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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 June 30, 2014
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 001-34246

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

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

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

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

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

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

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

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

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

As of August 22, 2014, there were 6,783,399 shares of common stock outstanding.
 
 

Table of Contents
 
   
Page
Note about Forward-Looking Statements
1
     
PART I. FINANCIAL INFORMATION
     
Item 1.
3
Item 2.
30
Item 3.
42
Item 4.
42
     
PART II. OTHER INFORMATION
     
Item 1.
43
Item 1A.
43
Item 2.
43
Item 3.
43
Item 4.
43
Item 5.
43
Item 6.
43
     
 
44
     
 
45
 
 
NOTE ABOUT FORWARD-LOOKING STATEMENTS AND OTHER INFORMATION

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

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

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

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

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

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

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

Effective February 7, 2012, we implemented a one-for-ten reverse stock split of our common stock. Unless otherwise indicated, all share amounts and per share prices in this report were retroactively adjusted to reflect the effect of this reverse stock split. See Note 1 of the consolidated financial statements included herein.
 
 
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SMARTHEAT INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 
   
June 30, 2014
   
December 31, 2013
 
   
(UNAUDITED)
 
ASSETS
           
             
CURRENT ASSETS
           
     Cash & equivalents
  $ 18,996,617     $ 13,602,399  
     Restricted cash
    670,830       2,458,758  
     Accounts receivable, net
    15,099,549       12,167,565  
     Retentions receivable, net
    2,597,790       4,202,109  
     Advances to suppliers, net
    5,018,613       6,584,833  
     Other receivables (net), prepayments and deposits
    3,972,878       2,644,522  
     Inventories, net
    54,194,515       56,324,363  
     Taxes receivable
    633,406       989,635  
     Notes receivable - bank acceptances
    683,906       2,759,251  
                 
        Total current assets
    101,868,104       101,733,434  
                 
NONCURRENT ASSETS
               
     Long term investment
    912,044       934,805  
     Restricted cash
    316,899       135,926  
     Retentions receivable
    -       237,882  
     Advance for equipment purchase
    1,241,933       -  
     Construction in progress
    1,362,730       1,340,905  
     Property and equipment, net
    10,041,499       10,185,160  
     Intangible assets, net
    4,381,691       14,885,623  
                 
       Total noncurrent assets
    18,256,796       27,720,301  
                 
TOTAL ASSETS
  $ 120,124,900     $ 129,453,735  
                 
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
                 
CURRENT LIABILITIES
               
     Accounts payable
  $ 6,626,668     $ 6,683,860  
     Advance from customers
    2,744,657       2,630,061  
     Taxes payable
    26,761       197,078  
     Accrued liabilities and other payables
    17,531,682       17,215,006  
     Notes payable - bank acceptances
    -       2,590,025  
     Loans payable
    24,983,580       24,462,299  
                 
         Total current liabilities
    51,913,348       53,778,329  
                 
CREDIT LINE PAYABLE
    2,149,335       1,396,378  
                 
LONG-TERM LOAN
    2,112,859       2,132,231  
                 
DEFERRED TAX LIABILITY
    91,419       17,177  
                 
COMMITMENTS AND CONTINGENCIES
 
                 
STOCKHOLDERS' EQUITY
         
     Common stock, $0.001 par value; 75,000,000 shares authorized, 6,583,399 shares and  6,133,399 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively
    6,583       6,133  
     Paid-in capital
    81,733,320       81,901,266  
     Statutory reserve
    5,389,057       5,389,057  
     Accumulated other comprehensive income
    8,385,003       8,991,269  
     Accumulated deficit
    (57,812,734 )     (51,991,839 )
                 
         Total Company stockholders' equity
    37,701,229       44,295,886  
                 
         NONCONTROLLING INTEREST
    26,156,710       27,833,734  
                 
         TOTAL EQUITY
    63,857,939       72,129,620  
                 
TOTAL LIABILITIES AND EQUITY
  $ 120,124,900     $ 129,453,735  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
SMARTHEAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
 
   
SIX MONTHS ENDED JUNE 30,
   
THREE MONTHS ENDED JUNE 30,
 
   
2014
   
2013
   
2014
   
2013
 
   
(UNAUDITED)
   
(UNAUDITED)
 
                         
Net sales
  $ 10,669,833     $ 13,891,423     $ 5,709,867     $ 7,722,992  
Cost of goods sold
    12,701,080       14,265,228       7,337,123       5,320,037  
                                 
Gross loss (income)
    (2,031,247 )     (373,805 )     (1,627,256 )     2,402,955  
                                 
Operating expenses
                               
     Selling
    3,523,056       3,242,531       1,956,545       1,546,589  
     General and administrative
    4,661,513       4,818,674       1,747,185       2,482,031  
     Provision for bad debts
    (3,399,744 )     12,287,944       (12,149,019 )     7,524,870  
     Provision for advance to supplier
    108,270       1,529,595       33,480       288,916  
                                 
     Total operating expenses (income)
    4,893,095       21,878,744       (8,411,808 )     11,842,406  
                                 
Income (loss) from operations
    (6,924,342 )     (22,252,549 )     6,784,552       (9,439,451 )
                                 
Non-operating income (expenses)
                               
     Investment (loss) income
    (22,891 )     39,345       (19,282 )     38,784  
     Interest income
    64,583       28,975       36,900       13,585  
     Interest expense
    (857,146 )     (772,242 )     (488,004 )     (428,431 )
     Financial expense
    (276,171 )     (150,341 )     (224,035 )     (87,442 )
     Gain on issuance of stock
    70,000       -       70,000       -  
     Foreign exchange transaction gain
    5,550       3,339       2,151       840  
     Other income, net
    510,725       734,075       268,974       423,777  
                                 
     Total non-operating expenses, net
    (505,350 )     (116,849 )     (353,296 )     (38,887 )
                                 
Income (loss) before income tax
    (7,429,692 )     (22,369,398 )     6,431,256       (9,478,338 )
Income tax (benefit) expense
    75,493       (45,000 )     90,029       (22,556 )
                                 
Net income (loss) before noncontrolling interest
    (7,505,185 )     (22,324,398 )     6,341,227       (9,455,782 )
Less: income (loss) attributable to noncontrolling interest
    (1,684,289 )     (47,297 )     3,086,178       (2,555 )
                                 
Net income (loss) to SmartHeat Inc.
    (5,820,896 )     (22,277,101 )     3,255,049       (9,453,227 )
                                 
Other comprehensive item
                               
     Foreign currency translation gain (loss)
     attributable to SmartHeat Inc.
    (606,266 )     1,550,147       (43,960 )     1,361,630  
                                 
     Foreign currency translation gain (loss)
     attributable to noncontrolling interest
    7,265       17,806       (16,942 )     15,074  
                                 
Comprehensive income (loss) attributable to SmartHeat Inc.
  $ (6,427,162 )   $ (20,726,954 )   $ 3,211,089     $ (8,091,597 )
                                 
Comprehensive income (loss) attributable to noncontrolling interest
  $ (1,677,024 )   $ (29,491 )   $ 3,069,236     $ 12,519  
                                 
Basic and diluted weighted average shares outstanding
    6,364,338       5,733,399       6,579,003       5,733,399  
                                 
Basic and diluted earnings (loss) per share
  $ (0.91 )   $ (3.89 )   $ 0.49     $ (1.65 )
 
The accompanying notes are an integral part of these consolidated financial statements.

 
SMARTHEAT INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
SIX MONTHS ENDED JUNE 30,
 
   
2014
   
2013
 
   
(UNAUDITED)
       
             
CASH FLOWS FROM OPERATING ACTIVITIES:
           
            Loss including noncontrolling interest
  $ (7,505,185 )   $ (22,324,398 )
            Adjustments to reconcile loss including noncontrolling
            interest to net cash used in operating activities:
               
            Investment (income) loss
    22,891       (39,345 )
            Depreciation and amortization
    1,058,204       1,071,447  
            Provision for bad debts
    (3,399,743 )     12,287,944  
            Provision for inventory impairment
    2,775,603       4,188,169  
            Provision for advance to suppliers
    108,270       1,529,595  
            Changes in warranty reserves
    43,848       7,945  
            Gain on issuance of stock
    (70,000 )     -  
            Gain on disposal fixed asset
    (6,926 )     18,829  
            Stock based compensation for shares issued to officers and director
    37,500       -  
            Changes in deferred tax
    74,821       (43,451 )
                         (Increase) decrease in assets and liabilities:
               
                                   Accounts receivable
    3,495,711       2,240,647  
                                   Retentions receivable
    244,023       92,947  
                                   Advances to suppliers
    1,406,693       (1,363,211 )
                                   Other receivables, prepayments and deposits
    (3,158,078 )     (897,047 )
                                   Inventories
    (1,148,034 )     (3,274,909 )
                                   Taxes receivable
    241,227       (1,421,702 )
                                   Accounts payable
    (2,577,656 )     (2,126,638 )
                                   Advance from customers
    (2,838,655 )     570,467  
                                   Taxes payable
    (60,967 )     (687,227 )
                                   Accrued liabilities and other payables
    3,125,224       144,611  
                 
            Net cash used in operating activities
    (8,131,229 )     (10,025,327 )
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
                                   Change in restricted cash
    1,592,388       (387,158 )
                                   Cash received from assets disposal
    19,614       -  
                                   Acquisition of property & equipment
    (701,717 )     (516,140 )
                                   Government refund of land use right
    10,364,498       -  
                                   Notes receivable
    2,061,939       932,185  
                                   Construction in progress
    (6,908 )     -  
                                   Advance for equipment purchase
    (1,248,997 )     -  
                 
            Net cash provided by investing activities
    12,080,817       28,887  
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
                                   Proceeds from short-term loans
    13,716,733       13,767,295  
                                   Repayment on short-term loans
    (12,968,975 )     (11,920,593 )
                                   Credit line payable
    850,000       -  
                 
            Net cash provided by financing activities
    1,597,758       1,846,702  
                 
EFFECT OF EXCHANGE RATE CHANGE ON CASH & EQUIVALENTS
    (153,128 )     148,762  
                 
NET INCREASE (DECREASE) IN CASH & EQUIVALENTS
    5,394,218       (8,000,976 )
                 
CASH & EQUIVALENTS, BEGINNING OF PERIOD
    13,602,399       18,336,163  
                 
CASH & EQUIVALENTS, END OF PERIOD
  $ 18,996,617     $ 10,335,187  
                 
Supplemental cash flow data:
               
   Income tax paid
  $ -     $ 703,889  
   Interest paid
  $ 729,950     $ 878,062  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
SMARTHEAT INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2014 (UNAUDITED) AND DECEMBER 31, 2013
 
1. ORGANIZATION AND DESCRIPTION OF BUSINESS

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

On August 23 2013, the Company formed two new wholly-owned subsidiaries in the State of Nevada, Heat HP Inc., and HEAT PHE Inc.  On August 23, 2013, SmartHeat Inc., the Company’s United States parent company entered into Assignment Agreements with Heat HP Inc. and Heat PHE Inc., respectively. Under the Assignment Agreements, the Company agreed to transfer 100% of its right, title and interest in certain subsidiaries to Heat HP Inc. and Heat PHE Inc. The reorganization was performed so the Company’s subsidiaries would be organized along their respective operating segments with Heat HP holding those subsidiaries that operated in the heat pumps and related products segment and Heat PHE holding those subsidiaries that operated in the plate heating equipment, meters and related products segment.

After the assignment, Heat HP Inc. owned 100% of SmartHeat (China) Investment Co., Ltd. (“SmartHeat Investment”), SmartHeat (Shanghai) Trading Co., Ltd. (“SmartHeat Trading”), Beijing SmartHeat Jinhui Energy Technology Co., Ltd. (“Jinhui”), SmartHeat Deutschland GmbH (“SmartHeat Germany”), and 98.8% of SmartHeat (Shenyang) Heat Pump Technology Co., Ltd. (“SmartHeat Pump”).

After the assignment, Heat PHE Inc. owned 100% of SmartHeat Taiyu (Shenyang) Energy Technology Co., Ltd. (“Taiyu”), SanDeKe Co., Ltd., (“SanDeKe”), SmartHeat Siping Beifang Energy Technology Co., Ltd. (“SmartHeat Siping”), SmartHeat (Shenyang) Energy Equipment Co., Ltd. (“SmartHeat Energy”), and 51% of Hohhot Ruicheng Technology Co., Ltd. (“Ruicheng”).
 
On August 23, 2013, the Company entered into a Stock Pledge Agreement with Northtech Holdings Inc. (“Northtech”).  The Company agreed to deliver shares certificates to Northtech representing 55% of Heat HP Inc. and Heat PHE Inc. to perfect the security interest in each of the Company’s directly and wholly-owned subsidiaries granted to Northtech as collateral security for all of the obligations of the Company owed to Northtech.

In December 2013, SmartHeat US parent incorporated SmartHeat Heat Exchange Equipment Co. (“Heat Exchange”) in China with register capital of $3.00 million for manufacturing and sale of PHE and PHE related products.

On December 30, 2013, the Company, closed the transaction contemplated by the Equity Interest Purchase Agreement dated October 10, 2013, whereby the buyers purchased 40% of the Company’s equity interests in the following PHE segment subsidiaries: SmartHeat Taiyu (Shenyang) Energy; SmartHeat Siping Beifang Energy Technology Co., Ltd.; SmartHeat (Shenyang Energy Equipment) Co. Ltd.; Hohot Ruicheng Technology Co., Ltd.; and Urumchi XinRui Technology Limited Liability Company (collectively, the “Target Companies”). The purchase price was RMB 5,000,000. Urumchi XinRui Technology Limited Liability Company (“XinRui”) was 46% owned by SmartHeat US parent company prior to 40% equity interest sell.
 
The Company retained an option to repurchase the equity interests of the Target Companies from the buyers at a purchase price of RMB 5,600,000 which terminated on February 28, 2014.  On March 27, 2014, the buyers exercised their option to purchase an additional 40% equity interest in the Target Companies for an additional purchase price of RMB 6,000,000. The Company will seek the approval of its shareholders prior to completing the sale. In the event such approval is not obtained, the buyers may terminate the Equity Interest Purchase Agreement. Should the buyers exercise their option to purchase the additional 40% equity interest and the Company’s shareholders approve the sale, the Company has the option to require the buyers to purchase the remaining 20% equity interest for a purchase price of RMB 2,500,000.  The closing of transaction will be scheduled to occur after satisfaction of the conditions set forth in the Equity Interest Purchase Agreement, including, without limitation, approval of the transaction by a majority of the Company's shareholders entitled to vote.

The buyers consist of a group of 25 natural persons, all of whom are P.R.C. citizens, including Wen Sha, Jun Wang and Xudong Wang, managers of the Company’s subsidiaries engaged in the PHE segment of its business, and Huajuan Ai and Yingkai Wang, the Company’s Corporate Secretary and Acting Chief Accountant, respectively.  Huajuan Ai, Wen Sha, Jun Wang and Xudong Wang are also principals in Northtech Holdings Inc.  SmartHeat's subsidiaries made an application to State Administration for Industry and Commerce (“SAIC”) to register the ownership transfers as of June 30, 2014. 
 
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
 
The consolidated financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”).

The consolidated interim financial information as of June 30, 2014 and for the six and three months ended June 30, 2014 and 2013, were prepared without audit, pursuant to the rules and regulations of the SEC (“Security and Exchange Commission”). Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with U.S. GAAP are not included. The interim consolidated financial information should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2013, previously filed with the SEC.

In the opinion of management, all adjustments (which include normal recurring adjustments) necessary to present a fair statement of the Company’s consolidated financial position as of June 30, 2014, its consolidated results of operations and cash flows for the six and three months ended June 30, 2014 and 2013, as applicable, were made. The interim results of operations are not necessarily indicative of the operating results for the full fiscal year or any future periods.

Principles of Consolidation
 
The accompanying consolidated financial statements include the accounts of SmartHeat’s U.S. parent, its subsidiaries Heat HP and Heat PHE, and their subsidiaries Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment, SmartHeat Shenyang Energy, SmartHeat Trading, Ruicheng, SmartHeat Germany, SmartHeat Shenyang Heat Pump, and Heat Exchange, which are collectively referred to as the “Company.” All significant intercompany accounts and transactions were eliminated in consolidation. After the sale of 40% equity interest of Taiyu, Siping, Shenyang Energy, Ruicheng and Xinrui (See Note 9) on December 30, 2013, the Company now owns 60% of Taiyu, Siping and Shenyang Energy, and 30.6% of Ruicheng, which is accounted for under the equity method of accounting.
 
Equity Method Investee
 
Prior to the sale of 40% equity interest of Taiyu, Siping, Shenyang Energy, Ruicheng and Xinrui, the Company owned 46% of XinRui and accounts for this investment under the equity method of accounting (ASC 323-30). The Company recorded its investment at original cost. This investment increased with income and decreased for dividends and losses that accrued to the Company. After 40% equity interest sale on December 30, 2013, the Company now owns 30.6% of Ruicheng (See Note 9) and 27.6% of XinRui, which are accounted for under the equity method of accounting. 

Use of Estimates
 
In preparing the financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Significant estimates, required by management, include the recoverability of long-lived assets, allowance for doubtful accounts and the reserve for obsolete and slow-moving inventories. Actual results could differ from those estimates.
 
Cash and Equivalents
 
For purposes of the statement of cash flows, the Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.  As of June 30, 2014 and December 31, 2013, the Company maintained restricted cash deposit in several bank accounts for the purposes described below.
 
   
2014
   
2013
 
   
(In millions)
 
Support of performance guarantee
 
$
0.46
   
$
1.16
 
Support of bank acceptance
   
-
     
1.29
 
Support of letter of credit
   
0.21
     
0.01
 
Total restricted cash - current
 
0.67
   
2.46
 
Performance guarantee -- noncurrent
 
$
0.32
   
$
0.14
 
  
 
The following table presents in U.S. dollars (“USD”) the amount of cash and equivalents held by the Company as of June 30, 2014 and December 31, 2013, based on the jurisdiction of deposit. The Company’s U.S. parent holds cash and equivalents in U.S. bank accounts denominated in USD.
 
   
United States
   
China
   
Germany
   
Total
 
June 30, 2014
 
$
244,035
   
$
17,767,302
   
$
985,280
   
$
18,996,617
 
December 31, 2013
 
$
251,461
   
$
11,326,282
   
$
2,024,656
   
$
13,602,399
 
 
As of June 30, 2014, Taiyu had RMB 10 million ($1.63 million) deposited in a commercial bank as an investment to the financial product with term from June 20, 2014 to July 23, 2014 and annual yield between 4.5% to 4.7% depending on CSI 300 index at the observation date.  SmartHeat Energy had RMB 45 million ($7.31 million) deposited in a commercial bank as an investment to the financial product with term from June 26, 2014 to July 28, 2014 and annual yield of 5.4%.

Accounts and Retentions Receivable

The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves. Based on historical collection activity, the Company had allowances of $41.29 million and $48.25 million at June 30, 2014 and December 31, 2013, respectively.
  
At June 30, 2014 and December 31, 2013, the Company had retentions receivable from customers for product quality assurance of $3.92 and $4.44 million, respectively. The retention rate varies from 5% to 20% of the sales price with variable terms from 3 to 24 months depending on the shipping date, and for PHE Units, the customer acceptance date, of the products and the number of heating seasons that the warranty period covers. The Company had allowances of $1.56 million and $0 at June 30, 2014 and December 31, 2013, respectively.

Accounts receivable is net of unearned interest of $26,413 and $26,655 at June 30, 2014 and December 31, 2013, respectively. Unearned interest is imputed interest on accounts receivable with due dates over 1 year from the invoice date discounted at the Company’s borrowing rate of 6.15% at December 31, 2012. The Company did not record additional unearned interest after December 31, 2012 due to no long-term accounts receivable.

Bad Debt Allowance

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

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

Inventories

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

Certain raw materials, such as stainless steel products, plates, shims, gaskets, and pump valves, require longer than normal procurement periods, or “lead times,” with some procurement periods running longer than six months. To guarantee availability of raw materials for production and sales, the Company’s subsidiaries, based on historical sale patterns, estimate and purchase material for the upcoming period.
 
As part of inventory impairment analysis, the Company performs an evaluation of raw materials stored over one year and not anticipated to be consumed, and an evaluation of potential impairment to the quality of these raw materials. If management anticipates that obsolete raw materials in inventory can be utilized and will be consumed within the next six months through new customer orders or substitute orders, no impairment is recorded. The Company collects information about delayed and canceled contracts and met with affected customers to discuss their financing situation and their projections of future orders. Finished goods manufactured for delayed and canceled contracts that the Company does not expect to be reinstated and contracts for which the Company has been unable to find substitute customers become impaired.
 
 
Property and Equipment
 
Property and equipment are stated at cost, net of accumulated depreciation. Expenditures for maintenance and repairs are expensed as incurred; additions, renewals and betterments are capitalized. When property and equipment are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss is included in operations. Depreciation of property and equipment is provided using the straight-line method with a 10% salvage value and estimated lives as follows:
 
Buildings
20 years
Vehicles
5 years
Office equipment
5 years
Production equipment
5-10 years
 
Land Use Rights
 
Right to use land is stated at cost less accumulated amortization. Amortization is provided using the straight-line method over 50 years.
 
Warranties
 
The Company offers to all customers standard warranties on its products for one or two heating seasons depending on the terms negotiated. The Company accrues for warranty costs based on estimates of the costs that may be incurred under its warranty obligations. The warranty expense and related accrual is included in the Company’s selling expenses and other payables respectively, and is recorded when revenue is recognized. Factors that affect the Company’s warranty liability include the number of units sold, its estimates of anticipated rates of warranty claims, costs per claim and estimated support labor costs and the associated overhead. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.
 
Activity in the Company’s warranty reserve from January 1, 2013, to June 30, 2014, is as follows:
 
   
2014
   
2013
 
Beginning balance
 
$
472,558
   
$
517,076
 
Provisions
   
406,625
     
331,989
 
Actual costs incurred
   
(175,030
)
   
(376,507
Ending balance in current liabilities (Note 13)
 
$
560,924
   
$
472,558
 
 
Research and Development Costs
 
Research and development (“R&D”) costs are expensed as incurred and included in general and administrative expenses. These costs primarily consist of cost of materials used, salaries paid for the Company’s development department and fees paid to third parties. R&D costs for the six months ended June 30, 2014 and 2013, were $403,917 and $238,053, respectively. R&D costs for the three months ended June 30, 2014 and 2013, were $246,546 and $115,616, respectively.
 
Revenue Recognition
 
The Company’s revenue recognition policies comply with SEC Staff Accounting Bulletin (“SAB”) 104 (codified in FASB ASC Topic 605). Sales revenue is recognized when PHEs, heat meters and heat pumps are delivered, and for PHE Units when customer acceptance occurs, the price is fixed or determinable, no other significant obligations of the Company exist and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition met are recorded as unearned revenue under “Advance from customers.”
 
The Company’s sales generally provide for 30% of the purchase price on placement of an order, 30% on delivery, 30% upon installation and acceptance of the equipment after customer testing and 10% no later than the termination of the standard warranty period, which ranges from 3 to 24 months from the acceptance date.
 
Due to the slowdown of the Chinese economy and tightened monetary policy, and to attract and retain customers, the Company’s subsidiaries adjusted their contract and payment terms to permit more flexible and longer payment terms. 
 
 
Sales revenue is the invoiced value of goods, net of value-added tax (“VAT”). All of the Company’s products sold in the PRC are subject to a VAT of 17% of gross sales price. This VAT may be offset by the VAT paid by the Company on raw materials and other materials purchased in China and included in the cost of producing the Company’s finished product. The Company recorded VAT payable and VAT receivable net of payments in the financial statements. The Company files VAT tax returns on line with PRC tax authorities and offsets the payables against the receivables. SmartHeat Germany, the Company’s German subsidiary, is subject to 19% VAT.
 
Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government. VAT taxes are not affected by the income tax holiday.
 
Sales returns and allowances were $0 for the six and three months ended June 30, 2014 and 2013. The Company does not provide a right of return, price protection or any other concessions to its customers.
 
The Company provides a standard warranty to all customers, which is not considered an additional service; rather, an integral part of the product’s sale. The Company believes the existence of its standard product warranty in a sales contract does not constitute a deliverable in the arrangement and thus there is no need to apply the EITF 00-21 (codified in FASB ASC Topic 605-25) separation and allocation model for a multiple deliverable arrangement. SFAS 5 (codified in FASB ASC Topic 450) specifically addresses the accounting for standard warranties and neither SAB 104 nor EITF 00-21 supersedes SFAS 5. The Company believes that accounting for its standard warranty pursuant to SFAS 5 does not impact revenue recognition because the cost of honoring the warranty can be reliably estimated.
 
The Company charges for after-sales services provided after the expiration of the warranty period, with after-sales services mainly consisting of cleaning PHEs and repairing and exchanging parts. The Company recognizes such revenue when the service is provided. For the six months ended June 30, 2014 and 2013, revenue from after-sales services after the expiration of the warranty period was $93,784 and $129,406, respectively. For the three months ended June 30, 2014 and 2013, revenue from after-sales services after the expiration of the warranty period was $47,540 and $47,776, respectively, which was recorded in other income.
 
Cost of Goods Sold
 
Cost of goods sold (“COGS”) consists primarily of material costs and direct labor and manufacturing overhead that are directly attributable to the products. Write-down of inventories to the lower of cost or market is also recorded in COGS.  Company also records inventory reserve for inventories aging over 360 days to COGS.
 
Advance from Customers
 
The Company records payments received from customers in advance of their orders to advance account. These orders normally are delivered within a reasonable period of time based upon contract terms and customer demand.
 
Statement of Cash Flows

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

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

Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS is computed similarly, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. Diluted EPS are based on the assumption that all dilutive convertible shares and stock options were converted or exercised. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to have been exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.
 
Basic and diluted shares outstanding are the same for the six and three months ended June 30, 2014 and 2013, because the common stock equivalent of the convertible securities outstanding, consisting of unexercised options issued to the Company’s directors and an officer, are anti-dilutive and, accordingly, were excluded from the computation of diluted loss per share. At June 30, 2014 and December 31, 2013, options to purchase 2,500 shares of common stock were outstanding and exercisable, respectively.
 
 
Foreign Currency Translation and Comprehensive Income (Loss)

The accounts of the U.S. parent company are maintained in USD. The functional currency of the Company’s China subsidiaries is the Chinese Yuan Renminbi (“RMB”) and the functional currency of SmartHeat Germany, the Company’s subsidiary in Germany, is the Euro (“EUR”). The accounts of the China subsidiaries and German subsidiary were translated into USD in accordance with SFAS No. 52, “Foreign Currency Translation” (codified in FASB ASC Topic 830). According to SFAS No. 52, all assets and liabilities were translated at the exchange rate on the balance sheet date, stockholders’ equity was translated at the historical rates and statement of operations items were translated at the average exchange rate for the period. The resulting translation adjustments are reported under other comprehensive income in accordance with SFAS No. 130, “Reporting Comprehensive Income” (codified in FASB ASC Topic 220).
  
The RMB to USD exchange rates and EUR to USD exchange rates in effect as of June 30, 2014 and December 31, 2013, and the average exchange rates for the six months ended June 30, 2014 and 2013 are as following.  The exchange rates used in translation from RMB to USD were published by State Administration of Foreign Exchange of the People’s Republic of China (“SAFE”). The exchange rates used in translation from EUR to USD were published by OANDA Rates.
 
   
Average Exchange Rate
   
Balance Sheet Date
 
   
For the Six Months Ended
   
Exchange Rate
 
   
6/30/14
   
6/30/13
   
6/30/14
   
12/31/13
 
RMB - USD
   
6.1180
     
6.2413
     
6.1528
     
6.0969
 
                                 
EUR - USD
   
0.7295
     
0.7616
     
0.7329
     
0.7263
 
 
Segment Reporting

FASB ASC Topic 280, Disclosures about Segments of an Enterprise and Related Information, requires use of the “management approach” model for segment reporting.  The management approach model is based on the way a company’s management organizes segments within the company for making operating decisions and assessing performance.  Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregates a company.
 
The Company has two operating segments: 1) plate heating equipment, meters and related products; and 2) heat pumps and related products.   These operating segments were determined based on the nature of the products offered.  Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance.  The Company's chief executive officer and acting chief accountant were identified as the chief operating decision makers.  The Company’s chief operating decision makers direct the allocation of resources to operating segments based on the profitability, cash flows, and other measurement factors of each respective segment.  Historically they were not segmented because the heat pump business was relatively small compared to the plate heating business and both businesses reported to the same executives; however, the Company’s Board and senior management determined that it is useful and efficient to analyze and manage these businesses separately starting from 2013.
 
 
The Company evaluates performance based on several factors, of which the primary financial measure is business segment income before taxes. The following table shows the operations of the Company's reportable segments for the six months ended June 30, 2014 and 2013, and as of June 30, 2014 and December 31, 2013, respectively. 
 
   
Six Months Ended June 30,
 
   
2014
   
2013
 
             
Revenue from unaffiliated customers:
           
Plate heating, meters and related
 
$
9,359,142
   
$
11,808,874
 
Heat pumps and related
   
1,310,691
     
2,082,549
 
Consolidated
 
10,669,833
   
13,891,423
 
Loss from operations:
               
Plate heating, meters and related
 
(3,731,906
)
 
(19,942,874
)
Heat pumps and related
   
(2,493,824
)
   
(1,866,988
)
Corporation
   
(698,612
)
   
(442,687
)
Consolidated
 
(6,924,342
)
 
(22,252,549
)
Net loss from continuing operations before non-controlling:
               
Plate heating, meters and related
 
(4,606,347
)
 
(20,406,465
)
Heat pumps and related
   
(2,373,653
)
   
(1,433,574
)
Corporation
   
(525,185
)
   
(484,359
)
Consolidated
 
(7,505,185
)
 
(22,324,398
)
Depreciation and amortization:
               
Plate heating, meters and related
 
740,608
   
771,634
 
Heat pumps and related
   
242,495
     
234,432
 
Corporation
   
75,101
     
65,381
 
Consolidated
 
1,058,204
   
1,071,447
 
Total assets:
               
Plate heating, meters and related
 
121,769,638
   
126,673,776
 
Heat pumps and related
   
41,671,724
     
14,480,873
 
Corporation
   
4,099,158
     
4,189,018
 
Inter-segment elimination
   
(47,415,620
)
   
(15,889,932
)
Consolidated
 
$
120,124,900
   
$
129,453,735
 
 
The following table shows the operations of the Company's reportable segments for the three months ended June 30, 2014 and 2013, respectively. 

   
Three Months Ended June 30,
 
   
2014
   
2013
 
             
Revenue from unaffiliated customers
           
Plate heating, meters and related
 
$
4,974,000
   
$
6,137,081
 
Heat pumps and related
   
735,867
     
1,585,911
 
Consolidated
 
$
5,709,867
   
$
7,722,992
 
Operating income (loss):
               
Plate heating, meters and related
 
$
8,317,577
   
$
(8,528,664
)
Heat pumps and related
   
(1,361,240
)
   
(641,294
)
Corporation
   
(171,785
)
   
(269,493
)
Consolidated
 
$
6,784,552
   
$
(9,439,451
)
Net income (loss) from continuing operations before non-controlling:
               
Plate heating, meters and related
 
$
7,590,477
   
$
(8,806,823
)
Heat pumps and related
   
(1,307,874
)
   
(379,331
)
Corporation
   
58,624
     
(269,628
)
Consolidated
 
$
6,341,227
   
$
(9,455,782
Depreciation and amortization:
               
Plate heating, meters and related
 
$
7,496
   
$
388,967
 
Heat pumps and related
   
4,875
     
111,451
 
Corporation
   
21,514
     
47,236
 
Consolidated
 
$
33,885
   
$
547,654
 

 
New Accounting Pronouncements

In January 2014, FASB issued, Accounting Standards Update 2014-01, Investments—Equity Method and Joint Ventures (Topic 323), Accounting for Investments in Qualified Affordable Housing Projects. The objective of this Update is to provide guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit. The amendments in this Update permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. The amendments in this Update should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this Update are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014.  The adoption of this ASU will not affect the Company’s financial statements.

In January 2014, FASB issued, Accounting Standards Update 2014-05, Service Concession Arrangements (Topic 853), The objective of this Update is to specify that an operating entity should not account for a service concession arrangement within the scope of this Update as a lease in accordance with Topic 840, Leases. Service concession arrangements may become more prevalent in the United States as public-sector entities seek alternative ways to provide public services on a more efficient and cost-effective basis. The amendments apply to an operating entity of a service concession arrangement entered into with a public-sector entity grantor when the arrangement meets certain conditions. The amendments in this Update should be applied on a modified retrospective basis to service concession arrangements that exist at the beginning of an entity’s fiscal year of adoption. The modified retrospective approach requires the cumulative effect of applying this Update to arrangements existing at the beginning of the period of adoption to be recognized as an adjustment to the opening retained earnings balance for the annual period of adoption. The amendments are effective for a public business entity for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The adoption of this ASU will not affect the Company’s financial statements.
 
As of June 30, 2014, there is no recently issued accounting standards not yet adopted that would have a material effect on the Company’s consolidated financial statements.

Reclassification
 
Certain prior year amounts were reclassified to conform to the manner of presentation in the current period, which includes the reclassification of a $2.99 million advance from customers to other payable in the balance sheet. 
 
3. INVENTORIES

Inventories at June 30, 2014 and December 31, 2013, were as follows:
 
   
2014
   
2013
 
Raw materials
 
$
48,753,774
   
$
48,258,773
 
Work in process
   
8,053,865
     
6,822,102
 
Finished goods
   
11,438,961
     
12,639,202
 
Total
   
68,246,600
     
67,720,077
 
Inventory allowance
   
(14,052,085
)
   
(11,395,714
)
Inventories, net
 
$
54,194,515
   
$
56,324,363
 
 
4. NOTES RECEIVABLE – BANK ACCEPTANCES

The Company sold goods to its customers and received commercial notes (bank acceptance) from them in lieu of payments for accounts receivable. The Company discounted the commercial notes with the bank or endorsed the commercial notes to vendors for payment of their own obligations or to get cash from third parties. Most of the commercial notes have a maturity of less than six months. As of June 30, 2014, the Company was contingently liable for the notes endorsed to vendors of $1.47 million.
 
 
5. PROPERTY AND EQUIPMENT, NET

Property and equipment consisted of the following at June 30, 2014 and December 31, 2013:
 
   
2014
   
2013
 
Buildings
 
$
4,934,937
   
$
4,980,184
 
Production equipment
   
9,054,038
     
8,599,701
 
Office equipment
   
1,126,136
     
1,124,176
 
Vehicles
   
872,964
     
940,624
 
Total
   
15,988,075
     
15,644,685
 
Less: accumulated depreciation
   
(5,946,576
)
   
(5,459,525
)
Property & equipment, net
 
$
10,041,499
   
$
10,185,160
 

Depreciation for the six months ended June 30, 2014 and 2013, was $713,770 and $707,900, respectively. Depreciation expense for the three months ended June 30, 2014 and 2013, was $358,370 and $353,400, respectively. 

6. OTHER RECEIVABLES, PREPAYMENTS AND DEPOSITS

Other receivables, prepayments and deposits consisted of the following at June 30, 2014 and December 31, 2013, respectively:
 
   
2014
   
2013
 
Advance to third party companies
 
$
12,914,392
   
$
10,059,572
 
Deposit for public bids of sales contracts
   
767,262
     
758,465
 
Prepayment for freight, related, insurance, advertisement and consulting expenses
   
109,299
     
73,773
 
Other deposits
   
86,892
     
53,863
 
Advance to employees
   
519,161
     
926,441
 
Advance to unrelated individuals
   
323,028
     
-
 
Others
   
649,669
     
680,588
 
Total
   
15,369,703
     
12,552,702
 
Less: bad debt allowance
   
(11,396,825
)
   
(9,908,180
Other receivables (net), prepayments & deposits
 
$
3,972,878
   
 $
2,644,522
 
  
Advance to third party companies were short-term unsecured advances to unrelated parties with payment usually due within a year and includes an advance to Siping Beifang of RMB 22.13 million ($3.60 million) that is non-interest bearing and with due date extended to September 2014.

Deposits for public bidding represented the deposits for bidding on expected contracts, which will be returned to the Company after the bidding process is completed, usually within three to four months from the payment date. Prepayment for freight, related insurance expenses and advertisement represented prepaid shipping and freight insurance expenses for customers and is generally repaid upon customer receipt of products and prepaid advertising expense.

Other deposits mainly consisted of deposits for rents, payroll expense and utilities. Advance to employees represented short-term loans to employees and advances for business trips and related expenses. Other receivables (consisting of advance to third parties and employees, deposit for public bids and others), prepayments and deposits are reimbursed or settled within 12 months.

7. INTANGIBLE ASSETS

Intangible assets consisted mainly of land use rights, trademarks, computer software, know-how technology, customer lists and covenants not to compete. All land in the PRC is government-owned and cannot be sold to any individual or company. However, the government grants the user a “land use right” to use the land. The Company acquired land use rights during 2005 for RMB 3,549,682 ($0.44 million). In June 2009, the Company acquired land use rights for $3.1 million from Siping Beifang. In November 2010, the Company’s subsidiary, SmartHeat Energy, acquired land use rights for $10.10 million. The Company has the right to use the land for 50 years and is amortizing such rights on a straight-line basis for 50 years.

SmartHeat Energy later cancelled the purchase of the land use right due to the adjustments of the overall development plan of the area by the local authority. On May 21, 2014, SmartHeat Energy and Shenyang City Development and Land Resource Bureau Economy and Technology Development Office entered into an official agreement, whereby full purchase price of the land use right will be returned to SmartHeat Energy in installments within 5 days from the effective date of the official agreement.  SmartHeat Energy will make the ownership change of the land use right upon receiving the refund from the local authority. SmartHeat Energy received accumulated amount of $14.89 million (RMB 91,622,000) as of June 30, 2014 and is in the process of title transfer, which is expected to complete by the end of 2014. Currently the land is used by the third party.

 
Intangible assets consisted of the following at June 30, 2014 and December 31, 2013, respectively:
 
 
Estimated Useful
Life (In years)
 
2014
   
2013
 
Land use rights
50
 
$
4,111,874
   
$
15,167,552
 
Know-how technology
5 – 10
   
903,143
     
911,423
 
Customer lists
5
   
212,889
     
214,841
 
Covenants not to compete
5
   
115,811
     
116,873
 
Software
5
   
459,272
     
680,049
 
Trademarks
7
   
295,837
     
298,549
 
Total
     
6,098,826
     
17,389,287
 
Less: accumulated amortization
     
(1,717,135
)
   
(2,503,664
)
Intangible assets, net
   
$
4,381,691
   
$
14,885,623
 
 
Amortization of intangible assets for the six months ended June 30, 2014 and 2013, was $269,333 and $298,209, respectively. Amortization expense of intangible assets for the three months ended June 30, 2014 and 2013, was $106,733 and $146,982, respectively. Annual amortization for the next five years from June 30, 2014, is expected to be $271,930, $234,260, $233,290, $201,430 and $167,720, and $3,273,060 thereafter.

8. CONSTRUCTION IN PROGRESS

The Company had construction in progress of $1.36 million at June 30, 2014, consisting of three ongoing projects.

1) SmartHeat Energy was building a factory for a total estimated cost of $9.00 million, of which the Company paid $0.47 million as of June 30, 2014. The Company halted construction of the factory resulting from SmartHeat Energy returning the previously purchased land use right to the local authority where the factory was being built due to the adjustment of the overall development plan of the area by the local authority (see Note 13).

2) SmartHeat Siping has a construction project of $71,000 for the laying of a foundation for its machinery installation. This foundation project will be completed in the third quarter of 2014. 
 
3) Taiyu paid $0.83 million for equipment and installation, this project was completed in July 2013 and is in the testing stage with continuous improvements.  The Company expects to complete the testing and put into operation in the third quarter of 2014.
 
9. LONG TERM INVESTMENT

Prior to December 30, 2013, the Company invested $722,700 to establish XinRui. The Company owned 46% of XinRui and accounted for this investment under the equity method. On December 30, 2013, the Company sold 40% equity interest of XinRui and owns 27.6% of Xinrui after the sale (See Note 2). The investment in Xinrui after the sale was $612,808. The investment loss from XinRui was $3,829 during the six months ended June 30, 2014.

The unaudited condensed Statement of Income of XinRui for the six months ended June 30, 2014 is below:
 
Net revenue
 
$
234,096
 
Cost of revenue
   
(140,279
)
Gross profit
   
93,817
 
Operating expenses
   
105,496
 
Loss from operations
   
(11,679
Non-operating loss
   
(3
Income tax expense
   
(2,192
Net loss
 
$
(13,874

Prior to December 30, 2013, the Company invested $771,600 for 51% of the equity in Ruicheng.  The Company sold 40% equity interest of Ruicheng on December 30, 2013, and owns 30.6% of Ruicheng after the sale (See Note 2). The investment in Ruicheng after the sale was $321,997. The investment loss from Ruicheng was $19,062 during the six months ended June 30, 2014.
 

The unaudited condensed Statement of Income of Ruicheng for the six months ended June 30, 2014 is below:
 
Net revenue
 
$
75,127
 
Cost of revenue
   
(54,319
)
Gross profit
   
20,808
 
Operating expenses
   
86,369
 
Loss from operations
   
(65,561
Non-operating income
   
3,269
 
Income tax expense
   
-
 
Net loss
 
$
(62,292

10. MAJOR CUSTOMERS AND VENDORS

One customer accounted for 11% of total sales for the six months ended June 30, 2014.  At June 30, 2014, total receivable from the customer was $0. For the three months ended June 30, 2014, one customer accounted for 17% of total sales.

For the six months ended June 30, 2013, one customer accounted for 16% of the Company’s total sales. At June 30, 2013, the total accounts receivable from this customer was $7,364,488. For the three months ended June 30, 2013, no customer accounted for over 10% of the Company’s total sales.

For the six and three months ended June 30, 2014 and 2013, no vendors accounted for over 10% of the Company’s total purchases.

11. TAXES RECEIVABLE

Taxes receivable consisted of the following at June 30, 2014 and December 31, 2013:
 
   
2014
   
2013
 
Income
 
$
179,122
   
$
180,764
 
Value-added
   
436,528
     
787,293
 
Other
   
17,756
     
21,578
 
Total
 
$
633,406
   
$
989,635
 

12. TAXES PAYABLE

Taxes payable consisted of the following at June 30, 2014 and December 31, 2013:
 
   
2014
   
2013
 
Income
 
$
-
   
$
516
 
Value-added
   
5,361
     
160,118
 
Other
   
21,400
     
36,444
 
Total
 
$
26,761
   
$
197,078
 
 
 
13. ACCRUED LIABILITIES AND OTHER PAYABLES
 
Accrued liabilities and other payables consisted of the following at June 30, 2014 and December 31, 2013:
 
   
2014
   
2013
 
Advance from third parties
 
$
3,329,957
   
$
3,378,167
 
Payable to Siping Beifang
   
2,198,923
     
2,306,184
 
Payable for equipment purchase
   
328,086
     
322,295
 
Payable to employees
   
144,578
     
-
 
Deposit from customer
   
2,961,091
     
2,988,240
 
Refund of land use right purchased
   
4,790,279
     
4,627,270
 
Others
   
1,551,574
     
1,738,241
 
Warranty reserve (See Note 2)
   
560,924
     
472,558
 
Accrued expenses
   
1,666,270
     
1,382,051
 
Total
 
$
17,531,682
   
$
17,215,006
 
 
Advances from third parties were short-term, non-interest-bearing advances from third parties due on demand.  Payable to Siping Beifang represented loans to them without interest and payable upon demand.  Deposit from customer represented advance payment from a customer for the Company to execute the sales order; however, the customer wanted to cancel the order after the Company commenced manufacturing and the Company refused to return the deposit claiming breach of the contract by the customer. The dispute was filed with the court and is currently docketed for trial.

Refund of land use right previously purchased represented the refund received for the land use right SmartHeat Energy purchased in November 2010. SmartHeat Energy later cancelled the purchase due to the adjustments of the overall development plan of the area by the local authority. The local government agreed to the cancellation and refunded SmartHeat Energy $4.59 million as of December 31, 2013, and was committed to refund SmartHeat Energy the remaining purchase price.  On May 21, 2014, SmartHeat Energy and Shenyang City Development and Land Resource Bureau Economy and Technology Development Office entered into an official agreement, whereby full purchase price of the land use right will be returned to SmartHeat Energy in installments within 5 days from the effective date of the official agreement.  SmartHeat Energy will make the ownership change of the land use right upon receiving the refund from the local authority. As of June 30, 2014, SmartHeat Energy received a total of $14.89 million (RMB 91,622,000), of which, $4.79 million was the amount received in excess of the amount paid to acquire land use right. The local government has not yet made qualitative determination about the excess amount and until such time that SmartHeat Energy receives further information, the excess amount from the refund of land use right will be recorded as other payable. The land use right title transfer is expected to complete by the end of 2014. Currently the land is used by the third party.

Others represented payables for the Company’s certain construction and installation projects, and miscellaneous expenses including postage, business insurance, employee benefits, project bidding fee, and medical insurance, etc. Accrued expenses mainly consisted of accrued property and land rental fee of $0.91 million, accrued payroll of $0.41 million, accrued welfare, interest and utility.  The accrued rental of $0.91 million represented the office and factory lease of HeatPump from Shenyang Economic and Technological Development Zone State-owned Assets Management Co., Ltd, whom is the minority shareholder of HeatPump, there was no contract for the lease and the lease was on month-to-month basis.

14. NOTES PAYABLE – BANK ACCEPTANCES

Notes payable represented the conversion of accounts payable into notes payable, which were issued by a bank. The Company deposited a portion of the acceptance amount into the bank as collateral. The terms of the notes range from 3-6 months and bear no interest. At June 30, 2014 and December 31, 2013, the Company deposited $0 million and $1.29 million with the bank as restricted cash for the bank issuing the notes (See note 2). The restricted cash is refundable when the notes are repaid. 
  
 
15. LOANS PAYABLE

Short-Term Bank Loans

The Company was obligated for the following short-term loans as of June 30, 2014 and December 31, 2013:
 
   
2014
   
2013
 
Subsidiary obligated
From a commercial bank in the PRC for RMB 7,200,000 entered into on February 20, 2014.The loan bore interest at 6% with maturity on February 19, 2015.
 
$
1,170,199
   
$
-
 
Taiyu
From a commercial bank in the PRC for RMB 2,640,565 entered into on January 3, 2014. The loan bore interest at 6.22% with maturity on July 29, 2014.  This loan was pledged by the Taiyu’s accounts receivable. The loan was paid in full at maturity.
   
429,165
     
-
 
Taiyu
From a commercial bank in the PRC for RMB 7,935,243 entered into on January 3, 2014. The loan bore interest at 6.22% with maturity on July 29, 2014. The loan was pledged by the Taiyu’s accounts receivable.  The loan was paid in full at maturity.
   
1,289,696
     
-
 
Taiyu
From a commercial bank in the PRC for RMB 16,080,000 entered into on January 16, 2014. The loan bore interest at 6.22% with maturity on August 8, 2014. The loan was pledged by Taiyu’s accounts receivable. The loan was paid in full at maturity.
   
2,613,444
     
-
 
Taiyu
From a commercial bank in the PRC for RMB 4,685,723 entered into on January 22, 2014. The loan bore interest at 6.22% with maturity on August 20, 2014. The loan was pledged by Taiyu’s accounts receivable. The loan was paid in full at maturity.
   
761,559
     
-
 
Taiyu
From a commercial bank in the PRC for RMB 5,377,441 entered into on January 22, 2014. The loan bore interest at 6.22% with maturity on August 20, 2014.  The loan was pledged by the Taiyu’s accounts receivable. The loan was paid in full at maturity.
   
873,983
     
-
 
Taiyu
From a commercial bank in the PRC for RMB 13,344,190 entered into on June 26, 2012. The loan bore interest at 6.16% with maturity on January 18, 2014. The loan was repaid at maturity.
   
-
     
2,188,684
 
Taiyu
From a commercial bank in the PRC for RMB 10,000,000 entered into on November 30, 2012. The loan bore interest at 7.87% with maturity on November 22, 2014. The loan was guaranteed by Taiyu.
   
1,625,277
     
1,640,178
 
Siping
From a commercial bank in the PRC for RMB 40,000,000 entered into on March 11, 2013. The loan bore interest at 6.60% with maturity on March 10, 2014. The loan was guaranteed by Siping, HeatPump and management of Chinese subsidiaries. This loan was repaid at maturity.
   
-
     
6,560,711
 
Taiyu
From a commercial bank in the PRC for RMB 10,000,000 entered into on May 21, 2013. The loan bore interest at 6.60% with maturity on May 20, 2014. This loan was repaid at maturity.
   
-
     
1,640,178
 
Taiyu
From a commercial bank in the PRC for RMB 5,000,000 entered into on August 29, 2013. The loan bore interest at 7.20% with maturity on August 29, 2014.  The loan was guaranteed by Taiyu. This loan was repaid at maturity.
   
812,638
     
820,089
 
Siping
From a commercial bank in the PRC for RMB 5,000,000 entered into on September 4, 2013. The loan bore interest at 7.20% with maturity on September 4, 2014.  The loan was guaranteed by Taiyu.
   
812,638
     
 820,089
 
Siping
From a commercial bank in the PRC for RMB 30,000,000 entered into on August 8, 2013. The loan bore interest at 6.90% with maturity on August 7, 2014. The loan was paid in full at maturity.
   
4,875,829
     
4,920,533
 
Taiyu
From a commercial bank in the PRC for RMB 9,900,000 entered into on September 18, 2013. The loan bore interest at 6.0% with maturity on September 17, 2014.  This loan was pledged by Taiyu’s accounts receivable.
   
1,609,023
     
1,623,776
 
Taiyu
From a commercial bank in the PRC for RMB 9,900,000 entered into on October 11, 2013.  The loan bore interest at 6.0% with maturity on October 10, 2014. This loan was pledged by Taiyu’s accounts receivable.
   
1,609,023
     
1,623,776
 
Taiyu
From a commercial bank in the PRC for RMB 16,000,000 entered into on July 10, 2013. The loan bore interest at 6.0% with maturity on January 9, 2014. This loan was pledged by Taiyu’s accounts receivable. This loan was repaid at maturity.
   
 
-
     
 
2,624,285
 
Taiyu
From a commercial bank in the PRC for RMB 36,000,000 entered into on April 23, 2014. The loan bore interest at 7.2% with maturity on April 22, 2015. This loan was pledged by Siping, Heat Pump, SanDeKe, and two officers of the Chinese subsidiaries.
   
5,850,995
     
-
 
Taiyu
From a commercial bank in the PRC for RMB 4,000,000 entered into on April 23, 2014. The loan bore interest at 7.2% with maturity on April 22, 2015. This loan was pledged by Siping, Heat Pump, SanDeKe, and two officers of  the Chinese subsidiaries.
   
650,111
     
-
 
Taiyu
TOTAL
 
$
24,983,580
   
$
24,462,299
   
  
 
The banks sometimes require loan guarantee provided by a third party to the Company, the third party loan guarantor was Liaoning Wugang Metal Trading Co., Ltd. (“Liaoning Wugang”), with a maximum guarantee of RMB 46 million ($7.32 million). The guarantee is for the loans entered from February 20, 2012 to August 16, 2013, with the guarantee length equal to the loan term; the guarantee service was extended for the loans entered or will be entered from September 18, 2013 to September 12, 2014 with the guarantee length equal to the loan term, the maximum guarantee amount was revised to RMB 44 million ($7.05 million).  The Company was not required to pay any guarantee fees. However, the Company has contracted to provide similar guarantees for up to RMB 20 million ($3.18 million) to Liaoning Guorui Commercial Trading Co., Ltd. (“Guorui”). The guarantee is for the loans entered from January 12, 2012 to January 11, 2013 with the guarantee length equal to the loan term, the Company does not require Guorui to pay any guarantee fees.  The Company did not extend the guarantee term for Guorui after January 11, 2013.  These arrangements are common to the banking industry in China, and there are no other relationships between the Company and Liaoning Wugang or Guorui, both of whom were referred to the Company by the lending bank.  As of June 30, 2014 and December 31, 2013, the Company did not have any loan guarantees from Liaoning Wugang.
 
Holding Company Credit Agreement – Credit Line Payable
 
On July 27, 2012, the Company, entered into a secured, revolving credit facility under the terms of a Secured Credit Agreement (the “Credit Facility” or the “Credit Agreement”) with Northtech Holdings Inc., a British Virgin Islands business corporation (“Northtech”), owned by certain members of the Company’s former management, James Wang, Rhett Wang and Wen Sha. Jane Ai, the Company’s Corporate Secretary is also a part owner of Northtech. As amended on December 21, 2012, the Credit Facility provides for borrowings of up to $2.5 million. 

Borrowings under the Credit Facility are secured by the Company’s deposit accounts located in the United States, its trademarks in the PRC and 55% of its equity in each of its wholly-, directly owned subsidiaries.  An origination fee of 4% of the Committed Amount was accrued to Northtech upon the signing of the Credit Agreement. As amended, Borrowings bear interest of 10% annually, payable quarterly, and the Credit Facility matured on April 30, 2013, and extended to April 30, 2014 with an extension fee of 4% of the Committed Amount. Generally, borrowings may be prepaid at any time without premium or penalty, provided however that if the Company prepays any amount due under the Credit Facility from the proceeds of another instrument or agreement of indebtedness, the Company shall pay a 10% prepayment fee.  All amounts due under the Credit Facility may, at the Company’s option, be paid in either cash or restricted shares of the Company’s common stock.  

On June 25, 2013, the Board approved second amendment to the credit and security agreement and on August 23, 2013, the Company entered into second amendment to the credit and security agreement with Northtech, which redefined the “base rate”, and adjusted the base rate to 10% annually, compounded quarterly, effective January 1, 2013.  The Company delivered to Northtech 100,000 restricted shares of the Company’s common stock as an Amendment Fee (see Note 19), issued in September 2013.

On December 21, 2012, the Company’s BOD approved the issuance of 1,300,000 Restricted Shares of Common Stock to Northtech in cancellation of $1,301,300 of indebtedness under the Credit Facility.  The balance owing to Northtech under the Credit Agreement as of June 30, 2014 and December 31, 2013 was $2,149,335 and $1,396,378, respectively, and was recorded as a noncurrent obligation under ASC 470-10-45-12 through ASC 470-10-45-14 due to the Note being secured by 55% of the equity interest in each of HEAT PHE Inc. and HEAT HP Inc., and the Company’s option to repay the note by issuance of the Company’s shares.
 
The Company had $100,000 payable to a consulting firm that was paid by a third party on behalf of the Company during 2012, this payable to the third party was assumed by Northtech on August 23, 2013, in exchange for 200,000 shares of the Company’s common stock issued in September 2013, and payable for a credit line balance from Northtech.  The stock price was $0.60 on August 23, 2013, the Company recognized $20,000 loss for the settlement of this payable by shares with Northtech.

On March 26, 2014, the Company gave notice to Northtech pursuant to the terms of the Credit and Security Agreement between the Company and Northtech, dated July 27, 2012, as amended, extending the maturity date on the Credit Agreement from April 30, 2014 to January 3, 2015. The Company elected to pay the extension fee of 4% of the credit line amount of $2.5 million by issuing 200,000 shares of its common stock to Northtech at $0.50 per share. The BOD approved such extension on March 27, 2014.
 
Long-Term Bank Loan

Taiyu entered into a long-term loan of $2,112,859 (RMB 13 million) with China Construction Bank on November 30, 2013 with maturity on November 29, 2015. The interest rate for the loan is variable currently at 6.46%, and to be paid on the 20th of each month. This loan is guaranteed by Taiyu’s building and land.
 
 
16. DEFERRED TAX ASSET (LIABILITY)

Deferred tax asset (liability) represented differences between the tax bases and book bases of property and equipment and intangible assets arising from the acquisition of SanDeKe and SmartHeat Pump, and bad debt allowance and provision of inventory impairment booked by the Company which was not allowed per tax purpose. As of June 30, 2014 and December 31, 2013, deferred tax asset (liability) consisted of the following:
 
   
2014
   
2013
 
Deferred tax asset - current (bad debt allowance for accounts receivable)
 
$
6,528,146
   
$
7,715,041
 
Deferred tax asset - current (bad debt allowance to retention receivable)
   
257,679
     
-
 
Deferred tax asset - current (inventory allowance)
   
2,903,505
     
2,321,878
 
Deferred tax asset – current (bad debt allowance for other receivables)
   
2,356,665
     
2,099,125
 
Deferred tax asset – current (allowance for advance to supplier)
   
421,520
     
398,224
 
Deferred tax asset – current (reserve for warranty)
   
90,640
     
75,808
 
Deferred tax asset – noncurrent (NOL)
   
2,642,802
     
2,464,239
 
Less: valuation allowance
   
(15,200,957
)
   
(15,074,315
)
Deferred tax assets, net
 
$
                                    -
   
$
  -
 
Deferred tax liability - noncurrent (depreciation of fixed assets)
 
$
(91,419
 
$
(17,177

17. INCOME TAXES

The Company is subject to income taxes by entity on income arising in or derived from the tax jurisdiction in which each entity is domiciled.  The Company’s PRC subsidiaries file their income tax returns online with PRC tax authorities.
 
SmartHeat, the parent company, was incorporated in the U.S. and has net operating losses (“NOL”) for income tax purposes, which can be carried forward for up to 20 years from the year the loss is incurred. SmartHeat has NOL carry forwards for income taxes of approximately $7.77 million at June 30, 2014, which may be available to reduce future years’ taxable income. Management believes the realization of benefits from these losses remains uncertain due to SmartHeat’s limited operating history and continuing losses. Accordingly, a 100% deferred tax asset valuation allowance was provided.

Taiyu and SanDeKe are governed by the Income Tax Law of the PRC concerning privately-run enterprises, which are generally subject to tax at 25% on income reported in the statutory financial statements after appropriate tax adjustments. Under the Income Tax Law that became effective January 1, 2008, new high-tech enterprises given special support by the PRC government are subject to an income tax rate of 15%. Taiyu has been classified as a high-tech enterprise since 2009 and eligible for an income tax rate of 15% through 2014.  Local PRC government reviews the high-tech status of such enterprises annually. The income tax rate for SanDeKe was 13% for 2012, because of its foreign-invested enterprise status, and its income tax rate increased to 24% in 2013 and 25% in 2014.

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

The following table reconciles the U.S. statutory rates to the Company’s effective tax (benefit) rate for the six months ended June 30, 2014 and 2013:
 
   
2014
   
2013
 
U.S. statutory tax (benefit) rates
   
(34.0
)%
   
(34.0
)%
Tax rate difference
   
8.3
%
   
8.9
%
Effect of tax holiday
   
3.8
%
   
2.9
%
Other
   
(0.1
)%
   
-
%
Valuation allowance
   
23.0
%
   
22.0
%
Tax benefit per financial statements
   
1.0
%
   
(0.2
)%
 
 
The following table reconciles the U.S. statutory rates to the Company’s effective tax (benefit) rate for the three months ended June 30, 2014 and 2013:
 
   
2014
   
2013
 
U.S. statutory tax (benefit) rates
   
34.0
%
   
(34.0
)%
Tax rate difference
   
(9.0
)%
   
8.7
%
Effect of tax holiday
   
(12.2
)%
   
8.0
%
Other
   
(0.1
)%
   
-
%
Valuation allowance
   
(11.3
)%
   
17.1
%
Tax benefit per financial statements
   
1.4
%
   
(0.2
)%

The income tax (benefit) for the six months ended June 30, 2014 and 2013, consisted of the following:

   
2014
   
2013
 
Income tax expense (benefit) - current
 
$
672
   
$
(1,549
Income tax expense (benefit) - deferred
   
74,821
     
(43,451
)
Total income tax expense (benefit), net
 
$
75,493
   
$
(45,000

The income tax (benefit) for the three months ended June 30, 2014 and 2013, consisted of the following:

   
2014
   
2013
 
Income tax expense - current
 
$
1,058
   
$
(1,794
Income tax expense (benefit) - deferred
   
88,971
     
(20,762
)
Total income tax expense (benefit), net
 
$
90,029
   
$
(22,556

18. STATUTORY RESERVES AND RESTRICTED NET ASSETS

The Company’s ability to pay dividends primarily depends on the Company receiving funds from its subsidiaries. Relevant PRC statutory laws and regulations permit payments of dividends by the Company’s PRC subsidiaries only out of the subsidiary’s retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. The results of operations reflected in the financial statements prepared in accordance with U.S. GAAP differ from those reflected in the statutory financial statements of the Company’s PRC subsidiaries.
 
In accordance with the PRC Regulations on Enterprises with Foreign Investment and their articles of association, a foreign-invested enterprise (“FIE”) established in the PRC is required to provide certain statutory reserves, which are appropriated from net profit as reported in the FIE’s PRC statutory accounts. An FIE is required to allocate at least 10% of its annual after-tax profit to the surplus reserve until such reserve has reached 50% of its respective registered capital based on the FIE’s PRC statutory accounts. Appropriations to other funds are at the discretion of the board of directors for all FIEs. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. Additionally, shareholders of an FIE are required to contribute capital to satisfy the registered capital requirement of the FIE. Until such contribution of capital is satisfied, the FIE is not allowed to repatriate profits to its shareholders, unless otherwise approved by the State Administration of Foreign Exchange. Taiyu, SanDeKe, SmartHeat Siping, Jinhui, SmartHeat Investment and Ruicheng were established as FIEs and therefore are subject to the above-mandated restrictions on distributable profits. As of June 30, 2014, the Company met all registered capital requirements for its FIEs except for SmartHeat Investment, for which the Company is committed to contribute an additional $40.00 million in registered capital by April 2015 (See note 20).
 
Additionally, in accordance with the Company Law of the PRC, a domestic enterprise is required to provide surplus reserve at least 10% of its annual after-tax profit until such reserve has reached 50% of its respective registered capital based on the enterprise’s PRC statutory accounts. A domestic enterprise is also required to provide discretionary surplus reserve, at the discretion of the board of directors, from the profits determined in accordance with the enterprise’s PRC statutory accounts. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. SmartHeat Energy, SmartHeat Trading and SmartHeat Pump were established as domestic enterprises and therefore are subject to the above-mentioned restrictions on distributable profits.
 
 
As a result of these PRC laws and regulations that require annual appropriations of 10% of after-tax income to be set aside prior to payment of dividends as general reserve fund, the Company’s PRC subsidiaries are restricted in their ability to transfer a portion of their net assets to the Company as a dividend.

19. STOCKHOLDERS’ EQUITY
 
Stock Options to Independent Directors and Officer
 
On February 1, 2010, the Company issued stock options to an officer. The terms of the options were 5,000 shares at an exercise price per share of $118.50, with a life of five years and vesting over two years as follows: 2,500 shares vested on June 30, 2011, and 2,500 shares vested on June 29, 2012. The options were valued using a volatility of 74%, risk free interest rate of 2.76%, and dividend yield of 0%. The grant-date FV of the options was $367,107. On May 25, 2012, the officer resigned from his position as VP of Strategy and Development of the Company, and was not entitled to the remaining unvested options. The remaining obligations of the Company to the officer were released pursuant to a severance agreement and mutual release.
 
Based on the FV method under SFAS No. 123 (Revised), “Share Based Payment” (“SFAS 123(R)”) (codified in FASB ASC Financial Instruments, Topic 718 & 505), the FV of each stock option granted is estimated on the date of the grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model has assumptions for risk-free interest rates, dividends, stock volatility and expected life of an option grant. The risk-free interest rate is based upon market yields for U.S. Treasury debt securities at a maturity near the term remaining on the option. Dividend rates are based on the Company’s dividend history. The stock volatility factor is based on the historical volatility of the Company’s stock price. The expected life of an option grant is based on management’s estimate. The FV of each option grant to independent directors is calculated by the Black-Scholes method and is recognized as compensation expense over the vesting period of each stock option award.
 
Following is a summary of the option activity:
 
   
Number of
Shares
   
Average
Exercise
Price per Share
   
Weighted
Average
Remaining
Contractual
Term in Years
 
Outstanding at January 1, 2013
   
3,500
     
97.80
     
1.65
 
Exercisable at January 1, 2013
   
3,500
     
97.80
     
1.65
 
Granted
   
-
     
-
     
-
 
Exercised
   
-
     
-
     
-
 
Forfeited
   
1,000
     
46.00
     
-
 
Outstanding at December31, 2013
   
2,500
     
118.5
     
1.34
 
Exercisable at December31, 2013
   
2,500
     
118.5
     
1.34
 
Granted
   
-
     
-
     
-
 
Exercised
   
-
     
-
     
-
 
Forfeited
   
-
     
-
     
-
 
Outstanding at June 30, 2014
   
2,500
   
$
118.5
     
0.58
 
Exercisable at June 30, 2014
   
2,500
   
$
118.5
     
0.58
 
 
There were no options exercised during the six and three months ended June 30, 2014 and 2013. The Company recorded $0 as compensation expense for stock options during the six and three months ended June 30, 2014 and 2013.

Common Stock Issued
 
The Company had $100,000 payable to a consulting firm that was paid by a third party on behalf of the Company during 2012, this payable to the third party was assumed by Northtech on August 23, 2013, for 200,000 shares of the Company’s common stock issued in September 2013.  The stock price was $0.60 on August 23, 2013, the Company recognized $20,000 loss for the settlement of this payable by shares with Northtech (see Note 15).
 
On June 25, 2013, the Board approved second amendment to the credit and security agreement and on August 23, 2013, the Company entered into second amendment to the credit and security agreement with Northtech, which redefined the “base rate”, and adjusted the base rate to 10% annually, compounded quarterly, effective January 1, 2013.  The Company delivered Northtech 100,000 restricted shares of the Company’s common stock as an Amendment Fee.  The FV of the stocks issued for the Amendment fee was $60,000 (See Note 15).
 
 
On September 17, 2013, the Company’s BOD approved the issuance of 100,000 restricted shares of common stock to Northtech for their consent to the Company to enter into an Equity Interest Purchase Agreement as contemplated by the stalking horse proposal and approved by the Company’s Board. The stock price on the approval date was $0.30, the fair value of the shares issued was $30,000. Under the terms of the Equity Interest Purchase Agreement, the buyers agreed to purchase 40% of the Company’s equity interests in the following PHE segment subsidiaries: Taiyu, SmartHeat Siping, SmartHeat Energy, Ruicheng, and XinRui (collectively, the “Target Companies”).  The purchase price was RMB 5,000,000 ($801,000), was paid by the buyers on December 30, 2013.

On March 27, 2014, The Compensation Committee of the Board approved to grant certain individuals the Company’s common stock in recognition of their valuable services to the Company and its subsidiaries in 2013. The individual and number of shares granted is as follows: 100,000 shares to Oliver Bialowons, 50,000 shares to Huajun Ai, 50,000 shares to Xudong Wang and 50,000 shares to Kenneth Scipta. The stock price was $0.15 on grant date, and the FV of the shares granted at the grant date was $37,500 and was recorded as shares to be issued.

On March 27, 2014, the BOD approved the Company’s request to Northtech for extending the maturity date on the Credit Agreement from April 30, 2014 to January 3, 2015, and pay the extension fee of 4% of the credit line amount of $2.5 million by issuing 200,000 shares of its common stock to Northtech at $0.50 per share. The FV of 200,000 shares was $30,000 and the Company recognized $70,000 gain from such stock issuance.

20. COMMITMENTS

Lease Agreements

The Company leased offices for its sales representative in several different cities under various one-year, non-cancellable and renewable operating lease agreements. Rental expense for the six months ended June 30, 2014 and 2013, was $199,574 and $250,912, respectively. Rental expense for the three months ended June 30, 2014 and 2013, was $115,396 and $118,553, respectively.

Capital Contribution

The Company formed SmartHeat Investment on April 7, 2010, as an investment holding company with registered capital of $70 million to enable its establishment and investment in new businesses in China. Under PRC company law, registered capital must be used in the operations of the domestic company within its approved business scope. SmartHeat Investment was established as a separate subsidiary of the Company to allow allocation of capital to new businesses in China separate from its existing subsidiaries and operations. As a PRC investment holding company, the $70 million in approved registered capital of SmartHeat Investment is deemed a planned investment amount for the entity, not a traditional registered capital requirement under PRC corporate law. The Company contributed $30 million in capital to SmartHeat Investment on April 15, 2010, from proceeds of its public offering that closed on September 22, 2009. On April 12, 2010, SmartHeat Investment formed SmartHeat Energy, a wholly owned subsidiary in Shenyang with registered capital of $30 million, subsequently satisfied out of the registered capital of SmartHeat Investment, for the research, development, manufacturing and sale of energy products. As of June 30, 2014, the Company is committed to contributing the remaining $40 million in registered capital to SmartHeat Investment by April 2015. The Company may satisfy this contribution through cash flow provided by operations, sales of assets, such as physical assets, financial assets, or interests in its subsidiaries, and funds raised through offerings of its securities, if and when the Company determines such offerings are required, and at such time that the Company identifies a new acquisition, investment or business opportunity to be financed through SmartHeat Investment, although no specific investment candidate has been identified to date.
 
Restructuring Agreement with a Consulting Firm
 
On April 23, 2012, the Company entered into an agreement (“Agreement”) with Nimbus Restructuring Manager LLC (“Nimbus”), for advice on raising capital and restructuring the Company to maximize value for the benefit of all of the stockholders of the Company.

Upon execution of the Agreement, the Company paid $200,000 as a deposit and a $50,000 advance for future expenses incurred by Nimbus. Additionally, the Company paid $70,000 per month for 6 months. An additional $600,000 is to be paid upon the completion of the Company’s restructuring to the satisfaction of the Board.

The Company also issued and sold to Nimbus 300,000 shares of the Company’s restricted common stock for $15,000, or $0.05 per share, the Company has the right to repurchase such shares for $0.20 per share until January 31, 2013, $0.40 per share until September 30, 2013, $0.60 per share until June 30, 2014, $0.80 per share until March 31, 2015 and $1.00 per share until January 31, 2016. On October 12, 2012, the Company issued 300,000 shares of stock to an affiliate of Nimbus at $0.05 per share in accordance with the restructuring agreement.

The Company shall reimburse Nimbus and its affiliates for all reasonable and appropriate out-of-pocket expenses actually incurred in performance of the services specified in the Agreement.
 
 
On May 9, 2013, the Company entered a Restated Restructuring Agreement with Nimbus, which was intended to be a legally binding restatement of the Restructuring Agreement entered on April 23, 2012. Pursuant to the Restated Restructuring Agreement, the term was extended for an additional 12 monthly periods from original expiration date of January 23, 2013 to January 22, 2014. A monthly service fee of $30,000 is to be paid on the first day of each month for 10 months through November 2013. In addition, a $300,000 termination fee will be paid on the earlier of the expiration of the stated term or the termination by the Company.
 
On September 18, 2013, the Company entered Amendment #1 to the Restated Restructuring Agreement with Nimbus, pursuant to the Amendment, the service term was revised after the initial expiration date of January 23, 2013, for an extension of 10 additional month until November 2013, and thereafter extended for 4 additional months until March 2014.  The termination fee of $300,000 will be paid in 4 equal monthly payments of $75,000 each commencing in December 2013 and running through March 2014 or on the earlier of the expiration of the Stated Term or the earlier termination by the Company.

As of June 30, 2014, the Company owed $75,000 to Nimbus, which was included in other payable.
 
21. CONTINGENCIES

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

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

On August 31, 2012, a putative class action lawsuit, Steven Leshinsky v. James Wang, et. al., which purported to allege federal securities law claims against the Company and certain of its former officers and directors, was filed in the United States District Court for the Southern District of New York.  Thereafter, two plaintiffs filed competing motions to be appointed lead plaintiff in the proceeding.  A lead plaintiff was appointed and an amended complaint was filed on January 28, 2013, by the Rosen Law Firm. The amended complaint included Oliver Bialowons, our President, and Michael Wilhelm, our former Chief Financial Officer, as defendants in the proceeding though they were not officers of the Company during the alleged class period. A second amended complaint was filed on April 8, 2013, under the caption  Stream Sicav, Dharanendra Rai et al. v. James Jun Wang , SmartHeat, Inc. et al., removing Messrs. Wilhelm and Bialowons as defendants.  The second amended complaint alleges two counts against the Company, both asserting violations of the federal securities laws arising from alleged insider sales or management sales of securities and alleged false disclosures relating to those sales. On May 8, 2013, we filed a motion to dismiss the second amended complaint which was denied. On March 17, 2014 the court, denied, the lead plaintiff's motion for class certification, without prejudice. On August 6, 2014, the lead plaintiffs once again filed a motion for class certification, which we will be opposing. Discovery is also proceeding. The pleadings and court orders are publicly available. We intend to vigorously defend this action, as we believe the allegations against us are without merit.
 
22. PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS
 
On December 30, 2013, the Company, closed the transaction contemplated by the Equity Interest Purchase Agreement dated October 10, 2013, whereby the buyers purchased 40% of the Company’s equity interests in the following PHE segment subsidiaries: SmartHeat Taiyu (Shenyang) Energy; SmartHeat Siping Beifang Energy Technology Co., Ltd.; SmartHeat (Shenyang Energy Equipment) Co. Ltd.; Hohot Ruicheng Technology Co., Ltd.; and Urumchi XinRui Technology Limited Liability Company (collectively, the “Target Companies”). The purchase price was RMB 5,000,000.  Hohot Ruicheng Technology Co., Ltd. was 51% owned and Urumchi XinRui Technology Limited Liability Company (“XinRui”) was 46% owned by SmartHeat US parent company prior to 40% equity interest sell.
 
On March 27, 2014, the buyers exercised their option to purchase an additional 40% equity interest in the Target Companies for an additional purchase price of RMB 6,000,000. The Company will seek the approval of its shareholders prior to completing the sale. As of June 30, 2014, the Company evaluated it is highly probably the shareholders will approve the additional 40% equity sale, and accordingly, the pro forma consolidated financial statements reflecting the total of 80% equity interest sale of Target Companies were presented as following.
 
 
The following pro forma consolidated statements of operations present the SmartHeat Inc. for the six and three months ended June 30, 2014 and 2013, as if the 80% equity sale occurred on January 1, 2013, and January 1, 2014, for the purpose of the statements of operations, respectively. The accompanying pro forma consolidated balance sheet presents the accounts of SmartHeat Inc. as if the 80% equity sale occurred on June 30, 2014.  The 80% equity sales results in deconsolidation of disposed entities and the remaining  20% investment in these entities is accounted for under  equity method of accounting (ASC Topic 323-10-15) as a result of SmartHeat Inc. having significant influence over the disposed entities’ operational and financial policies..
 
SMARTHEAT INC. AND SUBSIDIARIES
UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEETS
REFLECTING THE SALE OF CERTAIN ENTITIES OF PHE SEGMENT
 
   
AS OF JUNE 30, 2014
               
    Company Historical (1)     Sales of PHE segment (2)     Pro Forma adjustments       Company Pro Forma  
                           
ASSETS
                         
                           
CURRENT ASSETS
                         
     Cash & equivalents
  $ 18,996,617     $ 15,470,662     $ -       $ 3,525,955  
     Restricted cash
    670,830       426,713                 244,117  
     Accounts receivable, net
    15,099,549       18,910,294       5,824,393   a     2,013,648  
     Retentions receivable, net
    2,597,790       2,539,455                 58,335  
     Advances to suppliers, net
    5,018,613       3,319,356                 1,699,257  
     Other receivables (net), prepayments and deposits
    3,972,878       28,060,221       39,106,268   a, b     15,018,925  
     Inventories, net
    54,194,515       46,604,713                 7,589,802  
     Taxes receivable
    633,406       604,594                 28,812  
     Notes receivable - bank acceptances
    683,906       460,660                 223,246  
                                   
        Total current assets
    101,868,104       116,396,668       44,930,661         30,402,097  
                                   
NONCURRENT ASSETS
                                 
     Long term investment
    912,044       -       11,770,769   b     12,682,813  
     Restricted cash
    316,899       304,485                 12,414  
     Advance to supplier for equipment
    1,241,933       1,241,933                 -  
     Construction in progress
    1,362,730       1,362,730                 -  
     Property and equipment, net
    10,041,499       8,581,833                 1,459,666  
     Intangible assets, net
    4,381,691       3,738,189                 643,502  
                                   
       Total noncurrent assets
    18,256,796       15,229,170       11,770,769         14,798,395  
                                   
TOTAL ASSETS
  $ 120,124,900     $ 131,625,838     $ 56,701,431       $ 45,200,493