UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2010
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from ____________________________ to _____________________________
Commission File Number: 000-53283
CHINA ENERGY RECOVERY, INC.
(Exact Name of Registrant as Specified in Its Charter)
Delaware | 90-0459730 | |
(State or Other Jurisdiction of | (I.R.S. Employer | |
Incorporation or Organization) | Identification No.) |
7F, No. 267 Qu Yang Road | ||
Hongkou District | ||
Shanghai, China | 200081 | |
(Address of Principal Executive Offices) | (Zip Code) |
+86 (0)21 5556-0020
(Registrant's Telephone Number, Including Area Code)
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ¨ No x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer | ¨ | Accelerated filer | ¨ |
Non-accelerated filer | ¨ | Smaller reporting company | x |
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Number of shares outstanding of the registrant's common stock as of March 31, 2011:
30,956,651 shares of Common Stock, $0.001 par value per share
TABLE OF CONTENTS
Page | ||||
Part I | Financial Information | |||
Item 1. | Unaudited Consolidated Financial Statements | 3 | ||
Consolidated Balance Sheets as of December 31, 2009 and September 30, 2010 | 3 | |||
Consolidated Statements of Operations and Other Comprehensive Income(Loss) for the Three and Nine Months Ended September 30, 2009 and 2010 | 4 | |||
Consolidated Statements of Shareholders' Equity for the Year Ended December 31, 2009 and Nine Months Ended September 30, 2010 | 5 | |||
Consolidated Statements of Cash Flow for the Nine Months Ended September 30, 2009 and 2010 | 6 | |||
Notes to the Consolidated Financial Statements | 7 | |||
Item 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 37 | ||
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 50 | ||
Item 4. | Controls and Procedures | 50 | ||
Part II | Other Information | |||
Item 1. | Legal Proceedings | 50 | ||
Item 1A. | Risk Factors | 50 | ||
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 51 | ||
Item 3. | Defaults Upon Senior Securities | 51 | ||
Item 4. | [Reserved] | 51 | ||
Item 5. | Other Information | 51 | ||
Item 6. | Exhibits | 51 |
2
PART I
FINANCIAL INFORMATION
Item 1. Unaudited Consolidated Financial Statements
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2009 AND SEPTEMBER 30, 2010
(UNAUDITED)
December 31, | September 30, | |||||||
2009 | 2010 | |||||||
ASSETS | ||||||||
CURRENT ASSETS: | ||||||||
Cash | $ | 2,386,573 | $ | 780,509 | ||||
Notes receivable | 411,049 | - | ||||||
Accounts receivable, net of allowance for doubtful accounts | 6,601,921 | 7,919,723 | ||||||
Inventories | 8,574,775 | 8,033,415 | ||||||
Other current assets and receivables | 892,657 | 884,720 | ||||||
Deferred financial cost - current | 674,748 | 289,975 | ||||||
Deferred tax assets - current | 67,276 | - | ||||||
Advances on purchases | 4,271,054 | 8,186,270 | ||||||
Total current assets | 23,880,053 | 26,094,612 | ||||||
NON-CURRENT ASSETS: | ||||||||
Property, plant and equipment, net | 758,888 | 5,040,492 | ||||||
Deferred tax assets | 133,758 | 145,678 | ||||||
Intangible assets | 2,439,022 | 2,469,786 | ||||||
Deferred financial cost | 215,623 | - | ||||||
Long-term accounts receivable | 6,830,615 | 5,163,359 | ||||||
Total non-current assets | 10,377,906 | 12, 819,315 | ||||||
Total assets | $ | 34,257,959 | $ | 38,913,927 | ||||
LIABILITIES AND SHAREHOLDERS' EQUITY | ||||||||
CURRENT LIABILITIES: | ||||||||
Accounts payable | $ | 4,188,205 | $ | 3,825,658 | ||||
Accrued expenses and other liabilities | 1,745,082 | 2,079,967 | ||||||
Advances from customers | 11,226,273 | 13,859,605 | ||||||
Taxes payable | 2,956,476 | 2,308,684 | ||||||
Short-term bank loans | 880,200 | - | ||||||
Convertible note, current | 2,023,720 | 4,659,381 | ||||||
Derivative liability, current | 435,500 | 155,645 | ||||||
Long-term loans ,current | - | 3,540,687 | ||||||
Total current liabilities | 23,455,456 | 30,429,627 | ||||||
NON-CURRENT LIABILITIES: | ||||||||
Warrant liability | 1,372,947 | 392,330 | ||||||
Derivative liability | 435,500 | - | ||||||
Convertible note | 1,938,408 | - | ||||||
Long-term loans | - | 1,003,778 | ||||||
Total non-current liabilities | 3,746,855 | 1,396,108 | ||||||
Total Liabilities | 27,202,311 | 31,825,735 | ||||||
SHAREHOLDERS' EQUITY: | ||||||||
Preferred stock(US$0.001 par value; 50,000,000 shares authorized, 662,963 and 200,000 shares issued and outstanding as of December 31, 2009 and September 30, 2010, respectively) | 626 | 189 | ||||||
Common stock(US$0.001 par value; 100,000,000 shares authorized, 30,638,720 and 30,883,818 shares issued and outstanding as of December 31, 2009 and September 30, 2010, respectively) | 30,639 | 30,884 | ||||||
Additional paid-in-capital | 8,163,224 | 8,269,175 | ||||||
Accumulated deficits | (1,194,158 | ) | (1,588,263 | ) | ||||
Statutory reserves | 132,802 | 132,802 | ||||||
Accumulated other comprehensive income (loss) | (77,485 | ) | 243,405 | |||||
Total shareholders' equity | 7,055,648 | 7,088,192 | ||||||
Total liabilities and shareholders' equity | $ | 34,257,959 | $ | 38,913,927 |
The accompanying notes are an integral part of these unaudited consolidated financial statements.
3
CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (LOSS)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2010
(UNAUDITED)
Three months ended September 30, | Nine months ended September 30, | |||||||||||||||
2009 | 2010 | 2009 | 2010 | |||||||||||||
(Restated) | (Restated) | |||||||||||||||
REVENUES | $ | 5,320,518 | $ | 6,147,651 | $ | 14,743,413 | $ | 17,447,570 | ||||||||
COST OF REVENUES | (4,466,987 | ) | (4,752,909 | ) | (11,521,307 | ) | (14,444,768 | ) | ||||||||
GROSS PROFIT | 853,531 | 1,394,742 | 3,222,106 | 3,002,802 | ||||||||||||
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES | (1,759,236 | ) | (1,588,818 | ) | (4,027,167 | ) | (4,095,102 | ) | ||||||||
LOSS FROM OPERATIONS | (905,705 | ) | (194,076 | ) | (805,061 | ) | (1,092,300 | ) | ||||||||
OTHER INCOME/(EXPENSE), NET: | ||||||||||||||||
Change in fair value of warrants | 685,611 | (97,281 | ) | 1,236,678 | 980,617 | |||||||||||
Change in fair value of derivative liabilities | - | 28,920 | - | 847,825 | ||||||||||||
Non-operating income/(loss), net | 33,144 | 30,424 | (44,994 | ) | 1,001,780 | |||||||||||
Interest expenses | (210,550 | ) | (477,239 | ) | (296,247 | ) | (1,786,380 | ) | ||||||||
Total other income/(loss), net | 508,205 | (515,176 | ) | 895,437 | 1,043,842 | |||||||||||
(LOSS)/INCOME FROM OPERATIONS BEFORE INCOME TAXES | (397,500 | ) | (709,252 | ) | 90,376 | (48,458 | ) | |||||||||
BENEFIT/(PROVISION) FOR INCOME TAXES | 139,382 | (144,497 | ) | (8,900 | ) | (345,647 | ) | |||||||||
NET (LOSS)/INCOME | (258,118 | ) | (853,749 | ) | 81,476 | (394,105 | ) | |||||||||
OTHER COMPREHENSIVE (LOSS)/INCOME | ||||||||||||||||
Foreign currency translation adjustment | 8,784 | 292,890 | 37,837 | 320,890 | ||||||||||||
COMPREHENSIVE INCOME/(LOSS) | $ | (249,334 | ) | $ | (560,859 | ) | $ | 119,313 | $ | (73,215 | ) | |||||
(LOSS)/ EARNINGS PER COMMON SHARE: | ||||||||||||||||
Basic | (0.009 | ) | (0.028 | ) | 0.003 | (0.013 | ) | |||||||||
Diluted | (0.009 | ) | (0.028 | ) | 0.003 | (0.013 | ) | |||||||||
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING: | ||||||||||||||||
Basic | 29,936,405 | 30,883,916 | 29,931,858 | 30,834,537 | ||||||||||||
Diluted | 29,936,405 | 30,883,916 | 29,931,858 | 30,834,537 |
The accompanying notes are an integral part of these unaudited consolidated financial statements.
4
CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(UNAUDITED)
Preferred Stock | Common stock | Additional paid-in | Statutory | Accumulated | Accumulated other comprehensive | |||||||||||||||||||||||||||||||
Shares | Amount | Shares | Amount | capital | reserves | deficits | loss | Total | ||||||||||||||||||||||||||||
BALANCE, at January 1, 2009 | 714,963 | $ | 715 | 29,912,573 | $ | 29,913 | 7,534,015 | 132,802 | (307,678 | ) | (106,637 | ) | 7,283,130 | |||||||||||||||||||||||
Common stock for consulting services | - | - | 700,000 | 700 | 839,300 | - | - | - | 840,000 | |||||||||||||||||||||||||||
Change of convertible rate | - | (37 | ) | - | - | 37 | - | - | - | - | ||||||||||||||||||||||||||
Stock based compensation | - | - | - | - | 221,816 | - | - | - | 221,816 | |||||||||||||||||||||||||||
Conversion of preferred stock | (52,000 | ) | (52 | ) | 26,147 | 26 | 26 | - | - | - | - | |||||||||||||||||||||||||
Deferred tax liability due to discount unconvertible notes | - | - | - | - | (431,970 | ) | - | - | - | (431,970 | ) | |||||||||||||||||||||||||
Net loss | - | - | - | - | - | - | (886,480 | ) | - | (886,480 | ) | |||||||||||||||||||||||||
Foreign currency translation gain | - | - | - | - | - | - | - | 29,152 | 29,152 | |||||||||||||||||||||||||||
BALANCE, at December 31, 2009 | 662,963 | $ | 626 | 30,638,720 | $ | 30,639 | 8,163,224 | 132,802 | (1,194,158 | ) | (77,485 | ) | 7,055,648 | |||||||||||||||||||||||
Conversion of preferred stock | (462,963 | ) | (437 | ) | 245,098 | 245 | 192 | - | - | - | - | |||||||||||||||||||||||||
Stock based compensation | - | - | - | - | 105,759 | - | - | - | 105,759 | |||||||||||||||||||||||||||
Net loss | - | - | - | - | - | - | (394,105 | ) | - | (394,105 | ) | |||||||||||||||||||||||||
Foreign currency translation gain | - | - | - | - | - | - | - | 320,890 | 320,890 | |||||||||||||||||||||||||||
BALANCE, at September 30, 2010 | 200,000 | $ | 189 | 30,883,818 | $ | 30,884 | 8,269,175 | 132,802 | (1,588,263 | ) | 243,405 | 7,088,192 |
The accompanying notes are an integral part of these unaudited consolidated financial statements.
5
CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2010
(UNAUDITED)
Nine months ended September 30, | ||||||||
2009 | 2010 | |||||||
(Restated) | ||||||||
CASH FLOWS FROM OPERATING ACTIVITIES: | ||||||||
Net income (loss) | $ | 81,476 | $ | (394,105 | ) | |||
Adjustments to reconcile net income (loss) to cash (used in) provided by operating activities: | ||||||||
Depreciation and amortization | 102,807 | 242,627 | ||||||
Change in allowance for uncollectible accounts | - | (68,049 | ) | |||||
Stock based compensation | 147,644 | 105,759 | ||||||
Change in fair value of warrants | (1,236,678 | ) | (980,617 | ) | ||||
Change in value of derivative liabilities | - | (847,825 | ) | |||||
Accretion of interest on the convertible note and long term loan | - | 731,233 | ||||||
Amortization of deferred financing cost | 293,072 | 600,396 | ||||||
Capitalized interest expenses | - | (114,329 | ) | |||||
Deferred tax expense | (117,814 | ) | 55,356 | |||||
Change in operating assets and liabilities: | ||||||||
Notes receivable | (395,342 | ) | 411,049 | |||||
Accounts receivable | 1,126,540 | (1,317,802 | ) | |||||
Inventories | 368,418 | 541,360 | ||||||
Other current assets and receivables | (630,504 | ) | 7,937 | |||||
Advances on purchases | (3,057,428 | ) | (2,821,431 | ) | ||||
Long term accounts receivable | (5,056,994 | ) | 1,725,146 | |||||
Accounts payable | 2,016,978 | (453,572 | ) | |||||
Other payables and accrued liabilities | 387,588 | 334,885 | ||||||
Advances from customers | 739,990 | 2,633,332 | ||||||
Taxes payable | (169,968 | ) | (647,792 | ) | ||||
Effects of exchange rate change in operating activities | 35,518 | 285,942 | ||||||
Net cash provided by (used in) operating activities | (5,364,697 | ) | 29,500 | |||||
CASH FLOWS FROM INVESTING ACTIVITIES: | ||||||||
Purchase of property, plant and equipment | (173,706 | ) | (5,361,821 | ) | ||||
Purchase intangible assets | - | (38,958 | ) | |||||
Restricted cash | 106,286 | - | ||||||
Net cash used in investing activities | (67,420 | ) | (5,400,779 | ) | ||||
CASH FLOWS FROM FINANCING ACTIVITIES: | ||||||||
Cash proceeds from long term loans | - | 5,003,778 | ||||||
Cash proceeds from convertible note | 5,000,000 | - | ||||||
Cash proceeds from short term bank loans | 880,200 | - | ||||||
Principal repayment of short term bank loans and long term loans | (381,420 | ) | (1,241,023 | ) | ||||
Net cash provided by financing activities | 5,498,780 | 3,762,755 | ||||||
EFFECTS OF EXCHANGE RATE CHANGE IN CASH | (25 | ) | 2,460 | |||||
INCREASE/(DECREASE) IN CASH | 66,638 | (1,606,064 | ) | |||||
CASH, beginning | $ | 6,136,403 | $ | 2,386,573 | ||||
CASH, ending | $ | 6,203,041 | $ | 780,509 | ||||
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION | ||||||||
Cash paid during the year for income taxes | - | 53,446 | ||||||
Cash paid during the year for interest | 6,337 | 451,303 | ||||||
Supplemental schedule of non-cash investing and financing activities: | ||||||||
Accounts payable relating to purchase of property, plant and equipment | - | 91,025 |
The accompanying notes are an integral part of these unaudited consolidated financial statements.
6
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note 1 – Organization
China Energy Recovery, Inc. ("CER" or the "Company"), formerly known as MMA Media Inc. and Commerce Development Corporation Ltd., was incorporated under the laws of the State of Maryland in May, 1998. On April 7, 2006, the Company entered into an Agreement and Plan of Merger with its wholly-owned subsidiary, Commerce Development Corporation, Ltd., a Delaware corporation, which changed the Company's state of incorporation from Maryland to Delaware as a result. On February 5, 2008, the Company changed its name to China Energy Recovery, Inc.
On January 24, 2008, the Company entered into a Share Exchange Agreement with Poise Profit International, Ltd. ("Poise Profit"), a company incorporated on November 23, 2007, under the laws of the British Virgin Islands, and the shareholders of Poise Profit. The share exchange transaction (the "Share Exchange") was consummated on April 15, 2008 and Poise Profit became a wholly-owned subsidiary of the Company. On April 16, 2008, the Company conducted a 1-for-2 reverse stock split pursuant to which each two shares of CER's common stock, issued and outstanding on the record date of April 15, 2008, converted into one share of CER's common stock. Pursuant to the Share Exchange Agreement, the Company agreed to acquire all of the issued and outstanding shares of Poise Profit's common stock in exchange for the issuance of 20,757,090 shares, or 81.5% of the Company's common stock on a post 1-for-2 reverse stock split basis, to the shareholders of Poise Profit. Because the acquisition is treated as a reverse acquisition and recapitalization whereby Poise Profit is deemed to be the accounting acquirer (legal acquiree) and the Company to be the accounting acquiree (legal acquirer), the financial statements of the Company have been retroactively adjusted to reflect the acquisition from the beginning of the reported period. The historical financial statements for periods prior to April 15, 2008 are those of Poise Profit except that the equity section and earnings per share have been retroactively restated to reflect the reverse acquisition and recapitalization.
Poise Profit is an off-shore holding company and has no operating business activities. Poise Profit owns 100% of HAIE Hi-tech Engineering (Hong Kong) Company, Limited ("Hi-tech") and CER (Hong Kong) Holdings Limited (“CER Hong Kong”), which were incorporated in Hong Kong on January 4, 2002 and August 13, 2008, respectively.
Shanghai Hai Lu Kun Lun Hi-tech Engineering Co., Ltd ("Shanghai Engineering") was established in Shanghai, China in July 1999. Shanghai Xin Ye Environmental Protection Engineering Technology Co., Ltd ("Shanghai Environmental") was incorporated in Shanghai on May 23, 2007. Mr. Qinghuan Wu, the Company’s chairman and Chief Executive Officer, became the sole shareholder of Shanghai Environmental in November 2007. Shanghai Environmental is not an operating company but serves as a vehicle for arranging sales and maximizing tax benefits.
All of Shanghai Engineering’s manufacturing activities are conducted through a Leasing and Operation Agreement, a form of cooperative manufacturing agreement, originally effective as of May 1, 2003 and subsequently renewed and amended with a state-owned enterprise, Shanghai Si Fang. Pursuant to the agreement, Shanghai Si Fang leases certain land use right, buildings and fixed assets (lease elements) in one of its subsidiaries, Vessel Works Division, and provides management services and licenses the “Si Fang” brand and manufacturing license (non-lease elements) of Vessel Works Division to Shanghai Engineering. Because the arrangement contains both the lease and non-lease elements, the amount of quarterly payment is allocated between the lease and non-lease deliverables based on their fair values. The lease elements are classified and accounted for as operating leases and the lease expense is recorded on a straight-line basis. The non-lease elements are accounted for as prepayment for management and licensing fees and the payment is amortized on a straight-line basis over each contractual period.
7
Shanghai Engineering does not have a variable interest in Vessel Works Division through this agreement as the arrangement is established between Shanghai Engineering and Shanghai Si Fang. Shanghai Engineering does not have any contractual or ownership interest in Vessel Works Division.
The arrangement, however, may result in Shanghai Engineering having a variable interest in Shanghai Si Fang, but as Shanghai Si Fang is a state-owned enterprise that has substantive operations other than the Lease and Operation arrangement, Shanghai Engineering is not the primary beneficiary of Shanghai Si Fang.
Effective on January 1, 2006, Hi-tech executed a series of contractual arrangements with Shanghai Engineering and its shareholders, including a Consulting Services Agreement and an Operating Agreement, through which Hi-tech has the right to advise, consult, manage and operate Shanghai Engineering, and collect and own all of its net profits. Additionally, Shanghai Engineering's shareholders have assigned their voting rights over Shanghai Engineering to Hi-tech. In order to further reinforce Hi-tech's rights to control and operate Shanghai Engineering, Shanghai Engineering and its shareholders have granted Hi-tech the exclusive right and option to acquire all of their equity interests in Shanghai Engineering. Further, Shanghai Engineering shareholders have pledged all of their rights, titles and interests in Shanghai Engineering to Hi-tech.
Effective on May 23, 2007, Hi-tech executed a series of contractual arrangements with Shanghai Environmental and its shareholders, including a Consulting Services Agreement and an Operating Agreement, through which Hi-tech has the right to advise, consult, manage and operate Shanghai Environmental, and collect and own all of its net profits. Additionally, Mr. Qinghuan Wu, Shanghai Environmental's sole shareholder has assigned his voting rights over Shanghai Environmental to Hi-tech. In order to further reinforce Hi-tech's rights to control and operate Shanghai Environmental, Shanghai Environmental and Mr. Qinghuan Wu have granted Hi-tech the exclusive right and option to acquire all of his equity interest in Shanghai Environmental. Further, Mr. Wu has pledged all of his right, title and interests in Shanghai Environmental. Shanghai Environmental was dissolved on June 12, 2010 and the registered capital was transferred to Shanghai Engineering in 2010.
In order to restructure the holding structure of the Company (the “Restructuring”), on December 2, 2008, 100% of the shares of CER Hong Kong were transferred to Poise Profit from Mr. Qinghuan Wu and his wife, Mrs. Zhou, and all the contracts between Hi-tech and Shanghai Engineering, and between Hi-tech and Shanghai Environmental were transferred to CER Hong Kong. Thereafter, CER Hong Kong, through its variable interest entities located in the People's Republic of China ("PRC"), designs, develops, manufactures and markets waste heat boilers and pressure vessels in the fields of chemical industry, petrochemical industry, oil refinery, fine chemicals, water and power conservancy, metallurgical, environmental protection, waste heat utilization and power generation from waste heat recovery.
On November 11, 2008, CER Energy Recovery (Shanghai) Co., Ltd. (“CER Shanghai”) was incorporated in Shanghai by CER Hong Kong. CER Shanghai’s registered capital is $5,000,000. As of September 30, 2010, CER Hong Kong has contributed approximately $3,380,000 capital in CER Shanghai, and the remaining amount has been injected at November 4, 2010. CER Shanghai is mainly engaged in the development of energy recovery and environmental protection technologies, and design, installation and servicing of waste heat recovery systems.
CER Energy Recovery (Yangzhou) Co., Ltd. (“CER Yangzhou”) was incorporated on August 28, 2009 in Yangzhou by CER Hong Kong. CER Yangzhou’s registered capital is $20,000,000 and the contributed capital was approximately $10,500,000 as of December 31, 2010. CER Yangzhou is mainly engaged in the development and manufacturing of waste heat recovery systems and other related energy efficiency equipment.
As all the above entities are under common control, the arrangements described above have been accounted for as a reorganization of entities and the financial statements have been prepared as if the reorganization had occurred retroactively. CER, Poise Profit, CER Hong Kong, Hi-tech, Shanghai Engineering, CER Shanghai, CER Yangzhou, and Shanghai Environmental, are collectively hereinafter referred to as the “Group”.
8
Note 2 Restatement of Consolidated Financial Statements for three and nine months ended September 30, 2009
Consolidated Statements of Income and other comprehensive income (loss) Impact:
The following table sets forth the effects of the restatement and reclassification adjustments on the Company’s consolidated statements of income and other comprehensive income (loss):
Three months ended September 30, 2009 | ||||||||||||
Previously | ||||||||||||
Reported | Adjustments | Restated | ||||||||||
REVENUES (note(a)) | $ | 6,064,800 | $ | (744,282 | ) | $ | 5,320,518 | |||||
COST OF REVENUES (note(b)) | (4,691,381 | ) | 224,394 | (4,466,987 | ) | |||||||
GROSS PROFIT | 1,373,419 | (519,888 | ) | 853,531 | ||||||||
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES(note(c)) | (2,292,301 | ) | 533,065 | (1,759,236 | ) | |||||||
LOSS FROM OPERATIONS | (918,882 | ) | 13,177 | (905,705 | ) | |||||||
OTHER INCOME (EXPENSE), NET: | ||||||||||||
Change in fair value of warrants(note(d)) | 941,277 | (255,666 | ) | 685,611 | ||||||||
Non-operating income (expense), net(note(e)) | 149,371 | (116,227 | ) | 33,144 | ||||||||
Interest expenses(note(f)) | (332,490 | ) | 121,940 | (210,550 | ) | |||||||
Total other income (expense), net | 758,158 | (249,953 | ) | 508,205 | ||||||||
LOSS FROM OPERATIONS BEFORE PROVISION FOR INCOME TAXES | (160,724 | ) | (236,776 | ) | (397,500 | ) | ||||||
BENEFIT/(PROVISION) FOR INCOME TAXES(note(g)) | 43,718 | 95,664 | 139,382 | |||||||||
NET(LOSS)/INCOME | (117,006 | ) | (141,112 | ) | (258,118 | ) | ||||||
OTHER COMPREHENSIVE INCOME | ||||||||||||
Foreign currency translation adjustment | 8,784 | - | 8,784 | |||||||||
COMPREHENSIVE LOSS | $ | (108,222 | ) | $ | (141,112 | ) | $ | (249,334 | ) | |||
(LOSS)/EARNINGS PER COMMON SHARE: | ||||||||||||
Basic and diluted(note(h)) | $ | (0.004 | ) | (0.005 | ) | (0.009 | ) | |||||
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING: | ||||||||||||
Basic | 29,936,493 | (88 | ) | 29,936,405 | ||||||||
Diluted | 30,287,473 | (351,068 | ) | 29,936,405 |
(a) | The restated revenues decreased by $744,282 because the Company over recognized certain revenue by $862,075, offset by recognizing retainage of $117,793 as revenue for the three months ended September 30, 2009, since the recoverability of the retainage could be reasonably assured. |
(b) | The restated cost of revenues decreased by $224,394, representing overcharged costs and sales taxes of $192,064 and $32,330, respectively. |
(c) | The restated selling, general and administrative expenses decreased by $533,065, representing overcharged stock based compensation of $244,311, allowance of doubtful accounts of $187,883 and rental expenses of $117,331, offset by undercharged salary payable of $16,460. |
(d) | The restated change in fair value of warrants decreased by $255,666, representing the underestimated value of the warrants. |
(e) | The restated non-operating income decreased by $116,227, representing overcharged income between Si Fang and Shanghai Engineering. |
(f) | The restated interest expenses decreased by $121,940, representing the over amortized value of warrants related to the convertible notes. |
(g) | The adjustment to income tax expense has been calculated based on the above adjustments. |
(h) | The number of weighted average common shares has been adjusted to correct a computational difference in the previously disclosed balance. |
9
Nine months ended September 30, 2009 | ||||||||||||
Previously | ||||||||||||
Reported | Adjustments | Restated | ||||||||||
REVENUES | $ | 14,942,533 | $ | (199,120 | ) | $ | 14,743,413 | |||||
COST OF REVENUES | (11,936,853 | ) | 415,546 | (11,521,307 | ) | |||||||
GROSS PROFIT | 3,005,680 | 216,426 | 3,222,106 | |||||||||
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES(note(c)) | (5,648,822 | ) | 1,621,655 | (4,027,167 | ) | |||||||
LOSS FROM OPERATIONS | (2,643,142 | ) | 1,838,081 | (805,061 | ) | |||||||
OTHER INCOME (EXPENSE), NET: | ||||||||||||
Change in fair value of warrants(note(d)) | 2,108,556 | (871,878 | ) | 1,236,678 | ||||||||
Non-operating expense, net(note(e)) | (1,148 | ) | (43,846 | ) | (44,994 | ) | ||||||
Interest expenses(note(f)) | (329,584 | ) | 33,337 | (296,247 | ) | |||||||
Total other income (expense), net | 1,777,824 | (882,387 | ) | 895,437 | ||||||||
(LOSS)/INCOME FROM OPERATIONS BEFORE PROVISION FOR INCOME TAXES | (865,318 | ) | 955,694 | 90,376 | ||||||||
BENEFIT/(PROVISION) FOR INCOME TAXES(note(g)) | 119,210 | (128,110 | ) | (8,900 | ) | |||||||
NET(LOSS)/INCOME | (746,108 | ) | 827,584 | 81,476 | ||||||||
OTHER COMPREHENSIVE INCOME | ||||||||||||
Foreign currency translation adjustment | 37,837 | - | 37,837 | |||||||||
COMPREHENSIVE (LOSS)/INCOME | $ | (708,271 | ) | $ | 827,584 | $ | 119,313 | |||||
(LOSS)/ EARNINGS PER COMMON SHARE: | ||||||||||||
Basic and diluted(note(h)) | $ | (0.024 | ) | 0.027 | 0.003 | |||||||
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING: | ||||||||||||
Basic and diluted | 29,931,806 | 52 | 29,931,858 |
(a) | The restated revenues decreased by $199,120 because the Company over recognized certain revenue by $862,075, offset by recognizing retainage of $662,955 as revenue for the nine months ended September 30, 2009, since the recoverability of the retainage could be reasonably assured. |
(b) | The restated cost of revenues decreased by $415,546, representing overcharged costs and sales taxes of $344,987 and $70,559, respectively. |
(c) | The restated selling, general and administrative expenses decreased by $1,621,655, representing overcharged stock based compensation of $999,483 and allowance of doubtful accounts of $671,553, offset by undercharged salary payable of $49,381. |
(d) | The restated change in fair value of warrants decreased by $871,878, representing the under estimated value of the warrants. |
(e) | The restated non-operating expense increased by $43,846, representing undercharged expense between Sifang and Shanghai Engineering. |
(f) | The restated interest expenses decreased by $33,337, representing the over amortized value of warrants related to the convertible notes. |
(g) | The adjustment to income tax expense has been calculated based on the above adjustments. |
(h) | The number of weighted average common shares has been adjusted to correct a computational difference in the previously disclosed balance. |
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Consolidated Statement of Cash Flows Impact:
The following table presents selected unaudited consolidated statements of cash flows information for the Company showing previously reported and restated cash flows, for the nine months ended September 30, 2009:
Nine months ended September 30, 2009 | ||||||||||||
Previously Reported | Adjustments | Restated | ||||||||||
Net cash used in operating activities | $ | (5,399,559 | ) | $ | 34,862 | (1) | $ | (5,364,697 | ) | |||
Net cash used in investing activities | (160,319 | ) | 92,899 | (1) | (67,420 | ) | ||||||
Net cash provided by financing activities | 5,604,613 | (105,833 | ) | 5,498,780 | ||||||||
Subtract: Restricted cash - special use | (5,000,000 | ) | 5,000,000 | - | ||||||||
Effects of exchange rate change in cash | $ | 21,903 | $ | (21,928 | ) | $ | (25 | ) |
(1) Included in the adjustments is a revision to restricted cash in the unaudited Consolidated Statements of Cash Flows for the nine months ended September 30, 2009: The Company revised the net change in restricted cash during the first half of 2009 from operating activities to investing activities because of a contractual requirement to maintain a certain amount of cash on deposit with a bank to support the completion of certain projects. Since the restricted cash is deposited in a bank account for specific purposes, such activity is deemed to be an investing activity and as a result, net cash used in operating activities has been increased by $106,286 and net cash used in investing activities has decreased accordingly. The revision had no effect on previously reported results of operations or accumulated deficit.
Note 3 – Summary of Significant Accounting Policies
The principal accounting policies adopted in the preparation of these consolidated financial statements are set out below:
(a) | Principal of consolidation |
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“US GAAP”). The consolidated financial statements include the financial statements of the Company, its wholly-owned subsidiaries Poise Profit, CER Hong Kong, Hi-tech, CER Shanghai, CER Yangzhou, and its variable interest entities (“VIEs”), Shanghai Engineering, and Shanghai Environmental. All significant inter-company transactions and balances among the Company, its subsidiaries and VIEs are eliminated upon consolidation.
In accordance with the Accounting Standard Codification (“ASC”) 810-10, variable interest entities (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.
The Company has concluded that Shanghai Engineering, and Shanghai Environmental are VIEs and that the Company is the primary beneficiary. Under the requirements of US GAAP, the Company consolidated the financial statements of Shanghai Engineering and Shanghai Environmental.
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(b) Use of estimates
In preparing financial statements in conformity with US GAAP, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reported periods. Significant estimates include useful lives of property, plant and equipment, allowance for doubtful accounts, deferred tax assets and the completion percentage of the construction contracts. Actual results could differ from those estimates.
(c) Concentration of risk
The Company maintains cash balances at financial institutions within the U.S. Hong Kong and PRC. Balances at financial institutions or state owned banks within the PRC are not covered by insurance. Balances at financial institutions within the United States are covered by the Federal Deposit Insurance Corporation for $250,000 per depositor per institution. Balances at financial institutions within Hong Kong are fully covered by the government provided insurance until the end of 2010. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risks on its cash in bank accounts.
For the three months ended September 30, 2009 and 2010, the Company’s five top customers accounted for 85% and 83% of the Company's sales, respectively. For the nine months ended September 30, 2009 and 2010, the Company’s five top customers accounted for 69% and 72% of the Company's sales, respectively. Receivables from the five top customers were 16% and 5% of total accounts receivable ended September 30, 2009 and 2010, respectively.
For the three months ended September 30, 2009 and 2010, five top suppliers provided approximately13% and 43% of the Company's purchases of raw materials, respectively. For the nine months ended September 30, 2009 and 2010, five top suppliers provided approximately 41% and 36% of the Company's purchases of raw materials, respectively. Payables to the five suppliers were about 9% and 2% of total accounts payable as of September 30, 2009 and 2010, respectively.
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 country, and by the general state of the country's economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies carrying out operations in the United States. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. The Company's results may be adversely affected 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.
(d) Foreign currency translations
The reporting currency of the Company is the U.S. dollar. Shanghai Engineering, CER Shanghai, CER Yangzhou, Hi-tech and CER Hong Kong use Renminbi ("RMB") as their functional currency. Results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the end of period exchange rates. Cash flows are also translated at average translation rates for the period, therefore, amounts reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheet. Translation adjustments resulting from this process are included in accumulated other comprehensive income (loss) in stockholders' equity. Transaction gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. For the three months ended September 30, 2009 and 2010, foreign currency translation income amounted to $8,784 and income amounted to $292,890, respectively. For the nine months ended September 30, 2009 and 2010, foreign currency translation income amounted to $37,837 and loss amounted to $320,890, respectively.
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The PRC government imposes significant exchange restrictions on fund transfers out of the PRC that are not related to business operations. These restrictions have not had a material impact on the Company because it has not engaged in any significant transactions that are subject to the restrictions.
Accumulated other comprehensive loss amounted to $77,485 and income amounted to $243,405 as of December 31, 2009 and September 30, 2010, respectively. The balance sheet accounts with the exception of equity at December 31, 2009 and September 30, 2010 were translated at RMB6.82 to $1.00, and were translated at RMB 6.70 to $1.00 respectively.
The average translation rates applied to income and cash flow statement amounts for the three months ended September 30, 2009 and 2010 were RMB6.82 to $1.00 and RMB6.80 to $1.00, respectively. For the nine months ended September 30, 2009 and 2010, the average translation rates were RMB6.82 to $1.00 and RMB6.80 to $1.00, respectively.
(e) Cash
Cash includes cash on hand and demand deposits with banks, which are unrestricted as to withdrawal and use, and which have original maturities less than three months.
(f) Notes receivable
Notes receivable represent trade accounts receivable due from various customers where the customers’ banks have guaranteed the payment of the receivables. The notes are non-interest bearing and normally paid within three to nine months. The Company has the ability to submit request for payment to the customer’s bank earlier than the scheduled payment date, but will incur an interest charge and a processing fee. There was no notes receivable as of September 30, 2010.
(g) Receivables and allowance for doubtful accounts
Receivables include trade accounts due from the customers, and other receivables from cash advances to employees or third parties. Management regularly reviews aging of receivables and changes in payment trends by its customers, and records a reserve when they believe collection of amounts due are at risk.
Allowance for doubtful account, December 31, 2008 | $ | 251,458 | ||
Addition | 337,383 | |||
Translation adjustment | 207 | |||
Allowance for doubtful account, December 31, 2009 | $ | 589,048 | ||
Addition | - | |||
Recovery | (68,049 | ) | ||
Translation adjustment | 10,159 | |||
Allowance for doubtful accounts, September 30, 2010 | $ | 531,158 |
Accounts receivable which are expected to be collected after twelve months are reclassified as long-term accounts receivable. The Company reserved a provision for account receivable balances based on the nature of the business and accounts receivable collection history (further discussed in Note 4).
(h) Inventories
Inventories are comprised of raw materials, work in progress and finished goods and are stated at the lower of cost or market value. Costs of work in progress include direct labor, direct materials, and production overhead before the goods are ready for sale. Management reviews inventories for obsolescence or cost in excess of market value periodically. The obsolescence, if any, is recorded as a reserve against the inventory. The cost in excess of market value is written off and recorded as cost of revenues.
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(i) Advances on purchase
Advances on purchases are monies advanced to outside vendors for inventory purchases and property, plant and equipment purchases. This amount is refundable and bears no interest.
(j) Property, plant and equipment, net
Property, plant and equipment are stated at cost. Depreciation is provided principally by use of the straight-line method over the estimated useful lives of the related assets. Expenditures for maintenance and repairs, which do not improve or extend the expected useful lives of the assets, are charged to operations as incurred, while renewals and betterments are capitalized.
Management established a 5% residual value for property, plant and equipment. The estimated useful lives of the property, plant and equipment are as follows:
Plant | 20 years |
Transportation equipment | 3-10 years |
Machinery equipment | 5-10 years |
Office equipment | 3-5 years |
The gain or loss on disposal of property, plant and equipment is the difference between the net sales proceeds and the carrying amount of the relevant assets; gains or losses, if any, are recognized in the statement of operations. There was no disposal of assets during the three and nine months ended September 30, 2009 and 2010.
(k) Impairment of assets
The Company assesses the carrying value of long-lived assets each reporting period, more often when factors indicating impairment are present, and reduces the carrying value of such assets by the amount of the impairment. The Company determines the existence of such impairment by measuring the expected future cash flows (undiscounted and without interest charges) and comparing such amount to the net asset carrying value. An impairment loss, if it exists, is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Fair value generally means based on either quoted market price, if available, or discounted cash flow analysis. There were no impairment of long lived assets recognized for the three and nine months ended September 30, 2009 and 2010.
(l) Advances from customers
Advances from customers represent amounts advanced by customers on product or service orders. The product (service) normally is shipped (rendered) within one year after receipt of the advance payment, and the related sales are recognized in accordance with the Company’s revenue recognition policy.
(m) Income taxes
Income taxes are accounted for under the asset and liability method. Deferred income taxes are recognized for temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements, net operating loss carry forwards and credits, by applying enacted statutory tax rate in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Current income taxes are provided for in accordance with the laws of the relevant taxing authorities.
(n) Value added tax
Sales revenue represents the invoiced value of goods, net of a value-added tax ("VAT"). All of the Company's products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing its finished product. The Company 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.
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(o) Operation leases
Leases where substantial all the rewards and risks of ownership of assets remain with the leasing company are accounted for as operating leases. Payments made under operating leases are charged to the statement of operation on a straight line basis over the lease periods.
(p) Stock based compensation
In accordance with ASC 718, Compensation-Stock Compensation, the Company measures the cost of employee services received in exchange for stock based compensation at the grant date fair value of the award.
The Group recognizes the stock based compensation costs, net of a forfeiture rate, on a straight-line basis over the requisite service period for each award.
ASC 718 requires forfeitures to be estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from those estimates.
Cost of goods acquired or services received from non-employees is measured based on the fair value of the awards issued on the measurement date as defined in ASC 505. Awards granted to non-employees are remeasured at each reporting date using the fair value as at each period end. Changes in fair values between the interim reporting dates are attributed consistent with the method used in recognizing the original stock based compensation costs.
(q) Shipping and handling costs
Shipping and handling costs are included in selling, general and administrative expenses which totaled $83,013 and $82,453 for the three months period ended September 30, 2009 and 2010, respectively, $346,090 and $192,369 for the nine months period ended September 30, 2009 and 2010, respectively.
(r) Revenue recognition
The Company derives revenues principally from
(a) | Sales of energy recovery systems, and |
(b) | Provision of design services, and |
(c) | Provision of Engineering, Procurement and Construction ("EPC") services, which are essentially turnkey contracts where the Company provides all services in the whole construction process from design, development, engineering, manufacturing, procurement to installation. |
Revenue by the above categories for the three and nine months ended September 30, 2009 and 2010 are summarized as follows:
Three months ended September 30, | ||||||||
2009 | 2010 | |||||||
Revenue: | ||||||||
Product | $ | 2,845,939 | $ | 3,067,962 | ||||
EPC contracts | 2,474,579 | 3,079,689 | ||||||
Totals | $ | 5,320,518 | $ | 6,147,651 |
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Nine months ended September 30, | ||||||||
2009 | 2010 | |||||||
Revenue: | ||||||||
Product | $ | 10,147,408 | $ | 6,058,268 | ||||
EPC contracts | 4,596,005 | 11,389,302 | ||||||
Totals | $ | 14,743,413 | $ | 17,447,570 |
In providing design services, the Company designs energy recovery systems and other related systems based on a customer's requirements and the deliverable consists of engineering drawings. The customer may elect to engage the Company to manufacture the designed system or choose to present the Company's drawings to other manufacturers for manufacturing and installation. There were no service revenue for the three and nine months ended September 30, 2009 and 2010. In contrast, when providing EPC services, the customer is purchasing a turnkey energy recovery system and the Company is involved throughout the entire process from design to installation.
Sales of the Company's energy recovery systems and related products are essentially product sales. The products consist mainly of waste heat boilers and other related equipment manufactured according to specific customers' specifications. Once manufactured, the Company ships the products to its customers in their entirety in one batch. The Company’s arrangement also includes a limited warranty to its customers pursuant to which the customers retain between 5% and 10% of the particular contract price as retainage during the limited warranty period (usually 12-18 months). The Company generally recognizes revenues including retainage from product sales when (i) persuasive evidence of an arrangement exists, which is generally represented by a contract between the Company and the customer; (ii) products are shipped; (iii) title and risk of ownership have passed to the customer, which generally occurs at the time of delivery; (iv) the customer accepts the products upon quality inspection performed by them; (v) the purchase price is agreed to between the Company and the customer; and (vi) collectability is reasonably assured. Net revenues represent the invoiced value of products, less returns and discounts, and net of value-added tax.
The Company recognizes revenues from design services when the services are provided, the design drawings are delivered, invoices are issued and collectability is reasonably assured. The Company generally delivers the drawings in one batch.
In accordance with the accounting standard regarding performance of construction-type and certain production-type contracts, and long-term construction-type contracts, the company adopted the percentage of completion method to recognize revenues and cost of sales for EPC contracts. EPC contracts are long-term, complex contracts involving multiple elements, such as design, manufacturing and installation, which all form one integral EPC project. The energy recovery system involved in an EPC project is highly customized to the specific customer's facilities and essentially not transferable to any other facilities without significant modification and cost. It would be difficult, if not impossible, to beneficially use a single element of a specific EPC project on a standalone basis other than in connection with the facilities for which it was intended. EPC contracts are by nature long-term construction-type contracts, usually lasting more than one accounting period, and the Company is able to reasonably estimate the progress toward completion, including contracts revenues and contracts costs. EPC contacts specify the customers' rights to the goods, the consideration to be paid and received, and the terms of payment. Specifically, the Company has the right to require a customer to make progress payments upon completion of determined stages of the project which serve as evidence of the customer's approval and acceptance of the work completed to date as complying with the terms of the particular EPC contract and upon which the Company recognizes the revenue.
(s) Fair value of financial instruments
The accounting standard regarding fair value of financial instruments and related fair value measurements defines financial instruments and requires fair value disclosures of those financial instruments. On January 1, 2008, the Company adopted accounting standard regarding fair value measurements, which defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosures requirements for fair value measures. The carrying amounts reported in the accompanying consolidated balance sheets for current assets and current liabilities qualify as financial instruments. Management concluded the carrying values of these financial instruments 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 the current market rates of interest. The three levels of valuation hierarchy are defined as follows:
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Level 1 | Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Fair valued assets and liabilities that are generally included in this category are assets comprised of cash, restricted cash, accounts and notes receivable, and liabilities comprised of bank loans, accounts payable, accrued liabilities and other payables. As of December 31, 2009 and September 30, 2010, the carrying values of these assets and liabilities approximated their fair values. |
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 assets or liability, either directly or indirectly, for substantially the full term of the financial instruments. At December 31, 2009 and September 30, 2010, the Company did not have any fair value assets or liabilities classified as Level 2. |
Level 3 | Inputs to the valuation methodology are unobservable and significant to the fair value. Inputs reflected management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. |
The following table presents information about the Company’s financial liabilities classified as Level 3 as of September 30, 2010 and December 31, 2009.
Balance as of September 30, 2010 | ||||||||||||||||
Carrying | Fair Value Measurements | |||||||||||||||
Value | Using Fair Value Hierarchy | |||||||||||||||
Level 1 | Level 2 | Level 3 | ||||||||||||||
Derivative liability, current (Note 14) | $ | 155,645 | - | - | $ | 155,645 | ||||||||||
Warrant liability (Note 14) | $ | 392,330 | - | - | $ | 392,330 |
Balance as of December 31, 2009 | ||||||||||||||||
Carrying | Fair Value Measurements | |||||||||||||||
Value | Using Fair Value Hierarchy | |||||||||||||||
Level 1 | Level 2 | Level 3 | ||||||||||||||
Derivative liability, current (Note 14) | $ | 435,500 | $ | 435,500 | ||||||||||||
Derivative liability (Note 14) | $ | 435,500 | - | - | $ | 435,500 | ||||||||||
Warrant liability (Note 14) | $ | 1,372,947 | - | - | $ | 1,372,947 |
A summary of changes in Level 3 derivative and warrant liabilities for the years ended December 31, 2009 and for the nine months ended September 30, 2010 were as follows:
Balance at January 1, 2009 | $ | 1,524,268 | ||
Warrants issued at issuance of convertible notes (Note 14) | 1,387,912 | |||
Derivative liability at issuance of convertible notes (Note 14) | 1,270,500 | |||
Change in fair value of warrant liability recognized in earnings | (1,539,233 | ) | ||
Change in fair value of derivative liability recognized in earnings | (399,500 | ) | ||
Balance at December 31, 2009 | 2,243,947 | |||
Derivative liability of long term loan, current (Note 9) | 132,470 | |||
Change in fair value of warrant liability recognized in earnings | (980,617 | ) | ||
Change in fair value of derivative liability recognized in earnings | (847,825 | ) | ||
Balance at September 30, 2010 | $ | 547,975 |
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The following presents the carrying value and the estimated value of the Company’s convertible note at September 30, 2010:
Carrying Value | Fair Value | |||||||
Convertible note | $ | 4,659,381 | $ | 4,448,399 |
The fair value of the convertible note is based on the market interest rate for debt with similar terms and maturity.
The long term account receivable is recorded at cost, which is discounted from the contractual balance. The carrying value of the long term account receivable, which is estimated based upon future cash flows, approximates fair value at September 30, 2010 and December 31, 2009.
(t) Segment reporting
The group has adopted ASC 280, Segment Reporting, for its Segment reporting. The group mainly operates in China and measures its business as a single segment.
(u) Recent accounting pronouncements
In January 2010, the FASB issued new accounting guidance related to the disclosure requirements for fair value measurements and provides clarification for existing disclosures requirements. More specifically, this update will require (a) an entity to disclose separately the amounts of significant transfers in and out of Levels 1 and 2 fair value measurements and to describe the reasons for the transfers; and (b) information about purchases, sales, issuances and settlements to be presented separately (i.e. present the activity on a gross basis rather than net) in the reconciliation for fair value measurements using significant unobservable inputs (Level 3 inputs). This guidance clarifies existing disclosure requirements for the level of disaggregation used for classes of assets and liabilities measured at fair value and require disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements using Level 2 and Level 3 inputs. The new disclosures and clarifications of existing disclosure are effective for fiscal years beginning after December 15, 2009, except for the disclosure requirements for related to the purchases, sales, issuances and settlements in the rollforward activity of Level 3 fair value measurements. Those disclosure requirements are effective for fiscal years ending after December 31, 2010. The Company does not expect the adoption of the updated guidance will have a material impact on its consolidated financial position, results of operations and cash flows.
In February 2010, the FASB issued accounting standards update which amends the accounting standard on subsequent event. The accounting update provides guidance on events that occur after the balance sheet date but prior to the issuance of the financial statements. The accounting standard distinguishes events requiring recognition in the financial statements and those that may require disclosure in the financial statements. As a result of the accounting update, SEC registrants will not disclose the date through which management evaluated subsequent events in the financial statements, either in originally issued financial statements or reissued financial statements. The accounting standard was effective for interim and annual periods ending after June 15, 2009, and the accounting update is effective immediately. We have evaluated subsequent events in accordance with the accounting update.
In April 2010, the FASB issued an authoritative pronouncement on effect of denominating the exercise price of a share-based payment award in the currency of the market in which the underlying equity securities trades and that currency is different from (1) entity’s functional currency, (2) functional currency of the foreign operation for which the employee provides services, and (3) payroll currency of the employee. The guidance clarifies that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should be considered an equity award assuming all other criteria for equity classification are met. The pronouncement will be effective for interim and annual periods beginning on or after December 15, 2010, and will be applied prospectively. Affected entities will be required to record a cumulative catch-up adjustment for all awards outstanding as of the beginning of the annual period in which the guidance is adopted. The Company does not expect the adoption of this pronouncement to have a significant impact on its consolidated financial position or results of operations.
In July 2010, the FASB issued new disclosure guidance related to the credit quality of financing receivables and the allowance for credit losses. The guidance will require companies to provide more information about the credit quality of their financing receivables in the disclosures to financial statements including, but not limited to, significant purchases and sales of financing receivables, aging information and credit quality indicators. We will adopt this accounting standard upon its effective date for periods ending on or after December 15, 2010, and do not anticipate that this adoption will have a significant impact on our financial position or results of operations.
In October 2009, the Financial Accounting Standards Board (“FASB”) issued new guidance on “revenue recognition for arrangements with multiple deliverables and certain revenue arrangements that include software elements.” By providing another alternative for determining the selling price of deliverables, the guidance for arrangements with multiple deliverables will allow companies to allocate consideration in multiple deliverable arrangements in a manner that better reflects the transaction’s economics and will often result in earlier revenue recognition. The new guidance modifies the fair value requirements of previous guidance by allowing “best estimate of selling price” in addition to vendor-specific objective evidence (“VSOE”) and other vendor objective evidence (“VOE,” now referred to as “TPE,” standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted under the new guidance.
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The new guidance for certain revenue arrangements that include software elements removes non-software components of tangible products and certain software components of tangible products from the scope of existing software revenue guidance, resulting in the recognition of revenue similar to that for other tangible products. The new guidance is effective for fiscal years beginning on or after June 15, 2010. However, companies may adopt the guidance as early as interim periods ended September 30, 2009. The guidance may be applied either prospectively from the beginning of the fiscal year for new or materially modified arrangements or retrospectively.
The Company has not early adopted the new guidance and the adoption of the new guidance does not have a significant impact on our financial position or results of operations.
In December 2010, FASB issued revised guidance on “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” The revised guidance specifies that an entity with reporting units that have carrying amounts that are zero or negative is required to assess whether it is more likely than not that the reporting units’ goodwill is impaired. If the entity determines that it is more likely than not that the goodwill of one or more of its reporting units is impaired, the entity should perform Step 2 of the goodwill impairment test for those reporting unit(s). Any resulting goodwill impairment should be recorded as a cumulative-effect adjustment to beginning retained earnings in the period of adoption. Any goodwill impairments occurring after the initial adoption of the revised guidance should be included in earnings as required by Section 350-20-35. The revised guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. The adoption does not have a significant impact on our financial position or results of operations.
In December 2010, FASB issued revised guidance on the “Disclosure of Supplementary Pro Forma Information for Business Combinations.” The revised guidance specifies that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The revised guidance also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The revised guidance is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company has not early adopted the new guidance and the adoption does not have a significant impact on our financial position or results of operations.
Note 4 – Accounts Receivable
(a) | Accounts Receivable |
December 31, | September 30, | |||||||
2009 | 2010 | |||||||
Current accounts receivable | $ | 6,601,921 | $ | 7,919,723 | ||||
Subtract: Allowance for doubtful accounts | - | - | ||||||
Current accounts receivable, net | $ | 6,601,921 | $ | 7,919,723 |
The Company reclassified accounts receivable which are expected to be collected after one year as long- term assets.
Current accounts receivable also consisted revenue recognized in excess of amounts billed for the EPC contracts recognized using the percentage of completion method. As of December 31, 2009 and September 30, 2010, the revenue recognized in excess of amounts billed amounted to approximately $2,382,315 and $2,301,126, respectively.
(b) | Long-term Accounts Receivable |
December 31, | September 30, | |||||||
2009 | 2010 | |||||||
Long-term accounts receivable | $ | 7,419,663 | $ | 5,694,517 | ||||
Subtract: Allowance for doubtful accounts | (589,048 | ) | (531,158 | ) | ||||
Long-term accounts receivable, net | $ | 6,830,615 | $ | 5,163,359 |
Long-term accounts receivable consisted revenue recognized in excess of amounts billed of approximately $6,220,710 and $5,163,359 as of December 31, 2009 and September 30, 2010, respectively.
19
Note 5 – Inventories
As of December 31, 2009 and September 30, 2010, inventories consist of the following:
December 31, | September 30, | |||||||
2009 | 2010 | |||||||
Raw materials | $ | 1,539,322 | $ | 1,563,281 | ||||
Work in progress | 6,988,199 | 6,408,355 | ||||||
Finished goods | 47,254 | 61,779 | ||||||
Total inventories | $ | 8,574,775 | $ | 8,033,415 |
For the three and nine months ended September 30, 2010 and 2009, management determined that no additional provisions to inventory balances were required.
Note 6 – Property, plant and equipment, Net
As of December 31, 2009 and September 30, 2010, property, plant and equipment consist of the following:
December 31, | September 30, | |||||||
2009 | 2010 | |||||||
Machinery equipment | $ | 626,485 | $ | 668,282 | ||||
Transportation equipment | 270,419 | 346,789 | ||||||
Office equipment | 431,905 | 483,602 | ||||||
Construction in progress | - | 4,303,526 | ||||||
Subtotal | 1,328,809 | 5,802,199 | ||||||
Accumulated depreciation | (569,921 | ) | (761,707 | ) | ||||
Property, plant and equipment, net | $ | 758,888 | $ | 5,040,492 |
Depreciation expense for the three months ended September 30, 2009 and 2010 was $50,383 and $88,979, respectively. Depreciation expense for the nine months ended September 30, 2009 and 2010 was $139,862 and $191,786, respectively.
Note 7 – Intangible Assets
Intangible assets mainly represent purchase for usage of a parcel of land in Yangzhou where the manufacturing plant is located. The Company has obtained the legal usage title of the land in November 2009. The land use right is recorded at cost of $2,438,632 and is amortized over the lease term of 50 years starting from November 2009 when it is acquired. The amortization expense recorded for the three and nine months ended September 30, 2010 amounted to $16,740 and $50,841, respectively. The remaining balance represents the net value of purchased software.
Note 8 – Short Term Bank Loans
On September 1, 2009, the Company borrowed $880,200 a short-term loan from one bank in China which matured on August 31, 2010 with a 5.841% annual interest rate. The bank loan was collateralized by Shanghai Engineering’s leased office space, which is owned jointly by Mr. Qinghuan Wu, the Chairman of the Board and Chief Executive Officer of the Company, and his son. The full amount of $880,200 was repaid on January 5, 2010.
20
Interest expenses of short-term bank loans for the three months ended September 30, 2009 and 2010 was $4,282 and $0. Interest expenses of short-term bank loans for the nine months ended September 30, 2009 and 2010 was $6,337 and $1,571, respectively.
Note 9 – Long Term Loans
On February 1, 2010, the Company, through its subsidiaries, CER Shanghai (“Borrower”) and CER Hong Kong (“Paying Agent”) entered into a series of agreements for a loan arrangement with two lenders (the “Loan Agreements”). The proceeds of this loan are for construction of the new plant in China for the production of the Company’s products.
The aggregate principal amount of the loan under the two Loan Agreements is $4,000,000. The principal is due January 15, 2013, and bears interest at the annual rate of 15.1%. The loan repayments are to be made three times a year starting May 15, 2010, and are fully amortizing, such that the principal and interest will be fully repaid at maturity. The Company will pay the sum of US$ 566,023 at the end of every four calendar months, commencing May 15, 2010. The Company has entered into other agreements to provide that moneys due from a certain sale and service contract and related guarantee will be directed to pay the amounts due under the Loan Agreements, with the balance paid to the Company or its affiliates. The loan agreement between the lender and the Company and related agreements have been registered with State Administration of Foreign Exchange (SAFE) for the inflow of funds and the repayment of the loan obligations. The loans may be prepaid at any time with a premium of 1.25% of the principal amount being paid. The Loan Agreements provide for the typical events of default, including a cross default clause, and the Company has made various representations and given various covenants to the lenders as are typical of such arrangements.
As a guarantor of the payments under the Loan Agreements, Mr. Qinghuan Wu, the Chief Executive Officer of the Company and the principal officer of the Borrower, Paying Agent and other affiliates, has pledged 8,000,006 shares for the repayment of the obligations under the Loan Agreements.
As a result of the Company not filing its periodic reports with the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934, as amended, on a timely basis for the fiscal year ended December 31, 2009 and the quarters ended March 31, 2010, June 30, 2010 and September 30, 2010, the Company was in violation of various loan covenants and default terms with respect its obligation to file SEC reports and comply with applicable laws under the terms of the loan for $4,000,000 in principal amount due January 15, 2013. The violation of the covenants and default permit the note holders to accelerate the repayment of the full amount of the principal and interest due on the loan. To date, the lenders have not delivered any notice of acceleration and have not indicated that they intend to give such a notice. One of the lenders representing $2,000,000 in principal amount of the loans provided to the Company on November 1, 2010, a waiver of the covenant and default terms and also provided the Company sufficient time to make the necessary past due filings, before a covenant violation or default would result again concerning these issues.
According to the loan agreement provisions, as an additional inducement to the Lender to make the Loan, which payment will not be considered interest hereunder, CER will issue to the Lender or its designee, on each date that an amount of principal of the Loan is paid, shares of common stock of CER, on a restricted basis, without registration rights, as follows: If the RMB exchange rate between the RMB and United States Dollar (“USD”) is less than RMB 6.8271(the agreed upon exchange rate on the date of the making of the Loan), such that the value of the RMB is greater than the USD, then the difference in the principal installment calculated at the rate of RMB and calculated at the rate of RMB to USD on such repayment date will be converted into a US dollar amount and divided by the closing price of one share of common stock of CER on the OTC or stock exchange, the result of which will represent that number of shares to be issued to the Lender as of such date, in restricted stock. As of September 30, 2010, the derivative liabilities amounted to $133,299.The change in fair value of the derivative liability income amounted to $3,095 and loss amounted to $829 was recorded in the consolidated statements of operations for the three and nine months ended September 30, 2010, respectively. The interest expenses recognized for accretion to the redemption value of the long term loan was $16,951 and $33,980 for the three and nine months ended September 30, 2010.
21
Since the lenders have right to request early repayment, thus the long term loans and the derivative liabilities were reclassified to current liabilities as of September 30, 2010.
Contemporaneously with the funding of the Loan Agreements, on February 1, 2010, Mr. Qinghuan Wu, arranged for a loan from Haide Engineering (Hong Kong) Limited (“Haide”),a company controlled by Mr. Qinghuan Wu, to lend to the Company the sum of $1,000,000. The proceeds of this loan will be forwarded to CER Yangzhou for additional paid-in capital which will help fund the new plant being built in China. The loan bears interest at the annual rate of 9.5%, and is unsecured; the Company will pay the interest $23,750 at the end of every three calendar months. The principal is due in full on January 30, 2012. The loan is unsecured and there are no guarantees of the interest or principal. CER Hong Kong has subordinated its loan to those under the Loan Agreements.
Note 10 – Convertible Notes
On May 21, 2009, the Company entered into a term loan agreement (“Convertible Notes Agreement”) with an investment company (the “Lender”). Pursuant to the Convertible Notes Agreement, the lender provides term loan financing (“Convertible Notes”) to the Company in an amount of up to $5,000,000 within 6 months, which may be drawn from time to time, in whole or in installments, upon notice, but once repaid shall not be subject to reborrowing. The proceeds from this Convertible Note are for the construction of a new plant located in China for the production of the products, including, but not limited to, the purchase of land for the plant, buildings, equipment and for the facilitating of financing loans from one or more in-China banks and other institutional lenders. Any amount borrowed will bear interest at 9.5%, payable every six months, calculated and compounded quarterly. Each draw is due twenty-four (24) months after the draw down date, together with any accrued and unpaid interest. The Company drew down $5,000,000 on September 29, 2009. For the three months ended September 30, 2010, interest expense of $565,170 was incurred. The Convertible Notes could be converted to 2,777,778 shares of common stock at the conversion price of $1.80. In addition, the Company has issued the Lender a five-year common stock purchase warrant (“Warrants”) to purchase up to 1,388,889 shares of the Company’s common stock, which is that number of shares of the Company’s common stock equal to 50% of the principal sum of this Convertible Note divided by the conversion price of $1.80. In connection with these Convertible Notes, the Company issued to the Lender one hundred shares of Series B preferred stock, that provides for voting rights and the ability to appoint directors in the event of defaults equal to or exceeding $1,000,000 in the aggregate amount.
The Lender may recall a Convertible Note after the first anniversary of the draw down at a redemption price equal to the outstanding principal plus any accrued and unpaid interest upon the closing by the Company of any debt and/or equity financing (except for debt financings with banks or institutional lenders in China), in an amount up to 50% of the amount financed. Additionally, upon occurrence of certain events, the Lender can demand the entire outstanding principal, together with any accrued and unpaid interest to be immediately repaid in full or in part. The Company can also prepay the Convertible Note at any time it desires with accrued interest and unpaid interest. On September 13, 2010, the Lender agreed not to exercise its right to request an early repayment prior to January 1, 2011.
As of September 30, 2010, all of the convertible notes are classified as a current liability. The embedded conversion feature is accounted for as a derivative liability separately in the balance sheet in accordance with ASC 815, Derivatives and Hedging, because the conversion price is denominated in USD, which is a currency other than the Company’s functional currency, RMB. All of the derivative liability is classified as current liability based on the timing of the cash flows derived from the Convertible Notes. The Convertible Notes were recorded with a discount equal to the fair value of the conversion feature at the transaction date and were accreted to the redemption value of the Convertible Notes from the draw down date to the earliest redemption date using interest method. The change in fair value of the derivative liability of $25,825 and $848,654 was recorded in the consolidated statements of operations for the three and nine months ended September 30, 2010, respectively. The interest expenses recognized for accretion to the redemption value of the Convertible Notes was $231,997 and $697,253 for the three and nine months ended September 30, 2010, respectively.
22
The grant value of the warrants issued in conjunction with the Convertible Notes was treated as a commitment fee for obtaining the Convertible Notes, and therefore the value was recorded as deferred financing cost to be amortized over the period from grant date to the earliest redemption date of the Convertible Notes. For the three and nine months ended September 30, 2010, $ 191,458 and $600,396 of deferred financing cost was amortized and charged to financial expenses, respectively. The Commitment Warrants were recorded as derivative liabilities in accordance with ASC 815, Derivatives and Hedging, because the exercise price of the Commitment Warrant is denominated in USD, which is a currency other than the Company’s functional currency, RMB. Changes in fair value of the Commitment Warrants (Note 14) for the three months ended September 30, 2010 was recorded in the consolidated statements of operations.
23
Note 11 – Taxation
USA
CER, the Delaware holding company, was subject to US income tax at a rate of 34% on its assessable profits. No such tax has been assessed as the Group did not have assessable profit that was earned in or derived in the US during the years presented.
Hong Kong
CER Hong Kong subsidiaries were subject to Hong Kong profit tax at a rate of 16.5% on their assessable profits. No Hong Kong profit tax has been provided as the Group did not have assessable profit that was earned in or derived from Hong Kong subsidiaries during the years presented.
PRC
The New Enterprise Income Tax ("EIT") law was effective January 1, 2008 and the standard EIT rate is 25%. Pursuant to the PRC tax law, net operating loss can be carried forward 5 years to offset future taxable income.
Pursuant to the PRC income tax laws, Shanghai Engineering is subject to enterprise income tax at a statutory rate of 15% as a high technology entity. Shanghai Environmental, CER Shanghai and CER Yangzhou are subject to enterprise income tax at a statutory rate of 25%.
Three months ended September 30, | ||||||||
2009 (Restated) | 2010 | |||||||
Statutory CIT rate | 34.00 | % | 34.00 | % | ||||
Tax differential from statutory rate applicable to entities in the PRC | (12.24 | )% | 0.30 | % | ||||
Permanent difference | 57.47 | % | (9.60 | )% | ||||
Allowance for deferred income tax assets | (44.16 | )% | (45.07 | )% | ||||
Effective CIT rate | 35.07 | % | (20.37 | )% |
Nine months ended September 30, | ||||||||
2009 (Restated) | 2010 | |||||||
Statutory CIT rate | 34.00 | % | 34.00 | % | ||||
Tax differential from statutory rate applicable to entities in the PRC | (57.04 | )% | 6.82 | % | ||||
Permanent difference | (455.65 | )% | 1,098.86 | % | ||||
Allowance for deferred income tax assets | 488.54 | % | (1,852.97 | )% | ||||
Effective CIT rate | 9.85 | % | (713.29 | )% |
24
Deferred tax assets and liabilities without taking into consideration the offsetting of balances are as follows:
December 31, | September 30, | |||||||
2009 | 2010 | |||||||
Deferred tax assets, current | ||||||||
Rental expenses | 67,276 | - | ||||||
Deferred tax assets, non-current: | ||||||||
Tax loss carry forwards | 2,178,667 | 2,892,892 | ||||||
-Allowance for doubtful accounts and provision for inventory | 130,192 | 122,229 | ||||||
Valuation allowance | (1,822,225 | ) | (2,720,145 | ) | ||||
486,634 | 294,976 | |||||||
Total deferred tax assets | 553,910 | 294,976 | ||||||
Deferred tax liabilities, non-current: | ||||||||
Taxable temporary difference related to derivative liabilities | (352,876 | ) | (149,298 | ) | ||||
Total deferred tax liabilities | (352,876 | ) | (149,298 | ) |
The net balances of deferred tax assets and liabilities after offsetting are as follows:
December 31, | September 30, | |||||||
2009 | 2010 | |||||||
Deferred tax assets, current, net | 67,276 | - | ||||||
Deferred tax assets, non-current net | 133,758 | 145,678 | ||||||
Deferred tax liabilities, net | - | - |
On February 22, 2008, the Ministry of Finance (“MOF”) and the State Administration of Taxation (“SAT”) jointly issued Cai Shui [2008] Circular 1 (“Circular 1”). According to Article 4 of Circular 1, distributions of accumulated profits earned by a foreign investment enterprise (“FIE”) prior to January 1, 2008 to foreign investor(s) in 2008 or after will be exempt from withholding tax (“WHT”) while distribution of the profit earned by an FIE after January 1, 2008 to its foreign investor(s) shall be subject to WHT at a rate up to 10% (lower rate is available under the protection of tax treaties). Since the Company intends to indefinitely reinvest its earnings to further expand the businesses in mainland China, the foreign invested enterprises do not intend to declare dividends to their immediate foreign holding companies in the foreseeable future. As a result, if any dividends are declared out of the cumulative retained earnings as of December 31, 2007, they should be exempt from WHT. Accumulated profit of foreign subsidiaries as of December 31, 2009 and September 31, 2010 were approximately $1,059,500 (RMB 7,844,000) and $1,006,928(RMB 7,485,886), respectively, and they are considered to be indefinitely reinvested. Accordingly, no provision has been made. No dividend was declared out of the cumulative retained earnings as of December 31, 2009 and September 30, 2010.
No provision for taxation has been made for CER Hong Kong, and CER Yangzhou for the three months ended September 30, 2009 and 2010, as those subsidiaries did not generate any taxable profits during the periods.
Three months ended September 30, | ||||||||
2009 (Restated) | 2010 | |||||||
US income tax benefit | $ | - | $ | - | ||||
HK income tax expense | - | - | ||||||
PRC income tax (benefit)/expense | (139,382 | ) | 144,497 | |||||
Total provision for income taxes expense | $ | (139,382 | ) | $ | 144,497 |
25
Nine months ended September 30, | ||||||||
2009 (Restated) | 2010 | |||||||
US income tax expense | $ | - | $ | - | ||||
HK income tax expense | - | - | ||||||
PRC income tax expense | 8,900 | 345,647 | ||||||
Total provision for income taxes (benefit)/expense | $ | 8,900 | $ | 345,647 |
The Company is incorporated in the U.S. and incurred a net operating loss for income tax purposes for the nine months ended September 30, 2009 and 2010. The net operating loss carry forwards for the U.S. income tax purposes is approximately $5,735,965 and $6,615,870 as of September 30, 2009 and 2010, respectively, which may be available to reduce future years' taxable income. These carry forwards will expire, if not utilized, in 20 years. Management believes that the realization of the benefits arising from this loss are uncertain due to Company's limited operating history and continuing losses for United States income tax purposes. In the year ended 31 December 2009, the Company accrued deferred tax liability due to convertible note of $431,970 of which the balance as of December 31, 2009 and September 30, 2010 was $352,876 and $149,298 respectively. Therefore the Company offset equivalent deferred tax asset and deferred tax liability. Except for the above mentioned deferred tax asset, the Company has provided a 100% valuation allowance of deferred tax asset at December 31, 2009 and September 30 2010. Management reviews this valuation allowance periodically and makes adjustments as warranted.
The valuation allowances as of December 31, 2009 and September 30, 2010 were as follows:
Amount | ||||
Balance of December 31, 2008 | 1,173,146 | |||
Increase | 649,079 | |||
Balance of December 31, 2009 | $ | 1,822,225 | ||
Increase | 897,920 | |||
Balance of September 30, 2010 | $ | 2,720,145 |
Note 12 – (Loss)/Earnings per Share
The Company reports earnings per share in accordance with the provisions of ASC 260, “Earnings Per Share”. This standard requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings(losses) per share excludes dilution and is computed by dividing net income(losses) available to common stockholders by the weighted average common shares outstanding during the period under the two-class method. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. In computing the dilutive effect of convertible securities, the number of shares is adjusted for the additional common stock to be issued as if the convertible securities are converted at the beginning of the period (or at the time of issuance, if later). In computing the dilutive effect of options and warrants, the treasury method is used. Under this method, options and warrants are assumed to be exercised at the beginning of the period and as if funds obtained thereby were used to purchase common stock at the average market price during the period.
26
The following is a reconciliation of the basic and diluted earnings per share computations for the three and nine months ended September 30, 2009 and 2010:
Three months ended September 30, | ||||||||
2009 | 2010 | |||||||
(Restated) | ||||||||
Numerator: | ||||||||
Net loss for the period | (258,118 | ) | (853,749 | ) | ||||
Amount allocated to preferred stockholders | - | - | ||||||
Net loss available to common stock holders – Basic and diluted | (258,118 | ) | (853,749 | ) | ||||
Denominator: | ||||||||
Denominator for basic earnings per share -weighted average common stocks outstanding | 29,936,405 | 30,883,916 | ||||||
Dilutive effect of series A preferred shares | - | - | ||||||
Denominator for diluted earnings per share | 29,936,405 | 30,883,916 | ||||||
Basic loss per share | (0.009 | ) | (0.028 | ) | ||||
Diluted loss per share | (0.009 | ) | (0.028 | ) |
Nine months ended September 30, | ||||||||
2009 | 2010 | |||||||
(Restated) | ||||||||
Numerator: | ||||||||
Net income/(loss) for the period | 81,476 | (394,105 | ) | |||||
Amount allocated to preferred stockholders | (936 | ) | - | |||||
Net income (loss) available to common stock holders – Basic and diluted | 80,540 | (394,105 | ) | |||||
Denominator: | ||||||||
Denominator for basic earnings per share -weighted average common stocks outstanding | 29,931,858 | 30,834,537 | ||||||
Dilutive effect of series A preferred shares | - | - | ||||||
Denominator for diluted earnings per share | 29,931,858 | 30,834,537 | ||||||
Basic (loss)/earnings per share | 0.003 | (0.013 | ) | |||||
Diluted (loss)/earnings per share | 0.003 | (0.013 | ) |
For the three and nine months ended September 30, 2009, there was no diluted effect to loss per share due to the anti-dilutive effect. Warrants to purchase 3,357,450 shares of common stock and options to purchase 760,000 shares of common stock as of September 30, 2009 were not included in the calculation of dilutive earnings/(loss) per share because of the anti-dilutive effect.
For the three and nine months ended September 30, 2010, there was no diluted effect to earnings per share due to loss position. Warrants to purchase 3,357,450 shares of common stock and options to purchase 560,000 shares of common stock as of September 30, 2010 were not included in the calculation of dilutive loss per share because of their loss effect.
27
Note 13 – Convertible Preferred Stock
Series A Convertible Preferred Stock
On April 15, 2008 and as a condition to closing of the Share Exchange, CER entered into Securities Purchase Agreements with 25 accredited investors pursuant to which CER issued and sold an aggregate of 7,874,241 units at a unit price of $1.08 (the "Financing"). Each unit consisted of one share of CER's Series A convertible preferred stock, par value of $0.001, and one warrant to purchase one-half of one share of CER's common stock at an exercise price of $1.29 per share. After the 1-for-2 reverse stock split conducted on April 16, 2008, the 7,874,241 shares of the Company’s Series A convertible preferred stock are convertible into 3,937,121 shares of common stock and the warrants are exercisable into 1,968,561 shares of the Company's common stock at an exercise price of $2.58 per share. The issuance costs of $1,859,902, including commissions, legal fees and transaction expenses were taken from the gross proceeds received. The net proceeds were allocated between the shares of Series A convertible preferred stock and warrants based on their relative fair values. As of the closing date, the fair value of Series A convertible preferred stock is estimated at $1.68 where as the fair value of the warrants is estimated at $0.85. As a result, an aggregate amount of $5,307,539 was allocated to shares of Series A convertible preferred stock and $1,336,739 was allocated to the warrants. The fair value of the warrants was initially valued using the binomial model with assumptions such as, stock price, volatility, expected term, dividend, risk-free interest rate, etc.
The rights, preferences and privileges with respect to the convertible preferred stock are as follows:
Voting
Holders of Series A convertible preferred stock are entitled to the number of votes equal to the number of shares of common stock into which such shares of preferred stock could be converted and to vote as a single class.
Dividends
Holders of Series A convertible preferred stock are entitled to dividends when dividends are declared for common stockholders. There have been no dividends declared to date.
Liquidation
In the event of any liquidation, dissolution or winding up of the Company, the holders of Series A convertible preferred stock shall be entitled to receive the amount of the original issue price per share (as adjusted for the 1-for-2 reverse stock split) for each Series A convertible preferred stock, plus all declared and unpaid dividends.
Conversion
Each share of Series A convertible preferred stock is convertible into common stock on a one-for-one basis, anytime at the option of the holder. The initial conversion price is $2.16 after taking into effect the 1-for-2 reverse stock split, and the conversion price is subject to adjustment in accordance with the anti-dilution clause.
There was no beneficial conversion feature recognized for the issuance of the shares of Series A convertible preferred stock on the issuance date as the estimated fair value of the common stock is less than the conversion price on the date of issuance. The Company’s common stock was quoted on the OTCBB and has been publicly traded. However, with the high volatility and extremely low volume traded during the time when the Company entered into this Financing transaction, the fair value of the Company’s common stock as of April 15, 2008 was determined based on the Company’s estimate relied in part on a valuation report prepared by an independent valuer. The estimated fair value of the common stock was $1.55 per share.
28
Adjustment of Series A Convertible Preferred Stock Conversion Price and Warrant Exercise Price
In accordance to the anti-dilution clause of the afore-mentioned Financing, if the Company shall issue additional shares without consideration or for consideration per share less than the conversion price and/or the warrant exercise price immediately prior to the issuance, such conversion price and exercise price shall be adjusted.
For the three months ended September 30, 2010, no Series A convertible preferred stock was converted to common stock. For the nine months ended September 30, 2010, 462,963 shares of Series A convertible preferred stock were converted to 245,098 shares of common stock.
As of December 31, 2009 and September 30, 2010, the Company had 662,963 and 200,000 shares of Series A convertible preferred stock issued and outstanding, respectively.
In connection with the Convertible Notes Agreement discussed in Note 10, the Company was required to issue to the Lender one hundred shares of Series B Preferred Stock, par value at $0.001. The Series B preferred stock provides voting rights and the right to appoint directors only in the event of defaults which equal or exceed $1,000,000 in the aggregate. The Series B preferred stock is senior to all other capital stock of the Company. The holder of the Series B preferred stock will not be entitled to any dividends, any liquidation preference of any kind, or any conversion right to convert the Series B preferred stock into the Company’s common stock.
Note 14 – Warrant and Derivative Liabilities
In June 2008, the FASB issued authoritative guidance on determining whether an instrument (or embedded feature) is indexed to an entity’s own stock. Under the authoritative guidance, effective January 1, 2009, instruments, which do not have fixed settlement provisions, are deemed to be derivative instruments. The conversion feature of the Company’s convertible note (described in Note 10), the related warrants and the warrants issued in connection with the Series A convertible preferred stock, do not have fixed settlement provisions because their conversion and exercise prices are denominated in US dollars, which is a currency other than the Company’s functional currency. Additionally, the Company was required to include the reset provision in order to protect the holders from potential dilution associated with future financings. In accordance with the FASB authoritative guidance, the conversion feature of the Convertible Notes was separated from the host contract (i.e. the Convertible Notes) and recognized as a derivative liability in the balance sheet, and the warrants issued in connection with the Convertible Notes and Series A preferred stock have been recorded as warranty liabilities in the balance sheet to be re-measured at the end of every reporting period with changes in fair values reported in the consolidated statements of income and other comprehensive income.
The derivative liabilities were valued using both the Black-Scholes and Binomial valuation techniques with the following assumptions:
September 29, 2009 | December 31, 2009 | September30, 2010 | ||||||||||
(Issuance date) | ||||||||||||
Conversion feature of Convertible Note: | ||||||||||||
Risk-free interest rate | 0.95 | % | 1.14 | % | 1.05 | % | ||||||
Expected volatility | 79.86 | % | 83.32 | % | 60.0 | % | ||||||
Expected life (in years) | 2.00 years | 1.75years | 1.00year | |||||||||
Expected dividend yield | - | - | - | |||||||||
Fair Value: | ||||||||||||
Conversion feature | $ | 1,270,500 | $ | 871,000 | $ | 22,346 |
29
We calculated the derivative liability on exchange rate based on the following key assumptions:
September 30, 2010 | ||||
Estimated forward rate | 6.6826-6.5232 | |||
Discount rate | 0.30%-0.67 | % | ||
Discount factor | 1-0.98 | |||
Fair value | $ | 133,299 |
Warrants issued in connection with convertible notes:
May 21, 2009 (Issuance date) | December 31, 2009 | September 30,2010 | ||||||||||
Number of shares exercisable | 1,388,889 | 1,388,889 | 1,388,889 | |||||||||
Stock price | $ | 1.73 | 1.05 | 0.55 | ||||||||
Exercise price | $ | 1.8 | 1.8 | 1.8 | ||||||||
Expected dividend yield | - | - | - | |||||||||
Expected life (in years) | 5 | 4.39 | 3.64 | |||||||||
Risk-free interest rate | 2.15 | % | 2.38 | % | 0.85 | % | ||||||
Expected volatility | 70 | % | 73 | % | 77 | % | ||||||
Fair Value: | ||||||||||||
Commitment Warrants issued in connection with Convertible Note | $ | 1,387,912 | 666,793 | 210,738 |
Warrants issued in connection with Series A convertible preferred stock:
December 31, 2009 | September 30, 2010 | |||||||
Number of shares exercisable | 1,968,561 | 1,968,561 | ||||||
Risk-free interest rate | 1.81 | % | 0.57 | % | ||||
Expected volatility | 79 | % | 84 | % | ||||
Expected life (in years) | 3.29 years | 2.54 years | ||||||
Expected dividend yield | - | - | ||||||
Fair Value: | ||||||||
Warrants issued in connection with Series A convertible preferred stock | $ | 703,850 | $ | 181,593 |
(a) | The risk-free interest rate is based on the U.S. Treasury securities with compatible life terms. |
(b) | Due to the short trading history of the Company’s stock, the Company uses the volatility of comparable guideline companies to estimate volatility. |
(c) | The expected life of the conversion feature of the notes was based on the term of the notes and the expected life of the warrants was determined by the expiration date of the warrants. |
(d) | The expected dividend yield was based on the fact that the Company has not paid dividends to common shareholders in the past and does not expect to pay dividends to common shareholders in the future. |
Note 15 - Stock-Based Compensation
Common Stocks
On December 7, 2009, the Board approved the issuance of 700,000 shares of the Company’s common stock to a consulting company in exchange for consulting service received for the period of July 1, 2009 through December 31, 2009. The value of those shares issued is $840,000, which was measured based on the fair value of the Company’s common stock at December 7, 2009.
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Stock Options
On September 18, 2008, the Company appointed three new independent directors and granted them stock options to purchase an aggregate of 260,000 shares of the Company’s common stock. The options will vest and become exercisable in eight equal installments evenly spread out during the two year period beginning from October 1, 2008. On June 24, 2009, the Company appointed another independent director and granted him stock options to purchase 500,000 shares of the Company’s common stock. The options will vest and become exercisable in eight equal installments evenly spread out during the three year period beginning from July 1, 2009. On September 7, 2009, the Company appointed another independent director and granted her a stock option to purchase 60,000 shares of the Company’s common stock. The options will vest and become exercisable in eight equal installments evenly spread out during the two year period beginning from October 1, 2009. Unvested options shall be terminated and forfeited upon the termination of a holder’s director status.
The Company used the Black-Scholes Model to value the options at the time they were granted. The following table summarizes the assumptions used in the Black-Scholes Model when calculating the fair value of the options at the grant dates:
Grant date Fair value per share | $ 0.58- $ 1.20 |
Expected Term(Years) | 1.81 |
Exercise Price | $1.22-$2.90 |
Expected Volatility | 79%-94% |
Risk Free Interest Rate | 0.84%-1.45% |
Since the Company does not have sufficient applicable history of employee stock options activity, the Company uses the simplified method to estimate the life of the options by taking the sum of the vesting period and the contractual life and then calculating the midpoint which is the estimated term of the options.
For the three months ended September 30, 2009 and 2010, the Company recognized $69,806 and, $35,250 compensation expenses in the form of options. For the nine months ended September 30, 2009 and 2010, the Company recognized $147,644 and, $105,759 compensation expenses in the form of options. Following is a summary of the status of options outstanding at September 30, 2010:
Outstanding Options | Exercisable Options | |||||||||||||||||||||
Exercise | Number | Average | Average | Number | Average | |||||||||||||||||
price | remaining | exercise | remaining | |||||||||||||||||||
contractual | Price | contractual | ||||||||||||||||||||
Term | term | |||||||||||||||||||||
$ | 1.22 | 60,000 | 2.25 | $ | 1.22 | 30,000 | 2.25 | |||||||||||||||
$ | 1.58 | 500,000 | 2.00 | $ | 1.58 | 250,000 | 2.00 | |||||||||||||||
Total | 560,000 | 280,000 |
Following is a summary of the option activity:
Outstanding as of January 1, 2008 | - | |||
Granted | 335,000 | |||
Forfeited | - | |||
Exercised | - | |||
Outstanding as of December 31, 2008 | 335,000 | |||
Granted | 560,000 | |||
Forfeited | (335,000 | ) | ||
Exercised | - | |||
Outstanding as of December 31, 2009 | 560,000 | |||
Granted | - | |||
Forfeited | - | |||
Exercised | - | |||
Outstanding as of September 30, 2010 | 560,000 | |||
Vested and exercisable as of September 30, 2010 | 280,000 |
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On July 20, 2009, the Company terminated the service contract with a consultant. As a result, the options granted to him on September 18, 2008 to purchase 25,000 shares of the Company’s common stock expired on October 21, 2009.
In September 2009, another consultant gave up the options to purchase 50,000 shares of the Company’s common stock.
On September 7, 2009, one of the Company’s independent directors resigned from the Company’s Board of Directors, effective October 1, 2009. The options granted to her on September 18, 2008 to purchase 50,000 shares of the Company’s common stock expired on December 31, 2009.
On December 31, 2009, two of the Company’s independent directors resigned from the Company’s Board of Directors, effective January 1, 2010. The options granted to them on September 18, 2008 to purchase 210,000 shares of the Company’s common stock were forfeited.
Note 16 – Interest Expenses
Three months ended September 30, | ||||||||
2009 | 2010 | |||||||
(Restated) | ||||||||
Interest on convertible notes | - | 121,570 | ||||||
Interest on long-term loan | - | 163,768 | ||||||
Amortization of deferred financing cost | 204,469 | 191,458 | ||||||
Accretion of convertible notes | - | 231,998 | ||||||
Accretion of long term loan | - | 16,951 | ||||||
Interest of short-term bank loans | 6,884 | - | ||||||
Discount interest | - | 2,643 | ||||||
Interest capitalized | - | (73,116 | ) | |||||
Interest income from long-term accounts receivable | - | (176,798 | ) | |||||
Interest income | (803 | ) | (1,235 | ) | ||||
Total | $ | 210,550 | 477,239 |
Nine months ended September 30, | ||||||||
2009 | 2010 | |||||||
(Restated) | ||||||||
Interest on convertible notes | - | 359,287 | ||||||
Interest on long-term loan | - | 446,769 | ||||||
Amortization of deferred financing cost | 293,072 | 600,396 | ||||||
Accretion of convertible notes | - | 697,253 | ||||||
Accretion of long term loan | - | 33,980 | ||||||
Interest of short-term bank loans | 8,940 | 1,571 | ||||||
Discount interest | - | 2,643 | ||||||
Interest capitalized | - | (114,329 | ) | |||||
Interest income from long-term accounts receivable | - | (237,659 | ) | |||||
Interest income | (5,765 | ) | (3,531 | ) | ||||
Total | $ | 296,247 | 1,786,380 |
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Note 17 – Related Party Transactions
In 2005, Shanghai Engineering entered into agreements with the son of Mr. Qinghuan Wu to lease the office at Quyang Road, Hongkou District, Shanghai for 5 years. For the three months ended September 30, 2009 and 2010, the Company incurred $13,177 and $13,259, respectively; for the nine months ended September 30, 2009 and 2010, the Company incurred $39,520 and $39,663, respectively, as rental expense to Mr. Qinghuan Wu's son.
On February 1, 2010, Mr. Qinghuan Wu, arranged for a loan from Haide Engineering (Hong Kong) Limited (“Haide”), a company controlled by Mr. Qinghuan Wu, to the Company in the sum of $1,000,000. The proceeds of this loan will be forwarded to CER Yangzhou for additional paid-in capital which will help fund the new plant being built in China. The loan is an interest only loan, bearing interest at the annual rate of 9.5%, and is unsecured; the Company will pay the sum of $23,750 at the end of every three calendar months. The principal is due in full on January 30, 2012. The loan is unsecured and there are no guarantees of the interest or principal. CER Hong Kong has subordinated its loan to those under the Loan Agreements.
Note 18 – Retirement Benefits
As stipulated by the relevant laws and regulations applicable to enterprises operating in the PRC, the Company and its PRC subsidiaries and affiliates are required to maintain a defined contribution retirement plan for all of its employees who are residents of the PRC. The Company contributes to a statutory government retirement plan approximately 22% of the base salary of each of its employees and has no further obligations for the actual pension payments or post-retirement benefits beyond the annual contributions. The statutory government retirement plan is responsible for the entire pension obligations payable for all past and present employees.
The Company made contributions of $10,555 and $91,767 for employment benefits, including pension payments for the three months ended September 30, 2009 and 2010, respectively. The Company made contributions of $70,124 and $214,527 for employment benefits, including pension payments for the nine months ended September 30, 2009 and 2010, respectively.
Note 19 – Statutory Reserve
As stipulated by the relevant laws and regulations applicable to enterprises operating in the PRC, the Company and its PRC subsidiaries and affiliates are required to make annual appropriations to a statutory surplus reserve fund. Specifically, the Company is required to deposit 10% of its profits after taxes, as determined in accordance with the PRC accounting standards applicable to the Company, to a statutory surplus reserve until such reserve reaches 50% of the registered capital of the Company.
The transfer to this reserve must be made before distribution of any dividend to shareholders. For the years ended December 31, 2009, the Company transferred $0, because the China subsidiaries were making losses in 2009. Statutory reserve amounted to $132,802 as of December 31, 2009 and September 30, 2010.
The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years' losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of the shares currently held by them, provided that the remaining reserve balance after such issue is not less than 50% of the registered capital. The remaining required contributions to the statutory reserves required were approximately $12,718,305 as of September 30, 2010.
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Note 20 – Commitments and Contingencies
Capital contribution to CER Shanghai and CER Yangzhou
As described in Note 1, CER Shanghai has registered capital of $5,000,000 of which $3,380,000 was invested before September 30, 2010 and the remaining capital was injected as of November 4, 2010. CER Yangzhou has registered capital of $20,000,000 of which $7,500,000 has been invested before September 30, 2010; the remaining capital is scheduled to be injected before August 28, 2011.
Lease and Operation Commitments
According to the renewed and amended Lease and Operation Agreement (Note 1) entered into by Shanghai Engineering and Shanghai Si Fang, for the three months ended September 30, 2009 and 2010, Shanghai Engineering has recorded lease expenses and an integrated management fee of $132,633 and $124,745 under cost of revenue and general administrative expenses, respectively. For the nine months ended September 30, 2009 and 2010, Shanghai Engineering has recorded lease expenses and a management fee of $397,515 and $374,234 under cost of revenue and general administrative expenses, respectively.
Lease | Non-lease | Total | ||||||||||
Three Months Ending December 31, 2010 | $ | 66,309 | 58,680 | 124,989 |
Rental commitments
On January 1, 2009, Shanghai Engineering renewed the lease agreement with the son of Mr. Qinghuan Wu to continue the lease of the current office space (approximately 375 square meters) for one year until December 31, 2010 at a monthly rental of $4,398, which is approximately the market price in Shanghai. After moving into the new office space in Zhangjiang (as described below), this lease agreement will be terminated. For the three months ended September 30, 2009 and 2010, the company incurred $13,177 and $13,259, respectively. For the nine months ended September 30, 2009 and 2010, the Company incurred $39,520 and $39,663, respectively.
On March 19, 2009, CER Shanghai entered into an office lease agreement with Shanghai Zhangjiang Integrated Circuit Industrial Zone Development Co., Ltd., to lease an office space (approximately 2,664 square meters) in the Shanghai Zhangjiang Hi-tech Park (“Zhangjiang”), which is to be the new office space and the design and engineering center of the Company in China. The lease is for two years from March 1, 2009 through February 28, 2011. The Company is also required to make a security deposit of approximately $292,613 in addition to the annual lease payments. Then rental expenses have been recognized on a straight-line basis. CER Shanghai also has an option to purchase the office space. If CER Shanghai exercises the purchase option, all the lease payments and the deposit payment made can be credited against the purchase price and counted as a partial purchase payment. The Company has paid the first year’s rental fee in the amount of $146,304 and the security deposit of $292,613 in April 2009, and has also paid the second year’s rental fee in the amount of $851,525 in February 2010. The Company has amortized the total rental fee using straight-line method over the 2-year lease period. For the three and nine months ended September 30, 2010, $125,333 and $374,925 was charged to rental expense. Management is planning to exercise the option to purchase the building.
The Company has paid all the lease payments under this lease, therefore there is no future lease payment under this lease as of September 30, 2010.
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Commitments related to CER Yangzhou
On August 18, 2009, CER Hong Kong entered into a series of contracts with Yangzhou (Yizheng) Automobile Industrial Park Administration Committee, a government entity of the City of Yangzhou, Jiangsu Province, China, to acquire a tract of land on which the Company plans to build a new manufacturing facility. The new plant is planned as a world-class, state-of-the-art facility and will be dedicated to developing and manufacturing large-sized and sophisticated waste heat recovery systems and other related energy efficiency equipment.
Further to support CER’s waste heat recovery system development, the government will provide various preferential policies, including a government research and development grant at $2.44 million, which is recorded as other income, to be available to CER over time. CER is obligated to establish a foreign investment enterprise for its investment, to meet certain minimum capital levels, to make certain minimum levels of investment in the plant (approximately $293,255, or equivalent to RMB 2 million, per Chinese acre, to be made by August 2011, otherwise either a portion of the land would need to be returned or the deficient investment would need to be made), and to satisfy established construction schedules (i.e., start construction within 6 months upon obtaining the land). If construction does not start in one year, or the area developed would be less than 1/3 of the land, or the investment is less than 1/4 of the proposed investment, or the Company stops the development without approval, then an unused land fee would be imposed and part of the land unused for over 2 years would need to be returned. As of January 2011, the Company has met the above-mentioned minimum capital requirements and investments.
Note 21 – Subsequent events
In conjunction with the preparation of these financial statements, an evaluation of subsequent events was performed through April 18, 2011, which is the date of the financial statements were issued.
On December 9, 2010, CER Yangzhou entered into a three-year, loan facility with the Bank of China, Yizheng Branch. The facility is for RMB 30,000,000 (approximately $4,500,000). The funds may be used either as a short term loan or for trade financing and similar purposes. Any amounts due under the loan are repayable on November 24, 2013. The loan has been guaranteed by each of the Company’s Chief Executive Officer and a director, two of the Company’s subsidiaries, CER Shanghai, Shanghai Engineering and Yizheng Auto Industrial Park Investment and Development Co., Ltd. The Company has also pledged the land use right in Yizheng. The Company has drawn RMB 21,000,000 (approximately $3,150,000) under the facility as a short-term loan, due in one year, which amount carries an annual interest rate of 5.838%. These funds will be used for working capital.
On December 31 2010, the Company entered into a loan agreement with the lender (Note 9) to replace and continue the prior lending arrangement which was entered into on March 21, 2009, to extend the term until which the principal amount of $5,000,000 is due to September 29, 2012, and to change certain of the terms of the loan. The aggregate principal amount of the loan extension is $5,000,000, and bears interest at the annual rate of 15.1%, calculated on a monthly compounded basis. The principal and accrued interest are due September 29, 2012. The loan may be prepaid by the Company, without penalty. The loan agreement provides for the typical events of default (which includes default in payment of any part of the principal of or interest, performance or compliance with the collateral agreement, assets attached or seized by any third person and or any part of the loan agreement being declared null and void or its enforceability being challenged), including a cross default clause, and the Company has made various representations and given various covenants to the lender, which includes the audit of the Company’s annual financial statements and review of the interim financial statements as well as the timely filing of such statements. In the event of a default, the lender would have the right to exercise the rights under the Class B Preferred Stock that was issued in connection with the 2009 loan, which will continue with respect to the new loan. The lender continues to have a right of first refusal with respect to future debt and equity fundings and a right to consent to certain debt and equity fundings by the Company and its subsidiaries and affiliates. As a guarantee of the payments under the loan extension, Mr. Wu, the Chief Executive Officer of the Company and the principal officer of the Company pledged 8,000,006 shares for the repayment of the principal due under the loan agreement. The pledge will only take effect when the shares are released from the current pledge under another loan entered into by the Company. Additionally, since the loan is fixed in United States dollars, the lender will receive compensation for the value of the difference in the Renminbi/US Dollar exchange rate between September 29, 2011, and the payment date, provided the Renminbi exchange rate increases against the US dollar, times the amount of being paid.
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On March 30, 2011, CER Shanghai exercised the purchase option with Shanghai Zhangjiang Integrated Circuit Industrial Zone Development Co., Ltd. The total purchase price of the building is $7,392,770 (RMB 48,486,224), which represents the price of the building and related land use right. CER Shanghai paid cash of $1,174,226 (RMB 7,698,697) and bank acceptance of $ 747,361 (RMB 4,900,000) on March 31, 2011. The maturity date of the bank acceptance shall be no later than October 10, 2011. The remaining payment will be made after March 30, 2011, by means of cash or bank acceptance according to the contract.
On April 8, 2011, CER Shanghai entered into an early repayment agreement with Zhenjiang Sopo Chemical New Development Co., Ltd. (“Sopo”). According to the agreement, Sopo will make a lump sum payment in the amount of $4.6 million (RMB30 million) and the remaining amount of $1.9 million (RMB12 million) will be paid in an interest-free manner from April 2011 to March 2012.
On April 15, 2011, CER prepaid the remaining principal due under the $4 million long-term loan (note 8). The prepayment sum is $2,981,244, representing the principle amount due, the prepayment premium and the net interest due. Additionally, CER will issue 117,230 shares to the lenders based on the principle amount due under the terms of the Exchange Rate Differential Payment provisions of the Loan Agreement.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains disclosures which are forward-looking statements. Forward-looking statements include all statements that do not relate solely to historical or current facts, such as, but not limited to, the discussion of economic conditions in market areas and their effect on revenue growth, the discussion of our growth strategy, the potential for and effect of future governmental regulation, fluctuation in global energy costs, the effectiveness of our management information systems, and the availability of financing and working capital to meet funding requirements, and can generally be identified by the use of words such as "may," "believe," "will," "expect," "project," "estimate," "anticipate," "plan" or "continue." These forward-looking statements are based on the current plans and expectations of our management and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. These factors include, but are not limited to: the general economic conditions that may affect our customers desire or ability to invest in energy recovery systems; the cost of raw materials; the availability of environmental credits; the positive and adverse effect of governmental regulation affecting energy recovery systems; our reliance on customers in heavy industry, such as chemicals and steel production, and state owned or controlled enterprises; competition in the industry of heat and energy recovery systems; the availability of and costs associated with potential sources of financing; difficulties associated with managing future growth; our ability to increase manufacturing capacity to meet demand; fluctuations in currency exchange rates; restrictions on foreign investments in China; uncertainties associated with the Chinese legal system; the loss of key personnel; and our ability to attract and retain new qualified personnel.
These forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise
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Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
On January 24, 2008, we entered into a Share Exchange Agreement (the "Share Exchange Agreement") with Poise Profit International, Ltd. ("Poise Profit") and the shareholders of Poise Profit. Pursuant to the Share Exchange Agreement, we acquired 100% of the issued and outstanding shares of Poise Profit's common stock in exchange for the issuance of 41,514,179 (pre reverse split) shares of our common stock to the shareholders of Poise Profit. The share exchange (the "Share Exchange") transaction was consummated on April 15, 2008.
As a result of the closing of the Share Exchange on April 15, 2008, our new business operations consist of those of Poise Profit's Chinese subsidiary, Hi-tech, which were subsequently transferred to CER (Hong Kong) Holdings Limited (“CER Hong Kong”). CER Hong Kong is principally engaged in designing, marketing, licensing, fabricating, implementing and servicing industrial energy recovery systems capable of capturing industrial waste energy for reuse in industrial processes or to produce electricity and thermal power.
Poise Profit, a wholly-owned subsidiary of the Company, was incorporated on November 23, 2007 under the laws of the British Virgin Islands. Poise Profit, in turn, owns 100% of the issued and outstanding equity interests in Hi-tech and CER Hong Kong. Historically, all of our operations were conducted through Hi-tech via contractual arrangements with affiliated Chinese entities, but we are in the process of transferring our assets and operations from Hi-tech to CER Hong Kong and its wholly-owned subsidiary CER Energy Recovery (Shanghai) Co., Ltd. ("CER Shanghai"). As part of our reorganization, CER Hong Kong was incorporated on August 13, 2008 under the laws of the Hong Kong Special Administrative Region, China and was originally jointly owned by Mr. Qinghuan Wu, one of our directors and our Chairman of the Board and Chief Executive Officer, and his spouse, Mrs. Jialing Zhou, who is one of our directors. On December 3, 2008, Mr. Qinghuan Wu and Mrs. Zhou transferred ownership of CER Hong Kong to Poise Profit. CER Shanghai was incorporated on November 11, 2008 as a wholly foreign-owned enterprise in Shanghai, China. After our reorganization is complete, CER Shanghai will be our primary operating entity in China and CER Hong Kong will be our primary holding entity holding all equity interests in our Chinese subsidiaries, including CER Shanghai. While we are gradually transferring our current assets and operations to CER Shanghai, we plan that CER Shanghai will enter into the majority of all new business contracts.
Before December 3, 2008, all of our operations were conducted through Hi-tech and its affiliated companies. Hi-Tech was engaged in the marketing and sale of energy recovery systems which were designed, manufactured and installed by affiliated companies. Hi-tech had entered into contractual relationships with two entities incorporated in Shanghai, China: Shanghai Hai Lu Kun Lun Hi-tech Engineering Co., Ltd. ("Shanghai Engineering") and Shanghai Xin Ye Environmental Protection Engineering Technology Co., Ltd. ("Shanghai Environmental"). Each of Shanghai Engineering and Shanghai Environmental was considered a "variable interest entity" and its financial information was consolidated with Hi-tech's pursuant to the Accounting Standard Codification (“ASC”) 810-10. Hi-tech entered into contractual relationships with Shanghai Engineering and Shanghai Environmental to comply with Chinese laws regulating foreign-ownership of Chinese companies. Shanghai Engineering is engaged in the business of designing, manufacturing and installing energy recovery systems. All manufacturing is done by Vessel Works Division pursuant to a cooperative manufacturing agreement between Shanghai Engineering and Vessel Works Division's parent, Shanghai Si Fang Boiler Factory ("Shanghai Si Fang"), as further described below. Vessel Works Division holds important permits for the manufacturing and installation of boilers used in our energy recovery systems. Shanghai Environmental is not an operating company but it served in the past as a vehicle for arranging sales and maximizing tax benefits. Since we no longer use Shanghai Environmental for these purposes, Shanghai Environmental was dissolved in June 2010. Shanghai Engineering is owned jointly by Mr. Qinghuan Wu, our Chairman of the Board and Chief Executive Officer, and his spouse, Mrs. Jialing Zhou, who is one of our directors.
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All of Shanghai Engineering’s manufacturing activities are conducted through a Leasing and Operation Agreement, a form of cooperative manufacturing agreement, originally effective as of May 1, 2003 and subsequently renewed and amended with a state-owned enterprise, Shanghai Si Fang. Pursuant to the agreement, Shanghai Si Fang leases certain land use rights, buildings and fixed assets (lease elements) in one of its subsidiaries, Vessel Works Division, and provides management services and licenses the “Si Fang” brand and manufacturing license (non-lease elements) of Vessel Works Division to Shanghai Engineering. Because the arrangement contains both the lease and non-lease elements, the amount of quarterly payment is allocated between the lease and non-lease deliverables. The lease elements are classified and accounted for as operating leases and the lease expense is recorded on a straight-line basis. The non-lease elements are accounted for as prepayment for management and licensing fees and the payment is amortized on a straight-line basis over each contractual period.
In August 2009, CER Hong Kong entered into a series of contracts with Yangzhou (Yizheng) Automobile Industrial Park Administration Committee, a government entity of the City of Yangzhou, Jiangsu Province, China, to acquire a tract of land on which CER Hong Kong plans to build a new manufacturing facility. The plant is currently under construction, and is expected to be completed in January 2011. Once the plant is operational, we intend to transfer the production function of Vessel Works Division to CER Yangzhou.
Energy is a major strategic issue affecting the development of the global and Chinese economy. The Chinese government has committed to adjusting the economic structure and changing the mode of economic growth in order to encourage the use of more advanced and more environment-friendly technologies. Also, the Chinese government has been promoting the development of recycling and the circulated use of resources by encouraging enterprises to engage in the energy recovery industry. Various government issued documents indicate the government’s plan to promote the use of energy saving and recycling equipment and systems.
Critical Accounting Policies and Estimates
While our significant accounting policies are more fully described in Note 3 to our Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q, we believe that the accounting policies described below are the most critical to aid you in fully understanding and evaluating this management discussion and analysis.
Fair Value Measurements
The accounting standard regarding fair value of financial instruments and related fair value measurements defines financial instruments and requires fair value disclosures of those financial instruments. On January 1, 2008, the Company adopted accounting standard regarding fair value measurements, which defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosures requirements for fair value measures. The carrying amounts reported in the accompanying consolidated balance sheets for current assets and current liabilities qualify as financial instruments. Management concluded the carrying values of these financial instruments 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 the current market rates of interest. The three levels of valuation hierarchy are defined as follows:
Level 1 | Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Fair valued assets and liabilities that are generally included in this category are assets comprised of cash, restricted cash, accounts and notes receivable, and liabilities comprised of bank loans, accounts payable, accrued liabilities and other payables. As of December 31, 2009 and September 30, 2010, the carrying values of these assets and liabilities approximated their fair values. |
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 assets or liability, either directly or indirectly, for substantially the full term of the financial instruments. At December 31, 2009 and September 30, 2010, the Company did not have any fair value assets or liabilities classified as Level 2. |
Level 3 | Inputs to the valuation methodology are unobservable and significant to the fair value. Inputs reflected management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. |
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The following table presents information about the company’s financial liabilities classified as Level 3 as of September 30, 2010.
Balance as of September 30, 2010 | ||||||||||||||||
Carrying | Fair Value Measurements | |||||||||||||||
Value | Using Fair Value Hierarchy | |||||||||||||||
Level 1 | Level 2 | Level 3 | ||||||||||||||
Derivative liability, current (Note 14) | $ | 155,645 | - | - | $ | 155,645 | ||||||||||
Warrant liability (Note 14) | $ | 392,330 | - | - | $ | 392,330 |
A summary of changes in Level 3 derivative and warrant liabilities for the years ended December 31, 2009and for the nine months ended September 30, 2010 were as follows:
Balance at January 1, 2009 | $ | 1,524,268 | ||
Warrants issued at issuance of convertible notes (Note 14) | 1,387,912 | |||
Derivative liability at issuance of convertible notes (Note 14) | 1,270,500 | |||
Change in fair value of warrant liability recognized in earnings | (1,539,233 | ) | ||
Change in fair value of derivative liability recognized in earnings | (399,500 | ) | ||
Balance at December 31, 2009 | $ | 2,243,947 | ||
Derivative liability of long term loan, current (Note 9) | 132,470 | |||
Change in fair value of warrant liability recognized in earnings | (980,617 | ) | ||
Change in fair value of derivative liability recognized in earnings | (847,825 | ) | ||
Balance at September 30, 2010 | $ | 547,975 |
The following presents the carrying value and the estimated value of the Company’s convertible note at September 30, 2010:
Carrying Value | Fair Value | |||||||
Convertible note | $ | 4,659,381 | $ | 4,448,399 |
The fair value of the convertible note is based on the market interest rate for debt with similar terms and maturity.
The long term account receivable is recorded at cost, which is discounted from the contractual balance. The carrying value of the long term account receivable, which is estimated based upon future cash flows, approximates fair value at September 30, 2010 and December 31, 2009.
Liability for Warrants
Effective January 1, 2009, the Company adopted the provisions of an accounting standard regarding instruments that are Indexed to an Entity’s Own Stock. This accounting standard specifies that a contract that would otherwise meet the definition of a derivative but is both (a) indexed to the Company’s own stock and (b) classified in stockholders’ equity in the statement of financial position would not be considered a derivative financial instrument. It 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 scope exception within the standards.
Consolidation of Variable Interest Entities
In accordance with the FASB’s Interpretation regarding the consolidation of variable interest entities, variable interest entities 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. Each variable interest entity with which the Company is affiliated must be evaluated to determine who is the primary beneficiary of the risks and rewards of ownership of the variable interest entity. The primary beneficiary is required to consolidate the variable interest entity's financial information for financial reporting purposes.
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We have concluded that Shanghai Engineering and Shanghai Environmental are variable interest entities and that Poise Profit and CER Hong Kong are the primary beneficiaries. Under the requirements of FASB’s accounting standard, Poise Profit and CER Hong Kong consolidated the financial statements of Shanghai Engineering and Shanghai Environmental. As all companies are under common control (see Note 1 to our consolidated financial statements), the consolidated financial statements have been prepared as if the arrangements by which these entities became variable interest entities had occurred retroactively. We have eliminated inter-company items from our consolidated financial statements.
All of Shanghai Engineering’s manufacturing activities are conducted through a Leasing and Operation Agreement, a form of cooperative manufacturing agreement, originally effective as of May 1, 2003 and subsequently renewed and amended with a state-owned enterprise, Shanghai Si Fang. Pursuant to the agreement, Shanghai Si Fang leases certain land use rights, buildings and fixed assets (lease elements) in one of its subsidiaries, Vessel Works Division, and provides management services and licenses the “Si Fang” brand and manufacturing license (non-lease elements) of Vessel Works Division to Shanghai Engineering. Because the arrangement contains both the lease and non-lease elements, the amount of quarterly payments is allocated between the lease and non-lease deliverables. The lease elements are classified and accounted for as operating leases and the lease expense is recorded on a straight-line basis. The non-lease elements are accounted for as prepayment for management and licensing fees and the payment is amortized on a straight-line basis over each contractual period.
Shanghai Engineering does not have a variable interest in Vessel Works Division through this agreement as the arrangement is established between Shanghai Engineering and Shanghai Si Fang. Shanghai Engineering does not have any contractual or ownership interest in Vessel Works Division, and therefore, Shanghai Engineering does not have variable interests in Vessel Works Division.
The arrangement, however, may result in Shanghai Engineering having variable interests in Shanghai Si Fang, but as Shanghai Si Fang is a state-owned enterprise that has substantive operations other than this lease and operation arrangement, Shanghai Engineering is not the primary beneficiary of Shanghai Si Fang.
Revenue Recognition
The Company derives revenues principally from
(a) | Sales of energy recovery systems, and |
(b) | Provision of design services, and |
(c) | Provision of Engineering, Procurement and Construction ("EPC") services, which are essentially turnkey contracts where the Company provides all services in the whole construction process from design, development, engineering, manufacturing, procurement to installation. |
Revenue by the above categories for the three and nine months ended September 30, 2009 and 2010 are summarized as follows:
Three months ended September 30, | ||||||||
2009 | 2010 | |||||||
Revenue: | ||||||||
Product | $ | 2,845,939 | $ | 3,067,962 | ||||
EPC contracts | 2,474,579 | 3,079,689 | ||||||
Totals | $ | 5,320,518 | $ | 6,147,651 |
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Nine months ended September 30, | ||||||||
2009 | 2010 | |||||||
Revenue: | ||||||||
Product | $ | 10,147,408 | $ | 6,058,268 | ||||
EPC contracts | 4,596,005 | 11,389,302 | ||||||
Totals | $ | 14,743,413 | $ | 17,447,570 |
In providing design services, the Company designs energy recovery systems and other related systems based on a customer's requirements and the deliverable consists of engineering drawings. The customer may elect to engage the Company to manufacture the designed system or choose to present the Company's drawings to other manufacturers for manufacturing and installation. In contrast, when providing EPC services, the customer is purchasing a turnkey energy recovery system and the Company is involved throughout the entire process from design to installation.
Sales of the Company's energy recovery systems and related products are essentially product sales. The products consist mainly of waste heat boilers and other related equipment manufactured according to specific customers' specifications. Once manufactured, the Company ships the products to its customers in their entirety in one batch. The Company’s service arrangement also includes a limited warranty to its customers pursuant to which the customers retain between 5% and 10% of the particular contract price as retainage during the limited warranty period (usually 12-18 months). The Company generally recognizes revenues including retainage from product sales when (i) persuasive evidence of an arrangement exists, which is generally represented by a contract between the Company and the customer; (ii) products are shipped; (iii) title and risk of ownership have passed to the customer, which generally occurs at the time of delivery; (iv) the customer accepts the products upon quality inspection performed by them; (v) the purchase price is agreed to between the Company and the customer; and (vi) collectability is reasonably assured. Net revenues represent the invoiced value of products, less returns and discounts, and net of value-added tax.
The Company recognizes revenues from design services when the services are provided, the design drawings are delivered, invoices are issued and collectability is reasonably assured. The Company generally delivers the drawings in one batch.
In accordance with the accounting standard regarding performance of construction-type and certain production-type contracts, and long-term construction-type contracts, the company adopted the percentage of completion method to recognize revenues and cost of sales for EPC contracts. EPC contracts are long-term, complex contracts involving multiple elements, such as design, manufacturing and installation, which all form one integral EPC project. The energy recovery system involved in an EPC project is highly customized to the specific customer's facilities and essentially not transferable to any other facilities without significant modification and cost. It would be difficult, if not impossible, to beneficially use a single element of a specific EPC project on a standalone basis other than in connection with the facilities for which it was intended EPC contracts are by nature long-term construction-type contracts, usually lasting more than one accounting period, and the Company is able to reasonably estimate the progress toward completion, including contracts revenues and contracts costs. EPC contacts specify the customers' rights to the goods, the consideration to be paid and received, and the terms of payment. Specifically, the Company has the right to require a customer to make progress payments upon completion of determined stages of the project which serve as evidence of the customer's approval and acceptance of the work completed to date as complying with the terms of the particular EPC contract and upon which the company recognize the revenue.
Classification of Current/Non-Current Receivables
We have reviewed our receivable balances and reassessed each balance and its collectability during the forthcoming 12 months. We have reclassified certain of these outstanding balances to non-current assets where these outstanding balances are expected to be collected after 12 months.
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Recent Accounting Pronouncements
IIn January 2010, the FASB issued new accounting guidance related to the disclosure requirements for fair value measurements and provides clarification for existing disclosures requirements. More specifically, this update will require (a) an entity to disclose separately the amounts of significant transfers in and out of Levels 1 and 2 fair value measurements and to describe the reasons for the transfers; and (b) information about purchases, sales, issuances and settlements to be presented separately (i.e. present the activity on a gross basis rather than net) in the reconciliation for fair value measurements using significant unobservable inputs (Level 3 inputs). This guidance clarifies existing disclosure requirements for the level of disaggregation used for classes of assets and liabilities measured at fair value and require disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements using Level 2 and Level 3 inputs. The new disclosures and clarifications of existing disclosure are effective for fiscal years beginning after December 15, 2009, except for the disclosure requirements for related to the purchases, sales, issuances and settlements in the rollforward activity of Level 3 fair value measurements. Those disclosure requirements are effective for fiscal years ending after December 31, 2010. The Company does not expect the adoption of the updated guidance will have a material impact on its consolidated financial position, results of operations and cash flows.
In February 2010, the FASB issued accounting standards update which amends the accounting standard on subsequent event. The accounting update provides guidance on events that occur after the balance sheet date but prior to the issuance of the financial statements. The accounting standard distinguishes events requiring recognition in the financial statements and those that may require disclosure in the financial statements. As a result of the accounting update, SEC registrants will not disclose the date through which management evaluated subsequent events in the financial statements, either in originally issued financial statements or reissued financial statements. The accounting standard was effective for interim and annual periods ending after June 15, 2009, and the accounting update is effective immediately. We have evaluated subsequent events in accordance with the accounting update.
In April 2010, the FASB issued an authoritative pronouncement on effect of denominating the exercise price of a share-based payment award in the currency of the market in which the underlying equity securities trades and that currency is different from (1) entity’s functional currency, (2) functional currency of the foreign operation for which the employee provides services, and (3) payroll currency of the employee. The guidance clarifies that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should be considered an equity award assuming all other criteria for equity classification are met. The pronouncement will be effective for interim and annual periods beginning on or after December 15, 2010, and will be applied prospectively. Affected entities will be required to record a cumulative catch-up adjustment for all awards outstanding as of the beginning of the annual period in which the guidance is adopted. The Company does not expect the adoption of this pronouncement to have a significant impact on its consolidated financial position or results of operations.
In July 2010, the FASB issued new disclosure guidance related to the credit quality of financing receivables and the allowance for credit losses. The guidance will require companies to provide more information about the credit quality of their financing receivables in the disclosures to financial statements including, but not limited to, significant purchases and sales of financing receivables, aging information and credit quality indicators. We will adopt this accounting standard upon its effective date for periods ending on or after December 15, 2010, and do not anticipate that this adoption will have a significant impact on our financial position or results of operations.
In October 2009, the Financial Accounting Standards Board (“FASB”) issued new guidance on “revenue recognition for arrangements with multiple deliverables and certain revenue arrangements that include software elements.” By providing another alternative for determining the selling price of deliverables, the guidance for arrangements with multiple deliverables will allow companies to allocate consideration in multiple deliverable arrangements in a manner that better reflects the transaction’s economics and will often result in earlier revenue recognition. The new guidance modifies the fair value requirements of previous guidance by allowing “best estimate of selling price” in addition to vendor-specific objective evidence (“VSOE”) and other vendor objective evidence (“VOE,” now referred to as “TPE,” standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted under the new guidance.
The new guidance for certain revenue arrangements that include software elements removes non-software components of tangible products and certain software components of tangible products from the scope of existing software revenue guidance, resulting in the recognition of revenue similar to that for other tangible products. The new guidance is effective for fiscal years beginning on or after June 15, 2010. However, companies may adopt the guidance as early as interim periods ended September 30, 2009. The guidance may be applied either prospectively from the beginning of the fiscal year for new or materially modified arrangements or retrospectively.
The Company has not early adopted the new guidance and the adoption of the new guidance does not have a significant impact on our financial position or results of operations.
In December 2010, FASB issued revised guidance on “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” The revised guidance specifies that an entity with reporting units that have carrying amounts that are zero or negative is required to assess whether it is more likely than not that the reporting units’ goodwill is impaired. If the entity determines that it is more likely than not that the goodwill of one or more of its reporting units is impaired, the entity should perform Step 2 of the goodwill impairment test for those reporting unit(s). Any resulting goodwill impairment should be recorded as a cumulative-effect adjustment to beginning retained earnings in the period of adoption. Any goodwill impairments occurring after the initial adoption of the revised guidance should be included in earnings as required by Section 350-20-35. The revised guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. The adoption does not have a significant impact on our financial position or results of operations.
In December 2010, FASB issued revised guidance on the “Disclosure of Supplementary Pro Forma Information for Business Combinations.” The revised guidance specifies that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The revised guidance also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The revised guidance is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company has not early adopted the new guidance and the adoption does not have a significant impact on our financial position or results of operations
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Results of Operations
Comparison of Three Months ended September 30, 2009 and September 30, 2010
The following table sets forth the results of our operations for the periods indicated as a percentage of revenues:
Three months ended September 30, | ||||||||||||||||
2009 | % of Revenue | 2010 | % of Revenue | |||||||||||||
REVENUES | ||||||||||||||||
Third parties | $ | 5,320,518 | 100.0 | % | 6,147,651 | 100.0 | % | |||||||||
Total revenue | 5,320,518 | 100.0 | % | 6,147,651 | 100.0 | % | ||||||||||
COST OF REVENUES | ||||||||||||||||
Third parties | (4,466,987 | ) | (84.0 | )% | (4,752,909 | ) | (77.3 | )% | ||||||||
Total cost of revenues | (4,466,987 | ) | (84.0 | )% | (4,752,909 | ) | (77.3 | )% | ||||||||
GROSS PROFIT | 853,531 | 16.0 | % | 1,394,742 | 22.7 | % | ||||||||||
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES | (1,759,236 | ) | (33.1 | )% | (1,588,818 | ) | (25.8 | )% | ||||||||
LOSS FROM OPERATIONS | (905,705 | ) | (17.0 | )% | (194,076 | ) | (3.2 | )% | ||||||||
OTHER INCOME/(EXPENSE ), NET: | ||||||||||||||||
Change in fair value of warrants | 685,611 | 12.9 | % | (97,281 | ) | (1.6 | )% | |||||||||
Change in fair value of derivative liabilities | - | 28,920 | 0.5 | % | ||||||||||||
Non-operating income, net | 33,144 | 0.6 | % | 30,424 | 0.5 | % | ||||||||||
Interest expenses | (210,550 | ) | (4.0 | )% | (477,239 | ) | (7.8 | )% | ||||||||
Total other income (expense), net | 508,205 | 9.6 | % | (515,176 | ) | (8.4 | )% | |||||||||
LOSS FROM OPERATIONS BEFORE INCOME TAXES | (397,500 | ) | (7.5 | )% | (709,252 | ) | (11.6 | )% | ||||||||
(PROVISION)/BENEFIT FOR INCOME TAXES | 139,382 | 2.6 | % | (144,497 | ) | (2.4 | )% | |||||||||
NET LOSS | (258,118 | ) | (4.9 | )% | (853,749 | ) | (14.0 | )% | ||||||||
OTHER COMPREHENSIVE (LOSS)/INCOME | ||||||||||||||||
Foreign currency translation adjustment | 8,784 | 0.2 | % | 292,890 | 4.8 | % | ||||||||||
COMPREHENSIVE INCOME (LOSS) | $ | (249,334 | ) | (4.7 | )% | (560,859 | ) | (9.2 | )% |
Revenues. Revenue was $6,147,651 for the three months ended September 30, 2010, as compared to $5,320,518 for the three months ended September 30, 2009, an increase of $827,133 or 15.5%. The increase is mainly attributable to the increase in average revenues per product contract and an increase in the number of EPC contracts. The average revenue recognized from one single product contract increased by $195,937 from $316,170 for the three months ended September 30, 2009 to $512,107 for the same period of 2010. For the three months ended September 30, 2010, we completed one large product contract, which has contributed the rather high average product revenue. In the meantime, we are continuing our focus on EPC project. For the three months ended September 30, 2010, we have started 7 EPC contracts as compared to only 3 EPC contracts in the comparative period of 2009.
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The detailed changes are as follows:
Three months ended September 30, | ||||||||||||||||
2009 | 2010 | Change ($) | Change (%) | |||||||||||||
Average Revenue per Contract | ||||||||||||||||
Products | $ | 316,170 | $ | 512,107 | 195,937 | 61.97 | % | |||||||||
EPC | 824,995 | 439,287 | (385,708 | ) | (46.75 | )% | ||||||||||
Average Revenue per Contract | $ | 1,141,165 | 951,394 | (189,771 | ) | (16.63 | )% | |||||||||
Number of Contracts Completed | ||||||||||||||||
Products | 9 | 6 | (3 | ) | (33 | )% | ||||||||||
EPC | 3 | 7 | 4 | 133 | % | |||||||||||
Total Number of Contracts Completed | 12 | 13 | 1 | 8.33 | % |
Cost of Revenues. Cost of revenues increased to $4,752,909 for the three months ended September 30, 2010, as compared to $4,466,987 for the three months ended September 30, 2009, an increase of $285,922, or 6.4%. As a percentage of revenues, cost of sales decreased from 84.0% for the three months ended September 30, 2009 to 77.3% for the three months ended September 30, 2010, an decrease of 6.64%.The increase in absolute amount is consistent with the increase of revenue for the three months ended September 30, 2010 over the same period of 2009. The percentage decrease is mainly due to the contracts in 2009 having a much lower margin due to the different pricing strategy we employed to respond to the recent economic downturn. Additionally, as we focused more on EPC contracts, we also monitor and control the costs so as to improve the margins.
Gross Profit. Gross profit was $1,394,742 for the three months ended September 30, 2010, as compared to $853,531 for the three months ended September 30, 2009, an increase of $541,211 or 63.4%. The higher gross profit mainly resulted from the higher revenues and relatively lower costs in 2010. For the three months ended September 30, 2010, we have one product contract which had a much higher gross profit due to the end user willing to pay us a premium for our reliable quality.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $1,588,818 for the three months ended September 30, 2010, as compared to $1,759,236 for the three months ended September 30, 2009, a decrease of $170,418 or 9.7%. Selling, general and administrative expenses, as a percentage of revenue, decreased from 33.1% for the three months ended September 30, 2009 to 25.8% for the same period in 2010, a decrease of 7.22%. The decrease is the net result of salary increases and decreases of consulting fees and stock option compensation. Firstly, the salary expense increased by $285,935 or 76% for the three months ended September 30, 2010 as compared to the same period of 2009, as a result of the addition of staff with approximately an increase of 70 employees from 2009 to 2010 as well as a company-wide gradual salary increases, which is the main factor causing an increase in expenses. Secondly, the consulting service fee decreased by $546,134 for the three months ended September 30, 2010 as compared to the same period of 2009 because the Company signed an agreement with a consulting company which provides financing and marketing advisory services for the Company’s international development since July 1, 2009. There was no such service provided for the three month ended September 30, 2010. Thirdly, the stock option compensation expense decreased by $44,909 because several of the options expired in the first half of 2010.
Loss from Operations. Loss from operations totaled $194,076 for the three months ended September 30, 2010, as compared to $905,705 for the same period in 2009, a difference of $711,629. The decrease in the amount of loss period over period is mainly attributable to increases in revenue and gross profit.
Other Income/(Expense). For the three months ended September 30, 2010, the Company incurred other expenses of $515,176 as compared to other income of $508,205 for the three months ended September 2009, an absolute difference of $1,023,381. The change in other income for the period ended September 30, 2010 consisted primary of $753,972 of change in fair value of warrants and derivative liabilities, and $2,720 of non-operating income, and $266,689 in interest expenses, all as further described below.
Change in fair value of warrants and derivative liabilities. This resulted from the valuation of warrants and derivative liabilities. The gain for the three months ended September 30, 2009 is mainly due to the decrease of the Company’s stock price. The loss for the three month ended September 30, 2010 is mainly due to the increase of the Company’s stock price.
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Non-operating Income, net. Non-operating income for the three months ended September 30, 2010 mainly consisted of subsidy income of Shanghai Engineering from a technology support fund funded by the Shanghai Yangpu science and technology commission. There was no such subsidy in the corresponding period in 2009.
Interest Expense. Interest expense increased to $477,239 for the three months ended September 30, 2010, as compared to $210,550 for the three months ended September 30, 2009, an increase of $266,689 or 126.6%. This change is mainly due to the interest expense of $121,570 incurred for convertible notes, $140,018 for the $4,000,000 loan and $23,750 for the $1,000,000 loan of which $73,116 were offset as capitalized interest. In addition, the accretion on the convertible notes of $231,998 and amortized long term deferred financial cost of $191,458 were charged as interest expenses. The interest expenses were offset by $176,798 for interest income from the long-term accounts receivable.
Benefit/(provision) for Income Taxes. The normal applicable income tax rate for the operating entities in China is 25%. Pursuant to the PRC income tax laws, Shanghai Engineering is subject to enterprise income tax at a statutory rate of 15% as a high technology entity. For the three months ended September 30, 2010, the Company incurred $144,497 of income tax provision, as compared to benefit of $139,382 for the three months ended September 30, 2009, an absolute difference of $283,879. The difference is mainly due to the increase in allowance for deferred income tax assets.
Net Loss. Net loss was $853,749 for the three months ended September 30, 2010, as compared to net loss of $258,118 for the three months ended September 30, 2009, a decrease of $595,631. The net loss is mainly due to our operating loss and interest expenses.
Comparison of nine Months Ended September 30, 2009 and September 30, 2010
The following table sets forth the results of our operations for the periods indicated as a percentage of revenues:
Nine months ended September 30, | ||||||||||||||||
2009 | % of Revenue | 2010 | % of Revenue | |||||||||||||
REVENUES | $ | 14,743,413 | 100.0 | % | 17,447,570 | 100.0 | % | |||||||||
COST OF REVENUES | (11,521,307 | ) | (78.1 | )% | (14,444,768 | ) | (82.8 | )% | ||||||||
GROSS PROFIT | 3,222,106 | 21.9 | % | 3,002,802 | 17.2 | % | ||||||||||
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES | (4,027,167 | ) | (27.3 | )% | (4,095,102 | ) | (23.5 | )% | ||||||||
LOSS FROM OPERATIONS | (805,061 | ) | (5.5 | )% | (1,092,300 | ) | (6.3 | )% | ||||||||
OTHER INCOME/(EXPENSE ), NET: | ||||||||||||||||
Change in fair value of warrants | 1,236,678 | 8.4 | % | 980,617 | 5.6 | % | ||||||||||
Change in fair value of derivative liabilities | - | 847,825 | 4.9 | % | ||||||||||||
Non-operating expense, net | (44,994 | ) | (0.3 | )% | 1,001,780 | 5.7 | % | |||||||||
Interest income/(expenses) | (296,247 | ) | (2.0 | )% | (1,786,380 | ) | (10.2 | )% | ||||||||
Total other income, net | 895,437 | 6.1 | % | 1,043,842 | 6.0 | % | ||||||||||
INCOME/(LOSS) FROM OPERATIONS BEFORE PROVISION FOR INCOME TAXES | 90,376 | 0.6 | % | (48,458 | ) | (0.3 | )% | |||||||||
(PROVISION FOR INCOME TAXES | (8,900 | ) | (0.1 | )% | (345,647 | ) | (2.0 | )% | ||||||||
NET INCOME/(LOSS) | 81,476 | 0.6 | % | (394,105 | ) | (2.3 | )% | |||||||||
OTHER COMPREHENSIVE INCOME | ||||||||||||||||
Foreign currency translation adjustment | 37,837 | 0.3 | % | 320,890 | 1.8 | % | ||||||||||
COMPREHENSIVE INCOME/(LOSS) | $ | 119,313 | 0.8 | % | (73,215 | ) | (0.4 | )% |
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Revenues. Revenue was $17,447,570 for the nine months ended September 30, 2010, as compared to $14,743,413 for the nine months ended September 30, 2009, an increase of $2,704,157 or 18.3%. The increase is mainly attributable to the increase in the number of EPC and product contracts. In China, since our customers are facing fierce competition in their respective markets, they have had to reduce their respective selling prices in order to win business. In addition, the price of energy, such as coal, petroleum and steam, are increasing after the worldwide economic crisis. Given the increasing costs and reduced selling prices, our customers have had to increase the capacity of their manufacturing facilities, which can lead to greater efficiencies and greatly reduce costs by reducing the amount of energy generated during the production cycle. In this area, we are the major player. Accordingly, since the beginning of the 2010, we have increased our focus on EPC contracts to secure our leadership position. EPC contracts have a lower margin, but higher revenue and absolute profit. As of September 30, 2010, we have completed eight EPC contracts, as opposed to only three such contracts in the comparative period of 2009. The number of product contracts increased from 16 for the nine months ended September 30, 2009 to 20 for the same period of 2010, but average revenue per product contract decreased during the nine months ended September 30, 2010 as compared to the same period of 2009. This is mainly because our Vessel Works Division was schedule to close by the end of 2010, while our new facility was still under construction in the third quarter, so we had to out-source some smaller product contracts to ensure these contracts would be completed before our Vessel Works Division closed at the end of 2010, as well as not missing the orders from our clients.
The detailed changes are as follows:
Nine months ended September 30, | ||||||||||||||||
2009 | 2010 | Change ($) | Change (%) | |||||||||||||
Average Revenue per Contract | ||||||||||||||||
Products | $ | 634,213 | $ | 302,913 | (331,300 | ) | (52.24 | )% | ||||||||
EPC | 1,532,002 | 1,423,663 | (108,339 | ) | (7.07 | )% | ||||||||||
Average Revenue per Contract | $ | 2,166,215 | 1,726,576 | (439,639 | ) | (20.30 | )% | |||||||||
Number of Contracts Completed | ||||||||||||||||
Products | 16 | 20 | 4 | 25 | % | |||||||||||
EPC | 3 | 8 | 5 | 167 | % | |||||||||||
Total Number of Contracts Completed | 19 | 28 | 9 | 47 | % |
Cost of Revenues. Cost of revenues increased to $14,444,768 for the nine months ended September 30, 2010, as compared to $11,521,307 for the nine months ended September 30, 2009, an increase of $2,923,461, or 25.4%. As a percentage of revenues, cost of revenues increased from 78.1% for the nine months ended September 30, 2009 to 82.8% for the nine months ended September 30, 2010, an increase of 4.6%. The increase is consistent with the increase of revenue for the nine months ended September 30, 2010 over the same period of 2009. It is also due to the greater number of EPC projects completed in 2010, which usually have a higher cost of revenue, especially with respect to purchased parts. In addition, for the nine months ended September 30, 2009, one of the three EPC projects just started and only the design has been finished, which had very little cost.
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Gross Profit. Gross profit was $3,002,802 for the nine months ended September 30, 2010, as compared to $3,222,106 for the nine months ended September 30, 2009, a decrease of $219,304 or 6.8%. The lower gross profit mainly resulted from different product mix for nine months ended 2010 compared with that for nine months ended 2009, as the EPC project has a lower margin.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased to $4,095,102 for the nine months ended September 30, 2010, as compared to $4,027,167 for the nine months ended September 30, 2009, an increase of $67,935 or 1.7%. Selling, general and administrative expenses, as a percentage of revenue, decreased from 27.3% for the nine months ended September 30, 2009 to 23.5% for the same period in 2010, a decrease of 3.8%. The relative decrease is consistent with the increase of revenue for the nine months ended September 30, 2010 as compared to the same period of 2009. The absolute increase is the net result of increase of salary and administrative expenses and decrease of consulting fees. Firstly, salary expense increased by $476,722 or 41% for the nine months ended September 30, 2010 as compared to the same period of 2009, as a result of the addition of staff with approximately an increase of 70 employees from 2009 to 2010 and a company-wide gradual salary increases. Secondly, the consulting service fee decreased by $468,435 for the nine months ended September 30, 2010 as compared to the same period of 2009 because the Company signed an agreement with a consulting company which provide financing and marketing advisory service for the Company’s international development since July 1, 2009. There was no such service provided for the nine months ended September 30, 2010. Thirdly, the administrative expenses increased by $59,036 because of the opening of CER’s Yangzhou plant.
Loss from Operations. Loss from operations totaled $1,092,300 for the nine months ended September 30, 2010, as compared to loss of $805,061 for the same period in 2009, an increase of $287,239. The increase is mainly attributable to decrease in gross profit and increase in selling, general and administrative expenses.
Other Income/(Expense). For the nine months ended September 30, 2010, the Company generated other income of $1,043,842 as compared to $895,437 for the nine months ended September 2009, an increase of $148,405. The change in other income for the period ended September 30, 2010 consisted primary of $591,764 of change in fair value of warrants and derivative liabilities, $1,046,774 of non-operating income, offset by $1,490,133 in interest expenses, all as further described below.
Change in fair value of warrants and derivative liabilities. This resulted from the valuation of warrants and derivative liabilities. The change in fair value of warrants decreased by $256,061 mainly due to the decrease of the Company’s stock price for the nine months ended September 30, 2010 being less than that during the corresponding period of 2009. The $847,825 of income from change in fair value of derivative liabilities is mainly due to the decrease of the Company’s stock price since those securities were issued.
Non-operating Income, net. Non-operating income for the nine months ended September 30, 2010 mainly consisted of subsidy income received by CER Yangzhou from a research and development fund from the Yizheng industrial park, and income of Shanghai Engineering on technology support fund from Shanghai Yangpu science and technology commission. There was no such subsidy in the corresponding period in 2009.
Interest Expense. Interest expense increased to $1,786,380 for the nine months ended September 30, 2010, as compared to $296,247 for the nine months ended September 30, 2009, an increase of $1,490,133. This change is mainly due to the interest expense of $359,287 incurred for convertible notes, $391,890 for the $4,000,000 loan and $54,879 for the $1,000,000 loan of which $114,329 were offset as capitalized interest. In addition, the Company accretion on the convertible notes of $697,253 and amortization of long term deferred financial cost of $600,396 were charged as financial expense, offset by $237,660 for interest income from long term accounts.
Benefit/(provision) for Income Taxes. The normal applicable income tax rate for the operating entities in China is 25%. Pursuant to the PRC income tax laws, Shanghai Engineering is subject to enterprise income tax at a statutory rate of 15% as a high technology entity. For the nine months ended September 30, 2010, the Company incurred $345,647 of income tax provision, as compared to income tax provision of $8,900 for the nine months ended September 30, 2009, an absolute change of $336,747. The difference is mainly due to the increase in allowance for deferred income tax assets.
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Net (Loss)/Income. Net loss was $394,105 for the nine months ended September 30, 2010, as compared to net income of $81,476 for the nine months ended September 30, 2009, a decrease of $475,581. It is mainly due to the Company’s operating loss for the quarter.
Liquidity and Capital Resources
Our principal sources of liquidity have been cash generated from operations, the proceeds from the sale of equity to investors and borrowings from banks and other lenders. Our principal uses of cash have been to finance working capital, facility expansion and other capital expenditures.
It is our practice to carefully monitor the state of our business, cash requirements and capital structure. We believe that funds generated from our operations and available from our credit facilities will be sufficient to fund current business operations over at least the next twelve months. Notwithstanding our resources for operations on a going forward basis at current operating levels we will need capital for our expansion plans, including funding for the building of our proposed new plant. To improve our cash and cash requirement position, we are continuing our efforts to improve the collection of receivables, examine costs in an attempt to control or reduce expenses and use non-cash compensation, such as stock grants, where appropriate, all of which should have a positive effect on our working capital and increase our cash resources.
Cash Flows
The following table sets forth a summary of our cash flows for the periods indicated below:
Nine months ended September 30, | ||||||||
2009 (Restated) | 2010 | |||||||
Net cash provided by (used in) operating activities | $ | (5,364,697 | ) | 29,500 | ||||
Net cash used in investing activities | (67,420 | ) | (5,400,779 | ) | ||||
Net cash provided by financing activities | 5,498,780 | 3,762,755 | ||||||
Effects of exchange rate change in cash | (25 | ) | 2,460 | |||||
Increase/(Decrease) in cash | 66,638 | (1,606,064 | ) | |||||
Cash, beginning | 6,136,403 | 2,386,573 | ||||||
Cash, ending | $ | 6,203,041 | 780,509 |
Operating Activities
Net cash provided by operating activities was $29,500 for the nine months ended September 30, 2010 compared with net cash used in operating activities of $5,364,697 for the nine months ended September 30, 2009. The decrease of cash used in operating activities was due to the Company receiving more advance deposits from customers in 2010 than in 2009 mainly as a result of the increase of EPC contracts for the sale of finished goods and the provision of services. It is also due to the Company building and transferring a project for one customer in 2009, in which we paid all the cost during the production and did not receive any money until the project was finished in June 2010, at which time we collected money owed to us.
Investing Activities
Net cash used in investing activities was $5,400,779 for the nine months ended September 30, 2010 compared to net cash used in investing activities of $67,420 for the nine months ended September 30, 2009. The change was because the expenditures incurred in the construction of CER’s Yangzhou plant, (as described below).
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On August 18, 2009, CER Hong Kong entered into a series of contracts with Yangzhou (Yizheng) Automobile Industrial Park Administration Committee, a government entity of the City of Yangzhou, Jiangsu Province, China, to acquire a tract of land on which CER Hong Kong plans to build a new manufacturing facility. The Company has been meeting the construction schedules and fulfilling the investment requirement.
Financing Activities
Net cash provided by financing activities was $3,762,755 for the nine months ended September 30, 2010 compared to net cash provided by financing activities of $5,498,780 for the nine months ended September 30, 2009, a decrease of $1,736,025. This is because in September 2009, the Company drew down $5,000,000 in convertible notes and received a short-term bank loan of $880,200 while in 2010 the Company borrowed long-term loans in the total amount of $5,003,778, of which $360,822 has been repaid, and offset in part by a repayment of a short-term bank loan of $880,200. This amount is for Yangzhou plant construction and operating usage.
Capital Resources
On February 1, 2010, the Company entered into a series of agreements for a loan arrangement with two lenders (the “Loan Agreements”). The proceeds of this loan are primarily for the construction of a new plant in China. The aggregate principal amount of the loan under the two Loan Agreements is $4,000,000. The principal is due on January 15, 2013, and bears interest at the annual rate of 15.1%. As security for these Loan Agreements, Mr. Qinghuan Wu has pledged 8,000,006 shares of common stock of the Company, which shares will be held in escrow for the benefit of all the Lenders.
Contemporaneously with the funding of the Loan Agreements, on February 1, 2010, Mr. Qinghuan Wu, arranged for Haide Engineering (Hong Kong) Limited (“Haide”), a company that Mr. Qinghuan Wu controls, to lend to CER Hong Kong the sum of $1,000,000. The loan bears interest at the annual rate of 9.5%, interest payable quarterly. The principal is due in full on January 30, 2012. The loan is unsecured and there are no guarantees of the interest or principal. CER Hong Kong has subordinated its loan to those under the Loan Agreements.
On December 9, 2010, CER Yangzhou entered into a three-year, loan facility with the Bank of China, Yizheng Branch. The facility is for RMB 30,000,000 (approximately $4,500,000). The funds may be used either as a short term loan or for trade financing and similar purposes. Any amounts due under the loan are repayable on November 24, 2013. The loan has been guaranteed by each of the Company’s Chief Executive Officer and a director, two of the Company’s subsidiaries, CER Shanghai, Shanghai Engineering and Yizheng Auto Industrial Park Investment and Development Co., Ltd. The Company has also pledged the land use right in Yizheng. The Company has drawn RMB 21,000,000 (approximately $3,150,000) under the facility as a short-term loan, due in one year, which amount carries an annual interest rate of 5.838%. These funds will be used for working capital.
Contractual Obligations
Table Disclosure of Contractual Obligations
The following table sets forth our contractual obligations as of September 30, 2010:
Payment Due by Period | ||||||||||||
Total | Less than 1 year | 1-3 years | ||||||||||
Investment capital commitments | 14,120,000 | 14,120,000 | - | |||||||||
Operating leases | 66,309 | 66,309 | - | |||||||||
Long term loans | 4,544,465 | 3,540,687 | 1,003,778 | |||||||||
Convertible notes | 4,659,381 | 4,659,381 | - | |||||||||
Purchasing obligations | 4,528,016 | 4,528,016 | - | |||||||||
Total | 27,918,171 | 26,914,393 | 1,003,778 |
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Off-Balance Sheet Arrangements
We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as stockholders’ equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.
Item 3 Quantitative and Qualitative Disclosures about Market Risk
Not required.
Item 4 Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The management team evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2010. The term “disclosure controls and procedures,” as defined in Rule 13a-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, to allow timely decisions regarding required disclosure. Notwithstanding improvement made by the management in respect of its disclosure controls and procedures during the fiscal year, based on the evaluation of our disclosure controls and procedures as of September 30, 2010, management concluded that, as of such date, our disclosure controls and procedures were not effective.
Changes in Internal Control over Financial Reporting
There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended September 30, 2010 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting..
PART II
OTHER INFORMATION
Item 1 Legal Proceedings
We are not a party and our property is not subject to any material pending legal proceedings nor are we aware of any threatened or contemplated proceeding by any governmental authority against the Company.
Item 1A Risk Factors
Not Required.
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Item 2 Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3 Defaults upon Senior Securities
None
Item 4 [Reserved]
Item 5 Other Information
None
Item 6 Exhibits
Exhibits:
31.1 | Certification of Chief Executive Officer Pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934 |
31.2 | Certification of Chief Financial Officer Pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934 |
32.1 | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CHINA ENERGY RECOVERY, INC. | |||
April 18, 2011 | By: | /s/ Qinghuan Wu | |
Qinghuan Wu | |||
Chief Executive Officer and acting Chief Financial Officer (Principal Financial Officer) |
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