10-Q 1 v034795_10q.htm Unassociated Document


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

FORM 10-Q
(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2005

o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

COMMISSION FILE NUMBER 0-31047

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
___________________________________________________________________________
(Exact Name of Registrant as Specified in Its Charter)

NEVADA
 
86-0995730
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer Identification No.)

 Central Plaza, 18 Harbour Road
Suite 3203A, 32nd Floor
Hong Kong, China
(Address of Principal Executive Offices)
(Zip Code)

(852) 2588-1228
(Registrants Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
YES x NO o

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).
YES o NO x
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of the issuers common stock as of February 14, 2006:

CLASS
 
NUMBER OF SHARES OUTSTANDING
Common Stock, par value
$0.001 per share
 
25,421,853 shares

 





CHINA ENERGY SAVINGS TECHNOLOGY, INC.
TABLE OF CONTENTS
TO QUARTERLY REPORT ON FORM 10-Q
FOR PERIOD ENDED DECEMBER 31, 2005



PART I
FINANCIAL INFORMATION
Page
Item 1.
Financial Statements
 
 
Consolidated Balance Sheets as of December 31, 2005 and September 30, 2005 (audited)
F-1
 
Consolidated Statements of Income and Other Comprehensive Income (Loss) for the Three Months Ended December 31, 2005 and 2004
F-2
 
Consolidated Statements of Shareholders’ Equity for the Period Ended December 31, 2005
F-3
 
Consolidated Statements of Cash Flows for the Three Months Ended December 31, 2005 and 2004
F-4
 
Condensed Notes to Consolidated Financial Statements
F-5
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
22
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
27
Item 4.
Controls and Procedures
27


PART II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
28
Item 1A.
Risk Factors
28
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
31
Item 3.
Defaults Upon Senior Securities
31
Item 4.
Submission of Matters to a Vote of Security Holders
31
Item 5.
Other Information
32
Item 6.
Exhibits
32
Signatures
 
33
Exhibits
 
34


(REMAINDER OF PAGE INTENTIONALLY LEFT BLANK)


 
CHINA ENERGY SAVINGS TECHNOLOGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2005 AND SEPTEMBER 30, 2005
 
A S S E T S
 
           
   
December 31,
 
September 30,
 
   
2005
 
2005
 
   
Unaudited
 
Audited
 
CURRENT ASSETS:
         
Cash
 
$
25,089,074
 
$
30,926,619
 
Accounts receivable, trade, net of allowance for doubtful
             
accounts of $768,151 as of December 31, 2005 and  
             
September 30, 2005, respectively 
   
11,406,561
   
6,471,689
 
Current maturities of notes receivable, net
   
8,833,066
   
9,744,786
 
Inventories
   
4,031,982
   
1,584,213
 
Prepaid expenses
   
2,466,686
   
1,890,688
 
Due from related party
   
122,115
   
123,602
 
Total current assets 
   
51,949,484
   
50,741,597
 
               
PLANT AND EQUIPMENT, net
   
424,596
   
443,600
 
               
OTHER ASSETS:
             
Long-term loan receivable
   
1,978,480
   
1,857,000
 
Long-term notes receivable, net
   
22,716,619
   
21,166,175
 
Other receivables
   
635,671
   
419,859
 
Other assets
   
75,400
   
77,743
 
Total other assets 
   
25,406,170
   
23,520,777
 
               
Total assets
 
$
77,780,250
 
$
74,705,974
 
               
L I A B I L I T I E S  A N D  S H A R E H O L D E R S  E Q U I T Y
 
           
CURRENT LIABILITIES:
             
Accounts payable and accrued expenses
 
$
1,358,131
 
$
1,442,931
 
Current portion note payable
   
8,369
   
11,874
 
Other payables
   
489,520
   
201,391
 
Customer deposits
   
1,969,230
   
1,858,452
 
Taxes payable
   
966,038
   
4,849,550
 
Total current liabilities 
   
4,791,288
   
8,364,198
 
               
SHAREHOLDERS’ EQUITY:
           
Common stock, $0.001 par value, 50,000,000 shares authorized,
             
24,699,753 and 24,699,753 shares issued and outstanding 
             
as of December 31, 2005 and September 30, 2005, respectively 
   
24,700
   
24,700
 
Additional paid-in capital
   
36,889,732
   
36,889,732
 
Statutory reserves
   
324,583
   
324,583
 
Deferred compensation
   
(4,025,744
)
 
(4,379,203
)
Retained earnings
   
38,174,186
   
32,082,555
 
Accumulated other comprehensive income
   
1,601,505
   
1,399,409
 
Total shareholders’ equity 
   
72,988,962
   
66,341,776
 
 Total liabilities and shareholders’ equity
 
$
77,780,250
 
$
74,705,974
 
 
 
The accompanying notes are integral part of this statement.
 
F-1

 
CHINA ENERGY SAVINGS TECHNOLOGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME (LOSS)
FOR THE THREE MONTHS ENDED DECEMBER 31, 2005 AND 2004

       
Restated
 
   
Three Months Ended
 
Three Months Ended
 
   
December 31,
 
December 31,
 
   
2005
 
2004
 
   
Unaudited
 
Unaudited
 
REVENUES
 
$
10,696,397
 
$
11,708,690
 
               
COST OF GOOD SOLD
   
4,161,941
   
4,891,408
 
               
GROSS PROFIT
   
6,534,456
   
6,817,282
 
               
OPERATING EXPENSES
             
Operating expense 
   
467,164
   
612,700
 
Selling, general and administrative expenses 
   
652,119
   
971,839
 
Total Operating Expenses
   
1,119,283
   
1,584,539
 
               
INCOME FROM OPERATIONS
   
5,415,173
   
5,232,743
 
               
OTHER INCOME (EXPENSE)
             
Interest income 
   
675,847
   
348,179
 
Interest expense 
   
-
   
(514
)
Other income (expense) 
   
611
   
(2,277
)
Total Other Income
   
676,458
   
345,388
 
               
INCOME BEFORE INCOME TAXES AND MINORITY INTEREST
   
6,091,631
   
5,578,131
 
               
LESS PROVISION FOR INCOME TAXES
   
-
   
-
 
               
INCOME BEFORE MINORITY INTEREST
   
6,091,631
   
5,578,131
 
               
MINORITY INTEREST
   
-
   
2,719,853
 
               
NET INCOME
   
6,091,631
   
2,858,278
 
               
OTHER COMPREHENSIVE INCOME (LOSS):
             
Foreign currency translation adjustment 
   
202,096
   
-
 
COMPREHENSIVE INCOME
 
$
6,293,727
 
$
2,858,278
 
               
Net income per share - basic and diluted
 
$
0.25
 
$
0.19
 
               
Weighted average number of shares outstanding - basic and diluted
   
24,699,753
   
14,881,540
 
 
 
The accompanying notes are integral part of this statement.
 
F-2

 
CHINA ENERGY SAVINGS TECHNOLOGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
FOR THE PERIOD ENDED DECEMBER 31, 2005
 
 
                           
Accumulated
     
           
Additional
         
Unappropriated
 
other
     
   
Number
 
Common
 
Paid-in
 
Statutory
 
Deferred
 
Retained
 
comprehensive
     
   
of shares
 
stock
 
capital
 
Reserves
 
Compensation
 
Earnings
 
income (loss)
 
Totals
 
BALANCE, September 30, 2004, audited
   
12,968,401
 
$
12,968
 
$
8,655,339
 
$
324,583
 
$
   
$
9,666,676
 
$
3,340
 
$
18,662,906
 
Stock issued for the
acquisition of additional 
                                                 
15% investment in Starway
Management Limited 
   
3,346,100
   
3,346
   
6,102,341
                           
6,105,687
 
Net income
                                 
2,858,278
         
2,858,278
 
Stock issued for services
   
477,683
   
478
   
5,327,262
         
(4,554,945
)
             
772,795
 
BALANCE, December 31, 2004, unaudited
   
16,792,184
   
16,792
   
20,084,942
   
324,583
   
(4,554,945
)
 
12,524,954
   
3,340
   
28,399,666
 
Stock issued for the
acquisition of additional 
                                                 
35% investment in Starway
Management Limited 
   
7,807,569
   
7,808
   
15,808,193
                           
15,816,001
 
Stock issued for services
   
100,000
   
100
   
996,597
         
175,742
               
1,172,439
 
Foreign currency translation adjustments
                                       
1,396,069
   
1,396,069
 
Net income
                                 
19,557,601
         
19,557,601
 
BALANCE, September 30, 2005, audited
   
24,699,753
   
24,700
   
36,889,732
   
324,583
   
(4,379,203
)
 
32,082,555
   
1,399,409
   
66,341,776
 
Net income
                                 
6,091,631
         
6,091,631
 
Amortization of deferred compensation
                           
353,459
               
353,459
 
Foreign currency translation adjustments
                                       
202,096
   
202,096
 
BALANCE, December 31, 2005, unaudited
   
24,699,753
 
$
24,700
 
$
36,889,732
 
$
324,583
 
$
(4,025,744
)
$
38,174,186
 
$
1,601,505
 
$
72,988,962
 
 
 
The accompanying notes are integral part of this statement.
 
F-3

 
CHINA ENERGY SAVINGS TECHNOLOGY, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED DECEMBER 31, 2005 AND 2004
 
           
Restated
 
     
December 31,
   
December 31,
 
     
2005
   
2004
 
     
Unaudited
   
Unaudited
 
               
CASH FLOWS FROM OPERATING ACTIVITIES:
             
Net income
 
$
6,091,631
 
$
2,858,278
 
Adjustments to reconcile net income to cash
             
provided by (used in) operating activities:
             
Minority interest income 
         
2,719,853
 
Depreciation and amortization 
   
372,463
   
15,808
 
Stock issued for services 
         
772,795
 
Change in operating assets and liabilities:
             
(Increase) decrease in assets:
             
Accounts receivable 
   
(4,934,872
)
 
(487,315
)
Inventories 
   
(2,447,769
)
 
9,748
 
Prepaid expenses 
   
(575,998
)
 
388,056
 
Amount due from related parties 
   
1,487
   
101,290
 
Other receivables 
   
(215,812
)
 
(194,788
)
Long-term notes receivable, net 
   
(760,204
)
 
776,965
 
Other assets 
   
2,343
       
Increase (decrease) in liabilities:
             
Accounts payable and accrued expenses 
   
(84,800
)
 
(529,374
)
Other payable 
   
288,129
   
210,422
 
Customer deposits 
   
110,778
   
1,116,495
 
Tax payable 
   
(3,883,512
)
 
631,923
 
Net cash (used in) provided by operating activities
   
(6,036,136
)
 
8,390,156
 
               
CASH FLOWS FROM INVESTING ACTIVITIES:
             
Purchase of equipment
         
(3,013
)
Net cash used in investing activities
         
(3,013
)
               
CASH FLOWS FROM FINANCING ACTIVITIES:
             
Payments on notes payable
   
(3,505
)
 
(8,215
)
Proceeds from notes payable
         
5,080
 
Net cash (used in) financing activities
   
(3,505
)
 
(3,135
)
               
EFFECT OF EXCHANGE RATE ON CASH
   
202,096
       
               
(DECREASE) INCREASE IN CASH
   
(5,837,545
)
 
8,384,008
 
               
CASH, beginning of period
   
30,926,619
   
18,442,862
 
               
CASH, end of period
 
$
25,089,074
 
$
26,826,870
 
               
               
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
             
               
Cash paid for interest expense
 
$
   
$
514
 
               
NON-CASH TRANSACTIONS:
             
Stock issued to acquire additional interest in Starway
             
Management Limited
 
$
   
$
6,095,901
 
               
Stock issued for services
 
$
   
$
5,327,740
 
 
The accompanying notes are integral part of this statement.
 
F-4

 
CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Organization

Organization

On August 23, 2004, China Energy Savings Technology, Inc. (the “Company”) formally changed its name from Rim Holdings Inc. to China Energy Savings Technology, Inc.

On June 30, 2004 (“the Closing Date”) Rim Holdings Inc., a Nevada corporation (“Rim”) and Eurofaith Holdings, Inc., a British Virgin Islands Corporation (“Eurofaith”), entered into a Stock Purchase Agreement (the Eurofaith Stock Purchase Agreement”). Pursuant to the Eurofaith Stock Purchase Agreement, Rim acquired 50% of the outstanding shares of Starway Management Ltd., a British Virgin Islands company (“Starway”) from Eurofaith (the “Acquisition”). The purchase price for such stock was $120,000,000 payable by Rim’s issuance of a convertible promissory note on the Closing Date. The Note's Maturity Date was December 31, 2004.  The Interest Rate was 5% per annum. The note may be convertible into 223,073,380 shares of Rim’s common stock upon maturity at the discretion of Rim. Eurofaith may also convert at any time prior to the maturity. On June 30, 2004, the fair value of the convertible note payable was discounted to the fair value of the equity interest acquired of $6,633,440 which is 50% of the net book value of Starway as December 31, 2003. On August  25, 2004 a 1 for 20 reverse split reduced the outstanding shares to 887,048.  The next day, on August 26, 2004 Eurofaith converted the note and received 11,153,669 shares post-split shares (223,073,380 pre split). Of these shares, 6,900,000 were transferred to New Solomon Consultants Limited. (“New Solomon”), New Solomon is 55% owned by Mr. Sun Li (through Mr. Lis sole ownership of Able Stars Enterprises Ltd., which owns 55% of New Solomon), who owned 50% of Eurofaith and who became the Chairman and CEO of the Company.  Thus,  after the acquisition on August 26, 2004 New Solomon owned 6,900,000 shares of common stock (55.9%) of the Issuer.
 
Immediately after the closing of this transaction, Rim redeemed 1,000,000 shares pre-split shares (50,000 shares post-split) of its common stock from Christina M. Strauch in exchange for all of the shares of Rimmer Computer, Inc., an Arizona corporation (“Rimmer”). The following is a summary of the shares issued due to the recapitalization:
   
No. of Shares
 
   
Issued
 
Shares issued to current stock holders
     
in connection with recapitalization
   
1,234,632
 
Shares issued to Eurofaith due to note conversion
   
11,153,669
 
Shares redeemed from Christina Strauch
   
(50,000
)
Net shares issued due to recapitalization
   
12,338,301
 
 
Prior to the transaction, Rim was a holding company holding all of the shares of Rimmer. Rimmer was an approved technical service provider for computer hardware and software system manufacturers. All of Rimmer’s customers were located in the Phoenix, Arizona area. Since the closing, Rim’s primary operations consist of the operations of Starway.

As a result, the transaction was treated for accounting purposes as a recapitalization by the accounting acquirer Starway Management Limited. The stock issuance represented 50% of the issued and outstanding stock of Starway Management Limited at the time of issuance. The acquisition of Starway Management Limited by the Company was accounted for as a recapitalization of Starway Management Limited, pursuant to which the accounting basis of Starway Management Limited continued unchanged subsequent to the transaction date.
 
F-5

 
CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Organization, (continued)

Organization (continued)

The historical financial statements of the Company relate to Starway Management Limited and its subsidiaries Shenzhen Dicken Industrial Development Limited and Shenzhen Dicken Technology Development Limited. The financial statements have been restated to reflect the recapitalization as if the transaction happened as of January 1, 2002.

On November 17, 2004, the Company acquired an additional 15% of Starway Management Limited from Eurofaith in exchange for 3,346,100 new shares of the Company’s Common Stock, or the same exchange ratio as it had paid for the first 50% of Sarway to bring its stock ownership to 65% as of December 31, 2004, as further described in note 14. On February 1, 2005, the Company acquired the remaining 35% of Starway Management Limited, as described in note 14, from Sky Beyond Investments Limited and Starway Management Limited became a wholly owned subsidiary of the Company at that time.

Starway was incorporated in the British Virgin Islands on September 15, 1998. Starway owns all of the equity interest in Shenzhen Dicken Industrial Development Limited, a company incorporated in the People’s Republic of China on November 20, 1996 (SDID), which in turn owns all of the equity interest in Shenzhen Dicken Technology Development Limited, a company incorporated in the People’s Republic of China on November 9, 1999 (SDID). In 2003, Eurofaith, the shareholder of SDID exchanged 100% of the common shares of SDID for 100 shares of Starway.
 
Activities

Starway, through its two subsidiaries SDTD and SDID, is a Peoples Republic of China-based marketer, distributor and manufacturer of energy saving products for use in commercial and industrial settings. SDID is a foreign-owned enterprise and responsible for the operation and sales of its products. SDTD is a wholly-owned subsidiary of SDID and is a limited liability company incorporated in the PRC and is responsible for the development of energy saving projects of Shenzhen Dicken Group. The Company through its subsidiaries mainly sells their products within the People’s Republic of China.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation

The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The accompany consolidated financial statements include the accounts of Starway Management Limited, Shenzhen Dicken Technology Development Limited and Shenzhen Dicken Industrial Development Limited, (collectively the “Company”). All material intercompany transactions and balances have been eliminated in the consolidation.


 
F-6

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Summary of significant accounting polices, (continued)

Use of Estimates

In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reported period. Actual results could differ from these estimates.

Cash and Cash Equivalents

For purposes of the cash flow statements, the Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.
 
Notes Receivable

The Company carries its notes receivable at the net present value of the notes, net of allowance for doubtful accounts. The Company uses the best lending rate in China as of the quarter ending in determining the net present value of notes receivable outstanding on energy savings sharing contracts at the time the contract was entered into. In accordance with APBO 21, Interest on Receivables and Payables, the Company believes that using this rate reflects what a company would be charged on this type of transaction if the funds were borrowed from an independent lender. The interest rates used to discount the notes receivable are reviewed on a monthly basis compared to the current market rates to determine if the rates used are still applicable. The interest rates used in determining this discount may change if the Company determines that a permanent decline in interest rates has occurred.

Inventory

Inventory is stated at the lower of cost or market value, cost being determined on a first-in, first-out (FIFO) method.

Allowance for doubtful accounts

The Company reviews its accounts and notes receivable on a monthly basis to determine if the allowance for bad debts is sufficient. As of December 31, 2005 and September 30, 2005, the allowance for doubtful accounts amounted to $768,151 and $768,151, respectively.

 
F-7

 
 
CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Summary of significant accounting polices, (continued)

Plant and Equipment

The Company’s plant and equipment are stated at cost. Depreciation is provided over the estimated useful lives of the respective assets on a straight-line basis from five to fifteen years.

Intangibles

Under the Statement of Accounting Standards (“SFAS”) No. 142,“Goodwill and Other Intangible Assets”, all goodwill and certain intangible assets determined to have indefinite lives will not be amortized but will be tested for impairment at least annually. Intangible assets other than goodwill will be amortized over their useful lives of 10 years and reviewed for impairment in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”

Impairment of Long-Lived Assets

Per SFAS No. 144, long-lived assets will be analyzed annually for indications of impairment. Impairment of long-lived assets is assessed by the Company whenever there is an indication that the carrying amount of the asset may not be recovered. Recoverability if these assets are determined by comparing the forecasted undiscounted cash flows generated by those assets to the assets' net carrying value. The amount of impairment loss, if any, is measured as the difference between the net book value of the assets and the estimated fair value of the related assets.

The Company evaluates the recoverability of long-lived assets by measuring the carrying amount of the assets against the estimated undiscounted future cash flows associated with them. At the time such flows of certain long-lived assets are not sufficient to recover the carrying value of such assets, the assets are adjusted to their fair values.

Revenue and Deferred Revenue Recognition

The Company recognizes revenue when all four of the following criteria are met: (1) persuasive evidence has been received that an arrangement exists; (2) delivery of the products and/or services has occurred; (3) the selling price is fixed or determinable; and (4) collectibility is reasonably assured. The Company follows the provisions of SAB No. 104 which sets forth guidelines in the timing of revenue recognition based upon factors such as passage of title, installation, payments and customer acceptance. Any amounts received prior to satisfying the Company’s revenue recognition criteria is recorded as deferred revenue.

 
F-8

 
CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Summary of significant accounting polices, (continued)

Revenue and Deferred Revenue Recognition (continued)

The Company has two types of contracts for its product sales: energy savings sharing contracts and equipment sales contracts.

(a)  
Energy savings sharing

Under this arrangement, the customers do not need to bear the initial cost of the energy saving equipments. They have to make energy savings sharing contracts with the Company which is entitled to receive a share of the aggregated amount of estimated energy saving within a specified period of the arrangement.

The Company’s revenue arising from sales of energy savings equipments and notes receivable under this arrangement is recognized when:

1.  
the agreement of energy savings sharing is signed by both parties;
2.  
the original estimated cost savings can be ascertained; and
3.  
the equipment is installed and tested for an average rate of energy savings.

The receipt of each installment made by the customer during the period of the contract will be recognized as the repayments of the outstanding notes receivable when the amount of energy savings can be quantified and agreed by both parties. The excess amount received of the original estimated savings stated in the contract will be recognized as interest income by the Company.

Effective April 2005, the Company changed the terms of its energy saving contracts to include a minimum interest rate that will be earned on customer contracts. If the amount of energy savings does not meet this minimum rate of return, the customer is now required to pay the minimum rate of return stated in the contract.

(b)  
Outright equipment sales

Under this arrangement, the Company’s customer has to pay the cost of the energy saving equipments and then they can keep all benefits of energy saving to them.

Revenue arising from the sales of the energy saving equipment to customers is only recognized when the goods are taken and accepted by the customer and the customer assumes all the related risks and rewards of ownership. Revenue represents the sales value of goods to customers after allowances for goods returned, excludes value added tax (“VAT”) and is after deduction of any trade discounts.


 
F-9

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Summary of significant accounting polices, (continued)

Product Development Costs

Product development costs incurred in the process of developing product improvements and enhancements or new products are charged to expense as incurred. Statement of Financial Accounting Standards (“SFAS”) No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, requires capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on the Company’s product development process, technological feasibility is established upon the completion of a working model. Costs incurred by the Company between the completion of the working model and the point at which the product is ready for general release have been insignificant.

Foreign Currency Translation

The functional currency of the Company is the Chinese Renminbi. The financial statements of the Company are translated to United Stated dollars using year-end exchange rates as to assets and liabilities and average exchange rates as to revenues and expenses. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. Net gains and losses resulting from foreign exchange translations are included in the statements of operations and stockholders' equity as other comprehensive income.

This quotation of the exchange rates does not necessarily imply free convertibility of RMB to other foreign currencies. All foreign exchange transactions continue to take place either through the People’s Bank of China or other banks authorized to buy and sell foreign currencies at the exchange rate quoted by the People’s Bank of China.

Approval of foreign currency payments by the People’s Bank of China or other institutions requires submitting a payment application form together with invoices, shipping documents and signed contracts.

Translation adjustments resulting from this process are included in accumulated other comprehensive income in the consolidated statement of shareholders’ equity and amounted to $1,601,505 and $1,399,409 as of December 31, 2005 and September 30, 2005, respectively. The balance sheet amounts with the exception of equity at December 31, 2005 were translated at 8.06 RMB to $1.00 USD compare to 8.07 to $1.00 USD at September 30, 2005. The equity accounts were stated at their historical rate. The average translation rate of 8.07 RMB for the three months ended December 31, 2005 was applied to income statement accounts.

Comprehensive Income (Loss)

This foreign currency translation gain or loss resulting from the translation of the financial statements expressed in Chinese Renminbi to United States dollars is reported as other comprehensive income (loss) in the statement of income and stockholders’ equity.


 
F-10

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Summary of significant accounting polices, (continued)

Income Taxes

The Company accounts for income taxes under the Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“Statement 109”).

Under Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Starway is organized in the British Virgin Islands and both SDID and SDTD are organized in the Peoples Republic of China and no tax benefit is expected from the tax credits in the future. The Company located its factories in a special economic region in China. This economic region allows foreign enterprises a two-year income tax exemption and a 50% income tax reduction for the following three years. The Company's wholly owned subsidiary, SDID, was approved as a wholly owned foreign enterprise in 2004. The Company has income tax exemption for 2004 and 2005 and 50% income tax reduction for 2006, 2007 and 2008.
 
Fair Value of Financial Instruments

The carrying amounts of the Company’s financial instruments including accounts receivable, stockholder loans and notes payable approximate fair value due to the relatively short period to maturity of these instruments.

The fair value of short-term and long-term notes receivable was determined using a discounted cash flow analysis based on the Company’s borrowing rate. At December 31, 2005 and September 30, 2005, the carrying value of these notes approximated their fair value.

Earnings Per Share

The Company reports earnings per share in accordance with the provisions of SFAS No. 128, “Earnings Per Share.” SFAS No. 128 requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average common shares outstanding during the period. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock.


 
F-11

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Summary of significant accounting polices, (continued)

Earnings Per Share, (continued)

On February 1, 2005, the Company acquired the remaining 35% interest (the Acquisition”) in Starway Management Limited (“Starway”) from Sky Beyond Investments Limited (“Sky Beyond”) by issuing a total of 7,807,569 shares of common stock of the Company to Sky Beyond and its assignees. Sky Beyond had acquired the 35% interest in Starway from Golden Resorts Group Limited (formerly known as “Meditech Group Company Limited”). However, management of the Company then learned that the stock sale between Sky Beyond and Golden Resorts Group Limited was subject to approval by the shareholders of Golden Resorts. On July 28, 2005, the shareholders of Golden Resorts approved the sale of the Starway interest to Sky Beyond. In the financial statements of the Company as of March 31, 2005, the Company took a conservative approach in reflecting the acquisition of Starway and did not record the additional earnings and additional paid in capital attributed to the acquisition. Since the transaction has been approved, the Company has reflected the earnings and additional paid-in-capital from February 1, 2005 in its financial statements as of September 30, 2005.

Concentrations and Credit Risks

During 2005 and 2004, 100% of the Company’s sales were to companies located in the PRC. At December 31, 2005 and September 30, 2005, all the Company’s assets were located in the PRC. For the three months ended December 31, 2005, approximately $1.9 million or approximately 19% of the total sales revenue was generated from energy savings sharing contracts with one customer. There was no revenue generated from energy savings sharing contract for the three months ended December 31, 2004.

The Company’s operations may be adversely affected by significant political, economic and social uncertainties in China. Although the Chinese government has pursued economic reform policies in the past, there is no assurance that the Chinese government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption or unforeseen circumstances affect China’s political, economic and social conditions. There is also no guarantee that the Chinese government’s pursuit of economic reforms will be consistent or effective.

Cash in Bank Accounts

Cash includes cash on hand and demand deposits in accounts maintained with state-owned banks within the People’s Republic of China. The total cash balance in state-owned banks at December 31, 2005 and September 30, 2005 amounted to $24,962,957 and $30,896,309, respectively, of which 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.


 
F-12

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Summary of significant accounting polices, (continued)

Recently issued accounting pronouncements

In October 2005, FASB Staff Position (FSP) FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period” was issued. This FSP concluded that rental costs associated with ground or building operating leases that are incurred during a construction period should be expensed. The guidance in the FSP is required to be applied to the first reporting period beginning after December 15, 2005. The Company’s adoption of this pronouncement is not expected to have a material impact on the Company’s financial position or results of operations.
 
Note 3 - Condensed financial statements and condensed footnotes
 
The interim condensed consolidated financial statements presented herein have been prepared by the Company and include the unaudited accounts of the Company and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in the consolidation.

These condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in financial statements presented in accordance with generally accepted accounting principles have been condensed or omitted. Management of the Company believes the disclosures made are adequate to make the information presented not misleading.

The condensed consolidated financial statements should be read in conjunction with the Company’s audited financial statements for the period ended September 30, 2005 and notes thereto included in the Company’s Form 10-K dated December 19, 2005.

In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position of the Company as of December 31, 2005 and the results of operations for the three months ended December 31, 2005 and 2004, respectively. Interim results are not necessarily indicative of full year performance because of the impact of seasonal and short-term variations.


 
F-13

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 4 - Accounts receivable

Accounts receivable as of December 31, 2005 and September 30, 2005 consisted of the following:

   
December 31,
 
September 30,
 
   
2005
 
2005
 
   
Unaudited
 
Audited
 
Accounts receivable
 
$
12,174,712
 
$
7,239,840
 
Less: allowance for
             
doubtful accounts
   
768,151
   
768,151
 
Totals
 
$
11,406,561
 
$
6,471,689
 

 
Note 5 - Notes receivable

The notes receivable represent amounts due on energy savings sharing contracts. The Company carries its notes receivable at the net present value of the discounted contract price. The notes receivable are secured by the related equipment. The notes receivable amounted to the following:
 

   
December 31,
 
September 30,
 
   
2005
 
2005
 
   
Unaudited
 
Audited
 
Notes receivable
 
$
31,549,685
 
$
30,910,961
 
Less:
             
Current portion of notes receivable
   
8,833,066
   
9,744,786
 
Totals
 
$
22,716,619
 
$
21,166,175
 
 
The following table represents as of December 31, 2005 the estimated principal collections on notes receivable for the next five years:
 

Period Ending
 
 
 
December 31,
 
Amount
 
2006
 
$
8,833,066
 
2007
   
7,860,342
 
2008
    6,154,814  
2009
    5,328,993  
2010
    3,372,470  
 

 
F-14

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 6 - Inventories

Inventories as of December 31, 2005 and September 30, 2005 consisted of the following:

   
December 31,
 
September 30,
 
   
2005
 
2005
 
   
Unaudited
 
Audited
 
Raw materials
 
$
1,517,947
 
$
719,530
 
Work in progress
         
1,937
 
Finished goods
   
2,514,035
   
862,746
 
Totals
 
$
4,031,982
 
$
1,584,213
 
 
Note 7 - Prepaid expenses

Prepaid expenses at December 31, 2005 and September 30, 2005 amounted to $2,466,686 and $1,890,688, respectively. Prepaid expenses represent advances to suppliers on inventory purchases.

Note 8 - Plant and equipment

Plant and equipment as of December 31, 2005 and September 30, 2005 are summarized as follows:

   
December 31,
 
September 30,
 
   
2005
 
2005
 
   
Unaudited
 
Audited
 
Building
 
$
419,373
 
$
419,373
 
Office equipment
   
87,877
   
86,613
 
Furniture and fixtures
   
42,328
   
42,328
 
Plant, machinery and equipment
   
81,981
   
81,981
 
Vehicle
   
152,024
   
152,024
 
     
783,583
   
782,319
 
Less: accumulated depreciation
   
358,987
   
338,719
 
Plant and equipment, net
 
$
424,596
 
$
443,600
 

Depreciation expense for the three months ended December 31, 2005 and 2004 amounted to $$20,268 and $15,808, respectively.


 
F-15

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
Note 9 - Related party transactions
 
As of December 31, 2005, the amount due from related parties was $122,115. A majority of this amount was generated from making cash advances to the shareholders for ordinary business expenses. In addition, certain shareholders had collected payments on receivables on the Company’s behalf from the customers and those payments had not been repaid to the Company by December 31, 2005. These amounts are unsecured, interest free and have no fixed terms of repayment.
 
Note 10 - Customer deposits

The Company requires its customers to deposit monies with the Company when they place an order for their products. The Company does not pay interest on these amounts in customer deposits which amounted to $1,969,230 and $1,858,451 as of December 31, 2005 and September 30, 2005, respectively.

Note 11 - Taxes payable
 
Taxes payable at December 31, 2005 and September 30, 2005 consisted of the following:
 
Taxes Payable

   
December 31,
 
September 30,
 
 
 
2005
 
2005
 
 
 
Unaudited
 
Audited
 
Urban maintenance and
         
construction tax
 
$
8,750
 
$
43,925
 
Education tax
   
1,099
   
5,523
 
Value added tax
   
956,189
   
4,800,102
 
Totals
 
$
966,038
 
$
4,849,550
 
 

 
F-16

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
Note 11 - Taxes payable, (continued)
 
Provision for Income Taxes (continued)
 
The following table reconciles the U.S. Statutory rates to the Company’s effective tax rate:

   
December 31,
 
   
2005
 
2004
 
U.S. Statutory rates
   
34.0
%
 
34.0
%
Foreign income not recognized in USA
   
(34.0
)
 
(34.0
)
China income taxes
   
-
   
17.0
 
               
Totals
   
-
%
 
17.0
%

The Company’s factories are located in a special economic region in China. This economic region allows foreign enterprises to take a two-year income tax exemption and a 50% income tax reduction for the following three years. The Company’s wholly-owned subsidiary, SDID, was approved as a wholly-owned foreign enterprise in 2004. The Company has income tax exemption through December 31, 2005 and 50% income tax reduction for the years ending September 30, 2006, 2007 and 2008.

The estimated tax savings for the three months ending December 31, 2005 amounted to $979,032. The net effect on earnings per share if the income tax had been applied would decrease earnings per share from $0.25 to $0.19.

The Company has a net operating loss carry forward of $9,946,234 for US income tax purposes that will expire during the year 2025. The Company has recorded a valuation allowance for the entire amount of the loss carry forward. Since the Company’s main operations are located in the PRC and any income subject to US income taxes will be dependent upon the Company having operations in the US or other US taxable events will have to occur. Since the Company is not sure at this time that the Company will be able utilize the tax benefits of this operating loss management has decided to record a valuation allowance for the entire amount of the operating loss.

Note 12 - Commitments and contingencies 

Operating Leases
 
The Company leases its facilities under long term, non-cancelable operating lease agreements expiring through June 2009. The non-cancelable operating lease agreements provide that the Company pays certain operating expenses applicable to the leased premises. The Company leased a new office space in Hong Kong during the last quarter of 2005. The lease is for twelve months expiring in September 2006 at a monthly rental rate of $7,800.

Total rent expense for the three months ended December 31, 2005 and 2004 amounted to $17,397 and $36,719, respectively.
 
F-17


CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 12 - Commitments and contingencies, continued 

As of December 31, 2005, the future minimum annual lease payments required under the operating leases for the next five years are as follows:

Period Ending
     
December 31,
 
Amount
 
2006
   
108,117
 
2007
   
58,436
 
2008
   
58,436
 
2009
   
40,580
 
 
Note 13 - Equity incentive plan

On September 8, 2004, the Company adopted the China Energy Savings Technology, Inc. 2004 Equity Incentive Plan (the “Plan”). The purpose of this plan is to provide incentives to attract, retain and motivate eligible persons whose current and potential contributions are important to the success of the Company by offering them an opportunity to participate in the Company’s future performance through awards of Options, the right to purchase common stock and stock bonuses. A total of 1,200,000 shares of common stock have been registered with the Securities and Exchange Commission (the “SEC”) under this Plan pursuant to a Registration statement on form S-8 filed with the SEC on September 17, 2004.

On September 17, 2004, the Company issued 10,000 shares to non-employee consultants and 620,000 shares of its common stock to certain qualifying employees at $12.70 per share. The total shares were valued at $8,001,000, based upon the closing price of the stock at the date the shares were issued of $12.70 per share. The stock is fully vested.

The Company accounts for its employee stock option grants in accordance with the fair value provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). SFAS 123 established a fair-value-based method of accounting for stock-based compensation plans. Pursuant to the transition provisions of SFAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (SFAS 148), the Company has elected the prospective method and will apply the fair value method of accounting to all equity instruments issued to employees. As of September 30, 2004, total stock based compensation expense amounted to $7,874,000.
 
 
F-18

 

CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13 - Equity incentive plan, (continued)

Compensation expense related to stock options granted to non-employees is accounted for under Statement of Financial Accounting Standards No. (SFAS) 123, “Accounting for Stock-Based Compensation” and Emerging Issues Task Force (EITF) 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in conjunction with Selling, Goods, or Services,” which require entities to recognize an expense, based on the fair value of the related awards. As of September 30, 2005 and 2004, total stock compensation to non-employees amounted to $996,697 and $127,000, respectively.

During October and November 2004, the Company issued 470,000 shares to non-employee consultants of its common stock at $11.00 and $13.15 per share. The total shares were valued at $5,256,000, based upon the closing price of the stock at the date the shares were issued.

On April 15, 2005, the Company issued to non-employee consultants and an employee 100,000 shares  of its common stock at $10.00 per share as compensation for services performed. The total shares were valued at $996,697.

Note 14 - Shareholders’ equity
 
Stock Issuances
 
On November 17, 2004, the Company completed an acquisition of an additional 15% interest in Starway. Prior to the acquisition, the Company owned 50% of the outstanding shares of capital stock of Starway. After the acquisition, the Company owns a total of 65% of the outstanding shares of Starway capital stock. The Company acquired the additional 15% interest in Starway from Eurofaith. The sole director of Eurofaith is also a director and Corporate Secretary of the Company. The Company’s former CEO, Mr. Sun Li then owned 50% of Eurofaith and was the controlling shareholder of New Solomon, the Company’s principal shareholder.

The Company acquired the 15% interest in Starway by issuing a total of 3,346,100 shares of common stock of the Company. The amount of consideration given by the Company for the acquisition was determined with reference to the acquisition of shares of Starway capital stock as reported in the Company’s Current Report on Form 8-K filed on June 30, 2004, as amended by a Form 8-K/A filed on August 20, 2004. The closing of the Acquisition (the “Closing”) occurred on November 17, 2004 (the “Closing Date”). The sole consideration for the Acquisition was common stock of the Company.

In accordance with SFAS 141, the Company is required to record the acquisition of a minority interest in accordance with purchase accounting. However entities that are under common control are required to record the acquisition of the assets and liabilities transferred at their carrying amounts. Due to the common majority ownership in the Company by New Solomon and Eurofaith, by Sun Li who also controls New Solomon,  the Company and Eurofaith are deemed to be under common control in accordance with SAB No. 47. Due to the common control element in accordance with SFAS 141 the Company has recorded the 15% acquisition from Eurofaith at historical cost value of $6,095,901.

During November and December 2004, the Company issued 7,683 shares of common stock for legal services and director fees. The total shares were valued at $71,740.

F-19



CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
Note 14 - Shareholders’ equity, (continued)
 
Stock Issuances (continued)
 
The Company acquired the remaining 35% interest (the “Acquisition”) in Starway Management Limited (“Starway”) from Sky Beyond Investments Limited (“Sky Beyond”) on February 1, 2005 by issuing a total of 7,807,569 shares of common stock of the Company to Sky Beyond and its assignees. Sky Beyond had acquired the 35% interest in Starway from Golden Resorts Group Limited (formerly known as “Meditech Group Company Limited”). The amount of consideration given by the Company for the Acquisition was determined with reference to the acquisitions of the 50% and subsequently the 15% interest in Starway as reported in the Companys Form 8-K filed on June 30, 2004 and November 18, 2004, respectively. The closing of the Acquisition (the “closing”) occurred on February 1, 2005 and the Company owns 100% of Starway after the Acquisition.

Preferred Stock
 
The Company has 10,000,000 shares of preferred stock authoized $.001 par value per share. As of December 31, 2005, there was no preferred stock issued and outstanding.
 
Common Stock
 
As of December 31, 2005, the Company had 24,418,853 common shares outstanding of which 719,100 shares of common stock was inadvertently issued by the transfer agent. The Company is in the process of having the shares cancelled and reissued in the correct amounts. The shares of common stock that should be outstanding at December 31, 2005 is 24,699,753.
 
Statutory Reserves and Restricted Retained earnings
 
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 Peoples Republic of China (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. Appropriations to the statutory public welfare fund are at 5% to 10% of the after tax net income determined in accordance with the PRC GAAP.

The statutory public welfare fund is established for the purpose of providing employee facilities and other collective benefits to the employees and is non-distributable other than in liquidation. Appropriations to the discretionary surplus reserve are made at the discretion of the Board of Directors.

Note 15 - Restatement

The Company had restated the financial statements for the period ended December 31, 2004 in order to include information regarding the stock issuance of 470,000 shares in the amount of $5,256,000 to consultants and other service providers. The effect of the restatement on the Company’s previously released consolidated income statements was a reduction of net income of $772,795 for the three months ended December 31, 2004. The effect on earnings per share is to reduce earnings per share from $0.25 as previously reported to $0.19.


F-20



CHINA ENERGY SAVINGS TECHNOLOGY, INC.
AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16 - Subsequent event
 
On January 17, 2006, the Company entered into a placement agreement with Empire Financial Group, Inc. (the “Placement Agent”) in order to raise $50 million through a private placement of the Company’s preferred stock. The proceeds from the private placement will be used to finance acquisitions of new infrastructure and energy ventures. The Placement Agent will earn a placement fee of 8% of the aggregate purchase price of the preferred stock. In addition, at the closing of the sale of the preferred shares of stock, the Company will issue the Placement Agent warrants to purchase shares of common stock in the Company in an amount equal to 8.0% of the total amount raised. The warrants shall be exercisable at the price paid for any common stock sold in the offering.
 
On January 20, 2006, the Company filed two Form S-3 registration statements with the United States Securities and Exchange Commission (the “SEC”) under which the Company intends to register 10,000,000 shares of its Common Stock by itself, and 6,050,000 additional shares by New Solomon Consultants Limited, principal stockholder of the Company.

The independent auditors of the Company and the Company itself were advised by the SEC on January 31, 2006 and February 9, 2006 respectively that the SEC is conducting an informal and non public inquiry in the “Matter of China Energy Savings Technology, Inc”, and requested that the Company and its auditors furnish certain documents. The Company intends to fully cooperate with these inquiries and supply all available materials requested.
 
 
F-21


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

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and related notes thereto.
 
OVERVIEW

We are a Nevada corporation headquartered in Hong Kong, China that invests in, develops, markets, distributes and manufactures energy saving products for use in commercial and industrial settings. Since February 2005 we owned 100% of Starway Management Limited, a British Virgin Islands corporation (“Starway”) which owns all of the equity interests in Shenzhen Dicken Industrial Development Limited, a company incorporated in the Republic of China on November 20, 1996 (“SDID”) which, in turn, owns all of the equity interest in Shenzhen Dicken Technology Development Limited, a company incorporated in the Republic of China on November 9, 1999 (“SDTD”). SDID and SDTD develop, market distribute and manufacture energy saving products for use in commercial and industrial settings in China.
 
RESTATEMENT DECEMBER 31, 2004

The Company had restated the financial statements for the period ending December 31, 2004 in order to include information regarding the stock issuance of 470,000 shares in the amount of $5,256,000 to consultants and other service providers. The effect of the restatement on the Company’s previously released consolidated income statements was a reduction of net income of $772,795 for the three months ended December 31, 2004. The effect on earnings per share was to reduce earnings per share from $0.25 as previously reported to $0.19. The December 31, 2004 amounts discussed in this 10Q reflect the restated amounts.

CRITICAL ACCOUNTING POLICIES

Our management’s discussion and analysis of its financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Our financial statements reflect the selection and application of accounting policies which require management to make significant estimates and judgments. See note 1 to the Company’s consolidated financial statements, “Summary of Significant Accounting Policies.” Our management bases their estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ substantially from these estimates under different assumptions or conditions. We believe that the following reflect the more critical accounting policies that currently affect our financial condition and results of operations.

Revenue and Deferred Revenue Recognition

We recognize product sales under the following two types of contracts:

1)  
Equipment sale contract - Under the Equipment sale contract, we recognize revenue when persuasive evidence of an arrangement exists, the sales price to the buyer is fixed or determinable, collectability is reasonably assured, delivery has occurred and accepted by the buyers.

2)  
Energy savings sharing contract - Under this contract, we grant customers extended payment terms under contracts of sale. These contracts are generally for a period of one to five years at prevailing interest rates and are collateralized by the related equipment, which if repossessed, may be less than the receivable balance outstanding. We recognize revenue under profit sharing agreements when the amounts are fixed and determinable and collectability is reasonably assured. Amounts received by us in excess of the original estimated cost savings on the contract is recorded as interest income.

22

 
RESULTS OF OPERATIONS

QUARTER ENDED DECEMBER 31, 2005 COMPARED TO THE QUARTER ENDED DECEMBER 31, 2004.

Quarter Ended
             
December 31,
 
2005
 
2004
 
Change
 
Revenues
 
$
10,696,397
 
$
11,708,690
   
-8.65
%
Cost of goods sold
   
4,161,941
   
4,891,408
   
-14.91
%
Gross profit
   
6,534,456
   
6,817,282
   
-4.15
%
Operating expenses
   
1,119,283
   
1,584,539
   
-29.36
%
Other income
   
676,458
   
345,388
   
95.85
%
Income before
                   
minority interest
   
6,091,631
   
5,578,131
   
9.21
%
Net Income (After
                   
Minority Interest)
   
6,091,631
   
2,858,278
   
113.12
%
 
INCOME BEFORE MINORITY INTEREST AND NET INCOME

Our net income before minority interest for the three months ended December 31, 2005 and December 31, 2004 was $6,091,631 and $5,578,131, respectively. Our net income before minority interest for the three months ended December 31, 2005 increased by approximately 9.21% when compared to our net income before minority interest for the three months ended December 31, 2004. Such increase in net income before minority interest was due to a decrease in cost of goods sold and operating expenses as further discussed below.

As of December 31, 2004, we held a 65% interest in Starway which incurred a minority interest charge to our profit and loss statement of $2,719,853 for the period ended December 31, 2004. As a result, our net income after minority interest for the three months ended December 31, 2005 and December 31, 2004 was $6,091,631 and $2,858,278, respectively.

REVENUES

Our revenues are derived primarily from SDID’s sales of its energy savings products and entering into energy savings sharing contracts. Revenues for the three months ended December 31, 2005 were $10,696,397, a net decrease of approximately 8.65% compared with revenues of $11,708,690 for the three months ended December 31, 2004. The decrease was a result of an energy savings sharing contract amounting to $2,800,000 under installation during this quarter, which was not yet completed in this quarter and will contribute to the revenue in the next quarter. Our management expects that revenue will grow in 2006 because of our marketing and sales efforts and strong demand for our products due to electricity shortages in many parts of China. Further, our management believes that we will be able to maintain our price levels due to strong demand and a lack of strong competitive products. While our products may be used internationally, we currently have focused our sales efforts in China, targeting large businesses and local governments. Management hopes to continue to increase our market share in China.

GROSS PROFIT

We had a gross profit of $6,534,456 and $6,817,282 for the three months ended December 31, 2005 and December 31, 2004, respectively, resulting in a 4.15% decrease. The decrease in our cost of goods sold is a result of a slight decrease in revenues and better cost control.

The main factor for the decrease in cost of goods sold is a result of better control over production costs. We have seen an increase in suppliers for the supplies and materials used for the production of our products which results in more competitive pricing for such supplies and materials. As a result, the cost of materials such as chipsets and other hardware used in the production of our products has decreased substantially which in turn produces better profit margins for us. Such a decrease is expected to continue in the short term but we expect it to be minimized in the future.
 
23


OPERATING EXPENSES

Below is a breakdown comparison of the operating expenses for the Three Months Ended December 31, 2005 and December 31, 2004:

Three Months
             
Ended December 31,
 
2005
 
2004
 
Changes
 
Operating expenses
 
$
467,164
 
$
612,700
   
-23.75
%
Sales, marketing and
                   
administrative expenses
   
652,119
   
971,839
   
-32.90
%
Total operating expenses
 
$
1,119,283
 
$
1,584,539
   
-29.36
%

There was a 29.36% decrease in total operating expenses from $1,584,539 to $1,119,283 for the three months ended December 31, 2004 and December 31, 2005, respectively. The decrease in sales, marketing and administrative expenses was mainly due to the decrease in consulting expenses. We believe expenses related to the marketing and selling of our products will continue to increase substantially to handle our growing sales volume. We expect that professional fees and expenses to ensure compliance with U.S. securities laws, the Sarbanes-Oxley Act and marketplace rules for the NASDAQ National Market will increase substantially.

MATERIAL CHANGES IN FINANCIAL CONDITION

FINANCIAL CONDITION AS AT DECEMBER 31, 2005 COMPARED TO FINANCIAL CONDITION AS AT SEPTEMBER 30, 2005

The material changes in financial condition is discussed as follows:

CASH

Cash as at December 31, 2005 and September 30, 2005 was $25,089,074 and $30,926,619 respectively. Cash as at December 31, 2005 decreased by 18.88% as compared to cash as at September 30, 2005. Such large decrease in cash was mainly due to payment of accrued value added tax accumulated as at September 30, 2005. As at September 30, 2005, the Company was trying to obtain wavier of accrued value added tax by the local Chinese tax authority. However, the Company confirmed that it could not obtain the waiver successfully and paid the accrued value added tax accumulated as at September 30, 2005 in this quarter.

ACCOUNTS RECEIVABLE, TRADE, NET OF ALLOWANCE FOR DOUBTFUL ACCOUNTS

Accounts receivable as at December 31, 2005 and September 30, 2005 was $11,406,561 and $6,471,689, respectively. Accounts receivable as at December 31, 2005 increased by 76.25% as compared to accounts receivable as at September 30, 2005. Such a large increase in accounts receivable was mainly due to an increase in current accounts receivable aged within three months. The Company considered that adequate provision has been made for doubtful accounts and has confidence in collecting the remaining accounts receivable.

INVENTORIES

Inventories as at December 31, 2005 and September 30, 2005 was $4,031,982 and $1,584,213 respectively. Inventories as at December 31, 2005 increased by 154.51% as compared to inventories as at September 30, 2005. Such a large increase in inventories was mainly due to an energy savings sharing contract amounting to $2,800,000 under installation during this quarter, which was not yet completed as at the end of this quarter. Moreover, more raw materials were purchased during this quarter in order to prepare for the orders of our customers.
 
24

 
PREPAID EXPENSES

Prepaid expenses as at December 31, 2005 and September 30, 2005 was $2,466,686 and $1,890,688 respectively. Prepaid expenses as at December 31, 2005 increased by 30.46% as compared to prepaid expenses as at September 30, 2005. Such a large increase in prepaid expenses was mainly due to an increase in deposits paid to suppliers in light of the purchase orders placed to the suppliers.

TAXES PAYABLE

Taxes payable as at December 31, 2005 and September 30, 2005 was $966,038 and $4,849,550, respectively. Taxes payable as at December 31, 2005 decreased by 80.08% as compared to taxes payable as at September 30, 2005. Such a large decrease in taxes payable was mainly due to payment of accrued value added tax accumulated as at September 30, 2005. As at September 30, 2005, the Company was trying to obtain a wavier of accrued value added tax by the local Chinese tax authority. However, the Company confirmed that it could not obtain the waiver successfully and paid the accrued value added tax accumulated as at September 30, 2005 in this quarter.
 
25

 
LIQUIDITY AND CAPITAL RESOURCES

Three Months
             
Ended December 31,
 
2005
 
2004
 
Change
 
Net cash provided by (used in)
             
operating activities
   
(6,036,136
)
 
8,390,156
   
(14,426,292
)
Net cash (used in)
                   
investing activities
   
-
   
(3,013
)
 
3,013
 
Net cash (used in)
                   
financing activities
   
(3,505
)
 
(3,135
)
 
(370
)

 
The increase of $14,426,292 in net cash used in operating activities primarily reflects increase in notes and account receivables and increase in inventories and repayment of taxes payable.

The decrease of $3,013 in net cash used in investing activities was due to no equipment was purchased during the quarter.

The increase of $370 in net cash used in financing activities was due to payments on notes payable.

We believe that we have adequate capital resources to continue our operations and will not need to raise capital in the near future. We believe that our current cash balance and the revenues that will be generated will cover anticipated operating expenses for a period of at least one year without supplementing our cash reserves. We may, however, raise additional capital to further develop our other products.

EFFECT OF FLUCTUATION IN FOREIGN EXCHANGE RATES

Our operating subsidiaries are located in China, and our Company buys all raw materials in China and sells all our products in China using Chinese Renminbi as the functional currency. Based on China government regulation, all foreign currencies under the category of current accounts are allowed to be freely exchanged with hard currencies. During the past two years of operation, there were no significant changes in exchange rates; however, unforeseen developments may cause a significant change in exchange rates.

INVESTMENT IN SUBSIDIARIES

As of December 31, 2005, we owned a 100% interest in Starway.

Starway holds 100% interest in Shenzhen Dicken Industrial Development Limited (“SDID”), which subsequently holds 100% interest in the energy savings project, Shenzhen Dicken Technology Development Limited (“SDTD”) as well as owns the intellectual property of their energy savings products in China.

OFF-BALANCE SHEET ARRANGEMENTS

We do not have any off-balance sheet arrangements.
 
Forward Looking Statements
 
Statements in this Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this document are certain statements which are not historical or current fact and constitute “forward-looking statements” within the meaning of such term in Section 27A of the  Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  Such forward-looking statements involve known and unknown risks, uncertainties and other factors that could cause the actual financial or operating results of the Company to be materially different from the historical results or from any future results expressed or implied by such forward-looking statements.  Such risks include, among others, the following: international, national and local general economic and market conditions: our ability to sustain, manage or forecast our growth; raw material costs and availability; new product development and introduction; existing government regulations and changes in, or the failure to comply with, government regulations; adverse publicity; competition; the loss of significant customers or suppliers; fluctuations and difficulty in forecasting operating results; changes in business strategy or development plans; business disruptions; the ability to attract and retain qualified personnel; the ability to protect technology; and other factors referenced in this and previous filings.  Such forward looking statements are based on our best estimates of future results, performance or achievements, based on currrent conditions and the most recent results of the Company. In addition to statements which explicitly describe such risks and uncertainties, readers are urged to consider statements labeled with the terms “may”, “will”, “potential”, “opportunity”, “believes”, “belief”, “expects”, “intends”, “estimates”, “anticipates” or “plans” to be uncertain and forward-looking.  The forward-looking statements contained herein are also subject generally to other risks and uncertainties that are also subject generally to other risks and uncertainties that are described from time to time in the Company’s reports and registration statements filed with the Securities and Exchange Commission.
 
Consequently, all of the foward-looking statements made in this Form 10-Q are qualified by these cautionary statements and there can be no assurance that the actual results anticipated by management will be realized or, even if substantially realized, that they will have the expected consequences to or effects on our business operations.
 
As used in this Form 10-Q, unless the context requires otherwise, “we” or “us” or the “Company” means China Energy Savings Technology, Inc. and its subsidiaries.
 
26


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

While our reporting currency is the U.S. dollar, to date, virtually all of our revenues and costs are denominated in Renminbi and a significant portion of our assets and liabilities are denominated in Renminbi. As a result, we are exposed to foreign exchange risk as our revenues and results of operations may be impacted by fluctuations in the exchange rate between U.S. Dollars and Renminbi. If the Renminbi depreciates against the U.S. Dollar, the value of our Renminbi revenues and assets as expressed in our U.S. Dollar financial statements will decline. We do not hold any derivative or other financial instruments that expose us to substantial market risk.
 
The Renminbi is currently freely convertible under the current account, which includes dividends, trade and service-related foreign exchange transactions, but not under the capital account, which includes foreign direct investment.  To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the effectiveness of these hedges may be limited and we may not be able to successfully hedge our exposure at all. Accordingly, we may incur economic losses in the future due to foreign exchange rate fluctuations, which could have a negative impact on our financial condition and results of operations.

ITEM 4. CONTROLS AND PROCEDURES

(a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES.

The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 (the “Exchange Act”), is recorded, processed, summarized and reported within the time period specified in the rules and forms of the Securities and Exchange Commission. As of the end of the period covered by this Report, the Company’s management, including its Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design of the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective as of December 31, 2005, because of the material weaknesses disclosed in “Management’s Report on Internal Control over Financial Reporting” included in its Form 10-K for the fiscal year ended September 30, 2005.
 
During the fiscal quarter ended December 31, 2005, the Company implemented the following changes in its internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company began to execute the remediation plans identified under “Management’s Report on Internal Control over Financial Reporting” in Item 9A of its Form 10-K.
Since October 1, 2005, the Company’s management has commenced the following steps to address the existing material weaknesses already identified:

1.  
We have hired one more PRC qualified accounting staff person and engaged an outside contractor with technical accounting expertise to review and reorganize the accounting and finance department; and

2.  
We have interviewed prospective new Directors and recruited a new CEO who joined our Board.
 
The Company will continue to execute the remediation plans during the second fiscal quarter of 2006.
 
In light of these material weaknesses, the Company performs additional analyses and other pre and post-closing procedures to ensure that our consolidated financial statements are presented fairly in all material respects in accordance with generally accepted accounting principles in the United States. These procedures include monthly business reviews led by our Chief Executive Officer and monthly operating and financial statement reviews by various levels of our management team, including our executive officers. Accordingly, management believes that the consolidated financial statements and schedules included in this Form 10-Q fairly present in all material respects our financial position, results of operations and cash flows for the periods presented.
 
There was no change in our internal control over financial reporting during the quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting, other than the remediation measures which are described above.

Moore Stephens Wurth Frazer and Torbet, LLP (MSFT), our independent registered public accounting firm, has audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of September 30, 2005 as stated in their report which appears in this Annual Report on Form 10-K. Since we were unable to complete our assessment of internal control, MSFT has disclaimed an opinion on the effectiveness of our controls.
 
27

 
PART II - OTHER INFORMATION


ITEM 1. LEGAL PROCEEDINGS

The management of China Energy Savings Technology, Inc. is not aware of any material legal proceedings pending against it, Starway or its subsidiaries.
 
ITEM 1A.  RISK FACTORS

We are subject to various risks. You should carefully consider the following risk factors, as well as other information included in this Form 10-Q.

A DROP IN THE RETAIL PRICE OF ELECTRICAL ENERGY MAY HAVE A NEGATIVE EFFECT ON OUR BUSINESS.

A customer’s decision to purchase our products is primarily driven by return on investment resulting from the increased energy savings. Although management believes that current retail energy prices support an attractive return on investment for our products, there can be no assurances that future retail pricing of electrical energy will remain at current levels.

THERE CAN BE NO ASSURANCE THAT WE CAN KEEP UP WITH THE RAPID TECHNOLOGICAL CHANGE IN THE ENERGY SAVINGS PRODUCT INDUSTRY.

We believe that our energy saving products are able to compete in the marketplace based upon, among other things, our intellectual property. Although the Company is developing and marketing its products with what it believes to be state-of-the art technology, these technologies, as well as those under development for future projects are evolving technologies. There is no assurance that any applications of our technologies or those of third parties, if developed, will not be rendered superfluous or obsolete by research efforts and technological advances by others in these fields. As new technologies are developed, we may need to adapt and change our products and services, our method of marketing or delivery or alter our current business in ways that may adversely affect revenue and our ability to achieve our proposed business goals. Accordingly, there is a risk that our technologies at a later date will not support a viable commercial enterprise.
 
WE MUST CONTINUALLY RESEARCH AND DEVELOP NEW TECHNOLOGIES AND PRODUCTS TO REMAIN COMPETITIVE.

There are approximately 50 companies in China that engage in the production and sale of energy savings products. Many competitors have considerably greater financial, technological, marketing and personnel resources than those currently available to us. We expect competition to intensify in all fields in which we are involved in view of the world’s need to conserve energy.

To achieve our strategy and obtain market share, we will need to continually research, develop and refine new technologies and offer new products. Many factors may limit our ability to develop and refine new products, including access to new products and technologies, as well as marketplace resistance to new products and technology.

WE MAY NOT BE SUCCESSFUL IN OUR PREVIOUSLY COMMENCED DIVERSIFICATION PROJECTS.

To date, our business concerns energy savings products using a soft switching system. We have recently announced several projects (“Projects”) with third parties to develop hydrogen fuel cell generators and Thermo - photovoltaic Cell Technology. Management anticipates that the fuel cell project will require many years and substantial capital to complete, which capital may not be available when needed. We do not expect to be in a position to generate significant revenues from any Project during its research and development stages. If we incur substantial costs for such research and development activities, until such time, if ever, that we derive meaningful revenues from such Projects, it is expected that such costs will have an adverse effect on our profitability, if any. Furthermore, if we enter into arrangements with third parties for the commercial development of such products through license, joint-venture or other agreements, there is no assurance that any product will be successfully manufactured and marketed since we would, in all likelihood, be required to give up control of such activities.

28

IF WE ARE UNABLE TO ADEQUATELY PROTECT OR ENFORCE OUR RIGHTS TO OUR INTELLECTUAL PROPERTY, WE MAY LOSE VALUABLE RIGHTS, EXPERIENCE REDUCED MARKET SHARE, IF ANY, OR INCUR COSTLY LITIGATION TO PROTECT SUCH RIGHTS.

We generally require our employees, consultants, advisors and collaborators to execute appropriate confidentiality agreements with the Company. These agreements typically provide that all material and confidential information developed or made known to the individual during the course of the individual’s relationship with us be kept confidential and not disclosed to third parties except in specific circumstances. These agreements may be breached, and in some instances, we may not have an appropriate remedy available for breach of the agreements. Furthermore, our competitors may independently develop substantial equivalent proprietary information and techniques, reverse engineer information and techniques, or otherwise gain access to our proprietary technology. In addition, the laws of China may not project proprietary rights to the same extent as U.S. law. Therefore, we may be unable to meaningfully protect our rights in trade secrets, technical know-how and other non-patented technology.

We may have to resort to litigation to protect our rights for certain intellectual property, or to determine their scope, validity or enforceability. Enforcing or defending our rights is expensive and may distract management from its development of the business if not properly managed. Such efforts may not prove successful. There is always a risk that patents, if issued, may be subsequently invalidated, either in whole or in part and this could diminish or extinguish protection for any technology we may license. Any failure to enforce or protect our rights could cause us to lose the ability to exclude others from issuing technology to develop or sell competing products.

WE MUST ATTRACT AND RETAIN HIGHLY SKILLED AND MOTIVATED EMPLOYEES TO SUCCESSFULLY MANAGE OUR GROWTH AND COMPETE IN THE ENERGY SAVINGS MARKETPLACE.

Our ability to manage our growth and operations going forward will depend on, among other things: expanding, training and managing our employee base, including attracting, retaining and motivating highly skilled personnel; developing or outsourcing our customer interface, operations, administration and maintenance systems; and controlling our expenses. We cannot assure that we will succeed in developing all or any of these capabilities.

OUR CURRENT STOCKHOLDERS EXERCISE SUBSTANTIAL CONTROL AND MAY MAKE DECISIONS THAT YOU DO NOT CONSIDER TO BE IN YOUR BEST INTERESTS.

As of January 12, 2006, our executive officers and principal shareholder beneficially owned in the aggregate approximately 56% of the outstanding Common Stock prior to this Offering. It is expected that these individuals will maintain a majority control of the Company. As a result, these stockholders, acting together, will be able to exercise control over all matters requiring approval of the stockholders of the Company.
 
OUR STOCK PRICE IS HIGHLY VOLATILE
 
The trading price of our common stock has fluctuated significantly. Our stock price could be subject to wide fluctuations in the future in response to many events or factors, including those discussed in the preceding risk factors relating to our operations, as well as:
 
·   
actual or anticipated fluctuations in operating results, actual or anticipated gross profit as a percentage of net sales, levels of inventory, our actual or anticipated rate of growth and our actual or anticipated earnings per share;
 
·   
changes in expectations as to future financial performance or changes in financial estimates or buy/sell recommendations of securities analysts;
 
·   
changes in governmental regulations or policies in China;
 
 
29

 
·   
our, or a competitor’s, announcement of new products, services or technological innovations;
 
·   
the operating and stock price performance of other comparable companies; and
 
·   
news and commentary emanating from the media, securities analysts or government bodies in China relating to us and to the industry in general.

 
General market conditions and domestic or international macroeconomic factors unrelated to our performance may also affect our stock price.  For these reasons, investors should not rely on recent trends to predict future stock prices or financial results. In addition, following periods of volatility in a company’s securities, securities class action litigation against a company is sometimes instituted. This type of litigation could result in substantial costs and the diversion of management’s time and resources.

PAST ACTIVITIES OF THE COMPANY AND ITS AFFILIATES MAY LEAD TO FUTURE LIABILITY FOR THE COMPANY.

Prior to the acquisition of Starway, the Company engaged in businesses unrelated to its current operations. Although the major shareholders of the Company prior to the acquisition of Starway indemnified Rim Holdings against any loss, liability, claim, damage or expense arising out of or based on any breach of or inaccuracy in any of their representations and warranties made regarding such acquisition, any liabilities relating to such prior business against which the Company is not completely indemnified may have a material adverse effect on the Company.

OUR AUDITORS ARE UNABLE TO EXPRESS AN OPINION ON MANAGEMENT’S ASSESSMENT OR ON THE EFFECTIVENESS OF OUR INTERNAL CONTROLS OVER FINANCIAL REPORTING

In connection with the audit of our financial statements for the fiscal year ended September 30, 2005, we were unable to complete management’s assessment of internal control over financial reporting. Because of that scope limitation, our auditors were unable to perform any procedures required in an audit of internal control over financial reporting or an audit of management’s assessment of the effectiveness of internal control over financial reporting. During the fiscal quarter ended December 31, 2005, we began to execute remediation plans discussed under Controls and Procedures in Item 4 of Part I of this Report.  Until such time as we are able to complete our assessment of internal controls, we can give no assurance that we can prevent or detect misstatements. Also, any projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. While we expect to complete our assessment during the first half of calendar 2006, there can be no assurance of such, which could have a material adverse affect on the accuracy of our financial statements.

RISKS RELATED TO DOING BUSINESS IN THE PRC

ADVERSE CHANGES IN ECONOMIC AND POLITICAL POLICIES OF THE PRC GOVERNMENT COULD HAVE A MATERIAL ADVERSE EFFECT ON THE OVERALL ECONOMIC GROWTH OF CHINA, WHICH COULD ADVERSELY AFFECT OUR BUSINESS.

All of our business operations are conducted in China. Accordingly, our results of operations, financial condition and prospects are subject to a significant degree to economic, political and legal developments in China. China’s economy differs from the economies of most developed countries in many respects, including with respect to the amount of government involvement, level of development, growth rate, control of foreign exchange and allocation of resources. While the PRC economy has experienced significant growth in the past 20 years, growth has been uneven across different regions and among various economic sectors of China. The PRC government has implemented various measures to encourage economic development and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely effected by government control over capital investments or changes in tax regulations that are applicable to us. Since early 2004, the PRC government has implemented certain measures to control the pace of economic growth. Such measures may cause a decrease in the level of economic activity in China, which in turn could adversely affect our results of operations and financial condition.

30

FUTURE FLUCTUATION IN THE VALUE OF THE RENMINBI MAY NEGATIVELY AFFECT OUR ABILITY TO CONVERT OUR RETURN ON OPERATIONS TO U.S. DOLLARS IN A PROFITABLE MANNER AND OUR SALES GLOBALLY.

Until 1994, the Renminbi experienced a gradual but significant devaluation against most major currencies, including U.S. dollars, and there was a significant devaluation of the Renminbi on January 1, 1994 in connection with the replacement of the dual exchange rate system with a unified managed floating rate foreign exchange system. Since 1994, the value of the Renminbi relative to the U.S. Dollar has remained stable and has appreciated slightly against the U.S. dollar. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the RMB to the U.S. dollar. Under the new policy, the RMB is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 2.0% appreciation of the RMB against the U.S. dollar. While the international reaction to the RMB revaluation has generally been positive, there remains significant international pressure on the PEC government to adopt an even more flexible currency policy, which could result in a further and more significant revaluation of the RMB against the U.S. dollar. Any significant revaluation of RMB may be attributable to adjustments resulting from the translation of our financial statements, which will be recorded as part of accumulated comprehensive income in shareholders’ equity.

If any devaluation of the Renminbi were to occur in the future, our return on our operations in China, which are expected to be in the form of Renminbi, will be negatively affected upon conversion to U.S. dollars We attempt to have most future payments, mainly repayments of loans and capital contributions, denominated in U.S. dollars. If any increase in the value of the Renminbi were to occur in the future, the sales of our products in China and in other countries may be negatively affected.

UNCERTAINTIES WITH RESPECT TO THE CHINESE LEGAL SYSTEM MAY ADVERSELY AFFECT US.

Our business is generally subject to laws and regulations applicable to foreign investment in China. Accordingly, our business will be affected by Chinas developing legal system. Since 1978, many new laws and regulations covering general economic matters have been promulgated in China, and government policies and internal rules promulgated by governmental agencies may not be published in time, or at all. As a result, we may operate our business in violation of new rules and policies without having any knowledge of their existence. In addition, there are uncertainties regarding the interpretation and enforcement of laws, rules and policies in China. The Chinese legal system is based on written statutes, and prior court decisions have limited precedential value. Because many laws and regulations are relatively new and the Chinese legal system is still evolving, the interpretations of many laws, regulations and rules are not always uniform. Moreover, the relative inexperience of Chinas judiciary in many cases creates additional uncertainty as to the outcome of any litigation, and the interpretation of statutes and regulations may be subject to government policies reflecting domestic political changes. Finally, enforcement of existing laws or contracts based on existing law may be uncertain and sporadic, and it may be difficult to obtain swift and equitable enforcement, or to obtain enforcement of a judgment by a court of another jurisdiction. Any litigation in China may be protracted and result in substantial costs and diversion of resources and managements attention.

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

Not Applicable.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not Applicable.

31

ITEM 5.  OTHER INFORMATION

(a) None.

(b) There were no changes to the procedures by which security holders may recommend nominees to our board of directors.

ITEM 6.  EXHIBITS

Exhibit
Number
 
 
Description
 
 
 
3.1
 
Certificate of Incorporation (2)
3.2
 
Bylaws (2)
10.1
 
Agreement and Plan of Share Exchange dated November 16, 2004 by and between Eurofaith Holdings, Inc. and China Energy Savings Technology, Inc. (1)
10.2
 
Agreement and Plan of Share Exchange dated February 1, 2005 by and between Sky Beyond Investments Limited and China Energy Savings Technology, Inc. (3)
10.3
 
China Energy Savings Technology, Inc. 2004 Equity Incentive Plan (4)
14
 
Code of Business Ethics (5)
21
 
Subsidiaries of Registrant (5)
31.1
 
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)
31.2
 
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)
32.1
 
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (6)
32.2
 
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (6)
___________

(1)
Previously filed with the SEC as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on November 18, 2004 and incorporated herein by reference.
(2)
Previously filed with the SEC as an exhibit to the Registration Statement on Form 10 filed on July 11, 2000 and incorporated herein by reference.
(3)
Previously filed with the SEC as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on February 4, 2005 and incorporated herein by reference.
(4)
Previously filed with the SEC as an exhibit to the Form S-8 on September 17, 2004.
(5)
Previously filed with the SEC as an exhibit to the Form 10-K filed on January 13, 2005.
(6)
Filed herewith.

[SIGNATURES PAGE FOLLOWS]
 
32


SIGNATURES

In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
CHINA ENERGY SAVINGS TECHNOLOGY, INC.
(Registrant)
 
 
 
Date: February 14, 2006
By:
/s/ Kwun-Luen Siu
 
Kwun-Luen Siu
Chief Executive Officer
 
 
 
 
 
 
 
Date: February 14, 2006
By:
/s/ Lawrence Lok Yuen-Ming
 
Lawrence Lok Yuen-Ming
Chief Financial Officer

33