10-Q 1 v131985_10q.htm Unassociated Document
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, 2008

OR

o 
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
 
33-0843696
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification No.)
     
7F, De Yang Garden
   
No. 267 Qu Yang Road
   
Hongkou District, Shanghai
   
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 o

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):
 
Accelerated filer o
Non-accelerated filer o
Smaller reporting company x

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

Number of shares outstanding of the registrant's common stock as of September 30, 2008:

28,774,088 shares of Common Stock, $0.001 par value per share
 


TABLE OF CONTENTS

       
Page
Part I
 
Financial Information
   
         
 
Item 1.
Unaudited Consolidated Financial Statements
  1
         
   
Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007 (unaudited)
  1
         
   
Consolidated Statements of Operations and Other Comprehensive Income for the Three Months and Nine Months Ended September 30, 2008 and 2007 (unaudited)
  2
         
   
Consolidated Statements of Cash Flow for the Nine Months Ended September 30, 2008 and 2007 (unaudited)
  3
         
   
Consolidated Statements of Shareholders' Equity
  4
         
   
Notes to the Consolidated Financial Statements (unaudited)
  5
         
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
  24
         
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
  35
         
 
Item 4T.
Controls and Procedures
  35
         
Part II
 
Other Information
 
         
 
Item 1.
Legal Proceedings
  36
         
 
Item 1A.
Risk Factors
  36
         
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
  36
         
 
Item 3.
Defaults Upon Senior Securities
  37
         
 
Item 4.
Submission of Matters to a Vote of Security Holders
  37
         
 
Item 5.
Other Information
  37
         
 
Item 6.
Exhibits
  37
 
i


PART I
FINANCIAL INFORMATION

Item 1. Unaudited Consolidated Financial Statements

CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
AS OF SEPTEMBER 30, 2008 AND DECEMBER 31, 2007
 
   
September 30,
 
December 31,
 
   
2008
 
2007
 
   
UNAUDITED
     
ASSETS
         
CURRENT ASSETS:
         
Cash
 
$
6,368,633
 
$
306,150
 
Restricted cash
   
596,319
   
89,115
 
Accounts receivable, net of allowance for doubtful accounts of $127,794
             
and $237,475 as of September 30, 2008 and December 31, 2007, respectively 
   
4,968,881
   
577,005
 
Accounts receivable - related parties
   
-
   
572,036
 
Notes receivable
   
641,745
   
351,799
 
Inventories
   
8,592,517
   
5,262,329
 
Costs and estimated earnings in excess of billings
   
2,089,938
   
1,155,909
 
Other receivables
   
88,388
   
37,852
 
Advances on inventory purchases
   
2,829,012
   
1,995,345
 
Total current assets  
   
26,175,433
   
10,347,540
 
 
             
PLANT AND EQUIPMENT, net
   
765,034
   
649,392
 
 
             
OTHER ASSETS:
             
Long term accounts receivable, retainage
   
820,694
   
588,433
 
Due from shareholder
   
371,172
   
463,663
 
Total other assets 
   
1,191,866
   
1,052,096
 
 
             
 Total assets
 
$
28,132,333
 
$
12,049,028
 
               
LIABILITIES AND SHAREHOLDERS' EQUITY
             
               
CURRENT LIABILITIES:
             
Accounts payable
 
$
4,580,760
 
$
2,196,508
 
Other payables
   
318,330
   
275,591
 
Other payables - related parties
   
64,900
   
60,819
 
Accrued liabilities
   
143,017
   
27,850
 
Customer deposits
   
9,529,208
   
8,052,570
 
Customer deposits - related parties
   
2,765,598
   
-
 
Taxes payable
   
1,571,719
   
719,132
 
Deferred revenue
   
1,737,839
   
930,546
 
Short term loan payable
   
380,380
   
-
 
Total current liabilities 
   
21,091,751
   
12,263,016
 
               
COMMITMENTS AND CONTINGENCIES
   
-
   
-
 
               
SHAREHOLDERS' EQUITY:
             
Preferred stock ($0.001 par value, 50,000,000 shares authorized,
             
2,991,934 issued and outstanding as of September 30, 2008 and  
   
2,992
   
-
 
0 issued and outstanding as of December 31, 2007) 
             
Common stock ($0.001 par value, 100,000,000 shares authorized,
             
28,774,088 issued and outstanding as of September 30, 2008 and  
   
28,774
   
20,757
 
20,757,090 issued and outstanding as of December 31, 2007) 
             
Paid-in-capital
   
9,111,556
   
871,787
 
Deferred compensation
   
(1,760,860
)
 
-
 
Contribution receivables
   
(1,000
)
 
(1,000
)
Accumulated deficit
   
(648,297
)
 
(1,270,165
)
Statutory reserves
   
391,978
   
204,758
 
Accumulated other comprehensive loss
   
(84,561
)
 
(40,125
)
Total shareholders' equity 
   
7,040,582
   
(213,988
)
               
 Total liabilities and shareholders' equity
 
$
28,132,333
 
$
12,049,028
 

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

1


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007
(UNAUDITED)
 
   
Three months ended
 
Nine months ended
 
 
 
September 30
 
September 30
 
 
 
2008
 
2007
 
2008
 
2007
 
REVENUES
                 
Third parties 
 
$
4,208,911
 
$
3,908,221
 
$
14,017,367
 
$
7,538,493
 
Related party 
   
1,914,793
   
-
   
1,962,824
       
 Total revenue
   
6,123,704
   
3,908,221
   
15,980,191
   
7,538,493
 
                           
COST OF SALES
                         
Third parties 
   
3,343,536
   
3,773,927
   
11,297,946
   
6,851,603
 
Related party 
   
1,169,502
   
-
   
1,169,502
       
 Total cost of sales
   
4,513,038
   
3,773,927
   
12,467,448
   
6,851,603
 
                           
GROSS PROFIT
   
1,610,666
   
134,294
   
3,512,743
   
686,890
 
                           
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
   
1,184,844
   
212,597
   
2,273,105
   
842,776
 
                           
INCOME (LOSS) FROM OPERATIONS
   
425,822
   
(78,303
)
 
1,239,638
   
(155,886
)
                           
OTHER INCOME (EXPENSE), NET
                         
Non-operating income (expense), net 
   
8,645
   
(7,236
)
 
31,043
   
11,170
 
Interest income (expense), net 
   
14,823
   
(8,688
)
 
(49,954
)
 
(37,289
)
 Total other income (expense), net
   
23,468
   
(15,924
)
 
(18,911
)
 
(26,119
)
                           
INCOME (LOSS) FROM OPERATIONS BEFORE
                         
PROVISION FOR INCOME TAXES 
   
449,290
   
(94,227
)
 
1,220,727
   
(182,005
)
                           
PROVISION FOR INCOME TAXES
   
204,434
   
1,583
   
411,639
   
7,944
 
                           
NET INCOME (LOSS)
   
244,856
   
(95,810
)
 
809,088
   
(189,949
)
                           
OTHER COMPREHENSIVE INCOME (LOSS)
                         
Foreign currency translation adjustment 
   
469
   
8,174
   
(44,436
)
 
(49,414
)
                           
COMPREHENSIVE INCOME (LOSS)
 
$
245,325
   
(87,636
)
 
764,652
 
$
(239,363
)
                           
EARNING (LOSS) PER SHARE
                         
Basic 
                         
 Weighted average number of shares
   
27,460,695
   
20,757,090
   
24,415,471
   
20,757,090
 
 Earning (loss) per share
 
$
0.009
 
$
(0.005
)
$
0.033
 
$
(0.009
)
Diluted 
                         
 Weighted average number of shares
   
30,171,968
   
20,757,090
   
26,044,405
   
20,757,090
 
 Earning (loss) per share
 
$
0.008
 
$
(0.005
)
$
0.031
 
$
(0.009
)

The accompanying notes are an integral part of these consolidated financial statements.
 
2


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007
(UNAUDITED)
 
   
2008
 
2007
 
CASH FLOWS FROM OPERATING ACTIVITIES:
         
Net income (loss)
 
$
809,088
 
$
(189,949
)
Adjustments to reconcile net income to cash
             
provided by (used in) operating activities:
             
Depreciation  
   
84,142
   
50,485
 
Change in allowance for uncollectible accounts 
   
80,031
   
27,657
 
Common stock issued for services 
   
239,512
   
-
 
Option issued for services 
   
73,254
   
-
 
Amortization of stock-based compensation to consultants 
   
49,000
   
-
 
Write off fixed assets 
   
39,427
   
-
 
Loss on fixed assets disposal 
   
-
   
9,637
 
Change in operating assets and liabilities
             
Accounts receivable 
   
(4,400,769
)
 
42,330
 
Accounts receivable - related parties 
   
598,197
   
-
 
Notes receivable 
   
(261,005
)
 
78,163
 
Inventories 
   
(2,917,441
)
 
(3,752,200
)
Costs and estimated earnings in excess of billings 
   
(839,310
)
 
(2,571,036
)
Other receivable 
   
(88,098
)
 
(7,328
)
Advances on inventory purchases 
   
(641,934
)
 
(1,307,345
)
Long term accounts receivable, retainage 
   
(134,149
)
 
-
 
Other assets 
   
(4,158
)
 
575
 
Accounts payable 
   
2,175,697
   
1,156,844
 
Other payables 
   
(15,047
)
 
135,479
 
Other payables - related parties 
   
-
   
24,056
 
Accrued liabilities 
   
112,521
   
117,600
 
Customer deposits 
   
917,524
   
5,977,142
 
Customer deposits - related parties 
   
2,710,211
   
317,074
 
Taxes payable 
   
788,221
   
(612,821
)
Deferred revenue 
   
729,932
   
509,028
 
 Net cash provided by operating activities
   
104,846
   
5,391
 
               
CASH FLOWS FROM INVESTING ACTIVITIES:
             
Purchase equipment
   
(194,188
)
 
(92,250
)
 Net cash used in investing activities
   
(194,188
)
 
(92,250
)
               
CASH FLOWS FROM FINANCING ACTIVITIES:
             
Proceeds received from a shareholder
   
160,731
   
76,548
 
Increase in restricted cash
   
(491,186
)
 
(84,916
)
Cash received from re-orgnization
   
119
   
-
 
Capital contribution
   
-
   
65,320
 
Proceeds from issuing preferred stock, net of offering costs
   
6,619,278
   
-
 
Shareholder distribution from VIE
   
(575,771
)
 
(214,250
)
Cash proceeds from short term bank loans
   
359,060
   
298,760
 
 Net cash provided by financing activities
   
6,072,231
   
141,462
 
               
EFFECTS OF EXCHANGE RATE CHANGE IN CASH
   
79,594
   
(6,650
)
               
INCREASE IN CASH
   
6,062,483
   
47,953
 
               
CASH, beginning of period
   
306,150
   
147,605
 
               
CASH, end of period
 
$
6,368,633
 
$
195,558
 
 
The accompanying notes are an integral part of these consolidated financial statements.

3


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
 
                               
Accumulated deficit
 
Accumulated other
 
   
Preferred stock
 
Common stock
 
Paid-in
 
Deferred
 
Contribution
 
 
 
Statutory
 
comprehensive
 
 
 
 
 
Shares
 
Amount
 
Shares
 
Amount
 
capital
 
Compensation
 
receivable
 
Unrestricted
 
reserves
 
income (loss)
 
Totals
 
                                               
BALANCE, January 1, 2007
   
-
 
$
-
   
20,757,090
 
$
20,757
 
$
3,798,393
 
$
-
 
$
(1,000
)
$
(1,871,567
)
$
165,241
 
$
161,434
 
$
2,273,258
 
                                                                     
Shareholder contribution
                           
67,150
                                 
67,150
 
Shareholder distribution from VIE
                           
(2,993,756
)
             
-
               
(2,993,756
)
Adjustment to statutory reserve
                                             
(18,229
)
 
18,229
         
-
 
Net loss
                                             
(189,949
)
             
(189,949
)
Foreign currency translation loss
                                                         
(49,414
)
 
(49,414
)
                                                                     
BALANCE, September 30, 2007, Unaudited
   
-
 
$
-
   
20,757,090
 
$
20,757
 
$
871,787
 
$
-
 
$
(1,000
)
$
(2,079,745
)
$
183,470
 
$
112,020
 
$
(892,711
)
                                                                     
Adjustment to statutory reserve
                                             
(21,288
)
 
21,288
         
-
 
Net income
                                             
830,868
               
830,868
 
Foreign currency translation loss
                                                         
(152,145
)
 
(152,145
)
                                                                     
BALANCE, December 31, 2007
   
-
 
$
-
   
20,757,090
 
$
20,757
 
$
871,787
 
$
-
 
$
(1,000
)
$
(1,270,165
)
$
204,758
 
$
(40,125
)
$
(213,988
)
                                                                     
Preferred stock issued for cash at $1.08
   
7,874,241
   
7,874
               
6,636,404
                                 
6,644,278
 
Shares issued for reorganization on
                                                                   
April 15, 2008
               
4,717,890
   
4,718
   
3,698
                                 
8,416
 
Common stock issued for service
               
662,500
   
663
   
1,710,616
   
(1,471,767
)
                         
239,512
 
Warrants issued for service at $2.16
                           
338,093
   
(289,093
)
                         
49,000
 
Value of option granted to directors
                           
73,254
                                 
73,254
 
Cashless exercise of warrant
               
195,454
   
195
   
(195
)
                               
-
 
Conversion of preferred stock
   
(4,882,307
)
 
(4,882
)
 
2,441,154
   
2,441
   
2,441
                                 
-
 
Shareholder distribution from VIE
                           
(524,542
)
                         
(8,794
)
 
(533,336
)
Adjustment to statutory reserve
                                             
(187,220
)
 
187,220
         
-
 
Net income
                                             
809,088
               
809,088
 
Foreign currency translation loss
                                                         
(35,642
)
 
(35,642
)
                                                                     
BALANCE, September 30, 2008, Unaudited
   
2,991,934
 
$
2,992
   
28,774,088
 
$
28,774
 
$
9,111,556
 
$
(1,760,860
)
$
(1,000
)
$
(648,297
)
$
391,978
 
$
(84,561
)
$
7,040,582
 

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

4


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(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. From inception to March 31, 2002, the Company was a wholly-owned subsidiary of The Majestic Companies, Ltd. ("Majestic"), and in March 2002, Majestic's Board of Directors approved a plan to spin-off the Company to an entity controlled by Majestic's former Chief Executive Officer and to Majestic's stockholders. On September 24, 2002, the Company acquired USM Financial Solutions, Inc. through a Capital Stock Exchange Agreement (the "USM Agreement"). Pursuant to the USM Agreement, USM Financial Solutions, Inc. became a wholly-owned subsidiary of the Company. 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, for purposes of changing the Company's state of incorporation from Maryland to Delaware. On June 5, 2007, the Company changed its name to MMA Media, Inc. Immediately before the closing of the Share Exchange (as defined below), the Company was considered to be in the development stage because its operations principally involved market research and other business planning activities. In addition, no revenue was generated from its operations. 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 (the "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") closed on April 15, 2008 and resulted in Poise Profit becoming 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.

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 consists 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 for $8,504,181. 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 issued in the Financing are convertible into 3,937,120 shares of the Company's common stock and the warrants exercisable into 1,968,561 shares of the Company's common stock at an exercise price of $2.58 per share. The issuance costs, including commissions, legal fees and transaction expenses directly in connection with the Financing were $1,884,902.

Poise Profit is an off-shore holding company and has no operating business activities. The majority shareholders of Poise Profit before the closing of the Share Exchange were Chinese citizens. Poise Profit owns 100% of HAIE Hi-tech Engineering (Hong Kong) Company, Limited ("Hi-tech"). Hi-tech was incorporated in Hong Kong on January 4, 2002. Hi-tech has a registered capital of approximately $1,000 (HK$10,000). Hi-tech, 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. As of September 30, 2008, there was $1,000 contribution receivable from the shareholder.

5


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

Shanghai Hai Lu Kun Lun Hi-tech Engineering Co., Ltd ("Shanghai Engineering") was established in July 1999 and has a registered capital of approximately $805,000 (RMB 6,500,000). The owners of Shanghai Engineering are Mr. Qinghuan Wu (60%), one of the Company's directors and its Chairman of the Board, Chief Executive Officer and Secretary and Mrs. Jialing Zhou (40%), one of the Company's directors. Mr. Wu is the executive director of Shanghai Engineering. Mr. Wu and Mrs. Zhou are husband and wife.
 
On December 28, 2005 and effective January 1, 2006, Hi-tech entered into a series of contractual arrangements with Shanghai Engineering and its shareholders comprised of a series of agreements, 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 granted 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. As both companies are under common control, this has been accounted for as a reorganization of entities and the financial statements have been prepared as if the reorganization had occurred retroactively. Poise Profit consolidates Shanghai Engineering's results, assets and liabilities in its financial statements.

Shanghai Xin Ye Environmental Protection Engineering Technology Co., Ltd ("Shanghai Environmental") was incorporated in Shanghai on May 23, 2007. Shanghai Environmental has a registered capital of approximately $67,150 (RMB 500,000). The owners of Shanghai Environmental originally were Mr. Qi Chen (60%), one of the Company's directors and its General Manager, and Mrs. Yajun Liu (40%). According to the share transfer meeting on November 6, 2007, the shares of Mr. Qi Chen and Mrs. Yajun Liu were transferred to Mr. Qinghuan Wu, who became the sole shareholder of Shanghai Environmental. Shanghai Environmental is not an operating company but serves as a vehicle for arranging sales and maximizing tax benefits.

On December 28, 2005 and effective May 23, 2007, Hi-tech entered into a series of contractual arrangements with Shanghai Environmental and its shareholders comprised of a series of agreements, 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, Shanghai Environmental's shareholder has granted 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 its shareholder have granted Hi-tech the exclusive right and option to acquire all of the shareholders' equity interest in Shanghai Environmental. Further, Shanghai Environmental's shareholder has pledged all of his rights, titles and interests in Shanghai Environmental. As both companies are under common control, this has been accounted for as a reorganization of entities and the financial statements have been prepared as if the reorganization had occurred retroactively. Poise Profit consolidates Shanghai Environmental's results, assets and liabilities in its financial statements.

Through Hi-tech, Poise Profit operates and controls Shanghai Engineering and Shanghai Environmental through the contractual arrangements described above. The reasons that Poise Profit used the contractual arrangements to acquire control over Shanghai Engineering and Shanghai Environmental, instead of acquiring Shanghai Engineering and Shanghai Environmental's assets or equity, are that (i) new PRC laws governing share exchanges with foreign entities, which became effective on September 8, 2006, make the consequences of such acquisitions uncertain and (ii) other than by share exchange, PRC law requires Shanghai Engineering and Shanghai Environmental to be acquired for cash and Poise Profit was not able to raise sufficient funds to pay the full appraised value of Shanghai Engineering and Shanghai Environmental's assets or equity as required under PRC law.

6


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

On May 1, 2003, Shanghai Engineering entered into a cooperative manufacturing agreement with a PRC state-owned enterprise, Shanghai Si Fang Boiler Factory ("Shanghai Si Fang"). Pursuant to the agreement, Shanghai Si Fang leases one of its manufacturing facilities and obtains use of the Si Fang brand, Shanghai Si Fang Boiler Factory-Vessel Works Division ("Vessel Works Division") to Shanghai Engineering. Vessel Works Division is a separate legal entity. The agreement is renewed every one to two years and expires on December 31, 2009. According to the agreement, Shanghai Engineering has the following rights: (i) complete control over the operations of Vessel Works Division; (ii) right of use of the property, plant and equipment of Vessel Works Division; (iii) use of the "Si Fang" brand name and license for pressure vessels; and (iv) right to the net profit of Vessel Works Division. Shanghai Si Fang provides quality control for the manufactured products. Shanghai Engineering pays Shanghai Si Fang rent and a management fee. Although Shanghai Engineering owns none of the outstanding equity interests in Vessel Works Division, the agreement provides Shanghai Engineering control over Vessel Works Division and the risks and rewards associated with equity ownership. Shanghai Engineering and Vessel Works Division are the primary operating entities owned or controlled by Poise Profit.
 
Shanghai Zhuyi Industry Co. Ltd. ("Zhuyi") was incorporated in Shanghai on April 10, 2006. The business scope of Zhuyi was trading in construction materials, metal materials, mechanical equipment, and computers hardware, and providing mechanical equipment design and consultation services. Zhuyi had a registered capital of approximately $63,900 (RMB 500,000). The owners of Zhuyi were Mr. Qi Chen (60%) and Mrs. Jialing Zhou (40%). According to the meeting of shareholders and the revised bylaws dated November 8, 2006, the registered capital was increased to RMB1,000,000. Zhuyi was dissolved in July 2007. Capital of $127,650 (RMB1,000,000) was returned to the owner in January 2008.

Shanghai Haiyin Hi-Tech Engineering Co. Ltd. ("Haiyin") was incorporated in Shanghai on December 3, 2003 with registered capital of approximately $2,904,000 (RMB 24,000,000). The owners of Haiyin were Mr. Qinghuan Wu (60%) and Mrs. Jialing Zhou (40%). Haiyin was engaged in four technology services (development, transfer, consultation and other technology services) in chemical engineering, energy saving, computer and other professional technical fields. Haiyin also was engaged in processing, selling and installing computer hardware, heat recovery boiler and auxiliary equipment, and chemical engineering devices. In accordance with a shareholders meeting and revision of the company bylaws, the registered capital was decreased to approximately $1,452,000 (RMB 12,000,000) on February 28, 2007 and approximately $121,000 (RMB 1,000,000) on May 28, 2007, separately. Haiyin's application for dissolution was approved by the PRC government authority in December 2007. Haiyin had no business activity after December of 2007, and on April 18, 2008, the remaining registered capital of $121,000 had been returned as the result of a distribution from another variable interest entity.

On March 5, 2008, Hi-tech and Shanghai Engineering jointly formed Shanghai Haie Investment Consultation Co., Ltd. ("JV Entity"). JV Entity was 10% owned by Shanghai Engineering and 90% owned by Hi-tech with registered capital of approximately $9.23 million (RMB 65,000,000). On March 21, 2008, JV Entity received an Enterprise Corporation Business License from the Shanghai Administration for Industry and Commerce. On April 25, 2008, $6 million registered capital was injected, and contribution receivables amounted to $3.23 million as of June 30, 2008. In compliance with the new Chinese regulation effective January 2008, on June 16, 2008, JV Entity's Board of Director approved the plan to dissolve the JV Entity. The business closure application was approved by the PRC government in July 2008. JV Entity was dissolved on September 1, 2008. The paid-in portion of registered capital of $6 million was returned to Hi-tech on September 19, 2008.

As all the above entities are under common control, the arrangements described above have been accounted for as a reorganization of entities and the financials statements have been prepared as if the reorganization had occurred retroactively. CER, Poise Profit, Hi-tech, Shanghai Engineering, Vessel Works Division, Zhuyi, Haiyin, Shanghai Environmental, and JV Entity are collectively hereinafter referred to as ("the Company").

Note 2 - Summary of Significant Accounting Policies

(a) Consolidation of variable interest entities
 

7


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

The Company has concluded that Shanghai Engineering, Vessel Works Division, Zhuyi, Haiyin and Shanghai Environmental are VIEs and that the Company is the primary beneficiary. Under the requirements of FIN 46R, the Company consolidated the financial statements of Hi-tech, Shanghai Engineering, Vessel Works Division, Zhuyi, Haiyin and Shanghai Environmental. As all companies are under common control, the financial statements have been prepared as if the arrangements described above had occurred retroactively. Intercompany items have been eliminated.
 
(b) Use of estimates

In preparing financial statements in conformity with generally accepted accounting principles in the United States of America, 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 depreciation and allowance for doubtful accounts receivable. Actual results could differ from those estimates.

Management has included all normal recurring adjustments considered necessary to give a fair presentation of operating results for the periods presented. Interim results are not necessarily indicative of results for a full year. The information included in these interim financial statements should be read in conjunction with information included in the Company's financial statements for the year ended December 31, 2007 appearing elsewhere and in the Company's Current Report on Form 8-K filed on April 21, 2008.

(c) Cash and concentration of risk

The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents for cash flow statement purposes. Cash includes cash on hand and demand deposits in accounts maintained with state owned banks within the PRC. Certain financial instruments, which subject the Company to concentration of credit risk, consist of cash. The Company maintains balances at financial institutions or state owned banks within the PRC and in banks located in Hong Kong which amounts are not covered by insurance. As of September 30, 2008 and December 31 2007, the Company had deposits totaling $7,063,522 and $395,265 that are not covered by insurance, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.

For the nine months ended September 30, 2008, four customers accounted for 60% of the Company's sales. For the nine months ended September 30, 2007, 57% of the Company's sales were from two customers, although different customers than those referred to in the previous sentence for the nine months ended September 30, 2008. Receivables from the four customers were 46% of total account receivables at September 30, 2008.

For the nine months ended September 30, 2008, two suppliers provided approximately 20% of the Company's purchases of raw materials. There was one supplier which provided approximately 15% of the Company’s purchases of raw materials for the nine months ended September 30, 2007.

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 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.
 
8


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)
 
(d) Restricted cash

Restricted cash represents a cash portion of the purchase price deposited in a separate bank account subject to withdrawal restrictions controlled by the customer to secure the Company’s performance of the projects in question. The deposit cannot be drawn or transferred by the Company until the restriction period has expired. The amounts of restricted cash were $596,319 and $89,115 as of September 30, 2008 and December 31, 2007, respectively.

(e) Allowance for doubtful accounts

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. Accounts considered uncollectible are written off. As of September 30, 2008 and December 31, 2007, management concluded its allowance for bad debts were sufficient.

The following table consists of allowance for doubtful accounts.
 
Allowance for bad debt, 1/1/2007
 
$
61,948
 
Addition
   
171,556
 
Recovery
   
(7,111
)
Translation adjustment
   
11,082
 
Allowance for bad debt, 12/31/2007
 
$
237,475
 
Addition
   
80,031
 
Recovery
   
(203,131
)
Translation adjustment
   
13,419
 
Allowance for bad debt, 9/30/2008 (Unaudited)
 
$
127,794
 

(f) Inventories

Inventories are comprised of raw materials and work in progress 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.

(g) Plant and equipment, net

Fixed assets are stated at cost. Depreciation is provided principally by use of the straight-line method over the 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 expensed to operations while major repairs are capitalized.

Management considers that the Company has a 5% residual value for equipment. The estimated useful lives are as follows:

Transportation equipment
10 years
Machinery equipment
10 years
Office equipment
5-10 years

The gain or loss on disposal of fixed assets is the difference between the net sales proceeds and the carrying amount of the relevant assets, and, if any, is recognized in the statement of operations.

(h) Impairment of assets


9


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

(i) Income taxes

The Company accounts for income taxes under SFAS 109, "Accounting for Income Taxes". Under SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
 
The Company adopted Financial Accounting Standards Board ("FASB") Interpretation 48, "Accounting for Uncertainty in Income Taxes" ("FIN 48"), on January 1, 2007. A tax position is recognized as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded. The adoption had no effect on the Company's financial statements.

The Company reviewed the differences between the tax bases under PRC tax laws and financial reporting under US GAAP, and no material differences were found, thus, there were no deferred tax assets or liabilities as of September 30, 2008 and December 31, 2007, respectively.

Under current PRC tax laws, no tax is imposed in respect to distributions paid to owners except for individual income tax.

(j) 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 their 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.

(k) Stock based compensation to other than employees

The Company accounts for equity instruments issued in exchange for the receipt of goods or services from other than employees in accordance with SFAS 123R, "Accounting for Stock-Based Compensation," and the conclusions reached by EITF 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services." Costs are measured at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably determinable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services as defined by EITF 96-18. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement.

(l) Revenue recognition

The Company derives revenues principally from (a) sales of energy recovery systems, (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 to installation. 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.

10


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)
 
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 generally recognizes revenues 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 Statement of Position (SOP) 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts" and (1981) and Accounting Research Bulletin Opinion No. 45, Long-Term Construction-Type Contracts ("ARB 45"), 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 we recognize revenue.

The Company offers 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 one to two years). Pursuant to paragraph 14 of FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, when disclosing product warranties, the guarantor is required to disclose: (i) the guarantor's accounting policy and methodology used in determining its liability for product warranties, and (ii) a tabular reconciliation of the changes in the guarantor's aggregate product warranty liability for the reporting period. The Company records the retainage as deferred revenue until the customers pay it after the warranty period expires, at which time the Company recognizes revenue. Further, a tabular reconciliation of the changes in the company's aggregate product warranty liability for the reporting period is included in note 7 to these consolidated financial statements.

Shipping and handling costs related to costs of goods sold are included in selling, general and administrative costs which totaled $69,987 and $46,257 for the three months ended September 30, 2008 and 2007, respectively; and $333,269 and $55,363 for the nine months ended September 30, 2008 and 2007, respectively.
 
11


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)
 
(m) Foreign currency translations
 
The reporting currency of the Company is the U.S. dollar. Shanghai Engineering, Vessel Works Division, Zhuyi, Haiyin and Shanghai Environmental use their local currency, Renminbi ("RMB") as their functional currency. Hi-tech uses its local currency, Hong Kong dollar ("HK$") as its 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. Translation adjustments resulting from this process are included in accumulated other comprehensive income 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 nine months ended September 30, 2008 and 2007, foreign currency translation loss amounted to $44,436 and $49,414, respectively. For the three ended September 30, 2008 and 2007, foreign currency translation income was $469 and $8,174, respectively.
 
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 in the consolidated statement of shareholders' equity amounted to $84,561 and $40,125 as of September 30, 2008 and December 31, 2007, respectively. The balance sheet accounts with the exception of equity at September 30, 2008 were translated at RMB6.84 to $1.00 or HK$7.77 to $1.00., and were translated at RMB7.29 to $1.00 or HK$7.80 to $1.00 at December 31, 2007.

The average translation rates applied to income and cash flow statement amounts for the nine months ended September 30, 2008 and 2007 were RMB6.98 to $1.00 or HK$7.79 to $1.00, and RMB7.66 to $1.00 or HK$7.81 to $1.00, respectively.

(n) Fair value of financial instruments

On January 1, 2008, the Company adopted SFAS No. 157, "Fair Value Measurements" ("SFAS 157") defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosure requirements for fair value measurements. The carrying amounts reported in the balance sheets for current assets and current liabilities qualify as financial instruments and 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 their current market rate of interest. The three levels are defined as follow:

 
· 
Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
 
· 
Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.
 
· 
Level 3 inputs to the valuation methodology are unobservable and significant to the fair value.

The Company's long term accounts receivable retainage amounted to $820,694 at September 30, 2008. Because there is no quoted or observable market price for the fair value of retainage, the Company used the level 3 inputs for its valuation methodology. The determination of the fair value was based on the contracted amount. The contracted amount of the long term accounts receivable, retainage approximated the fair value as of September 30, 2008.

The balance of Due from shareholder was $371,172 at September 30, 2008. Because Due from shareholders was expected to be collected in the near future, the Company used the level 3 inputs for its valuation methodology. The determination of the fair value was based on the carrying value. The carrying value of the Due from shareholder approximated the fair value as of September 30, 2008.
 
12


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

 
 
Carrying Value as of 
September 30, 2008 
 
Fair Value Measurements at September 30, 2008 Using 
Fair Value Hierarchy 
 
 
 
   
 
  Level 1
 
  Level 2
 
  Level 3
 
Assets
                 
Long term accounts receivable, retainage
 
$
820,694
             
$
820,694
 
Due from shareholder
 
$
371,172
             
$
371,172
 

The Company did not identify any assets and liabilities that are required to be presented on the balance sheet at fair value in accordance with SFAS No. 157.
 
(o) Costs and estimated earnings in excess of billings
 
The current assets, "Costs and estimated earnings in excess of billings", represent revenue recognized in excess of amounts billed for the EPC contracts recognized using the percentage of completion method.
 
   
September 30,
2008
 
December 31,
2007
 
 
 
(Unaudited)
 
 
 
Contracts costs incurred plus profits less recognized losses to date
 
$
2,089,938
 
$
2,991,865
 
Less progress billings
   
-
   
1,835,956
 
Costs and estimated earnings in excess of billings
 
$
2,089,938
 
$
1,155,909
 

(p) Beneficial conversion feature of Series A Convertible Preferred Stock

The Company determined that the Series A Convertible Preferred Stock contains a beneficial conversion feature and should be accounted for using EITF 98-5 "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios" and EITF 00-27 ''Application of Issue 98-5 to Certain Convertible Instruments'' because the Series A Convertible Preferred Stock was issued at a price below the per share price for the Company’s common share price at the date of issuance.

In accordance with EITF 00-27 and EITF 98-5, the Company used the Black-Scholes option-pricing model in calculating the fair value of detachable warrants at the date of issuance based on the following assumptions and resulted in the total value of warrants was $8,023,271:

Number of 
Warrants Valued 
 
Expected 
Life (years) 
 
Exercise 
Price 
 
Expected 
Volatility 
 
Dividend 
Yield 
 
Stock Price at 
valuation date 
 
Risk Free Interest 
Rate
 
3,937,122
   
5.00
 
$
1.29
   
125
%
 
-
 
$
2.30
   
1.84
%

The Company then used the relative value to allocate the value of the warrants and the value of the Series A Convertible Preferred Stock. Based on this method, the amount allocated to the Series A Convertible Preferred Stock and the warrants was $2,992,296 and $ 3,626,982, respectively, out of the net proceeds of $6,619,278 that the Company received in the Financing.

(q) Recent accounting pronouncements

In February 2007, the FASB issued SFAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115". SFAS 159 is expected to expand the use of fair value accounting but does not affect existing standards which require certain assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may choose, at specified election dates, to measure eligible items at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted SFAS No. 159 on January 1, 2008. The Company chose not to elect the option to measure the fair value of eligible financial assets and liabilities.

13


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)
 
In December 2007, the FASB issued SFAS 160, "Noncontrolling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin No. 51", which establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest and the valuation of retained non-controlling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company has not determined the effect that the application of SFAS 160 will have on its consolidated financial statements.

In December 2007, SFAS 141(R), "Business Combinations",   was issued. SFAS No. 141R replaces SFAS No. 141, "Business Combinations" . SFAS 141R retains the fundamental requirements in SFAS 141 that the acquisition method of accounting (which SFAS 141 called the purchase method ) be used for all business combinations and for an acquirer to be identified for each business combination. SFAS 141R requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. This replaces SFAS 141's cost-allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. SFAS 141R also requires the acquirer in a business combination achieved in stages (sometimes referred to as a step acquisition) to recognize the identifiable assets and liabilities, as well as the noncontrolling interest in the acquiree, at the full amounts of their fair values (or other amounts determined in accordance with SFAS 141R). SFAS 141R applies prospectively to 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, 2008. An entity may not apply it before that date. The Company is currently evaluating the impact that adopting SFAS No. 141R will have on its financial statements.

In March 2008, the FASB issued SFAS 161, "Disclosures about Derivative Instruments and Hedging Activities - An Amendment of SFAS No. 133". SFAS 161 seeks to improve financial reporting for derivative instruments and hedging activities by requiring enhanced disclosures regarding the impact on financial position, financial performance, and cash flows. To achieve this increased transparency, SFAS 161 requires (1) the disclosure of the fair value of derivative instruments and gains and losses in a tabular format; (2) the disclosure of derivative features that are credit risk-related; and (3) cross-referencing within the footnotes. SFAS 161 is effective on January 1, 2009. The Company is in the process of evaluating the new disclosure requirements under SFAS 161.

In May 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles." This Statement identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). This Statement will not have an impact on the Company's financial statements.
 
In May 2008, the FASB issued SFAS 163, "Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60." The scope of this Statement is limited to financial guarantee insurance (and reinsurance) contracts, as described in this Statement, issued by enterprises included within the scope of Statement 60. Accordingly, this Statement does not apply to financial guarantee contracts issued by enterprises excluded from the scope of Statement 60 or to some insurance contracts that seem similar to financial guarantee insurance contracts issued by insurance enterprises (such as mortgage guaranty insurance or credit insurance on trade receivables). This Statement also does not apply to financial guarantee insurance contracts that are derivative instruments included within the scope of FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement will not have an impact on the Company's financial statements.

14


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

In June 2008, the FASB issued EITF 07-5 "Determining whether an Instrument (or Embedded Feature) is indexed to an Entity's Own Stock". This Issue is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. Paragraph 11(a) of SFAS 133 "Accounting for Derivatives and Hedging Activities" 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. EITF 07-5 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 SFAS 133 paragraph 11(a) scope exception. This standard will trigger liability accounting on all options and warrants exercisable at strike prices denominated in any currency other than the functional currency of the operating entity in Chinese (Renminbi). The Company is currently evaluating the impact of adoption of EITF No. 07-5 on the Company's consolidated financial statements.
 
In June 2008, FASB issued EITF 08-4, "Transition Guidance for Conforming Changes to Issue No. 98-5". The objective of EITF 08-4 is to provide transition guidance for conforming changes made to EITF 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios", that result from EITF 00-27 "Application of Issue No. 98-5 to Certain Convertible Instruments", and SFAS 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". This Issue is effective for financial statements issued for fiscal years ending after December 15, 2008. Early application is permitted.  Management is currently evaluating the impact of adoption of EITF 08-4 on the accounting for the consolidated financial statements.

On October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” which clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 became effective on October 10, 2008, and its adoption did not have a material impact on the Company’s financial position or results for the quarter ended September 30, 2008.

(r) Reclassifications 
 
Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current year.

Note 3 – Earnings per Share

The Company reports earnings per share in accordance with the provisions of SFAS 128, "Earnings Per Share." SFAS 128 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 per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average common shares outstanding during the period. 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. The following is a reconciliation of the basic and diluted earnings per share computations for period ended September 30, 2008 and 2007:

 
 
2008
 
2007
 
For the three months ended September 30, 2008 and 2007
         
Net loss for basic and diluted earnings per share
 
$
244,856
 
$
(95,810
)
 
         
Weighted average shares - basic
   
27,460,695
   
20,757,090
 
Diluted effect of convertible preferred stocks and warrants
   
2,711,273
   
-
 
Weighted average shares - diluted
   
30,171,968
   
20.757.090
 
 
         
Earnings (loss) per share:
         
Basic
 
$
0.009
 
$
(0.005
)
Diluted
 
$
0.008
 
$
(0.005
)
               
For the nine months ended September 30, 2008 and 2007
         
Net income(loss) for basic and diluted earnings per share
 
$
809,088
 
$
(189,949
)
 
         
Weighted average shares - basic
   
24,415,471
   
20,757,090
 
Diluted effect of convertible preferred stocks and warrants
   
1,628,934
   
-
 
Weighted average shares - diluted
   
26,044,405
   
20,757,090
 
 
         
Earnings(loss) per share:
         
Basic
 
$
0.033
 
$
(0.009
)
Diluted
 
$
0.031
 
$
(0.009
)

15


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

 
All warrants and convertible preferred stock were excluded from the diluted loss per share due to the anti-diluted effect.

Note 4 - Accounts Receivable

 
 
September 30, 2008 
 
December 31, 2007 
 
 
 
(Unaudited)
 
 
 
Accounts receivable
 
$
5,917,369
 
$
1,402,913
 
Allowance for bad debts
   
(127,794
)
 
(237,475
)
Accounts receivable, net
   
5,789,575
   
1,165,438
 
Account receivables-non-current retainage
   
(820,694
)
 
(588,433
)
Account receivable - current, net
 
$
4,968,881
 
$
577,005
 

The Company offers a limited warranty to its customers pursuant to which the customers retain between 5% and 10% of the particular contract price as retainage for pending completion of quality inspection during the limited warranty period. Generally, the Company provides most of its customers with a limited one to two years warranty period during which to complete the quality inspection. The Company records the retainage as deferred revenue (see note 8). When the products pass the quality inspection or the warranty period expires, customers pay the retainage fee and the Company recognizes sales revenue.

As of September 30, 2008 and December 31, 2007, amounts billed under contracted retainage provisions were $1,737,839 and $930,546, respectively. These amounts are included in deferred revenue until earned.

The following table consists of Long term retainage receivables expected to be collected in 2009.

 
 
Amount
 
For the year ended December 31, 2009
 
$
820,694
 
Thereafter
   
-
 
Total
 
$
820,694
 
 
16


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)
 
Note 5 - Related Party Transactions
 
As of September 30, 2008 and December 31, 2007, the Company had the following amounts due from/to Mr. Qinghuan Wu, one of the Company's directors, a significant shareholder, and the Company's Chairman of the Board and Chief Executive Officer. Mr. Wu was also a majority shareholder of Poise Profits before the April 15, 2008 acquisition and is currently a significant shareholder of all of the Company's variable interest entities. Mr. Wu and his spouse, Mrs. Jialing Zhou, one of our directors, jointly hold a non-controlling interest in Zhejiang Jia Hua Industry Park Investment Development Co., Ltd. ("Jiahua Investment").

 
 
September 30, 2008
 
December 31, 2007
 
 
 
(Unaudited)
 
 
 
Loan to shareholder, Mr. Wu
 
$
371,172
 
$
463,663
 
Jiahua Investment
         
Account receivable
 
$
-
 
$
572,036
 
Customer deposit
 
$
2,765,598
 
$
-
 
Other payable
 
$
64,900
 
$
60,819
 

All due from/to related parties for convenience purposes will be settled on demand with cash. The Company expects that Mr. Wu will pay off the remaining balance by the end of 2008.

For the three months and nine months ended September 30, 2008, the Company's recognized sales to Jiahua Investment amounted to $1,914,793 and $1,962,824, respectively. For the same periods of last year, no related party sale was recognized.

In 2005, Shanghai Engineering entered into agreements with the son of Mr. Wu to lease an office. For the nine months ended September 30, 2008 and 2007, the Company incurred approximately $2,000 each quarter to Mr. Wu's son for rental expense.

Note 6 - Inventories

As of September 30, 2008 and December 31, 2007, inventories consist of the following:
 
 
 
September 30, 2008 
 
December 31, 2007 
 
 
 
(Unaudited)
 
 
 
Raw materials
 
$
2,768,031
 
$
1,228,140
 
Work in progress
   
5,824,486
   
4,034,189
 
Total
 
$
8,592,517
 
$
5,262,329
 

There was no allowance for potential losses on inventories as of September 30, 2008 and December 31, 2007.

Note 7 - Plant and Equipment, Net

Plant and equipment consist of the following:

 
 
September 30, 2008 
 
December 31, 2007
 
 
 
(Unaudited)
 
 
 
Machinery equipment
 
$
517,421
 
$
461,466
 
Transportation equipment
   
248,498
   
232,871
 
Office equipment
   
381,053
   
232,514
 
Subtotal
   
1,146,972
   
926,851
 
Accumulated depreciation:
   
(381,938
)
 
(277,459
)
Plant and equipment, net
 
$
765,034
 
$
649,392
 

17


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)
 
Depreciation expense for the three months ended September 30, 2008 and 2007 were $32,967 and $18,283, respectively; depreciation expense for the nine months ended September 30, 2008 and 2007 were $84,142 and $50,485, respectively.

Note 8 – Deferred Revenue

Deferred revenue represents the retainage held by customers during the quality inspection process. When the products pass the inspection, customers pay the retainage fee and the Company recognizes sales revenue (See note 4). As of September 30, 2008 and December 31, 2007, deferred revenue amounted to $1,737,839 and $930,546, respectively.

Deferred revenue, 1/1/2007
 
$
710,859
 
Addition
   
532,220
 
Collection
   
(368,626
)
Translation adjustment
   
56,093
 
Deferred revenue, 12/31/2007
 
$
930,546
 
Addition
   
947,643
 
Collection
   
(202,794
)
Translation adjustment
   
62,444
 
Deferred revenue, 6/30/2008
 
$
1,737,839
 
 
Note 9 – Short Term Bank Loans

The Company had a total of $380,380 and $0 in short term loans from one bank in China at September 30, 2008 and December 31, 2007, respectively. This loan matures in one year or less. The average interest rates were approximately 7.47%. The bank loan was collateralized by Shanghai Engineering's office building, which is owned by Mr. Wu.

Interest expense for the three months ended September 30, 2008 and 2007 were $7,944 and $5,235, respectively; and interest expense for the nine months ended September 30, 2008 and 2007 were $20,111 and $14,384, respectively.

Note 10 - Taxation

Effective January 1, 2008, the New Enterprise Income Tax ("EIT") law replaced the existing laws for Domestic Enterprises ("DES") and Foreign Invested Enterprises ("FIEs") in the PRC. The new standard EIT rate of 25% has replaced the 33% rate previously applicable to both DES and FIEs. Companies established before March 16, 2007 will continue to enjoy tax holiday treatment approved by local government for a grace period of the next 5 years or until the tax holiday term is completed, whichever is sooner.

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.

Vessel Works Division was subject to enterprise income tax at a statutory rate of 33% before January 1, 2008, and is subject to a 25% income tax rate thereafter.


18


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

Zhuyi was subject to enterprise income tax at a statutory rate of 6% on design service revenue and 0.6% on products revenue.

Haiyin is subject to enterprise income tax at a statutory rate of 4% on service revenue and 0.5% on products revenue.

Shanghai Environmental enjoyed a tax exemption from June 2007 to December 2008 according to tax bureau declaration.

 
 
September 30, 
2008 
 
September 30, 
2007 
 
 
 
(Unaudited)
 
(Unaudited)
 
Provision for China income tax
 
$
374,217
 
$
7,226
 
Provision for China local tax
   
37,422
   
718
 
Total provision for taxes
 
$
411,639
 
$
7,944
 
 
The following table reconciles the statutory rates to the Company's effective tax rate for the nine months ended September 30, 2008 and 2007.

 
 
2008
 
2007
 
U.S. Statutory rates
   
34.0
%
 
34.0
%
Foreign income not recognized in USA
   
(34.0
)
 
(34.0
)
China income taxes
   
25.0
   
33.0
 
China income tax exemption
   
(8.5
)
 
(25.5
)
Effective tax rate
   
16.5
%
 
7.5
%

The estimated tax savings from the tax exemptions for the three months ended September 30, 2008 and 2007 amounted to $14,085 and $1,527, respectively. The net effect on loss per share had the income tax been applied would increase basic loss per share from $0.009 to $0.008 for the three months ended September 30, 2008. The net effect on basic earnings per shares had the income tax been applied would be immaterial for three months ended September 30, 2007. The estimated tax savings from the tax exemptions for the nine months ended September 30, 2008 and 2007 amounted to $123,521 and $1,018, respectively. The net effect on basic earnings per share had the income tax been applied would decrease earning per share from $0.033 to $0.027 for the nine months ended September 30, 2008 and no material effect for the nine months ended June 30, 2007.

Value added tax

Value Added Tax ("VAT") on sales and VAT on purchases were $1,270,568 and $1,355,375 for the three months ended September 30, 2008 and $ 614,430 and $674,535 for the three months ended September 30, 2007, respectively. VAT on sales and VAT on purchases amounted to $3,452,434 and $3,094,739 for the nine months ended September 30, 2008 and $2,641,426 and $2,659,345 for the nine months ended September 30, 2007, respectively.

Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government. VAT taxes are not impacted by the income tax holiday.
 
19


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)
 
Taxes payable consisted of the following:

   
September 30, 2008
 
December 31, 2007
 
   
(Unaudited)
     
VAT tax
 
$
1,005,031
 
$
490,875
 
Other taxes
   
566,688
   
228,257
 
Total tax payable
 
$
1,571,719
 
$
719,132
 

Note 11 - Commitments and Contingencies

Operating lease

As of September 30, 2008, the Company had commitments under an operating lease with Mr. Wu's son (see Note 5) for office premises, requiring annual minimum future rentals as follows:

   
Amount
 
For year ended December 31, 2008
 
  2,000
 
Thereafter
   
-
 
 
Note 12 - Segment Information

The Company derives revenue from the following sources (i) manufacture and sale of products; (ii) design services and (iii) EPC contracts that involve the whole process of the construction of projects from design, development, engineering, manufacturing up to installation. Revenue by the above categories for the three months ended September 30, 2008 and 2007 are summarized as follows:

 
 
2008
 
2007
 
 
 
(Unaudited)
 
(Unaudited)
 
Revenue:
         
Product
 
$
3,885,389
 
$
1,622,612
 
Services
   
323,522
   
-
 
EPC contracts
   
1,914,793
   
2,285,609
 
Totals
 
$
6,123,704
 
$
3,908,221
 

Revenue by the above categories for the nine months ended September 30, 2008 and 2007 are summarized as follows:

 
 
2008
 
2007
 
 
 
(Unaudited)
 
(Unaudited)
 
Revenue:
         
Product
 
$
12,877,085
 
$
4,983,765
 
Services
   
1,134,057
   
269,119
 
EPC contracts
   
1,969,049
   
2,285,609
 
Totals
 
$
15,980,191
 
$
7,538,493
 

Note 13 – Supplemental Disclosure of Cash Flow

Total interest paid amounted to $20,111 and $38,383 for the nine months ended September 30, 2008 and 2007, respectively.

Total income tax paid amounted to $88,813 and $7,774 for the nine months ended September 30, 2008 and 2007, respectively.

20


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

The Company prepares its statements of cash flows using the indirect method as defined under the SFAS 95. The following information relates to non-cash investing and financing activities for 2008.

Note 14 - Retirement Benefits

As stipulated by the relevant laws and regulations applicable to enterprises operating in the PRC, the Company and its PRC subsidiary and affiliates are required to maintain a defined contribution retirement plan for all of its employees who are residents of the PRC. All retired employees of the Company are entitled to an annual pension equal to their basic annual salary upon retirement. The Company contributes to a state sponsored 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 state sponsored retirement plan is responsible for the entire pension obligations payable for all past and present employees.

The Company made contribution of $39,234 and $33,376 for employment benefits, including pension for the nine months ended September 30, 2008 and 2007, respectively.

Note 15 - Statutory reserve

As stipulated by the relevant laws and regulations applicable to enterprises operating in the PRC, the Company and its PRC subsidiary and affiliates are required to make annual appropriations to a statutory surplus reserve fund. Specifically, the Company is required to allocate 15% (10% starting from January 1, 2007) 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 nine months ended September 30, 2008 and 2007, the Company transferred $187,220 and $21,288, respectively, representing 10% of the year's net income determined in accordance with PRC accounting rules and regulations, to this reserve.
 
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.

Note 16 – Shareholders' equity

Series A Convertible Preferred Stock

On April 15, 2008, the Company issued 7,874,241 shares of Series A Convertible Preferred Stock as a result of closing of the Share Exchange disclosed in Note 1. 4,882,307 shares of Series A Convertible Preferred Stock were converted to 2,441,154 shares of the Company's common stock as of September 30, 2008.

Common stock

On April 15, 2008, as the result of closing of the Share Exchange disclosed in Note 1, the Company acquired all of the issued and outstanding shares of Poise Profit's common stock in exchange for the issuance of 20,757,090 (on a post-stock split basis) shares of the Company's common stock.

At the closing of the Share Exchange, the Company placed 1,779,180 shares of its common stock into an escrow account. Those shares are to be released to the former Poise Profit shareholders if Hi-tech meets certain financial targets described below for the year ending December 31, 2008:

 
(i)
gross revenue is at least RMB 150 million (approximately $21.3 million) and
 
(ii)
gross margin is at least RMB30 million (approximately $4.3 million).

21


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)

In the event Hi-tech does not achieve the aforementioned financial targets, the escrowed shares will be released to the 25 investors in the Financing closed on April 15, 2008 pro rata based upon their investment amounts.

In February 2008, the Company entered into several agreements with five third party companies and agreed to issue a total of 475,000 shares (post the 1-for-2 reverse stock conducted on April 16, 2008) of common stock in exchange for investor relationship services. Market value of the services to be received amounted to $950,000. 475,000 shares were issued in May 2008.

On March 17, 2008, the Company entered into an agreement with a third party company and agreed to issue 175,000 shares (post the 1-for-2 reverse stock conducted on April 16, 2008) of the Company's common stock in exchange for consulting services which are worth $700,000. 175,000 shares of common stock were issued in June 2008.

On June 6, 2008, the Company issued 12,500 shares of common stock as payment for service. The agreement was entered into in January 2008 while the market value of the service to be received was approximately $9,000.

On June 20, 2008, the Company issued 250,000 warrants to ARC China, Inc., a company controlled by Mr. Adam Roseman, whose affiliates are shareholders of the Company, in exchange for consulting services. Total value of the services to be received was $338,093. 250,000 warrants were exercised in a cashless manner, and 195,454 shares of common stock were issued on June 23, 2008.

Distribution from variable interest entities

For the nine months ended September 30, 2008 and 2007, distributions from the variable interest entities prior to the Share Exchange amounted to $524,542 and $2,993,756, respectively.

Warrants

On August 27, 2007, the Company issued 57,870 warrants at an exercise price of $2.16 with expected life of 3 years as a condition to making a Convertible Promissory Note. The fair values of the warrants were estimated using the Black-Scholes option-pricing model at the closing date of the Financing on April 15, 2008 per the Share Exchange Agreement disclosed in Note 1.

Pursuant to the Securities Purchase Agreements executed on April 15, 2008 as disclosed in Note 1, the Company issued 3,937,122 warrants exercisable into shares of the Company's common stock at an exercise price of $1.29, exercisable six months after issuance with expected life of five years. The fair values of the warrants were estimated at the grant date using the Black-Scholes option-pricing model.

On June 20, 2008, the Company entered into a consulting agreement with ARC China, Inc., a company controlled by Adam Roseman, whose affiliated are shareholders of the Company. Pursuant to the agreement, 250,000 warrants were vested and became exercisable upon execution of the consulting agreement. The fair values of the warrants were estimated at the grant date using the Black-Scholes option-pricing model.

The Company has granted the holders of certain of the Company's warrants registration rights for the underlying shares of the Company's common stock. The Company has complied with the registration requirements through September 30, 2008, and therefore, has not accrued any penalties under the applicable registration rights.

The following table summarizes the assumptions used in the Black-Scholes option-pricing model when calculating the fair value of the warrants:

Number of
Warrants Valued
 
Expected
Life (Years)
 
Exercise
Price
 
Expected
Volatility
 
Dividend
Yield
 
Risk Free
Interest Rate
 
Grant Date Fair
Value
 
57,870
   
1.00
   
$
2.16
     
125
%  
 
-
     
1.49
%  
$
52,279
 
3,937,122
   
5.00
 
$
1.29
   
125
%
 
-
   
1.84
%
$
3,626,982
 
250,000
   
2.50
 
$
2.16
   
125
%
 
-
   
2.91
%
$
338,093
 

22


CHINA ENERGY RECOVERY, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2008
(UNAUDITED)


Due to the short trading history of the Company's common stock, the Company used the market price of the common stock of similar public companies (similar industry, similar size, length of operating) to calculate the volatility, which was 125%.

ARC China exercised 250,000 warrants listed in above table into 195,454 shares of the Company's common stock on June 23, 2008 in a cashless manner.

Following is a summary of the warrant activity:

Outstanding as of January 1, 2007
   
-
 
Granted
   
57,870
 
Forfeited
   
-
 
Exercised
   
-
 
Outstanding as of December 31, 2007
   
57,870
 
Granted
   
4,187,122
 
Forfeited
   
-
 
Exercised
   
250,000
 
Outstanding as of September 30, 2008
   
3,994,992
 
 
Following is a summary of the status of warrants outstanding at September 30, 2008:
 
 
Outstanding Warrants
 
Exercisable Warrants
 
 
Exercise Price
 
Number
 
Average
Remaining
Contractual Life
 
Average Exercise
Price
 
Number
 
Average
Remaining
Contractual Life
 
$
2.16
   
57,870
   
1.92
 
$
2.16
   
57,870
   
1.92
 
$ 
1.29
   
3,937,122
   
4.75
   
-
   
-
   
-
 
 
Total
   
3,994,992
           
57,870
     

Stock Options

On September 18, 2008, the Company appointed three new independent directors and granted them stock options to purchase 260,000 shares of the Company’s common stock. The options will vest and become exercisable in eight equal installments on each October 1, January 1, April 1 and July 1 beginning in 2008. Unvested options shall be terminated and forfeited upon the termination of a holder’s director status. Also on September 18, 2008, the Company granted options to purchase 75,000 shares of the Company’s common stock to two consultants who contract with the Company on a month-to-month basis. Those options are vested immediately upon being granted. All stock options granted are subject to the Company’s stock option plan which was approved by the Board of the Company on October 29, 2008.

The Company used the Black-Scholes option pricing model to value the options at the time they were granted, based on volatility of 125%, dividend yield of 0%, the stated exercise price of $2.90, the risk free rate of 2.67%, and the expected life of 1.81 years for the options granted to directors and 0.38 years for the ones granted to consultants.

23


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: economic conditions affecting manufacturers of energy recovery systems and the industry segments they serve; the adverse effect of governmental regulation and other matters affecting energy recovery system manufacturers; increased competition in the industry; our dependence on certain customer segments; the availability of and costs associated with potential sources of financing; difficulties associated with managing future growth; our inability 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 inability 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. You should also read, among other things, the risks and uncertainties described in the Part II, Item 1A "Risk Factors" of this Quarterly Report on Form 10-Q.

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

Overview

The disclosures about our history reflect the Company's capital structure as of the time of the occurrences described and do not take into account subsequent stock splits or other adjustments to the Company's capital structure.

We incorporated in the State of Maryland in May 1998 under the name Majestic Financial, Ltd. From inception to March 31, 2002, we were a wholly-owned subsidiary of The Majestic Companies, Ltd. In March 2002, The Majestic Companies, Ltd.'s board of directors approved a plan to spin-off our company to an entity controlled by The Majestic Companies, Ltd.'s former chief executive officer and to The Majestic Companies, Ltd.'s stockholders.

In 2002, we conducted a 1-for-10 reverse stock split of our issued and outstanding capital stock pursuant to which each ten shares of our common stock issued and outstanding on the record date of August 31, 2002 was converted into one share of our common stock. We had 27,150,000 shares of common stock issued and outstanding immediately prior to the reverse stock split and 2,715,000 shares thereafter.
 
We changed our name to Commerce Development Corporation, Ltd. in April 2002.
 
On September 24, 2002, we acquired USM Financial Solutions, Inc. through a Capital Stock Exchange Agreement. Pursuant to the agreement, USM Financial Solutions, Inc. became our wholly-owned subsidiary. USM Financial Solutions, Inc. has no assets and liabilities and has had no business activities since December 31, 2002.
 
On April 7, 2006, we entered into an Agreement and Plan of Merger with a newly formed wholly-owned subsidiary, Commerce Development Corporation, Ltd., a Delaware corporation, for purposes of changing our state of incorporation from Maryland to Delaware. On the same day, we conducted a 2,184-to-1 reverse stock split of our issued and outstanding capital stock pursuant to which each 2,184 shares of our common stock issued and outstanding on the record date of April 5, 2006 was converted into one share of our common stock. We had 98,285,596 shares of common stock issued and outstanding immediately prior to the reverse stock split and 45,096 shares thereafter.


24


On August 14, 2007, we launched our website announcing our entry into a new line of business. We sought to capitalize on the explosive growth of mixed martial arts by creating what we believed to be the first comprehensive media company dedicated solely to the sport. We planned to distribute third party and proprietary mixed martial arts media content, goods and services through multiple media platforms such as the Internet, television and print. These media platforms were expected to be secured through acquisitions and strategic partnerships.

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 agreed to acquire 100% of the issued and outstanding shares of Poise Profit's common stock in exchange for the issuance of 41,514,179 shares of our common stock to the shareholders of Poise Profit. The share exchange (the "Share Exchange") transaction was consummated on April 15, 2008.

On January 25, 2008, we entered into and closed an Asset Purchase Agreement with MMA Acquisition Company, a Delaware corporation, pursuant to which we sold substantially all of our assets to MMA Acquisition Company in exchange for MMA Acquisition Company's assuming a substantial majority of our outstanding liabilities. The transferred assets consisted of letters of intent for the proposed acquisitions of MMAWeekly.com, dated June 9, 2007, and Blackbelt TV, Inc., dated July 16, 2007, and all shares of common stock in Blackbelt TV, Inc. we owned, among other things. The total book value of the assets acquired was approximately $317,000. The assumed liabilities consist of accounts payable, convertible debt, accrued expenses and shareholder advances of approximately $360,000.
 
Effective February 5, 2008, we changed our name to China Energy Recovery, Inc. and conducted a 1-for-9 reverse stock split of our issued and outstanding capital stock pursuant to which each nine shares of our common stock issued and outstanding on the record date of February 4, 2008 was converted into one share of our common stock. We had 85,067,000 shares of common stock issued and outstanding immediately prior to the reverse stock split and 9,451,889 shares thereafter.

On April 15, 2008, we closed the Share Exchange pursuant to which we acquired all of the issued and outstanding shares of Poise Profit's common stock in exchange for the issuance of 41,514,179 shares of our common stock to Poise Profit's stockholders. Upon the closing of the transaction, Poise Profit became our wholly-owned subsidiary.
 
On April 16, 2008, we conducted a 1-for-2 reverse stock split of our issued and outstanding capital stock pursuant to which each two shares of our common stock issued and outstanding on the record date of April 15, 2008 was converted into one share of our common stock. We had 50,966,068 shares of common stock issued and outstanding immediately prior to the reverse stock split and 25,483,034 shares thereafter.

From inception until 2000, we were engaged in the limited origination and servicing of new modular building leases. We conducted such activity primarily in the State of California and accounted for all the leases we entered into as operating leases. We ceased entering into new leases in 2000. Immediately before the closing of the Share Exchange, we were considered to be in the development stage because our operations principally involved market research and other business planning activities. 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, HAIE Hi-tech Engineering (Hong Kong) Company, Limited ("Hi-tech"), which is principally engaged in designing, marketing, licensing, fabricating, implementing and servicing industrial energy recovery systems. Poise Profit was incorporated on November 23, 2007 under the laws of the British Virgin Islands. Hi-tech was incorporated under the laws of the Hong Kong Special Administration Region, China on January 4, 2002. Hi-tech carries out its operations mainly through Shanghai Hai Lu Kun Lun Hi-tech Engineering Co., Ltd. ("Shanghai Engineering") with which Hi-tech has a contractual relationship. This arrangement reflects Chinese limitations on foreign investments and ownership in Chinese businesses. Shanghai Engineering's manufacturing activities are carried out by Shanghai Si Fang Boiler Factory-Vessel Works Division ("Vessel Works Division") located in Shanghai, China through a lease agreement with Vessel Works Division's owner. We are headquartered in Shanghai, China.


25


Critical Accounting Policies and Estimates

Our management's discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us 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 as well as the reported net sales and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

While our significant accounting policies are more fully described in Note 2 to our 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.

Consolidation of Variable Interest Entities

In accordance with the Financial Accounting Standards Board ("FASB") Interpretation No. 46(R), "Consolidation of Variable Interest Entities" ("FIN 46R"), 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 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.

We have concluded that Shanghai Engineering, Vessel Works Division (the leased manufacturing facilities), Shanghai Zhuyi Industry Co., Ltd. ("Zhuyi"), a former affiliated company liquidated in July 2007 originally formed to derive tax benefits, Shanghai Haiyin Hi-Tech Engineering Co., Ltd. ("Haiyin") a former affiliated company liquidated in January 2008 originally formed to derive tax benefits, and Shanghai Xin Ye Environmental Protection Engineering Technology Co., Ltd. ("Shanghai Environmental") are variable interest entities and that Poise Profit and Hi-tech are the primary beneficiaries. Under the requirements of FIN 46R, Poise Profit and Hi-tech consolidated the financial statements of Shanghai Engineering, Vessel Works Division, Zhuyi, Haiyin 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.

Revenue Recognition

We derive revenues principally from (a) sales of our energy recovery systems; (b) provision of design services; and (c) provision of Engineering, Procurement and Construction ("EPC") services, which are essentially turnkey contracts where we provide all services in the whole construction process from design, development, engineering, manufacturing to installation. In providing design services, we design 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 us to manufacture the designed system or choose to present our drawings to other manufacturers for manufacturing and installation. In contrast, when providing EPC services, the customer is purchasing a turnkey energy recovery system and we are involved throughout the entire process from design to installation.

Sales of our 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, we ship the products to our customers in their entirety in one batch.

26


We generally recognize revenues from product sales when (a) persuasive evidence of an arrangement exists, which is generally represented by a contract between us and the customer; (b) products are shipped; (c) title and risk of ownership have passed to the customer, which generally occurs at the time of delivery; (d) the customer accept the products upon quality inspection performed by the customer; (e) the purchase price is agreed to between us and the customer; and (f) collectability is reasonably assured. Sales revenues represent the invoiced value of products, less returns and discounts, and net of value added tax.

We recognize revenues from design services when (a) the services are provided; (b) the design drawings are delivered; (c) invoices are issued; and (d) collectability is reasonably assured. We generally deliver the drawings in one batch.

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. Statement of Position (SOP) 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts (1981)" issued by the American Institute of Certified Public Accountants ("SOP 81-1") requires use of the percentage of completion method in lieu of the completed contract method when: (a) it is possible to make reasonably reliable estimates of revenues and costs for the construction project; (b) the contract specifies the parties' rights as to the goods, consideration to be paid and received, and the resulting terms of payment or settlement; (c) the purchaser has the ability and expectation to perform all contractual duties; and (d) the contractor has the same ability and expectation to perform. In contrast, SOP 81-1 provides that the completed contract method should be used in rare circumstances where: (a) the contract is of a short duration; (b) the contract violates any one of the prongs described above for the percentage of completion method; or (c) the project involves documented extraordinary, nonrecurring business risks. EPC contracts are by nature long-term construction-type contracts, usually lasting more than one accounting period, and we are 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, we have 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 we recognize revenues. The risks and rewards of ownership of the installed goods pass to the customer upon completion of each stage of the project. Hence, EPC contracts involve a continuous sale and transfer of ownership rights that occurs as the work progresses as described in paragraph 22 of SOP 81-1. Further, a customer has the right to require specific performance of the contract and the contracts do not involve any documented extraordinary nonrecurring business risks. Finally, according to Accounting Research Bulletin Opinion No. 45, "Long-Term Construction-Type Contracts" ("ARB 45"), paragraph 15, the percentage of completion method is preferable when recognizing revenues when the estimates of costs of completion and the extent of progress toward completion of long-term contracts are reasonably dependable. For the above-mentioned reasons, we recognize revenues from EPC contracts using the percentage of completion method based on the guidance provided by SOP 81-1 and on the percentage of actual costs incurred to date in relation to total estimated costs for each contract in accordance with ARB 45.

We offer a limited warranty to our customers pursuant to which our customers retain between 5% and 10% of the particular contract price as retainage during the limited warranty period (usually one to two years). We record the retainage as deferred revenue until our customers pay it after the warranty period expires, at which time we recognize it as revenue.

Recent Accounting Pronouncements

In February 2007, FASB issued Statement of Financial Accounting Standards ("SFAS") No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115" ("SFAS 159"). SFAS 159 is expected to expand the use of fair value accounting but does not affect existing standards which require certain assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may choose, at specified election dates, to measure eligible items at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We adopted SFAS 159 on January 1, 2008. We chose not to elect the option to measure the fair value of eligible financial assets and liabilities.

27


In December 2007, FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin No. 51" ("SFAS 160"), which establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest and the valuation of retained non-controlling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We have not determined the effect that the application of SFAS 160 will have on our consolidated financial statements.

In December 2007, FASB issued SFAS No. 141(R), "Business Combinations" ("SFAS 141R"). SFAS 141R replaces SFAS No. 141, "Business Combinations" ("SFAS 141"). SFAS 141R retains the fundamental requirements in SFAS 141 that the acquisition method of accounting (which SFAS 141 called the "purchase method") be used and an acquirer to be identified for each business combination. SFAS 141R requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. This replaces SFAS 141's cost-allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. SFAS 141R also requires the acquirer in a business combination achieved in stages (sometimes referred to as a step acquisition) to recognize the identifiable assets and liabilities, as well as the noncontrolling interest in the acquiree, at the full amounts of their fair values (or other amounts determined in accordance with SFAS 141R). SFAS 141R applies prospectively to 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, 2008. An entity may not apply it before that date. We are currently evaluating the impact that adopting SFAS 141R will have on our financial statements.

In March 2008, FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities - An Amendment of SFAS No. 133" ("SFAS 161"). SFAS 161 seeks to improve financial reporting for derivative instruments and hedging activities by requiring enhanced disclosures regarding the impact on financial position, financial performance, and cash flows. To achieve this increased transparency, SFAS 161 requires (a) the disclosure of the fair value of derivative instruments and gains and losses in a tabular format; (b) the disclosure of derivative features that are credit risk-related; and (c) cross-referencing within the footnotes. SFAS 161 is effective on January 1, 2009. We are in the process of evaluating the new disclosure requirements under SFAS 161.

In May 2008, FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles" ("SFAS 162"). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with accounting principles generally accepted in the United States. We do not expect that SFAS 162 will have an impact on our financial statements.
 
In May 2008, FASB issued SFAS No. 163, "Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60" ("SFAS 163"). The scope of SFAS 163 is limited to financial guarantee insurance (and reinsurance) contracts, as described in SFAS 163, issued by enterprises included within the scope of SFAS No. 60. Accordingly, SFAS 163 does not apply to financial guarantee contracts issued by enterprises excluded from the scope of SFAS No. 60 or to some insurance contracts that seem similar to financial guarantee insurance contracts issued by insurance enterprises (such as mortgage guaranty insurance or credit insurance on trade receivables). SFAS 163 also does not apply to financial guarantee insurance contracts that are derivative instruments included within the scope of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). We do not expect that SFAS 165 will have an impact on our financial statements.

In June 2008, FASB issued EITF 07-5 "Determining whether an Instrument (or Embedded Feature) is indexed to an Entity's Own Stock" ("EITF 07-5"). EITF 07-5 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. Paragraph 11(a) of SFAS 133 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. EITF 07-5 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 SFAS 133 paragraph 11(a) scope exception. This standard will trigger liability accounting on all options and warrants exercisable at strike prices denominated in any currency other than the functional currency of the operating entity in China (Renminbi). We are currently evaluating the impact of adoption of EITF No. 07-5 on our consolidated financial statements.

28


In June 2008, FASB issued EITF 08-4, "Transition Guidance for Conforming Changes to Issue No. 98-5" (EITF 08-4"). The objective of EITF 08-4 is to provide transition guidance for conforming changes made to EITF 98-5, that result from EITF 00-27, "Application of Issue No. 98-5 to Certain Convertible Instruments", and SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". EITF 08-4 is effective for financial statements issued for fiscal years ending after December 15, 2008. Early application is permitted. We are currently evaluating the impact of adoption of EITF 08-4 on our consolidated financial statements.

On October 10, 2008, FASB issued FSP 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active" ("FSP 157-3") which clarifies the application of SFAS 157, "Fair Value Measurements," in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 became effective on October 10, 2008, and its adoption did not have a material impact on our financial position or results for the three months ended September 30, 2008.

Results of Operations

Comparison of Three Months Ended September 30, 2008 and September 30, 2007

The following table sets forth the results of our operations for the periods indicated as a percentage of revenues:

   
Three Months ended September 30, 
 
   
2008
 
2007