 after taking into effect the 1-for-2 reverse stock split, and the conversion price is subject to adjustment in accordance with the anti-dilution provisions.
 
There was no beneficial conversion feature charge recognized for the issuance of Series A convertible preferred stock on the issuance date as the estimated fair value of the common stock is less than the conversion price on the date of issuance.  The Company’s common stock was quoted on the OTCBB and has been publicly traded.  However, with the high volatility and extremely low trading volume during the time when the Company entered into this Financing transaction, the fair value of the Company’s common stock as of April 15, 2008 was determined based on the Company’s estimate, which considered a valuation report prepared by an  independent valuer. The estimated fair value of the common stock was $1.55 per share.

Adjustment of Series A Convertible Preferred Stock Conversion Price and Warrant Exercise Price

In accordance to the anti-dilution provisions of the afore-mentioned Financing, if the Company shall issue additional shares without consideration or for consideration per share less than the conversion price and/or the warrant exercise price in effect immediately prior to the issuance, such conversion price and exercise price shall be adjusted.  

For the year ended December 31, 2010, 462,963 shares of Series A convertible preferred stock were converted into 245,098 shares of common stock. During the nine months ended September 30, 2011, no shares of Series A convertible preferred stock were converted.

As of December 31, 2010 and September 30, 2011, the Company had 200,000 and 200,000 shares of Series A convertible preferred stock issued and outstanding, respectively.

Series B Convertible Preferred Stock

In connection with the Convertible Notes Agreement discussed in Note 9, the Company was required to issue to the Lender one hundred shares of Series B Preferred Stock, par value at $0.001. The Series B preferred stock provides voting rights and the right to appoint directors only in the event of defaults which equal or exceed $1,000,000 in the aggregate. The Series B preferred stock is senior to all other capital stock of the Company. The holder of the Series B preferred stock will not be entitled to any dividends, any liquidation preference of any kind, or any conversion right to convert the Series B preferred stock into the Company’s common stock.  

 
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Note 13 – Warrant and Derivative Liabilities

In June 2008, the FASB issued authoritative guidance on determining whether an instrument (or embedded feature) is indexed to an entity’s own stock.  Under the authoritative guidance, effective January 1, 2009, instruments, that do not have fixed settlement provisions, are deemed to be derivative instruments.  The conversion feature and embedded derivative of the Company’s convertible note (described in Note 9), the related warrants and the warrants issued in connection with the Series A convertible preferred stock, do not have fixed settlement provisions because their conversion and exercise prices are denominated in US dollars, which is a currency other than the Company’s functional currency.  Additionally, the Company was required to include the reset provision in order to protect the holders from potential dilution associated with future financings. In accordance with the FASB authoritative guidance, the conversion feature and embedded derivative of the Convertible Notes was separated from the host contract (i.e. the Convertible Notes) and recognized as a derivative liability in the balance sheet, and the warrants issued in connection with the Convertible Notes and Series A preferred stock have been recorded as warranty liabilities in the balance sheet to be re-measured at the end of every reporting period with changes in fair values reported in the consolidated statements of operation and other comprehensive income. 

As of September 30, 2011, the conversion feature expired and there is no conversion term on the modified loan.

The derivative liabilities were valued using both the Black-Scholes and binomial valuation techniques with the following assumptions:

We calculated the derivative liability on exchange rate based on the following key assumptions.

Derivative liability from convertible notes
 
September 30, 2011
 
       
Estimated forward rate
    6.3665  
Discount rate
    0.53 %
Discount factor
    0.995  
         
Fair value
  $ 26,825  

Warrants issued in connection with convertible notes:

   
May 21, 2009
(Issuance date)
   
December 31,
2010
   
September
30, 2011
 
Number of shares exercisable
    1,388,889       1,388,889       1,388,889  
Stock price
  $ 1.73     $ 1.15     $ 0.6  
Exercise price
  $ 1.8     $ 1.8     $ 1.8  
Expected dividend yield
    -       -       -  
Expected life (in years)
    5       3.39       2.64  
Risk-free interest rate
    2.15 %     1.22 %     0.38 %
Expected volatility
    70 %     78 %     69.5 %
Fair Value:
                       
Warrants issued in connection with Convertible Note
  $ 1,387,912     $ 687,182     $ 131,048  

 
32

 

Warrants issued in connection with Series A convertible preferred stock:

   
December 31, 2010
   
September 30, 2011
 
Number of shares exercisable
    1,968,561       1,852,820  
Risk-free interest rate
    0.72 %     0.23 %
Expected volatility
    83 %     62 %
Expected life (in years)
    2.29       1.54  
Expected dividend yield
    -       -  
Fair Value:
               
Warrants issued in connection with Series A convertible preferred stock
  $ 645,578     $ 22,043  

 
(a)
The risk-free interest rate is based on U.S. Treasury securities with compatible life terms.
 
(b)
Due to the short trading history of the Company’s stock, the Company uses the volatility of comparable guideline companies to estimate volatility.
 
(c)
The expected life of the conversion feature of the notes was based on the term of the notes and the expected life of the warrants was determined by the expiration date of the warrants.
 
(d)
The expected dividend yield was based on the fact that the Company has not paid dividends to common shareholders in the past and does not expect to pay dividends to common shareholders in the future.
 
(e)
On March 2011, one warrant holder with the right to purchase 115,741 shares surrendered its warrant to the Company for cancellation and abandonment of all rights thereunder.

Note 14 - Stock-Based Compensation

Stock Options

On June 24, 2009, the Company appointed one independent director and granted him stock options to purchase 500,000 shares of the Company’s common stock. The options will vest and become exercisable in eight equal installments evenly spread out during the three year period beginning from July 1, 2009. On September 7, 2009, the Company appointed another independent director and granted her a stock option to purchase 60,000 shares of the Company’s common stock. The options will vest and become exercisable in eight equal installments evenly spread out during the two year period beginning from October 1, 2009.

On June 7, 2011, the Board of Directors resolved to modify these option grants and adjusted the exercise price of one incumbent director’s options from $1.22 to $0.73 per share and another director’s options from $1.58 to $0.73 per share. The Board also resolved to accelerate the vesting period of one retired director, such that all the shares underlying the option were deemed vested as of June 7, 2011.  The total incremental compensation cost in respect of such acceleration and option modification is $202,106.

On June 13, 2011, with the resignation of two former directors, the Company appointed another two directors and granted them both stock options to purchase 60,000 shares of the Company’s common stock. The options will vest and become exercisable in eight equal quarterly installments evenly spread out during the two year period beginning from July 1, 2011. Unvested options shall be terminated and forfeited upon the termination of a holder’s director status.

The Company used the Black-Scholes model to value the options at the time they were granted and revalue the options when the option agreement terms were changed. The following table summarizes the assumptions used in the Black-Scholes model when calculating the fair value of the options at the grant dates or revaluation dates:

 
33

 

Fair value per share
  $ 0.39- $ 0.47  
Expected Term(Years)
    4.00-5.56  
Exercise Price
  $ 0.73  
Expected Volatility
    72%-76 %
Risk Free Interest Rate
    1.16%-1.82 %

Since the Company does not have sufficient applicable history of employee stock options activity, the Company uses the simplified method to estimate the life of the options by taking the sum of the vesting period and the contractual life and then calculating the midpoint which is the estimated term of the options.

For the three months ended September 30, 2010 and 2011, the Company recognized $35,250 and $12,090 of compensation expense, respectively. For the nine months ended September 30, 2010 and 2011, the Company recognized $105,759 and $253,158 of compensation expense, respectively.

Following is a summary of options outstanding and exercisable for each of the company’s four individual stock option grants to directors at September 30, 2011.

Outstanding Options
   
Exercisable Options
 
 
   
 
   
Remaining
         
 
   
Remaining
 
Exercise 
         
contractual
   
Exercise
         
contractual
 
price      Number     
term (years)
   
price
    Number     
term (years)
 
                                 
$ 0.73       60,000       8.00     $ 0.73       60,000       8.00  
$ 0.73       500,000       7.75     $ 0.73       500,000       7.75  
$ 0.73       60,000       9.75     $ 0.73       7,500       9.75  
$ 0.73       60,000       9.75     $ 0.73       7,500       9.75  
Total
      680,000                       575,000          

Following is a summary of the option activity:
Outstanding as of December 31, 2009
    560,000  
Granted
    -  
Forfeited
    -  
Exercised
    -  
Outstanding as of  December 31, 2010
    560,000  
Granted
    120,000  
Forfeited
    -  
Exercised
    -  
Outstanding as of  September 30, 2011
    680,000  
         
Vested and exercisable as of September 30, 2011
    575,000  

 
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Note 15 – Interest Expense, Net

   
Three months ended September 30,
 
   
2010
   
2011
 
Interest on convertible notes
  $ 121,570     $ 161,651  
Interest on long-term loan
    163,768       12,825  
Amortization of deferred financing costs
    191,458       66,919  
Accretion on convertible notes
    231,998       40,535  
Accretion on long term loan
    16,951       -  
Interest on short-term bank loans
    -       98,370  
Bank note discount interest
    2,643       566  
Interest capitalized
    (73,116 )     (6,829 )
Interest income
    (178,033 )     (3,637 )
Total
  $ 477,239     $ 370,400  

    Nine months ended September 30,  
   
2010
   
2011
 
Interest on convertible notes
  $ 359,287     $ 484,745  
Interest on long-term loan
    446,769       200,476  
Amortization of deferred financing costs
    600,396       215,623  
Accretion on convertible notes
    697,253       116,714  
Accretion on long term loan
    33,980       81,870  
Restricted common stock issued to lender
    -       184,806  
Interest on short-term bank loans
    1,571       224,492  
Bank note discount interest
    2,643       84,744  
Warrant cancellation
    -       (15,547 )
Interest capitalized
    (114,329 )     (6,829 )
Interest income
    (241,190 )     (225,430 )
Total
  $ 1,786,380     $ 1,345,664  
 
Note 16 – Related Party Transactions

In 2005, Shanghai Engineering entered into agreements with the son of Mr. Qinghuan Wu to lease the office at Quyang Road, Hongkou District, Shanghai for 5 years. For the three months ended September 30, 2010 and 2011, the Company paid $13,259 and $0, respectively, as rental expense to Mr. Qinghuan Wu's son. For the nine months ended September 30, 2010 and 2011, the Company paid $39,663 and $18,373, respectively, as rental expense to Mr. Qinghuan Wu's son. In May 2011, CER terminated the lease agreement and moved to a new Shanghai office.

On February 1, 2010, Mr. Qinghuan Wu, arranged for a loan from Haide, a company controlled by Mr. Qinghuan Wu, to the Company in the sum of $1,000,000.  The proceeds of this loan were forwarded to CER Yangzhou for additional paid-in capital which helped fund the Company’s new plant in Yangzhou, China.  The loan is an interest only loan, bearing interest at the annual rate of 9.5%, and is unsecured. The Company is scheduled to pay the sum of $23,750 at the end of every three calendar months. The principal is due in full on January 30, 2012, hence the remaining loan is classified as a current liability (long-term loan, current). The loan is unsecured and there are no guarantees of the interest or principal. The Company repaid principal of $ 460,000 in December 2010 and the balance as of September 30, 2011 was $543,778, after taking the exchange rate into account.
 
 
35

 

On January 8, 2011, CER signed a contract for the design, manufacture and installation of a major waste heat recovery system with Zhenjiang Kailin Clean Heat Energy Co., Ltd. (“Zhenjiang Kailin”) of Zhenjiang City. The contract was valued at RMB 300 million (approximately $46 million), including the engineering part of RMB 8 million (approximately $1 million), procurement part of RMB 240 million (approximately $37 million) and construction part of RMB 52 million (approximately $8 million). The system will be part of a new sulfuric acid plant and is capable of producing up to 122 tons of steam-per-hour at 485° C and 5.4 MPa from operations at the plant.  57 percent of the project was completed as of September 30, 2011 and is scheduled for fully completion by the end of 2011. Transactions between CER and Zhenjiang Kailin were presented as related party transactions because the Chairman, Chief Executive Officer and majority shareholder of Green Asia Resources, Inc. (“Green Asia”), the parent company of Zhenjiang Kailin, is the owner of a significant creditor and less than 5% shareholder of CER, our executive officers own, as a result of a private placement and prior consulting arrangement, a small number (less than 1%) of shares in Green Asia, and, that at the time the contract was signed, a less than 5% shareholder of both CER and Green Asia was a member of CER’s Board of Directors. However, management of each company is different and the directors at Green Asia and Zhenjiang Kailin are independent of CER, CER confirms the contracts were negotiated and approved on an arms-length basis. For the three and nine months ended September 30, 2011, revenue earned from the contract amounted to $10,563,392 and $23,631,431 respectively. The cost of revenue associated with the revenue is $ 9,293,922 and $ 20,164,797 respectively; accounts receivables from the related party for the work under contract amounted to $7,063,336 as of September 30, 2011.

Note 17 – Retirement Benefits

As stipulated by the relevant laws and regulations applicable to enterprises operating in the PRC, the Company and its PRC subsidiaries and affiliates are required to maintain a defined contribution retirement plan for all of its employees who are residents of the PRC. The Company contributes to a statutory government retirement plan approximately 22% of the base salary of each of its employees and has no further obligations for the actual pension payments or post-retirement benefits beyond the annual contributions. The statutory government retirement plan is responsible for the entire pension obligations payable for all past and present employees.

The Company made contributions of $91,767 and $108,269 for employment benefits, including pension payments for the three months ended September 30, 2010 and 2011, respectively. The Company made contributions of $214,527 and $222,427 for employment benefits, including pension payments for the nine months ended September 30, 2010 and 2011, respectively.

 
36

 

Note 18 – Statutory Reserve

As stipulated by the relevant laws and regulations applicable to enterprises operating in the PRC, the Company and its PRC subsidiaries and affiliates are required to make annual appropriations to a statutory surplus reserve fund. Specifically, the Company is required to deposit 10% of its profits after taxes, as determined in accordance with the PRC accounting standards applicable to the Company, to a statutory surplus reserve until such reserve reaches 50% of the registered capital of the Company.

The transfer to this reserve must be made before distribution of any dividend to shareholders. For the year ended December 31, 2010, the Company transferred $0, because its China subsidiaries incurred losses in 2010. Statutory reserve amounted to $132,802 as of December 31, 2010 and September 30, 2011.
 
The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years' losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of the shares currently held by them, provided that the remaining reserve balance after such issue is not less than 50% of the registered capital.  The remaining required contributions to the statutory reserves required were approximately $12,763,961 as of September 30, 2011.

Note 19 – Commitments and Contingencies

Capital contribution to CER Yangzhou

As described in Note 1, CER Yangzhou has registered capital of $20,000,000 and all has been injected as of September 30, 2011; therefore there is no commitment for future capital contribution as of September 30, 2011.

Lease and Operational Commitments

According to the renewed and amended Leasing and Operation Agreement (Note 1) between Shanghai Engineering and Shanghai Si Fang, Shanghai Engineering has recorded a lease expense and integrated management fee in the amount of $124,745 and $0 under cost of revenue and general administrative expenses for the nine months ended September 30, 2010 and 2011, respectively; For the nine months ended September 30, 2010 and 2011, Shanghai Engineering recorded lease payment and the integrated management fees under cost of revenue in the amount of $374,234 and $0, respectively.

The Company has paid all the lease payments under this lease; therefore there is no future lease payment under this lease as of September 30, 2011.

 
37

 

Rental commitments

On January 1, 2009, Shanghai Engineering renewed the lease agreement with the son of Mr. Qinghuan Wu to continue the lease of the current office space (approximately 375 square meters) for one year until December 31, 2010 and the monthly rental was $4,398, which is approximately the market price in Shanghai.  After moving into the new office space in Shanghai Zhangjiang Hi-tech Park (“Zhangjiang”), the lease agreement terminated as of April 30, 2011. For the three months ended September 30, 2010 and 2011, the company incurred $13,259 and $0, respectively, as rental expense under the lease. For the nine months ended September 30, 2010 and 2011, the company incurred $39,663 and $18,373, respectively, as rental expense under the lease.

On March 19, 2009, CER Shanghai entered into an office lease agreement with Shanghai Zhangjiang Integrated Circuit Industrial Zone Development Co., Ltd., to lease an office space (approximately 2,664 square meters) in the Shanghai Zhangjiang Hi-tech Park (“Zhangjiang”), which is the new office space and the design and engineering center of the Company in China.  The lease is for two years from March 1, 2009 through February 28, 2011.  The Company is also required to make a security deposit of approximately $292,613 in addition to the annual lease payments. CER Shanghai also has an option to purchase the office space. If CER Shanghai exercises the purchase option, all the lease payments and the deposit payment made can be credited against the purchase price and counted as a partial purchase payment. The Company has amortized the total rental fee using straight-line method over the 2-year lease period. For the three months ended September 30, 2010 and 2011, the rental expense was $125,333 and $0, respectively. For the nine months ended September 30, 2010 and 2011, the rental expense was $374,925 and $86,311, respectively.

On March 30, 2011, CER Shanghai exercised the purchase option with Shanghai Zhangjiang Integrated Circuit Industrial Zone Development Co., Ltd. The total purchase price of the building is RMB 48,526,172 (approximately $7,498,264), which represents the price of the building. CER Shanghai paid in full by cash and bank acceptance, as of June 2011.

Note 20 –Subsequent Events

On October 10, 2011, CER paid the remaining outstanding principal due under the $1 million long-term loan. The prepayment sum of $548,550 represented the principal amount and the interest due.

On November 2, 2011, the Company paid back the $2 million borrowing from Hold And Opt Investments Limited. The prepayment sum of $2,026,928 represented the principal amount and the interest due.

On November 7, 2011, the Company paid back the $2.5 million short-term bank loan to the Industrial and Commercial Bank of China Limited, Zhangjiang Branch. The prepayment sum of $2,503,860 represented the principal amount and the outstanding interest due. The Company is working with the bank to renew the credit facility.

 
38

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains disclosures which are forward-looking statements. Forward-looking statements include all statements that do not relate solely to historical or current facts, such as, but not limited to, the discussion of economic conditions in market areas and their effect on revenue growth, the discussion of our growth strategy, the potential for and effect of future governmental regulation, fluctuation in global energy costs, the effectiveness of our management information systems, and the availability of financing and working capital to meet funding requirements, and can generally be identified by the use of words such as "may," "believe," "will," "expect," "project," "estimate," "anticipate," "plan" or "continue." These forward-looking statements are based on the current plans and expectations of our management and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. These factors include, but are not limited to: the general economic conditions that may affect our customers desire or ability to invest in energy recovery systems; the cost of raw materials; the availability of environmental credits; the positive and adverse effect of governmental regulation affecting energy recovery systems; our reliance on customers in heavy industry, such as chemicals and steel production,  and state owned or controlled enterprises; competition in the industry of heat and energy recovery systems; the availability of and costs associated with potential sources of financing; difficulties associated with managing future growth; our ability to increase manufacturing capacity to meet demand; fluctuations in currency exchange rates; restrictions on foreign investments in China; uncertainties associated with the Chinese legal system; the loss of key personnel; and our ability to attract and retain new qualified personnel.

These forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise

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

Overview

China Energy Recovery, Inc. (the "Company," "we," "us," or "our") is headquartered in Shanghai, China, and, through its subsidiaries and affiliates, is in the business of designing, fabricating, implementing and servicing industrial energy recovery systems. The Company's energy recovery systems capture industrial waste energy for reuse in industrial processes or to produce electricity and thermal power, thereby allowing industrial manufacturers to reduce their energy costs, shrink their emissions and generate sellable emissions credits. The manufacturing took place at the Company's leased manufacturing facilities in Shanghai, China prior to completion of Phase of our new Yangzhou plant. From May 2011, all of our production was carried out in our Yangzhou plant. The Company transports the manufactured systems in parts via truck, train or ship to the customers' facilities where the system is assembled and installed. The Company has primarily sold energy recovery systems to chemical manufacturing plants to reduce their energy costs by increasing the efficiency of their manufacturing equipment. The Company mainly sells its energy recovery systems and services directly to customers.
 
 
39

 
 
On January 24, 2008, we entered into a Share Exchange Agreement (the "Share Exchange Agreement") with Poise Profit International, Ltd. ("Poise Profit") and the shareholders of Poise Profit. Pursuant to the Share Exchange Agreement, we acquired 100% of the issued and outstanding shares of Poise Profit's common stock in exchange for the issuance of 41,514,179 (pre reverse split) shares of our common stock to the shareholders of Poise Profit. The share exchange (the "Share Exchange") transaction was consummated on April 15, 2008. As a result of the closing of the Share Exchange on April 15, 2008, our new business operations consist of those of Poise Profit's Chinese subsidiary, Hi-tech, which were subsequently transferred to CER (Hong Kong) Holdings Limited (“CER Hong Kong”). CER Hong Kong is principally engaged in designing, marketing, licensing, fabricating, implementing and servicing industrial energy recovery systems capable of capturing industrial waste energy for reuse in industrial processes or to produce electricity and thermal power.

CER Hong Kong carries out its operations through its subsidiary CER Shanghai, CER Yangzhou and an affiliated entity with which CER Hong Kong has a contractual relationship, Shanghai Engineering. Shanghai Engineering's manufacturing activities were carried out by Vessel Works Division located in Shanghai, China, through a lease agreement with Vessel Works Division's owner, which agreement has since been terminated. The term “Company” refers to the group of companies described above.

The energy recovery systems that we produce capture industrial waste energy for reuse in industrial processes or to produce electricity and thermal power, which allow industrial manufacturers to reduce a portion of their energy costs, shrink their emissions and potentially generate saleable emissions credits. We have primarily sold energy recovery systems to chemical manufacturing plants to reduce their energy costs by increasing the efficiency of their manufacturing equipment and help control their pollution output. We have installed more than 122 energy recovery systems throughout China and in a variety of international markets.

In October 2010, the State Council announced that China will continue to focus on supporting and developing certain strategic new industries, such as energy-saving, new energy, high-side equipment manufacturing industries. The government encourages energy recycling and recovery to increase the efficiency of energy utilization. The goal is to increase the GDP of such strategic new industries to 8% and 15% of the total GDP, for the years 2015 and 2020, respectively. In February 2011, the Ministry of Industry and Information Technology announced that China will continue to encourage energy-saving industries, to accelerate the development of recycling economics, recovery industries and energy-saving equipment. The supporting measures will be launched to achieve reductions in energy utilization and to mitigate the release of harmful emissions.

All of Shanghai Engineering’s manufacturing activities were conducted through a Leasing and Operation Agreement, a form of cooperative manufacturing agreement, originally effective as of May 1, 2003 and subsequently renewed and amended with a state-owned enterprise, Shanghai Si Fang.  Pursuant to the agreement, Shanghai Si Fang leased a land use right, and certain buildings and fixed assets (lease elements) in one of its subsidiaries, Vessel Works Division, and provided management services and licenses the “Si Fang” brand and manufacturing license (non-lease elements) of Vessel Works Division to Shanghai Engineering.  Because the arrangement contained both the lease and non-lease elements, the amount of quarterly payments were allocated between the lease and non-lease deliverables.  The lease elements are classified and accounted for as operating leases and the lease expense was recorded on a straight-line basis.  The non-lease elements were accounted for as prepayment for management and licensing fees and the payment was amortized on a straight-line basis over each contractual period. This agreement was terminated in April, 2011.
 
 
40

 

Facing a possible large market opportunity and potential government supports, we decided to enlarge our production capacity by setting up a new production base. Our plan is to establish CER Yangzhou as a world-class international manufacturing facility of waste heat equipment, in both products and technology. We plan to make highly efficient energy-saving products, using advanced manufacturing processes and equipment. We intend, for this manufacturing facility to embody a completely new look of a modern factory, thus making the Company more competitive; while promoting the development of the local economy and further exploiting the manufacturing advantages in renewable energy equipment and waste heat recovery core equipment. During 2010, we focused much of our energies on the construction of our new manufacturing facility in, Yangzhou, China, and completed the first phase of construction of the plant by January 2011. We completed the transfer of the remaining production function from Vessel Works Division to CER Yangzhou by end of April 2011. From May 2011, all of our production was carried out in CER Yangzhou. Phase two of the facility is still under construction and is anticipated to be complete in 2012.

With phase one of the new facility completed, we are prepared to expand our customer base and enter into more sectors. We expect to incur separate (unrelated to any particular customer project) research and development expenditures to support an expansion into new sectors, such as coke refining and cement, including adding more specialized skills to our engineering and design team. We are also planning on entering into marketing partnerships and licensing deals that should enable us to reach a boarder segment of the market. We believe that there is significant opportunity in international markets and we intend to enter these markets through partnerships.

Critical Accounting Policies and Estimates

While our significant accounting policies are more fully described in Note 2 to our Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q, we believe that the accounting policies described below are the most critical to aid you in fully understanding and evaluating this management discussion and analysis.

Fair Value Measurements

The accounting standard regarding fair value of financial instruments and related fair value measurements defines financial instruments and requires fair value disclosures of those financial instruments. On January 1, 2008, the Company adopted accounting standard regarding fair value measurements, which defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosures requirements for fair value measures.  The carrying amounts reported in the accompanying consolidated balance sheets for current assets and current liabilities qualify as financial instruments. Management concluded the carrying values of these financial instruments are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and the current market rates of interest.  The three levels of valuation hierarchy are defined as follows:

 
41

 

o
Level 1
Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Fair valued assets and liabilities that are generally included in this category are assets comprised of cash, accounts and notes receivable, and liabilities comprised of bank loans, accounts payable, accrued liabilities and other payables. As of December 31, 2010 and September 30, 2011, the carrying values of these assets and liabilities approximated their fair values.

o
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 assets or liability, either directly or indirectly, for substantially the full term of the financial instruments. At December 31, 2010 and September 30, 2011, the Company did not have any fair value assets or liabilities classified as Level 2.

o
Level 3 
Inputs to the valuation methodology are unobservable and significant to the fair value. Inputs reflected management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The following table presents information about the company’s financial liabilities classified as Level 3 as of September 30, 2011.

         
Balance as of September 30, 2011
 
   
Carrying
   
Fair Value Measurements