10-Q 1 v202507_10q.htm Unassociated Document

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

FORM 10-Q

(Mark One)

x QUARTERLY REPORT UNDER SECTION 13 OR 15 (D) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

¨ TRANSITION REPORT UNDER SECTION 13 OR 15 (D) OF THE EXCHANGE ACT

For the transition period from __________ to __________

COMMISSION FILE NUMBER: 001-34591

CHINA WIND SYSTEMS, INC.
 (Name of Registrant as specified in its charter)

DELAWARE
74-2235008
(State or other jurisdiction of
(I.R.S. Employer
incorporation of organization)
Identification No.)

No. 9 Yanyu Middle Road
Qianzhou Township, Huishan District, Wuxi City
Jiangsu Province, China 150090
 (Address of principal executive office)

(86) 51083397559
 (Registrant’s telephone number)

Not applicable
(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 þ No ¨

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

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

Large accelerated filer
¨
Accelerated filer
¨
Non-accelerated filer
¨
Smaller reporting company
þ
 (Do not check if smaller reporting company)
   

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.  18,557,071 shares of common stock are issued and outstanding as of November 12, 2010.

 
 

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
September 30, 2010

TABLE OF CONTENTS
 
   
Page
No.
PART I. - FINANCIAL INFORMATION
Item 1.
Financial Statements
3
 
Consolidated Balance Sheets as of September 30, 2010 (Unaudited) and December 31, 2009 (Audited)
 
 
Consolidated Statements of Income and Comprehensive Income for the Three and Nine Months Ended September 30, 2010 and 2009 (unaudited)
4
 
Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2010 and 2009 (unaudited)
5
 
Notes to Unaudited Consolidated Financial Statements.
6
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations.
27
Item 3
Quantitative and Qualitative Disclosures About Market Risk.
45
Item 4
Controls and Procedures.
45
PART II - OTHER INFORMATION
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.
46
Item 6.
Exhibits.
46
 
FORWARD LOOKING STATEMENTS
 
This report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not deemed to represent an all-inclusive means of identifying forward-looking statements as denoted in this report. Additionally, statements concerning future matters are forward-looking statements.
 
Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed under the headings “Risks Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-Q and in other reports that we file with the SEC.   You are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report.
 
We file reports with the SEC. The SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including us. You can also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
 
We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report, except as required by law. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this quarterly report, which are designed to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

 
2

 

PART 1 - FINANCIAL INFORMATION

Item 1.                 Financial Statements.

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

   
September 30, 2010
   
December 31, 2009
 
   
(Unaudited)
   
(Audited)
 
ASSETS
           
             
CURRENT ASSETS:
           
Cash and cash equivalents
  $ 1,773,709     $ 2,278,638  
Notes receivable
    353,226       329,492  
Accounts receivable, net of allowance for doubtful accounts
    8,631,036       6,046,422  
Inventories, net of reserve for obsolete inventory
    4,230,887       2,232,264  
Advances to suppliers
    1,506,709       450,507  
Prepaid VAT on purchases
    1,978,549       378,543  
Prepaid expenses and other
    42,994       213,835  
                 
Total Current Assets
    18,517,110       11,929,701  
                 
PROPERTY AND EQUIPMENT - net
    44,820,520       36,863,501  
                 
OTHER ASSETS:
               
Land use rights, net
    3,740,686       3,729,427  
                 
Total Assets
  $ 67,078,316     $ 52,522,629  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
CURRENT LIABILITIES:
               
Loans payable
  $ 1,343,665     $ 2,040,111  
Accounts payable
    6,880,157       3,404,521  
Accrued expenses
    351,863       556,662  
VAT and service taxes payable
    89,221       25,284  
Advances from customers
    237,671       143,261  
Income taxes payable
    1,190,504       1,018,514  
                 
Total Current Liabilities
    10,093,081       7,188,353  
                 
STOCKHOLDERS' EQUITY:
               
Preferred stock $0.001 par value (60,000,000 shares authorized, all of which  were designated as as series A convertible preferred, 14,257,264 and 15,419,088 shares issued and outstanding; at September 30, 2010 and December 31, 2009, respectively)
    14,257       15,419  
Common stock ($0.001 par value; 150,000,000 shares authorized; 18,270,571 and 16,402,204 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively)
    18,270       16,402  
Additional paid-in capital
    24,914,339       22,332,756  
Retained earnings
    26,366,830       18,595,037  
Statutory reserve
    1,424,971       1,252,980  
Accumulated other comprehensive gain - foreign currency translation adjustment
    4,246,568       3,121,682  
                 
Total Stockholders' Equity
    56,985,235       45,334,276  
                 
Total Liabilities and Stockholders' Equity
  $ 67,078,316     $ 52,522,629  

See notes to unaudited consolidated financial statements

 
3

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

   
For the Three Months Ended
   
For the Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                         
NET REVENUES
  $ 21,262,054     $ 16,132,270     $ 57,080,010     $ 37,577,167  
                                 
COST OF REVENUES
    15,840,889       12,242,778       42,264,893       28,986,366  
                                 
GROSS PROFIT
    5,421,165       3,889,492       14,815,117       8,590,801  
                                 
OPERATING EXPENSES:
                               
Depreciation
    78,478       83,053       239,493       243,976  
Selling, general and administrative
    1,206,058       386,702       3,502,239       1,397,058  
                                 
Total Operating Expenses
    1,284,536       469,755       3,741,732       1,641,034  
                                 
INCOME FROM OPERATIONS
    4,136,629       3,419,737       11,073,385       6,949,767  
                                 
OTHER INCOME (EXPENSE):
                               
Interest income
    490       530       3,212       858  
Interest expense
    (23,923 )     (54,251 )     (117,336 )     (253,980 )
Foreign currency loss
    (6,172 )     (3,395 )     (13,073 )     (3,406 )
Grant income
    132       15       49,278       146,145  
Debt issuance costs
    -       (2,000 )     -       (14,000 )
                                 
Total Other Income (Expense)
    (29,473 )     (59,101 )     (77,919 )     (124,383 )
                                 
INCOME BEFORE INCOME TAXES
    4,107,156       3,360,636       10,995,466       6,825,384  
                                 
INCOME TAXES
    1,133,566       862,199       3,051,682       1,900,354  
                                 
NET INCOME
    2,973,590       2,498,437       7,943,784       4,925,030  
                                 
DEEMED PREFERRED STOCK DIVIDEND
    -       (462,000 )     -       (462,000 )
                                 
NET INCOME ALLOCABLE TO COMMON SHAREHOLDERS
  $ 2,973,590     $ 2,036,437     $ 7,943,784     $ 4,463,030  
                                 
                                 
NET INCOME
  $ 2,973,590     $ 2,498,437     $ 7,943,784     $ 4,925,030  
                                 
OTHER COMPREHENSIVE INCOME:
                               
Unrealized foreign currency translation gain
    908,803       39,536       1,124,886       84,329  
                                 
COMPREHENSIVE INCOME
  $ 3,882,393     $ 2,537,973     $ 9,068,670     $ 5,009,359  
                                 
NET INCOME PER COMMON SHARE:
                               
Basic
  $ 0.16     $ 0.13     $ 0.45     $ 0.29  
Diluted
  $ 0.12     $ 0.09     $ 0.32     $ 0.20  
                                 
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
                               
Basic
    18,177,405       15,406,842       17,671,530       15,141,927  
Diluted
    25,312,979       23,506,936       24,904,210       21,969,692  

See notes to unaudited consolidated financial statements

 
4

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

   
For the Nine Months Ended
 
   
September 30,
 
   
2010
   
2009
 
   
(Unaudited)
   
(Unaudited)
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 7,943,784     $ 4,925,030  
Adjustments to reconcile net income from operations to net cash provided by operating activities:
               
Depreciation
    2,145,463       1,237,922  
Amortization of debt discount to interest expense
    44,993       32,495  
Amortization of land use rights
    65,042       64,794  
Increase in allowance for doubtful accounts
    550,006       132,073  
Interest expense related to debt conversion
    -       128,489  
Stock-based compensation expense
    478,390       157,778  
Changes in assets and liabilities:
               
Notes receivable
    (16,598 )     182,322  
Accounts receivable
    (2,966,377 )     (1,606,523 )
Inventories
    (1,918,385 )     (1,114,510 )
Prepaid value-added taxes on purchases
    (1,564,513 )     (312,090 )
Prepaid and other current assets
    174,823       (52,097 )
Advances to suppliers
    (1,028,678 )     (152,139 )
Due from related party
    -       438,436  
Accounts payable
    3,345,974       162,519  
Accrued expenses
    (212,262 )     266,205  
VAT and service taxes payable
    62,311       118,609  
Income taxes payable
    148,220       291,746  
Advances from customers
    89,848       19,750  
                 
NET CASH PROVIDED BY OPERATING ACTIVITIES
    7,342,041       4,920,809  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Purchase of property and equipment
    (9,212,125 )     (6,485,956 )
                 
NET CASH USED IN INVESTING ACTIVITIES
    (9,212,125 )     (6,485,956 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from loans payable
    1,320,345       1,213,689  
Repayment of loans payable
    (2,090,460 )     -  
Proceeds from sale of preferred stock, net
    -       1,098,000  
Proceeds from exercise of warrants
    2,100,000       83,112  
                 
NET CASH PROVIDED BY FINANCING ACTIVITIES
    1,329,885       2,394,801  
                 
EFFECT OF EXCHANGE RATE ON CASH AND CASH EQUIVALENTS
    35,270       720  
                 
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
    (504,929 )     830,374  
                 
CASH AND CASH EQUILAVENTS - beginning of year
    2,278,638       328,614  
                 
CASH AND CASH EQUIVALENTS - end of period
  $ 1,773,709     $ 1,158,988  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Cash paid for:
               
Interest
  $ 74,486     $ 83,782  
Income taxes
  $ 2,903,462     $ 1,623,260  
                 
NON-CASH INVESTING AND FINANCING ACTIVITIES:
               
Debt discount for grant of warrants
  $ -     $ 92,985  
Deemed preferred stock dividend reflected in paid-in capital
  $ -     $ 462,000  
Series A preferred converted to common shares
  $ 2,911     $ 669  
Reclassification of common stock to paid-in capital due to reverse split
  $ -     $ 30,926  
Common stock issued for debt
  $ -     $ 152,963  
Common stock issued for future service
  $ 3,900     $ 46,667  

See notes to unaudited consolidated financial statements.

 
5

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

China Winds Systems, Inc. (the “Company”) was incorporated in Delaware on June 24, 1987 under the name of Malex, Inc.  On December 18, 2007, the Company’s corporate name was changed to China Wind Systems, Inc.  Through its affiliated companies and subsidiaries, the Company manufactures and sells high precision forged rolled rings and related products for the wind power industry and other industries.  The Company also makes textile dyeing and finishing machines.  The Company previously manufactured electric power auxiliary apparatuses (including coking equipment). In the fourth quarter of 2009, the Company ceased the production of electric power auxiliary apparatuses and sold its remaining units. The Company is the sole owner of Fulland Limited, a Cayman Island limited liability company, which was organized on May 9, 2007.  Fulland owns 100% of the capital stock of Green Power Environment Technology (Shanghai) Co., Ltd. (“Green Power”) and Wuxi Fulland Wind Energy Equipment Co., Ltd. (“Fulland Wind Energy”), which are wholly foreign-owned enterprises (“WFOE”) organized under the laws of the People’s Republic of China (“PRC” or “China”).  Green Power is a party to a series of contractual arrangements, as fully described below, dated October 12, 2007 with Wuxi Huayang Electrical Power Equipment Co., Ltd. (“Electrical”) and Wuxi Huayang Dyeing Machinery Co., Ltd. (“Dyeing”), both of which are limited liability companies organized under the laws of, and based in, the PRC.   Electrical and Dyeing are sometimes collectively referred to as the “Huayang Companies.”

Fulland was organized by the owners of the Huayang Companies as a special purpose vehicle for purposes of raising capital, in accordance with requirements of the PRC State Administration of Foreign Exchange (“SAFE”). On May 31, 2007, SAFE issued an official notice known as Hui Zong Fa [2007] No. 106 (“Circular 106”), which requires the owners of any Chinese company to obtain SAFE’s approval before establishing any offshore holding company structure for foreign financing as well as subsequent acquisition matters in China. Accordingly, the owners of the Huayang Companies, Mr. Jianhua Wu and Ms. Lihua Tang, submitted their application to SAFE in early September 2007. On October 11, 2007, SAFE approved their application, permitting these Chinese citizens to establish Fulland as a special purpose vehicle for any foreign ownership and capital raising activities by the Huayang Companies.

Electric was formed on May 21, 2004, and Fulland Wind Energy was formed on August 27, 2008.  Beginning in April 2007, Electric began to produce large-scaled forged rolled rings that are up to three meters in diameter for the wind-power and other industries.  In 2009, the Company began to produce and sell forged products through Fulland Wind Energy. Fulland Wind Energy manufactures forged rolled rings in the Company’s new facilities.  The Company refers to this segment of its business as the forged rolled rings and related products division.  The Company’s electric power equipment business was also included in this division prior to its discontinuation.

Dyeing, which was formed on August 17, 1995, produces and sells a variety of high and low temperature dyeing and finishing machinery.  The Company refers to this segment as the dyeing division.

Basis of presentation; management’s responsibility for preparation of financial statements

Management acknowledges its responsibility for the preparation of the accompanying interim consolidated financial statements which reflect all adjustments, consisting of normal recurring adjustments, considered necessary in its opinion for a fair statement of its consolidated financial position and the results of its operations for the interim period presented.

These consolidated financial statements should be read in conjunction with the summary of significant accounting policies and notes to consolidated financial statements included in the Company’s Form 10-K annual report for the year ended December 31, 2009.

 
6

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

The accompanying unaudited condensed consolidated financial statements for China Wind Systems, Inc., its subsidiaries and variable interest entities, have been prepared in accordance with accounting principles generally accepted in the United States of America (the “U.S.”) for interim financial information and with the instructions to Form 10-Q and Article 8-03 of Regulation S-X. Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole.

The Company’s consolidated financial statements include the financial statements of its wholly-owned subsidiaries, Fulland, Greenpower and Fulland Wind Energy, as well as the financial statements of Huayang Companies, Dyeing and Electric.  All significant intercompany accounts and transactions have been eliminated in consolidation.

The Huayang Companies are considered variable interest entities (“VIE”), and the Company is the primary beneficiary.  The Company’s relationships with the Huayang Companies and their shareholders are governed by a series of contractual arrangements between Green Power, the Company’s wholly foreign-owned enterprise in the PRC, and each of the Huayang Companies, which are the operating companies of the Company in the PRC. Under PRC laws, each of Green Power, Huayang Dye Machine and Huayang Electrical Power Equipment is an independent legal entity and none of them is exposed to liabilities incurred by the other parties. The contractual arrangements constitute valid and binding obligations of the parties of such agreements. Each of the contractual arrangements and the rights and obligations of the parties thereto are enforceable and valid in accordance with the laws of the PRC. On October 12, 2007, the Company entered into the following contractual arrangements with each of Huayang Dye Machine and Huayang Electrical Power Equipment:

Consulting Services Agreement. Pursuant to the exclusive consulting services agreements between Green Power and the Huayang Companies, Green Power has the exclusive right to provide to the Huayang Companies general business operation services, including advice and strategic planning, as well as consulting services related to the technological research and development of dye and finishing machines, electrical equipments and related products (the “Services”). Under this agreement, Green Power owns the intellectual property rights developed or discovered through research and development, in the course of providing the Services, or derived from the provision of the Services. The Huayang Companies shall pay a quarterly consulting service fees in Renminbi (“RMB”) to Fulland that is equal to all of the Huayang Companies’ profits for such quarter.

Operating Agreement. Pursuant to the operating agreement among Green Power, the Huayang Companies and all shareholders of the Huayang Companies, Green Power provides guidance and instructions on the Huayang Companies’ daily operations, financial management and employment issues. The Huayang Companies shareholders must designate the candidates recommended by Green Power as their representatives on the boards of directors of each of the Huayang Companies. Green Power has the right to appoint senior executives of the Huayang Companies. In addition, Green Power agrees to guarantee the Huayang Companies’ performance under any agreements or arrangements relating to the Huayang Companies’ business arrangements with any third party. The Huayang Companies, in return, agree to pledge their accounts receivable and all of their assets to Green Power. Moreover, each of the Huayang Companies agrees that, without the prior consent of Green Power, it will not engage in any transactions that could materially affect its assets, liabilities, rights or operations, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of their assets or intellectual property rights in favor of a third party or transfer of any agreements relating to their business operation to any third party. The term of this agreement, as amended on November 1, 2008, is 20 years from October 12, 2007 and may be extended only upon Green Power’s written confirmation prior to the expiration of the this agreement, with the extended term to be mutually agreed upon by the parties.

 
7

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Equity Pledge Agreement. Under the equity pledge agreement between the Huayang Companies’ shareholders and Green Power, the Huayang Companies’ shareholders pledged all of their equity interests in the Huayang Companies to Green Power to guarantee the Huayang Companies’ performance of their respective obligations under the consulting services agreement. If the Huayang Companies or the Huayang Companies’ shareholders breach their respective contractual obligations, Green Power, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. The Huayang Companies’ shareholders also agreed that, upon occurrence of any event of default, Green Power shall be granted an exclusive, irrevocable power of attorney to take actions in the place and stead of the Huayang Companies’ shareholders to carry out the security provisions of the equity pledge agreement and take any action and execute any instrument that Green Power may deem necessary or advisable to accomplish the purposes of the equity pledge agreement. The Huayang Companies’ shareholders agreed not to dispose of the pledged equity interests or take any actions that would prejudice Green Power’s interest. The equity pledge agreement will expire two years after the Huayang Companies’ obligations under the consulting services agreements have been fulfilled.


The accounts of the Huayang Companies are consolidated in the accompanying financial statements.  As VIEs, the Huayang Companies’ sales are included in the Company’s total sales, its income from operations is consolidated with the Company’s, and the Company’s net income includes all of the Huayang Companies net income. The Company does not have any non-controlling interest and, accordingly, did not subtract any net income in calculating the net income attributable to the Company. Because of the contractual arrangements, the Company had a pecuniary interest in the Huayang Companies that requires consolidation of the Company’s and the Huayang Companies’ financial statements.

Use of estimates

The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosures at the date of the financial statements and during the reporting period. Actual results could materially differ from these estimates. Significant estimates in 2010 and 2009 include the allowance for doubtful accounts, the allowance for obsolete inventory, the useful life of property and equipment and intangible assets, assumptions used in assessing impairment of long-term assets and valuation of deferred tax assets, accruals for taxes due, the calculation of the value of any beneficial conversion feature related to preferred stock, and the value of warrants granted upon the conversion of debt to preferred stock.

Cash and cash equivalents

For purposes of the consolidated statements of cash flows, the Company considers all highly liquid instruments purchased with a maturity of three months or less and money market accounts to be cash equivalents. The Company maintains cash and cash equivalents with various financial institutions mainly in the PRC and the U.S. Balances in the U.S are insured up to $250,000 at each bank.  Balances in banks in the PRC are uninsured.

 
8

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Fair value of financial instruments

The Company adopted the guidance of Accounting Standards Codification (“ASC”) 820 for fair value measurements which clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:

Level 1-Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.
 
Level 2-Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other then quoted prices that are observable, and inputs derived from or corroborated by observable market data.
 
Level 3-Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

The carrying amounts reported in the balance sheets for cash, accounts receivable, loans payable, accounts payable and accrued expenses, customer advances, and amounts due from related parties approximate their fair market value based on the short-term maturity of these instruments. The Company did not identify any assets or liabilities that are required to be presented on the consolidated balance sheets at fair value in accordance with the accounting guidance.

ASC 825-10 “Financial Instruments,” allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, unrealized gains and losses for that instrument should be reported in earnings at each subsequent reporting date. The Company did not elect to apply the fair value option to any outstanding instruments.

Concentrations of credit risk

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 environment in the PRC, and by the general state of the PRC's economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in North America. 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.

Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially all of the Company’s cash is maintained with state-owned banks within the PRC, and no deposits are covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any risks on its cash in bank accounts. A significant portion of the Company’s sales are credit sales which are primarily to customers whose ability to pay is dependent upon the industry economics prevailing in these areas; however, concentrations of credit risk with respect to trade accounts receivables is limited due to generally short payment terms.  The Company also performs ongoing credit evaluations of its customers to help further reduce credit risk. At September 30, 2010 and December 31, 2009, the Company’s cash balances by geographic area were as follows:

   
September 30, 2010
   
December 31, 2009
 
Country:
                       
United States
  $ 199,857       11.3 %   $ 506,777       22.2 %
China
    1,573,852       88.7 %     1,771,861       77.8 %
Total cash and cash equivalents
  $ 1,773,709       100.0 %   $ 2,278,638       100.0 %

 
9

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)


Notes receivable represents trade accounts receivable due from various customers where the customers’ bank has guaranteed the payment of the receivable. This amount is non-interest bearing and is normally paid within three to six months.   Historically, the Company has experienced no losses on notes receivable. The Company‘s notes receivable totaled $353,226 and $329,492 at September 30, 2010 and December 31, 2009, respectively.

Accounts receivable

Accounts receivable are presented net of an allowance for doubtful accounts. The Company maintains allowances for doubtful accounts for estimated losses. The Company reviews the accounts receivable on a periodic basis and makes general and specific allowances when there is doubt as to the collectability of individual balances. In evaluating the collectability of individual receivable balances, the Company considers many factors, including the age of the balance, a customer’s historical payment history, its current credit-worthiness and current economic trends. Accounts are written off after exhaustive efforts at collection. At September 30, 2010 and December 31, 2009, the Company has established, based on a review of its outstanding balances, an allowance for doubtful accounts in the amount of $1,333,560 and $758,096, respectively.

Inventories

Inventories, consisting of raw materials, work in process and finished goods related to the Company’s products are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, the Company will record reserves for the difference between the cost and the market value. These reserves are recorded based on estimates.  The Company recorded an inventory reserve of $163,968 and $160,632 at September 30, 2010 and December 31, 2009, respectively.

Advances to suppliers
 
Advances to suppliers represent the cash paid in advance for purchasing of raw material from suppliers. The advance payments are intended to ensure preferential pricing and delivery. The amounts advanced under such arrangements totaled $1,506,709 and $450,507 as of September 30, 2010 and December 31, 2009, respectively.

Property and equipment

Property and equipment are carried at cost and are depreciated on a straight-line basis over the estimated useful lives of the assets. The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized.  When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. The Company examines the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.

Included in property and equipment is construction-in-progress which consisted of factories and office buildings under construction and machinery pending installation and includes the costs of construction, machinery and equipment, and any interest charges arising from borrowings used to finance these assets during the period of construction or installation. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use. Property purchased from a related party is recorded at the cost to the related party and any payment to or on behalf of the related party in excess of the cost is reflected as a distribution to related party.

 
10

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Impairment of long-lived assets

In accordance with ASC Topic 360, the Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable, or at least annually. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value. The Company did not record any impairment charges for the nine months ended September 30, 2010 and 2009.

Advances from customers

Advances from customers at September 30, 2010 and December 31, 2009 amounted to $237,671 and $143,261, respectively, and consist of prepayments from customers for merchandise that had not yet been shipped. The Company will recognize the deposits as revenue as customers take delivery of the goods, in accordance with its revenue recognition policy.

Revenue recognition

Pursuant to the guidance of ASC Topic 605 and ASC Topic 360, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. The Company accounts for the product sale as a multiple element arrangement. Revenue from multiple element arrangements is allocated among the separate accounting units based on the residual method. Under the residual method, the revenue is allocated to undelivered elements based on fair value of such undelivered elements and the residual amounts of revenue allocated to delivered elements. The Company recognizes revenues from the sale of dyeing equipment, forged rolled rings and other components upon shipment and transfer of title. The other elements may include installation and, generally, a one-year warranty. Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally within a couple days of the delivery of the equipment. Grant income is recognized when funds have been received and all significant terms of the grant have been fulfilled by the Company. Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period.  For the nine months ended September 30, 2010 and 2009, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal.
 
All other product sales with customer specific acceptance provisions, including the forged rolled rings, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.

Income taxes

The Company is governed by the Income Tax Law of the People’s Republic of China and the United States. The Company accounts for income taxes using the liability method prescribed by ASC 740, “Income Taxes”. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the year in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rates is recognized as income or loss in the period that includes the enactment date.

 
11

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Income taxes (continued)

Pursuant to accounting standards related to the accounting for uncertainty in income taxes, the evaluation of a tax position is a two-step process. The first step is to determine whether it is more likely than not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50% likelihood of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met. The accounting standard also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition.  

Stock-based compensation

Stock based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively, the vesting period). The Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (”ASC”) also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.

Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the vesting period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. The Company records compensation expense based on the fair value of the award at the reporting date. The awards to consultants and other third-parties are then revalued, or the total compensation is recalculated based on the then current fair value, at each subsequent reporting date.

Shipping costs

Shipping costs are included in selling expenses and totaled $1,120,177 and $111,776 for the nine months ended September 30, 2010 and 2009, respectively.

Employee benefits

The Company’s operations and employees are all located in the PRC.  The Company makes mandatory contributions to the PRC government’s health, retirement benefit and unemployment funds in accordance with the relevant Chinese social security laws, equal to approximately 25% of salaries. The costs of these payments are charged to income in the same period as the related salary costs and are not material.

Advertising

Advertising is expensed as incurred and is included in selling, general and administrative expenses on the accompanying consolidated statements of income and comprehensive income and was not material.

Research and development

Research and development costs are expensed as incurred. For the nine months ended September 30, 2010 and 2009, research and development costs were not material.

 
12

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Foreign currency translation

The reporting currency of the Company is the U.S. dollar. The functional currency of the parent company is the U.S. dollar and the functional currency of the Company’s operating subsidiaries is the Chinese Renminbi (“RMB”). For the subsidiaries and affiliates whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the unified exchange rate at the end of the period, and equity is translated at historical exchange rates. As a result, amounts relating to assets and liabilities reported on the statements of cash flows may not necessarily agree with the changes in the corresponding balances on the balance sheets.  Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income.  The cumulative translation adjustment and effect of exchange rate changes on cash for the nine months ended September 30, 2010 and 2009 was $35,270 and $720, respectively. Transactions denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing on the transaction dates. Assets and liabilities denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing at the balance sheet date with any transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.

All of the Company’s revenue transactions are transacted in the functional currency. Other than for the purchase of equipment, the Company does not enter any material transaction in foreign currencies.  Transaction gains or losses have not had, and are not expected to have, a material effect on the results of operations of the Company.

Asset and liability accounts at September 30, 2010 and December 31, 2009 were translated at 6.6981 RMB to $1.00 and at 6.8372 RMB to $1.00, respectively, which were the exchange rates on the balance sheet dates. Equity accounts were stated at their historical rate. The average translation rates applied to the statements of income for the nine months ended September 30, 2010 and 2009 were 6.8164 RMB and 6.84251 RMB to $1.00, respectively.  Cash flows from the Company’s operations are calculated based upon the local currencies using the average translation rate. As a result, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheets.

Reverse stock split

The Company effected a one-for-three reverse stock split on September 22, 2009.  All share and per share information has been retroactively adjusted to reflect the reverse split.

Income per share of common stock
 
ASC 260 “Earnings Per Share,” requires dual presentation of basic and diluted earnings per share (“EPS”) with a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic EPS excludes dilution. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
 
Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during each period. Potentially dilutive common shares consist of common shares issuable upon the conversion of series A preferred stock (using the if-converted method) and common stock warrants (using the treasury stock method).  The following table presents a reconciliation of basic and diluted net income per share:

 
13

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Income per share of common stock (continued)

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Net income available to common shareholders for basic and diluted net income per common share
  $ 2,973,590     $ 2,036,437     $ 7,943,784     $ 4,463,030  
                                 
Weighted average common shares outstanding - basic
    18,177,405       15,406,842       17,671,530       15,141,927  
Effect of dilutive securities:
                               
Series A convertible preferred stock
    4,752,421       4,819,696       4,752,421       4,819,696  
Warrants
    2,383,153       3,280,398       2,480,259       2,008,069  
Weighted average common shares outstanding - diluted
    25,312,979       23,506,936       24,904,210       21,969,692  
Net income per common share - basic
  $ 0.16     $ 0.13     $ 0.45     $ 0.29  
Net income per common share - diluted
  $ 0.12     $ 0.09     $ 0.32     $ 0.20  


The Company's aggregate common stock equivalents at September 30, 2010 and 2009 include the following:

   
September 30, 2010
   
September 30, 2009
 
Warrants
    3,541,322       5,438,835  
Series A convertible preferred stock
    4,752,421       4,819,696  
Total
    8,293,743       10,258,531  

Deemed preferred stock dividend

When we issue shares of convertible preferred stock at a price that is, on an “as if converted” basis, less than the market price of the underlying shares of common stock, the difference between the value of the underlying shares of common stock and the purchase price of the convertible preferred stock is treated as a deemed preferred stock dividend.  In connection with the issuance of shares of preferred stock upon exercise of warrants as a result of board approval of the issuance of series A preferred stock instead of common stock, the Company does not record a deemed preferred stock dividend since the number of shares of series A preferred stock that the Company issues is convertible into the number of shares of common stock which would have been issued upon exercise.

Accumulated other comprehensive income
 
Comprehensive income is comprised of net income and all changes to the statements of stockholders' equity, except those due to investments by stockholders, changes in paid-in capital and distributions to stockholders. For the Company, comprehensive income for the nine months ended September 30, 2010 and 2009 included net income and unrealized gains from foreign currency translation adjustments.

 
14

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Related parties

Parties are considered to be related to the Company if the parties, directly or indirectly, through one or more intermediaries, control, are controlled by, or are under common control with the Company. Related parties also include principal owners of the Company, its management, members of the immediate families of principal owners of the Company and its management and other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests. The Company discloses all related party transactions. All transactions shall be recorded at fair value of the goods or services exchanged. Property purchased from a related party is recorded at the cost to the related party and any payment to or on behalf of the related party in excess of the cost is reflected as a distribution to related party.

Subsequent events

For purposes of determining whether a post-balance sheet event should be evaluated to determine whether it has an effect on the financial statements for the period ending September 30, 2010, subsequent events were evaluated by the Company as of the date on which the unaudited consolidated financial statements were available to be issued.

Recent accounting pronouncements

In October 2009, the FASB issued ASU No. 2009-13, “Multiple-Deliverable Revenue Arrangements.” This ASU establishes the accounting and reporting guidance for arrangements including multiple revenue-generating activities. This ASU provides amendments to the criteria for separating deliverables, measuring and allocating arrangement consideration to one or more units of accounting. The amendments in this ASU also establish a selling price hierarchy for determining the selling price of a deliverable. Significantly enhanced disclosures are also required to provide information about a vendor’s multiple-deliverable revenue arrangements, including information about the nature and terms, significant deliverables, and its performance within arrangements. The amendments also require providing information about the significant judgments made and changes to those judgments and about how the application of the relative selling-price method affects the timing or amount of revenue recognition. The amendments in this ASU are effective prospectively for revenue arrangements entered into or materially modified in the fiscal years beginning on or after June 15, 2010. Early application is permitted. The adoption of this new ASU is not expected to have any material impact on the Company’s consolidated financial statements.

In October 2009, the FASB issued ASU No. 2009-14, “Certain Revenue Arrangements That Include Software Elements.” This ASU changes the accounting model for revenue arrangements that include both tangible products and software elements that are “essential to the functionality,” and scopes these products out of current software revenue guidance. The new guidance will include factors to help companies determine what software elements are considered “essential to the functionality.” The amendments will now subject software-enabled products to other revenue guidance and disclosure requirements, such as guidance surrounding revenue arrangements with multiple-deliverables. The amendments in this ASU are effective prospectively for revenue arrangements entered into or materially modified in the fiscal years beginning on or after June 15, 2010. Early application is permitted. The adoption of this new ASU is not expected to have any material impact on the Company’s consolidated financial statements.

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

 
15

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

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

In February 2010, the FASB issued ASU 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements”.  This amendment addresses both the interaction of the requirements of this Topic with the SEC’s reporting requirements and the intended breadth of the reissuance disclosure provision related to subsequent events (paragraph 855-10-50-4).  All of the amendments in this Update are effective upon issuance of the final Update, except for the use of the issued date for conduit debt obligors. That amendment is effective for interim or annual periods ending after June 15, 2010.  The adoption of this ASU did not have a material impact on the Company’s financial statements.

In March 2010, the FASB issued ASU 2010-11, Derivatives and Hedging (Topic 815): Scope Exception Related to Embedded Credit Derivatives.  The amendments in this Update are effective for each reporting entity at the beginning of its first fiscal quarter beginning after June 15, 2010.  Early adoption is permitted at the beginning of each entity’s first fiscal quarter beginning after issuance of this Update.  The Company does not expect the provisions of ASU 2010-11 to have a material effect on the financial position, results of operations or cash flows of the Company.

In April 2010, the FASB issued ASU 2010-13, Compensation-Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades - a consensus of the FASB Emerging Issues Task Force.  The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010.  Earlier application is permitted.  The Company does not expect the provisions of ASU 2010-13 to have a material effect on the financial position, results of operations or cash flows of the Company.

In May 2010, the FASB issued ASU 2010-19, Foreign Currency (Topic 830): Foreign Currency Issues: Multiple Foreign Currency Exchange Rates.  The amendments in this Update are effective as of the announcement date of March 18, 2010. The adoption of this update did not have a material effect on the financial position, results of operations or cash flows of the Company.

 
16

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Recent accounting pronouncements (continued)

Other accounting standards that have been issued or proposed by FASB that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.

NOTE 2 – ACCOUNTS RECEIVABLE


   
September 30, 2010
   
December 31, 2009
 
Accounts receivable
  $ 9,964,596     $ 6,804,518  
Less: allowance for doubtful accounts
    (1,333,560 )     (758,096 )
    $ 8,631,036     $   6,046,422  

NOTE 3 - INVENTORIES

At September 30, 2010 and December 31, 2009, inventories consisted of the following:

   
September 30, 2010
   
December 31, 2009
 
Raw materials
  $ 2,715,741     $ 1,366,220  
Work in process
    1,211,377       288,811  
Finished goods
    467,737       737,865  
      4,394,855       2,392,896  
Less: reserve for obsolete inventory
    (163,968 )     (160,632 )
    $ 4,230,887     $   2,232,264  

NOTE 4 - PROPERTY AND EQUIPMENT

At September 30, 2010 and December 31, 2009, property and equipment consist of the following:

   
Useful Life
   
September 30, 
2010
   
December 31, 2009
 
Office equipment and furniture
 
5 Years
    $ 125,879     $ 103,320  
Manufacturing equipment
 
5 – 10 Years
      35,028,308       17,405,814  
Vehicles
 
5 Years
      118,028       79,570  
Construction in progress
 
-
      421,947       9,546,200  
Building and building improvements
 
20 Years
      16,779,633       15,153,046  
            52,473,795       42,287,950  
Less: accumulated depreciation
          (7,653,275 )     (5,424,449 )
                       
          $ 44,820,520     $ 36,863,501  

For the nine months ended September 30, 2010 and 2009, depreciation expense amounted to $2,145,463 and $1,237,922, of which $1,905,970 and $993,946 is included in cost of sales, respectively.  Upon completion of the construction in progress, the assets will be classified to its respective property and equipment category.

 
17

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010
 
NOTE 5 – LAND USE RIGHTS
 
There is no private ownership of land in China. Land is owned by the government and the government grants land use rights for specified terms.   The Company’s land use rights have terms of 45 and 50 years and expire on January 1, 2053 and October 30, 2053.  The Company amortizes the land use rights over the term of the respective land use right. For the nine months ended September 30, 2010 and 2009, amortization of land use rights amounted to $65,042 and $64,794, respectively.

At September 30, 2010 and December 31, 2009, land use rights consist of the following:

   
Useful Life
 
September 30, 2010
   
December 31, 2009
 
Land Use Rights
 
45 - 50 years
  $ 4,031,113     $ 3,949,101  
Less: Accumulated Amortization
        (290,427 )     (219,674 )
        $ 3,740,686     $ 3,729,427  

Amortization of land use rights attributable to future periods is as follows:

Periods ending September 30:
     
2011
  $ 88,255  
2012
    88,255  
2013
    88,255  
2014
    88,255  
2015
    88,255  
Thereafter
    3,299,411  
    $ 3,740,686  

NOTE 6 – STOCKHOLDERS’ EQUITY

(a)
Common stock issued for services

During the nine months ended September 30, 2010, the Company issued 3,000 shares of common stock to its Chief Financial Officer for services rendered pursuant to an employment agreement. The shares, which were issued pursuant to the Company’s 2010 long–term incentive plan, were valued at fair value on the respective dates of grant, and the Company recorded stock-based compensation of $10,770 and prepaid expense of $3,900.

During the nine months ended September 30, 2010, the Company issued an aggregate of 49,000 shares of common stock to its Chief Executive Officer pursuant to its 2010 long-term incentive plan. The shares were valued at fair value of the common stock on the date of grant, and the Company recorded stock-based compensation of $249,970.

During the nine months ended September 30, 2010, the Company issued an aggregate of 35,000 shares of common stock to two key employees who are not executive officers pursuant to its 2010 long-term incentive plan. The shares were valued at fair value on the respective dates of grant, and the Company recorded stock-based compensation of $178,550.

 
18

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 6 – STOCKHOLDERS’ EQUITY (continued)

(a)
Common stock issued for services (continued)

The Company has a consulting agreement with a company that provides the services of its vice president of financial reporting.  Pursuant to this agreement, the Company issued 2,000 shares of common stock on each of March 31, 2010, June 30, 2010 and September 30, 2010 for an aggregate of 6,000 shares of common stock.  The shares were valued at fair value on the respective dates of grant, and the Company recorded stock-based compensation of $27,400 during the nine months ended September 30, 2010.

On July 29, 2010, the Company entered into an amended director’s agreement with a director for the period from July 1, 2010 to June 30, 2011.  Pursuant to this agreement, the Company is to issue an aggregate of 10,000 shares of its common stock of which 2,500 were issued on July 29, 2010 and 2,500 are issuable on a quarterly basis on each of October 1, 2010, January 1, 2011 and April 1, 2011.  The shares are valued at fair value on the date of grant, and the Company recorded stock-based compensation of $11,700 during the nine months ended September 30, 2010.

(b) Common stock issued for exercise of warrants and preferred share conversions

On May 4, 2010, the Company issued 43,750 shares of its common stock upon cashless exercise of warrants to purchase 58,333 shares of common stock.

On July 9, 2010, the Company issued 100,118 shares of its common stock upon the exercise of warrants for which the Company received cash proceeds of $170,000.

On July 16, 2010, the Company issued 825,000 shares of its series A preferred stock to an investor upon the exercise of warrants, for which the Company received cash proceeds of $330,000.

During the nine months ended September 30, 2010, the Company issued 1,455,666 shares of common stock upon the conversion of 4,367,000 shares of series A preferred stock.

In January and February 2010, the Company issued 173,333 shares of its common stock and 2,380,176 shares of its series A preferred stock to investors upon the exercise of warrants, for which the Company received cash proceeds of $1,600,000.  In connection with the issuance of the 2,380,176 shares of series A preferred stock, the investor entered into an agreement with the Company’s chief executive officer, who is the Company’s principal beneficial owner of common stock, pursuant to which the chief executive officer has the right to vote the series A preferred stock and the underlying common stock as to all matters for which stockholder approval is obtained as long as the investor or its affiliates own the stock.  Upon the sale of the series A preferred stock or the underlying common stock to a person other than an affiliate of the investor, the voting agreement terminates as to the transferred shares and the chief executive officer has no voting rights with respect to the transferred shares.  The investor had executed similar agreements in connection with the purchase of series A preferred stock in September and October 2009.

 
19

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 6 – STOCKHOLDERS’ EQUITY (continued)

(c)
Agreement with respect to Series A Preferred Stock and Common Stock Purchase Warrants

On March 26, 2010, the holders of the outstanding shares of series A preferred shareholders and the sole holder of all of the Company’s common stock purchase warrants that included a provision that provided for an adjustment in the exercise price in the event of a sale of common stock at a price below the exercise price of the warrants agreed to eliminate and waive any rights they may have under the provisions of the Statement of Designations relating to the series A preferred stock that provide for a reduction in the conversion price of the series A preferred stock, in the event that the Company issues stock at a price which is less than the conversion price of the series A preferred stock; and the warrant holder agreed to delete from the warrants the provisions that provide for a reduction in the exercise price of the warrants in the event that the Company issues stock at a price which is less than the exercise price of the warrants. The Company agreed not to issue shares of Common Stock at a price, or options, warrants or convertible securities with an exercise or conversion price, that is less than the conversion price of the then outstanding series A preferred stock or the exercise price of the then outstanding warrants, as the case may be.   Accordingly, the Company did not record a derivative liability related to the warrants at December 31, 2009.

(d)
Series A Preferred Stock

The series A preferred stock has the following rights, preferences and limitations:

 
·
There are 60,000,000 authorized shares of series A preferred stock.   

 
·
No dividends shall be payable with respect to the series A preferred stock. No dividends shall be declared or payable with respect to the common stock while the series A preferred stock is outstanding. The Company shall not redeem or purchase any shares of Common Stock or any other class or series of capital stock which is junior to or on parity with the series A preferred stock while the series A preferred stock is outstanding.

 
·
The holders of the series A preferred stock have no voting rights except as required by law. However, so long as any shares of series A preferred stock are outstanding, the Company shall not, without the affirmative approval of the holders of 75% of the shares of the series A preferred stock then outstanding, (a) alter or change adversely the powers, preferences or rights given to the series A preferred stock or alter or amend the statement of designations relating to the series A preferred stock, (b) authorize or create any class of stock ranking as to dividends or distribution of assets upon a liquidation senior to or pari passu with the series A preferred stock, or any of preferred stock possessing greater voting rights or the right to convert at a more favorable price than the series A preferred stock, (c) amend its certificate of incorporation or other charter documents in breach of any of the provisions of the certificate of designation, (d) increase the authorized number of shares of series A preferred stock or the number of authorized shares of preferred stock, or (e) enter into any agreement with respect to the foregoing.

 
·
Upon any liquidation, dissolution or winding-up of the Company, whether voluntary or involuntary, the holders of the series A preferred stock have a liquidation preference of $0.374 per share. 

 
·
Each share of series A preferred stock is convertible at any time (subject to the 4.9% limitations described below) into one-third share of common stock, subject to adjustment. 

 
·
All of the outstanding shares of series A preferred stock shall be automatically converted into common stock upon the close of business on the business day immediately preceding the date fixed for consummation of any transaction resulting in a change of control of the Company, as defined in the statement of designation.

 
20

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 6 – STOCKHOLDERS’ EQUITY (continued)

(d)
Series A Preferred Stock (continued)

 
·
The holders may not convert the series A preferred stock to the extent that such conversion would result in the holder and its affiliates beneficially owning more than 4.9% of the Company’s common stock.  This provision may not be waived or amended.

(e)
November 2007 Securities Purchase Agreement

Pursuant to the securities purchase agreement relating to the Company’s November 2007 private placement, as amended:
 
 
·
The Company agreed to have appointed such number of independent directors that would result in a majority of its directors being independent directors, that the audit committee would be composed solely of not less than three independent directors and the compensation committee would have at least three directors, a majority of which shall be independent directors.  If the Company does not meet these requirements for a period of 60 days for an excused reason, as defined in the securities purchase agreement, or 75 days for a reason which is not an excused reason, the Company would be required to pay liquidated damages.   The Company is in compliance with this covenant.
 
 
·
The Company agreed to have a qualified chief financial officer.  If the Company cannot hire a qualified chief financial officer promptly upon the resignation or termination of employment of a former chief financial officer, the Company may engage an accountant or accounting firm to perform the duties of the chief financial officer.  In no event shall the Company either (i) fail to file an annual, quarterly or other report in a timely manner because of the absence of a qualified chief financial officer, or (ii) not have a person who can make the statements and sign the certifications required to be filed in an annual or quarterly report under the Securities Exchange Act of 1934.
 
 
·
Liquidated damages for failure to comply with the preceding two covenants are computed in an amount equal to 12% per annum of the purchase price, up to a maximum of 12% of the purchase price, which is $663,000, which is payable in cash or series A preferred stock, at the election of the investors.  If payment is made in shares of series A preferred stock, each share is valued at $0.374 per share.  The liquidated damage amount is based on the purchase price of the shares of series A preferred stock that were then outstanding.
 
 
·
Until the earlier of November 13, 2010 or such time as the investors cease to own at least 5% of the total number of shares that were issued or are issuable upon conversion of the series A preferred stock that were issued upon conversion of the 3% convertible subordinated notes issued in November 2007, the Investors have a right of first refusal on future financings.
 
 
·
Until the earlier of November 13, 2011 or such time as the Investors shall have sold all of the underlying shares of common stock, the Company is restricted from issuing convertible debt or preferred stock.

 
·
Until the earlier of November 13, 2010 or such time as the Investors have sold 90% of the underlying shares of common stock, the Company’s debt cannot exceed twice the preceding four quarters earnings before interest, taxes, depreciation and amortization.

 
·
The Company’s officers and directors agreed, with certain limited exceptions, not to publicly sell shares of common stock for 27 months or such earlier date as all of the convertible securities and warrants have been converted or exercised and the underlying shares of common stock have been sold.  This 27 month period expired on February 13, 2010.

 
21

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 6 – STOCKHOLDERS’ EQUITY (continued)

(f)
March 2009 Issuance of Notes and Warrants and Other Warrant Matters
 
On March 23, 2009, Company sold to two investors, for $250,000, its 18-month, 15% notes in the aggregate principal amount of $250,000 and five-year warrants purchasing 145,833 shares at an exercise price of $1.20 per share.  These warrants were treated as a discount on the secured notes and were valued at $92,985 to be amortized over the 18-month note term. The fair value of these warrants was estimated on the date of grant using the Black-Scholes option-pricing model using the following weighted-average assumptions: expected dividend yield of 0%; expected volatility of 137.51%; risk-free interest rate of 1.69% and an expected holding period of five years.  The Company repaid the notes in full in February 2010 and fully amortized the balance of the debt discount in February 2010.  For the nine months ended September 30, 2010 and 2009, amortization of debt discount to interest expense was $44,993 and $32,495, respectively.

Warrant activities for the nine months ended September 30, 2010 are summarized as follows:

   
Nine Months Ended September 30, 2010
 
   
Number of
Warrants
   
Weighted Average
Exercise Price
 
Balance at beginning of year
    4,941,498     $ 1.49  
Granted
    -       -  
Exercised
    (1,400,176 )     1.55  
Forfeited
    -       -  
Balance at end of period
    3,541,322     $ 1.47  
                 
Warrants exercisable at end of period
    3,541,322     $ 1.47  

The following table summarizes the shares of the Company's common stock issuable upon exercise of warrants outstanding at September 30, 2010:
Warrants Outstanding
   
Warrants Exercisable
 
 
Range of
Exercise
Price
   
Number
Outstanding at
September 30,
2010
   
Weighted
Average
Remaining
Contractual
Life (Years)
   
Weighted
Average
Exercise
Price
   
Number
Exercisable at
September 30,
2010
   
Weighted
Average
Exercise Price
 
$
1.698       1,885,563       2.12     $ 1.698       1,885,563     $ 1.698  
$
1.200       1,655,759       2.19       1.200       1,655,759       1.200  
          3,541,322       2.16     $ 1.47       3,541,322     $ 1.47  

2010 Long-Term Incentive Plan

In January 2010, the Company’s board of directors adopted, and in March 2010, the stockholders approved the Company’s 2010 long-term incentive plan, which covers 2,000,000 shares of common stock.  The plan provides for the grant of incentive and non-qualified options and stock grants to employees, including officers, directors and consultants. The plan is to be administered by a committee of not less than three directors, each of whom is to be an independent director.  In the absence of a committee, the plan is administered by the board of directors.   Members of the committee are not eligible for stock options or stock grants pursuant to the plan unless such stock options or stock grant are granted by a majority of the Company’s independent directors other than the proposed grantee.  As of September 30, 2010, the Company had issued a total of 95,500 shares of common stock, for which it expensed compensation in the amount of $478,390 and recorded prepaid expenses of $3,900.

 
22

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 7 – INCOME TAXES

The Company accounts for income taxes pursuant to the accounting standards that requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statements and the tax basis of assets and liabilities, and for the expected future tax benefit to be derived from tax losses and tax credit carryforwards.  Additionally, the accounting standards require the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Realization of deferred tax assets, including those related to the U.S. net operating loss carryforwards, are dependent upon future earnings, if any, of which the timing and amount are uncertain.

Accordingly, the net deferred tax asset related to the U.S. net operating loss carryforward has been fully offset by a valuation allowance. The Company is governed by the Income Tax Law of the People’s Republic of China and the United States. In 2010 and 2009, under the Income Tax Laws of PRC, Chinese companies are generally subject to an income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments. The Company’s VIEs (Dyeing and Electric) and the Company’s subsidiary, Fulland Wind Energy, are subject to these statutory rates. The Company’s wholly-owned subsidiary, Fulland Limited was incorporated in the Cayman Islands. Under the current laws of the Cayman Islands, this entity is not subject to income taxes.

NOTE 8 – LOANS PAYABLE

At September 30, 2010 and December 31, 2009, loans payable consisted of the following:

   
September 30,
   
December 31,
 
   
2010
   
2009
 
Loan payable to Industrial and Commercial Bank of China, due on September 24, 2010 with annual interest at September 30, 2010 and December 31, 2009 of 5.84% and 5.84%, respectively, secured by assets of the Company and repaid in August 2010.
  $ -     $ 146,259  
                 
Loan payable to Industrial and Commercial Bank of China, due on September 15, 2010 with annual interest at September 30, 2010 and December 31, 2009 of 5.58% and 5.58%, respectively, secured by assets of the Company and repaid in August 2010.
    -       146,259  
                 
Loan payable to Industrial and Commercial Bank of China, due on September 22, 2010 with annual interest at September 30, 2010 and December 31, 2009 of 5.58% and 5.58%, respectively, secured by assets of the Company and repaid in August 2010.
    -       146,259  
                 
Loan payable to Bank of Communications, due on June 8, 2010 with annual interest at December 31, 2009 of 5.84%, respectively, the rate being adjusted quarterly based on People’s Bank of China’s base rate times 120% and repaid on due date
    -       438,775  
                 
Loan payable to Bank of Communications, due on June 14, 2010 with annual interest at December 31, 2009 of 5.84%, respectively, the rate being adjusted quarterly based on People’s Bank of China’s base rate times 120% and repaid on due date
    -       292,517  
 
 
23

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 8 – LOANS PAYABLE (continued)

Loan payable to Bank of Communications, due on February 1, 2011 with annual interest at September 30, 2010 of 4.86%, respectively, the rate being adjusted quarterly based on People’s Bank of China’s base rate times 120%.
    746,481       -  
                 
Loan payable to Agricultural and Commercial Bank, due on March 31, 2011 with annual interest at September 30, 2010 and December 31, 2009 of 5.75% and 6.90%, respectively, secured by certain assets of the Company.
    597,184       585,035  
                 
Principal amount of loan payable to an investor, due on February 7, 2011 with annual interest at December 31, 2009 of 12% and repaid in January 2010.
    -       80,000  
                 
Principal amount of loan payable to investors, due on September 23, 2010, with interest of 15% per annum (see (a) below) and repaid in January 2010.
    -       250,000  
Total loans payable
    1,343,665       2,085,104  
Less: debt discount (a)
    -       (44,993 )
Current portion of  loans payable – net
  $ 1,343,665     $ 2,040,111  

(a)
In March 2009, the Company sold to two investors its 18-month, 15% notes in the aggregate principal amount of $250,000 and warrants to purchase 145,833 shares at an exercise price of $1.20 per share for a total of $250,000. The debt discount represents the unamortized value of the warrants issued in the transaction.  The notes were paid during the quarter ended March 31, 2010 (See Note 6(f)).

NOTE 9 - SEGMENT INFORMATION

For the three and nine months ended September 30, 2010 and 2009, the Company operated in two reportable business segments - (1) the manufacture of dyeing and finishing equipment and (2) the manufacture of forged rolled rings and related components for the wind power and other industries and, in the three and nine months ended September 30, 2009, electric power auxiliary apparatuses (including coking equipment) although no revenue was generated from and no expenses were incurred in connection with the electric power auxiliary equipment business, which was discontinued in the fourth quarter of 2009. The Company's reportable segments are strategic business units that offer different products. They are managed separately based on the fundamental differences in their operations.  All of the Company’s operations are conducted in the PRC. Information with respect to these reportable business segments for the three and nine months ended September 30, 2010 and 2009 is as follows:

 
24

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 9 - SEGMENT INFORMATION (continued)
   
For the Three Months Ended
   
For the Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenues:
                       
Dyeing and finishing equipment
  $ 5,559,091     $ 4,983,302     $ 15,776,814     $ 12,309,750  
Forged rolled rings and related components
    15,702,963       11,148,968       41,303,196       25,267,417  
                                 
      21,262,054       16,132,270       57,080,010       37,577,167  
Depreciation:
                               
Dyeing and finishing equipment
    136,649       104,335       371,751       308,027  
Forged rolled rings and related components
    808,172       436,460       1,773,712       929,895  
                                 
      944,821       540,795       2,145,463       1,237,922  
Interest expense:
                               
Dyeing and finishing equipment
    -       -       -       -  
Forged rolled rings and related components
    23,923       27,965       69,393       72,104  
Other (a)
    -       26,286       47,943       181,876  
                                 
      23,923       54,251       117,336       253,980  
Net income (loss):
                               
Dyeing and finishing equipment
    580,281       705,206       1,782,784       1,596,797  
Forged rolled rings and related components
    2,580,906       2,032,910       7,068,661       4,104,264  
Other (a)
    (187,597 )     (239,679 )     (907,661 )     (776,031 )
                                 
      2,973,590       2,498,437       7,943,784       4,925,030  

Identifiable long-lived tangible assets at September 30, 2010 and December 31, 2009 by segment:
                           
Dyeing and finishing equipment
  $ 6,113,165     $ 5,728,590                  
Forged rolled rings and related components
    38,707,355       31,134,911                  
                                 
    $ 44,820,520     $ 36,863,501                  
Identifiable long-lived tangible assets at September 30, 2010 and December 31, 2009 by geographical location:
                               
China
  $ 44,820,520     $ 36,863,501                  
United States
    -       -                  
                                 
    $ 44,820,520     $ 36,863,501                  

(a)      The Company does not allocate any general and administrative expenses of its U.S. activities to its reportable segments, because these activities are managed at a corporate level.

NOTE 10 – STATUTORY RESERVES

The Company is required to make appropriations to reserve funds, comprising the statutory surplus reserve, statutory public welfare fund and discretionary surplus reserve, based on after-tax net income determined in accordance with generally accepted accounting principles of the PRC (the “PRC GAAP”). Appropriation to the statutory surplus reserve should be at least 10% of the after tax net income determined in accordance with the PRC GAAP until the reserve is equal to 50% of the entities’ registered capital or members’ equity. Appropriations to the statutory public welfare fund are at a minimum of 5% of the after tax net income determined in accordance with PRC GAAP. Commencing on January 1, 2006, the new PRC regulations waived the requirement for appropriating retained earnings to a welfare fund. Prior to December 31, 2009, the Company appropriated the required maximum 50% of its registered capital to statutory reserves for Dyeing and Electric.

 
25

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010

NOTE 10 – STATUTORY RESERVES (continued)

For the nine months ended September 30, 2010, statutory reserve activity is as follows:

   
Dyeing
   
Electric
   
Wuxi Fulland
   
Total
 
Balance – December 31, 2009
  $ 72,407     $ 1,168,796     $ 11,777     $ 1,252,980  
Additional to statutory reserves
    -       -       171,991       171,991  
Balance – September 30, 2010
  $ 72,407     $ 1,168,796     $ 183,768     $ 1,424,971  

NOTE 11 – CONCENTRATIONS

Customers

During the nine months ended September 30, 2010, one customer of the forged rolled rings and related components segment accounted for 15% of the Company’s total sales. No customer accounted for more than 10% of the Company’s total sales for the nine months ended September 30, 2009.

Suppliers

Three major suppliers provided approximately 47% of the Company’s purchases of raw materials for the nine months ended September 30, 2010 primarily consisting of steel for the forged rolled rings and related components segment. No supplier provided more than 10% of the Company’s purchases of raw materials for the nine months ended September 30, 2009.

NOTE 12 – RESTRICTED NET ASSETS

Regulations in the PRC permit payments of dividends by our PRC VIEs only out of retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. Subject to certain cumulative limit, a statutory reserve fund requires annual appropriations of at least 10% of after-tax profit, if any, of the relevant PRC VIE’s and subsidiary. The statutory reserve funds are not distributable as cash dividends.

Pursuant to PRC regulations, our PRC subsidiaries and VIEs require government approval in order to transfer assets, including cash, outside of the PRC, and certain transfers may be subject to a 10% tax.  As a result, the net assets of our PRC subsidiaries and VIEs are treated as restricted assets.  As of September 30, 2010 and December 31, 2009, the Company’s restricted net assets were approximately $65,516,000 and $51,652,000, respectively.

NOTE 13 – SUBSEQUENT EVENTS

On October 1, 2010, the Company issued 2,500 shares of its common stock to its director for services pursuant to an amended director’s agreement described in Note 6. The shares were valued at fair value on the date of grant and the Company recorded prepaid expense of $10,850.

During October and November 2010, the Company issued 284,000 shares of its common stock upon the conversion of 852,000shares of Series A Convertible Preferred Stock.

During October 2010, the Company issued 1,375,002 shares of its series A preferred stock to an investor upon the exercise of warrants, for which the Company received cash proceeds of $550,000.

 
26

 

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We are engaged in two business segments – the forged rolled rings and related components segment, in which we manufacture and sell high precision forged rolled rings, shafts, flanges, and other forged components for the wind power and other industries, and the dyeing and finishing equipment segment, in which we manufacture and sell textile dyeing and finishing machines.
  
The following table sets forth information as to revenue of our forged rolled rings and related components and dyeing and finishing equipment segments in dollars and as a percent of revenue (dollars in thousands):

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2010
   
2009
   
2010
     
2009
 
   
Dollars
   
%
     
Dollars
   
%
   
Dollars
 
%
       
Dollars
   
%
 
Forged rolled rings and related components
- wind power industry
 
$
     12,425
   
58.4
%
 
$
   6,877
   
42.9
%  
$
    28,559
 
50.0
%    
$
   13,243
   
35.2
%
                                                         
Forged rolled rings and related components- other industries
   
     3,278
   
15.5
%
   
   4,272
   
26.6
   
    12,744
 
22.4
%      
   12,024
   
32.0
%
                                                         
Dyeing and finishing equipment
   
                   5,559
   
26.1
%    
                  4,983
   
30.5
   
                   15,777
 
27.6
%      
                  12,310
   
32.8
%
                                                                      
Total
 
$
     21,262
   
100
%  
$
   16,132
   
100
 
$
  57,080
 
100
%    
$
 37,577
   
100
%

Forged Rolled Rings and Related Components Segment

Through our forged rolled rings and other related products division, we supply precision forged rolled rings and other forged components to the wind industry.  These components are used in wind turbines, which are used to generate wind power.  The government of the PRC has announced its desire to expand significantly its goal for installed wind energy capacity.  We began to manufacture shafts and forged rolled rings for gear rims, flanges and other applications in our new 108,000 square foot manufacturing facility which became operational in March 2009.
 
We produce precision forgings using axial close-die forging technology, which is a new technology for producing rotary precision forgings, using forging equipment which we manufactured for our own use. The axial close-die forging technology reduces the use of raw materials by as much as 35%, provides a high precision and surface flatness, reduces the cutting output, has excellent mechanical strength and high flexibility, and is a fully automatic operation. We believe that our forging capabilities will continue to increase as we implement our expansion plans.

In addition to the wind industry, we sell our forged rolled rings and other forged components in other industries, including heavy machinery manufacturing, petrochemical, metallurgical, sea port machinery, defense and radar manufacturing industries, which use our forged rolled rings railway as components in the manufacture of equipment.

In October 2009, we ordered the initial machinery to expand our completed state-of-the-art forged product facility with a new production line, enabling us to manufacture electro-slag re-melted (“ESR”) forged products for the high performance components market for various industries.  We believe that ESR forged products will be important components in the next generation of larger wind turbines and other high performance components, which will require stronger steel alloy precision forged components than the smaller turbines.  ESR is used to increase the durability and quality of steel and to blend specific alloys that are required to meet the anticipated strength requirements of the next generation of wind turbines.  We delivered the initial units from this production line in July 2010 to one customer, which has been our only ESR customer through September 30, 2010.  We generated revenue of $3,167,000 from this sale during the three and nine months ended September 30, 2010.  This customer will use our ESR products in light industry, automobile, construction and railway industries.

 
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The forged rolled rings segment has become a more significant percentage of our total revenues since we expanded our manufacturing facilities to enable us to manufacture forged rolled rings with a larger diameter in order to meet the perceived needs of the wind power industry. Our rolled rings are essentially hollow cylindrical sections forged from a stainless steel stock piece with varying thickness and height; the rings are created from the forging process. Forging is a manufacturing process where metal is pressed, pounded or squeezed under great pressure into high strength parts. Rolled ring forging turns a hollow round piece of metal under extreme pressure against a rotating roller, thereby squeezing out a single-piece ring without any welding required. We believe that there is a market for our rolled rings in the wind power industry. Through this division, which was formerly known as the forged rolled ring and electric power equipment division, until the end of 2009, we designed, manufactured and sold both standard and custom auxiliary equipment used to improve and promote efficient coal use at both coking and power plants. In the fourth quarter of 2009, we sold our remaining units of auxiliary electrical equipment and we no longer produce these products.

Currently, wind power accounts for an insignificant percentage of the power generated in the PRC, According to the Global Wind Energy Council’s “Global Wind 2008 Report, Annual installed capacity by region 2003-2008” as published on the website, global installed wind energy capacity reached 120 GW and the global market topped 27 GW at year-end 2008. Further, investment in new power generation equipment topped $50 billion during 2008. China’s installed capacity doubled for the fourth consecutive year and surpassed 12 GW in 2008. While China ranked fourth in the world in installed capacity at the end of 2008, behind the United States (25 GW), Germany (24 GW), and Spain (17 GW), China ranked second globally for installed new capacity in 2008 with 6 GW, behind the United States with 8 GW. According to an  article titled “High Winds in China” at www.compositesworld.com/articles/high-wind-in-china, the Chinese government announced its new goal to increase China's projected installed wind capacity to 150 GW by 2020, representing a potential $200 billion market for wind power components and projects in China.   Our ability to market to this segment is dependent upon both the growth of the acceptance of wind power as an energy source in the PRC and the acceptance of our products.

Our products are sold for use by manufacturers of industrial equipment.  The demand for products used in manufacturing in general including wind power industries, is uncertain.  Although we believe that over the long term, the Forged Rolled Rings and Related Components Segment will expand and the government of the PRC has announced its desire to increase the use of wind power as an energy source, in the short term these factors may affect the requirements by our customers and potential customers for our products.  To the extent that the demand for our forged rolled rings and related components declines, our revenue and net income will be affected.

In November 2010, we signed a conditional purchase contract for approximately $1.0 million to supply precision manufactured subassemblies for solar cell manufacturing equipment that indicates our expansion into the solar market.  The purchase contract is conditional upon the successful inspection and acceptance by the customer of sample units by the end of December 2010. Upon successful inspection and acceptance of the initial components, we agreed to supply initial production units for the balance of the contract during first and second quarters of 2011. Based on our customer's current estimates and anticipated order flow, if this initial order proves successful, its potential purchases from us on annual basis during 2011 could total between $12 million and $20 million.

Dyeing and Finishing Equipment Segment

Prior to 2009, the manufacturing of textile dyeing and finishing machines was our principal source of revenue. We have changed our focus to the manufacture of forged rolled rings, shafts, gear rims and yaw bearings in order to meet the growing demands of China’s wind energy industry. 

In connection with our Dyeing and finishing equipment segment, despite the world economic slowdown, for the whole year of 2009, China’s gross output value of textile rose by 10.3% year in year to RMB 3.8 trillion, while the amount of clothes produced increased by 6.9% year on year to 23.75 billion units (source: China National Textile and Apparel Council, Ministry and Industry Information Technology). We believe weak overseas demand has been more than offset by strong demand within China. If the local demand for textile machinery deteriorates, we will discontinue the business and focus on the fast-growing wind components business.

Recently, we developed a new model of dyeing machine – High (Low) Temperature Airflow Dyeing Machine.  We believe that this new model of dyeing machine is highly efficient and cost effective and can provide the competitive edge to meet the most challenge of the market today.  As of September 30, 2010, we sold two units of the new dyeing machine model.

 
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Raw Materials
 
A major element of our cost of revenues is raw materials, principally steel and other metals. These metals are subject to price fluctuations, and recently these fluctuations have been significant.  In times of increasing prices, we need to try to fix the price at which we purchase raw materials in order to avoid increases in costs which we cannot recoup through increases in sales prices.  Similarly, in times of decreasing prices, we may have purchased metals at prices which are high in terms of the price at which we can sell our products, which also can impair our margins. Three major suppliers provided approximately 47% of our purchases of raw materials for the nine months ended September 30, 2010 primarily consisting of steel for the forged rolled rings and related components segment. No supplier provided more than 10% of the Company’s purchases of raw materials for the nine months ended September 30, 2009.

Restricted Assets

Regulations in the PRC permit payments of dividends by our PRC VIEs only out of retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. Subject to certain cumulative limit, a statutory reserve fund requires annual appropriations of at least 10% of after-tax profit, if any, of the relevant PRC VIE’s and subsidiary. The statutory reserve funds are not distributable as cash dividends.

Pursuant to PRC regulations, our PRC subsidiaries and VIEs require government approval in order to transfer assets, including cash, outside of the PRC, and certain transfers may be subject to a 10% tax.  As a result, the net assets of our PRC subsidiaries and VIEs are treated as restricted assets.  As of September 30, 2010 and December 31, 2009, the Company’s restricted net assets were approximately $65,516,000 and $51,652,000, respectively.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon 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 judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to bad debts, inventories, recovery of long-lived assets, income taxes, and the valuation of equity transactions. We base our estimates on historical experience and on various other assumptions that we believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Any future changes to these estimates and assumptions could cause a material change to our reported amounts of revenues, expenses, assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the financial statements

Variable Interest Entities

Pursuant to Accounting Standards Codification, we are required to include in our consolidated financial statements the financial statements of variable interest entities (“VIEs”).  The accounting standards require a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE’s residual returns. VIEs are those entities in which we, through contractual arrangements, bear the risk of, and enjoy the rewards normally associated with ownership of the entity, and therefore we are the primary beneficiary of the entity.

The Huayang Companies are considered VIEs, and we are the primary beneficiary. On November 13, 2007, we entered into agreements with the Huayang Companies pursuant to which we shall receive 100% of the Huayang Companies’ net income. In accordance with these agreements, the Huayang Companies shall pay consulting fees equal to 100% of its net income to our wholly-owned subsidiary, Green Power, and Green Power shall supply the technology and administrative services needed to service the Huayang Companies.

 
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The accounts of the Huayang Companies are consolidated in the accompanying financial statements. As VIEs, the Huayang Companies sales are included in our total sales, their income from operations is consolidated with ours, and our net income includes all of the Huayang Companies’ net income, and their assets and liabilities are included in our consolidated balance sheet. The VIEs do not have any non-controlling interest and accordingly, we did not subtract any net income in calculating the net income attributable to us. Because of the contractual arrangements, we have pecuniary interest in the Huayang Companies that require consolidation of the Huayang Companies financial statements with our financial statements.

Accounts receivable

We have a policy of reserving for uncollectible accounts based on our best estimate of the amount of probable credit losses in our existing accounts receivable.  We periodically review our accounts receivable to determine whether an allowance is necessary based on an analysis of past due accounts and other factors that may indicate that the realization of an account may be in doubt.  Account balances deemed to be uncollectible are charged to the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.

As a basis for accurately estimating the likelihood of collection has been established, we consider a number of factors when determining reserves for uncollectable accounts.   We believe that we use a reasonably reliable methodology to estimate the collectability of our accounts receivable. We review our allowances for doubtful accounts on at least a quarterly basis. We also consider whether the historical economic conditions are comparable to current economic conditions. If the financial condition of our customers or other parties that we have business relations with were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventories

Inventories, consisting of raw materials, work-in-process and finished goods, are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, we will record additional reserves for the difference between the cost and the market value. These reserves are recorded based on estimates.  We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory, if necessary. If the results of the review determine that a write-down is necessary, we recognize a loss in the period in which the loss is identified, whether or not the inventory is retained. Our inventory reserves establish a new cost basis for inventory and are not reversed until we sell or dispose of the related inventory. Such provisions are established based on historical usage, adjusted for known changes in demands for such products, or the estimated forecast of product demand and production requirements.

Property and equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are as follows:
 
 
Useful Life
Building and building improvements
 
20
 
Years
Manufacturing equipment
 
5 – 10
 
Years
Office equipment and furniture
 
5
 
Years
Vehicle
 
5
 
Years
 
The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition.

Included in property and equipment is construction-in-progress which consists of factories and office buildings under construction and machinery pending installation and includes the costs of construction, machinery and equipment, and any interest charges arising from borrowings used to finance these assets during the period of construction or installation. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use.

We examine the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable. We recognize an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value.

 
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Land use rights

There is no private ownership of land in the PRC. All land in the PRC is owned by the government and cannot be sold to any individual or company. The government grants a land use right that permits the holder of the land use right to use the land for a specified period. Our land use rights were granted with a term of 45 or 50 years.  Any transfer of the land use right requires government approval.  We have recorded as an intangible asset the costs paid to acquire a land use right. The land use rights are amortized on the straight-line method over the land use right terms.

Revenue recognition

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. We account for the product sales as a multiple element arrangement. Revenue from multiple element arrangements is allocated among the separate accounting units based on the residual method. Under the residual method, the revenue is allocated to undelivered elements based on fair value of such undelivered elements and the residual amounts of revenue allocated to delivered elements. We recognize revenue from the sale of dyeing and electric equipment upon shipment and transfer of title. The other elements may include installation and generally a one-year warranty.

Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally within a close to the date of delivery of the equipment.

Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period. For the nine months ended September 30, 2010 and 2009, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal.
 
All other product sales, including the forged rolled rings, with customer specific acceptance provisions, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.

Research and development

Research and development costs are expensed as incurred.  We incurred minimal research and development expenses in the nine months ended September 30, 2010 and 2009.  Product development expenses are included in general and administrative expenses. These costs primarily consist of cost of material used and salaries paid for the development of our products and fees paid to third parties.

Income taxes

We are governed by the Income Tax Law of the PRC and the United States. Income taxes are accounted for pursuant to accounting standards, which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. The charge for taxes is based on the results for the year as adjusted for items, which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.

Deferred tax is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit. In principle, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probably that taxable profit will be available against which deductible temporary differences can be utilized.

Deferred tax is calculated using tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it is related to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity.

Deferred tax assets and liabilities are offset when they related to income taxes levied by the same taxation authority and the Company intends to settle its current tax assets and liabilities on a net basis.

 
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Deemed preferred stock dividend

When we sell shares of convertible preferred stock at a price that is, on an “as if converted” basis, less than the market price of the underlying shares of common stock, the difference between the value of the underlying shares of common stock and the purchase price of the convertible preferred stock is treated as a deemed preferred stock dividend.  In connection with the issuance of shares of preferred stock upon exercise of warrants as a result of board approval of the issuance of series A preferred stock instead of common stock, the Company does not record a deemed preferred stock dividend since the Company issues the number of shares of series A preferred stock which are convertible into the number of shares of common stock that were issuable upon exercise.

Stock-based compensation

Stock based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively, the vesting period). The Accounting Standards Codification also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.

Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the vesting period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. The Company records compensation expense based on the fair value of the aw