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EX-31.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER, PURSUANT TO 18 U.S.C. 1350, AS ADOPTED PURSUANT TO SECTION 302 OF 2002 - China Xuefeng Environmental Engineering Inc.exh31_2.htm
EX-32.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER, PURSUANT TO 18 U.S.C. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002* - China Xuefeng Environmental Engineering Inc.exh32_2.htm
EX-32.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER, PURSUANT TO 18 U.S.C. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh32_1.htm
EX-31.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER, PURSUANT TO 18 U.S.C. 1350, AS ADOPTED PURSUANT TO SECTION 302 OF 2002* - China Xuefeng Environmental Engineering Inc.exh31_1.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

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

For the quarter ended: August 31, 2016

OR

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

For the Transition Period from ___________ to____________

Commission File Number: 000-53741

CHINA XUEFENG ENVIORNMENTAL ENGINEERING INC.
(Exact name of Registrant as specified in its charter)

Nevada
99-0364975
(State or other jurisdiction of incorporation)
(IRS Employer I.D. No.)

The Beijing-Hangzhou Grand Canal Service Center
229 Tongda Avenue
Economic and Technological Development Zone,
Suqian, Jiangsu Province, P.R. China 223800
(Address of principal executive offices and zip Code)

+86 (527) 8437-0508
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months, and (2) has been subject to such filing requirements for the past 90 days.  Yes   No 
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.  Yes   No 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act:
 
Large accelerated filer
 
Accelerated filer
 
 
 
 
 
Non-accelerated filer
(Do not check if a smaller reporting company)
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 o No 
 
As of October 17, 2016, there were 63,020,871 outstanding shares of common stock of the registrant, par value $0.001 per share.
 

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC.
FORM 10-Q

TABLE OF CONTENTS
 
PART I – FINANCIAL INFORMATION
 
Page
   
Item 1. Financial Statements.
 1
 
 
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
 34
 
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 41
 
 
Item 4. Controls and Procedures.
 42
 
 
PART II – OTHER INFORMATION
 
 
Item 1. Legal Proceedings.
 43
 
 
Item 1A. Risk Factors.
 43
 
 
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds.
 43
 
 
Item 3 Defaults Upon Senior Securities.
 43
 
 
Item 4. Mine Safety Disclosures.
 43
 
 
Item 5. Other Information.
 44
 
 
Item 6. Exhibits.
 44
 
 
Signatures
 45
 

 
ITEM 1. FINANCIAL STATEMENTS.
 
 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN U.S. $) (UNAUDITED)
   
August 31,
   
May 31,
 
ASSETS
 
2016
   
2016
 
         
Current assets:
       
  Cash  
$
7,670,907
   
$
5,912,106
 
  Accounts receivable
   
4,166,689
     
4,173,156
 
  Prepaid VAT
   
3,581,274
     
3,735,575
 
  Prepaid expenses
   
500,347
     
88,477
 
                 
    Total current assets
   
15,919,217
     
13,909,314
 
                 
Noncurrent assets:
               
Fixed assets, net
   
40,706,868
     
41,603,297
 
Prepaid Lease
   
5,797,156
     
5,913,880
 
Accounts receivable-non-current
   
4,760,339
     
5,907,361
 
Deferred income tax assets
   
300,187
     
280,184
 
                 
Total noncurrent assets
   
51,564,550
     
53,704,722
 
                 
Total Assets
 
$
67,483,767
     
67,614,036
 
 
See accompanying notes to the consolidated financial statements.
1

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN U.S. $) (UNAUDITED)
   
August 31,
   
May 31,
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
2016
   
2016
 
         
Current liabilities:
       
       
  Accounts payable  
$
690,399
   
$
1,247,399
 
  Deferred revenues    
3,058,646
     
2,967,016
 
  Taxes payable
   
750,814
     
810,428
 
  Loan from stockholder
   
8,696,914
     
8,781,471
 
  Accrued liabilities
   
148,116
     
165,097
 
    Total current liabilities
   
13,344,889
     
13,971,411
 
                 
Security deposits payable
   
2,754,278
     
2,794,868
 
                 
TOTAL LIABILITIES
   
16,099,167
     
16,766,279
 
                 
Stockholders' equity:
               
  Common stock, $0.001 par value per share, 75,000,000 shares authorized; 63,020,871 shares issued and outstanding
   
63,021
     
63,021
 
  Additional paid-in capital
   
33,518,248
     
33,518,248
 
  Statutory reserve fund
   
1,956,240
     
1,843,520
 
  Retained earnings
   
17,352,579
     
16,234,031
 
  Other comprehensive income
   
(2,574,371
)    
(1,838,853
)
                 
  Stockholders' equity before noncontrolling interests
   
50,315,717
     
49,819,967
 
  Noncontrolling interest
   
1,068,883
     
1,027,790
 
                 
    Total stockholders' equity
   
51,384,600
     
50,847,757
 
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
67,483,767
   
$
67,614,036
 
 

See accompanying notes to the consolidated financial statements.
2


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
   
Three Months Ended
 August 31,  
 
   
2016
   
2015
 
         
Revenue:
       
       
    Sales  
$
1,536,109
   
$
10,865,073
 
    Lease income
   
592,099
     
-
 
                 
Total revenue
   
2,128,208
     
10,865,073
 
                 
Cost of goods sold:
               
    Cost of sales
   
139,786
     
8,103,499
 
    Depreciation expense - leased equipment
   
286,323
     
-
 
                 
Total cost of goods sold
   
426,109
     
8,103,499
 
                 
  Gross profit
   
1,702,099
     
2,761,574
 
                 
Operating expenses:
               
    Selling and marketing
   
151,438
     
252,257
 
    General and administrative
   
261,854
     
287,207
 
                 
      Total operating expenses
   
413,292
     
539,464
 
See accompanying notes to the consolidated financial statements.
3


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
   
Three Months Ended,
August 31,  
 
   
2016
   
2015
 
         
Income from operations
   
1,288,807
     
2,222,110
 
    Interest income
   
135,165
     
21,865
 
    Government subsidy
   
225,899
     
241,970
 
                 
Income before provision for income taxes
   
1,649,871
     
2,485,945
 
Provision for income taxes
   
362,243
     
566,744
 
                 
Net income
   
1,287,628
     
1,919,201
 
Noncontrolling interest
   
(56,360
)    
(87,987
)
                 
Net income attributable to common stockholders
 
$
1,231,268
   
$
1,831,214
 
                 
Earnings per common share, basic and diluted
 
$
0.02
   
$
0.03
 
                 
Weighted average shares outstanding, basic and diluted
   
63,020,871
     
63,020,871
 
                 
Comprehensive Income:
               
Net Income
 
$
1,287,628
   
$
1,919,201
 
Foreign currency translation adjustment
   
(750,785
)    
(1,154,335
)
                 
Comprehensive income
   
536,843
     
764,866
 
     Comprehensive income attributable to noncontrolling interests
   
(41,093
)    
(50,662
)
                 
Net Comprehensive income attributable to common  stockholders
 
$
495,750
   
$
714,204
 
 
See accompanying notes to the consolidated financial statements.
4

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 (IN U.S. $) (UNAUDITED)
   
Common
Stock
   
Additional
 Paid-in
Capital
   
Retained
 Earnings
   
Noncontrolling
 Interests
   
Statutory
Reserve
Fund
   
Other
Comprehensive
 Income
   
Total
 
                             
Balance, May 31, 2016
 
$
63,021
   
$
33,518,248
   
$
16,234,031
   
$
1,027,790
   
$
1,843,520
   
$
(1,838,853
)
 
$
50,847,757
 
                                                         
   Net income
   
-
     
-
     
1,231,268
     
56,360
     
-
     
-
     
1,287,628
 
                                                         
   Appropriation to statutory reserve
   
-
     
-
     
(112,720
)
   
-
     
112,720
     
-
     
-
 
                                                       
   Foreign currencytranslation adjustment
   
-
     
-
     
-
     
(15,267
)
   
-
     
(735,518
)
   
(750,785
)
                                                         
Balance, August 31, 2016
 
$
63,021
   
$
33,518,248
   
$
17,352,579
   
$
1,068,883
   
$
1,956,240
   
$
(2,574,371
)
 
$
51,384,600
 

 
See accompanying notes to the consolidated financial statements.
5

 
CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
   
For The Three Month Ended
 
   
August 31,
 
   
2016
   
2015
 
         
Cash flows from operating activities:
 
$
1,287,628
   
$
1,919,201
 
     Net income
               
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation
   
311,417
     
7,373
 
Amortization for the land lease
31,024
33,230
 
Increase in deferred income tax assets
   
(24,219
)    
(30,974
)
Changes in operating assets and liabilities:
             
Decrease (increase) in accounts receivable
   
968,029
     
(10,050,668
)
Decrease in prepaid VAT
   
100,657
     
-
 
(Increase) decrease in prepaid expenses
   
(415,653
)    
43,437
 
(Increase) in advance to supplier
   
-
     
(2,625,840
)
(Decrease) increase in accounts payable and accrued liabilities
   
(473,197
)    
543,921
 
Increase in deferred revenue
   
135,544
     
209,399
 
(Decrease) increase in taxes payable
   
(48,136
)    
231,334
 
                 
              Net cash provided by (used in) operating activities
   
1,873,094
     
(9,719,587
)
                 
Cash flows from investing activities:
               
   Purchase of fixed assets
   
(17,423
)    
(9,741,051
)
                 
Cash flows from financing activities:
               
    Proceeds from shareholder
   
-
     
12,259,848
 
Effect of exchange rate changes on cash
   
(96,870
)    
(1,142,809
)
                 
Net increase (decrease) in cash
   
1,758,801
     
(8,343,599
)
Cash, beginning
   
5,912,106
     
26,493,540
 
                 
Cash, end
 
$
7,670,907
   
$
18,149,941
 
See accompanying notes to the consolidated financial statements.
6

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 
For The Three Month Ended
 
 
August 31,
 
 
2016
 
2015
 
Supplemental disclosure of cash flow information
   
Cash paid during the period for:
   
Interest
 
$
-
   
$
627
 
Income taxes
  $
436,072
    $
689,855
 
                 
Supplemental disclosure of non-cash activities
               
Property, equipment, construction in process transferred from prepayment
 
$
-
   
$
834,302
 
Property, equipment, construction in process accrued
 
$
-
   
$
(11,615
)
Payment of accrued liabilities by shareholder
 
$
39,000
    $    

See accompanying notes to the consolidated financial statements.
7

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

NOTE 1.   ORGANIZATION
China Xuefeng Environmental Engineering Inc. (the "Company"), formerly known as NYC Moda Inc., was incorporated under the laws of the State of Nevada on March 30, 2011.  Since its inception until the closing of the Exchange Agreement, the Company was a development-stage company.
On November 27, 2012, the Company completed a reverse acquisition transaction through a share exchange with the stockholders of Inclusion Business Limited ("Inclusion"), whereby the Company acquired 100% of the outstanding shares of Inclusion in exchange for 7,895,000 shares of its common stock, representing 76.65% of the issued and outstanding shares of common stock.  As a result of the reverse acquisition, Inclusion became the Company's wholly-owned subsidiary and the former Inclusion Stockholders became our controlling stockholders.  The share exchange transaction was treated as a reverse acquisition, with Inclusion as the acquirer and the Company as the acquired party for accounting purposes.
In November, 2012, the Company filed a certificate of amendment to its articles of incorporation to change its name from "NYC Moda, Inc." to "China Xuefeng Environmental Engineering Inc." (the "Name Change") and to initiate a 4-for-1 forward stock split (the "Forward Split") of its outstanding shares of common stock. The Name Change and the Forward Split were effective in December, 2012. Upon the effectiveness of the Forward Split, the number of outstanding shares of the Company's common stock increased from 10,300,000 to 41,200,000 shares. In March, 2013, the Company sold 14,000,000 shares of common stock to 12 unrelated individuals in a private offering, generating $7,000,000 in net proceeds.
As a result of the transaction with Inclusion, the Company owns all of the issued and outstanding common stock of Lotus International Holdings Limited ("Lotus"), a wholly-owned subsidiary of Inclusion, which in turn owns all of the issued and outstanding capital stock of Baichuang Information Consulting (Shenzhen) Co. Ltd ("Baichuang Consulting"). In addition, the Company effectively and substantially controls Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng") through a series of captive agreements with Baichuang Consulting.
The Company conducts its operations through its controlled consolidated variable interest entity ("VIE"), Jiangsu Xuefeng.  Jiangsu Xuefeng, incorporated under the laws of the People's Republic of China ("PRC") in December, 2007, is primarily engaged in the sale, lease and installation of garbage recycling equipment and provides improvement and upgrading services of garbage recycling processing technology and equipment. 
In October 2012, Baichuang Consulting (the "WFOE"), a wholly-owned subsidiary of Lotus, entered into a series of contractual arrangements (the "VIE Agreements"). The VIE Agreements include (i) an Exclusive Technical Service and Business Consulting Agreement; (ii) a Proxy Agreement, (iii) Share Pledge Agreement and, (iv) Call Option Agreement with the stockholders of Jiangsu Xuefeng.

8

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

NOTE 1.   ORGANIZATION (CONTINUED)
Exclusive Technical Service and Business Consulting Agreement: Pursuant to the Exclusive Technical Service and Business Consulting Agreement, the WFOE provides technical support, consulting, training, marketing and operational consulting services to Jiangsu Xuefeng. In consideration for such services, Jiangsu Xuefeng has agreed to pay an annual service fee to the WFOE of 95% of Jiangsu Xuefeng's annual net income and an additional payment of approximately US$15,910 (RMB 100,000) each month. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.
Proxy Agreement: Pursuant to the Proxy Agreement, the stockholders of Jiangsu Xuefeng agreed to irrevocably entrust the WFOE to designate a qualified person acceptable under PRC law and foreign investment policies, all of the equity interests in Jiangsu Xuefeng held by the stockholders of Jiangsu Xuefeng. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.
Call Option Agreement: Pursuant to the Call Option agreement, the WFOE has an exclusive option to purchase, or to designate a purchaser, to the extent permitted by PRC law and foreign investment policies, part or all of the equity interests in Jiangsu Xuefeng held by each of the stockholders. To the extent permitted by PRC laws, the purchase price for the entire equity interest is approximately US$0.16 (RMB1.00) or the minimum amount required by PRC law or government practice. This Agreement remains effective until all the call options under the Agreement have been exercised by Baichuang Consulting or its designated entities or natural persons.
Share Pledge Agreement: Pursuant to the Share Pledge agreement, each of the stockholders pledged their shares in Jiangsu Xuefeng to the WFOE, to secure their obligations under the Exclusive Technical Service and Business Consulting Agreement. In addition, the stockholders of Jiangsu Xuefeng agreed not to transfer, sell, pledge, dispose of or create any encumbrance on their interests in Jiangsu Xuefeng that would affect the WFOE's interests. This Agreement remains effective until the obligations under the Exclusive Technical Service and Business Consulting Agreement, Call Option Agreement and Proxy Agreement have been fulfilled or terminated.
On August 4, 2016, Baichuang Information Consulting Co., Ltd ("Baichuang Information") entered into an agreement with Mr. Li Yuan, the sole shareholder of Linyi County Xuefeng Renewable Resources Utilization Technology Co., Ltd ("Linyi Xuefeng"), to purchase his 100% ownership of Linyi Xuefeng. Mr. Li Yuan is the Chief Executive Officer and main shareholder of the Company. The purchase price is to be determined by the audited net assets of the Company as of May 31, 2016, ("payment anticipated to be RMB10,000,000 ($1,500,000 US) in cash and the balance to be paid in common shares of China Xuefeng at 75% of the closing price of the last trading day of stock delivery").  In any event, the payment method of specific amount and securities shall be separately accounted for and discussed after the audit report is issued.
On October 7, 2016, a supplementary agreement was entered between both parties to finalize the purchase based upon the audited net asset value of $ 23,462,612 on May 31, 2016. The supplementary agreement indicated that the transfer price is $3 per share consisting entirely of stock of the Company.  Accordingly, 7,820,871 shares were issued to Mr. Li Yuan.

9

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)


NOTE 1.   ORGANIZATION (CONTINUED)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF ACCOUNTING AND PRESENTATION
The unaudited interim consolidated financial statements of the Company as of August 31, 2016 and for the three months ended August 31, 2016 and 2015, have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC which apply to interim financial statements. Accordingly, they do not include all of the information and footnotes normally required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, such information contains all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for the periods presented. The interim consolidated financial information should be read in conjunction with the consolidated financial statements and the notes thereto, included in the Company's Form 10-K filed with the SEC. The results of operations for the three months ended August 31, 2016 are not necessarily indicative of the results to be expected for future three months or for the year ending May 31, 2017.
The acquisition of Linyi Xuefeng was treated as a combination of entities under common as Mr. Li Yuan was the chief executive officer and major shareholder of both companies. An acquisition of an entity under common control is treated similar to a "pooling of interest." Accordingly, the financial statements of the Company include the historical balances of Linyi Xuefeng as if the acquisition occurred on the first day of the earliest period presented.
All consolidated financial statements and notes to the consolidated financial statements are presented in United States dollars ("US Dollar" or "US$" or "$").

10

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY
Pursuant to Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 810, "Consolidation" ("ASC 810"), the Company is required to include in its consolidated financial statements, the financial statements of its variable interest entities ("VIEs").  ASC 810 requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE's residual returns.  VIEs are those entities in which a company, through contractual arrangements, bears the risk of, and enjoys the rewards normally associated with ownership of the entity, and therefore the company is the primary beneficiary of the entity.
Under ASC 810, a reporting entity has a controlling financial interest in a VIE, and must consolidate that VIE, if the reporting entity has both of the following characteristics: (a) the power to direct the activities of the VIE that most significantly affect the VIE's economic performance; and (b) the obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the VIE.  The reporting entity's determination of whether it has this power is not affected by the existence of kick-out rights or participating rights, unless a single enterprise, including its related parties and de facto agents, have the unilateral ability to exercise those rights.  Jiangsu Xuefeng's actual stockholders do not hold any kick-out rights that affect the consolidation determination.
Through the VIE agreements disclosed in Note 1, the Company is deemed the primary beneficiary of Jiangsu Xuefeng. Accordingly, the results of Jiangsu Xuefeng have been included in the accompanying consolidated financial statements. Jiangsu Xuefeng has no assets that are collateral for or restricted solely to settle their obligations. The creditors of Jiangsu Xuefeng do not have recourse to the Company's general credit.

11

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY (CONTINUED)
The following financial statement amounts and balances of Jiangsu Xuefeng have been included in the accompanying consolidated financial statements.
 
ASSETS
 
August 31,
2016
   
May 31,
2016
 
   
(Unaudited)
     
Current assets:
       
 Cash
 
$
6,538,804
   
$
5,587,133
 
 Account receivable
   
4,165,891
     
4,172,406
 
 Prepaid VAT
   
2,153,313
     
2,286,570
 
 Prepaid expenses
   
497,566
     
87,492
 
                 
  Total current assets
   
13,355,574
     
12,133,601
 
                 
Fixed assets, net
   
16,542,498
     
17,070,774
 
                 
Account receivable-noncurrent
   
4,760,339
     
5,907,361
 
                 
TOTAL ASSETS
 
$
34,658,411
   
$
35,111,736
 
                 
LIABILITIES
               
                 
Current liabilities:
               
 Due to China Xuefeng Environmental Engineering, Inc. (1)
 
$
6,513,058
   
$
6,609,043
 
 Payable to WFOE (2)
   
15,700,755
     
13,958,489
 
 Accounts payable
   
254,471
     
774,665
 
 Deferred revenue
   
2,385,045
     
2,967,016
 
 Taxes payable
   
565,832
     
635,027
 
 Loan from stockholder
   
272,866
     
276,888
 
 Accrued liabilities
   
41,235
     
42,746
 
                 
  Total current liabilities
   
25,733,262
     
25,263,874
 
                 
Deposit payable-noncurrent
   
2,754,278
     
2,794,868
 
                 
TOTAL LIABILITIES
 
$
28,487,540
   
$
28,058,742
 

12

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY (CONTINUED)
(1)
Due to China Xuefeng Environmental Engineering, Inc. is for the proceeds from the sale of common stock which proceeds were received by Jiangsu Xuefeng for 14,000,000 common shares issued by China Xuefeng Environmental Engineering, Inc. on March 19, 2013 at $0.50 each (approximately US$7,000,000).

(2)
Payable to WFOE represents outstanding amounts due to Baichuang Information Consulting (Shenzhen) Co. Ltd. under the Exclusive Technical Service and Business Consulting Agreement for consulting services provided to Jiangsu Xuefeng in exchange for 95% of Jiangsu Xuefeng's net income and additional monthly payments of RMB 100,000 (approximately US$15,630).  During the three months ended August 31, 2016 and 2015, Jiangsu Xuefeng did not make any payment to the WOFE.
 
   
For The Three Months Ended
August 31,
 
   
2016
   
2015
 
   
(Unaudited)
   
(Unaudited)
 
Revenue
 
$
2,128,208
   
$
10,865,073
 
                 
Net income (3)
 
$
1,127,203
   
$
1,759,742
 
 
(3)
Under the Exclusive Technical Service and Business Consulting Agreement, 95% of the net income is to be remitted to the WFOE, which is not reflected above.

   
For The Three Months Ended
August 31,
 
   
2016
   
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
Net cash provided by (used in) operating activities
 
$
1,056,516
   
$
(9,650,785
)
Net cash (used in) investing activities
   
(17,423
)
   
(178,100
)
Effect of exchange rate changes on cash
   
(87,422
)
   
(740,497
)
                 
Net increase (decrease) in cash
 
$
951,671
   
$
(10,569,382
)


13

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY (CONTINUED)
The Company believes that Baichuang Consulting's contractual agreements with Jiangsu Xuefeng are in compliance with PRC law and are legally enforceable.  The stockholders of Jiangsu Xuefeng are also the senior management of the Company and therefore the Company believes that they have no current interest in seeking to act contrary to the contractual arrangements.  However, Jiangsu Xuefeng and its stockholders may fail to take certain actions required for the Company's business or to follow the Company's instructions despite their contractual obligations to do so.  Furthermore, if Jiangsu Xuefeng or its stockholders do not act in the best interests of the Company under the contractual arrangements and any dispute relating to these contractual arrangements remains unresolved, the Company will have to enforce its rights under these contractual arrangements through PRC law and courts and therefore will be subject to uncertainties in the PRC legal system.  All of these contractual arrangements are governed by PRC law and provide for the resolution of disputes through arbitration in the PRC.  Accordingly, these contracts would be interpreted in accordance with PRC law and any disputes would be resolved in accordance with PRC legal procedures.  As a result, uncertainties in the PRC legal system could limit the Company's ability to enforce these contractual arrangements, which may make it difficult to exert effective control over Jiangsu Xuefeng, and its ability to conduct the Company's business may be adversely affected.
ACQUISITION OF LINYI XUEFENG
The following financial statement amounts and balances of Linyi Xuefeng have been included in the accompanying consolidated financial statements.
   
August 31,
   
May 31,
 
   
2016
   
2016
 
   
(Unaudited)
     
         
TOTAL ASSETS
 
$
32,642,934
   
$
32,316,617
 
                 
TOTAL LIABILITIES
  $
9,368,758
    $
8,854,005
 
 
   
For The Three Months Ended
August 31,
 
   
2016
   
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
TOTAL OPERATING EXPENSES
 
$
97,035
   
$
124,240
 
                 
TOTAL OTHER INCOME
  $
226,058
    $
242,315
 
                 
NET INCOME
  $
153,242
    $
149,049
 

14

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.
FOREIGN CURRENCY TRANSLATION
Almost all Company assets are located in the PRC.  The functional currency for the majority of the Company's operations is the Renminbi ("RMB").  The Company uses the United States dollar ("US Dollar" or "US$" or "$") for financial reporting purposes.  The financial statements of the Company have been translated into US dollars in accordance with FASB ASC 830, "Foreign Currency Matters."
All asset and liability accounts have been translated using the exchange rate in effect at the balance sheet date.  Equity accounts have been translated at their historical exchange rates when the capital transactions occurred.  Statements of income amounts have been translated using the average exchange rate for the periods presented.  Adjustments resulting from the translation of the Company's financial statements are recorded as other comprehensive income (loss).
The exchange rates used to translate amounts in RMB into US dollars for the purposes of preparing the financial statements are as follows:
   
August 31,
2016
   
May 31,
2016
   
August 31,
2015
 
             
Balance sheet items, except for stockholders' equity, as of year end
   
0.1497
     
0.1519
     
N/A
 
                         
Amounts included in the statements of income, statements of changes in stockholders' equity and statements of cash flows
   
0.1506
     
N/A
 
   
0.1613
 
 
For the three months ended August 31, 2016 and 2015, foreign currency translation adjustments of $(750,785) and $(1,154,335), respectively, have been reported as other comprehensive income.  Other comprehensive income of the Company consists entirely of foreign currency translation adjustments.  Pursuant to ASC 740-30-25-17, "Exceptions to Comprehensive Recognition of Deferred Income Taxes," the Company does not recognize deferred U.S. taxes related to the undistributed earnings of its foreign subsidiaries and, accordingly, recognizes no income tax expense or benefit from foreign currency translation adjustments.
15

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FOREIGN CURRENCY TRANSLATION (CONTINUED)
Although government regulations now allow convertibility of the RMB for current account transactions, significant restrictions still remain.  Hence, such translations should not be construed as representations that the RMB could be converted into US dollars at that rate or any other rate.
The value of the RMB against the US dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC's political and economic conditions.  Any significant revaluation of the RMB may materially affect the Company's financial condition in terms of US dollar reporting.
REVENUE RECOGNITION
Revenues are primarily derived from selling and leasing garbage processing equipment, providing garbage recycling processing system technology support, renovation and upgrade services and patent licensing to customers.  The Company's revenue recognition policies comply with FASB ASC 605 "Revenue Recognition."  In general, the Company recognizes revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the products or services have been delivered or performed and collectability of the resulting receivable is reasonably assured.
Improvement and upgrading service is a one-time service provided to upgrade customer's existing equipment before they opt to license and use our patented technology. The fee for the service would be paid within thirty (30) days upon execution of the contract.
Inspection would be conducted by the customers according to industry standards within three days upon completion of the improvement and upgrading service. Performance testing would then be conducted on the upgraded equipment, which typically can be done within a month. A final inspection assessment report would be provided to the customers within five days upon completion of the testing and Customers would provide the Company with a signed acceptance form if they are satisfied. The Company will recognize the revenue for the improvement and upgrading service once the performance testing is passed and the final evaluation report is provided by the customer.
Patent licensing is limited to five (5) years with payments due annually in advance and recognized as revenue monthly. We are responsible to provide repairing service when necessary, but customers would bear any out of pocket expense relating to the repairing service.
We believe that lease receivables have four potential risks: operation risk, credit risk, accident risk and natural disasters risk.

16

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
First, there is no guarantee that the licensee of our patent will have sufficient capital resources to perform the licensing agreement and pay the licensing fee on time or at all. The length of the agreement is up to five (5) years and therefore the Company may not able to collect fees for the entire agreement. Second, there is a potential credit risk for which the licensee may unilaterally terminate the agreement and thus affect the payout of the licensing agreement. Third, accident involving the equipment caused by employees of the licensee may have material adverse effect on the operation of the licensee. This unforeseeable risk could impact the licensee's ability to perform throughout the length of the agreement. Lastly, unforeseeable natural disasters could have a material adverse effect on the production and operation of the Company's licensees. If their operation is impacted by events such as fire, flood or earthquakes, they may need to cease their operation and therefore may be unable to perform their obligations under the agreement.
Linyi Xuefeng's income relates solely to government for city pollution garbage processing system constructions.  Government subsidy are recognized as earned when grant expenses are incurred up to the maximum amount allowed for each grant award.
Sales-Type Leases
The Company entered into three sales-type lease arrangements during the three months ended August 31, 2015, with two customers for financing of their purchase of garbage processing equipment.  The arrangements with the customers have a fixed term of three years. Revenue from the sale of the equipment is recognized at the inception of the lease. The payments have been present valued with an annual interest rate of 5.25%. In connection with these arrangements, the Company recognized revenue of $14,300,324 for the year ended May 31, 2016. Future minimum collections for the year ending May 31 are as follows:

Year Ending  
May 31, Amount  
   
2017
 
$
3,102,134
 
2018
   
4,329,537
 
2019
   
1,492,458
 
         
   
$
8,924,129
 
 
17

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
Operating Leases
The Company entered into three operating lease arrangements with two customers for garbage processing equipment on April 25, 2016, December 28, 2015 and November 6, 2015, respectively. The arrangement with the customer has a fixed term of five years with three monthly payments of $180,719, $361,438 and $150,599, respectively. Revenue from the leasing of the equipment is recognized monthly. In addition, the lease required a security deposit on $718,507, $1,437,014 and $598,756, respectively. At the end of the five years lease term, it will be determined whether the lease will be extended, leased to a new customer or returned to the Company. Future minimum payments for the years ending May 31 are as follows:
Year Ending
     
May 31,
   
Amount
 
       
2017
   
$
2,078,266
 
2018
     
2,771,022
 
2019
     
2,771,022
 
2020
     
2,771,022
 
2021
     
1,756,988
 
           
     
$
12,148,320
 
Multiple-Element Arrangements
In October 2009, the FASB issued Accounting Standards Update ("ASU") No. 2009-13, "Multiple Deliverable Revenue Arrangements." ASU No. 2009-13 amended the guidance on arrangements with multiple deliverables under ASC 605-25, "Revenue Recognition—Multiple-Element Arrangements."  To qualify as a separate unit of accounting under ASC 605-25, the delivered item must have value to the customer on a standalone basis.  The significant deliverables under the Company's multiple-element arrangements are improvement and upgrade services and patent licensing.
18

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
Multiple-Element Arrangements (Continued)
Improvement and Upgrade Service
The improvement and upgrade service is a one-time service. By the end of improvement and upgrading services, there is persuasive evidence of an arrangement exists since company has a signed contract with a customer; delivery has occurred and a customer has completed inspection and accepted the improvement and upgrading services then delivered; the fee is fixed and become due within 30 days upon the signing of the contract; and collectability is probable. An inspection is conducted by the customer according to industry standards within three days of the completion of the improvement and upgrade.  An acceptance form is provided by the customer if the inspection is satisfactory.  Performance testing is conducted on the upgraded equipment within one month. A final evaluation report is provided within five days of the completion of the performance testing.  The fee for improvement and upgrade services is fixed and becomes due within 30 days, upon the signing of the contract.  The fees for the improvement and upgrading services are not subject to refund, forfeiture or any other concession if patent licensing is not completed.
The Company has met the agreed upon specifications and has not been required to make any refunds for its services.  No warranty is provided by the Company.
The customer is responsible for repair services when necessary.  The out of pocket expenses for the repair services will be charged separately to the customer by the Company.
Patent Licensing
Patent licensing is limited to 5 years with payments due annually in advance.  The patent technology of "harmless and comprehensive garbage processing equipment" provided by the Company to its customers has high garbage processing capacity and stable operation capacity.  It is the first modern system equipment in China to use DCS (Distributed Control System) centralized control, by which mechanical automation will be realized for the comprehensive treatment of life garbage.  Its core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization, with a utilization rate approaching 100%.  The resource recovery products, biogas, not only can be used for meeting the needs of the plant itself, but also can be sold as a separate product, which greatly improves the efficiency of garbage processing of the customer's equipment, decreases production cost, and increases the recovery return of garbage processing.
19

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
Multiple-Element Arrangements (Continued)
Patent Licensing (continued)
The Company's customer who pays for an upgrade and improvement fee is not required to enter into a licensing agreement to continue to use the patented technology.  If the customer does not require the garbage processing equipment to reach the level of the patented technology which can process 500 tons to 1,000 tons of garbage per day, then the customer does not need to enter into the patent licensing agreement.
Multiple Elements
The Company determined that its improvement and upgrade services are individually a separate unit of accounting.  In determining whether the improvement and upgrade services has standalone value, the Company considered factors including the availability of similar services from other vendors, its fee structure based on inclusion and exclusion of the service, and its marketing and delivery of the services.  The Company uses the vendor-specific objective evidence to determine the selling price for its improvement and upgrade services when sold in multiple-element arrangements.  Although not yet being sold separately, the price established by the management has the relevant authority.
The Company also determined that the patent licensing has standalone value because the patent can be licensed separately. The Company uses the vendor-specific objective evidence to determine the price for patent licensing when sold in multiple-element arrangements.  Although not yet being licensed separately, the price established by the management has the relevant authority.  The Company establishes the price of  upgrading and improvement service and the price of patent licensing is determined based on the following method:
Since equipment improvement and upgrade service and patent leasing service are derived from the Company's patented technology, which the Company has the exclusive right to while others must obtain licensing rights to use the technology, the Company have a strong bargaining power in the market to undertake the promotion of its brand and corporate image. Furthermore, the Company uses a profit cost pricing method to determine the price of its product. The Company calculates the price by adding its target profit, or a 90% gross profit margin, to the base product cost to derive the final sale price of its services.
The Company allocates the arrangement consideration based on their relative selling prices.  Revenues for the improvement and upgrade services are recognized when completed, the performance testing is passed and the final evaluation report is provided by the customer, which generally is within 30 days, assuming all other revenue recognition criteria are met.  Revenues for patent licensing are recognized monthly over the licensing period.
 
20

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
Multiple-Element Arrangements (Continued)
Multiple Elements (continued)
The Company believes the effect of changes in the selling price for improvement and upgrade services and patent licensing will not have significant effect on the allocation of the arrangement.
FAIR VALUE OF FINANCIAL INSTRUMENTS
FASB ASC 820, "Fair Value Measurement," defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability.  The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity.
Level 1 Inputs – Unadjusted quoted market prices for identical assets and liabilities in an active market that the Company has the ability to access.
Level 2 Inputs – Inputs other than the quoted prices in active markets that are observable either directly or indirectly.
Level 3 Inputs – Inputs based on prices or valuation techniques that are both unobservable and significant to the overall fair value measurements.
ASC 820 requires the use of observable market data, when available, in making fair value measurements.  When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement.  Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.  As of August 31, 2016 and May 31, 2016, none of the Company's assets and liabilities were required to be reported at fair value on a recurring basis.  Carrying values of non-derivative financial instruments, including cash, accounts receivable, prepaid VAT, accounts payable and accrued expenses, and deferred revenue approximate their fair values due to the short term nature of these financial instruments.  There were no changes in methods or assumptions during the periods presented.
CASH AND CASH EQUIVALENTS
The Company considers all demand and time deposits and all highly liquid investments with an original maturity of three months or less to be cash equivalents.
21

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FIXED ASSETS
Fixed assets are recorded at cost, less accumulated depreciation.  Cost includes the price paid to acquire the asset, and any expenditures that substantially increase the asset's value or extends the useful life of an existing asset.  Depreciation is computed using the straight-line method over the estimated useful lives of the assets.  Major repairs and betterments that significantly extend the original useful life or improve productivity are capitalized and depreciated over the periods benefited.  Maintenance and repairs are generally expensed as incurred.  The estimated useful lives for fixed asset categories are as follows:
Computers and equipment
3 years
Motor vehicles
4 years
Furniture and fixtures
5 years
Investment in leased property
15 years
Machinery
10 years
Building and improvement
20 years
IMPAIRMENT OF LONG-LIVED ASSETS
The Company applies FASB ASC 360, "Property, Plant and Equipment," which addresses the financial accounting and reporting for the recognition and measurement of impairment losses for long-lived assets.  In accordance with ASC 360, long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  The Company may recognize the impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to those assets.  No impairment of long-lived assets was recognized for the periods presented.
DEFERRED REVENUE
Deferred revenue is advance payments received for patent licensing fees and received from government for city pollution garbage processing system constructions. These payments received, but not yet earned, are recognized as deferred revenue in the consolidated balance sheets.
22

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INCOME TAXES
The Company accounts for income taxes in accordance with FASB ASC 740, "Income Taxes" ("ASC 740"), which requires the recognition of deferred income taxes for differences between the basis of assets and liabilities for financial statement and income tax purposes.  Deferred tax assets and liabilities represent the future tax consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.  At August 31, 2016 and May 31, 2016, the differences relate entirely to revenue deferred for financial statement purposes.  During the year ended May 31, 2015, as permitted by the PRC tax law, the Company began recognizing revenue from patent licensing fees for income tax purposes, based on when it is earned rather than when it is collected, consistent with the financial statement recognition.  As a result, there are no differences between the basis of assets and liabilities for financial statements and income tax purposes for deferred revenue and, as a result, deferred income taxes are no longer required to be recognized.  A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized.
ASC 740 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements.  Under ASC 740, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position would be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.  ASC 740 also provides guidance on de-recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, and accounting for interest and penalties associated with tax positions.  As of August 31, 2016 and May 31, 2016, the Company does not have a liability for any unrecognized tax benefits.
The income tax laws of various jurisdictions in which the Company, its subsidiaries and the VIE operate are summarized as follows:
United States
The Company is subject to United States tax at graduated rates from 15% to 34%.  No provision for income taxes in the United States has been made as the Company had no U.S. taxable income for the three months ended August 31, 2016 and 2015.
PRC
Jiangsu Xuefeng and Baichuang Consulting are subject to an Enterprise Income Tax at 25% and file their own tax returns.  Consolidated tax returns are not permitted in China.
BVI
Inclusion is incorporated in the BVI and is governed by their income tax laws.  According to current BVI income tax law, the applicable income tax rate for the Company is 0%.
23

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INCOME TAXES (CONTINUED)
Hong Kong
Lotus is incorporated in Hong Kong.  Pursuant to the income tax laws of Hong Kong, the Company is not subject to tax on non-Hong Kong source income.
ADVERTISING COSTS
Advertising costs are charged to operations when incurred.  For the three months ended August 31, 2016 and 2015, advertising expense was $90,359 and $183,076, respectively.
STATUTORY RESERVE FUND
Pursuant to corporate law in the PRC, the Company is required to transfer 10% of its net income, as determined under PRC accounting rules and regulations, to a statutory reserve fund until such reserve balance reaches 50% of the Company's registered capital.  The statutory reserve fund is non-distributable other than during liquidation and can be used to fund previous years' losses, if any, and may be utilized for business expansion or used to increase registered capital, provided that the remaining reserve balance after such use is not less than 25% of the registered capital.  For the three months ended August 31, 2016 and 2015, a statutory reserve of $112,720 and $194,220, respectively, was required to be allocated to the Company.
VALUE ADDED TAX ("VAT")
All China-based enterprises are subject to a VAT imposed by the PRC government on their domestic product sales.  The output VAT is charged to customers who purchase goods from the Company and the input VAT is paid when the Company purchases goods from its vendors. Input VAT rates are 17% for the purchasing activities conducted by the Company. Output VAT rate is 17% for all products.  The input VAT can be offset against the output VAT.  The VAT payable will be presented on the balance sheets when input VAT is less than the output VAT.  Recoverable balance will be presented on the balance sheets when input VAT is larger than the output VAT.
NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS
In April 2016, the FASB issued Accounting Standards Update No. 2016-12, Revenue from Contracts with Customers. In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606).'' This guidance supersedes current guidance on revenue recognition in Topic 605, "Revenue Recognition.'' In addition, there are disclosure requirements related to the nature, amount, timing, and uncertainty of revenue recognition. In August 2015, the FASB issued ASU No.2015-14 to defer the effective date of ASU No. 2014-09 for all entities by one year. For public business entities that follow U.S. GAAP, the deferral results in the new revenue standard are being effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted for interim and annual periods beginning after December 15, 2016. The Company is currently evaluating the impact of adopting this standard on its consolidated financial statements.
24

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS (CONTINUED)
In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases. The new standard establishes a right-of-use ("ROU") model that requires a lessee to record an ROU asset and a lease liability on the balance sheet for all leases with terms longer than twelve months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. This accounting standard update is not expected to have a material impact on the Company's consolidated financial statements.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. The update to the standard is effective for the Company beginning June 1, 2018. The Company is currently evaluating the effect the guidance will have on the consolidated financial statements.
In August 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. The amendment is effective for all entities for fiscal years and interim periods within those fiscal years, beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is evaluating the impact of this standard on its consolidated financial statements.
In March 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-03 – Interest – Imputation of Interest (Subtopic 835-30). This ASU addressed the simplification of debt issuance costs presentation by presenting debt issuance costs in the balance sheet as a direct deduction from the carrying amount of debt liability, consistent with debt discounts or premiums. For public business entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. This accounting standard update is not expected to have a material impact on the Company's consolidated financial statements.
25

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS (CONTINUED)
In January 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-01 – Income Statement – Extraordinary and Unusual Items (Subtopic 225-20).  This ASU addressed the simplification of income statement presentation by eliminating the concept of extraordinary items.  The objective of the Simplification Initiative is to identify, evaluate, and improve areas of generally accepted accounting principles (GAAP) for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to the users of financial statements.  The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively.  A reporting entity also may apply the amendments retrospectively to all prior periods presented in the financial statements.  Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption.  This accounting standard update did not have a material impact on the Company's consolidated financial statements.
NOTE 4.   FIXED ASSETS
Fixed assets are summarized as follows:
   
August 31,
   
May 31,
 
   
2016
   
2016
 
   
(Unaudited)
     
         
Computers and equipment
  $
81,193
    $
64,818
 
Vehicles
   
86,707
     
87,984
 
Investment in leased property
   
17,172,179
     
17,425,249
 
Production facilities
   
8,391,757
     
8,515,428
 
Furniture and fixtures
   
18,177
     
18,445
 
Building and improvement
   
15,792,189
     
16,024,922
 
                 
     
41,542,202
     
42,136,846
 
Less: accumulated depreciation
   
(835,334
)    
(533,549
)
                 
   
$
40,706,868
   
$
41,603,297
 
For the three months ended August 31, 2016 and 2015, depreciation expense was $311,417 and $7,373 respectively.
 
26

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 
NOTE 5.   INCOME TAXES

   
For the Three Months Ended
 August 31,
 
   
2016
   
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
Current
 
$
386,462
   
$
597,718
 
Deferred
   
(24,219
)
   
(30,974
)
                 
Total
 
$
362,243
   
$
566,744
 

As of August 31, 2016, the Company had unused operating loss carry-forwards of approximately $1,200,000 expiring in various years through 2022. 

The expected tax rate for income in the PRC is 25%.  The following table reconciles the effective income tax rates with the statutory rates for the three months ended August 31:
   
2016
   
2015
 
         
Statutory rate
   
25
%
   
25
%
Government subsidy
   
3
%
   
2
%
                 
Effective income tax rate
   
22
%
   
23
%

The recognized government subsidy by Linyi Xuefeng was tax exempt per notice form the PRC tax authorities and accordingly there is no tax provision to be recognized.
The Company is required to file income tax returns in both the PRC and the United States.  PRC tax filings for the tax year ended December 31, 2015 and 2014 were examined by the PRC tax authorities in May 2016 and 2015, respectively. The tax filings were accepted and no adjustments were proposed by the PRC tax authorities.
The Company did not file its U.S. federal income tax returns, including, without limitation, information returns on Internal Revenue Service ("IRS") Form 5471, "Information Return of U.S. Persons with Respect to Certain Foreign Corporations" for the fiscal years ended May 31, 2016, May 31, 2015, and May 31, 2014, which is a short year income tax return required to be filed as a result of the change in fiscal year.  Failure to furnish any income tax returns and information returns with respect to any foreign business entity required, within the time prescribed by the IRS, subjects the Company to certain civil penalties.  Management is of the opinion that penalties, if any, that may be assessed would not be material to the consolidated financial statements.
27

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
 (IN U.S. $) (UNAUDITED)
 

NOTE 5.   INCOME TAXES (CONTINUED)
In addition, because the Company did not generate any income in the United States or otherwise have any U.S. taxable income, the Company does not believe that it has any U.S. Federal income tax liabilities with respect to any transactions that the Company or any of its subsidiaries may have engaged in through May 31, 2016. However, there can be no assurance that the IRS will agree with this position, and therefore the Company ultimately could be liable for U.S. Federal income taxes, interest and penalties. The tax years ended May 31, 2016, 2015 and 2014 remain open to examination by the IRS.
NOTE 6.   RELATED PARTY TRANSACTIONS
On August 5, 2012, the Company entered into an agreement to lease the patent rights on garbage recycling processing technology from Li Yuan, one of the Company's stockholders.  Under the current terms, the Company is required to pay a fee of $12,048 (RMB 80,000) each month for five years from September 2012 to August 2017.  The related prepaid patent leasing fees of $47,900 and $85,061 are included in prepaid expenses on the consolidated balance sheets as of August 31, 2016 and May 31, 2016, respectively.
The remaining payments for the patent rights are as follows:
Year Ending
   
May 31,
 
Amount
 
     
2017
 
$
108,432
 
2018
   
36,144
 
         
   
$
144,576
 

The Company obtained a demand loan from Li Yuan, a stockholder which is non-interest bearing.  The total loan of approximately $519,000 represents $440,000 of expenses paid by the stockholder and  payments of approximately $79,000 representing the registered capital and operating expenses of Baichuang Information Consulting (Shenzhen) Co., Ltd. The balance is reflected as loan from stockholder as of August 31, 2016 and May 31, 2016.
On June 25, 2013, Linyi Xuefeng and the shareholder, Mr. Li Yuan, entered into a loan agreement pursuant to which Mr. Li Yuan provides a loan facility to the Linyi Xuefeng, which are non-interest bearing and expiring on June 30, 2017. The maximum amount of the loan is RMB 200,000,000 (US $32,389,400). Any borrowings in excess of this amount may be negotiated between the parties. On December 17, 2015, a resolution of the board was signed by Mr. Li Yuan, who is the sole shareholder of Linyi Xuefeng, surrendered a loan to the Linyi Xuefeng of RMB 140,000,000 (USD $21,813,260) and treated as a capital contribution to the Linyi Xuefeng. The loans outstanding were $8,180,354 and $8,300,910 as of August 31, 2016 and May 31, 2016, respectively.
28

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 6.   RELATED PARTY TRANSACTIONS (CONTINUED)
Linyi Xuefeng also signed a series of agreements with Jiangsu Liding Machinery Manufacturing Co., Ltd ("Jiangsu Liding") for the construction of the garbage recycling processing plant and production facilities purchase. The shareholder of the Company, Mr. Li Yuan, is also the shareholder of Jiangsu Liding. As of August 31, 2016 and May 31, 2016, the purchase amount of $7,714,280 from Jiangsu Liding was delivered in December 2015, and included in the fixed assets of the accompanying consolidated balance sheet as of August 31, 2016 and May 31, 2016.
NOTE 7.  LAND USE RIGHT
On September 6, 2013, the Company signed with Linyi Yanjiazhuang Beizhi Village government to obtain a land use right 66,667 square meters of land at total RMB 40,000,000 (USD$ 6,477,880). In addition, the Company was required to subject a deed tax of RMB 1,200,000 (USD$ 194,336). The purchase of the land was approved by local government on September 9, 2013. The Company fully paid the deed tax of $194,336 when the purchase agreement was signed. The Company paid RMB 25,000,000 (USD$ 4,048,675) on September 25, 2013 and RMB 15,000,000 (USD$ 2,429,205) on November 12, 2013 to local government for the land purchase. The land use right started on September 9, 2013 and ends on September 8, 2063.
The amortization for the land use right for the three months ended August 31, 2016 and 2015 was $31,024 and $33,230, respectively.
NOTE 8.   LEASES
The Company leases one office space under a one-year operating lease from an unrelated third party, which expired on March 31, 2016.  The lease required the Company to prepay the rental for one year of $6,784 (RMB 44,664). The lease provides for renewal options but the Company ceased the lease. The Company entered into a new lease agreement with an unrelated third party for new office space, which commenced on April 1, 2016 and expires on March 31, 2019.  The lease requires the Company to prepay the semi-annual rental of $3,593 (RMB 24,000). The lease provides for renewal options.
The Company leases another office space under a three-year operating lease from an unrelated third party, which expired on May 31, 2016. The lease required the Company to prepay the semi-annual rental. On May 26, 2016, the Company renewed the lease for another three years which ends on May 31, 2019. Rent expense for the three months ended August 31, 2016 and 2015 was $1,807 and $1,936, respectively.
29

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

 
NOTE 8.   LEASES (CONTINUED)
Future minimum payments for the years ending May 31 are as follows:
Year Ending
May 31,
 
Amount
 
     
2017
 
$
11,054
 
2018
   
15,030
 
2019
   
5,120
 
         
   
$
31,204
 
NOTE 9.   CONTINGENCIES
As disclosed in Note 6, the Company is delinquent in filing certain tax returns with the U.S. Internal Revenue Service.  The Company is unable to determine the amount of penalties, if any, that may be assessed at this time.  Management is of the opinion that penalties, if any, that may be assessed would not be material to the consolidated financial statements.
The Company did not file the information reports for the years ended December 31, 2015, 2014 and 2013 concerning its interest in foreign bank accounts on form TDF 90-22.1, "Report of Foreign Bank and Financial Accounts" ("FBAR"). Not complying with the FBAR reporting and recordkeeping requirements will subject the Company to civil penalties up to $10,000 for each year it has foreign bank accounts.  The Company has not determined the amount of any penalties that may be assessed at this time and believes that penalties, if any, that may be assessed would not be material to the consolidated financial statements.
NOTE 10.   VULNERABILITY DUE TO OPERATIONS IN THE PRC
The Company's operations may be adversely affected by significant political, economic and social uncertainties in the PRC. The different cultures, business preferences, corruption, diverse uncertain government regulations, tax systems and currency regulations are risks impacting the Company's current operations. Although the PRC government has been pursuing economic reform policies for more than twenty years, no assurance can be given that the PRC government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption or unforeseen circumstances affecting the PRC's political, economic and social conditions.  There is also no guarantee that the PRC government's pursuit of economic reforms will be consistent, effective or continue.
30

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 
NOTE 11.   CONCENTRATION OF CREDIT AND BUSINESS RISK
Cash and cash equivalents
Substantially all of the Company's bank accounts are in banks located in the PRC and are not covered by protection similar to that provided by the FDIC on funds held in United States banks.
Major customers
For the three months ended August 31, 2016 and 2015, the Company had three and one different customers that accounted for 49% and 67% of revenue, respectively. Two customers accounted for 100% accounts receivable at August 31, 2016 and May 31, 2016.
NOTE 12.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY
The condensed financial information of the Company's US parent only balance sheets as of May 31, 2016, and the US parent company only statements of income, and cash flows for the year ended May 31, 2016 are as follows:
Condensed Balance Sheets

ASSETS
May 31,
2016
 
   
   
  Investment in subsidiaries and VIE
 
$
50,355,645
 
         
TOTAL ASSETS
 
$
50,355,645
 

LIABILITIES AND STOCKHOLDERS' EQUITY
   
     
Current liabilities:
   
  Loan from stockholder   $
492,678
 
  Accrued liabilities
   
43,000
 
         
Total current liabilities
   
535,678
 
         
Stockholders' equity:
       
Common stock, $0.001 par value; 75,000,000 shares authorized; 63,020,871 shares issued and outstanding
   
63,021
 
 Additional paid-in capital
   
33,518,248
 
 Statutory reserve fund
   
1,843,520
 
 Retained earnings
   
16,234,031
 
 Other comprehensive income
   
(1,838,853
)
         
Total stockholders' equity
   
49,819,967
 
         
TOTAL LIABILITIES AND STOCKHOLDERS'  EQUITY
 
$
50,355,645
 

 
31

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)
 

NOTE 12.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY (CONTINUED)
Condensed Statements of Income

 
For The
Year Ended
May 31,
 
 
2016
 
   
Revenues:
 
 Share of earnings from investment in subsidiaries and VIE
 
$
3,948,073
 
         
Operating expenses:
       
 General and administrative
   
123,000
 
         
Net income
 
$
3,825,073
 

Condensed Statements of Cash Flows
   
For The
 Year Ended
May 31,
 
   
2016
 
     
Cash flows from operating activities:
   
 Net income
  $
3,825,073
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities
 
 Share of earnings from investment in subsidiaries and VIE
   
(3,948,073
)
     Increase in accrued liabilities
   
123,000
 
         
    Net cash (used by) operating activities
   
-
 
         
Net increase in cash
   
-
 
Cash, beginning of year
   
-
 
         
Cash, end of year
  $ -  
         
Noncash financing activities:
       
      Payment of accrued liabilities by shareholder
 
$
100,438
 
32

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED AUGUST 31, 2016 AND 2015
(IN U.S. $) (UNAUDITED)

 
NOTE 12.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY (CONTINUED)
Basis of Presentation
The Company records its investment in its subsidiaries and VIE under the equity method of accounting.  Such investment is presented as "Investment in subsidiaries and VIE" in the condensed balance sheet and the U.S. parent's share of the subsidiaries and VIE's profits are presented as "Share of earnings from investment in subsidiaries and VIE" in the condensed statements of income and cash flows.
Certain information and footnote disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted.  The parent only financial information has been derived from the Company's consolidated financial statements and should be read in conjunction with the Company's consolidated financial statements.
Restricted Net Assets
Under PRC laws and regulations, the Company's PRC subsidiary and VIE are restricted in their ability to transfer certain of their net assets to the parent company in the form of dividend payments, loans or advances.  The restricted net assets of the Company's PRC subsidiary and VIE amounted to $49,819,967  as of May 31, 2016.
In addition, the Company's operations and revenues are conducted and generated in the PRC; all of the Company's revenues being earned and currency received are denominated in RMB. RMB is subject to the foreign exchange control regulations in China, and, as a result, the Company may be unable to distribute any dividends outside of China due to PRC's foreign exchange control regulations that restrict the Company's ability to convert RMB into US Dollars.
Schedule I of Article 5-04 of Regulation S-X requires the condensed financial information of the parent company to be filed when the restricted net assets of consolidated subsidiaries and VIE's exceed 25 percent of consolidated net assets as of the end of the most recently completed fiscal year.  For purposes of this test, restricted net assets of consolidated subsidiaries and VIEs shall mean that amount of the registrant's proportionate share of net assets of its consolidated subsidiaries and VIEs (after intercompany eliminations) which as of the end of the most recent fiscal year may not be transferred to the parent company in the form of loans, advances or cash dividends without the consent of a third party.  The condensed parent company financial statements have been prepared in accordance with Rule 12-04, Schedule I of Regulation S-X as the restricted net assets of the Company's PRC subsidiary and VIE exceed 25% of the consolidated net assets of the Company.

33

 
ITEM 2.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements discuss matters that are not historical facts. Because they discuss future events or conditions, forward-looking statements may include words such as "anticipate," "believe," "estimate," "intend," "could," "should," "would," "may," "seek," "plan," "might," "will," "expect," "anticipate," "predict," "project," "forecast," "potential," "continue" negatives thereof or similar expressions. Forward-looking statements speak only as of the date they are made, are based on various underlying assumptions and current expectations about the future and are not guarantees. Such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, level of activity, performance or achievement to be materially different from the results of operations or plans expressed or implied by such forward-looking statements.

We cannot predict all of the risks and uncertainties. Accordingly, such information should not be regarded as representations that the results or conditions described in such statements or that our objectives and plans will be achieved and we do not assume any responsibility for the accuracy or completeness of any of these forward-looking statements. These forward-looking statements are found at various places throughout this Quarterly Report on Form 10-Q and include information concerning possible or assumed future results of our operations, including statements about potential acquisition or merger targets; business strategies; future cash flows; financing plans; plans and objectives of management; any other statements regarding future acquisitions, future cash needs, future operations, business plans and future financial results, and any other statements that are not historical facts.

These forward-looking statements represent our intentions, plans, expectations, assumptions and beliefs about future events and are subject to risks, uncertainties and other factors. Many of those factors are outside of our control and could cause actual results to differ materially from the results expressed or implied by those forward-looking statements. In light of these risks, uncertainties and assumptions, the events described in the forward-looking statements might not occur or might occur to a different extent or at a different time than we have described. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of the Quarterly Report on Form 10-Q. All subsequent written and oral forward-looking statements concerning other matters addressed in this Quarterly Report on Form 10-Q and attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this Quarterly Report on Form 10-Q.

Except to the extent required by law, we undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, a change in events, conditions, circumstances or assumptions underlying such statements, or otherwise.

Overview

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


The following discussion of our financial condition and results of operations should also be read in conjunction with our unaudited consolidated financial statements and the notes to those financial statements appearing elsewhere in this Form 10-Q. The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 relating to future events or our future performance. Actual results may materially differ from those projected in the forward-looking statements as a result of certain risks and uncertainties set forth in this Form 10-Q. Although management believes that the assumptions made and expectations reflected in the forward-looking statements are reasonable, there is no assurance that the underlying assumptions will, in fact, prove to be correct or that actual results will not be different from expectations expressed in this report.
34



Overview 
We are in the business of providing equipment and upgrade services to optimize garbage-recycling processes. We sell and lease comprehensive and environmental-friendly garbage recycling equipment. We also utilize our licensed patented technology of "comprehensive and harmless garbage-processing equipment" to upgrade software systems and reconstruct hardware for our clients and therefore expand the sorting scope and capacity of our clients' garbage recycling equipment. We also have manufactured and sell or lease garbage-processing equipment commencing during the twelve months ended May 31, 2016. We conduct our operations through our controlled consolidated affiliate Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng")
Our Services
With the development of the urbanization in China, the amount of household garbage is growing, whereas the processing capability of garbage processing equipment cannot satisfy the increasing amount of garbage. In order to improve the processing equipment of garbage processing plants, we provide upgrades and improvements to the software systems and hardware equipment by installing various systems of our licensed patented technology "comprehensive and harmless garbage-processing equipment" into customers' equipment, and reconstruct the hardware to expand the garbage sorting scope and capacity of their equipment.
The comprehensive and harmless garbage processing equipment that we sell or lease is comprised of a waste digestion pretreatment system, methane gas power generation system, sorting processing system, bricklaying building system, leachate treatment system, DCS (distribution control system), XFET-5 ecological and water-saving toilets and excrement comprehensive processing system and various material collection systems. The equipment technology is designed and manufactured based on the complicated situation of the household garbage in China. According to the features of various garbage, the equipment utilizes the wind-force, gravity, magnetic, shape, etc. to process the garbage by the combined way of machine selecting, winnowing, magnetic separation, automatic cutting, smashing and other technological processes. The equipment has large processing capacity and can run all day. The stand-alone equipment can process 500 to 1000 tons of garbage per day. It can sort and process complicated municipal solid waste, leaving almost no pollution and no residue, reaching the "3 without" standard of no waste gas, no waste water and no waste residue.
The licensed patented technology of "harmless and comprehensive garbage processing equipment" provided by Jiangsu Xuefeng to its customers has a high garbage processing capacity and stable operation capacity. It is the first modern system equipment in China to use DCS (Distributed Control System) centralized control, by which mechanical automation will be realized for the comprehensive treatment of life garbage. Its core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization rate, approaching 100%. The resource recovery products, biogas, can not only be used for meeting the needs of the plant itself, but also for sale outside the company, which greatly improves the efficiency of the garbage processing equipment, decreases production costs, and increases the recovery return of garbage processing.
After we sell or lease the equipment or complete the internal system upgrade and hardware equipment improvements of the clients' garbage equipment, we deliver the upgraded equipment to the customers. The customers will conduct an inspection and performance testing of the upgraded equipment within one month pursuant to the contract to inspect whether the internal control system and the hardware structure can operate steadily and achieve the expected results. The inspection includes the following: whether the quality of the equipment and accessories or after improvement can match the licensed patented technology and process various kinds of garbage, whether the various garbage systems can process automatically, and whether the daily garbage processing capacity reaches the expected results per the contract. If during the performance testing period, the performance meets the requirements of the contract, it would be deemed that we have fully fulfilled our obligations under the contract.
35

When we complete the upgrading service for a client, we go through the acceptance check and commissioning of the company in accordance with the contract, to make sure that the services provided met the expectations of the clients. After that, we are not subject to any additional services. The revenue we generated belongs to the service class income, with the main cost being the salaries of the staff and the leasing fees for the patent, whereas the hardware and software equipment, as well as the material used in the upgrading process are the responsibility of the client.


Acquisition of Linyi Xuefeng

On August 4, 2016, we entered into an agreement with Mr. Li Yuan, the sole shareholder of Linyi County Xuefeng Renewable Resources Utilization Technology Co., Ltd ("Linyi Xuefeng"), to purchase his 100% ownership of Linyi Xuefeng. Mr. Li Yuan is the Chief Executive Officer and main shareholder of the Company. The purchase price is determined by the audited net assets of Linyi Xuefeng as of May 31, 2016, with payment of RMB10,000,000 in cash and the rest to be paid in common shares of China Xuefeng depending on the 75% closing price of the last trading day. On October 7, 2016, a supplementary agreement was entered between both parties to finalized in accordance to the audited net asset value $ 23,462,612 on May 31, 2016. The transfer price is $3 per share and 7,820,871 shares in total to Mr. Li Yuan without cash consideration. Linyi Xuefeng is primarily engaged in garbage recycling processing and currently still in development stage without any production.
 
Upon acquisition, Linyi Xuefeng became a wholly-owned subsidiary. The acquisition will be accounted for as a business combination.


Implications of Being an Emerging Growth Company



We qualify as an emerging growth company as that term is used in the JOBS Act. An emerging growth company may take advantage of specified reduced reporting and other burdens that are otherwise applicable generally to public companies. These provisions include:
 

l
A requirement to have only two years of audited financial statements and only two years of related MD&A;
   
l
Exemption from the auditor attestation requirement in the assessment of the emerging growth company's internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002;
   
l
Reduced disclosure about the emerging growth company's executive compensation arrangements; and;
   
l
No non-binding advisory votes on executive compensation or golden parachute arrangements.




In addition, Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended (the "Securities Act") for complying with new or revised accounting standards. We have elected to use the extended transition period provided above and therefore our financial statements may not be comparable to companies that comply with public company effective dates.

 
36



We could remain an emerging growth company for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (ii) the date that we become a "large accelerated filer" as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period.




Results of Operations

Quarters Ended August 31, 2016 and 2015

The following table sets forth in U.S. dollars, key components of our audited results of operations for the quarters ended August 31, 2016 and 2015, and the percentage change between 2016 and 2015.


 
 
Quarters Ended August 31,
 
 
 
2016
   
2015
   
Percentage
 
 
 
(U.S. $)
   
(U.S. $)
   
Change
 
 
 
   
   
 
Revenue
 
$
2,128,208
   
$
10,865,073
     
(80
%)
Cost of revenue
   
(426,109
)
   
(8,103,499
)
   
(95
%)
      Gross profit
   
1,702,099
     
2,761,574
     
(38
%)
    Selling expenses
   
151,438
     
252,257
     
(40
%)
    General and administrative expenses
   
261,854
     
287,207
     
(9
%)
      Total operating expenses
   
413,292
     
539,464
     
(23
%)
Operating income
   
1,288,807
     
2,222,110
     
(42
%)
    Interest income
   
361,064
     
263,835
     
37
%
Income before provision for income taxes
   
1,649,871
     
2,485,945
     
(34
%)
Provision for income taxes
   
362,243
     
566,744
     
(36
%)
Net income
   
1,287,628
     
1,919,201
     
(33
%)
    Noncontrolling interests
   
(56,360
)
   
(87,987
)
   
(36
%)
Net income attributable to common  stockholders
 
$
1,231,268
   
$
1,831,214
     
(33
%)

37

Revenue
We provide improvement and upgrading services for garbage processing equipment to our customers. This is a one-time service. We also license a patent to our customers. The patent licensing is limited to five years with payments due annually in advance. During the fiscal year ended May 31, 2016, we began to sell or lease the garbage processing equipment to our customers.
We generated $2,128,208 in revenue for the quarter ended August 31, 2016, as compared to $10,865,073 for the quarter ended August 31, 2015. Our revenue for the quarter ended August 31, 2016 decreased by $8,736,865 or 80% compared to the revenue for the quarter ended August 31, 2015. The primary reason for the significant decrease in revenue was mainly due to the sale of two garbage processing equipment for the quarter ended August 31, 2015 but no such sales during the quarter ended August 31, 2016.
 The following table sets forth our revenue for the quarters ended August 31, 2016 and 2015: 

 
Quarters Ended August 31,
 
 
2016
 
2015
 
Percentage
 
 
(U.S. $)
 
(U.S. $)
 
Change
 
       
Improvements and Upgrading Services
 
$
451,796
   
$
-
 
 100
%
Patent Leasing
  1,084,313
 
  1,016,190
 
 7
%
Sales type lease
 -
 
 9,848,883
 
 (100
%)
Operating lease
   
592,099
     
-
     
100
%
 Total
 
$
2,128,208
   
$
10,865,073
     
(80
%)



Improvement and Upgrading Services
During the quarter ended August 31, 2016, we provided improvement and upgrading services to one customer and generated revenue of $451,797For the quarter ended August 31, 2015, we didn't provide such service to any customer and there was no improvement and upgrading service revenue generated. The services were completed and accepted by the customer and the payment was received in full as of August 31, 2016. While our core business still focuses on providing improvement and upgrading services for customers' garbage processing equipment, we have also begun selling or leasing our garbage processing equipment.
Patent Licensing
During the quarter ended August 31, 2016, we generated revenue of $1,084,313 from licensing our patent to 16 unrelated customers. As all these customers became licensees before this June 1, 2016, patent licensing revenue was recognized for the entire three months for these customers. During the quarter ended August 31, 2015, we generated revenue of $1,016,190 from patent licensing from 14 unrelated customers. As all the customers became our licensees in the previous year, the patent licensing revenue was also recognized for the whole three months.

 
Sales Type Lease
For the quarter ended August 31, 2016, we didn't have any sales type lease revenue. During the quarter ended August 31, 2015, we leased two equipment for garbage processing to one customers. These sales were recognized as sales type leases because title to the equipment will be transferred to the customers at the end of the lease. The two equipment were sold for $11,523,193 before value-added tax (the "VAT") and $9,848,883 after the VAT. We received 20% of the selling price from the customer during the quarter ended August 31, 2015. We will receive quarterly payments of approximate $1,150,000 during the following three years including interest at 5.25%.
Operating lease
During the quarter ended August 31, 2016, we had four operating leases for a 300-ton and three 500-ton garbage processing system. The lease period is 5 years with annual lease payments of $602,396 and $2,168,626 (for the two 500-ton garbage processing system), respectively, before VAT. The 300-ton garbage processing system was delivered and tested in the beginning of November 2015. The two 500-ton garbage processing systems were delivered and tested in the beginning of January 2016. Another 500-ton garbage processing system was delivered and tested in the end of April 2016. These leases are being accounted for as operating leases because they have no renewal or purchase option. At the end of the five years, either a new lease will be negotiated or the equipment will be returned. For the quarter ended August 31, 2016, we generated operating lease revenue of 592,099 for the four equipment. For the quarter ended August 31, 2015, we didn't have any operating lease revenue.
38





Cost of Goods Sold 
Our cost of goods sold decreased to $426,109 for the quarter ended August 31, 2016 from $8,103,499 for the quarter ended August 31, 2015, which represented a decrease of 95%. This is mainly attributable to the $7,939,056 cost of the garbage processing equipment sold under the sales type lease for the quarter ended August 31, 2015. For improvement and upgrading service and patent licensing revenue, the cost primarily consists of fees paid to the related party for licensing the patent, employees' salaries and training expenses. In addition, the cost of the garbage processing equipment also includes various equipment and supplies necessary for assembling and installing equipment and the related labor. For the operating lease revenue, the depreciation of the garbage processing equipment is also included in the cost of revenue.
Gross Profit
Our gross profit decreased to $1,702,099 for the quarter ended August 31, 2016 from $2,761,574 for the quarter ended August 31, 2015. Our gross profit ratio was significantly increased because our business stream has resulted in a high gross margin for the quarter ended August 31, 2016 without cost of garbage processing equipment under the sales type leases. Our cost of goods sold is almost entirely direct labor and patent licensing fees, and other operating expenses for the quarter ended August 31, 2016. The gross profit ratio for the quarters ended August 31, 2016 and 2015 was 80% and 25%, respectively.
Selling and Marketing Expenses 
Our selling and marketing expenses decreased to $151,438 for the quarter ended August 31, 2016 from $252,257 for the quarter ended August 31, 2015 which represented a decrease of 40%. Our selling and marketing expenses were primarily comprised of sales employees' salaries, advertising expenses, training expenses and travelling expenses. The decrease was mainly due to the significant decrease in advertising expenses. Our advertising expenses decreased to $90,359 for the quarter ended August 31, 2016 from $183,076 for the quarter ended August 31, 2015.
39

General and Administrative Expenses
Our general and administrative expenses decreased to $261,854 for the quarter ended August 31, 2016 from $287,207 for the quarter ended August 31, 2015, representing a 9% decrease.  Our general and administrative expenses were primarily comprised of employees' salaries, travelling expenses, entertainment expenses and professional fees such as legal and audit fees. The decrease was mainly caused by no fire protection expenses incurred for the quarter ended August 31, 2016 but the expense of $28,228 incurred for the quarter ended August 31, 2015.
Non-operating income
Out non-operating income included interest income and government subsidy. Despite our large cash balances, the interest income generated for the quarter ended August 31, 2016 and 2015 was nominal for principally two reasons: 1) extremely low bank's current deposit interest rate and 2) minimal fluctuation of the annual interest rates within a 0.30% range. The interest income reported is net after deducting bank service charges. For the quarter ended August 31, 2016 and 2015, our bank interest was $4,031 and $21,865, respectively. For the quarter ended August 31, 2016, our interest income also includes interest of $135,165 earned on the sales type leases. Our non-operating income also included government subsidy. Our wholly owned subsidiary, Linyi Xuefeng, received government subsidy of approximate $903,594 (RMB 6,000,000) annually. For the quarter ended August 31, 2016 and 2015, the income of government subsidy was $225,899 and $241,970 under accrue basis, respectively.

Provision for Income Taxes
Our provision for income taxes decreased to $362,243 for the quarter ended August 31, 2016 from $566,744 for the quarter ended August 31, 2015.  Our effective tax rate for the quarter ended August 31, 2016 and 2015 was approximately the statutory rate of 25%. Our tax filings for the calendar year ended December 31, 2015 were examined by the PRC tax authorities in May 2016. Our prior filings were accepted and no adjustments were proposed. The increase in the provision for income taxes was primarily due to the increase in our pre-tax income.
Net Income
For the quarter ended August 31, 2016 and 2015, we generated net income of $1,287,628 and $1,919,201, respectively.  This represented a decrease in net income of $631,573 or 33%. The entrusted management agreements assign to Baichuang Consulting 95% of the income generated from Jiangsu Xuefeng.  For that reason, we reflected a "non-controlling interest" of $56,360 and $87,987 for the quarter ended August 31, 2016 and 2015, respectively, before recognizing net income attributable to the common stockholders of the Company.  After the "non-controlling interest", our net income attributable to the common stockholders' of the Company for the quarter ended August 31, 2016 and 2015 was $1,231,268 and $1,831,214, respectively, representing $0.02 per share and $0.03 per share, respectively.
Foreign Currency Translation Adjustment
Our reporting currency is the U.S. dollar. Our local currency, Renminbi (RMB), is our functional currency. Results of operations and cash flows are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People's Bank of China at the end of the period. Equity transactions are recorded at their historical amounts. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of stockholders' equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. For the quarters ended August 31, 2016 and 2015, a foreign currency (loss) of $(750,785) and $(1,154,335), respectively, have been reported as other comprehensive income (loss) in the consolidated statements of income and other comprehensive income (loss). The foreign currency loss was mainly due to the devaluation of the Chinese currency by approximately 3.5%.
Liquidity and Capital Resources
As of August 31, 2016, we had cash and cash equivalents of $7,670,907, primarily consisting of cash on hand and demand deposits. The cash balance was principally derived from cash from operations and loan from shareholders.
To date, we have financed our operations primarily through cash flows from operations and loan from our shareholder. We believe that our cash on hand and cash flows from operations will meet our present cash needs for the next 12 months.
Operating activities
Net cash provided in operating activities was $1,873,094 for the quarter ended August 31, 2016, as compared with the net cash used by operating activities of $9,719,587 for the quarter ended August 31, 2015. For the quarter ended August 31, 2016, the decrease in the accounts receivable of $968,029, prepaid VAT of $100,657, depreciation expenses of $311,417, increase in deferred revenue of 135,544, the increase in prepaid expenses of $415,653 and the decrease in accounts payable and other accrued liabilities of $473,197 mainly caused the difference between the net cash provided by operating activities and the net income.  For the quarter ended August 31, 2015, the increase in accounts receivable of $10,050,668, the increase in advance to supplier, the increase in accounts payable of $543,921, the increase in deferred revenue of $209,399 and the increase in tax payable of $231,334 mainly caused the difference between the net cash used by operating activities and the net income.
40

Investing activities
Net cash used in investing activities was $17,423 for the quarter ended August 31, 2016, as compared with the net cash used in investing activities of $9,741,051 for the quarter ended August 31, 2015. We spent $17,423 and $9,741,051 for the quarter ended August 31, 2016 and 2015, respectively, for fixed assets purchases which were recorded as investing activities.
Financing activities
For the quarter ended August 31, 2016, we did not have any cash provided or used by any financing activities. For the quarter ended August 31, 2015, we received a loan of total $12,259,848 from our shareholder which was mainly used for the construction of Linyi Xuefeng and the payment for U.S professional expenses.
Effect of exchange rate on cash
The negative effect of the exchange rate on cash of $96,870 and $1,142,809, respectively, for the quarters ended August 31, 2016 and 2015 was principally due to the devaluation by the PRC government of their currency. There could be further negative adjustments should the PRC government or the exchange markets further devalue the Chinese currency.

Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition or results of operations.
ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
Interest Rate Risk
 
Changes in interest rates may affect the interest earned and therefore affect our cash flows and results of operations. However, we do not believe that this interest rate change risk is significant.

41

Currency Exchange Fluctuations

All of the Company's revenues are denominated in Chinese Renminbi, while its expenses are denominated primarily in Chinese Renminbi ("RMB"). The value of the RMB-to-U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. Since 1994, the conversion of Renminbi into foreign currencies, including U.S. dollars, has been based on rates set by the People's Bank of China ("PBOC"), which are set daily based on the previous day's inter-bank foreign exchange market rates and current exchange rates on the world financial markets. Since 1994, the official exchange rate for the conversion of Renminbi to U.S. dollars had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar. However, on July 21, 2005, the Chinese government changed its policy of pegging the value of Chinese Renminbi to the U.S. dollar. Under the new policy, Chinese Renminbi may fluctuate within a narrow and managed band against a basket of certain foreign currencies. Recently there has been increased political pressure on the Chinese government to decouple the Renminbi from the United States dollar. At the recent quarterly regular meeting of PBOC, its Currency Policy Committee affirmed the effects of the reform on Chinese Renminbi exchange rate. Since February 2006, the new currency rate system has been operated; the currency rate of Renminbi has become more flexible while basically maintaining stable and the expectation for a larger appreciation range is shrinking. In August 2015, the PRC government devalued its currency by approximately 3.0%. The Company has never engaged in currency hedging operations and has no present intention to do so.
 
Country Risk

A substantial portion of our assets and operations are located and conducted in PRC. While the PRC economy has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall economy of China, but may also have a negative effect on us. For example, our operating results and financial condition may be adversely affected by government control over capital investments or changes in tax regulations applicable to us.  If there are any changes in any policies by the Chinese government and our business is negatively affected as a result, then our financial results, including our ability to generate revenue and profits, will also be negatively affected. Economic growth in the PRC has recently begun to slow.
 
ITEM 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures
 
Pursuant to Rule 13a-15(b) under the Exchange Act, the Company carried out an evaluation, with the participation of the Company's management, including the Company's Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO") (the Company's principal financial and accounting officer), of the effectiveness of the Company's disclosure controls and procedures (as defined under Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, for the reasons set forth below, the Company's CEO and CFO concluded that the Company's disclosure controls and procedures were not effective as of August 31, 2016 to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act, is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including the Company's CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.
42

 
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis. In its assessment of the effectiveness of internal control over financial reporting as of August 31 2016, the Company determined that there were control deficiencies that constituted the following material weaknesses:

The Company does not have a sufficient number of accounting personnel, which would provide segregation of duties within our internal control procedures to support the accurate and timely reporting of our financial results.
 
 
The Company's current accounting personnel lack experience and knowledge in identifying and resolving complex accounting issues under U.S. Generally Accepted Accounting Principles (GAAP).

Changes in Internal Control over Financial Reporting

No change in our system of internal control over financial reporting occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.  
 
PART II - OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS.

We are currently not involved in any litigation that we believe could have a material adverse effect on our financial condition or results of operations. There is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries, threatened against or affecting our company, our common stock, any of our subsidiaries or of our companies or our subsidiaries officers or directors in their capacities as such, in which an adverse decision could have a material adverse effect.
 
ITEM 1A. RISK FACTORS.
 
We believe there are no changes that constitute material changes from the risk factors previously disclosed in our Annual Report on Form 10-K filed with the SEC on August 30, 2016.

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
On August 4, 2016, we entered into an agreement with Mr. Li Yuan, the sole shareholder of Linyi County Xuefeng Renewable Resources Utilization Technology Co., Ltd ("Linyi
Xuefeng"), to purchase his 100% ownership of Linyi Xuefeng. In connection with the acquisition of interest in Linyi Xuefeng, we issued 7,820,871 shares to Mr. Yuan at $3 per share, or an aggregate value of $23,462,612.
The issuance of the shares at the closing of the underlying transactions has been determined to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act.
ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.
 
There has been no default in the payment of principal, interest, sinking or purchase fund installment, or any other material default, with respect to any indebtedness of the Company.

ITEM 4.  MINE SAFETY DISCLOSURES.
 
Not Applicable.
 
43


ITEM 5.  OTHER INFORMATION.
 
None.
               
ITEM 6. EXHIBITS
 
Exhibit No.
 
Description
     
31.1
 
Certification of Principal Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of 2002*
     
31.2
 
Certification of Principal Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of 2002*
     
32.1
 
Certification of Principal Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002+
     
32.2
 
Certification of Principal Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002+
     
101.INS
 
XBRL Instance Document**
     
101.SCH
 
XBRL Taxonomy Extension Schema Document**
     
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document**
     
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document**
     
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document**
     
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document**
 
*
 
Filed herewith
**
 
In accordance with Regulation S-T, the XBRL related information on Exhibit No. 101 to this Quarterly Report on Form 10-Q shall be deemed "furnished" herewith not "filed".
  In accordance with SEC Release 33-8238, Exhibit 32.1 and 32.2 are being furnished and not filed".
 
44

 
 
SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
China Xuefeng Environmental Engineering Inc.
 
 
 
Date: October 17, 2016
By:
/s/ Li Yuan
 
 
Li Yuan
 
 
Chief Executive Officer
Principal Executive Officer
 
 
 
 
 
 
Date: October 17, 2016
By:
/s/ Kuanfu Fan
 
 
Kuanfu Fan
 
 
Chief Financial Officer
Principal Financial Officer
 
 
45