Unassociated Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)
x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
Or

o
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to _________
 
Commission file number: 000-33123

China Automotive Systems, Inc.
(Exact name of registrant as specified in its charter)

Delaware
33-0885775
(State or other jurisdiction of incorporation or
(I.R.S. employer identification number)
organization)
 

No. 1 Henglong Road, Yu Qiao Development Zone, Shashi District,
Jing Zhou City, Hubei Province, People’s Republic of China
(Address of principal executive offices)

 
(86) 716- 832- 9196
 
 
Issuer’s telephone number
 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the 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 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 x
Non-accelerated filer (Do not check if a smaller reporting company) ¨
Smaller reporting company ¨

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

As of November 8, 2011, the Company had 28,083,534 shares of common stock issued and outstanding.

 
 

 

CHINA AUTOMOTIVE SYSTEMS, INC.

INDEX

   
Page
     
 
Part I — Financial Information
 
     
Item 1.
Financial Statements.
4
Condensed Unaudited Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 2011 and 2010
4
Condensed Unaudited Consolidated Statements of Comprehensive Income for the Three Months and Nine Months Ended September 30, 2011 and 2010
6
Condensed Unaudited Consolidated Balance Sheets at September 30, 2011 and December 31, 2010
7
Condensed Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2011 and 2010
8
Notes to Condensed Unaudited Consolidated Financial Statements for the Three Months and Nine Months Ended September 30, 2011 and 2010
10
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
30
Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
44
Item 4.
Controls and Procedures.
45
     
 
Part II — Other Information
 
     
Item 1.
Legal Proceedings.
46
Item 1A.
Risk Factors.
46
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.
46
Item 3.
Defaults Upon Senior Securities.
46
Item 4.
(Removed and Reserved.)
46
Item 5.
Other Information.
46
 
 
 
Item 6.
Exhibits.
47
Signatures
48

 
2

 

Cautionary Statement

This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or the Company’s future financial performance. The Company has attempted to identify forward-looking statements by terminology including “anticipates,” “believes,” “expects,” “can,” “continues,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “should” or “will” or the negative of these terms or other comparable terminology. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report or other reports or documents the Company files with the Securities and Exchange Commission from time to time, which could cause actual results or outcomes to differ materially from those projected. 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. Undue reliance should not be placed on these forward-looking statements which speak only as of the date hereof. The Company undertakes no obligation to update these forward-looking statements. The Company’s expectations are as of the date this Form 10-Q is filed, and the Company does not intend to update any of the forward-looking statements after the date this quarterly report on Form 10-Q is filed to confirm these statements to actual results, unless required by law. All of the forward-looking statements are qualified in their entirety by reference to the factors discussed under Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission.

 
3

 

PART 1 — FINANCIAL INFORMATION

Item 1.
FINANCIAL STATEMENTS.

China Automotive Systems, Inc.
Condensed Unaudited Consolidated Statements of Income

    
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
Net product sales, including $7,817,723 and $1,717,483 to related parties for the three months ended September 30, 2011 and 2010
 
$
75,002,717
 
 
$
76,102,844
 
Cost of product sold, including $2,842,267 and $4,885,768 purchased from related parties for the three months ended September 30, 2011 and 2010
 
 
61,215,974
 
 
 
57,929,284
 
Gross profit
 
 
13,786,743
 
 
 
18,173,560
 
Add: Gain (loss) on other sales
 
 
465,950
 
 
 
(152,481
)
Less: Operating expenses
 
 
   
 
 
   
Selling expenses
 
 
2,170,775
 
 
 
2,095,321
 
General and administrative expenses
 
 
3,413,930
 
 
 
2,506,504
 
Research and development expenses
 
 
2,708,777
 
 
 
1,247,881
 
Total operating expenses
 
 
8,293,482
 
 
 
5,849,706
 
Income from operations
 
 
5,959,211
 
 
 
12,171,373
 
Add: Other income, net
 
 
48,891
 
 
 
-
 
Financial expenses, net
 
 
(1,279,008
)
 
 
(707,527
)
Gain on change in fair value of derivative
 
 
7,788,137
 
 
 
8,687,977
 
Income before income tax expenses and equity in earnings of affiliated companies
 
 
12,517,231
 
 
 
20,151,823
 
Less: Income taxes
 
 
1,068,548
 
 
 
1,866,157
 
Add: Equity in earnings of affiliated companies
 
 
42,817
 
 
 
-
 
Net income
 
 
11,491,500
 
 
 
18,285,666
 
Net income attributable to noncontrolling interest
 
 
(1,382,653
)
 
 
(2,350,280
)
Net income attributable to parent company
 
 
10,108,847
 
 
 
15,935,386
 
Allocation to convertible notes holders
 
 
(1,071,091
)
 
 
(2,153,261
)
Net income attributable to parent company’s common shareholders
 
$
9,037,756
 
 
$
13,782,125
 
Net income attributable to parent company’s common shareholders per share
 
 
   
 
 
   
Basic
 
$
0.32
 
 
$
0.51
 
Diluted
 
$
0.10
 
 
$
0.26
 
Weighted average number of common shares outstanding
 
 
   
 
 
   
Basic
 
 
28,083,534
 
 
 
27,112,689
 
Diluted
 
 
31,503,995
 
 
 
31,562,661
 

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

 

China Automotive Systems, Inc.
Condensed Unaudited Consolidated Statements of Income

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Net product sales, including $30,474,574 and $6,319,594 to related parties for the nine months ended September 30, 2011 and 2010
 
$
248,522,773
 
 
$
245,416,671
 
Cost of product sold, including $12,972,362 and $14,481,952 purchased from related parties for the nine months ended September 30, 2011 and 2010
 
 
199,950,452
 
 
 
184,897,834
 
Gross profit
 
 
48,572,321
 
 
 
60,518,837
 
Add: Gain on other sales
 
 
1,359,871
 
 
 
981,128
 
Less: Operating expenses
 
 
   
 
 
   
Selling expenses
 
 
7,123,063
 
 
 
6,866,249
 
General and administrative expenses
 
 
10,868,767
 
 
 
8,567,854
 
Research and development expenses
 
 
6,609,136
 
 
 
4,291,044
 
Total operating expenses
 
 
24,600,966
 
 
 
19,725,147
 
Income from operations
 
 
25,331,226
 
 
 
41,774,818
 
Add: Other income, net
 
 
154,465
 
 
 
266,379
 
Financial expenses, net
 
 
(2,902,150
)
 
 
(2,056,431
)
Gain on change in fair value of derivative
 
 
19,373,520
 
 
 
14,122,730
 
Gain on convertible notes conversion
 
 
1,564,418
 
 
 
-
 
Income before income tax expenses and equity in earnings of affiliated companies
 
 
43,521,479
 
 
 
54,107,496
 
Less: Income taxes
 
 
4,314,912
 
 
 
6,442,971
 
Add: Equity in earnings of affiliated companies
 
 
129,363
 
 
 
-
 
Net income
 
 
39,335,930
 
 
 
47,664,525
 
Net income attributable to noncontrolling interest
 
 
(5,241,143
)
 
 
(8,227,985
)
Net income attributable to parent company
 
 
34,094,787
 
 
 
39,436,540
 
Allocation to convertible notes holders
 
 
(3,831,484
)
 
 
(5,334,715
)
Net income attributable to parent company’s common shareholders
 
$
30,263,303
 
 
$
34,101,825
 
Net income attributable to parent company’s common shareholders per share
 
 
   
 
 
   
Basic
 
$
1.09
 
 
$
1.26
 
Diluted
 
$
0.50
 
 
$
0.87
 
Weighted average number of common shares outstanding
 
 
   
 
 
   
Basic
 
 
27,881,821
 
 
 
27,078,180
 
Diluted
 
 
31,531,253
 
 
 
31,560,119
 

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

 
5

 

China Automotive Systems, Inc.
Condensed Unaudited Consolidated Statements of Comprehensive Income

    
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
Net income
 
$
11,491,500
 
 
$
18,285,666
 
Other comprehensive income:
 
 
 
 
 
 
 
 
Foreign currency translation gain, net of tax
 
 
4,212,418
 
 
 
2,179,442
 
Comprehensive income
 
 
15,703,918
 
 
 
20,465,108
 
Comprehensive income attributable to noncontrolling interest
 
 
(2,112,396
)
 
 
(2,750,677
)
Comprehensive income attributable to parent company
 
$
13,591,522
 
 
$
17,714,431
 

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

China Automotive Systems, Inc.
Condensed Unaudited Consolidated Statements of Comprehensive Income

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Net income
 
$
39,335,930
 
 
$
47,664,525
 
Other comprehensive income:
 
 
 
 
 
 
 
 
Foreign currency translation gain, net of tax
 
 
9,228,737
 
 
 
3,105,593
 
Comprehensive income
 
 
48,564,667
 
 
 
50,770,118
 
Comprehensive income attributable to noncontrolling interest
 
 
(6,842,591
)
 
 
(8,779,852
)
Comprehensive income attributable to parent company
 
$
41,722,076
 
 
$
41,990,266
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
6

 

China Automotive Systems, Inc.
Condensed Unaudited Consolidated Balance Sheets

    
September 30,
2011
   
December 31, 2010
 
 
 
 
   
 
 
ASSETS
 
 
   
 
 
Current assets
 
 
   
 
 
Cash and cash equivalents
  $ 76,067,212     $ 49,424,979  
Pledged cash deposits
    20,368,026       20,983,891  
Accounts and notes receivable, net, including $9,716,604 and $5,466,842 from related parties at September 30, 2011 and December 31, 2010
    197,860,106       195,858,988  
Advance payments and other, including $1,061,303 and $1,334,069 to related parties at September 30, 2011 and December 31, 2010
    3,916,286       4,226,137  
Inventories
    51,304,394       36,870,272  
Current deferred tax assets
    3,525,332       3,511,421  
Total current assets
    353,041,356       310,875,688  
Long-term assets:
               
Other receivables, net, including $432,287 and $350,464 from related parties at September 30, 2011 and December 31, 2010
    2,249,222       2,801,434  
Long-term investments
    3,426,863       3,162,136  
Property, plant and equipment, net
    81,641,156       75,380,747  
Intangible assets, net
    683,972       662,089  
Advance payments for property, plant and equipment, including $5,507,634 and $7,534,440 to related parties at September 30, 2011 and December 31, 2010
    7,303,422       9,373,977  
Non-current deferred tax assets
    3,915,647       3,271,594  
Total assets
  $ 452,261,638     $ 405,527,665  
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Bank loans
  $ 11,801,917     $ 6,794,812  
Accounts and notes payable, including $1,584,274 and $1,867,926 to related parties at September 30, 2011 and December 31, 2010
    163,597,833       148,517,423  
Convertible notes payable
    -       30,000,000  
Compound derivative liabilities
    -       25,271,808  
Customer deposits
    1,019,821       720,883  
Accrued payroll and related costs
    4,866,414       4,927,200  
Accrued expenses and other payables
    23,361,401       29,072,710  
Accrued pension costs
    3,927,004       3,851,988  
Taxes payable
    4,302,174       6,860,946  
Amounts due to shareholders/directors
    355,512       353,817  
Deferred tax liabilities
    446,966       312,304  
Total current liabilities
    213,679,042       256,683,891  
Long-term liabilities:
               
Convertible notes payable
    23,571,429       -  
Compound derivative liabilities
    2,156,715       -  
Accrued make-whole redemption interest expense of convertible notes
    6,967,774       -  
Advances payable
    975,625       603,983  
Total liabilities
    247,350,585       257,287,874  
Commitments and contingencies
               
Stockholders' equity:
               
Preferred stock, $0.0001 par value - Authorized - 20,000,000 shares; issued and outstanding – None
    -       -  
Common stock, $0.0001 par value - Authorized - 80,000,000 shares; issued and outstanding – 28,083,534 shares and 27,175,826 shares at September 30, 2011 and December 31, 2010
    2,808       2,717  
Additional paid-in capital
    38,676,931       28,565,153  
Retained earnings-
               
Appropriated
    9,026,960       8,767,797  
Unappropriated
    92,815,475       58,979,851  
Accumulated other comprehensive income
    23,584,789       15,957,500  
Total parent company stockholders' equity
    164,106,963       112,273,018  
Noncontrolling interests
    40,804,090       35,966,773  
Total stockholders' equity
    204,911,053       148,239,791  
Total liabilities and stockholders' equity
  $ 452,261,638     $ 405,527,665  

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

 
7

 

China Automotive Systems, Inc.
Condensed Unaudited Consolidated Statements of Cash Flows

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
 
 
 
 
 
 
 
Cash flows from operating activities:
 
 
 
 
 
 
Net income
 
$
39,335,930
 
 
$
47,664,525
 
Adjustments to reconcile net income from continuing operations to net cash provided by operating activities:
 
 
   
 
 
   
Stock-based compensation
 
 
-
 
 
 
422,714
 
Depreciation and amortization
 
 
10,144,624
 
 
 
6,955,969
 
Allowance for doubtful accounts recovered
 
 
(78,263
)
 
 
(1,127,767
)
Deferred income taxes assets and liabilities
 
 
(250,819
)
 
 
(540,385
)
Equity in earnings of affiliated companies
 
 
(129,363
)
 
 
-
 
Gain on convertible notes conversion
 
 
(1,564,418
)
 
 
-
 
Gain on change in fair value of derivative
 
 
(19,373,520
)
 
 
(14,122,730
)
Other operating adjustments
 
 
116,271
 
 
 
324,963
 
Changes in operating assets and liabilities:
 
 
   
 
 
   
(Increase) decrease in:
 
 
   
 
 
   
Pledged deposits
 
 
1,459,912
 
 
 
(8,012,615
)
Accounts and notes receivable
 
 
6,713,715
 
 
 
(22,430,886
)
Advance payments and other
 
 
505,920
 
 
 
(678,156
)
Inventories
 
 
(12,614,377
)
 
 
(12,728,686
)
Increase (decrease) in:
 
 
   
 
 
   
Accounts and notes payable
 
 
8,504,008
 
 
 
33,298,924
 
Customer deposits
 
 
252,157
 
 
 
(34,138
)
Accrued payroll and related costs
 
 
(249,117
)
 
 
67,681
 
Accrued expenses and other payables
 
 
1,835,213
 
 
 
1,298,885
 
Accrued pension costs
 
 
(81,174
)
 
 
137,283
 
Taxes payable
 
 
(2,798,154
)
 
 
(891,031
)
Net cash provided by operating activities
 
 
31,728,545
 
 
 
29,604,550
 
Cash flows from investing activities:
 
 
   
 
 
   
Decrease (increase) in other receivables
 
 
624,969
 
 
 
(2,221,935
)
Cash received from disposal of equipment
 
 
134,039
 
 
 
396,489
 
Cash paid to acquire property, plant and equipment
 
 
(10,805,460
)
 
 
(24,005,602
)
Cash paid to acquire intangible assets
 
 
(121,132
)
 
 
(60,586
)
Net cash used in investing activities
 
 
(10,167,584
)
 
 
(25,891,634
)
Cash flows from financing activities:
 
 
   
 
 
   
Proceeds from bank loans
 
 
4,791,706
 
 
 
3,685,215
 
Dividends paid to the noncontrolling interest holders of joint-venture companies
 
 
(1,691,608
)
 
 
(2,871,603
)
Shares issued for stock options exercised
 
 
-
 
 
 
278,900
 
Increase (decrease) in amounts due to shareholders/directors
 
 
(19,938
)
 
 
97,406
 
Net cash provided by financing activities
 
 
3,080,160
 
 
 
1,189,918
 
Effects of exchange rate on cash and cash equivalents
 
 
2,001,112
 
 
 
818,849
 
Net increase in cash and cash equivalents
 
 
26,642,233
 
 
 
5,721,683
 
Cash and cash equivalents at beginning of period
 
 
49,424,979
 
 
 
43,480,176
 
Cash and cash equivalents at end of period
 
$
76,067,212
 
 
$
49,201,859
 

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

 
8

 

China Automotive Systems, Inc. and Subsidiaries
Condensed Unaudited Consolidated Statements of Cash Flows (continued)

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Cash paid for interest
 
$
1,689,318
 
 
$
1,146,971
 
Cash paid for income taxes
 
$
7,189,788
 
 
$
5,362,363
 

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Issuance of common shares for the conversion of convertible notes
 
$
10,111,869
 
 
$
-
 

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

 
9

 

China Automotive Systems, Inc. and Subsidiaries
 Notes to Condensed Unaudited Consolidated Financial Statements
Three Months and Nine Months Ended September 30, 2011 and 2010

1.
Organization and Business

China Automotive Systems, Inc., “China Automotive,” was incorporated in the State of Delaware on June 29, 1999 under the name Visions-In-Glass, Inc. China Automotive, including, when the context so requires, its subsidiaries and the subsidiaries’ interests in the Sino-foreign joint ventures described below, is referred to herein as the “Company.” The Company is primarily engaged in the manufacture and sale of automotive systems and components, as described below.

Great Genesis Holdings Limited, a company incorporated on January 3, 2003 under The Companies Ordinance in Hong Kong as a limited liability company, “Genesis,” is a wholly-owned subsidiary of the Company.

Henglong USA Corporation, “HLUSA,” incorporated on January 8, 2007 in Troy, Michigan, is a wholly-owned subsidiary of the Company, and mainly engages in marketing of automotive parts in North America, and provides after sales service and research and development support accordingly.

The Company owns the following aggregate net interests in seven Sino-foreign joint ventures, a wholly-owned subsidiary and two joint ventures organized in the PRC as of September 30, 2011 and 2010.

    
Percentage Interest
 
Name of Entity
 
September 30, 
2011
   
December 31,
2010
 
Shashi Jiulong Power Steering Gears Co., Ltd., “Jiulong” 1
 
 
81.00
%
 
 
81.00
%
Jingzhou Henglong Automotive Parts Co., Ltd., “Henglong” 2
 
 
80.00
%
 
 
80.00
%
Shenyang Jinbei Henglong Automotive Steering System Co., Ltd., “Shenyang” 3
 
 
70.00
%
 
 
70.00
%
Zhejiang Henglong & Vie Pump-Manu Co., Ltd., “Zhejiang” 4
 
 
51.00
%
 
 
51.00
%
Universal Sensor Application Inc., “USAI” 5
 
 
83.34
%
 
 
83.34
%
Wuhan Jielong Electric Power Steering Co., Ltd., “Jielong” 6
 
 
85.00
%
 
 
85.00
%
Wuhu HengLong Automotive Steering System Co., Ltd., “Wuhu” 7
 
 
77.33
%
 
 
77.33
%
Jingzhou Hengsheng Automotive System Co., Ltd, “Hengsheng” 8
 
 
100.00
%
 
 
100.00
%
Jingzhou Henglong Automotive Technology (Testing) Center, “Testing Center” 9
 
 
80.00
%
 
 
80.00
%
Beijing Henglong Automotive System Co., Ltd., “Beijing Henglong” 10
 
 
50.00
%
 
 
50.00
%
 
 
1.
Jiulong was established in 1993 and mainly engages in the production of integral power steering gear for heavy-duty vehicles.

 
2.
Henglong was established in 1997 and mainly engages in the production of rack and pinion power steering gear for cars and light-duty vehicles.

 
3.
Shenyang was established in 2002 and focuses on power steering parts for light duty vehicles.

 
4.
Zhejiang was established in 2002 to focus on power steering pumps.

 
5.
USAI was established in 2005 and mainly engages in production and sales of sensor modules.

 
6.
Jielong was established in 2006 and mainly engages in production and sales of electric power steering, “EPS.”

 
7.
Wuhu was established in 2006 and mainly engages in production and sales of automobile steering systems.

 
8.
Hengsheng was established in 2007 and mainly engages in production and sales of automobile steering systems.

 
9.
In December 2009, Henglong, a subsidiary of Genesis, formed Jingzhou Henglong Automotive Technology (Testing) Center, “Testing Center”.

 
10.
Beijing Henglong was established in 2010 and is mainly engaged in the design, development and manufacture of both hydraulic and electric power steering systems and parts. According to the joint venture agreement, the Company does not have voting control of Beijing Henglong. Therefore, the Company’s consolidated financial statements do not include Beijing Henglong, and such investment is accounted for by the equity method.

 
10

 

2.
Basis of Presentation and Significant Accounting Policies

(a)
Basis of Presentation

Basis of Presentation – For the three months and nine months ended September 30, 2011 and 2010, the accompanying unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. The subsidiaries include the seven Sino-foreign joint ventures, a wholly-owned subsidiary and two joint ventures organized in the PRC mentioned in Note 1. Significant inter-company balances and transactions have been eliminated upon consolidation. The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America.
  
The accompanying interim condensed consolidated financial statements are unaudited, but in the opinion of the Company’s management, contain all adjustments, which include normal recurring adjustments, necessary to present fairly the financial position, the results of operations and cash flows for the three months and nine months ended September 30, 2011 and 2010, respectively.

The consolidated balance sheet as of December 31, 2010 is derived from the Company’s audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

Certain information and footnote disclosures normally included in financial statements that have been prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission, although the Company’s management believes that the disclosures contained in these financial statements are adequate to make the information presented herein not misleading. For further information, refer to the financial statements and the notes thereto included in the Company’s 2010 Annual Report on Form 10-K, as filed with the Securities and Exchange Commission.

The results of operations for the nine months ended September 30, 2011 are not necessarily indicative of the results of operations to be expected for the full fiscal year ending December 31, 2011.

Estimation -The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

(b)
Recent Accounting Pronouncements
 
In July 2010, the FASB issued new disclosure guidance related to the credit quality of financing receivables and the allowance for credit losses. The guidance will require companies to provide more information about the credit quality of their financing receivables in the disclosures to financial statements including, but not limited to, significant purchases and sales of financing receivables, aging information and credit quality indicators. The Company adopted this accounting standard upon its effective date for years ending on or after December 15, 2010. The Company has evaluated the new disclosure requirement in accordance with the accounting guidance and the adoption did not have a significant impact on the Company’s financial position, results of operations or cash flows.

In December 2010, FASB issued revised guidance on the “Disclosure of Supplementary Pro Forma Information for Business Combinations.” The revised guidance specifies that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The revised guidance also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The revised guidance is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company adopted the new guidance as of January 1, 2011 and the adoption did not have a significant impact on the Company’s financial position, results of operations or cash flows.

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

In 2011, the FASB issued new disclosure guidance related to the presentation of the Statement of Comprehensive Income. This guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. The standard requires an entity to present the total of comprehensive income, net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company will adopt this accounting standard upon its effective date for periods ending on or after December 15, 2011, and does not anticipate that this adoption will have any impact on the Company's financial position or results of operations.

(c)
Significant Accounting Policies

Foreign Currencies – The Parent Company (CAAS) and Henglong USA Corporation (HLUSA) maintain their books and records in United States Dollars, “USD,” their functional currency. The Company’s subsidiaries based in the PRC and Genesis maintain their books and records in Renminbi, their functional currency. In accordance with ASC Topic 830, foreign currency transactions denominated in currencies other than the functional currency are remeasured into the functional currency at the rate of exchange prevailing at the balance sheet date for monetary items. Nonmonetary items are remeasured at historical rates. Income and expenses are remeasured at the rate in effect on the transaction dates. Transaction gains and losses, if any, are included in the determination of net income for the period.
 
 
11

 
 
In translating the financial statements of the Company’s China subsidiaries and Genesis from their functional currency into their reporting currency in United States dollars, balance sheet accounts are translated using the closing exchange rate in effect at the balance sheet date and income and expense accounts are translated using an average exchange rate prevailing during the reporting period. Adjustments resulting from the translation, if any, are included in cumulative other comprehensive income (loss) in stockholders’ equity.

Stock-Based Compensation – The Company may periodically issue shares of common stock for services rendered or for financing costs. Such shares will be valued based on the market price on the transaction date. The Company may periodically issue stock options to employees and stock options or warrants to non-employees in non-capital raising transactions for services and for financing costs.

In July 2004, the Company adopted a stock incentive plan. The maximum number of common shares for issuance under this plan is 2,200,000 with a period of 10 years. The stock incentive plan provides for the issuance, to the Company’s officers, directors, management and employees, of options to purchase shares of the Company’s common stock. Since the adoption of the stock incentive plan, the Company has issued 456,350 stock options under this plan, and there remain 1,743,650 stock options issuable in the future. As of September 30, 2011, the Company had 236,768 stock options outstanding.

The Company has adopted ASC Topic 718, “Accounting for Stock-Based Compensation,” which establishes a fair value method of accounting for stock based compensation plans. In accordance with ASC Topic 718, the cost of stock options issued to employees and non-employees is measured on the grant date based on the fair value. The fair value is determined using the Black-Scholes option pricing model. The resulting amount is charged to expense on the straight-line basis over the period in which the Company expects to receive benefit, which is generally the vesting period.

Comprehensive Income – The Company has adopted ASC Topic 220, “Reporting Comprehensive Income.” ASC Topic 220 establishes standards for the reporting and display of comprehensive income, its components and accumulated balances in a full set of general purpose financial statements. ASC Topic 220 defines comprehensive income to include all changes in equity except those resulting from investments by owners and distributions to owners, including adjustments to minimum pension liabilities, accumulated foreign currency translation, and unrealized gains or losses on marketable securities.

Financial Instruments The Company adopted the provisions of ASC 815, “Derivatives and Hedging Activities,” that address the determination of whether an instrument meets the definition of a derivative being indexed to a company’s own stock for purposes of applying the scope exception as provided for in accordance with ASC 815-15. Upon adoption of the standard on the effective date, the Company bifurcated the conversion feature embedded in the Convertible Notes (see Note 13), classifying it in liabilities and measuring it at fair value at each reporting period, with changes reflected in earnings, until the Convertible Notes are settled.

Fair Value Measurements – For purposes of fair value measurements, the Company applies the applicable provisions of ASC 820, “Fair Value Measurements”. Accordingly, fair value for the Company’s financial accounting and reporting purposes represents the estimated price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the designated measurement date. With an objective to increase consistency and comparability in fair value measurements and related disclosures, the Financial Accounting Standard Board established the fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels.
 
Level 1 Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available. As at September 30, 2011 and December 31, 2010, the Company does not have any fair value assets and liabilities classified as Level 1.

Level 2 Inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. As at September 30, 2011 and December 31, 2010, the Company does not have any fair value assets and liabilities classified as Level 2.

Level 3 Inputs are unobservable inputs for the asset or liability. Unobservable inputs are used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk. The compound derivative liabilities are classified as Level 3 as the inputs reflect management’s best estimate of what market participants would use in pricing the liability at the measurement date.
 
 
12

 
 
For a summary of changes in Level 3 derivative liabilities for the year ended December 31, 2010 and for the nine months ended September 30, 2011, please see note 14.
 
3.
Pledged cash deposits

Pledged cash deposits act as guarantee for the Company’s notes payable as it regularly pays some of its suppliers by bank notes. The Company has to deposit a cash deposit, equivalent to 30%- 40% of the face value of the relevant bank note, at a bank in order to obtain the bank note.
 
4.
Accounts and notes receivable

The Company’s accounts receivable at September 30, 2011 and December 31, 2010 are summarized as follows:

    
September 30,
2011
   
December 31, 2010
 
Accounts receivable
 
$
112,822,032
 
 
$
122,379,968
 
Notes receivable 1
 
 
88,000,471
 
 
 
76,407,523
 
 
 
 
200,822,503
 
 
 
198,787,491
 
Less: allowance for doubtful accounts
 
 
(2,962,397
)
 
 
(2,928,503
)
Balance at the end of the period
 
$
197,860,106
 
 
$
195,858,988
 
 
 
1.
Notes receivable represent accounts receivable in the form of bills of exchange whose acceptances are guaranteed and settlements are handled by banks.
 
5.
Inventories

The Company’s inventories at September 30, 2011 and December 31, 2010 consisted of the following:

    
September 30, 
2011
   
December 31, 
2010
 
Raw materials
 
$
15,692,397
 
 
$
11,394,670
 
Work in process
 
 
8,341,702
 
 
 
7,537,766
 
Finished goods
 
 
27,270,295
 
 
 
17,937,836
 
Balance at the end of the period
 
$
51,304,394
 
 
$
36,870,272
 

6.
Other receivables

The Company’s other receivables at September 30, 2011 and December 31, 2010 are summarized as follows:

    
September 30, 2011
   
December 31, 2010
 
Other receivables 1
 
$
2,987,734
 
 
$
3,501,967
 
Less: allowance for doubtful accounts
 
 
(738,512
)
 
 
(700,533
)
Balance at the end of the period
 
$
2,249,222
 
 
$
2,801,434
 
 
 
1.
Other receivables consist of amounts advanced to both related and unrelated parties, primarily as unsecured demand loans, with no stated interest rate or due date. These receivables originate as part of the Company's normal operating activities.

 
13

 

7.
Long term Investments

On September 30, 2011 and December 31, 2010, the Company’s balance of long-term investment was $3,426,863 and $3,162,136, respectively. For the long-term investments in which the Company has no voting control, such investments were accounted for using the equity method or cost method.

On January 24, 2010, the Company invested $3,095,414 to establish a fifty-fifty joint venture company, Beijing Henglong Automotive System Co., Ltd., “Beijing Henglong,” with an unrelated party. The Company accounts for its operating results with the equity method of accounting. On September 30, 2011 and December 31, 2010, the Company has $3,341,889 and $3,080,598 of net equity in Beijing Henglong, respectively.

The Company’s share of net assets and net income is reported in the consolidated financial statements as “long-term investment” on the consolidated balance sheets and “equity in earnings of affiliated companies” on the consolidated statements of operations. The Company’s consolidated financial statements reflect the equity earnings of non-consolidated affiliates of $42,817 and $129,363 in the three months and nine months ended September 30, 2011, respectively, and nil in the same periods of 2010.

8.
Property, plant and equipment

The Company’s property, plant and equipment at September 30, 2011 and December 31, 2010 are summarized as follows:

    
September 30,
2011
   
December 31, 
2010
 
 
 
 
 
 
 
 
Land use rights and buildings
 
$
39,204,983
 
 
$
36,983,940
 
Machinery and equipment
 
 
94,200,741
 
 
 
81,905,845
 
Electronic equipment
 
 
6,217,672
 
 
 
5,840,308
 
Motor vehicles
 
 
3,154,196
 
 
 
2,902,738
 
Construction in progress
 
 
6,636,312
 
 
 
4,686,699
 
 
 
 
149,413,904
 
 
 
132,319,530
 
Less: Accumulated depreciation
 
 
(67,772,748
)
 
 
(56,938,783
)
Balance at the end of the period
 
$
81,641,156
 
 
$
75,380,747
 

Depreciation expenses for the three months ended September 30, 2011 and 2010 were $3,527,206 and $2,097,734, respectively. Depreciation expenses for the nine months ended September 30, 2011 and 2010 were $10,019,376 and $6,910,835, respectively.

9.
Intangible assets

The Company’s intangible assets at September 30, 2011 and December 31, 2010 are summarized as follows:

    
September 30,
2011
   
December 31, 
2010
 
Costs:
 
 
 
 
 
 
Patent technology
 
$
1,700,533
 
 
$
1,536,268
 
Management software license
 
 
552,592
 
 
 
509,221
 
 
 
 
2,253,125
 
 
 
2,045,489
 
Less: Amortization
 
 
(1,569,153
)
 
 
(1,383,400
)
Balance at the end of the period
 
$
683,972
 
 
$
662,089
 

For the three months ended September 30, 2011 and 2010, amortization expenses were $43,856 and $38,092, respectively. For the nine months ended September 30, 2011 and 2010, amortization expenses were $125,248 and $45,134, respectively.
 
10.
Deferred Income Tax Assets

In accordance with the provisions of ASC Topic 740, “Income Taxes,” the Company assesses, on a quarterly basis, its ability to realize its deferred tax assets. Based on the more likely than not standard in the guidance and the weight of available evidence, the Company believes a valuation allowance against its deferred tax assets is required in entities where such deferred tax assets are deemed to be unrealizable. In determining the need for a valuation allowance, the Company considered the following significant factors: an assessment of recent years’ profitability and losses; the Company’s expectation of profits based on margins and volumes expected to be realized, which are based on current pricing and volume trends; the long period - ten years or more in all significant operating jurisdictions — before the expiry of net operating losses, noting further that a portion of the deferred tax asset is composed of deductible temporary differences that are subject to an expiry period until realized under tax law. The Company will continue to evaluate the provision of valuation allowance in future periods.

 
14

 

The components of estimated deferred income tax assets at September 30, 2011 and December 31, 2010 were as follows:

    
September 30,
2011
   
December 31, 
2010
 
Deferred Tax Assets
 
 
 
 
 
 
Losses carryforward (U.S.)
 
$
2,802,742
 
 
$
2,422,312
 
Losses carryforward (PRC)
 
 
966,815
 
 
 
804,147
 
Product warranties and other reserves
 
 
3,075,577
 
 
 
2,871,844
 
Property, plant and equipment, net
 
 
3,863,175
 
 
 
3,271,594
 
Accrued make-whole interest expense for convertible notes
 
 
2,438,721
 
 
 
2,320,938
 
Share-based compensation
 
 
366,464
 
 
 
366,464
 
Bonus accrual
 
 
109,777
 
 
 
182,970
 
Other accruals
 
 
842,789
 
 
 
943,373
 
Others
 
 
152,946
 
 
 
314,795
 
Total deferred tax assets
 
 
14,619,006
 
 
 
13,498,437
 
Less: taxable temporary difference related to revenue recognition
 
 
(655,757
)
 
 
(801,562
)
Total deferred tax assets, net
 
 
13,963,249
 
 
 
12,696,875
 
Less: Valuation allowance
 
 
(6,522,270
)
 
 
(5,913,860
)
Total deferred tax assets, net of valuation allowance
 
$
7,440,979
 
 
$
6,783,015
 
 
As of September 30, 2011, the valuation allowance was $6,522,270, including $5,607,927 allowance for the Company’s deferred tax assets in the U.S. and $914,343 allowance for the Company’s non-U.S. deferred tax assets. Based on the Company’s current operations in the U.S., management believes that the deferred tax assets in the U.S. are not likely to be realized in the future. For the non-U.S. deferred tax assets, pursuant to certain tax laws and regulations in China, management believes such amount will not be used to offset future taxable income.  No valuation allowance is made on the remaining deferred tax assets as management believes that these deferred tax assets will be realized in the future based on existing and expected operations.
 
11.
Bank loans

At September 30, 2011, the Company, through its Sino-foreign joint ventures, had outstanding fixed-rate short-term bank loans of $11,801,917 with weighted average interest rate at 6.64% per annum. These loans are secured with some of the property and equipment of the Company, and are repayable within one year.

At December 31, 2010, the Company, through its Sino-foreign joint ventures, had outstanding fixed-rate short-term bank loans of $6,794,812, with weighted average interest rate at 5.25% per annum. These loans are secured with some of the property and equipment of the Company and are repayable within one year.
 
12.
Accounts and notes payable

The Company’s accounts and notes payable at September 30, 2011 and December 31, 2010 are summarized as follows:

   
September 30,
2011
   
December 31, 
2010
 
Accounts payable
 
$
106,160,958
 
 
$
95,726,549
 
Notes payable 1
 
 
57,436,875
 
 
 
52,790,874
 
Balance at the end of the period
 
$
163,597,833
 
 
$
148,517,423
 
 
 
1.
Notes payable represent accounts payable in the form of bills of exchange whose acceptances are guaranteed and settlements are handled by banks. The Company has pledged cash deposits, notes receivable and certain property plant and machinery to secure notes payable granted by banks.

 
15

 

13. 
Convertible Notes payable

In February 2008, the Company sold to two accredited institutional investors $35 million of Convertible Notes, the "Convertible Notes,” with a scheduled maturity date of February 15, 2013. The Convertible Notes, including any accrued but unpaid interest, are convertible into common shares of the Company at a conversion price of $8.8527 per share, subject to adjustment upon the occurrence of certain events.

The Convertible Notes bear annual interest rates of 3%, 3.5%, 4%, 4.5%, 5% and 5% for each year of 2008, 2009, 2010, 2011, 2012 and 2013, respectively. The interest on the Convertible Notes shall be computed commencing from the issuance date and will be payable in cash in arrears semi-annually on January 15, and July 15 of each year with the first interest payable date on July 15, 2008. From and after the occurrence and during the continuance of an Event of Default defined in the relevant Convertible Notes agreements, the interest rate then in effect shall be increased by two percent (2%) until the event of default is remedied.

The holders of the Convertible Notes will be entitled to convert any portion of the conversion notes into shares of common stock at the conversion price at any time or times on or after the thirtieth (30th) day after the issuance date and prior to the thirtieth (30th) Business Day prior to the expiry date of the Convertible Notes. A penalty will be paid if share certificates are not delivered timely after any conversion.

The Company will have the right to require the Convertible Notes holders to convert a portion of the conversion amount then remaining under the Convertible Notes obligation into shares of common stock, “ Mandatory Conversion,” if at any time during a six-month period, the beginning day of each such six-month period, a “Mandatory Conversion Period Start Date,” the arithmetic average of the weighted average price of the common stock for a period of at least thirty (30) consecutive trading days following the Mandatory Conversion Period Start Date equals or exceeds the percentage set forth in the chart below multiplied by $8.8527 as applicable to the indicated six month period:

0-6 months:
    125 %
6-12 months:
    125 %
12-18 months:
    135 %
18-24 months:
    135 %
24-30 months:
    145 %
30-36 months:
    145 %
36-42 months:
    155 %
42-48 months:
    155 %

The Company will not effect a Mandatory Conversion of more than twelve percent (12%) of the original principal amount of the Convertible Notes, with the applicable accrued but unpaid interest, in any six month period or twenty-four percent (24%) of the original principal amount of the Convertible Notes, with the applicable accrued but unpaid interest, in any twelve (12) month period.

The Company will not effect any conversion of the Convertible Notes, and each holder of the Convertible Notes will not have the right to convert any portion of the Convertible Notes to the extent that after giving effect to such conversion, such holders would beneficially own in excess of 4.99% of the number of shares of Common Stock outstanding immediately after giving effect to such conversion.

On each six month anniversary of the issuance date beginning August 15, 2008, the conversion price will be adjusted downward to the Reset Reference Price, as defined below, if the weighted average price for the twenty (20) consecutive trading days immediately prior to the applicable six month anniversary, the “Reset Reference Price”, is less than 95% of the conversion price in effect as of such applicable six month anniversary date. The foregoing notwithstanding, the conversion price will not be reduced via such reset provision to less than $7.0822. The conversion price is also subject to weighted-average antidilution adjustments, but in no event will the conversion price be reduced to less than $6.7417. If and whenever on or after the issuance date, the Company issues or sells its shares of Common Stock or other convertible securities, except for certain defined exempt issuances, for a consideration per share less than a price equal to the conversion price in effect on the issuance date immediately prior to such issue or sale, the original conversion price then in effect shall be adjusted by a weighted-average antidilution formula.
 
According to the terms of the Convertible Notes, the conversion price was reset to $7.0822 as of August 15, 2008 based on the weighted average price of the stock on that date. In accordance with ASC Topic 470, a contingency feature that cannot be measured at inception of the instrument should be recorded when the contingent event occurs. Therefore, on the date of the reset, the difference in the number of indexed shares prior to the reset was compared to the indexed shares subsequent to the reset and this incremental number of shares was multiplied by the commitment date stock price to determine the incremental intrinsic value that resulted from the adjustment to the conversion price. At the commitment date, as the effective conversion price was higher than the market value of the stock, no beneficial conversion feature was present.

As of August 15, 2008, based on the inception conversion price and reset conversion price, the Convertible Note could be converted into 3,953,596 and 4,941,967 of common shares, respectively. At the commitment date, the stock price was $6.09, and the “effective” conversion price was $6.93. Accordingly, since the effective conversion price was higher than the market value of the stock, the debt instruments are not considered "in the money" and no beneficial conversion feature is present.

 
16

 

Upon the occurrence of an event of default with respect to the Convertible Notes, the Convertible Note holders may require the Company to redeem all or any portion of the Convertible Notes. Each portion of the Convertible Notes subject to redemption by the Company will be redeemed by the Company at a price equal to the sum of (i) the conversion amount to be redeemed and (ii) the Other Make Whole Amount. The “Other Make Whole Amount” will mean a premium to the conversion amount such that the total amount received by the Convertible Notes holder upon redemption represents a gross yield to the Convertible Notes holders on the original principal amount as of the redemption date equal to thirteen percent (13%), with interest computed on the basis of actual number of days elapsed over a 360-day year. The events of default include the Company’s failure to cure a conversion failure by delivery of the required number of shares of Common Stock, the Company’s failure to pay to the Convertible Notes holder any amount of principal, interest, late charges or other amounts when and as due under the Convertible Notes and other events as defined in the Convertible Notes agreements. Any amount of principal, interest or other amount due under the Convertible Notes which is not paid when due shall result in a late charge of 18% being incurred and payable by the Company until such amount has been paid.

Upon the consummation of a change of control as defined in the Convertible Notes agreements, the Convertible Notes holder may require the Company to redeem all or any portion of the Convertible Notes. The portion of the Convertible Notes subject to redemption shall be redeemed by the Company in cash at a price equal to the sum of the conversion amount being redeemed and the Other Make Whole Amount as defined above.

On each of February 15, 2010 and February 15, 2011, the Convertible Notes holders had the right, in their sole discretion, to require that the Company redeem the Convertible Notes in whole but not in part, by delivering written notice thereof to the Company. The portion of the Convertible Notes subject to redemption pursuant to this annual redemption right will be redeemed by the Company in cash at a price equal to the sum of the conversion amount being redeemed and the Annual Redemption Make Whole Amount. The “Annual Redemption Make Whole Amount” will mean a premium to the conversion amount such that the total amount received by the Convertible Notes holder upon any annual redemption represents a gross yield on the original principal amount of eleven percent (11%), with interest computed on the basis of actual number of days elapsed over a 360-day year. The Convertible Notes holders did not exercise their right on either of these dates.

At any time following February 15, 2009, if the Weighted Average Price (WAP) for twenty (20) consecutive trading days is less than 45% of the Conversion Price in effect on the Issuance Date, as adjusted, namely $3.187, the Convertible Notes holder shall have the right, in its sole discretion, to require that the Company redeem all or any portion of the Convertible Notes. The portion of this Convertible Notes subject to redemption in connection with the share price change of the underlying common stock will be redeemed by the Company in cash at a price equal to the sum of the conversion amount being redeemed and the Other Make Whole Amount as mentioned above.

Since the Company’s stock Weighted Average Price for twenty (20) consecutive trading days ended on March 16, 2009 was below $3.187, which is less than 45% of the Conversion Price in effect as of the Issuance Date, as adjusted, the “ WAP Default” , each Convertible Notes holder had the right, at its sole discretion, to require that the Company redeem all or any portion of the Convertible Notes by delivering written redemption notice to the Company within five (5) business days after the receipt of the Company’s notice of the WAP Default.

On March 17, 2009, the Company delivered two WAP Default notices to the Convertible Notes holders. On March 27, 2009, the Company received a letter from YA Global, one of the Convertible Notes holders, electing to require the Company to redeem all the three Convertible Notes it held in the total principal amount of $5,000,000, together with interest, late charges, and the Other Make Whole Amount as defined in Section 5(d) of the Convertible Notes. After negotiation, the Company and YA Global reached a settlement agreement on April 8, 2009 and under the terms of the settlement agreement, the Company paid on April 15, 2009 a redemption amount of $5,041,667 to YA Global and YA Global waived its entitlement to the Other Make Whole Amount. The amount waived was accounted for as a gain on debt extinguishment and recorded in interest expense.
 
Following the WAP Default notices, the Company received a letter from the provisional liquidator acting on behalf of Lehman Brothers Commercial Corporation Asia Limited, the “LBCCA Liquidator,” the other Convertible Notes holder, requesting an extension until April 15, 2009 to consider its rights under the Convertible Notes. The Company granted an extension to April 15, 2009. The LBCCA Liquidator further requested another extension to April 24, 2009. On April 24, 2009, LBCCA’s lawyers sent three Holder Redemption Notices electing to redeem the entire outstanding principal of $30,000,000, together with interest, late charges, if any, and the Other Make Whole Amount, to be paid on July 23, 2009. The Company discussed settlement with the LBCCA Liquidator, and on July 22, 2009, the Company and the LBCCA Liquidator agreed to extend the applicable holder mandatory redemption date for two months to September 23, 2009 to give more time to pursue settlement discussions. The Company received a letter dated September 22, 2009 from the LBCCA Liquidator stating that upon the Company’s acceptance of the revocation, all holder redemption notices dated April 24, 2009 shall be immediately revoked as if they were never issued, and the letter and the revocation did not purport to amend, restate or supplement any other terms and conditions under the three Notes and the Securities Purchase Agreement dated 1 February 2008 between the Company and LBCCA Liquidator. The Company accepted such revocation on September 23, 2009.

In connection with the Convertible Notes, the Company issued 1,317,864 detachable warrants, the “Warrants,” to purchase from the Company shares of common stock of the Company at the exercise price of $8.8527 per share. On February 15, 2009, the warrants expired unexercised and the warrants were forfeited.

 
17

 

On the issuance date, February 15, 2008, the Company has evaluated the Convertible Notes for terms and conditions that would be considered to be features of embedded derivatives. Generally, such features would be required to be separated from the host contract and accounted for as derivative financial instruments when certain conditions are met. Certain features, such as the conversion option, were found to be exempt, as they satisfied the conditions as set forth in ASC Topic 815 (formerly paragraph 11(a) of SFAS 133) for instruments that are being (1) indexed to the Company’s own stock, and (2) classified as equity in the financial position statement. Other features, such as puts, were not required to be bifurcated from the debt host as they are clearly and closely associated with the risk of the debt-type host instrument.

Upon the adoption of ASC 815-40 on January 1, 2009, the Company bifurcated the embedded conversion feature from the Convertible Debt and classified that financial instrument in liabilities at fair value. The Company has accounted for this change in accounting principle by reflecting the cumulative effect as an adjustment to its beginning retained earnings for the year ended December 31, 2009. The cumulative effect adjustment that the Company made is the difference between the amounts that it has recognized on the Convertible Notes payable (prior to the adoption of ASC 815-40) and the amounts that would have been recognized if the amended guidance had been effective on the issuance date of the Convertible Notes payable, which was February 15, 2008. The following table reflects the cumulative effect of the differences:

   
Convertible notes payable
 
   
Original Allocation
   
Allocation
 
Value allocated to debt
  $ 34,201,374     $ 28,379,704  
Warrants
    798,626       798,626  
Compound embedded derivative
    -       5,821,670  
Face value of convertible notes payable
  $ 35,000,000       35,000,000  
Unamortized discount
    660,193       3,891,148  
Unamortized value as of December 31, 2008
  $ 34,339,807        
Unamortized value as of January 1, 2009
    -     $ 31,108,852  

As indicated above, on the date of the Convertible Note issuance, allocation of basis in the financing arrangement to the warrants has resulted in an original issue discount to the face value of the Convertible Notes in the amount of $798,626, of which the amount was accreted to its face value over the term of the Convertible Note using the effective method. As of December 31, 2008, the interest expense recorded by the Company was $138,433, and the unamortized discount was $660,193. On January 1, 2009, the Company adopted and applied the provision of ASC 815 Derivatives and Hedging Activities (effective on January 1, 2009). The accounting for the cumulative effect change in this accounting principle resulted in a discount of $6,620,296, including $798,626 discount resulting from Warrants and $5,821,670 from the embedded conversion feature of the original unamortized discount and the subsequent amortization using the effective interest method. On January 1, 2009, unamortized discount was $3,891,148.
 
As indicated above, due to the Company’s WAP Default on March 17, 2009, the Convertible Notes holders had the option to elect to exercise their rights to require the Company to redeem the Convertible Notes. The remaining amount of $3,891,148 unamortized discount on the Convertible Notes was recorded to its full face value and the redemption make-whole amount of $520,000 was accrued. On April 8, 2009, the Company and YA Global reached a settlement agreement, whereby under the terms of the settlement agreement, the Company paid a redemption amount of $5,000,000 of principal and $41,667 of interest to YA Global, and accrual of $571,181 for make-whole redemption interest to YA Global was waived and accounted for as a gain on debt extinguishment. On September 22, 2009, LBCCA Liquidator revoked the redemption notices that were sent on April 24, 2009, and continued to hold the Company’s Convertible Notes, of which the face value was $30,000,000. The Company accepted such revocation on September 23, 2009.

On March 1, 2011, LBCCA Liquidator converted $6,428,571 principal amount of the Convertible Notes at a conversion price of $7.0822 per share, and the Company issued 907,708 shares of its common stock to the investor. On the conversion date, the market price of the common shares issued was $10,111,869 ($11.14 per share) and the value of the conversion consideration was $11,676,287, including $6,428,571 of principal, $1,506,143 of coupon interest and make-whole amount payable and $3,741,573 of derivative liabilities under such principal. The amount of coupon interest, make-whole and derivative liabilities included in the value of the conversion consideration were determined by pro-rating the accrued coupon interest, accrued make-whole amount and the fair value of the derivative liabilities based on the principal amount of the Convertible Notes converted as a percentage of the outstanding balance prior to their conversion. The Company recorded a gain on Convertible Notes conversion of $1,564,418, which is the difference between the market price of the common stock and the conversion consideration.

On September 30, 2011 and December 31, 2010, the carrying value of the Company’s Convertible Notes payable was $23,571,429 and $30,000,000, respectively.
 
14.
Compound derivative liabilities

Effective January 1, 2009, the Company adopted the provisions of ASC 815 Derivatives and Hedging Activities that addresses the determination of whether an instrument meets the definition of a derivative being indexed to a company’s own stock for purposes of applying the scope exception as provided for in accordance with ASC 815-15. Upon adoption of the standard on the effective date, the embedded conversion option that is embedded in the Company’s Convertible Notes Payable (see Note 13) no longer met the definition because it embodied certain anti-dilution protections that are not based on input to the fair value of a fixed-for-fixed option. As a result, the embedded conversion feature required bifurcation, classification in liabilities and measurement at fair value at each reporting period, with changes reflected in earnings, until the Convertible Notes are settled.

 
18

 

The Company’s derivative financial instruments (liabilities) consisted of a compound embedded derivative that originated in connection with the Company’s Convertible Note Payable and Warrant Financing Arrangement. Derivative liabilities are carried at fair value. The following table summarizes the compound derivative liabilities as of September 30, 2011 and December 31, 2010:

Financial Instrument
 
September 30, 2011
   
December 31, 2010
 
 
 
 
 
 
 
 
Compound derivative liability
 
$
2,156,715
 
 
$
25,271,808
 
Common shares to which the derivative liability is linked
 
 
3,328,264
 
 
 
4,235,972
 

Changes in the fair value of compound derivative liabilities are recorded in gain (loss) on change in fair value of derivative in the income statement. The following tables summarize the components of gain (loss) on change in fair value of derivative arising from fair value adjustments and other changes to compound derivative liabilities during the nine months ended September 30, 2011 and 2010:

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Balances at January 1
 
$
25,271,808
 
 
$
45,443,506
 
Decrease due to convertible notes conversion on March 1, 2011(see note 13)
 
 
(3,741,573
 
 
-
 
Decrease in fair value adjustments 1
 
 
(19,373,520
 
 
(14,122,730
Balances at September 30
 
$
2,156,715
 
 
$
31,320,776
 
 
 
1.
Recorded in the gain on change in fair value of derivative line in the statements of income.

The following tables summarize the components of gain (loss) on change in fair value of derivative arising from fair value adjustments and other changes to compound derivative liabilities during the three months ended September 30, 2011 and 2010:

    
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
Balances at July 1
 
$
9,944,852
 
 
$
40,008,753
 
Decrease in fair value adjustments 1
 
 
(7,788,137
 
 
(8,687,977
Balances at September 30
 
$
2,156,715
 
 
$
31,320,776
 
 
 
1.
Recorded in the gain on change in fair value of derivative line in the statements of income.

Estimating fair values of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, option-based techniques are highly volatile and sensitive to changes in the trading market price of the Company’s common stock, which has a high estimated volatility. Since derivative financial instruments are initially and subsequently carried at fair values, the Company’s income will reflect the volatility in these estimate and assumption changes.
 
The Company’s embedded conversion option derivative represents the conversion option, term-extending option, certain redemption and put features in the Company’s Convertible Notes payable. See Note 13 for additional information about the Company’s Convertible Notes payable. The features embedded in the Convertible Notes were combined into one compound embedded derivative that the Company measured at fair value using the Monte Carlo valuation technique. Monte Carlo was believed by the Company’s management to be the best available technique for this compound derivative because, in addition to providing for inputs such as trading market values, volatilities and risk free rates, Monte Carlo also embodies assumptions that provide for credit risk, interest risk and redemption behaviors, i.e., assumptions market participants exchanging debt-type instruments would also consider. Monte Carlo simulates multiple outcomes over the period to maturity using multiple assumption inputs also over the period to maturity. The following table sets forth (i) the range of inputs for each significant assumption and (ii) the equivalent, or averages, of each significant assumption as of September 30, 2011, December 31, 2010, September 30, 2010 and December 31, 2009 (effective date of accounting principle change):

 
 
Range
 
 
 
 
September 30, 2011 Assumptions:
 
Low
 
 
High
 
 
Equivalent
 
Volatility
 
 
49.84
%
 
 
76.78
%
 
 
63.59
%
Market adjusted interest rates
 
 
9.46
%
 
 
18.13
%
 
 
15.06
%
Credit risk adjusted rates
 
 
17.43
%
 
 
17.43
%
 
 
17.43
%
Implied expected life (years)
 
 
-
 
 
 
-
 
 
 
1.36
 

 
19

 
 
 
 
Range
 
 
 
 
 
December 31, 2010 Assumptions:
 
Low
 
 
High
 
 
Equivalent
 
Volatility
 
 
43.14
%
 
 
76.00
%
 
 
63.00
%
Market adjusted interest rates
 
 
5.14
%
 
 
20.15
%
 
 
9.64
%
Credit risk adjusted rates
 
 
14.75
%
 
 
15.82
%
 
 
15.11
%
Implied expected life (years)
 
 
 
 
 
 
 
 
1.73
 
 
 
 
Range
 
 
 
 
 
September 30, 2010 Assumptions:
 
Low
 
 
High
 
 
Equivalent
 
Volatility
 
 
58.71
%
 
 
78.45
%
 
 
71.75
%
Market adjusted interest rates
 
 
2.71
%
 
 
21.55
%
 
 
9.02
%
Credit risk adjusted rates
 
 
15.88
%
 
 
17.23
%
 
 
15.94
%
Implied expected life (years)
 
 
-
 
 
 
-
 
 
 
1.79
 
 
 
 
Range
 
 
 
 
 
December 31, 2009 Assumptions:
 
Low
 
 
High
 
 
Equivalent
 
Volatility
 
 
68.86
%
 
 
81.94
%
 
 
76.71
%
Market adjusted interest rates
 
 
6.40
%
 
 
7.87
%
 
 
7.05
%
Credit risk adjusted rates
 
 
13.39
%
 
 
14.20
%
 
 
13.63
%
Implied expected life (years)
 
 
 
 
 
 
 
 
1.96
 

The Monte Carlo technique requires the use of inputs that range across all levels in the fair value hierarchy. As a result, the technique is a Level 3 valuation technique in its entirety. The calculations of fair value utilized the Company’s trading market values on the calculation dates. The contractual conversion prices were adjusted to give effect to the value associated with the down-round, anti-dilution protection. Expected volatility for each interval in the Monte Carlo process was established based upon the Company’s historical volatility for historical periods consistent with the term of each interval in the calculation. Market adjusted interest rates give effect to expected trends or changes in market interest rates by reference to historical trends in LIBOR. Credit risk adjusted rates, or yields, were developed using bond curves, risk free rates, market and industry adjustment factors for companies with similar credit standings as the Company’s.
 
15.
Accrued expenses and other payables

The Company’s accrued expenses and other payables at September 30, 2011 and December 31, 2010 are summarized as follows:

    
September 30, 
2011
   
December 31, 2010
 
Accrued expenses
 
$
2,714,520
 
 
$
3,627,768
 
Accrued interest 1
 
 
354,375
 
 
 
7,143,751
 
Other payables
 
 
1,920,511
 
 
 
2,826,354
 
Warranty reserves 2
 
 
16,445,783
 
 
 
13,944,392
 
Dividend payable to noncontrolling interest shareholders of Joint-ventures
 
 
1,926,212
 
 
 
1,530,445
 
Balance at the end of the period
 
$
23,361,401
 
 
$
29,072,710
 
 
 
1.
On September 30, 2011 and December 31, 2010, the Company’s balance of accrued interest was $354,375 and $7,143,751, respectively, which includes nil and $6,631,251 of accrued provision on make-whole redemption interest for the annual redemption on the convertible notes, respectively. As of December 31, 2010, the Company’s balance of accrued interest includes make-whole redemption interest which was payable upon the Annual Redemption on February 15, 2011, if the Convertible Notes were redeemed. However, as of September 30, 2011, make-whole redemption interest was classified to long-term liabilities as there was no other mandatory annual redemption subsequent to February 15, 2011. (see note 16)

 
2.
The Company provides for the estimated cost of product warranties when the products are sold. Such estimates of product warranties were based on, among other things, historical experience, product changes, material expenses, services and transportation expenses arising from the manufactured products. Estimates will be adjusted on the basis of actual claims and circumstances.

For the nine months ended September 30, 2011 and 2010, the warranties activities were as follows:

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Balance at the beginning of period
 
$
13,944,392
 
 
$
9,092,462
 
Additions during the period
 
 
8,012,821
 
 
 
7,254,858
 
Settlement within period, by cash or actual material
 
 
(6,099,057
)
 
 
(5,459,215
)
Foreign currency translation gain
 
 
587,627
 
 
 
212,085
 
Balance at end of period
 
$
16,445,783
 
 
$
11,100,190
 

 
20

 

16.
Accrued make-whole redemption interest expense for Convertible Notes

In February 2008, the Company sold to two accredited institutional investors $35 million of convertible notes, the "Convertible Notes,” with a scheduled maturity date of February 15, 2013. Pursuant to the terms of the Convertible Notes, on each of February 15, 2010 and February 15, 2011, the Convertible Note holders had the right, in their sole discretion, to require that the Company redeem the Convertible Notes in whole but not in part, by delivering written notice thereof to the Company. The portion of the Convertible Note subject to redemption pursuant to this annual redemption right will be redeemed by the Company in cash at a price equal to the sum of the conversion amount being redeemed and the Annual Redemption Make Whole Amount. The “Annual Redemption Make Whole Amount” means a premium to the conversion amount such that the total amount received by the Convertible Notes holder upon any annual redemption represents a gross yield on the original principal amount of eleven percent (11%), with interest computed on the basis of actual number of days elapsed over a 360-day year. On February 15, 2011, the Convertible Notes holder did not exercise its annual redemption right. Therefore, the next scheduled redemption date is the maturity date of February 15, 2013 and the make-whole provision accrued after February 15, 2011 was based on the “Maturity Make Whole Amount.” “Maturity Make Whole Amount” means a premium to the Conversion Amount such that the total amount received by the Holder at Maturity represents a gross yield to the Holder on the Original Principal Amount as of the Maturity Date equal to thirteen percent (13%), with interest computed on the basis of actual number of days elapsed over a 360-day year. The make-whole redemption interest is recorded under accrued interest before February 15, 2011 due to its current liabilities feature and thereafter reclassified to and recorded as non-current liability.

During the nine months ended September 30, 2011 and 2010, the accrued provision on make-whole redemption interest pursuant to the term of Convertible Notes was as follows:

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Balance at beginning of the period
 
$
6,631,251
 
 
$
4,763,771
 
Amounts provided for during the period
 
 
1,838,648
 
 
 
1,324,146
 
Decrease due to convertible notes conversion
 
 
(1,502,125
)
 
 
-
 
Balance at end of period
 
$
6,967,774
 
 
$
6,087,917
 
 
17.
Taxes payable

The Company’s taxes payable at September 30, 2011 and December 31, 2010 are summarized as follows:

    
September 30, 2011
   
December 31, 2010
 
Value-added tax payable
 
$
3,776,613
 
 
$
3,203,808
 
Income tax payable
 
 
230,172
 
 
 
3,273,776
 
Other tax payable
 
 
295,389
 
 
 
383,362
 
Balance at end of the period
 
$
4,302,174
 
 
$
6,860,946
 
 
18.
Advances payable

The amounts mainly represent advances made by the Chinese government to the Company as subsidy on interest on loans related to production facilities expansion.
 
These subsidies have different rules and regulations governing the criteria necessary for the Company to enjoy the benefits and these subsidies are recognized as income upon the government’s inspection and approval.

The balances are unsecured, interest-free and will be repayable to the Chinese government if the usage of such advance does not continue to qualify for the subsidy when the Company fails to meet those criteria.

 
21

 

19.
Share capital and additional paid-in capital

The activities in the Company’s share capital and additional paid-in capital account during the nine months ended September 30, 2011 and 2010 are summarized as follows:

    Share Capital          
    Shares     Par Value     Additional paid-in capital  
Balance at January 1, 2011
    27,175,826     $ 2,717     $ 28,565,153  
Issuance of common shares for the conversion of convertible notes 1
    907,708       91       10,111,778  
Balance at September 30, 2011
    28,083,534     $ 2,808     $ 38,676,931  
 
    
Share Capital
   
 
 
   
Shares
   
Par Value
   
Additional paid-in capital
 
Balance at January 1, 2010
    27,046,244     $ 2,704     $ 27,515,064  
Shares issued for stock options exercised
    69,582       7       278,893  
Share-based compensation
    -       -       422,714  
Balance at September 30, 2010
    27,115,826     $ 2,711     $ 28,216,671  
 
 
1.
On March 1, 2011, an investor converted $6,428,571 principal amount of the Convertible Notes at a conversion price of $7.0822 per share, and the Company issued 907,708 shares of its common stock to the investor. No additional consideration was paid for the conversion of the Convertible Notes into common stock. The market price of the Company’s common stock was $11.14 on such date.

20.
Noncontrolling interests

The Company’s activities in respect of the amounts of the noncontrolling interests’ equity at September 30, 2011 and 2010 are summarized as follows:

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Balance at beginning of the period
 
$
35,966,773
   
$
27,138,357
 
Add: Additions during the period–
 
 
   
 
 
   
Income attributable to noncontrolling interests
 
 
5,241,143
 
 
 
8,227,985
 
Less: Decreases during the period
 
 
   
 
 
   
Dividends declared to the noncontrolling interest holders of joint-venture companies
 
 
(2,005,274
)
 
 
(3,288,909
)
Foreign currency translation gain
 
 
1,601,448
 
 
 
551,867
 
Balance at end of period
 
$
40,804,090
 
 
$
32,629,300
 
 
21.
Retained earnings—Appropriated
 
Pursuant to the relevant PRC laws and regulations of Sino-foreign joint venture enterprises, the profits distribution of the Company’s Sino-foreign joint ventures, which are based on their PRC statutory financial statements, other than based on the financial statement that was prepared in accordance with generally accepted accounting principles in the United States of America, are available for distribution in the form of cash dividends after these subsidiaries have paid all relevant PRC tax liabilities, provided for losses in previous years, and made appropriations to statutory surplus at 10%.
 
When the statutory surplus reserve reaches 50% of the registered capital of a company, additional reserve is no longer required. However, the reserve cannot be distributed to joint venture partners. Based on the business licenses of the Sino-foreign joint ventures, the registered capital of Henglong, Jiulong, Shenyang, Zhejiang, USAI, Jielong, Wuhu, and Hengsheng are $10,000,000, $4,283,170 (RMB35,000,000), $8,132,530 (RMB67,500,000), $7,000,000, $2,600,000, $6,000,000, $3,750,387 (RMB30,000,000), and $10,000,000, respectively.
 
During the nine months ended September 30, 2011 and 2010, the Company recorded appropriate statutory surplus reserve of $259,163 and $443,264, respectively.
 
22.
Financial expenses
 
During the three months ended September 30, 2011 and 2010, the Company recorded financial expenses which are summarized as follows:

    
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
Coupon interest and make-whole redemption interest
 
$
905,545
   
$
843,333
 
Interest (income) expense, net
 
 
(183,765
)
 
 
31,911
 
Foreign exchange (gain) loss, net
 
 
488,645
 
 
 
(157,538
)
(Gain) loss of note discount, net
 
 
39,821
 
 
 
(52,185
)
Handling charge
 
 
28,762
 
 
 
42,006
 
Total
 
$
1,279,008
 
 
$
707,527
 
 
 
22

 

During the nine months ended September 30, 2011 and 2010, the Company recorded financial expenses which are summarized as follows:

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
 
 
 
 
 
 
 
Interest expenses, net 1
 
$
2,261,130
 
 
$
2,109,210
 
Foreign exchange (gain) loss, net
 
 
431,333
 
 
 
(90,146
)
(Gain) loss of note discount, net
 
 
90,244
 
 
 
(65,261
)
Handling charge
 
 
119,443
 
 
 
102,628
 
Total
 
$
2,902,150
 
 
$
2,056,431
 
  
 
1.
Including coupon interest expenses and accrued make-whole redemption interest expenses associated with the Convertible Notes of $2,691,238 and $2,205,397 for the nine months ended September 30, 2011 and 2010, respectively.
  
23.
Gain on change in fair value of derivative
  
During the three months ended September 30, 2011 and 2010, the Company recorded gain on change in fair value of derivative is summarized as follows:
    
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
Gain from adjustment of fair value of compound derivative Liabilities
 
$
7,788,137
 
 
$
8,687,977
 
 
During the three months ended September 30, 2011, the Company’s common stock market price dropped to $4.72 from $8.63 at the closing of prior quarter. Thus, the intrinsic value of the embedded conversion feature in financial instruments decreased, the fair value of compound derivative liabilities decreased, and the gain on change in fair value of derivatives increased. (see note 14)
 
During the three months ended September 30, 2010, the Company’s common stock market price dropped to $15.28 from $17.60 at the beginning of the period. Thus, the intrinsic value of the embedded conversion feature in financial instruments decreased, the fair value of compound derivative liabilities decreased, and the gain on change in fair value of derivatives increased. (see note 14)
 
During the nine months ended September 30, 2011 and 2010, the Company recorded gain on change in fair value of derivative is summarized as follows:
    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Gain from adjustment of fair value of compound derivative Liabilities
 
$
19,373,520
 
 
$
14,122,730
 
 
During the nine months ended September 30, 2011, the Company’s common stock market price dropped to $4.72 from $13.62 at the beginning of the period. Thus, the intrinsic value of the embedded conversion feature in financial instruments decreased, the fair value of compound derivative liabilities decreased, and the gain on change in fair value of derivatives increased. (see note 14)
 
During the nine months ended September 30, 2010, the Company’s common stock market price dropped to $15.28 from $18.71 at the beginning of the period. Thus, the intrinsic value of the embedded conversion feature in financial instruments decreased, the fair value of compound derivative liabilities decreased, and the gain on change in fair value of derivatives increased. (see note 14)
 
24.
Gain on Convertible Notes conversion
 
During the three months ended September 30, 2011 and 2010, no Convertible Notes were converted.
 
During the nine months ended September 30, 2011, gain on Convertible Notes conversion was $1,564,418. During the nine months ended September 30, 2010, no Convertible Notes were converted. (see note 13)

 
23

 

25.
Income tax rate
 
The Company’s subsidiaries registered in the PRC are subject to state and local income taxes within the PRC at the applicable tax rate of 25% on the taxable income as reported in their PRC statutory financial statements in accordance with the relevant income tax laws applicable to foreign invested enterprise.

Pursuant to the New China Income Tax Law and the Implementing Rules (New CIT) which were effective as of January 1, 2008, dividends generated after January 1, 2008 and payable by a foreign-invested enterprise to its foreign investors will be subject to a 10% withholding tax if the foreign investors are considered as non-resident enterprises without any establishment or place within China or if the dividends payable have no connection with the establishment or place of the foreign investors within China, unless any such foreign investor’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement.
 
Genesis, the Company’s wholly owned subsidiary and the direct holder of the equity interests in the Company’s Joint Venture subsidiaries in China, is incorporated in Hong Kong. According to the Mainland and Hong Kong Taxation Arrangement, dividends paid by a foreign-invested enterprise in China to its direct holding company in Hong Kong will be subject to withholding tax at a rate of no more than 5%, if the foreign investor owns directly at least 25% of the shares of the foreign-invested enterprise. Under the New CIT Law and the Implementing Rules, if Genesis is regarded as a non-resident enterprise and therefore is required to pay a 5% withholding tax for any dividends payable to it from Joint Venture subsidiaries.
 
The Company provides for deferred income taxes on the unremitted earnings of foreign subsidiaries unless such earnings are deemed to be permanently reinvested outside the United States.
 
As of September 30, 2011, the Company still has undistributed earnings of approximately $93 million from investment in foreign subsidiaries that are considered permanently reinvested. Since these amounts are permanently reinvested, no deferred income tax has been provided on such earnings.
 
During 2009, Jiulong was awarded the title of Advanced Technology Enterprises, and based on the PRC income tax law, it was subject to enterprise income tax at a rate of 15% for 2008, 2009 and 2010. In 2011, the Company expects Jiulong to qualify for Advanced Technology Enterprises and continue to be taxed at the 15% tax rate based on the Company’s assessment of its qualification to obtain the preferential tax rate. However, this is subject to re-assessment by the government, and if approved, its term will be extended for another three years. If Jiulong fails to pass the re-assessment by the government, it would be subject to a tax rate of 25%.
 
During 2008, Henglong was awarded the title of Advanced Technology Enterprises, and based on the PRC income tax law, it was subject to enterprise income tax at a rate of 15% for 2008, 2009 and 2010. In 2011, the Company expects Henglong to qualify for Advanced Technology Enterprises and continue to be taxed at the 15% tax rate based on the Company’s assessment of its qualification to obtain the preferential tax rate. However, this is subject to re-assessment by the government, and if approved, its term will be extended for another three years. If Henglong fails to pass the re-assessment by the government, it would be subject to a tax rate of 25%.
 
During 2009, Shenyang was awarded the title of Advanced Technology Enterprises, and based on the PRC income tax law, it was subject to enterprise income tax at a rate of 15% for 2009, 2010 and 2011.
 
During 2009, Zhejiang was awarded the title of Advanced Technology Enterprises, and based on the PRC income tax law, it was subject to enterprise income tax at a rate of 15% for 2009, 2010 and 2011.
 
Wuhu is subject to income tax at a rate of 11%, 12% and 12.5% for the three years from 2010 to 2012, and Jielong and Hengsheng are subject to income tax at a rate of 12.5% for the three years from 2010 to 2012.
 
There is no assessable profit for USAI and Testing Center in 2010, 2009 and 2008. Based on PRC income tax laws, they are subject to income tax at a rate of 12.5% for 2011 and 2012 if they have taxable income.
 
No provision for Hong Kong tax is made as Genesis is an investment holding company, and has no operating income in Hong Kong for the three months and the nine months ended September 30, 2010 and 2011. The Hong Kong enterprise income tax rate is 16.5%.
 
No provision for US tax is made as the Company has no operating income in the US for the three months and the nine months ended September 30, 2010 and 2011. The US enterprise income tax rate is 35%.
 
26.
Income per share
 
In periods when the Company generates income, the Company calculates basic earnings per share (“EPS”) using the two-class method, pursuant to ASC 260, “Earnings Per Share” . The two-class method is required as the Company’s Convertible Notes qualify as participating securities, having the right to receive dividends should dividends be declared on common stock. Under this method, earnings for the period are allocated on a pro-rata basis to the common stockholders and to the holders of Convertible Notes based on the weighted average number of common shares outstanding and number of shares that could be converted. The Company does not use the two-class method in periods when it generates a loss as the holders of the Convertible Notes do not participate in losses.

 
24

 

For diluted earnings per share, the Company uses the more dilutive of the if-converted method or two-class method for Convertible Notes and treasury stock method for options, assuming the issuance of common shares, if dilutive, resulting from the exercise of options and warrants.
 
The calculations of diluted income per share attributable to the parent company were:
 
    
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
Numerator:
 
 
 
 
 
 
Net income attributable to the parent company
 
$
10,108,847
 
 
$
15,935,386
 
Allocation to Convertible Notes holders
 
 
(1,071,091
)
 
 
(2,153,261
)
Net income attributable to the parent company’s common shareholders – Basic
 
 
9,037,756
 
 
 
13,782,125
 
Dilutive effect of:
 
 
   
 
 
   
Add: Allocation to convertible Notes holders
 
 
1,071,091
 
 
 
2,153,261
 
Add: Interest expenses of convertible Notes payable
 
 
905,545
 
 
 
843,333
 
Less: Gain on change in fair value of derivative
 
 
(7,788,137
)
 
 
(8,687,977
)
Net income attributable to the parent company’s common shareholders – Diluted
 
$
3,226,255
 
 
$
8,090,742
 
 
 
 
   
 
 
   
Denominator:
 
 
   
 
 
   
Weighted average shares outstanding
 
 
28,083,534
 
 
 
27,112,689
 
Dilutive effects of stock options
 
 
92,197
 
 
 
214,000
 
Dilutive effect of convertible notes
 
 
3,328,264
 
 
 
4,235,972
 
Denominator for dilutive income per share – Diluted
 
 
31,503,995
 
 
 
31,562,661
 
 
 
 
   
 
 
   
Net income per common share attributable to parent company – Basic
 
$
0.32
 
 
$
0.51
 
Net income per common share attributable to parent company – Diluted
 
$
0.10
 
 
$
0.26
 
 
The following table summarizes potential common shares outstanding excluded from the calculation of diluted income per share for three months ended September 30, 2011 and 2010 because such an inclusion would have an anti-dilutive effect.
 
    
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
Shares issuable under stock options
 
 
52,500
 
 
 
-
 

    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
Numerator:
 
 
 
 
 
 
Net income attributable to the parent company
 
$
34,094,787
 
 
$
39,436,540
 
Allocation to convertible notes holders
 
 
(3,831,484
)
 
 
(5,334,715
)
Net income attributable to the parent company’s common shareholders – Basic
 
 
30,263,303
 
 
 
34,101,825
 
Dilutive effect of:
 
 
   
 
 
   
Add: Allocation to convertible notes holders
 
 
3,831,484
 
 
 
5,334,715
 
Add: Interest expenses of convertible notes payable
 
 
2,691,238
 
 
 
2,205,397
 
Less: Gain on change in fair value of derivative
 
 
(19,373,520
)
 
 
(14,122,730
)
Less: Gain on convertible notes conversion
 
 
(1,564,418
)
 
 
-
 
Net income attributable to the parent company’s common shareholders – Diluted
 
$
15,848,087
 
 
$
27,519,207
 
 
 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
 
Weighted average shares outstanding
 
 
27,881,821
 
 
 
27,078,180
 
Dilutive effects of stock options
 
 
119,455
 
 
 
245,967
 
Dilutive effect of convertible notes
 
 
3,529,977
 
 
 
4,235,972
 
Denominator for dilutive income per share – Diluted
 
 
31,531,253
 
 
 
31,560,119
 
 
 
 
 
 
 
 
 
 
Net income per common share attributable to parent company – Basic
 
$
1.09
 
 
$
1.26
 
Net income per common share attributable to parent company – Diluted
 
$
0.50
 
 
$
0.87
 

 
25

 

The following table summarizes potential common shares outstanding excluded from the calculation of diluted income per share for the nine months ended September 30, 2011 and 2010 because such an inclusion would have an anti-dilutive effect.
 
    
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
 
 
 
 
 
 
 
Shares issuable under stock options
 
 
37,500
 
 
 
-
 
 
27.
Significant concentrations
 
A significant portion of the Company’s business is conducted in China where the currency is the RMB. Regulations in China permit foreign owned entities to freely convert the RMB into foreign currency for transactions that fall under the "current account," which includes trade related receipts and payments, interest and dividends. Accordingly, the Company’s Chinese subsidiaries may use RMB to purchase foreign exchange for settlement of such "current account" transactions without pre-approval. However, pursuant to applicable regulations, foreign-invested enterprises in China may pay dividends only out of their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations. In calculating accumulated profits, foreign investment enterprises in China are required to allocate at least 10% of their accumulated profits each year, if any, to fund certain reserve funds, including mandated employee benefits funds, unless these reserves have reached 50% of the registered capital of the enterprises.
 
Transactions other than those that fall under the "current account" and that involve conversion of RMB into a foreign currency are classified as "capital account" transactions; examples of "capital account" transactions include repatriations of investment by or loans to foreign owners, or direct equity investments in a foreign entity by a China domiciled entity. "Capital account" transactions require prior approval from China's State Administration of Foreign Exchange, or SAFE, or its provincial branch to convert a remittance into a foreign currency, such as U.S. Dollars, and transmit the foreign currency outside of China.
 
This system could be changed at any time and any such change may affect the ability of the Company or its subsidiaries in China to repatriate capital or profits, if any, outside China. Furthermore, SAFE has a significant degree of administrative discretion in implementing the laws and has used this discretion to limit convertibility of current account payments out of China. Whether as a result of a deterioration in the Chinese balance of payments, a shift in the Chinese macroeconomic prospects or any number of other reasons, China could impose additional restrictions on capital remittances abroad. As a result of these and other restrictions under the laws and regulations of the People's Republic of China, or the PRC, the Company’s China subsidiaries are restricted in their ability to transfer a portion of their net assets to the parent. The Company has no assurance that the relevant Chinese governmental authorities in the future will not limit further or eliminate the ability of the Company’s Chinese subsidiaries to purchase foreign currencies and transfer such funds to the Company to meet its liquidity or other business needs.
 
The Company grants credit to its customers, generally on an open account basis. Majority of the Company’s customers are located in the PRC.
 
During the nine months ended September 30, 2011, the Company’s ten largest customers accounted for 73.1% of its consolidated net sales, with each of two customers individually accounting for more than 10% of consolidated net sales, i.e., 12.0%, and 10.0% individually, or an aggregate of 22.0%. At September 30, 2011, approximately 16.5% of accounts receivable were from trade transactions with the aforementioned two customers.
 
During the nine months ended September 30, 2010, the Company’s ten largest customers accounted for 76.3% of its consolidated net sales, with each of two customers individually accounting for more than 10% of consolidated net sales, i.e., 15.3%, and 11.7% individually, or an aggregate of 27.0%. At September 30, 2010, approximately 16.2% of accounts receivable were from trade transactions with the aforementioned two customers.
 
 
26

 
 
28.
 Related party transactions and balances
 
Related party transactions with companies with common directors are as follows:
 
Related sales
 
   
Three Months Ended September 30,
 
   
2011
   
2010
 
Merchandise sold to related parties
  $ 7,817,723     $ 1,717,483  

   
Nine Months Ended September 30,
 
   
2011
   
2010
 
Merchandise sold to related parties
  $ 30,474,574     $ 6,319,594  
 
Related purchases
 
   
Three Months Ended September 30,
 
 
 
2011
   
2010
 
Materials purchased from related parties
  $ 2,842,267     $ 4,885,768  
Technology purchased from related parties
    262,967       119,383  
Equipment purchased from related parties
    807,259       406,894  
Total
  $ 3,912,493     $ 5,412,045  

 
 
Nine Months Ended September 30,
 
 
 
2011
   
2010
 
Materials purchased from related parties
    12,972,362     $ 14,481,952  
Technology purchased from related parties
    324,776       295,861  
Equipment purchased from related parties
    3,078,861       1,741,842  
Total
  $ 16,375,999     $ 16,519,655  
 
Related receivables
 
   
September 30, 2011
   
December 31, 2010
 
Accounts receivable
  $ 9,716,604     $ 5,466,842  
Other receivables
    432,287       350,464  
Total
  $ 10,148,891     $ 5,817,306  
 
Related advances
 
   
September 30, 2011
   
December 31, 2010
 
Advanced equipment payment to related parties
  $ 5,507,634     $ 7,534,440  
Advanced components and parts processing charges and others
    1,061,303       1,334,069  
Total
  $ 6,568,937     $ 8,868,509  

Related payables
 
   
September 30, 2011
   
December 31, 2010
 
Accounts payable
  $ 1,584,274     $ 1,867,926  
 
These transactions were consummated under similar terms as those with the Company's customers and suppliers.
 
Related parties pledged certain land use rights and buildings as security for the Company’s credit facilities provided by banks.
 
As of November 8, 2011, the date the Company issued these financial statements, Hanlin Chen, Chairman, owns 63.6% of the common stock of the Company and has the effective power to control the vote on substantially all significant matters without the approval of other stockholders.
 
 
27

 

29.
Commitments and contingencies
 
Legal Proceedings – On October 25, 2011, a purported securities class action was filed in the United States District Court for the Southern District of New York on behalf of all purchasers of the Company’s securities between March 25, 2010 and March 17, 2011. The complaint alleges that the Company and certain of its present and former officers and directors violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and the rules promulgated thereunder, and seeks unspecified damages. The Company has not yet responded to the complaint, but believes the allegations in the complaint are without merit. The Company intends to defend itself vigorously against the claims.

Other than the above, the Company is not currently a party to any threatened or pending legal proceedings, other than incidental litigation arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows.
 
In addition to the convertible notes, bank loans, notes payables and the related interest, the following table summarizes the Company’s major commitments and contingencies as of September 30, 2011:
 
   
Payment Obligations by Period
 
      2011 1     2012       2013       2014    
Thereafter
   
Total
 
Obligations for service agreements
  $ -     $ 204,567     $ -     $ -     $ -     $ 204,567  
Interest on Convertible Notes, redemption at maturity and short-term bank loan
    178,098       1,353,204       4,442,107       -       -       5,973,409  
Obligations for purchasing agreements
    11,338,115       1,964,622       -       -       -       13,302,737  
Total
  $ 11,515,213     $ 3,522,393     $ 4,442,107     $ -     $