Unassociated Document

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

  
FORM 10-Q
(Amendment No. 1)
 


(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended: September 30, 2010
 
or
 
¨
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from to
 
For the transition period from              to              .

Commission File Number: 001-34373


 
CHINA NATURAL GAS, INC.
(Exact name of registrant as specified in its charter)
 

 
Delaware
 
98-0231607
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
 
19th Floor, Building B, Van Metropolis
35 Tang Yan Road, Hi-Tech Zone
Xi’an, 710065, Shaanxi Province, China
+86-29-8832-7391
 (Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)
 

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer   ¨
Accelerated filer                      x
Non-accelerated filer        ¨
Smaller reporting company     ¨
(Do not check if a smaller reporting company)
 

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

The number of shares outstanding of the registrant’s common stock as of November 10, 2010 was 21,321,904.
 
 
 

 

EXPLANATORY NOTE
 
This Amendment No. 1 on Form 10-Q/A (the “Amended Filing”) amends the Quarterly Report on Form 10-Q for the quarter ended September 30, 2010, originally filed on November 15, 2010 (the “Original Filing”).
 
As disclosed in the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2010, as of March 31, 2010, the Company had outstanding balances of $9,858,240 and $4,401,000 of loan receivables, extended to Ms. Taoxiang Wang (the “Wang Loan”) and Shanxi JunTai Housing Purchase Ltd. respectively (the “Juntai Loan”) (together with the Wang Loan, the “Loans”). As of September 30, 2010, the Loans have been repaid in full.

The Company’s Board of Directors has concluded that the Wang Loan was made to parties related to the Company’s Chief Executive Officer and Chairman of the Company’s Board of Directors, Mr. Qinan Ji, for the benefit of those related parties, and that the nature of the Wang Loan had not been properly disclosed to the Company's Board of Directors and Audit Committee, its Independent Registered Public Accounting Firm, Frazer Frost, LLP at the time the Wang Loan was made, or its current Independent Registered Public Accounting Firm, Friedman LLP at the time they were engaged as the Company’s new Independent Registered Public Accounting Firm in December 2010. Furthermore, neither of the Loans were reported to or approved by the Company’s Board of Directors.

As a result, the Company filed a Current Report on Form 8-K on September 21, 2011 to disclose that its financial statements in the Original Filing should no longer be relied upon due to a failure to correctly disclose the Wang Loan as a related party transaction.

The purpose of this Amended Filing is to reclassify the Wang Loan and properly disclose the related party transaction nature of the Wang Loan. The amendments herein include: (i) reclassification of the Wang Loan from Loan Receivables to Loan Receivables – Related Party, (ii) disclosure of the related party transaction nature of the Wang Loan; and (iii) other disclosures related to the foregoing, including additional material weaknesses in the Company’s disclosure controls and procedures and internal control over financial reporting and certain remediation measures related thereto.

In accordance with Rule 12b-15 under the Exchange Act, each item of the Original Filing, that is amended by this Amended Filing is also restated in its entirety, and this Amended Filing is accompanied by currently dated certifications on Exhibits 31.1, 31.2, 32.1 and 32.2 by the Company’s Chief Executive Officer and Chief Financial Officer. Except as described above, this Amended Filing does not amend, update, or change any items, financial statements, or other disclosures in the Original Filing, and does not reflect events occurring after the filing of the Original Filing, including as to any exhibits to the Original Filing affected by subsequent events. Information not affected by the changes described above is unchanged and reflects the disclosures made at the time of the Original Filing. Accordingly, this Amended Filing should be read in conjunction with the Original Filing and our other SEC filings subsequent to the filing of the Original Filing, including any other amendments to those filings. Capitalized terms not defined in the Amended Filing are as defined by the Original Filing.
 
 
 

 

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
   
Item 1.
Financial Statements
 
  3
 
Consolidated Balance Sheets as of September 30, 2010 (Unaudited) and December 31, 2009
 
  3
 
Unaudited Consolidated Statements of Income and Other Comprehensive Income for the three and nine months ended September 30, 2010 and 2009
 
4
 
Unaudited Consolidated Statements of Stockholders’ Equity
 
  5
 
Unaudited Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009
 
  6
 
Notes to Unaudited Consolidated Financial Statements
 
  7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
  32
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
  50
Item 4.
Controls and Procedures
 
  51
     
PART II. OTHER INFORMATION
   
Item 1.
Legal Proceedings
 
  53
Item 1A.
Risk Factors
 
  53
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
  54
Item 3.
Defaults Upon Senior Securities
 
  54
Item 4.
Removed and Reserved
 
  54
Item 5.
Other Information
 
  54
Item 6.
Exhibits
 
  55

 
2

 

CHINA NATURAL GAS, INC.

PART I—FINANCIAL INFORMATION

Item 1.  Financial Statements

CHINA NATURAL GAS, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
AS OF SEPTEMBER 30, 2010 AND DECEMBER 31, 2009

   
September 30,
   
December 31,
 
   
2010
       
   
(Unaudited)
   
2009
 
             
ASSETS
           
CURRENT ASSETS:
           
Cash & cash equivalents
  $ 36,340,993     $ 48,177,794  
Accounts receivable, net of allowance for doubtful accounts of $298,069 and
               
$163,280 as of September 30, 2010 and December 31, 2009, respectively
    1,388,340       1,289,116  
Other receivables
    152,828       709,741  
Other receivable - employee advances
    304,257       338,689  
Inventories
    942,683       841,837  
Advances to suppliers
    2,637,902       596,868  
Prepaid expense and other current assets
    4,011,747       1,076,915  
Loans receivable
    -       293,400  
Total current assets
    45,778,750       53,324,360  
                 
INVESTMENT IN UNCONSOLIDATED JOINT VENTURES
    1,497,000       1,467,000  
PROPERTY AND EQUIPMENT, NET
    81,451,064       72,713,012  
CONSTRUCTION IN PROGRESS
    90,032,715       52,918,236  
DEFERRED FINANCING COSTS
    1,029,624       1,336,998  
OTHER ASSETS
    17,512,159       15,854,910  
                 
TOTAL ASSETS
  $ 237,301,312     $ 197,614,516  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
CURRENT LIABILITIES:
               
Accounts payable and accrued liabilities
  $ 3,832,686     $ 2,081,261  
Other payables
    109,981       80,788  
Other payable - related party
    1,347,300       -  
Unearned revenue
    2,220,352       1,813,641  
Accrued interest
    135,415       786,052  
Taxes payable
    1,870,183       1,901,577  
Notes payable - current maturities, net of discount $856,949 and $0 as of
               
September 30, 2010 and December 31, 2009, respectively
    2,476,384       -  
Total current liabilities
    11,992,301       6,663,319  
                 
LONG TERM LIABILITIES:
               
Notes payable, net of discount $9,426,443 and $12,707,713 as of
               
September 30, 2010 and December 31, 2009, respectively
    27,240,224       27,292,287  
Derivative liabilities - warrants
    18,037,635       19,545,638  
Long term debt
    17,964,000       -  
Total long term liabilities
    63,241,859       46,837,925  
                 
Total liabilities
    75,234,160       53,501,244  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
STOCKHOLDERS' EQUITY:
               
Preferred stock, $0.0001 per share; 5,000,000 shares authorized; none issued;
    -       -  
Common stock, $0.0001 per share; 45,000,000 shares authorized,  21,321,904 and 21,183,904 shares issued and outstanding as of September 30, 2010 and December 31, 2009, respectively
    2,132       2,118  
Additional paid-in capital
    81,602,751       79,851,251  
Cumulative other comprehensive gain
    12,775,770       8,714,019  
Statutory reserves
    7,326,855       5,962,695  
Retained earnings
    60,359,644       49,583,189  
Total stockholders' equity
    162,067,152       144,113,272  
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 237,301,312     $ 197,614,516  
 
 The accompanying notes are an integral part of these consolidated statements.

 
3

 

CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
(Unaudited)
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Revenues
                       
Natural gas revenue
  $ 17,836,178     $ 15,454,386     $ 49,540,810     $ 46,140,884  
Gasoline revenue
    1,904,357       1,633,478       5,407,013       4,440,892  
Installation and others
    2,585,939       3,037,320       7,881,073       8,813,594  
Total revenues
    22,326,474       20,125,184       62,828,896       59,395,370  
                                 
Cost of revenues
                               
Natural gas cost
    9,904,265       7,536,188       26,126,909       21,773,635  
Gasoline cost
    1,798,825       1,534,806       5,076,397       4,194,615  
Installation and others
    1,234,189       1,336,498       3,525,895       3,797,586  
Total cost of revenues
    12,937,279       10,407,492       34,729,201       29,765,836  
                                 
Gross profit
    9,389,195       9,717,692       28,099,695       29,629,534  
                                 
Operating expenses
                               
Selling expenses
    3,663,654       2,668,175       9,610,436       7,845,784  
General and administrative expenses
    1,732,058       1,160,587       5,463,580       3,503,265  
Total operating expenses
    5,395,712       3,828,762       15,074,016       11,349,049  
                                 
Income from operations
    3,993,483       5,888,930       13,025,679       18,280,485  
                                 
Non-operating income (expense):
                               
Interest income
    49,403       7,248       398,790       23,940  
Interest expense
    -       (68,407 )     -       (745,064 )
Other income (expense), net
    (18,914 )     178,728       24,624       (137,954 )
Change in fair value of warrants
    449,820       (357,979 )     1,508,003       (1,473,762 )
Foreign currency exchange gain (loss)
    (54,167 )     280       (96,942 )     (50,527 )
Total non-operating income (expense)
    426,142       (240,130 )     1,834,475       (2,383,367 )
                                 
Income before income tax
    4,419,625       5,648,800       14,860,154       15,897,118  
                                 
Provision for income tax
    834,783       1,001,281       2,719,539       3,185,220  
                                 
Net income
    3,584,842       4,647,519       12,140,615       12,711,898  
                                 
Other comprehensive income
                               
Foreign currency translation gain
    3,302,747       195,040       4,061,751       39,928  
Comprehensive income
  $ 6,887,589     $ 4,842,559     $ 16,202,366     $ 12,751,826  
                                 
Weighted average shares outstanding
                               
Basic
    21,321,904       15,754,696       21,251,882       14,985,001  
Diluted
    21,422,527       16,139,820       21,532,612       15,035,172  
                                 
Earnings per share
                               
Basic
  $ 0.17     $ 0.29     $ 0.57     $ 0.85  
Diluted
  $ 0.17     $ 0.29     $ 0.56     $ 0.85  
 
The accompanying notes are an integral part of these consolidated statements.

 
4

 
 
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
               
Additional
   
Accumulative
   
Retained Earnings
   
Total
 
                Other                    
   
Common Stock
   
Paid-in
   
Comprehensive
   
Statutory
         
Stockholders'
 
   
Shares
   
Amount
   
Capital
   
Gain
   
Reserve
   
Unrestricted
   
Equity
 
Balance as of December 31, 2008
    14,600,154     $ 1,460     $ 32,115,043     $ 8,661,060     $ 3,730,083     $ 27,140,775     $ 71,648,421  
                                                         
Cumulative effect of reclassification of warrants
                    (6,858,547 )                     5,844,239       (1,014,308 )
Stock issuance for cash at $8.75
    6,583,750       658       57,607,155                               57,607,813  
Offering costs
                    (3,237,452 )                             (3,237,452 )
Options issued for services
                    44,526                               44,526  
Stock Based Compensation
                    142,146                               142,146  
Cumulative translation adjustment
                            39,928                       39,928  
Net Income
                                            12,711,898       12,711,898  
Transfer to statutory reserve
                                    1,687,330       (1,687,330 )     -  
                                                         
Balance as of September 30, 2009 (Unaudited)
    21,183,904     $ 2,118     $ 79,812,871     $ 8,700,988     $ 5,417,413     $ 44,009,582     $ 137,942,972  
                                                         
Options issued for services
                    22,008                               22,008  
Stock Based Compensation
                    16,371                               16,371  
Cumulative translation adjustment
                            13,031                       13,031  
Net Income
                                            6,118,889       6,118,889  
Transfer to statutory reserve
                                    545,282       (545,282 )     -  
                                                         
Balance as of December 31, 2009
    21,183,904     $ 2,118     $ 79,851,250     $ 8,714,019     $ 5,962,695     $ 49,583,189     $ 144,113,271  
                                                         
Exercise of stock options
    138,000       14       676,186                               676,200  
Options issued for services
                    66,024                               66,024  
Stock-based compensation
                    1,009,291                               1,009,291  
Cumulative translation adjustment
                            4,061,751                       4,061,751  
Net Income
                                            12,140,615       12,140,615  
Transfer to statutory reserve
                                    1,364,160       (1,364,160 )     -  
                                                         
Balance as of September 30, 2010 (Unaudited)
    21,321,904     $ 2,132     $ 81,602,751     $ 12,775,770     $ 7,326,855     $ 60,359,644     $ 162,067,152  
 
The accompanying notes are an integral part of these consolidated statements.

 
5

 

CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
(Unaudited)
 
   
Nine Months Ended
 
   
September 30,
 
   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 12,140,615     $ 12,711,898  
Adjustments to reconcile net income to net cash
               
provided by operating activities:
               
Depreciation and amortization
    4,798,446       4,175,175  
Loss on disposal of equipment
    -       21,372  
Provision for bad debt
    129,167       -  
Amortization of discount on senior notes
    -       280,250  
Amortization of financing costs
    -       63,940  
Stock based compensation
    1,075,315       186,672  
Change in fair value of warrants
    (1,508,003 )     1,473,762  
Change in assets and liabilities:
               
Accounts receivable
    (200,764 )     (235,396 )
Other receivable
    561,238       (31,011 )
Other receivable - employee advances
    40,640       93,231  
Inventories
    (82,178 )     (754,309 )
Advances to suppliers
    (1,993,592 )     (971,240 )
Prepaid expense and other current assets
    (2,778,533 )     223,206  
Accounts payable and accrued liabilities
    1,681,392       611,924  
Other payables
    27,211       121,234  
Unearned revenue
    363,203       796,827  
Accrued interest
    (650,637 )     (586,173 )
Taxes payable
    (69,060 )     80,025  
Net cash provided by operating activities
    13,534,460       18,261,387  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Loan to related party
    (9,858,240 )     -  
Loans to third party
    (4,401,000 )     -  
Repayment of loans receivable – related party
    9,858,240       -  
Repayment of loans receivable – third party
    4,695,200       -  
Proceeds from sales of equipment
    -       41,308  
Purchase of property and equipment
    (6,557,183 )     (47,797 )
Additions to construction in progress
    (22,433,455 )     (18,064,065 )
Return of acquisition deposit
    1,618,100       449,970  
Prepayment for long term assets
    (8,323,603 )     (4,434,118 )
Prepayment for land use rights
    (1,765,200 )     (455,830 )
Payment for acquisition of business
    (3,648,080 )     -  
Payment for intangible assets
    (4,882,939 )     (68,347 )
Net cash used in investing activities
    (45,698,160 )     (22,578,879 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from long term loan
    17,652,000       -  
Stock issued from exercise of stock options
    676,200       -  
Proceeds from stock issuance
    -       57,607,813  
Payment for offering costs
    -       (3,237,452 )
Proceeds from related party loan
    1,323,900       -  
Net cash provided by financing activities
    19,652,100       54,370,361  
                 
Effect of exchange rate changes on cash and cash equivalents
    674,799       24,327  
                 
NET (DECREASE) INCREASE IN CASH & CASH EQUIVALENTS
    (11,836,801 )     50,077,196  
                 
CASH & CASH EQUIVALENTS, BEGINNING OF PERIOD
    48,177,794       5,854,383  
                 
CASH & CASH EQUIVALENTS, END OF PERIOD
  $ 36,340,993     $ 55,931,579  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Interest paid, net of capitalized interest
  $ 2,629,926     $ 1,014,956  
Income taxes paid
  $ 3,012,334     $ 3,176,730  
                 
Non-cash transactions for investing and financing activities:
               
Construction in progress transferred to property and equipment
  $ 4,143,807     $ 2,199  
Prepayment on long term assets transferred to construction in process
  $ 15,924,502     $ 57,756  
Capitalized interest - amortization of  discount of notes payable and issuance cost
  $ 2,731,695     $ 1,983,698  
 
The accompanying notes are an integral part of these consolidated statements.

 
6

 

CHINA NATURAL GAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Note 1 - Organization

Organization and Line of Business

China Natural Gas, Inc. (the “Company”) was incorporated in the state of Delaware on March 31, 1999. The Company through its wholly-owned subsidiaries and variable interest entities, located in Hong Kong, Shaanxi Province, Henan Province and Hubei Province in the People’s Republic of China (“PRC”), engages in sales and distribution of natural gas and gasoline to commercial, industrial and residential customers through fueling stations and pipelines, construction of pipeline networks, installation of natural gas fittings and parts for end-users, and conversions of gasoline-fueled vehicles to hybrid (natural gas/gasoline) powered vehicles at automobile conversion sites.

Recent Developments

On September 8, 2009, Shaanxi Xilan Natural Gas Equipment Co., Ltd (“Xilan Equipment”) increased its registered capital by $26,000,000 from $53,929,260 to $79,929,260. The Company contributed $10,000,000 and $16,000,000 in registered capital to Xilan Equipment on September 29, 2009 and January 13, 2010, respectively.

On February 5, 2010 and April 23, 2010, Jingbian Liquefied Natural Gas Co., Ltd. (“JBLNG”) increased its registered capital by $6,026,343 and $11,668,376, respectively, which was invested by Xi’an Xilan Natural Gas Co., Ltd. (“XXNGC”) in the form of equipment and cash.

During the second quarter of 2010, XXNGC effectively acquired 100% of the assets and operating rights of four natural gas stations in Xi’an, PRC, for aggregate cash consideration of $10,502,490.

On May 29, 2010, Hubei Xilan Natural Gas Co., Ltd. (“Hubei Xilan”) agreed to purchase 100% of the equity interests of Hanchuan Makou Yuntong Compress Natural Gas Co., Ltd. (“Makou”), a limited liability company formed under the laws of the PRC, from eight individuals for a purchase price of $3,648,080.  Makou owns and operates a CNG compressor station in Hanchuan City, Hubei Province, and purchases natural gas from pipelines, conducts compressing and sells natural gas on a wholesale basis through tankers to fueling stations in Hubei Province. In July 2010, Hubei Xilan obtained full control of Makou’s assets, operations and financial policies.

Note 2 - Restatement of Previously Reported Consolidated Financial Statement

The Company is hereby restating its quarterly consolidated financial statements as of September 30, 2010, originally filed on November 15, 2010 (the “Original Filing”), to make appropriate disclosure of the related party transaction nature of certain unauthorized loan made by the Company, and reclassify the loan into appropriate account in the consolidated financial statements and revise the description in the notes to such financial statements .

In the first quarter of 2010, the Company extended loans of $9,858,240 to Ms. Taoxiang Wang (the “Wang Loan”) and $4,401,000 to Shanxi JunTai Housing Purchase Ltd. Respectively (the “Juntai Loan”) (together with the Wang Loan, the “Loans”). The Company’s Board of Directors has concluded that the Wang Loan was made to parties related to the Company’s Chief Executive Officer and Chairman of the Company’s Board of Directors, Mr. Qinan Ji, for the benefit of those related parties, and that the nature of the Wang Loan had not been properly disclosed to the Company's Board of Directors and Audit Committee, its Independent Registered Public Accounting Firm, Frazer Frost, LLP at the time the Wang Loan was made, or its current Independent Registered Public Accounting Firm, Friedman LLP at the time they were engaged as the Company’s new Independent Registered Public Accounting Firm in December 2010. Furthermore, neither of the Loans were reported to or approved by the Company’s Board of Directors.

The Company’s Board of Directors made a decision to restate the consolidated financial statements upon the recommendation of the Audit Committee and management. The general nature and scope of the adjustments are summarized as follows:
 
(1)
Disclosure of related party transaction nature and reclassification of loans receivable ——Xi’an Demaoxing Real Estate Co., Ltd. (“Demaoxing”) was formed in November 2007 by relatives of Mr. Qinan Ji, the Company’s Chief Executive Officer and Chairman of the Company’s Board of Directors (the “Demaoxing Promoters”). In January 2010, Shaanxi Xilan Natural Gas Equipment Co., Ltd.  (“SXNGE”), one of the Company’s major subsidiaries, extended a loan of US$9,858,240 to Ms. Taoxiang Wang (the “Wang Loan”), who obtained a 40% ownership interest in Demaoxing on January 21, 2010. Ms. Taoxiang Wang used her 40% ownership interest in Demaoxing and its assets as collateral for the Wang Loan. On January 21, 2010, the Demaoxing Promoters also transferred 30% of their ownership interests in Demaoxing to Shaanxi Rongxin Real Estate Co., Ltd. (“Rongxin”). On January 26, 2010, the Wang Loan funds were remitted by SXNGE to an account of Demaoxing. The Board of Directors has determined that the Demaoxing Promoters retained indirect beneficial interests in Demaoxing after transferring their ownership interests and thus the Wang Loan was a related party transaction. The Company herein makes appropriate disclosures of the related party transaction nature of the Wang Loan and reclassifies the Wang Loan from Loans Receivable to Loans Receivable – Related Party throughout its quarterly consolidated financial statements for the period ended September 30, 2010.
  
In the statement of cash flows for the nine months ended September 30, 2010, the following reclassification is made:

(1)
The item Loans to Third Parties of $14,259,240 is reclassified into two items, which are Loans to Related Party of $9,858,240 and Loans to Third Party of $4,401,000, respectively.

(2)
The item Repayment of loans receivable of $14,553,440 is reclassified into two items, which are Repayment of loans receivable – related party of $9,858,240 and Repayment of loans receivable – third party of $4,695,200

Note 3- Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company’s functional currency is the PRC Renminbi (“RMB”); however, the Company’s reporting currency is the United States dollar; therefore, the accompanying consolidated financial statements have been translated and presented in United States dollars.

In the opinion of management, the consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair presentation of the results for the interim period presented. Operating results for the period ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ended December 31, 2010. The information included in this Quarterly Report on Form 10-Q/A should be read in conjunction with information included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, as amended.

Use of Estimates

The preparation of consolidated 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, and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
 
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Principles of Consolidation

The accompanying financial statements include the accounts of China Natural Gas, Inc. and its wholly-owned subsidiaries, and its 100% variable interest entity (“VIE”), XXNGC, and XXNGC’s wholly-owned subsidiaries.  All inter-company accounts and transactions have been eliminated in the consolidation.

Consolidation of Variable Interest Entity

In accordance with Financial Accounting Standards Board’s (“FASB”) accounting standard regarding consolidation, VIEs are generally entities that lack sufficient equity to finance their activities without additional financial support from other parties or whose equity holders lack adequate decision making ability. All VIEs with which the Company is involved must be evaluated to determine the primary beneficiary of the risks and rewards of the VIE. The primary beneficiary is required to consolidate the VIE for financial reporting purposes.

On February 21, 2006, the Company formed Xilan Equipment as a wholly foreign owned enterprise (“WFOE”) under the laws of the PRC. Then, through Xilan Equipment, the Company entered into exclusive arrangements with XXNGC and its shareholders that give the Company the ability to substantially influence XXNGC’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholder approval. The Company memorialized these arrangements on August 17, 2007. As a result, the Company consolidates the financial results of XXNGC as a VIE. The Company’s arrangements with XXNGC consist of the following agreements:

 
Consulting Service Agreement, dated August 17, 2007. Under this agreement entered into between Xilan Equipment and XXNGC, Xilan Equipment provides XXNGC exclusive consulting services with respect to XXNGC’s general business operations, human resources and research and development. In return, XXNGC pays a quarterly service fee to Xilan Equipment, which is equal to XXNGC’s revenue for such quarter. The term of this agreement is indefinite unless Xilan Equipment notifies XXNGC of its intention to terminate this agreement. XXNGC may not terminate this agreement during its term. This agreement is retroactive to March 8, 2006.

 
Operating Agreement, dated August 17, 2007. Under this agreement entered into between Xilan Equipment, on the one hand, and XXNGC and certain shareholders of XXNGC, on the other hand, Xilan Equipment agrees to fully guarantee XXNGC’s performance of all operations-related contracts, agreements or transactions with third parties, and, in return, XXNGC agrees to pledge all of its assets, including accounts receivable, to Xilan Equipment. The XXNGC shareholders party to this operating agreement agree to, among other things, appoint as XXNGC’s directors, individuals recommended by XXNGC, and appoint Xilan Equipment’s senior officers as XXNGC’s general manager, chief financial officer and other senior officers. The term of this agreement is indefinite unless Xilan Equipment notifies XXNGC of its intention to terminate this agreement with 30 days prior notice. XXNGC may not terminate this agreement during its term. This agreement is retroactive to March 8, 2006.

 
Equity Pledge Agreement, dated August 17, 2007. Under this agreement entered into between Xilan Equipment, on the one hand, and XXNGC and certain shareholders of XXNGC, on the other hand, to secure the payment obligations of XXNGC under the consulting service agreement described above, the XXNGC shareholders party to this equity pledge agreement have pledged to Xilan Equipment all of their equity ownership interests in XXNGC. Upon the occurrence of certain events of default specified in this agreement, Xilan Equipment may exercise its rights and foreclose on the pledged equity interest. Under this agreement, the pledgors may not transfer the pledged equity interest without Xilan Equipment’s prior written consent. This agreement will also be binding upon successors of the pledgor and transferees of the pledged equity interest. The term of the pledge is two years after the obligations under the Consulting Service Agreement have been fulfilled. This agreement is retroactive to March 8, 2006.
 
 
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Option Agreement, dated August 17, 2007. Under this option agreement entered into between Xilan Equipment, on the one hand, and XXNGC and certain shareholders of XXNGC, on the other hand, the XXNGC shareholders party to this option agreement irrevocably granted to Xilan Equipment, or any third party designated by Xilan Equipment, the right to acquire, in whole or in part, the respective equity interests in XXNGC of these XXNGC shareholders. The option agreement can be terminated by Xilan Equipment by notifying XXNGC of its intention to terminate this agreement with 30 days prior notice. The option agreement is retroactive to March 8, 2006.

 
Addendum to the Option Agreement, dated August 8, 2008. Under this addendum to the option agreement entered into between Xilan Equipment, on the one hand, and XXNGC and certain shareholders of XXNGC, on the other hand, the XXNGC shareholders irrevocably granted to Xilan Equipment an option to purchase the XXNGC shareholders’ additional equity interests in XXNGC (the “Additional Equity Interest”) in connection with any increase in XXNGC’s registered capital subsequent to the execution of the option agreement described above, at $1.00 or the lowest price permissible under applicable law at the time that Xilan Equipment exercises the option to purchase the Additional Equity Interest. The option agreement can be terminated by Xilan Equipment by notifying XXNGC of its intention to terminate this agreement with 30 days prior notice. This addendum is retroactive to June 30, 2008.

 
Proxy Agreement, dated August 17, 2007. Under this agreement entered into between Xilan Equipment, on the one hand, and XXNGC and certain shareholders of XXNGC, on the other hand, the XXNGC shareholders irrevocably granted to Xilan Equipment the right to exercise their shareholder voting rights, including attendance at and voting of their shares at shareholders meetings in accordance with the applicable laws and XXNGC’s articles of association. This agreement is retroactive to March 8, 2006.

Foreign Currency Translation

The Company’s reporting currency is the United States dollar. The functional currency of XXNGC and the Company’s and XXNGC’s PRC subsidiaries, and, therefore, the functional currency of the Company, is the RMB. The results of operations and financial position of XXNGC and the Company’s and XXNGC’s PRC subsidiaries are translated to United States dollars using the period end exchange rates as to assets and liabilities and weighted average exchange rates as to revenues, expenses and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. The resulting currency translation adjustments are recorded as a component of accumulated other comprehensive income (loss) within stockholders’ equity. As a result, translation adjustment amounts related to assets and liabilities reported on the consolidated statement of cash flows will not necessarily agree with changes in the corresponding consolidated balances on the balance sheet. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.

The balance sheet amounts, with the exception of equity, were translated at the September 30, 2010 exchange rate of RMB 6.68 to $1.00 as compared to RMB 6.82 to $1.00 at December 31, 2009. The equity accounts were stated at their historical rate. The average translation rates applied to income and cash flow statement amounts for the three and nine months ended September 30, 2010 and 2009, were RMB 6.80 to $1.00 and RMB 6.82 to $1.00, respectively.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and demand deposits in accounts maintained with state-owned banks within the PRC, and private sector banks in Hong Kong and the United States. The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.

The Company maintains balances at financial institutions which, from time to time, may exceed Hong Kong Deposit Protection Board (“HKDPB”) insured limits for the banks located in Hong Kong or may exceed Federal Deposit Insurance Corporation (“FDIC”) insured limits for the banks located in the United States. Balances at financial institutions or state-owned banks within the PRC are not covered by insurance. As of September 30, 2010 and December 31, 2009, the Company had total deposits of $35,738,594 and $47,459,560, respectively, without insurance coverage or in excess of HKDPB or FDIC insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.
 
 
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Accounts Receivable

Accounts receivable are netted against an allowance for uncollectible accounts, as necessary. The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves.

Reserves are recorded primarily on a specific identification basis in the period of the related sales. Delinquent account balances are written-off after management has determined that the likelihood of collection is not probable, and known bad debts are written off against allowance for doubtful accounts when identified. The Company recorded an allowance for bad debts in the amount of $298,069 and $163,280 as of September 30, 2010 and December 31, 2009, respectively.

Other Receivable – Employee Advances

From time to time, the Company advances predetermined amounts based upon internal Company policy to certain employees and internal units to ensure certain transactions are performed in a timely manner. The Company has full oversight and control over the advanced accounts. As of September 30, 2010 and December 31, 2009, no allowance for the uncollectible accounts was deemed necessary.

Inventories

Inventories are stated at the lower of cost, as determined on a first-in, first-out basis, or market. Management compares the cost of inventories with the market value, and an allowance is made for writing down the inventories to their market value, if lower. Inventories consist of materials used in the construction of pipelines and in repairing and modifying vehicles. Inventories also consist of gasoline.

The following are the details of the inventories:

   
September 30.
       
   
2010
   
December 31,
 
   
(unaudited)
   
2009
 
Materials and supplies
  $ 438,872     $ 345,611  
Gasoline
    503,811       496,226  
Total
  $ 942,683     $ 841,837  

Advances to Suppliers

The Company makes advances to certain vendors for purchases of materials. The advances are interest-free and unsecured.

 
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Loans Receivable

Loans receivable consists of the following:

   
September 30,
       
   
2010
   
December 31,
 
   
(unaudited)
   
2009
 
Shanxi Tuojin Mining Company, due on November 30, 2009, extended to November 30, 2010, annual interest at 5.84% (1)
  $ -     $ 293,400  
Shanxi JunTai Housing Purchase Ltd., due on January 10, 2011, annual interest at 5.84% (2)
    -       -  
Total
  $ -     $ 293,400  

(1)
This loan was repaid on March 11, 2010.
 
(2)
In January 2010, XXNGC, the variable interest entity of SXNGE, extended another loan of US$4,401,000 to Juntai, which obtained a 30% ownership interest in Demaoxing on January 21, 2010. Juntai used an individual guarantee and its 30% ownership interest in Demaoxing and its assets as collateral for the Juntai Loan. XXNGC remitted the Juntai Loan funds to an account designated by Juntai on January 8, 2010 and January 11, 2010. The Company’s Board of Directors was not notified of the extension of the Juntai Loan by the Company, and did not approve the Juntai Loan. Upon learning of the existence of the Juntai Loan in April 2010, the Board of Directors required that the Juntai Loan be immediately repaid. In May 2010, the principal of the Juntai Loan was repaid together with an interest payment of US$87,923, settling the Juntai Loan in full. The applicable interest rate of this loan is the People’s Bank of China’s standard one-year rate, 5.31% at inception of the loan, which is subject to change with the government policy, plus an additional 10% interest rate float. Pursuant to these terms, the interest rates were 5.84% at the inception date and March 31, 2010.
  
Investments in Unconsolidated Joint Ventures

Investee companies that are not consolidated, but over which the Company exercises significant influence, are accounted for under the equity method of accounting. Whether or not the Company exercises significant influence with respect to an investee depends on an evaluation of several factors including, among others, representation on the investee company’s board of directors and ownership level, which is generally a 20% to 50% interest in the voting securities of the investee company. Under the equity method of accounting, an investee company’s accounts are not reflected within the Company’s consolidated balance sheets and statements of income and other comprehensive income; however, the Company’s share of the earnings or losses of the investee company is reflected in the caption “Earnings (loss) on equity investment” in the consolidated statements of income and other comprehensive income. The Company’s carrying value in an equity method investee company is reflected in the caption “Investments in Unconsolidated Joint Ventures” in the Company’s consolidated balance sheets.

When the Company’s carrying value in an equity method investee company is reduced to zero, no further losses are recorded in the Company’s consolidated financial statements unless the Company has guaranteed obligations of the investee company or has committed additional funding. If the investee company subsequently reports income, the Company will not record its share of such income until it equals the amount of its share of losses not previously recognized.

The Company’s investment in unconsolidated joint ventures that are accounted for on the equity method of accounting represents the Company’s 49% interest in Henan CNPC Kunlun Xilan Compressed Natural Gas Co., Ltd. (“JV”), which is engaged in building and operating compressed natural gas (“CNG”) compressor stations and fueling stations, selling CNG, providing vehicle conversion services from gasoline-fueled vehicles to hybrid (natural gas/gasoline) powered vehicles and technical advisory work services in Henan Province, PRC. The investment in the JV amounted to $1,497,000 and $1,467,000 at September 30, 2010 and December 31, 2009, respectively. The JV did not have any operations as of September 30, 2010.
 
 
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The financial position of the JV as of September 30, 2010 is summarized below:

   
September 30, 2010
       
   
(unaudited)
   
December 31, 2009
 
Current assets
  $ 3,055,102     $ 2,993,878  
Noncurrent assets
    -       -  
Total assets
  $ 3,055,102     $ 2,993,878  
Current liabilities
    -       -  
Noncurrent liabilities
    -       -  
Equity
  $ 3,055,102     $ 2,993,878  
Total liabilities and equity
  $ 3,055,102     $ 2,993,878  

Property and Equipment

Property and equipment are stated at cost. Expenditures for maintenance and repairs are charged to earnings as incurred while additions, renewals and betterments are capitalized. When property and equipment are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts, and any gain or loss is included in operations. Depreciation of property and equipment is provided using the straight-line method for substantially all assets with estimated lives as follows:

Office equipment
5 years
Operating equipment
5-20 years
Vehicles
5 years
Buildings and improvements
5-30 years

The following are the details of the property and equipment:

   
September 30,
       
   
2010
   
December 31,
 
   
(unaudited)
   
2009
 
Office equipment
  $ 516,000     $ 439,055  
Operating equipment
    69,477,224       61,350,503  
Vehicles
    3,171,359       2,486,614  
Buildings and improvements
    26,407,134       21,414,553  
Total property and equipment
    99,571,717       85,690,725  
Less accumulated depreciation
    (18,120,653 )     (12,977,713 )
Property and equipment, net
  $ 81,451,064     $ 72,713,012  

Depreciation expense for the three months ended September 30, 2010 and 2009 was $1,725,861 and $1,390,659 respectively. Depreciation expense for the nine months ended September 30, 2010 and 2009 was $4,792,833 and $4,170,241 respectively.

Construction in Progress

Construction in progress consists of the cost of constructing property and equipment for CNG fueling stations and liquefied natural gas (“LNG”) projects, a natural gas infrastructure project in the Xi’an International Port District and other projects, including technology licensing fees, equipment purchases, land use rights requisition cost, capitalized interest and other construction fees. No depreciation is provided for construction in progress until such time as the assets are completed and placed into service. Interest incurred during construction is capitalized into construction in progress. All other interest is expensed as incurred.

As of September 30, 2010 and December 31, 2009, the Company had construction in progress in the amount of $90,032,715 and $52,918,236, respectively. Interest cost capitalized into construction in progress for the three months ended September 30, 2010 and 2009, amounted to $1,730,719 and $1,388,870, respectively. Interest cost capitalized into construction in progress for the nine months ended September 30, 2010 and 2009, amounted to $4,721,416 and $3,419,796, respectively.
 
 
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Construction in progress at September 30, 2010 is set forth in the table below. The estimated additional cost to complete column reflects amounts currently estimated by management to be necessary to complete the relevant project as it is currently contemplated to be completed. As of September 30, 2010, the Company was not contractually or legally obligated to expend the estimated additional cost to complete these projects, except to the extent reflected in Note 14 to these consolidated financial statements.

       
September 30,
               
       
2010
   
Commencement
 
Expected
 
Estimated additional
 
Project Description
 
Location
 
(unaudited)
   
date
 
completion date
 
cost to complete
 
Phase I of LNG Project
 
Jingbian County, Shaanxi Province, PRC
  $ 61,908,112 (1)  
December 2006
 
December 2010 (2)
  $ 6,564,156 (3)
Phases II and III of LNG Project
 
Jingbian County, Shaanxi Province, PRC
    18,151,609 (4)  
December 2006
 
December 2015
    224,550,000 (5)
Sa Pu Mother Station
 
Henan Province, PRC
    901,695    
July 2008
 
June 2011
    6,300,000  
International port(6)
 
International Port District, Xi’an, PRC
    5,051,908    
May 2009
 
December 2020
    299,400,000  
Other projects
 
PRC
    4,019,391    
Various
 
Various
    500,000  
        $ 90,032,715             $ 537,314,156  
 

(1)
Includes $54,233,249 of construction cost and $7,674,863 of capitalized interest for phase I of the LNG Project.

(2)
The Company initiated its first test run in July 2010. The remaining aspects of the test run, which the Company aims to complete in December 2010, include testing the operation of various components and equipment of phase I of the plant.

(3)
Includes $4,387,479 of construction cost and $2,176,677 of capitalized interest that the Company currently expects to expend to complete test runs and satisfy installment payments to contractors. The total expected cost of $68,472,238 million is more than the Company anticipated. The increased costs to achieve LNG processing capacity of 500,000 cubic meters are attributable to unforeseen cost overruns and escalations, including increases in material and labor costs incurred to reinforce pilings based upon modified engineering analyses, as well as rising land prices, which the Company believes resulted from recent energy resource exploration activities in nearby areas. Phase I construction has also experienced delays due to changes in government policies with respect to tariff exemptions for core equipment imported by the Company and related additional document requirements of the customs agency of Shaanxi Province, and increased international shipment times for ordered equipment due to the modification by international shippers of traditional shipment routes to avoid pirates along the coast of Somalia.

(4)
Includes $15,901,321 of construction cost and $2,250,288 of capitalized interest for phase II and phase III of the LNG project.

(5)
This amount reflects management’s current estimate that an investment in phases II and III through December 15, 2015, including an estimated $204.5 million of construction cost and $20 million of capitalized interest, would finance the construction of a facility capable of processing 3,000,000 cubic meters of LNG per day, or approximately 900 million cubic meters per year. The Company has not made a final determination regarding the processing capacity for phases II and III.
 
 
13

 

 
(6)
The Xi’an International Port District Committee, a local government agency, has appointed XXNGC pursuant to a conditional non-binding agreement to be the developer of natural gas infrastructure for the Xi’an International Port District, a formerly agricultural area that has been zoned for urbanization. If XXNGC chooses to proceed with the project, it will be responsible for constructing, and all costs related to the construction of, a natural gas pipeline network that will service residential, commercial and industrial buildings and users, as well as fueling stations and related infrastructure. The estimated cost to complete the project of $299,400,000 is based upon a third party feasibility study and management’s current estimates. The Company is currently the only natural gas provider in the surrounding area and expects that it would supply natural gas to the International Port District once construction is completed. If the Company determines not to proceed further with this project, it expects to be able to obtain a refund from subcontractors of the $5,051,908 invested as of September 30, 2010 or transfer the construction in progress assets.

Goodwill

The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is recognized as goodwill. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis in the fourth quarter or more frequently if indicators of impairment exist. The Company uses a two-step goodwill impairment test to identify the potential impairment and to measure the amount of goodwill impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.

Intangible Assets

Intangible assets mainly consist of operating rights for four natural gas stations acquired in the second quarter of 2010 and land use rights.

The operating rights are deemed to have an indefinite useful life as cash flows are expected to continue indefinitely.  The operating rights will not be amortized until their useful life is deemed to be no longer indefinite. The Company evaluates intangible assets for impairment at least annually and whenever events or changes in circumstances indicate that the assets might be impaired.

All land in the PRC is owned by the government. However, the government grants the user “land use rights.” The costs of these rights are being amortized over the remaining life of the rights using the straight-line method as follows:

Intangible assets
 
Estimated useful lives
Land use rights
 
30 years

Long-Lived Assets

The Company evaluates the carrying value of long-lived assets to be held and used at least annually and whenever events or changes in circumstances indicate that the assets might be impaired. Impairment losses are recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amounts. In that event, a loss is recognized based on the amount by which the carrying amount exceeds the fair market value of the long-lived assets. Loss on long-lived assets to be disposed of is determined in a similar manner, except that fair market values are reduced for the cost of disposal. Based on its review, the Company believes that, as of September 30, 2010, there were no significant impairments of its long-lived assets.
 
 
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Unearned Revenue

Unearned revenue represents prepayments by customers for gas purchases and advance payments on installation of pipeline contracts. The Company records such prepayments as unearned revenue when the payments are received.

Fair Value of Financial Instruments

The accounting standards regarding fair value of financial instruments and related fair value measurements define fair value, establish a three-level valuation hierarchy for disclosures of fair value measurement, and provide disclosure requirements for fair value measures. The carrying amounts reported in the consolidated balance sheets for current receivables and payables qualify as financial instruments. Management concluded the carrying values are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and if applicable, their stated interest rate approximates current rates available. The three levels are defined as follows:

 
Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 
Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 
Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The FASB accounting standard regarding derivatives and hedging specifies that a contract that would otherwise meet the definition of a derivative but is both indexed to the Company’s own stock and classified in stockholders’ equity in the statement of financial position would not be considered a derivative financial instrument. This FASB accounting standard also provides a new two-step model to be applied in determining whether a financial instrument or an embedded feature is indexed to an issuer’s own stock and thus able to qualify for the exception.

As a result of adopting this FASB accounting standard, 383,654 warrants previously treated as equity pursuant to the derivative treatment exemption are no longer afforded equity treatment because the strike price of the warrants is denominated in United States dollars, a currency other than the Company’s functional currency, the RMB. As a result, the warrants are not considered indexed to the Company’s own stock, and as such, all future changes in the fair value of these warrants will be recognized in earnings until such time as the warrants are exercised or expire.

As such, effective January 1, 2009, the Company reclassified the fair value of these warrants from equity to liability, as if these warrants had been treated as a derivative liability since their issuance in October 2007. On January 1, 2009, the Company reclassified from additional paid-in capital, as a cumulative effect adjustment, $5,844,239 to retained earnings at the beginning of the period and $1,014,308 to warrant liabilities to recognize the fair value of such warrants. The fair value of the warrants was $537,635 and $2,045,638 on September 30, 2010 and December 31, 2009, respectively. The Company recognized a gain of $449,820 and a loss of $357,979 for the three months ended September 30, 2010 and 2009, respectively, to reflect the change in fair value of the warrants. The Company recognized a gain of $1,508,003 and a loss of $1,473,762 for the nine months ended September 30, 2010 and 2009, respectively, to reflect the change in fair value of the warrants.

These common stock purchase warrants do not trade in an active securities market and, as such, the Company estimates the fair value of these warrants using the Black-Scholes Option Pricing Model with the following assumptions:

   
September 30, 2010
       
   
(unaudited)
   
December 31, 2009
 
Annual dividend yield
    -       -  
Expected life (years)
    2.07       2.82  
Risk-free interest rate
    0.44 %     1.49 %
Expected volatility
    86 %     90 %
 
 
15

 
 
Expected volatility is based on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the term of the warrants. The Company believes this method produces an estimate that is representative of the Company’s expectations of future volatility over the expected term of these warrants. The Company has no reason to believe future volatility over the expected remaining life of these warrants is likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is based on United States Treasury securities with a term equal to the remaining term of the warrants.

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Depending on the product and the terms of the transaction, the fair value of the derivative liabilities were modeled using a series of techniques, including closed-form analytic formula, such as the Black-Scholes Option Pricing Model, which does not entail material subjectivity because the methodology employed does not necessitate significant judgment and the pricing inputs are observed from actively quoted markets.

The following table sets forth by level within the fair value hierarchy the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2010.
 
   
Carrying Value at
       
   
September 30,
   
Fair Value Measurement at September 30, 2010
 
   
2010
   
(unaudited)
 
   
(unaudited)
   
Level 1
   
Level 2
   
Level 3
 
Long-term debt
  $ 17,964,000     $ -     $ -     $ 17,412,814  
Senior notes
    29,716,608       -       -       38,052,554  
Redeemable liability - warrants
    17,500,000       -       -       16,666,352  
Derivative liability - warrants
    537,635       -       537,635       -  
Total liability measured at fair value
  $ 65,718,243     $ -     $ 537,635     $ 72,131,720  
 
Other than the assets and liabilities set forth in the table set forth above, the Company did not identify any other assets or liabilities that are required to be accounted for at fair value on the balance sheet.

Revenue Recognition

Revenue is recognized when services are rendered to customers and when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition are satisfied are recorded as unearned revenue. Revenue from gas and gasoline sales is recognized when gas and gasoline is pumped through pipelines to the end users. Revenue from installation of pipelines is recorded when the contract is completed and accepted by the customers. Construction contracts are usually completed within one to two months. Revenue from repairing and modifying vehicles is recorded when services are rendered to and accepted by the customers.

Enterprise Wide Disclosure

The Company’s chief operating decision-makers (i.e. chief executive officer and the employees that directly report to the chief executive officer) review financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by business lines for purposes of allocating resources and evaluating financial performance. There are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Based on qualitative and quantitative criteria established   by the FASB’s accounting standard for segment reporting, the Company considers itself to be operating within one reportable segment.
 
 
16

 

 
Advertising Costs

The Company expenses the cost of advertising as incurred or, as appropriate, the first time the advertising takes place. Advertising costs for the three and nine months ended September 30, 2010 and 2009, were insignificant.

Stock-Based Compensation

The Company records and reports stock-based compensation pursuant to FASB’s accounting standard regarding stock compensation which requires a fair-value-based method of accounting for stock-based employee compensation and transactions in which an entity issues its equity instruments to acquire goods and services from non-employees. Stock compensation for stock granted to non-employees has been determined in accordance with this accounting standard as the fair value of the consideration received or the fair value of equity instruments issued, whichever is more reliably measured.
 
Income Taxes

The FASB’s accounting standard regarding income taxes requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of temporary differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. At September 30, 2010 and 2009, there was no significant book to tax differences. There is no difference between book depreciation and tax depreciation as the Company uses the same method for both book depreciation and tax depreciation. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.  Penalties and interest incurred related to underpayment of income tax are classified as income tax expense in the year incurred. No significant penalties or interest relating to income taxes have been incurred during the three and nine months ended September 30, 2010 and 2009.

Local PRC Income Tax

The Company’s PRC subsidiary, XXNGC and XXNGC’s subsidiaries operate in the PRC. Starting January 1, 2008, pursuant to the tax laws of the PRC, general enterprises are subject to income tax at an effective rate of 25% compared to 33% prior to 2008.  However, under PRC income tax regulation, any company deemed to be engaged in the natural gas industry under such regulation enjoys a reduced income tax rate. Thus, XXNGC’s income is subject to a reduced tax rate of 15%. The Company’s PRC subsidiary and all of XXNGC’s subsidiaries are not deemed to be engaged in the natural gas industry under PRC income tax regulation and, accordingly, are subject to a 25% income tax rate. A reconciliation of tax at the United States federal statutory rate to the provision for income tax recorded in the financial statements is as follows:

   
For the three months ended
   
For the nine months ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
   
(unaudited)
   
(unaudited)
   
(unaudited)
   
(unaudited)
 
Tax provision (credit) at United States federal statutory rate
    34 %     34 %     34 %     34 %
Foreign tax rate difference
    (9 )%     (9 )%     (9 )%     (9 )%
Effect of favorable tax rate
    (7 )%     (9 )%     (8 )%     (8 )%
Other item (1)
    1 %     2 %     1 %     3 %
Total provision for income taxes
    19 %     18 %     18 %     20 %
 

(1)
The 1% represents $276,814 in expenses incurred by the Company that are not deductible in the PRC for the three months ended September 30, 2010. The 2% represents $649,484 in expenses incurred by the Company that are not deductible in the PRC for the three months ended September 30, 2009. The 1% represents $931,830 in expenses incurred by the Company that are not deductible in the PRC for the nine months ended September 30, 2010. The 3% represents $3,774,073 in expenses incurred by the Company that are not deductible in the PRC for the nine months ended September 30, 2009.
 
 
17

 

The estimated tax savings for the three months ended September 30, 2010 and 2009 amounted to approximately $445,812 and $570,006, respectively. The net effect on earnings per share, had the United States federal income tax rate been applied, would be a decrease in basic and diluted earnings per share for the three months ended September 30, 2010 and 2009 from $0.17 to $0.15 and $0.29 to $0.25, respectively.

The estimated tax savings for the nine months ended September 30, 2010 and 2009 amounted to approximately $1,472,254 and $1,801,782, respectively. The net effect on earnings per share, had the United States federal income tax rate been applied, would be a decrease in basic earnings per share for the nine months ended September 30, 2010 and 2009 from $0.57 to $0.50 and $0.85 to $0.73, respectively. The net effect on earnings per share, had the United States federal income tax rate been applied, would be a decrease in diluted earnings per share for the nine months ended September 30, 2010 and 2009, from $0.56 to $0.49 and $0.85 to $0.73, respectively.

The Company was incorporated in the United States and has incurred a net operating loss for United States income tax purpose for the period ended September 30, 2010. The estimated net operating loss carry forwards for United States income tax purposes amounted to $3,420,655 and $2,699,276 as of September 30, 2010 and December 31, 2009, respectively, which may be available to reduce future years’ taxable income. These carry forwards will expire, if not utilized, beginning in 2027 through 2030. Management believes that the realization of the benefits arising from this loss appear to be uncertain due to the Company’s limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance at September 30, 2010. Management reviews this valuation allowance periodically and makes adjustments as warranted. The valuation allowances were as follow:
 
   
For the nine months
       
   
ended
       
   
September 30.
   
For the year ended
 
   
2010
   
December 31,
 
Valuation allowance
 
(unaudited)
   
2009
 
Balance, beginning of period
  $ 917,754     $ 563,541  
Increase
    245,269       354,213  
Balance, end of period
  $ 1,163,023     $ 917,754  

The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $41,122,033 as of September 30, 2010, which is included in consolidated retained earnings and will continue to be indefinitely reinvested in international operations.  Accordingly, no provision has been made for United States deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if the Company concluded that such earnings will be remitted in the future.

Value added tax

Sales revenue represents the invoiced value of goods, net of a value-added tax (“VAT”). The products of the Company’s VIE, XXNGC, and two of XXNGC’s subsidiaries, Lingbao Yuxi Natural Gas Co., Ltd. (“Lingbao Yuxi”) and Makou, that are sold in the PRC are subject to a PRC VAT at a rate of 13% of the gross sales price. This VAT may be offset by VAT paid by XXNGC or Lingbao Yuxi, as applicable, on raw materials and other materials included in the cost of producing their finished products. XXNGC recorded VAT payable and VAT receivable net of payments in the financial statements. The VAT tax return is filed offsetting the payables against the receivables.

All revenues from XXNGC’s subsidiary Xi’an Xilan Auto Body Shop Co., Ltd. are subject to a PRC VAT at a rate of 6%. This VAT cannot offset with VAT paid for materials included in the cost of revenues.

 
18

 

Taxes Payable

Taxes payable at September 30, 2010 and December 31, 2009 consisted of the following:

   
September 30,
       
   
2010
   
December 31,
 
   
(unaudited)
   
2009
 
Value added tax payable
  $ 981,013     $ 740,772  
Business tax payable
    -       1,540  
Income tax payable
    844,177       1,127,961  
Urban maintenance tax payable
    40,076       27,442  
Income tax for individual payable
    4,917       3,862  
Total tax payable
  $ 1,870,183     $ 1,901,577  

Basic and Diluted Earnings Per Share

Earnings per share are calculated in accordance with the FASB’s accounting standard regarding earnings per share. Basic net earnings per share are based upon the weighted average number of common shares outstanding. Diluted net earnings per share are based on the assumption that all dilutive convertible shares and stock options were converted or exercised. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.

All share and per share amounts used in the Company’s consolidated financial statements and notes thereto have been retroactively restated to reflect the 1-for-2 reverse stock split, which was effective on April 28, 2009.

Recently issued accounting pronouncements

In January 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-01, Accounting for Distributions to Shareholders with Components of Stock and Cash , which clarifies that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in earnings per share prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. The Company’s adoption of this ASU did not have a material impact on its consolidated financial statements.

In January 2010, the FASB issued ASU No. 2010-02, Accounting and Reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification , which affects accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. This ASU also affects accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity. The amendments in this update are effective beginning in the period that an entity adopts Statement of Financial Accounting Standards (“SFAS”) No. 160,  Non-controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51 . If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. The Company’s adoption of this ASU did not have a material impact on consolidated financial statements.

In January 2010, the FASB issued ASU No. 2010-06, Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: (1) transfers in and out of Levels 1 and 2: a reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers; (2) activity in Level 3 fair value measurements in the reconciliation for fair value measurements using significant unobservable inputs (Level 3) a reporting entity should present separately information about purchases, sales, issuances and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarify existing disclosures as follows: (1) level of disaggregation: a reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities; (2) Disclosures about inputs and valuation techniques: A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company is currently evaluating the impact of this ASU, however, the Company does not expect the adoption of this ASU will have a material impact on its consolidated financial statements.
 
 
19

 

 
In February 2010, the FASB issued ASU No. 2010-9, Amendments to Certain Recognition and Disclosure Requirements. This update addresses certain implementation issues related to an entity’s requirement to perform and disclose subsequent-events procedures, and removes the requirement that public companies disclose the date of their financial statements in both issued and revised financial statements. According to the FASB, the revised statements include those that have been changed to correct an error or conform to a retrospective application of United States generally accepted accounting principles. The amendment is effective for interim and annual reporting periods in fiscal year ending after June 15, 2010. The Company’s adoption of this ASU did not have a material impact on its consolidated financial statements.

In March 2010, the FASB issued ASU No. 2010-10, Amendments for Certain Investment Funds. This update defers the effective date of the amendments to the consolidation requirements made by FASB Statement 167  based on a reporting entity’s interest in certain types of entities. The deferral will mainly impact the evaluation of reporting enterprises’ interests in mutual funds, private equity funds, hedge funds, real estate investment entities that measure their investment at fair value, real estate investment trusts, and venture capital funds. The ASU also clarifies guidance in Statement 167 that addresses whether fee arrangements represent a variable interest for all service providers and decision makers. The ASU is effective for interim and annual reporting periods in fiscal years beginning after November 15, 2009. The Company’s adoption of this ASU did not have a material impact on its consolidated financial statements.

In March 2010, the FASB issued ASU No. 2010-11, Scope Exception Related to Embedded Credit Derivatives. Embedded credit-derivative features related only to the transfer of credit risk in the form of subordination of one financial instrument to another are not subject to potential bifurcation and separate accounting as clarified by recently issued FASB guidance. Other embedded credit-derivative features are required to be analyzed to determine whether they must be accounted for separately. This update provides guidance on whether embedded credit-derivative features in financial instruments issued by structures such as collateralized debt obligations (“CDOs”) and synthetic CDOs are subject to bifurcation and separate accounting. The guidance is effective at the beginning of a company’s first fiscal quarter beginning after June 15, 2010. The Company’s adoption of this ASU did not have a material impact on its consolidated financial statements.

In April 2010, the FASB issued ASU 2010-13, Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades . This update provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in currency of a market in which a substantial porting of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The Company does not expect the adoption of this ASU will have a material impact on the Company’s consolidated financial statements.

In April 2010, the FASB issued ASU 2010-17, Revenue Recognition—Milestone Method (Topic 605): Milestone Method of Revenue Recognition . This update provides guidance on the recognition of revenue under the milestone method, which allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a substantive milestone (milestone consideration) in the period the milestone is achieved. The pronouncement is effective on a prospective basis for milestones achieved in fiscal years and interim periods within those years, beginning on or after June 15, 2010. The Company’s adoption of this ASU did not have a material impact on its consolidated financial statements.
 
 
20

 

 
In July 2010, the FASB issued ASU 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses . This update provides enhanced disclosures which are designed to assist financial statement users in assessing an entity’s credit risk exposure and in evaluating the adequacy of an entity’s allowance for credit losses. Public entities must apply the disclosure requirements applicable to period-end balances beginning with the first interim or annual reporting period ending on or after December 15, 2010. The Company does not expect the adoption of this ASU will have a material impact on the Company’s consolidated financial statements.

In September 2010, the FASB issued Accounting Standard Update 2010-25, Plan Accounting—Defined Contribution Pension Plans (Topic 962): Reporting Loans to Participants by Defined Contribution Pension Plans . This ASU clarifies how loans to participants should be classified and measured by defined contribution plans and how International Financial Reporting Standards compare to these provisions. The amendments in this update are effective for fiscal years ending after December 15 2010. The Company does not expect the adoption of this ASU will have a material impact on the Company’s consolidated financial statements.
 
Reclassification

Certain prior period amounts have been reclassified from general and administrative to selling to conform to the current period presentation. These reclassifications had no effect on net income or cash flows.

Note 4 – Other Assets

Other assets consisted of the following:

   
September 30,
       
   
2010
   
December 31,
 
   
(unaudited)
   
2009
 
Prepaid rent – natural gas stations
  $ 292,476     $ 340,211  
Goodwill
    598,800          
Prepayment for acquiring land use right
    3,772,440       1,936,440  
Advances on purchasing equipment and construction in progress
    3,842,239       12,056,964  
Refundable security deposits
    2,016,128       1,264,283  
Intangible assets
    6,990,076       257,012  
Total
  $ 17,512,159     $ 15,854,910  

The goodwill amount is the excess of the cost the Company paid to acquire 100% of the equity interests of Makou over the fair value of Makou’s net assets. Annual impairment testing is performed during the fourth quarter of each year unless events or circumstances indicate earlier impairment testing is required. No impairment loss was recognized during the nine months ended September 30, 2010.

All land in the PRC is government owned. However, the government grants users land use rights. As of September 30, 2010 and December 31, 2009, the Company prepaid $3,772,440 and $1,936,440, respectively, to PRC local government authorities to purchase land use rights. The Company is in the process of negotiating the final purchase price with the local government and the land use rights have not yet been granted to the Company. Therefore, the Company did not amortize the amounts prepaid for land use rights.

Advances on the purchase of equipment and construction in progress are monies deposited or advanced to outside vendors or subcontractors for the purchase of operating equipment or for services to be provided for construction in progress.
 
 
21

 

 
Refundable security deposits are monies deposited with one of the Company’s major vendors and a gas station landlord. These amounts will be returned to the Company if the other party terminates the business relationship or at the end of the lease.

Intangible assets represent operating rights acquired during acquisition of four natural gas stations, consisting of following:

   
September 30,
       
   
2010
   
December 31,
 
   
(unaudited)
   
2009
 
Operating rights
  $ 4,966,193     $ -  
Land use rights
    2,023,883       257,012  
Total
  $ 6,990,076     $ 257,012  

Note 5 – Senior Notes Payable

On December 30, 2007, the Company entered into a securities purchase agreement with Abax Lotus Ltd. (“Abax”) and, on January 29, 2008, the Company entered into an amendment to such agreement with Abax (as amended, the “Purchase Agreement”). Under the Purchase Agreement, on January 29, 2008, the Company sold to Abax $20,000,000 in principal amount of its 5.0% Guaranteed Senior Notes due 2014 (the “Senior Notes”) and warrants to purchase 1,450,000 shares of its common stock (the “Abax Warrants”), and on March 3, 2008, the Company issued to Abax an additional $20,000,000 in principal amount of Senior Notes.

In connection with the Purchase Agreement, on January 29, 2008, the Company entered into:

 
an indenture with DB Trustees (Hong Kong) Limited, as trustee (the “Trustee”), pursuant to which the Senior Notes were issued (the “Indenture”);

 
a warrant agreement with Deutsche Bank AG, Hong Kong Branch, as warrant agent, pursuant to which the Abax Warrants were issued;

 
an investor rights agreement with Abax, pursuant to which, among other things, Abax had the right to nominate a director for election to the Company’s board of directors so long as Abax held at least 10% of the outstanding shares of common stock on an as-converted, fully diluted basis. Abax no longer holds such amount of the Company’s common stock and therefore no longer has a director nomination right;

 
a registration rights agreement with Abax, pursuant to which the Company agreed to file a registration statement to register the resale of the shares of common stock issuable upon exercise of the Abax Warrants. The Company filed a registration statement on Form S-1 (File No. 149719), which was declared effective by the Securities and Exchange Commission on May 6, 2008, to register the resale of the shares of common stock issuable upon exercise of the Abax Warrants;

 
an information rights agreement with Abax, pursuant to which Abax has the right to receive certain information regarding the Company;

 
an onshore share pledge agreement with DB Trustees (Hong Kong) Limited, as pledgee, pursuant to which the Company granted to DB Trustees (Hong Kong) Limited, on behalf of the holders of the Senior Notes, a pledge on 65% of the Company’s equity interests in its PRC subsidiary; and

 
an account pledge and security agreement with DB Trustees (Hong Kong) Limited, as collateral agent, pursuant to which the Company granted to DB Trustees (Hong Kong) Limited a security interest in the account where the proceeds from the Company’s sale of the Senior Notes were deposited.

 
22

 
 
The Senior Notes will mature on January 30, 2014 and have borne interest at a rate of 5.0% per annum since issuance. On the dates set forth in the table below, the Company will be required make prepayments of the corresponding percentage of principal amount (or such lesser principal amount as shall then be outstanding) in respect of the aggregate outstanding principal amount of the Senior Notes as of July 30, 2011:

 
Date
 
Repayment
Percentage
 
July 30, 2011
    8.3333 %
January 30, 2012
    8.3333 %
July 30, 2012
    16.6667 %
January 30, 2013
    16.6667 %
July 30, 2013
    25.0000 %
January 30, 2014
    25.0000 %

The Company has the option to redeem all, but not less than all, of the Senior Notes at the redemption prices set forth below (in each case expressed as a percentage of the outstanding unpaid principal amount), plus accrued and unpaid interest, if redeemed during the twelve month period commencing on January 29 of the years set forth below:

Year
 
Principal
 
2010
  $ 42,400,000  
2011
    41,600,000  
2012
    40,800,000  
2013 and thereafter
    40,000,000  

Upon the occurrence of certain events defined in the indenture, the Company must offer the holders of the Senior Notes the right to require the Company to purchase the Senior Notes in an amount equal to 105% of the aggregate principal amount purchased plus accrued and unpaid interest on the Senior Notes purchased.

The Company has not made any payments of principal or interest on the Senior Notes, except as described below.

The terms of the Indenture obligated the Company to complete a qualifying listing, as defined therein, by January 29, 2009. As the Company did not complete a qualifying listing by such date, the Company was obligated to pay to Abax additional interest at the rate of 3.0% per annum, calculated from and including January 29, 2009 to the date of its qualifying listing. However, Abax caused the Trustee to waive the Company’s obligation to pay such additional interest in February 2009. The waiver extended the deadline for a qualifying listing to May 4, 2009, but provided that if a qualifying listing were not completed by such date, additional interest of 3.0% per annum would be payable from January 29, 2009 to the date of the Company’s qualifying listing. The Company completed its NASDAQ listing, which constituted a qualifying listing, on June 1, 2009, after the extended May 4, 2009 deadline. Therefore, under the terms of the initial waiver, the Company was required to pay additional interest at a rate of 3.0% per annum for the period from January 29, 2009 to June 1, 2009, or $406,667. However, in August 2009, the Company reached an agreement with Abax whereby the Company agreed to pay Abax $113,214, which reflected additional interest at the rate of 3.0% per annum for the period from April 30, 2009 to May 31, 2009, and $50,000, which reflected out-of-pocket expenses incurred by Abax in connection with a financing transaction proposed in 2008, but never consummated.

The indenture limits the Company’s ability to incur debt and liens, make dividend payments and stock repurchases, make investments, reinvest proceeds from asset sales and enter into transactions with affiliates, among other things. The indenture also requires the Company to maintain certain financial ratios.

In connection with the issuance of the Senior Notes, the Company paid $2,122,509 in debt issuance costs, which costs are being amortized over the life of the Senior Notes. For the three months ended September 30, 2010 and 2009, the Company amortized $0 and $11,505 of the aforesaid issuance costs, net of capitalized interest. For the nine months ended September 30, 2010 and 2009, the Company amortized $0 and $63,940 of the aforesaid issuance costs, net of capitalized interest.

 
23

 

 
The Abax Warrants are presently exercisable and have an exercise price of $7.3652 per share, although Abax has not exercised any of the Abax Warrants.

The Abax Warrants are considered derivative instruments that need to be bifurcated from the original security because there is a redemption requirement if the holder does not exercise the Warrants. If Abax does not exercise the Abax Warrants prior to their expiration date, January 29, 2015, Abax can require the Company to repurchase the Abax Warrants for $17,500,000. This amount is shown as a debt discount and is being amortized over the term of the Senior Notes. For the three months ended September 30, 2010 and 2009, the Company amortized $851,719 and $709,454 of the aforesaid discounts, of which $851,719 and $646,400, respectively, were capitalized into construction in progress. For the nine months ended September 30, 2010 and 2009, the Company amortized $2,424,321 and $2,020,515 of the aforesaid discounts, of which $2,424,321 and $1,740,265, respectively, were capitalized into construction in progress.

 Note 6 - Long term Loan

The outstanding balance of Company’s long term bank loan as of September 30, 2010 and December 31, 2009 are as follows:

   
September 30,
       
   
2010
   
December 31,
 
   
(unaudited)
   
2009
 
Loan from Pudong Development Bank Xi’an Branch, due various dates from 2012 to 2014. Interest at 5.76% for the first year and subject to adjustment after the second year, secured by equipment
  $ 17,964,000     $ -  

The above loan is secured by XXNGC’s equipment and vehicles located within the PRC. The carrying net value of the assets pledged is $12,314,211 as of September 30, 2010. Interest expense for the three months and nine months ended in September 30, 2010 were $275,996 and $488,621, respectively, all of which expenses were capitalized into construction in progress. XXNGC also entered into a guaranty with the lender to guaranty the repayment of the loans. The Company is required to make mandatory repayments on the long term loan as follows:

   
Repayment
Percentage
   
Repayment Amount
 
March 5, 2012
    25 %   $ 4,491,000  
March 5, 2013
    25 %     4,491,000  
March 5, 2014
    25 %     4,491,000  
December 5, 2014
    25 %     4,491,000  

Note 7 – Warrants

The following is a summary of the warrant activity:

   
Warrants
Outstanding
   
Weighted Average
Exercise Price
   
Aggregate Intrinsic
Value
 
Outstanding, December 31, 2008
    1,994,242     $ 14.28     $ -  
Granted
    -       -       -  
Forfeited
    (160,588 )     7.20       -  
Exercised
    -       -       -  
Outstanding, December 31, 2009
    1,833,654     $ 8.93     $ 4,008,434  
Granted
    -       -       -  
Forfeited
    -       -       -  
Exercised
    -       -       -  
Outstanding, September 30, 2010 (unaudited)
    1,833,654     $ 8.93     $ -  

 
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 The following is a summary of the status of warrants outstanding as of September 30, 2010:

Outstanding Warrants
 
         
Average
 
         
Remaining
 
Exercise Price
 
Number
   
Contractual Life
 
7.37
    1,450,000       4.33  
14.86
    383,654       2.07  
8.93
    1,833,654       3.86  

Note 8 – Defined Contribution Plan

The Company is required to participate in a defined contribution plan operated by the local municipal government in accordance with Chinese law and regulations. The Company contributes RMB 100 per employee per month to the plan. Starting from 2008, no minimum contribution is required but the maximum contribution cannot be more than 14% of current salary expense. The total contribution for the above plan was $59,584 and $53,128 for the three months ended September 30, 2010 and 2009, respectively. The total contribution for the above plan was $308,367 and $134,207 for the nine months ended September 30, 2010 and 2009, respectively.

Note 9 – Secondary Public Offering

On September 9, 2009, the Company completed an underwritten public offering for 5,725,000 shares of its common stock at a price of $8.75 per share. The Company also granted the underwriters a 30-day option to purchase up to an additional 858,750 shares to cover over-allotments at the public offering price.

On September 21, 2009, the Company closed the sale of an additional 858,750 shares of common stock at the public offering price of $8.75 per share, following the underwriters’ exercise of the over-allotment option in full.

The net proceeds, after deducting underwriting discounts and commissions and the relevant expenses, was approximately $54.4 million.
 
Note 10 – Statutory Reserve

As stipulated by the Company Law of the PRC as applicable to PRC companies with foreign ownership, net income after taxation can only be distributed as dividends after appropriation has been made for the following:

 
·
making up cumulative prior years’ losses, if any;

 
·
allocations to the “Statutory surplus reserve” of at least 10% of income after tax, as determined under PRC accounting rules and regulations, until the fund amounts to 50% of the Company’s registered capital; and

 
·
 allocations to the discretionary surplus reserve, if approved in the shareholders’ general meeting.

As of September 30, 2010, the remaining amount needed to fulfill the 50% registered capital requirement was approximately $74,651,448.

 
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Note 11 – Accounting for Stock-based Compensation

Options from CEO to pay for certain Company legal expenses

On September 22, 2007, Mr. Qinan Ji, chairman and shareholder of the Company, transferred 50,000 of his personally-owned options to the Company’s attorney to cover certain Company legal expenses. 30% of the options vested on September 22, 2008, 30% vested on September 22, 2009 and the remaining 40% vested on September 22, 2010. Upon termination of service to the Company, the attorney is required to return all unvested options. These options expire June 1, 2012.

The Company used the Black-Scholes Option Pricing Model to value the options at the time they were issued, based on the stock price on its grant date, the stated exercise prices and expiration dates of the instruments and using a risk-free rate of 4.10%. The estimated life is based on one half of the sum of the vesting period and the contractual life of the option. This is the same as assuming that the options are exercised at the mid-point between the vesting date and expiration date. $22,008 and $14,842 of compensation expense was recorded during the three months ended September 30, 2010 and 2009, respectively. $66,024 and $44,527 of compensation expense was recorded during the nine months ended September 30, 2010 and 2009, respectively.

As of September 30, 2010, $0 of estimated expense with respect to non-vested stock-based compensation has yet to be recognized.

2009 Stock Option and Stock Award Plan

On March 11, 2009, the Board approved by written consent the China Natural Gas, Inc. 2009 Employee Stock Option and Stock Award Plan (the “Plan”). Pursuant to the Plan, there are currently 1,460,000 shares of Company common stock authorized for issuance and the Company has granted 638,000 stock options as of September 30, 2010, of which 138,000 have been exercised and 75,000 have been cancelled and are available for reissuance. Thus, there are currently 897,000 shares of Company common stock available for future issuance under the Plan and 425,000 options outstanding. The exercise price for all of the outstanding options is $4.90 per share.

The Company used the Black-Scholes Option Pricing Model to value the options at the time they were issued, based on the stock price on its grant date, the stated exercise prices and expiration dates of the instruments and using risk-free rates. The volatility of the Company’s common stock was estimated by management based on the historical volatility of the Company’s common stock, the risk free interest rate was based on Treasury Constant Maturity Rates published by the United States Federal Reserve for periods applicable to the estimated life of the options, and the expected dividend yield was based on the current and expected dividend policy. The Company currently uses the “simplified” method to estimate the expected term for share option grants as it does not have sufficient historical experience to provide a reasonable estimate. The Company will continue to use the “simplified” method until it feels that it has sufficient historical experience to provide a reasonable estimate of expected terms. The estimated life is based on one half of the sum of the vesting period and the contractual life of the option. This is the same as assuming that the options are exercised at the mid-point between the vesting date and expiration date. Compensation expense of $186,211 and $1,009,291 was recorded during the three and nine months ended September 30, 2010, respectively.

During the nine months ended September 30, 2010, 138,000 shares of stock options have been exercised at the exercise price of $4.90 for $676,200.

As of September 30, 2010, $1,862,115 of estimated expense with respect to non-vested stock-based compensation has yet to be recognized and will be recognized in expense over the optionee’s remaining weighted average service period of approximately 2.5 years.

 
26

 

 
The following is a summary of the stock option activity:

         
Weighted
       
   
Options
   
Average
   
Aggregate
 
   
Outstanding
   
Exercise Price
   
Intrinsic Value
 
Outstanding, December 31, 2008
    -     $ -     $ -  
Granted
    318,850       4.90       1,983,247  
Forfeited
    (75,000 )     4.90       466,500  
Exercised
    -       -       -  
Outstanding, December 31, 2009
    243,850     $ 4.90     $ 1,516,747  
Granted
    380,850                  
Forfeited
    (61,700 )                
Exercised
    (138,000 )     -       -  
Outstanding, September 30, 2010 (unaudited)
    425,000     $ 4.90     $ 433,500  

The following is a summary of the status of stock options outstanding at September 30, 2010:

 
Outstanding Options
 
Exercisable Options
         
Average
           
Average
         
Remaining
           
Remaining
 
Exercise Price
 
Number
 
Contractual Life
 
Exercise Price
   
Number
 
Contractual Life
$
 4.90
    425,000  
4.5 years
  $ 4.90       2,750  
4.5 years

Note 12 – Earnings per Share

Earnings per share for the three and nine months ended September 30, 2010 and 2009 have been determined by dividing net income for the periods by the weighted average number of both basic and diluted shares of common stock and common stock equivalents outstanding. The following is an analysis of the differences between basic and diluted earnings per common share in accordance with the FASB’s accounting standard, and demonstrates the calculation for earnings per share for the periods ended September 30, 2010 and 2009:

   
For the three months ended
   
For the nine months ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
   
(unaudited)
   
(unaudited)
   
(unaudited)
   
(unaudited)
 
Basic earnings per share
                       
                         
Net income
  $ 3,584,842     $ 4,647,519     $ 12,140,615     $ 12,711,898  
Weighted shares outstanding – Basic
    21,321,904       15,754,696       21,251,882       14,985,001  
Earnings per share – Basic
  $ 0.17     $ 0.29     $ 0.57     $ 0.85  
                                 
Diluted earnings per share
                               
Net income
  $ 3,584,842     $ 4,647,519     $ 12,140,615     $ 12,711,898  
Weighted shares outstanding – Basic
    21,321,904       15,754,696       21,251,882       14,985,001  
Effect of diluted securities – Warrants
    -       385,124       155,510       50,171  
Effect of diluted securities – Options
    100,623       -       125,220       -  
Weighted shares outstanding - Diluted
    21,422,527       16,139,820       21,532,612       15,035,172  
Earnings per share - Diluted
  $ 0.17     $ 0.29     $ 0.56     $ 0.85  

The Company had 1,833,654 outstanding warrants at September 30, 2010 and 2009. For the three months ended September 30, 2010, all 1,833,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive. For the three months ended September 30, 2009, the average stock price was greater than the exercise prices of the 1,450,000 warrants which resulted in additional weighted average common stock equivalents of 385,124; 383,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive. For the nine months ended September 30, 2010 and 2009, the average stock price was greater than the exercise prices of the 1,450,000 warrants which resulted in additional weighted average common stock equivalents of 155,510 and 50,171, respectively; 383,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive.
 
 
27

 

 
The Company had 425,000 outstanding employee stock options at September 30, 2010. For the three and nine months ended September 30, 2010, the average stock price was greater than the exercise price of the options which resulted in additional weighted average common stock equivalents of 100,663 and 125,220, respectively.

Note 13 – Related Party Transactions (Restated)

a)
The Wang Loan

Demaoxing was formed in November 2007 by relatives of Mr. Qinan Ji, the Company’s Chief Executive Officer and Chairman of the Company’s Board of Directors (the “Demaoxing Promoters”). In January 2010, SXNGE, one of the Company’s major subsidiaries, extended a loan of US$9,858,240 to Ms. Taoxiang Wang, who obtained a 40% ownership interest in Demaoxing on January 21, 2010.  Ms. Taoxiang Wang used her 40% ownership interest in Demaoxing and its assets as collateral for the Wang Loan. On January 26, 2010, the Wang Loan funds were remitted by SXNGE to an account of Demaoxing. Management of the Company believed that the Wang Loan was adequately secured by collateral. On January 21, 2010, the Demaoxing Promoters also transferred 30% of their ownership interests in Demaoxing to Shaanxi Rongxin Real Estate Co., Ltd. (“Rongxin”). The Board of Directors has determined that the Demaoxing Promoters retained indirect beneficial interests in Demaoxing after transferring their ownership interests and thus the Wang Loan was a related party transaction.

The Company’s Board of Directors was not notified of the extension of the Wang Loan by the Company, and did not approve the Loans. Upon learning of the existence of the Wang Loan in April 2010, the Board of Directors required that the Wang Loan be immediately repaid. In April 2010, Demaoxing repaid the principal of the Wang Loan and made an interest payment of US$140,722, settling the Wang Loan in full.

b)
The Borrowing to the JV

On August 31, 2010, the Company temporarily borrowed $1,347,300 from the JV for working capital purpose. The borrowing does not have an explicit term, interest or collateral pledged.  The balance will be due upon demand.  The following is a summary of related party balances:

   
 
September 30, 2010
(unaudited)
   
December 31, 2009
 
Henan CNPC Kunlun Xilan Compressed Natural Gas Co., Ltd.  
  $ 1,347,300     $ -  

Note 14 – Current Vulnerability Due to Certain Concentrations

Concentration of natural gas vendors:

   
 
Three months ended September 30,
   
Nine months ended September 30,
 
   
 
2010
   
2009
   
2010
   
2009
 
   
(unaudited)
   
(unaudited)
   
(unaudited)
   
(unaudited)
 
Numbers of natural gas vendors  
    4       4       4       4  
                                 
Percentage of total natural gas purchases  
    88 %       99 %       92 %       99 %

As of September 30, 2010 and December 31, 2009, the Company had $120,767 and $82,146 payable due to its major suppliers.

      The Company maintains long-term natural gas purchase agreements with one of its vendors as of September 30, 2010. There are no minimum purchase requirements by the Company. Contracts are renewed on an annual basis. The Company’s management reports that it does not expect any issues or difficulty in continuing to renew the supply contracts with these vendors going forward.

The Company’s operations are carried out in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environments in the PRC and by the general state of the PRC economy. The Company’s business may be influenced by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things.

 
28

 

Note 15 – Commitments and Contingencies

Lease Commitments

The Company recognizes lease expense on a straight-line basis over the term of the lease in accordance with the FASB’s accounting standard regarding leases. The Company has entered into a series of long-term lease agreements with outside parties to lease land use rights for the Company’s CNG fueling stations located in the PRC. The agreements have terms ranging from 10 to 30 years. The Company makes annual prepayments for most lease agreements. The Company has also entered into two office leases in Xi’an, PRC, one office lease in Jingbian, PRC, one office lease in Wuhan, PRC and one office lease in New York, NY. The minimum future payment for leasing land use rights and offices is as follows:

Year ending December 31, 2010  
  $ 1,013,923  
Year ending December 31, 2011  
    2,287,605  
Year ending December 31, 2012  
    2,087,487  
Year ending December 31, 2013  
    2,001,803  
Year ending December 31, 2014  
    2,405,727  
Thereafter  
    35,726,814  
Total  
  $ 45,523,359  

For the three months ended September 30, 2010 and 2009, the land use right and office lease expenses were $671,781 and $411,452, respectively. For the nine months ended September 30, 2010 and 2009, the land use right and office lease expenses were $1,508,194 and $1,209,549, respectively.
 
Property and Equipment Purchase Commitments

The Company has purchase commitments for materials, supplies, services and property and equipment for constructing the LNG plant and other construction projects. The Company has future commitments as follows:

Year ending December 31, 2010  
  $ 18,931,831  
Year ending December 31, 2011  
    390,717  
Thereafter  
    -  
Total  
  $ 19,322,548  

Natural Gas Purchase Commitments

The Company has existing long-term natural gas purchase agreements with its major suppliers. However, none of those agreements stipulate any specific purchase amount or quota each year, thus giving the Company enough flexibility to constantly look for lower-cost sources of supply. Therefore, the Company is not legally bound in purchase commitments by those agreements.

Legal Proceedings