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EX-32.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS - China Xuefeng Environmental Engineering Inc.exh32_1.htm
EX-31.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARB - China Xuefeng Environmental Engineering Inc.exh31_1.htm

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

FORM 10-K

(Mark One)
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended May 31, 2018

or

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

For the transition period from _____________ to _____________

Commission File No. 333-175483

China Xuefeng Environmental Engineering Inc.
 (Exact name of registrant as specified in its charter)

Nevada
99-0364975
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
   
229 Tongda Avenue
Economic and Technological Development Zone,
Suqian, Jiangsu Province, P.R. China 223800
(Address of principal executive offices) (Zip Code)

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

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Securities registered under Section 12(b) of the Exchange Act:
   
Title of each class:
Name of each exchange on which registered:
None
None
 
Securities registered under Section 12(g) of the Exchange Act:
None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes   No 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes   No 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference Part III of this Form 10-K or any amendment to this Form 10-K. 

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

Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
(Do not check if a smaller reporting company)
 
Emerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, as of the last business day of the registrant's most recently completed second fiscal quarter: $118,154,316.8 based on 28,402,480 non-affiliates shares of common stock as of November 30, 2017. However, the Company has not developed an active trading market for its common stock.

As of August 29, 2018, the registrant had 66,520,871 shares of common stock, par value $0.001 per share, issued and outstanding.

Documents Incorporated by Reference: None.

 
TABLE OF CONTENTS

PART I
  Page
     
Item 1.
Business
 1
     
Item 1A.
Risk Factors
10
     
Item 1B.
Unresolved Staff Comments
10
     
Item 2.
Properties
10
     
Item 3.
Legal Proceedings
11
     
Item 4.
Mine Safety Disclosures
11
     
PART II
 
     
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
11
     
Item 6.
Selected Financial Data
12
     
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
12
     
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
17
     
Item 8.
Financial Statements and Supplementary Data
18
     
Item 9.
Changes in and Disagreements With Accountants On Accounting and Financial Disclosure
47
     
Item 9A.
Controls and Procedures
47
     
Item 9B.
Other Information
47
     
PART III
 
     
Item 10.
Directors, Executive Officers and Corporate Governance
48
     
Item 11.
Executive Compensation
50
     
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
51
     
Item 13.
Certain Relationships and Related Transactions, and Director Independence
52
     
Item 14.
Principal Accounting Fees and Services
53
     
PART IV
 
     
Item 15.
Exhibits, Financial Statement Schedules
54
     
SIGNATURES
55


 
CERTAIN USAGE OF TERMS
PART I

Item 1.  Business

Except as otherwise indicated by the context, references in this report to "we," "us," "our," "our Company," or "the Company" are to the combined business of China Xuefeng Environmental Engineering Inc.

Overview

We are in the business of providing services to optimize garbage-recycling processes. We utilize our 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 conduct our operations through our controlled consolidated affiliate Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng"). Jiangsu Xuefeng was incorporated under the laws of the People's Republic of China ("PRC") on December 14, 2007.

Our Corporate History and Background

We were incorporated in the state of Nevada on March 30, 2011. We were initially formed to engage in the business of clothing distribution.  Since our inception and until the acquisition of Inclusion Business Limited (BVI), we were a development stage company without significant assets or any revenue.

Acquisition of Inclusion

On November 27, 2012, we completed a reverse acquisition transaction through a share exchange with Inclusion Business Limited (BVI) ("Inclusion") and its stockholders (the "Inclusion Stockholders"), whereby we acquired 100% of the issued and outstanding capital stock of Inclusion and in exchange we issued 7,895,000 shares of our common stock (pre-Forward Split), or 76.65% of our issued and outstanding capital stock as of and immediately after the consummation of the reverse acquisition, to the Inclusion Stockholders. As a result of the reverse acquisition, Inclusion became our wholly-owned subsidiary and the former Inclusion Stockholders became our controlling stockholders. The share exchange transaction has been treated as a reverse acquisition, with Inclusion as the acquirer and the Company as the acquired party for accounting purposes.

Prior to the closing of the reverse acquisition, the Company's prior shareholder, Mr. Zhenxing Liu, surrendered 7,895,000 shares of the common stock of the Company. Mr. Zhenxing Liu did not receive any consideration from the Company for accounting purposes. However, Mr. Zhenxing Liu may be deemed to have received consideration from the increase in the value of 250,000 shares held by Mr. Zhenxing Liu as a result of the reverse acquisition. Mr. Zhenxing Liu purchased 8,145,000 shares at approximately $0.007 per share at the time when the Company was considered a shell and kept 250,000 shares after the surrender. On November 30, 2012, at the closing of the reverse acquisition, the stockholder's equity increased to $5,194,728. Accordingly, the value of the 250,000 shares held by Mr. Zhenxing Liu appreciated to approximately $124,673. Other than such appreciation in the value of his shares, Mr. Zhenxing Liu did not receive any other consideration in connection with the reverse acquisition.

As a result of our acquisition of Inclusion, we now own all of the issued and outstanding capital stock of Lotus International Holdings Limited ("Lotus"), which in turn owns all of the issued and outstanding capital stock of Baichuang Information Consulting (Shenzhen) Co. Ltd ("Baichuang Consulting"). In addition, we effectively and substantially control Jiangsu Xuefeng through a series of captive agreements with Baichuang Consulting.

Subsequent to the closing of the Exchange Agreement, we conduct our operations through our controlled consolidated affiliate Jiangsu Xuefeng. Jiangsu Xuefeng is primarily engaged in providing improvement and upgrading services of garbage recycling processing technology and equipment.
1


Name Change and Forward Split

On November 27, 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" and to effect a 4-for-1 forward stock split of its outstanding shares of common stock.  The name change went effective on December 14, 2012 and the forward split went effective on December 17, 2012, upon the approval of Financial Industry Regulatory Authority, Inc. (FINRA). 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, and the number of authorized shares of common stock remained 75,000,000 shares. The effect of the forward split was applied retroactively to the Company's consolidated financial statements for the periods presented.

Contractual Arrangements with our Controlled Consolidated Affiliate and its Shareholders

On October 17, 2012, prior to the reverse acquisition transaction, Baichuang Consulting and Jiangsu Xuefeng and its shareholders, Li Yuan and Yi Yuan, entered into a series of agreements known as variable interest agreements (the "VIE Agreements") pursuant to which Jiangsu Xuefeng became Baichuang Consulting's contractually controlled affiliate. The VIE Agreements included:

(1)
an Exclusive Technical Service and Business Consulting Agreement between Baichuang Consulting and Jiangsu Xuefeng pursuant to which Baichuang Consulting is to provide technical support and consulting services to Jiangsu Xuefeng in exchange for (i) 95% of the total annual net profit of Jiangsu Xuefeng plus (ii) RMB100,000 per month (approximately U.S.$16,000).
   
(2)
a Call Option Agreement among Li Yuan and Yi Yuan (together referred to as "Jiangsu Xuefeng Shareholders"), and Baichuang Consulting under which the Jiangsu Xuefeng Shareholders have granted to Baichuang Consulting the irrevocable right and option to acquire all of the equity interests in Jiangsu Xuefeng to the extent permitted by PRC law. If PRC law limits the percentage of Jiangsu Xuefeng that Baichuang Consulting may purchase at any time, then Baichuang Consulting may repeatedly exercise its option in such increments as may be allowed by PRC law. The exercise price of the option is RMB1.00 ($0.16) or any lower price permitted by PRC law. The Jiangsu Xuefeng Shareholders agreed to refrain from taking certain actions which might harm the value of Jiangsu Xuefeng or Baichuang Consulting's option;
   
(3)
a Proxy Agreement by Li Yuan and Yi Yuan pursuant to which they each authorize Baichuang Consulting to designate someone to exercise all of their shareholder decision rights with respect to Jiangsu Xuefeng; and
   
(4)
a Share Pledge Agreement among Li Yuan and Yi Yuan, Jiangsu Xuefeng, and Baichuang Consulting under which the Jiangsu Xuefeng Shareholders agree to pledge all of their equity in Jiangsu Xuefeng to Baichuang Consulting to guarantee Jiangsu Xuefeng's and its shareholders' performance of their obligations under the Exclusive Technical Service and Business Consulting Agreement, the Call Option Agreement and the Proxy Agreement.

Inclusion was established in the British Virgin Islands on August 9, 2012.  Lotus was established in Hong Kong on May 2, 2012 to serve as an intermediate holding company with authorized shares of 10,000 at HK$1.00 per share. Baichuang Consulting was established by Lotus as a wholly foreign owned enterprise (the "WFOE") in the PRC on September 5, 2012.  Jiangsu Xuefeng, our operating consolidated affiliate, was established in the PRC on December 14, 2007. The local government of the PRC issued a certificate of approval of the foreign ownership of Baichuang Consulting by Lotus, a Hong Kong entity on September 5, 2012.

Termination of contractual arrangements Jiangsu Xuefeng

On January 19, 2016, the Company effectively terminated its existing variable interest entity agreements, or VIEs, as permitted by the laws of the People's Republic of China (the "VIE Termination"), pursuant to certain Equity Transfer Agreements dated January 11, 2016 (the "Equity Transfer Agreements"), entered into by and among Mr. Li Yuan, Mr. Yi Yuan (each a shareholder of Jiangsu Xuefeng, together the "Jiangsu Xuefeng Shareholders") and Baichuang Consulting.  Pursuant to the Equity Transfer Agreement, the Jiangsu Xuefeng Shareholders collectively transferred 100% of their equity interest in Jiangsu Xuefeng to Baichuang Consulting, effectively terminating Company's contractual control of Jiangsu Xuefeng and providing Company with direct ownership of Jiangsu Xuefeng.  Upon the VIE Termination, Jiangsu Xuefeng became a wholly-owned subsidiary of the Company.
2


Acquisition of Linyi Xuefeng

On August 4, 2016, the Company entered into an agreement with Mr. Li Yuan, the sole shareholder of Linyi County Xuefeng Renewable Resources Utilization Technology Co., Ltd ("Linyi Xuefeng"), a company organized under the laws of the People's Republic of China, 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 was 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 was $3 per share and 7,820,871 shares in total to Mr. Li Yuan without cash consideration.

Linyi Xuefeng was officially approved and incorporated under the laws of the People's Republic of China ("PRC") in June 2013. Mr. Yuan Li was the sole owner since inception. Linyi Xuefeng is constructing a garbage processing plant which is planned to commerce operations in 2017. The only non-operating revenue was a subsidy received from the government for the city pollution garbage processing plant construction. Upon acquisition, Linyi Xuefeng became a wholly-owned subsidiary of the Company. The acquisition was accounted for as a business combination.

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.

See "Related Party Transactions" for further information on our contractual arrangements with these parties.

As a result of the entry into the foregoing agreements, our current organizational structure is as follows:


Our Services

As the urbanization in China progresses, the amount of household garbage increases. The processing capability of current garbage processing equipment in China cannot typically satisfy the increasing demands. We expand the garbage sorting scope and capacity of our clients' garbage processing equipment, by installing the various systems that embody the patented technology of "comprehensive and harmless garbage-processing equipment" into the client's garbage processing equipment and reconstructing their hardware, to provide upgrades and improvement to their equipment.
3

The patented technology of "harmless and comprehensive garbage processing equipment" helps to achieve high and stable garbage processing capacity, which uses a Distribution Control System (DCS) to realize mechanical automation for the comprehensive garbage treatment. The 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 its 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 outer supply, which greatly improves the efficiency of garbage processing of customer's equipment, decreases production cost, and increases the recovery return of garbage processing.

The comprehensive and harmless garbage processing equipment 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 tons to 1000 tons of garbage per day. It can sort and process complicated municipal solid waste, leaving no pollution and no residue, reaching the"3 without" standard of no waste gas, no waste water and no waste residue.

After we complete the internal system upgrade and hardware equipment improvement of the garbage equipment, we deliver the upgraded equipment to the customers. The customers will conduct inspection and performance testing to the upgraded equipment no more than one month pursuant to the contract to inspect whether the internal control system and the hardware structure can operate steadily and achieve the garbage process features. The inspection includes the following: whether the quality of the equipment and accessories after improvement can match the 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 standard of the contract. If during the performance testing period, all the performance index can fulfill the requirements of the contract are achieved, it would be deemed that we have fully executed the agreement.

Prior to the first service agreement in April 2012, we did not conduct any business activities except for the preparation of the business and the development of the clients, etc. When we complete the upgrading service for the client, we go through the acceptance check and commissioning of the company in accordance with the contract, to make sure that the service provided met the requirements of the clients. After that, we are not subject to any additional service. 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 are the responsibility of the clients.

Until August 31, 2012, the main revenue of Jiangsu Xuefeng was generated from providing improvement and upgrading services to garbage recycling processing plants. On August 5, 2012, Jiangsu Xuefeng entered into a license agreement with Li Yuan, one of its stockholders for the use of a patent on garbage recycling processing technology, a Utility Model Patent of Comprehensive and Harmless Garbage Processing Equipment, issued by the State Intellectual Property Office (SIPO) on July 7, 2010 and valid for ten years (Patent Number: ZL 2009 2 0232893.7).  The patent is owned by our Chief Executive Officer, Mr. Li Yuan.  Although the license commenced on September 1, 2012 and expired in August 2017, Mr. Li Yuan has agreed to allow the company continue to use the patent under the same terms and conditions.  Jiangsu Xuefeng expanded its business model from the sole service of providing upgrading to waste processing plants to also providing patent licensing based on its newly acquired use right of the patent technology.  We use the patent technology to help the clients to upgrade their internal system or reconstruct the hardware equipment we have, the Company has of the garbage processing equipment so that the equipment performance could reach the standard of our patent technology. After the upgrade and reconstruction, the patent technology will continue to be used in their equipment and we allow the clients to continue using the patent technology in their equipment for patent licensing revenue. License agreements will be offered to clients for a limited period of three to five years, within which period, the client shall pay patent royalties yearly to Jiangsu Xuefeng for their use of the equipment containing the patent technology. 
4


Therefore, under the new business model, Jiangsu Xuefeng generates its revenues from two sources: improvement and upgrading services of garbage processing equipment and patent licensing for the use of the upgraded technology.

For the year ended May 31, 2018, sales from improvement and upgrading services and patent licensing were $459,453 and $5,651,272, respectively. For the year ended May 31, 2017, sales from improvement and upgrading services and patent licensing were $3,062,413 and $4,704,044, respectively. For the year ended May 31, 2016, sales from improvement and upgrading services and patent licensing were $2,907,422 and $4,079,769, respectively. 
 
Linyi Xuefeng generates most of its revenue from the sale of garbage related products. Its main business model is to apply comprehensive treatment technology to recycle domestic garbage into new products. Its goals are to reduce the amount of garbage, to reduce the harm caused by garbage to the environment, and to make new products out of garbage. In this way, the company turns waste into treasure.

The company carried out trial production of waste treatment in September 2017, and sales started in February 2018. As of August 2018, the company is able to process 300 tons of domestic garbage per day. The whole waste treatment process is divided into primary processing and secondary processing. In the primary processing, organic soil, white plastic, construction waste and ferrous metal are sorted out. In the secondary processing, organic fertilizer, wood-plastic trays and hollow bricks are manufactured using the materials sorted out in the primary processing.
 
For the year ended May 31, 2018, sales from garbage related products were $1,720,772. For the year ended May 31, 2017, we did not generate revenue from garbage related products because we were going through trial production. 
 
Products and Facilities

We provide equipment improvement and upgrading service and license the patented technology to our customers. We also sell or lease garbage-processing units equipped with our patented technology.

We mainly incorporate and install the patented technology into garbage processing equipment's internal control and operation systems to achieve the requested processing capacity. During the internal system upgrading process, if any hardware equipment, such as the machine parts, is required to be reconstructed, the customers are responsible for the hardware purchase while we provide guided and assisted installation.

In addition, as our customers continue to use the equipment embodying the patented technology, they pay us a fee for the use of the patented technology.

We hope to construct our own garbage processing plant to process various environmental wastes.

In addition to patent licensing, we also generate revenue from the sale of garbage related products, which include ferrous metal, organic fertilizer, wood-plastic trays, and hollow bricks.

1.
Ferrous metal can be used as an auxiliary material for construction. Ferrous metal can be sold after they are sorted out in the primary processing from the domestic waste.
 
2.
Organic fertilizer is beneficial to crop growth and is the main nutrient for agricultural production. Its raw material is organic soil that is sorted out from domestic waste. During secondary processing, nitrogen, phosphorus, potassium, and organic fermentation agent are added to the organic soil.
 
3.
Wood-plastic trays are useful tools in daily life. We use white plastic sorted out from domestic waste as raw material, and process it into a composite material to manufacture wood-plastic trays.
 
4.
Hollow bricks are ideal filling materials for frame structure in construction industry. We use raw materials sorted out from domestic waste, add cement and sand to stir, and process it into hollow bricks. They are environmentally friendly and non-polluting.
      
We have continued to apply strict quality control on the products. We aim to provide solutions to waste treatment and build an eco-friendly living environment for people.
 
Customers

The following table sets forth our major customers for the year ended May 31, 2018:

Name
Revenue
 
Percentage
 
Relationship
 
       
                
Suzhou Zhonghe Solid Waste Recycling and Treatment Co., Ltd
 
$
1,561,685
     
13
%
None


The following table sets forth our major customers for the year ended May 31, 2017:

Name
Revenue
 
Percentage
 
Relationship
 
       
             
Suzhou Zhonghe Guti Rubbish Processing Co., Ltd
 
$
1,473,069
     
14
%
None


The following table sets forth our major customers for the year ended May 31, 2016:


Name
Revenue
 
Percentage
 
Relationship
 
       
          
Jinxiang Garbage Processing Factory
 
$
9,544,380
     
43
%
None
                   
Jiangsu Bowen Environmental Protection Co. Ltd
 
$
5,037,307
     
23
%
None

5

Our Industry

In the description below we rely on certain information and statistics regarding our industry and the economy in China from the reports published by National Bureau of Statistics of China and the PRC Ministry of Environmental Protection.  We have no reason to believe that the information and statistics we cite are not accurate.

The Chinese industry of garbage processing is highly fragmented and in a very early-stage of development. Benefiting from a series of encouraging and supportive policies on garbage processing formulated by the Chinese government, the urban garbage processing industry has been in rapid development. The current market is primarily dominated by small regional companies, like Jiangsu Xuefeng, which account for approximately 90% of all environmental protection enterprises in China.

The volume of solid waste generated by industrial companies directly correlates to the industrial rate of utilization of natural resources and is expected to grow by over 10% per year according to the National Bureau of Statistics of China. In addition, according to estimates from the PRC Ministry of Environmental Protection, the production of industrial waste was approximately 3.25 billion tons in 2013, excluding approximately 31.57 million tons of hazardous industrial waste.

According to the Opinions on Further the Municipal Solid Waste Processing Service issued by the Chinese government, the harmless garbage processing rate will reach over 80% by 2015.  This anticipated increase creates a strong incentive for companies to improve their garbage processing capability.  Thus, the Chinese garbage processing industry has significant potential for growth both in areas of equipment marketing and equipment upgrading and improvement.

Nationwide Innocuous Disposal Facilities MSW Facilities Construction Planning (2011-2015) ("Planning"), recently passed by the Chinese government, has gone into the implementation phase. In accordance with the Planning, the aggregate investment in the items of the Planning will reach RMB 260Billion Yuan (approximately US $41 billion).

According to the Environmental Protection Equipment "Twelfth Five-Year" Development Planning, the yearly growth rate of the environmental protection industry gross output during the Twelfth Five-Year period is 20% and will reach 500 billion yuan (approximately US $79 billion) by 2015.

Thus, recently issued policies reducing the cost of Jiangsu Xuefeng operations, and anticipated future industrial policies of the Chinese government show the Chinese government's encouragement and support for the long term development of the environmental waste processing industry, setting the stage for a larger market place for the environmental protection equipment upgrading and improvement business.

Competition

Competitive Advantages

The industry for environmental protection equipment upgrading and improvement in China, being in its early stage, creates a great amount of business opportunities. We believe that, with our services and products that are supported by the patented technology and gradually gaining its market acceptance, we are well positioned to take advantage of the opportunities presented in this industry.

Competitive Disadvantages

While we saw gross profit margins of 67%, 82% and 43% for the years of 2018, 2017 and 2016, respectively, we are uncertain that our high gross profit margins are sustainable if we have to commit to substantive research and development activities when the Chinese government adopts higher standards for environmental protection technologies and when the cost of our services become substantially higher.
6


Our Growth Strategy

As industrial development continues its rapid increase in growth, the demand for the Company service should also increase rapidly.  The Company hopes to seize the opportunity to use industrial growth of both large and medium-size enterprises, establishing cooperative relationships with high-quality customers by fully using its advantages in waste processing technology providing customers with improved environmental solutions and larger scale processing capability.

The Company will further develop the equipment upgrading business. Jiangsu Xuefeng will make the best use of its patented technology of comprehensive and harmless garbage processing equipment to carry on the improvement and upgrading service for Chinese clients. In addition, patent license agreements will be offered to clients for a limited period of three to five years, within which period, the client shall pay patent royalties yearly to Jiangsu Xuefeng for their use of the equipment containing the patent technology thus providing the Company with an additional source of revenue.

The Company hopes to establish an equipment manufacturing and sales center. While continuing to provide equipment upgrading services, Jiangsu Xuefeng intends to establish a garbage processing equipment manufacturing and sales center to meet the anticipated market needs for Chinese garbage processing equipment, gradually branching further into the Chinese garbage processing equipment market and improving the Company's revenue.

The Company plans to also undertake technical cooperation with key domestic and foreign R&D institutions and industry partners. Keeping abreast of domestic and foreign technical developments, the Company plans to make use of international and domestic newly advanced technology in comprehensive garbage processing with high daily processing capacity. The Company plans to constantly expand marketing channels and increase its market shares.

Markets, Sales and Distribution

Currently, our marketing and sales efforts largely rely on word of mouth among our existing clients.

Intellectual Property

The Company acquired the license of the patent technology of comprehensive and harmless garbage processing equipment" that passed the ISO9001:2008 International Quality Management System Certification through the Patent Licensing Service Agreement signed with our Chairman, Chief Executive Officer and a shareholder, Li Yuan. The Licensing Agreement commenced on September 1, 2012 with a monthly payment to Li Yuan of approximately $12,600 (RMB 80,000).  Although the Licensing Agreement expired in July 2017. Mr. Li Yuan has agreed to continue licensing our company the use of the patent under the same terms and conditions.  Provision 42 of the Patent Law of the People's Republic Of China (as amended in 2008) provides that "the time limit of patent for invention is twenty years, the time limit of patent of utility models and design patent is ten years, both of which are calculated from the date of application". Company has received Utility Model Patent Certificate and Certificate of Patent for Invention, from the State Intellectual Property Office of the People's Republic of China. Patent right of comprehensive disposal equipment for waste processing was terminated on July, 2009 due to the expiration of the protection period. We no longer enjoy the exclusive patent right to that technology. However, because patent for our waste sorting treatment technology was granted in July 2009 and its time limit is 20 years, we could license the use of the patent to other company until July 2029.

Comprehensive and Harmless Garbage Processing Equipment is a Utility Model Patent issued by the State Intellectual Property Office (SIPO) on July 7, 2010 and valid for ten years (Patent Number: ZL 2009 2 0232893.7). It is owned by with our Chairman.  This patented technology is for the treatment of complex municipal solid waste including sorting and classification, leaving almost no pollution and no residue.
 
Regulation

Because our operating affiliate Jiangsu Xuefeng is located in the PRC, our business is regulated by the national and local laws of the PRC. We believe our conduct of business complies with existing PRC laws, rules and regulations.
7


Environmental Law

Jiangsu Xuefeng is subject to China's national Environmental Protection Law, which was enacted on December 26, 1989, as well as a number of other national and local laws and regulations governing landfills, air, water, and noise pollution and establishing pollutant discharge standards for wastewater.

On July 1, 2004, the PRC central government adopted the Measures for the Administration of Permit for Operation of Dangerous Wastes (the "Measures"). The Measures are intended to strengthen supervision and administration of activities relating to the collection, storage and disposal of dangerous wastes, and preventing dangerous wastes from polluting the environment.

Both the PRC Ministry of Environment Protection and local bureaus of environmental protection, license and regulate companies engaged in waste disposal and treatment in China. The requirements for licensing have become more stringent, with applicants having to demonstrate a sufficient operating history and a number of professional technicians, as well as comply with national and local environmental standards. The licensing process is also very time consuming and requires lengthy lead times.

General Regulation of Businesses

We believe we are in material compliance with all applicable labor and safety laws and regulations in the PRC, including the PRC Labor Contract Law, the PRC Production Safety Law, the PRC Regulation for Insurance for Labor Injury, the PRC Unemployment Insurance Law, the PRC Provisional Insurance Measures for Maternity of Employees, PRC Interim Provisions on Registration of Social Insurance, PRC Interim Regulation on the Collection and Payment of Social Insurance Premiums and other related regulations, rules and provisions issued by the relevant governmental authorities from time to time, for our operations in the PRC.

According to the PRC Labor Contract Law, we are required to enter into labor contracts with our employees. We are required to pay no less than local minimum wages to our employees. We are also required to provide employees with labor safety and sanitation conditions meeting PRC government laws and regulations and carry out regular health examinations of our employees engaged in hazardous occupations.

Foreign Currency Exchange

The principal regulation governing foreign currency exchange in China is the Foreign Currency Administration Rules (1996), as amended (2008). Under these Rules, RMB is freely convertible for current account items, such as trade and service-related foreign exchange transactions, but not for capital account items, such as direct investment, loan or investment in securities outside China unless the prior approval of, and/or registration with, the State Administration of Foreign Exchange of the People's Republic of China, or SAFE, or its local counterparts (as the case may be) is obtained.

Pursuant to the Foreign Currency Administration Rules, foreign invested enterprises, or FIEs, in China may purchase foreign currency without the approval of SAFE for trade and service-related foreign exchange transactions by providing commercial documents evidencing these transactions. They may also retain foreign exchange (subject to a cap approved by SAFE) to satisfy foreign exchange liabilities or to pay dividends. In addition, if a foreign company acquires a company in China, the acquired company will also become an FIE. However, the relevant PRC government authorities may limit or eliminate the ability of FIEs to purchase and retain foreign currencies in the future. In addition, foreign exchange transactions for direct investment, loan and investment in securities outside China are still subject to limitations and require approvals from, and/or registration with, SAFE.

Regulation of Income Taxes

On March 16, 2007, the National People's Congress of China passed the Enterprise Income Tax Law, or the EIT Law, and its implementing rules, both of which became effective on January 1, 2008. The EIT Law and its implementing rules impose a unified EIT rate of 25.0% on all domestic-invested enterprises and FIEs, unless they qualify under certain limited exceptions.
8


Under the EIT Law, companies designated as High- and New-Technology Enterprises may enjoy a reduced national EIT rate of 15%. The Administrative Measures for Assessment of High-New Tech Enterprises and Catalogue of High/New Tech Domains Strongly Supported by the State (2008), jointly issued by the Ministry of Science and Technology and the Ministry of Finance and State Administration of Taxation set forth general guidelines regarding criteria as well as application procedures for qualification as a High- and New-Tech Enterprise under the EIT Law.

In addition to the changes to the current tax structure, under the EIT Law, an enterprise established outside of China with "de facto management bodies" within China is considered a resident enterprise and will normally be subject to an EIT of 25% on its global income. The implementing rules define the term "de facto management bodies" as "an establishment that exercises, in substance, overall management and control over the production, business, personnel, accounting, etc., of a Chinese enterprise." If the PRC tax authorities subsequently determine that we should be classified as a resident enterprise, then our organization's global income will be subject to PRC income tax of 25%. For detailed discussion of PRC tax issues related to resident enterprise status, see "Risk Factors – Risks Related to Our Business – Under the EIT Law, we may be classified as a 'resident enterprise' of China. Such classification will likely result in unfavorable tax consequences to us and our non-PRC stockholders."

Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income and non-tax deductible expenses incurred. Our management carefully monitors these legal developments and will timely adjust our effective income tax rate when necessary.

Dividend Distribution

Under applicable PRC regulations, FIEs in China may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, a FIE in China is required to set aside at least 10.0% of its after-tax profit based on PRC accounting standards each year to a general reserve until the cumulative amount of such reserve reaches 50.0% of its registered capital. These reserves are not distributable as cash dividends. The board of directors of a FIE has the discretion to allocate a portion of its after-tax profits to staff welfare and bonus funds, which may not be distributed to equity owners except in the event of liquidation.

The EIT Law and its implementing rules generally provide that a 10% withholding tax applies to China-sourced income derived by non-resident enterprises for PRC enterprise income tax purposes unless the jurisdiction of incorporation of such enterprises' shareholder has a tax treaty with China that provides for a different withholding arrangement. Baichuang Consulting is considered a FIE and is directly held by our subsidiary in Hong Kong, Lotus. According to a 2006 tax treaty between the Mainland and Hong Kong, dividends payable by an FIE in China to the company in Hong Kong who directly holds at least 25% of the equity interests in the FIE will be subject to a no more than 5% withholding tax. We expect that such 5% withholding tax will apply to dividends paid to Lotus by Baichuang Consulting, but this treatment will depend on our status as a non-resident enterprise.    

PRC M&A Rule, Circular 75 and Circular 638

On August 8, 2006, six Chinese government agencies, namely, the Ministry of Commerce, or MOFCOM, the State Administration for Industry and Commerce, or SAIC, the China Securities Regulatory Commission, or CSRC, the State Administration of Foreign Exchange, or SAFE, the State Assets Supervision and Administration Commission, or SASAC, and the State Administration for Taxation, or SAT, jointly issued the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, referred to as the "New M&A Rules", which became effective on September 8, 2006. The New M&A Rules purport, among other things, to require offshore "special purpose vehicles," that are (1) formed for the purpose of overseas listing of the equity interests of Chinese companies via acquisition and (2) are controlled directly or indirectly by Chinese companies and/or Chinese individuals, to obtain the approval of the CSRC prior to the listing and trading of their securities on overseas stock exchanges. Based on our understanding of current Chinese Laws and pursuant to a legal opinion issued by Jilin Changchun Law Firm dated October 17, 2012, (i) Baichuang Consulting was incorporated by a foreign investor and therefore has no Chinese shareholders; (ii) the share exchange between Inclusion and the Company,  is between two offshore companies and is not deemed as a transaction to acquire equity or assets of a "Chinese domestic company" as defined under the New M&A Rules and (ii) no provision in the New M&A Rules clearly classifies the contractual arrangements between Baichuang Consulting and Jiangsu Xuefeng as a type of transaction falling within the New M&A Rules.
9


The SAFE issued a public notice in October 2005, or the Circular 75, requiring Chinese residents to register with the local SAFE branch before establishing or controlling any company outside of China for the purpose of capital financing with assets or equity of Chinese companies, referred to in the Circular 75 as special purpose vehicles, or SPVs. Chinese residents who are shareholders of SPVs established before November 1, 2005 were required to register with the local SAFE branch before June 30, 2006. Further, Chinese residents are required to file amendments to their registrations with the local SAFE branch if their SPVs undergo a material event involving changes in capital, such as changes in share capital, mergers and acquisitions, share transfers or exchanges, spin-off transactions or long-term equity or debt investments.

Pursuant to the Circular 698, where a foreign investor transfers the equity interests of a Chinese resident enterprise indirectly via disposing of the equity interests of an overseas holding company, which we refer to as an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that: (i) has an effective tax rate less than 12.5% or (ii) does not tax foreign income of its residents, the foreign investor shall report such Indirect Transfer to the competent tax authority of the Chinese resident enterprise. The Chinese tax authority will examine the true nature of the Indirect Transfer, and if the tax authority considers that the foreign investor has adopted an abusive arrangement in order to avoid Chinese tax, they will disregard the existence of the overseas holding company and re-characterize the Indirect Transfer and as a result, gains derived from such Indirect Transfer may be subject to Chinese withholding tax at the rate of up to 10%. Circular 698 also provides that, where a non-Chinese resident enterprise transfers its equity interests in a Chinese resident enterprise to its related parties at a price lower than the fair market value, the competent tax authority has the power to make a reasonable adjustment to the taxable income of the transaction.

Insurance

Insurance companies in China offer limited business insurance products. While business interruption insurance is available to a limited extent in China, we have determined that the risks of interruption, cost of such insurance and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. As a result, we could face losses from the interruption of our business as summarized under "Risk Factors – Risks Related to Our Business – We do not carry business interruption insurance so we could incur unrecoverable losses if our business is interrupted."

Our Employees

As of August 29, 2018, we had a total of 139 employees. The Company employs a highly qualified team of technically trained personnel. Among the Company's employees, 11 employees have environmental assessment engineering degrees and 10 employees have ecological and environmental protection planning qualifications.  This team provides support for clients. 

Item 1A.       Risk Factors

Smaller reporting companies are not required to provide the information required by this item.

Item 1B.   Unresolved Staff Comments

None.

Item 2.   Properties

The Company entered into a lease agreement for office space from an unrelated third party, which commenced on April 1, 2016 and will expire on March 31, 2019.  The lease required the Company to prepay the semi-annual rental of $3,637 (RMB 24,000).  The lease provides for renewal options.  Rent expense for the year ended May 31, 2018, 2017 and 2016 was $15,070, $14,134 and $14,571 respectively.

10

Future minimum payments for the years ending May 31 are as follows:

Year Ending
   
May 31,
Amount
 
     
2019
 
$
14,212
 
         
   
$
14,212
 

Item 3.   Legal Proceedings

There are no actions, suits, proceedings, inquiries 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 4.  Mine Safety Disclosures

Not applicable 

PART II

Item 5.  Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market Information

Our common stock has been quoted on the OTCQB since May 9, 2012. Our initial symbol was "NYCM". In January 2013, our symbol was changed to "CXEE". The following table sets forth the range of the quarterly high and low bid price information for the past two fiscal years as reported by the OTCQB.

2018
 
High Bid* ($)
   
Low Bid* ($)
 
             
March 1, 2017 – May 31, 2018
   
4.2
     
3.5
 
December 1, 2017 – February 29, 2018
   
4.2
     
4.16
 
September 1, 2017 – November 30, 2017
   
4.16
     
4.16
 
June 1, 2017 – August 31, 2017
   
4.16
     
4.11
 
                 
2017
               
                 
March 1, 2017 – May 31, 2017
   
4.11
     
3.79
 
December 1, 2016 – February 29, 2017
   
3.79
     
3.66
 
September 1, 2016 – November 30, 2016
   
3.67
     
3.55
 
June 1, 2016 – August 31, 2016
   
4.48
     
2.78
 
                 
2016
               
                 
March 1, 2016 – May 31, 2016
   
4.51
     
3.00
 
December 1, 2015 – February 29, 2016
   
4.39
     
4.25
 
September 1, 2015 – November 30, 2015
   
4.38
     
3.92
 
June 1, 2015 – August 31, 2015
   
3.93
     
3.86
 

* The quotations of the closing prices reflect inter-dealer prices, without retail mark-up, markdown or commission, and may not necessarily represent actual transactions.

The market price of our common stock is subject to significant fluctuations in response to variations in our quarterly operating results, general trends in the market, and other factors, over many of which we have little or no control. In addition, broad market fluctuations, as well as general economic, business and political conditions, may adversely affect the market for our common stock, regardless of our actual or projected performance.

11

Holders

As of August 29, 2018, there are 1,374 stockholders of record of our common stock. This figure does not take into account those shareholders whose certificates are held in the name of broker-dealers or other nominees.

Dividends

Any future decisions regarding dividends will be made by our board of directors. We currently intend to retain and use any future earnings for the development and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Our board of directors has complete discretion on whether to pay dividends, subject to the approval of our stockholders. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, and capital requirements, general financial conditions, contractual restrictions, government restrictions and other factors that the board of directors may deem relevant.

PRC regulations restrict the ability of our PRC subsidiary to make dividend and other payments to its offshore parent company. PRC legal restrictions permit payments of dividends by our PRC subsidiary only out of its accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Our PRC subsidiary is also required under PRC laws and regulations to allocate at least 10% of our annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the amounts in said fund reaches 50% of our registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. Please refer to the section "Risk Factors — Risks Related to Doing Business in the PRC" beginning on page 16.

Furthermore, our present PRC subsidiaries' ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Circular 75 by our PRC resident beneficial holders. A failure by our PRC resident beneficial holders or future PRC resident stockholders to comply with Circular 75, if SAFE requires it, could limit our subsidiaries' ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects. See "Risk Factors — Risks Related to Doing Business in the PRC" beginning on page 16.

Recent Sales of Unregistered Securities

There were no unregistered sales of the Company's equity securities during the fiscal year ended May 31, 2018, that were not otherwise disclosed in a Quarterly Report on Form 10-Q or a Current Report on Form 8-K.

Item 6.   Selected Financial Data

   
Fiscal Year
Ended
May 31,
2018
   
Fiscal Year
Ended
May 31,
2017
   
Fiscal Year
Ended
May 31,
2016
   
Fiscal Year
Ended
May 31,
2015
   
Fiscal Year
Ended
May 31,
2014
 
 Revenue
 
$
11,805,088
   
$
10,434,240
   
$
22,187,094
   
$
6,996,100
   
$
4,710,165
 
 Net income attributable to common stockholders
 
$
4,597,492
   
$
6,382,819
   
$
6,553,586
   
$
5,299,795
   
$
2,806,120
 
 Earnings per common share
 
$
0.07
   
$
0.10
   
$
0.10
   
$
0.09
   
$
0.05
 
 Total Assets
 
$
92,495,554
   
$
81,270,897
   
$
67,333,852
   
$
26,488,007
   
$
20,750,926
 
 Long Term Obligations
 
$
4,991,680
   
$
3,404,670
   
$
2,794,868
   
$
-
   
$
-
 
 Cash Dividends Declared Per Common Share
 
$
0.00
   
$
0.00
   
$
0.00
   
$
0.00
   
$
0.00
 

Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations

 
This Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results.  The following discussion and analysis should be read in conjunction with our audited consolidated financial statements and the accompanying notes thereto included in "Item 8. Financial Statements and Supplementary Data."

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

Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, the Company cannot guarantee future results, levels of activity, performance, or achievements. Except as required by applicable law, including the securities laws of the United States, the Company does not intend to update any of the forward-looking statements to conform these statements to actual results.

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). These accounting principles require us to make certain estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments, and assumptions are made. These estimates, judgments, and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. Our financial statements would be affected to the extent there are material differences between these estimates and actual results. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management's judgment in its application. There are also areas in which management's judgment in selecting any available alternative would not produce a materially different result. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this report.

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, sold and leased garbage-processing equipment commencing since fiscal year ended May 31, 2016. We recycled the garbage and manufactured products by using the processed garbage to sell since the fiscal year ended May 31, 2018. We conduct our operations through our wholly-owned subsidiaries Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng") and Linyi County Renewable Resources Utilization Co., Ltd. ("Linyi 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.
12

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.

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 was 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 finalize the purchase and cost based upon 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.
   
Upon acquisition, Linyi Xuefeng became a wholly-owned subsidiary. The acquisition was accounted for as a business combination.
13

Results of Operations

Results of Operations for the Years Ended May 31, 2018 and 2017

The following table sets forth in U.S. dollars, key components of our audited results of operations for the years ended May 31, 2018 and 2017 and the percentage change between these comparable periods.
 
 
 
Years Ended May 31,
     Percentage  
 
 
2018
   
2017
   
Change
 
 
 
(U.S. $)
   
(U.S. $)
     
 
                 
Revenue
 
$
11,805,088
   
$
10,434,240
      13 %)
Cost of revenue
   
(3,847,707
)
   
(1,863,936
)
   
106
%
      Gross profit
   
7,957,381
     
8,570,304
     
(7
%)
    Selling expenses
   
1,054,958
     
682,986
     
54
%
    General and administrative expenses
   
2,288,841
     
1,020,167
     
124
%
      Total operating expenses
   
3,343,799
     
1,703,153
     
96
%
Operating income
   
4,613,582
     
6,867,151
     
(33
%)
    Non-operating income
   
1,174,604
     
1,336,523
     
(12
%)
Income before provision for income taxes
   
5,788,186
     
8,203,674
     
(29
%)
Provision for income taxes
   
1,190,694
     
1,820,855
     
(35
%)
Net income
   
4,597,492
     
6,382,819
     
(28
%)
    Noncontrolling interests
   
-
 
   
-
     
0
%
Net income attributable to common  stockholders
 
$
4,597,492
   
$
6,382,819
     
(28
%)


Revenue

We generated $11,805,088 in revenue for the year ended May 31, 2018, as compared to $10,434,240 for the year ended May 31, 2017. Our revenue for the year ended May 31, 2018 increased by $1,370,848 or 13% compared to the revenue for the year ended May 31, 2017, primarily resulting from the Linyi Xuefeng recycling plant beginning operations. The following table shows the details of our revenue in the years ended May 31, 2018 and 2017.
  Years Ended May 31,     Percentage  
 
2018
 
2017
 
Change
 
 
(U.S. $)
 
(U.S. $)
 
 
 
             
Improvements and Upgrading Services
 
$
459,453
   
$
3,062,413
 
 (85
 %)
Patent Leasing
  5,651,272
 
  4,704,044
 
 20
 %
Operating lease
  3,973,591
 
   2,667,783
 
 49
 %
Sales of garbage related products
   
1,720,772
     
-
     
100
%
 Total
 
$
11,805,088
   
$
10,434,240
     
13
%

Improvement and Upgrading Services
 
 
During the year ended May 31, 2018, we provided improvement and upgrading services to one customer and generated revenue of $459,453. During the year ended May 31, 2017, we provided improvement and upgrading services to eight customers and generated revenue of $3,062,413.  The service was completed and accepted by the customer and the payment was received in full as of May 31, 2018 and 2017. While our core business still focuses on providing improvement and upgrading services for potential customers' garbage processing equipment, our business has expanded to selling or leasing our garbage processing equipment and processing and selling garbage related products.
 
Patent Licensing
 
 
During the year ended May 31, 2018, we generated revenue of $5,651,272 from licensing our patent to 21 unrelated customers. During the year ended May 31, 2017, we generated revenue of $4,704,044 from licensing our patent to 19 unrelated customers. As all these customers became licensees before June 1, 2017 and 2016, respectively, patent licensing revenue was recognized for the entire twelve months for these customers during the related periods.
 
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Operating lease
            
During the year ended May 31, 2017, we had six operating leases for a 300-ton and five 500-ton garbage processing system. The lease period is 5 years with annual lease payments of $612,604 and $3,675,625 (for the total five 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 two 500-ton garbage processing system was delivered and tested in the end of April 2016 and December 2016, respectively. We also delivered and tested one 500-ton garbage processing system in the end of March 2017. 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 year ended May 31, 2017, we generated operating lease revenue of $2,667,783 from the six leases. During the year ended May 31, 2018, we have one new operating lease for a 500-ton garbage processing system. The lease period is still 5 years with annual lease payments of $612,604, before VAT. The 500-ton garbage processing system was delivered and tested on October 17, 2017. During the year ended May 31, 2018, we generated operating lease revenue of $3,973,691 from the seven leases.
         
Sales of garbage related products 

During the year ended May 31, 2018, we started to process and sell garbage related products, such as organic manure, hollow brick, wood plastic tray and ferrous metal. During the year ended May 31, 2018, we generated revenue of $1,720,772 from selling garbage related products. During the year ended May 31, 2017, we did not have such type of revenue.

Cost of Goods Sold 

Our cost of goods sold increased to $3,847,707 for the year ended May 31, 2018 from $1,863,936 for the year ended May 31, 2017, which represented an increase of 106%. It is primarily because the cost of leasing equipment increased and the new revenue stream was introduced which has a lower gross margin. For the 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. For the operating lease revenue, the depreciation of the garbage processing equipment is the main cost which also included in the cost of revenue. For the sales of garbage related products, we purchased raw material for the manufacturing and so the costs were increased.

Gross Profit

Our gross profit reduced to $7,957,381 for the year ended May 31, 2018 from $8,570,304 for the year ended May 31, 2017. Our gross profit ratio for the years ended May 31, 2018 and 2017 was 67% and 82%, respectively. For the year ended May 31, 2017, our business stream has resulted in a high gross margin because we have no cost of products sold. Our cost of goods sold is almost entirely direct labor and patent licensing fees, depreciation of leased equipment and other operating expenses. Since we started to sell garbage related products during the year ended May 31, 2018, we incurred an increased amount of cost of goods sold. As a result, we expect that gross profit margin to continue to decrease in the following periods.

Selling and Marketing Expenses 
 
Our selling and marketing expenses increased to $1,054,958 for the year ended May 31, 2018 from $682,986 for the year ended May 31, 2017 which represented an increase of 54%. Our selling and marketing expenses were primarily comprised of sales employees' salaries, advertising expenses, training expenses and travelling expenses. The primary reason why selling and marketing expenses increased significantly is because of the acquisition of Linyi Xuefeng.
 
General and Administrative Expenses

Our general and administrative expenses increased to $2,288,841 for the year ended May 31, 2018 from $1,020,167 for the year ended May 31, 2017 which represented an increase of 124%. 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 primary reason for the material increase in General and Administrative expenses is the acquisition of Linyi Xuefeng. In addition, we ceased our previous plan for an IPO on the Australian share exchange market and so the paid IPO related fees of approximate $143,800 was expensed and classified as General and Administrative expense in FY 2018.
 
15


Non-Operating Income

Despite our large cash balances, the interest income generated for the years ended May 31, 2018 and 2017 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 years ended May 31, 2018 and 2017, our interest income also includes interest of $226,446 and $434,099, respectively, 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 $918,906 (RMB 6,000,000) annually. For the years ended May 31, 2018 and 2017, the income of government subsidy was $918,906 and $883,389 under accrual basis, respectively.

Provision for Income Taxes

Our provision for income taxes decreased to $1,190,694 for the year ended May 31, 2018 from $1,820,855 for the year ended May 31, 2017.  Our effective tax rate for the years ended May 31, 2018 and 2017 was approximately 21% and 22%, respectively. The enterprise income tax rate is 25% in China. Our tax filing for the calendar year ended December 31, 2017 was examined by the PRC tax authorities in May 2018. Our prior filings were accepted and no adjustments were proposed. Due to the government subsidy is exempt from income tax, the decrease in the provision for income taxes was primarily due to the decrease in our pre-tax income.

Net Income

For the year ended May 31, 2018 and 2017, we generated net income of $4,597,492 and $6,382,819, respectively. Our net income attributable to the common stockholders of the Company for the years ended May 31, 2018 and 2017 was $4,597,492 and $6,382,819, respectively, representing $0.07 per share and $0.10 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 is included in the results of operations as incurred. For the years ended May 31, 2018 and 2017, a foreign currency gain (loss) of $3,853,411 and $(1,723,591), respectively,  have been reported as other comprehensive income in the consolidated statements of income and other comprehensive income. The foreign currency gain was mainly due to the revaluation of the Chinese currency during the fiscal year 2018.

Liquidity and Capital Resources
 
As of May 31, 2018, we had cash and cash equivalents of $17,559,007, primarily consisting of cash on hand and demand deposits. The cash balance was principally derived from cash from operations and issuance of stock of $7,009,000.

To date, we have financed our operations primarily through cash flows from operations. 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 $10,511,269 for the year ended May 31, 2018, as compared with the net cash provided by operating activities of $3,746,396 for the year ended May 31, 2017. For the year ended May 31, 2018, the decrease in the accounts receivable of $3,405,086, depreciation expenses of $3,040,292, increase in accounts payable and accrued liability of $4,187,205, increase in prepaid expenses of $4,464,331 primarily caused the difference between the net cash provided by operating activities and the net income.  For the fiscal years ended May 31, 2017, the increase in prepaid VAT of $1,043,873, prepaid expenses of $6,946,378 and accounts payable and accrued liabilities of $811,208, the decrease in accounts receivable of $3,923,951 and the increase in deferred revenue of $831,858 mainly caused the difference between the net cash provided by operating activities and the net income. 
16


Investing activities

Net cash used in investing activities was $3,789,218 for the year ended May 31, 2018 which included purchase of fixed assets of $6,065 and purchase leasing equipment of $3,783,153. Net cash used in investing activities was $8,879,502 for the year ended May 31, 2017 which included the purchase of fixed assets of $98,829 and purchase leasing equipment of $8,780,673.

Financing activities    
                        
For the year ended May 31, 2018, we received $7,000,000 from issue of our common stock, $735,125 from the security deposit received and repaid $7,625,011 loan to a shareholder. For the year ended May 31, 2017, we received security deposit payable of $706,711 for the leased equipment and loan of $9,052,167 from our shareholder. 
 
Effect of Exchange Rate on Cash
 
The positive (negative) effect of the exchange rate on cash of $382,879 and $(193,915) was principally due to the revaluation (devaluation) by the PRC government of their currency for the years ended May 31, 2018 and 2017, respectively. 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 7A.  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.

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.
17


Item 8. Financial Statements and Supplementary Data
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and
Stockholders of China Xuefeng Environmental Engineering, Inc. and Subsidiaries

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of China Xuefeng Environmental Engineering, Inc. and Subsidiaries (the "Company") as of May 31, 2018 and 2017 and the related consolidated statements of income and comprehensive income, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended May 31, 2018 and the related notes (collectively referred to as the "consolidated financial statements").  In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of May 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended May 31, 2018, in conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of May 31, 2017 (only) based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated August 28, 2017, expressed an adverse opinion.

Basic for Opinion

These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on the Company's consolidated financial statements based on our audits.  We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB.  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud.  Our audits included performing procedures to assess the risk of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks.  Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements.  Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.  We believe that our audits provide a reasonable basis for our opinion.

/s/ Wei, Wei & Co., LLP
Wei, Wei, & Co., LLP
We have served as the Company's auditor since 2012
Flushing, New York
August 29, 2018
 
18

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 (IN U.S. $)
 
 
   
May 31,
   
May 31,
 
ASSETS
 
2018
   
2017
 
             
Current assets:
           
  Cash
 
$
17,559,007
   
$
10,343,963
 
  Accounts receivable
   
2,607,798
     
4,365,854
 
  Inventory
   
37,669
     
-
 
  Prepaid Expenses
   
137,632
     
7,009,322
 
  Prepaid VAT
   
4,615,812
     
4,649,599
 
                 
    Total current assets
   
24,957,918
     
26,368,738
 
                 
Noncurrent assets:
               
Fixed assets, net
   
33,729,725
     
23,860,312
 
Lease equipment, net
   
27,167,719
     
23,774,359
 
Prepaid lease
   
5,816,243
     
5,592,757
 
Accounts receivable-non-current
   
-
     
1,463,078
 
Deferred income tax assets
   
823,949
     
211,653
 
                 
Total noncurrent assets
   
67,537,636
     
54,902,159
 
                 
TOTAL ASSETS
 
$
92,495,554
   
$
81,270,897
 
 
 
See accompanying notes to the consolidated financial statements.
19

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(CONTINUED)
 (IN U.S. $)


     May 31,      May 31,  
 LIABILITIES AND STOCKHOLDERS' EQUITY    2018      2017  
             
Current liabilities:
           
  Accounts payable
 
$
1,049,776
   
$
498,959
 
  Deferred revenues
   
3,995,944
     
3,695,730
 
  Taxes payable
   
489,349
     
596,765
 
  Loan from stockholder
   
10,892,539
     
17,468,486
 
  Accrued liabilities
   
118,375
     
99,299
 
                 
    Total current liabilities
   
16,545,983
     
22,359,239
 
                 
Security deposits payable
   
4,991,680
     
3,404,670
 
                 
TOTAL LIABILITIES
   
21,537,663
     
25,763,909
 
                 
Stockholders' equity:
               
  Common stock, $0.001 par value per share,  75,000,000 shares authorized; 66,520,871 and 63,020,871 shares issued and outstanding as of May 31,  2018 and 2017
   
66,521
     
63,021
 
  Additional paid-in capital
   
41,581,497
     
34,584,997
 
  Statutory reserve fund
   
2,595,662
     
2,437,684
 
  Retained earnings
   
26,462,203
     
22,022,689
 
  Other comprehensive income (loss)
   
252,008
     
(3,601,403
)
                 
    Total stockholders' equity
   
70,957,891
     
55,506,988
 
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
92,495,554
   
$
81,270,897
 

 
See accompanying notes to the consolidated financial statements.
20

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
(IN U.S. $)

   
Year Ended May 31,
 
     2018      2017      2016  
                   
Revenue:
                 
    Sales
 
$
7,831,497
   
$
7,766,457
   
$
21,287,515
 
    Lease income
   
3,973,591
     
2,667,783
     
899,579
 
                         
Total revenue
   
11,805,088
     
10,434,240
     
22,187,094
 
                         
Cost of goods sold:
                       
    Cost of sales
   
1,926,972
     
544,141
     
12,116,076
 
    Depreciation expense - leased equipment
   
1,920,735
     
1,319,795
     
434,474
 
                         
Total cost of goods sold
   
3,847,707
     
1,863,936
     
12,550,550
 
                         
  Gross profit
   
7,957,381
     
8,570,304
     
9,636,544
 
                         
Operating expenses:
                       
    Selling and marketing
   
1,054,958
     
682,986
     
1,229,968
 
    General and administrative
   
2,288,841
     
1,020,167
     
1,294,271
 
                         
      Total operating expenses
   
3,343,799
     
1,703,153
     
2,524,239
 

 
See accompanying notes to the consolidated financial statements.
21

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
(IN U.S. $)

 
Year Ended May 31,
 
 
  2018
   
2017
   
2016
 
                 
Income from operations
 
$
4,613,582
   
$
6,867,151
   
$
7,112,305
 
                         
    Interest income
   
255,698
     
453,134
     
416,317
 
    Government subsidy
   
918,906
     
883,389
     
937,878
 
                         
Income before provision for income taxes
   
5,788,186
     
8,203,674
     
8,466,500
 
Provision for income taxes
 1,190,694
     
1,820,855
     
1,912,914
 
                         
Net income
   
4,597,492
     
6,382,819
     
6,553,586
 
Earnings per common share, basic and diluted
 
$
0.07
   
$
0.10
     
0.10
 
                         
Weighted average shares outstanding, basic and diluted
   
64,209,912
     
63,020,871
     
63,020,871
 
                         
Comprehensive Income:
                       
Net Income
 
$
4,597,492
   
$
6,382,819
   
$
6,553,586
 
Foreign currency translation adjustment
   
3,853,411
     
(1,723,591
)
   
(2,492,980
)
                         
Comprehensive income
 
$
8,450,903
   
$
4,659,228
   
$
4,060,606
 

See accompanying notes to the consolidated financial statements.
22

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEAR ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)

   
Common
Stock
   
Additional
Paid-in
Capital
   
Retained
Earnings
   
Statutory
Reserve Fund
   
Other
 Comprehensive
Income
   
Total
 
                                     
Balance, May 31, 2015
 
$
55,200
   
$
12,156,473
   
$
10,601,811
   
$
1,221,482
   
$
615,168
   
$
24,650,134
 
   Net income
   
-
     
299,325
     
6,254,261
     
-
     
-
     
6,553,586
 
   Issue Common Stock
   
7,821
     
22,129,199
     
-
     
-
     
-
     
22,137,020
 
   Appropriation to statutory reserve
   
-
     
-
     
(622,038
)
   
622,038
     
-
     
-
 
   Foreign currency translation adjustment
   
-
     
-
     
-
     
-
     
(2,492,980
)
   
(2,492,980
)
                                                 
Balance, May 31, 2016
 
$
63,021
   
$
34,584,997
   
$
16,234,034
   
$
1,843,520
   
$
(1,877,812
)
 
$
50,847,760
 
   Net income
   
-
     
-
     
6,382,819
     
-
     
-
     
6,382,819
 
   Appropriation to statutory reserve
   
-
     
-
     
(594,164
)
   
594,164
     
-
     
-
 
   Foreign currency translation adjustment
   
-
     
-
     
-
     
-
     
(1,723,591
)
   
(1,723,591
)
                                                 
Balance, May 31, 2017
 
$
63,021
   
$
34,584,997
   
$
22,022,689
   
$
2,437,684
   
$
(3,601,403
)
 
$
55,506,988
 
   Net income
   
-
     
-
     
4,597,492
     
-
     
-
     
4,597,492
 
   Issue Common Stock
   
3,500
     
6,996,500
                             
7,000,000
 
Appropriation to statutory reserve
                   
(157,978
)
   
157,978
                 
   Foreign currency translation adjustment
   
-
     
-
     
-
     
-
     
3,853,411
     
3,853,411
 
Balance, May 31, 2018
 
$
66,521
   
$
41,581,497
   
$
26,462,203
   
$
2,595,662
   
$
252,008
   
$
70,957,891
 

 

See accompanying notes to the consolidated financial statements.
23

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 
     
For Year Ended May 31,
 
   
2018
   
2017
   
2016
 
                   
Cash flows from operating activities:                        
     Net income
 
$
4,597,492
   
$
6,382,819
   
$
6,553,586
 
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Depreciation
   
3,040,292
     
1,415,505
     
498,982
 
Amortization for the land
   
126,196
     
121,319
     
128,802
 
(Increase) decrease in deferred income tax assets
   
(588,072
)
   
(217,705
)
   
159,995
 
Changes in operating assets and liabilities:
                       
Decrease (increase) in accounts receivable
   
3,405,086
     
3,923,951
     
(10,079,795
)
(Increase) in inventory
   
(36,984
)
   
-
     
-
 
Decrease in prepayment for construction
   
-
     
-
     
854,431
 
Decrease (Increase) in prepaid VAT
   
320,503
     
(1,043,873
)
   
(3,732,450
)
(Increase) in prepaid expenses
   
(4,464,331
)
   
(6,946,378
)
   
-
 
(Decrease) increase in accounts payable and accrued liabilities
   
4,187,205
     
(811,208
)
   
1,463,310
 
Increase in deferred revenue
   
66,365
     
831,858
     
762,466
 
(Decrease) increase in taxes payable
   
(142,483
)
   
90,108
     
(128,695
)
                         
Net cash provided by (used in) operating activities
   
10,511,269
     
3,746,396
     
(3,519,368
)
                         
Cash flows from investing activities:
                       
Purchase of fixed assets
   
(6,065
)
   
(98,829
)
   
(30,767,344
)
Purchase of leasing equipment
   
(3,783,153
)
   
(8,780,673
)
   
(434,474
)
                         
Net cash (used in) investing activities
   
(3,789,218
)
   
(8,879,502
)
   
(31,201,818
)
                         
Cash flows from financing activities:
                       
    Cash received from stock issuance
   
7,000,000
     
-
     
-
 
    Loan received from shareholder
   
-
     
9,052,167
     
12,739,510
 
Repayment of shareholder loan
   
(7,625,011
)
   
-
     
-
 
    Increase in security deposit payable
   
735,125
     
706,711
     
2,794,868
 
                         
Net cash provided by financing activities
   
110,114
     
9,758,878
     
15,534,378
 
                         
Effect of exchange rate changes on cash
   
382,879
     
(193,915
)
   
(1,394,626
)

See accompanying notes to the consolidated financial statements.
24

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 
   
For Year Ended May 31,
 
   
2018
   
2017
   
2016
 
                   
Net increase (decrease) in cash
   
7,215,044
     
4,431,857
     
(20,581,434
)
Cash, beginning of year
   
10,343,963
     
5,912,106
     
26,493,540
 
                         
Cash, end of year
 
$
17,559,007
   
$
10,343,963
   
$
5,912,106
 
 
Supplemental disclosure of cash flow information
             
     Income taxes paid
 
$
1,921,500
   
$
1,948,452
   
$
1,845,154
 
                         
     Land appreciation tax paid
 
$
6,126
   
$
5,889
   
$
8,928
 
Supplemental disclosure of non-cash activities
                 
     Property, equipment, equipment and construction in progress accrued
 
$
9,328,192
   
$
427,852
   
$
681,364
 
                         
     Payment of accrued liabilities by shareholder
 
$
62,365
   
$
222,348
   
$
100,488
 
 

See accompanying notes to the consolidated financial statements.
25

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)

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

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 (RMB100,000) each month. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.
26

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 

NOTE 1.   ORGANIZATION (CONTINUED)

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, to oversee 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 January 19, 2016, the VIE structure was terminated upon Baichuang Consulting exercising its option to purchase all of the registered equity of Jiangsu Xuefeng.  Baichuang Consulting became the sole owner of Jiangsu Xuefeng.

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 was determined by the audited net assets of Linyi Xuefeng as of May 31, 2016, initially with a payment of 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 on August 4, 2016. 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 eliminated the cash payment making the entire purchase with stock of the Company. The price utilized was $3 per share and 7,820,871 shares were issued to Mr. Li Yuan.

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 majority shareholder of the Company, Mr. Li Yuan, is also the shareholder of Jiangsu Liding (see note 6). In 2016, the total purchase amount $7,714,280 from Jiangsu Liding, which was fully delivered in December 2015, was included in the fixed assets of the accompanying consolidated balance sheet as of  May 31, 2018, 2017 and 2016. In 2017, the total purchase amount $8,599,726 from Jiangsu Liding, and paid in advanced with $6,879,781 was included in prepaid expenses of the accompanying consolidated balance sheet as of  May 31, 2017. The total purchase in 2017 was fully delivered in July, 2017 and included in the fixed assets of the accompanying consolidated balance sheet as of May 31, 2018.
27

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 
NOTE 1.   ORGANIZATION (CONTINUED)

Linyi Xuefeng was officially approved and incorporated under the laws of the People's Republic of China ("PRC") in June 2013. Mr. Yuan Li was the sole owner since inception. Linyi Xuefeng constructed a garbage processing plant which commenced operations in February 2018. Previously Linyi Xufeng received non-operating revenue, which was a subsidy received from the government for the city pollution garbage processing plant construction.

On October 30, 2017, the Company completed a closing of private placement offering (the "Offering") of shares of the Company's common stock, par value $0.001 per share (the "Shares"), at a purchase price of RMB 13.275, or US$2.00 per share, based on the currency exchange rate of 6.6375 on October 27, 2017, for an aggregate purchase price of RMB 46,462,500, or approximately $7,000,000. Upon the closing, the Company issued a total of 3,500,000 shares of its common stock to the subscribers in the Offering.

As a result of the entry into the foregoing agreements, the Company has a corporate structure which is set forth as follows:


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF ACCOUNTING AND PRESENTATION

The accompanying consolidated financial statements have been prepared on the accrual basis of accounting.  The consolidated financial statements for each of the three years ended May 31, 2018 include China Xuefeng Environmental Engineering Inc., and its wholly owned subsidiaries, Inclusion, Lotus, Baichuang Consulting, Jiangsu Xuefeng and Linyi Xuefeng.  All significant intercompany accounts and transactions have been eliminated in consolidation when applicable.
28

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)



NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (CONTINUED)

BASIS OF ACCOUNTING AND PRESENTATION  (CONTINUED)

The acquisition of Linyi Xuefeng was treated as a combination of entities under common control as Mr. Li Yuan was the chief executive officer, a major shareholder and had voting control 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 have been restated and 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$" or "$").

VARIABLE INTEREST ENTITY

Until January 19, 2016, the consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries and its VIE for which it is deemed the primary beneficiary.  On January 19, 2016, the VIE structure was terminated upon Baichuang Consulting exercising its option to purchase all of the registered equity of Jiangsu Xuefeng.  Baichuang Consulting became the sole owner of Jiangsu Xuefeng.  All significant inter-company accounts and transactions have been eliminated in consolidation.

ACQUISITION OF LINYI XUEFENG

The following financial statement amounts and balances of Linyi Xuefeng have been included in the accompanying consolidated financial statements.

   
May 31,
   
May 31,
 
   
2018
   
2017
 
             
TOTAL ASSETS
 
$
43,579,311
   
$
40,133,685
 
                 
TOTAL LIABILITIES
 
$
19,077,496
   
$
16,877,408
 

   
For the year ended May 31,
 
   
2018
   
2017
   
2016
 
                   
TOTAL REVENUE
 
$
1,720,772
   
$
-
   
$
-
 
                         
TOTAL OPERATING EXPENSES
 
$
1,896,172
   
$
392,935
   
$
498,755
 
                         
TOTAL OTHER INCOME
 
$
924,290
   
$
884,930
   
$
933,682
 
                         
NET INCOME
 
$
(214,296
)
 
$
589,844
   
$
560,656
 


29

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)

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:

   
May 31,
2018
   
May 31,
2017
   
May 31,
2016
 
                   
Balance sheet items, except for stockholders' equity, as of periods end
   
0.1560
     
0.1468
     
0.1519
 
Amounts included in the statements of income, statements of changes in stockholders' equity and statements of cash flows for nine months
   
0.1532
     
0.1472
     
0.1563
 

For the year ended May 31, 2018, 2017 and 2016, foreign currency translation adjustments of $3,853,411 and $(1,723,591) and $(2,492,980), respectively, have been reported as other comprehensive income (loss).  Other comprehensive income (loss) 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.

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.

30

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

FOREIGN CURRENCY TRANSLATION (CONTINUED)

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 the operation of a garbage processing plant, 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.

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, an 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.
31

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)

 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Linyi Xuefeng's revenues are primarily derived from selling organic manure, hollow brick, wood plastic tray and ferrous metal. It's income also relates to government for city pollution garbage processing system constructions.  Government subsidies 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 no revenue for the years ended May 31, 2018 and 2017, and 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
 
     
2019
 
$
1,555,168
 
         
   
$
1,555,168
 

Operating Leases

The Company entered into seven operating lease arrangements with six customers for garbage processing equipment on October 20, 2017, March 31, 2017, December 28, 2016, April 25, 2016, December 28, 2015 and November 6, 2015, respectively. The arrangements with the customers have a fixed term of five years with quarterly payments of $153,151 (RMB1,000,000), $183,781 (RMB1,200,000), $183,781 (RMB1,200,000), $183,781 (RMB1,200,000), $367,562 (RMB2,400,000), and $153,151 (RMB1,000,000) respectively. Revenue from the leasing of the equipment is recognized monthly. In addition, the lease required a security deposit of $623,960 (RMB4,000,000), $748,752 (RMB4,800,000), $748,752 (RMB4,800,000), $748,752 (RMB4,800,000), $1,497,504 (RMB9,600,000) and $623,960 (RMB4,000,000), respectively. At the end of each of the five year lease terms, 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
 
       
2019
 
$
4,900,832
 
2020
   
4,900,832
 
2021
   
3,869,615
 
2022
   
1,654,031
 
2023
   
255,252
 
         
   
$
15,580,562
 
32

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)

 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

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.

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 that an arrangement exists since the 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.
33

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 
 
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Multiple-Element Arrangements (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 services and patent leasing services 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 has 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.

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.
34

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

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 May 31, 2018, 2017 and 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

FIXED ASSETS AND LEASE EQUIPMENT

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


35

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

FIXED ASSETS AND LEASE EQUIPMENT (CONTINUED)

Lease equipment
15 years
Machinery
10 years
Building and improvements
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 the 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.

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. 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 May 31, 2018, 2017 and 2016, the Company does not have a liability for any unrecognized tax benefits.
36

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

INCOME TAXES (CONTINUED)

The income tax laws of various jurisdictions in which the Company and its subsidiaries 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 year ended May 31, 2018, 2017 and 2016,.

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%.

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 year ended May 31, 2018, 2017 and 2016, advertising expense was $551,344, $485,864 and $897,944 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 year ended May 31, 2018, 2017 and 2016, a statutory reserve of $157,978, $594,164 and $622,038, respectively, was required to be allocated to the Company.
37

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)


 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

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 November 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-18, "Statement of Cash Flows: Restricted Cash". The amendments address diversity in practice that exists in the classification and presentation of changes in restricted cash on the statement of cash flows. The amendment is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not anticipate that this adoption will have a significant impact on its financial position, results of operations, or cash flows.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This ASU addresses the classification of certain specific cash flow issues including debt prepayment or extinguishment costs, settlement of certain debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of certain insurance claims and distributions received from equity method investees. This ASU is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted. An entity that elects early adoption must adopt all of the amendments in the same period. The Company is currently evaluating the effect this ASU will have on its consolidated statement of cash flows.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The new standard requires financial assets measured at amortized cost be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The standard will be effective for the Company beginning January 1, 2020, with early application permitted. The Company is evaluating the impact of adopting this new accounting guidance on its consolidated financial statements.

In May, 2016, the FASB issued ASU No. 2016-10, Revenue with Contracts with Customers: Narrow-scope Improvements and Practical Expedients, which is an amendment to ASU No. 2014-09 that clarifies the objective of the collectability criterion, to allow entities to exclude amounts collected from customers from all sales taxes from the transaction price, to specify the measurement date for noncash consideration is contract inception, variable consideration guidance applies only tovariability resulting from reasons other than the form of the consideration, and clarification on contract modifications at transition. The implementation guidelines follow ASU No. 2014-09.
38

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)



NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS (CONTINUED)

In April 2016, the FASB issued ASU 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 standardon its consolidated financial statements.

NOTE 4.   FIXED ASSETS

Fixed assets are summarized as follows:
 
   
May 31,
2018
   
May 31,
2017
 
             
Computers and equipment
 
$
90,789
   
$
79,601
 
Vehicles
   
90,356
     
85,007
 
Production facilities
   
18,332,771
     
8,308,691
 
Furniture and fixtures
   
120,242
     
112,548
 
Building and improvement
   
16,456,945
     
15,482,441
 
                 
     
35,091,103
     
24,068,288
 
Less: accumulated depreciation
   
(1,361,378
)
   
(207,976
)
                 
   
$
33,729,725
   
$
23,860,312
 
For the year ended May 31, 2018, 2017 and 2016, depreciation expense was $1,119,557, $100,719 and $64,508 respectively.

Building and improvements and production facilities include approximately $34 million relating to construction of the garbage recycling processing plant and production facilities purchase (see note 1).

NOTE 5.   LEASE EQUIPMENT

   
May 31,
2018
   
May 31,
2017
 
             
Leasing equipment
 
$
30,950,637
   
$
25,492,775
 
Less: accumulated depreciation
   
(3,782,918
)
   
(1,718,416
)
                 
   
$
27,167,719
   
$
23,774,359
 


39

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 

NOTE 5.   LEASE EQUIPMENT (CONTINUED)

For the year ended May 31, 2018, 2017 and 2016, depreciation expense was $1,920,735, $1,314,787 and $434,474 respectively.

Before leasing the equipment to their client, the Company will upgrade the equipment to meet the client's requirement. The Company records the equipment as equipment construction in process before it finishes the upgrading process. As of May 31, 2018, no equipment construction in process was included in lease equipment.

NOTE 6.   INCOME TAXES

The Company is required to file income tax returns in both the United States and the PRC.  Its operations in the United States have been insignificant and income taxes have not been accrued.  In the PRC, the Company files tax returns for Jiangsu Xuefeng.

The provision for (benefit from) income taxes consists of the following for the years ended May 31, 2018, 2017 and 2016:

   
For the Year Ended May 31,
 
   
2018
   
2017
   
2016
 
                   
Current
 
$
1,778,766
   
$
2,047,852
   
$
1,787,185
 
Deferred
   
(588,072
)
   
(226,997
)
   
159,995
 
                         
Total
 
$
1,190,694
   
$
1,820,855
   
$
1,912,914
 

As of May 31, 2018, the Company had unused operating loss carry-forwards of approximately $2,064,946  expiring in various years through 2023.  

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 years ended May 31:

   
2018
   
2017
   
2016
 
                   
Statutory rate
   
25
%
   
25
%
   
25
%
Government subsidy
   
4
%
   
3
%
   
3
%
                         
Effective income tax rate
   
21
%
   
22
%
   
22
%

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, 2017 was examined by the PRC tax authorities in May 2018. PRC tax filings for the tax year ended December 31, 2016 were examined by PRC tax authorities in May 2017. The tax filings were accepted and no adjustments were proposed by the PRC tax authorities.
40

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 


NOTE 6.   INCOME TAXES (CONTINUED)

During the year ended May 31, 2018, the Company filed 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, 2017, May 31, 2016, and May 31, 2015, which is a short year income tax return required to be filed as a result of the change in fiscal year. and the information reports for the years ended December 31, 2017, 2016 and 2015 concerning its interest in foreign bank accounts on form TDF 90-22.1, "Report of Foreign Bank and Financial Accounts" ("FBAR"). Currently, the 2015, 2016 and 2017 tax years are open and subject to examination by the taxing authorities.  Management is of the opinion that penalties, if any, that may be assessed would not be material to the consolidated financial statements.

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, 2018. 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, 2017, 2016 and 2015 remain open to examination by the IRS.

NOTE 7.   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 $12,123 (RMB80,000) each month for five years from September 2012 to August 2017.  The Company has renewed the agreement to pay the same fee each month for five years from September 2017 to August 2022. The related prepaid patent leasing fees of $87,354, $82,182 and $85,061 are included in prepaid expenses on the consolidated balance sheets as of May 31, 2018, 2017 and 2016, respectively.

The remaining payments for the patent rights are as follows:

Year Ending
     
May 31,
 
Amount
 
       
2019
 
$
62,396
 
2020
   
149,750
 
2021
   
149,750
 
2022
   
149,750
 
2023
   
37,438
 
         
Total
 
$
549,084
 

The Company obtained a demand loan from Li Yuan, a stockholder which is non-interest bearing.  The total loan of approximately $738,085 represents $659,085 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 May 31, 2018, 2017 and 2016.
41

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 

NOTE 7.   RELATED PARTY TRANSACTIONS (CONTINUED)

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 RMB200,000,000 ($29,350,600). 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 another loan to the Linyi Xuefeng of RMB140,000,000 (approximately $20,545,00) and treated as a capital contribution to the Linyi Xuefeng.  The loans outstanding were $10,154,453, $16,890,803 and $8,300,910 as of May 31, 2018, 2017 and 2016, respectively.

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. Total purchase amount $7,714,280 from Jiangsu Liding was fully delivered in December 2015, and included in the fixed assets of the accompanying consolidated balance sheet as of May 31, 2017 and 2016. In 2017, and the total purchase amount $8,599,726 from Jiangsu Liding, and advanced payment of $6,879,781 was included in prepaid expenses of the accompanying consolidated balance sheet as of  May 31, 2017. In 2018, and the total purchase in 2017 was fully delivered in July, 2017 and included in the fixed assets of the accompanying consolidated balance sheet as of May 31, 2018.

NOTE 8.   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 $5,870,120 (RMB40,000,000). In addition, the Company was required to subject a deed tax of $176,104 (RMB1,200,000 ). The purchase of the land was approved by local government on September 9, 2013. The Company fully paid the deed tax of $176,104 when the purchase agreement was signed. The Company paid $3,668,825 (RMB25,000,000) on September 25, 2013 and $2,201,295 (RMB15,000,000) 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 year ended May 31, 2018, 2017 and 2016 was $126,196, $121,319 and $128,802 respectively.

NOTE 9.   SECURITY DEPOSIT PAYABLE

The company leased out highly efficient waste disposal equipment to customers and received a one year leasing fee as a deposit. The security deposit payable was $4,991,680, $3,404,670 and $2,794,868,  as of May 31, 2018, 2017 and 2016, respectively.

NOTE 10.   LEASES

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 $3,637  (RMB24,000). The lease provides for renewal options.
42

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)



NOTE 10.   LEASES (CONTINUED)

The Company leases another office space for Linyi Xuefeng 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 year ended May 31, 2018, 2017 and 2016 was $15,070, $14,134 and $14,571 respectively.

Future minimum payments for the years ending May 31 are as follows:

Year Ending
   
May 31,
Amount
 
     
2019
 
$
14,212
 
         
   
$
14,212
 

NOTE 11.   CONTINGENCIES

As disclosed in Note 6, the 2015, 2016 and 2017 tax years are open and subject to examination by the taxing authorities. On July 17, 2017, the Company received a notice from the IRS with the amount due totaled of $30,208 in relates to the late filing of the Company's tax returns.  The Company is currently in the progress of communicating with the IRS to appeal to the amount.  As of the date of the report, the result is pending and the management is unable to assess the outcome of the communication.

NOTE 12.   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.

NOTE 13.   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.
43


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)


NOTE 13.   CONCENTRATION OF CREDIT AND BUSINESS RISK (CONTINUED)

Major customers

For the year ended May 31, 2018, 2017 and 2016, one customer of the Company accounted for 13% of revenue, one customer of the Company accounted for 14% of revenue, two customers accounted for 66% of revenue, respectively.  Four customers accounted for 99% as of May 31, 2018 and three customers accounted for 100% accounts receivable  as of May 31, 2017 and 2016.

NOTE 14.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY

The condensed financial information of the Company's US parent only balance sheets as of May 31, 2018, and the US parent company only statements of income, and cash flows for the year ended May 31, 2018 are as follows:

Condensed Balance Sheets

ASSETS
 
May 31,
2018
   
May 31,
2017
 
             
Investment in subsidiaries and VIE
 
$
64,698,260
   
$
56,110,357
 
Receivable from subsidiary
   
7,000,000
     
-
 
                 
TOTAL ASSETS
 
$
71,698,260
   
$
56,110,357
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
           
             
Current liabilities:
           
             
   Loan from stockholder
 
$
690,369
   
$
564,401
 
Accrued liabilities
   
50,000
     
38,968
 
                 
Total current liabilities
   
740,369
     
603,369
 
                 
Stockholders' equity:
               
 
 Common stock, $0.001 par value; 75,000,000 shares authorized; 63,020,871 shares issued and outstanding
   
66,521
     
63,021
 
 Additional paid-in capital
   
41,581,497
     
34,584,997
 
 Statutory reserve fund
   
2,595,662
     
2,437,684
 
 Retained earnings
   
26,462,203
     
22,022,689
 
 Other comprehensive income
   
252,008
     
(3,601,403
)
                 
Total stockholders' equity
   
70,957,891
     
55,506,988
 
                 
TOTAL LIABILITIES AND STOCKHOLDERS'  EQUITY
 
$
71,698,260
   
$
56,110,357
 
 
44

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 
 
NOTE 14.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY
(CONTINUED)

Condensed Statements of Income
 
  For the Year Ended May 31,  
  2018   2017   2016  
             
Revenues:
           
 Share of earnings from investment in subsidiaries and
 
$
8,587,902
   
$
4,659,228
   
$
4,060,606
 
                         
Operating expenses:
                       
 General and administrative
   
137,000
     
148,316
     
123,000
 
                         
Net income
 
$
8,450,902
   
$
4,510,912
   
$
3,937,606
 
 
Condensed Statements of Cash Flows
 
   
For The Year Ended May 31,
 
   
2018
   
2017
   
2016
 
                   
Cash flows from operating activities:
                 
 Net income
 
$
8,450,902
   
$
4,510,912
   
$
3,937,606
 
 Adjustments to reconcile net income to net cash  provided by (used in) operating activities
                       
    (Increase) in receivable from subsidiary
   
(7,000,000
)
               
 Share of earnings from investment in subsidiaries
   
(8,587,902
)
   
(4,659,228
)
   
(4,060,606
)
     Increase in accrued liabilities
   
137,000
     
148,316
     
123,000
 
                         
    Net cash from operating activities
   
(7,000,000
)
   
-
     
-
 
                         
Cash flows from financing activities:
                       
    Cash received from stock issuance
   
7,000,000
     
-
     
-
 
                         
Net increase in cash
   
-
     
-
     
-
 
Cash, beginning of year
   
-
     
-
     
-
 
                         
Cash, end of year
 
$
-
   
$
-
   
$
-
 
                         
Noncash financing activities:
                       
    Payment of accrued liabilities by shareholder
 
$
125,968
   
$
152,348
   
$
100,438
 
 

45

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MAY 31, 2018, 2017 AND 2016
 (IN U.S. $)
 

NOTE 14.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY
(CONTINUED)

Basis of Presentation

The Company records its investment in its subsidiaries under the equity method of accounting.   Such investments are presented as "Investment in subsidiaries" on the condensed balance sheet and the subsidiaries' profits are presented as "Share of earnings from investment in subsidiaries" in the condensed statement of operations.

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.

There were no cash transactions in the US parent company during the three months ended May 31, 2018.

Restricted Net Assets

Under PRC laws and regulations, the Company's PRC subsidiaries are restricted in their ability to transfer certain of their net assets to the Company in the form of dividend payments, loans or advances.  The restricted net assets of the Company's PRC subsidiaries amounted to approximately $57,459,659 as of  May 31, 2018.

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.
46

 
Item 9.   Changes in and Disagreements With Accountants On Accounting and Financial Disclosure.

Not applicable.

Item 9A.   Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures

Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 ("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"), 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, the Company's CEO and CFO concluded that the Company's disclosure controls and procedures were not effective as of May 31, 2018 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.

(b) Management's Annual Report on Internal Control over Financial Reporting

Management, including our CEO and CFO, is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a – 15(f).  Management conducted an assessment as of May 31, 2017 of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO").  Based on that evaluation, the CEO and CFO concluded that internal control over financial reporting was not effective as of May 31, 2017. In addition, the Company had a material weakness with respect to its internal controls over financial reporting because it did not have a sufficient number of personnel to provide for adequate segregation of duties and independent review and approval of specific transactions. The Company also lacked a sufficient number of personnel with an appropriate level of knowledge and experience of generally accepted accounting principles in the United States of America (U.S. GAAP).

Our management has identified the following steps to address the above material weakness:

(1) We have been working with a financial accountant to assist us in preparing our financial statements in accordance with US GAAP standards and SEC rules and regulations.

(2) We intend to hire, as needed, key accounting personnel with technical accounting expertise and reorganize the finance department to ensure that accounting personnel with adequate experience, skills and knowledge relating to complex, non-routine transactions are directly involved in the review and accounting evaluation of our complex, non-routine transactions.

Neither this 10-K nor its subsequent amendments include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management's report in this 10-K and its subsequent amendments.

(c) Changes in Internal Controls

There have been no changes in the Company's internal control over financial reporting during the latest fiscal quarter or year that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 

Item 9B.    Other Information

None.
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PART III

Item 10.     Directors, Executive Officers and Corporate Governance

Our directors, executive officers and key employees are listed below.

Name
 
Age
 
Position
 
Officer and/or Director Since
             
Li Yuan
 
44
 
Chairman of the Board, Chief Executive Officer and Chief Financial Officer
 
Chairman and CEO since November 2012; CFO since October 13, 2017
             
Yi Yuan
 
54
 
Director
 
November 2012
             
Xiaojun Zhuang
 
46
 
Director
 
November 2012
 
Mr. Li Yuan has served as our Chairman of the board of directors and Chief Executive Officer since November 2012, founded Jiangsu Xuefeng in December 2007 and served as Chairman and Chief Executive Officer of Jiangsu Xuefeng since then.  From February 1997 to October 2003, Mr. Yuan served as the Department Manager of First Hostel in Suqian City. From October 2003 to 2007, Mr. Yuan devoted himself to the research & development and experiments of environmental protection equipment.  Mr. Yuan acquired his bachelor's degree in international Relations Major from International Relations Faculty of Chinese People's Liberation Army. Mr. Yuan was selected as a director because of his extensive management experience, his background in the industry and his knowledge of the business of the Company.

Mr. Yi Yuan has served as our director from November 2012. From December 2007 until present, he founded Jiangsu Xuefeng and served as the chief engineer. From February 2001 to 2007, Mr. Yuan devoted himself to the R&D and experiments of environmental protection equipment. From August 1991 to February 2001, he served as a department manager at Suqian Urban Comprehensive Development Co, Ltd. From September 1990 to July 1991, he worked as a mechanical engineer at Suqian Garment Factory. From 1987 to August 1990, he acted as a machine maintenance class monitor at Suqian Furniture Factory. Mr. Yuan graduated with a senior high school degree and acquired abundant professional skills from years of working experience. Mr. Yuan was selected as a director because of his extensive management experience, his background in the industry and his knowledge of the business of the Company.

Mr. Xiaojun Zhuang has served as our director from November 2012 and is currently serving as a director of Jiangsu Xuefeng. From 2002 to 2010, Mr. Zhuang founded Ocean S&T Development Co, Ltd, a company focusing on the R&D, manufacture and sale of environmentally friendly coating and building materials, and served as the corporate juridical person. From November 1997 to March 2002, he worked at the government of Sucheng District in Suqian City. From August 1993 to October 1997, he worked at the government of Jingtou town in Suyu District. Mr. Zhuang graduated with a bachelor's degree in business administration. Mr. Zhuang was selected as a director because of his extensive management experience, his background in the industry and his knowledge of the business of the Company.

Family Relationships

Li Yuan and Yi Yuan are brothers.  There are no other family relationships among any of our officers or directors.

Board Committees

Our organizational documents authorize a board of not less than one member. Our board of directors does not have a lead independent director. Our board of directors has determined that its leadership structure was appropriate and effective for the Company given its stage of operations. We will re-evaluate our leadership structure once we have added additional members to our board of directors.

We presently do not have an audit committee, compensation committee or nominating committee or committee performing similar functions, as our management believes that until this point it has been premature at the early stage of our management and business development to form an audit, compensation or nominating committee. Until these committees are established, these decisions will continue to be made by our board of directors. Although our board of directors has not established any minimum qualifications for director candidates, when considering potential director candidates, our board of directors considers the candidate's character, judgment, skills and experience in the context of the needs of our Company and our board of directors.
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Director Independence

We currently do not have any independent directors, as the term "independent" is defined by the rules of the Nasdaq Marketplace Rules.

Involvement in Certain Legal Proceedings

To the best of our knowledge, none of our directors or executive officers has, during the past ten years:

been convicted in a criminal proceeding or been subject to a pending criminal proceeding (excluding traffic violations and other minor offenses);
   
had any bankruptcy petition filed by or against the business or property of the person, or of any partnership, corporation or business association of which he was a general partner or executive officer, either at the time of the bankruptcy filing or within two years prior to that time;
   
been subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction or federal or state authority, permanently or temporarily enjoining, barring, suspending or otherwise limiting, his involvement in any type of business, securities, futures, commodities, investment, banking, savings and loan, or insurance activities, or to be associated with persons engaged in any such activity;
   
been found by a court of competent jurisdiction in a civil action or by the Securities and Exchange Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated;
   
been the subject of, or a party to, any federal or state judicial or administrative order, judgment, decree, or finding, not subsequently reversed, suspended or vacated (not including any settlement of a civil proceeding among private litigants), relating to an alleged violation of any federal or state securities or commodities law or regulation, any law or regulation respecting financial institutions or insurance companies including, but not limited to, a temporary or permanent injunction, order of disgorgement or restitution, civil money penalty or temporary or permanent cease-and-desist order, or removal or prohibition order, or any law or regulation prohibiting mail or wire fraud or fraud in connection with any business entity; or
   
been the subject of, or a party to, any sanction or order, not subsequently reversed, suspended or vacated, of any self-regulatory organization (as defined in Section 3(a)(26) of the Exchange Act), any registered entity (as defined in Section 1(a)(29) of the Commodity Exchange Act), or any equivalent exchange, association, entity or organization that has disciplinary authority over its members or persons associated with a member.

Except as set forth in our discussion below in "Certain Relationships and Related Transactions," none of our directors or executive officers has been involved in any transactions with us or any of our directors, executive officers, affiliates or associates which are required to be disclosed pursuant to the rules and regulations of the Commission.

Term of Office

All directors hold office until the next annual meeting of the board or until their successors have been duly elected and qualified or until removed from office in accordance with our bylaws. Officers are appointed by the board of directors and their terms of office are, except to the extent governed by employment contract, at the discretion of the board of directors.

Section 16(a) Beneficial Ownership Reporting Compliance

The Company does not have a class of securities registered under the Exchange Act and therefore its directors, executive officers, and any persons holding more than ten percent of the Company's common stock are not required to comply with Section 16 of the Exchange Act.

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Code of Ethics

We have not adopted a Code of Ethics that is applicable to our Chief Executive Officer and chief financial and principal accounting officer. We are in the process of formulating a code of ethics and intend to adopt one in the future.

Item 11.   Executive Compensation

Summary Compensation Table
        
The following table sets forth in U.S. dollars information concerning all cash and non-cash compensation awarded to, earned by or paid to the named persons for services rendered to the Company in all capacities during the noted periods. All the officers were paid by Jiangsu Xuefeng in RMB an