Unassociated Document

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

AS OF JUNE 30, 2011 AND DECEMBER 31, 2010

	June 30,		December 31,
	2011		2010
	(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	87,578,920	$	98,753,870
Restricted cash		17,566,185		1,061,900
Notes receivable		9,860,951		1,845,883
Accounts receivable, net		100,158,684		85,899,332
Inventories, net		61,795,604		62,843,556
Other assets, current		3,915,991		2,501,695
Advances on inventory purchases		20,986,377		15,893,866
Total current assets		301,862,712		268,800,102

PLANT AND EQUIPMENT, net		201,878,629		173,074,138

OTHER ASSETS:
Debt issuance costs, net		413,470		496,804
Advances on plant and equipment purchases		36,624,941		48,830,831
Advances on intangible assets		27,198,715		3,645,361
Goodwill		56,005,824		54,919,738
Other intangible assets, net		22,655,995		23,147,079
Other assets, non-current		3,738,955		1,403,326
Total other assets		146,637,900		132,443,139

Total assets	$	650,379,241	$	574,317,379

LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
Notes payable - short term	$	36,895,950	$	2,123,800
Accounts payable		23,884,229		26,881,540
Short term loans		36,936,172		29,490,480
Customer deposits		12,450,791		14,621,882
Accrued liabilities and other payables		16,465,608		17,934,047
Taxes payable		10,720,587		8,205,807
Amounts due to original shareholders		773,500		758,500
Total current liabilities		138,126,837		100,016,056

LONG TERM LIABILITIES:
Long term loans		50,470,000		50,070,000
Warrant liability		1,394,418		1,526,530

Total liabilities		189,991,255		151,612,586

COMMITMENTS AND CONTINGENCIES

SHAREHOLDERS' EQUITY:
Common Stock, $0.00001 par value, 100,000,000 shares authorized, 31,250,820 shares issued and outstanding as of June 30, 2011 and December 31, 2010		312		312
Paid-in-capital		218,434,937		218,212,343
Retained earnings		160,380,410		136,149,513
Statutory reserves		36,866,080		33,129,367
Accumulated other comprehensive income		41,833,399		32,360,515
Total shareholders' equity		457,515,138		419,852,050

NONCONTROLLING INTERESTS		2,872,848		2,852,743

Total liabilities and shareholders' equity	$	650,379,241	$	574,317,379

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

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (LOSS)

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2011 AND 2010

(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2011			2010			2011			2010

REVENUES	$	131,401,787		$	105,435,970		$	235,231,211		$	210,921,127

COST OF SALES		95,197,678			70,103,783			168,823,314			139,846,870

GROSS PROFIT		36,204,109			35,332,187			66,407,897			71,074,257

RESEARCH AND DEVELOPMENT EXPENSE		947,674			362,783			4,826,202			956,978

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES		13,798,547			6,886,054			23,871,929			14,302,812

INCOME FROM OPERATIONS		21,457,888			28,083,350			37,709,766			55,814,467

OTHER EXPENSE (INCOME)
Other income, net		(2,389,536	)		(1,326,675	)		(3,510,737	)		(2,445,961	)
Interest expense, net		1,259,236			977,858			3,183,186			2,624,781
Loss from disposal of subdivision		-			623,158			-			623,158
Change in fair value of warrants		(565,867	)		(1,657,457	)		(132,112	)		(1,423,379	)
Total other expense, net		(1,696,167	)		(1,383,116	)		(459,663	)		(621,401	)

INCOME BEFORE PROVISION FOR INCOME TAXES		23,154,055			29,466,466			38,169,429			56,435,868

PROVISION FOR INCOME TAXES		5,986,251			3,790,892			10,181,684			7,854,253

NET INCOME BEFORE NONCONTROLLING INTEREST		17,167,804			25,675,574			27,987,745			48,581,615

LESS: NET INCOME ATTRIBUTABLE TO NONCONTROLLING INTEREST		5,866			770			20,135			2,353,123

NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST		17,161,938			25,674,804			27,967,610			46,228,492

OTHER COMPREHENSIVE INCOME (LOSS)
Foreign currency translation adjustment		7,024,063			1,320,473			9,472,884			1,412,069
Foreign currency translation adjustment attributable to noncontrolling interest		(30	)		611			(30	)		(191	)

COMPREHENSIVE INCOME	$	24,185,971		$	26,995,888		$	37,440,464		$	47,640,370

EARNINGS PER SHARE
Basic
Weighted average number of shares		31,250,820			31,067,471			31,250,820			31,067,471
Earnings per share before noncontrolling interest	$	0.55		$	0.83		$	0.90		$	1.56
Earnings per share attributable to controlling interest	$	0.55		$	0.83		$	0.89		$	1.49
Earnings per share attributable to noncontrolling interest	$	-		$	-		$	-		$	(0.08	)

Diluted
Weighted average number of shares		31,351,139			31,343,306			31,337,330			31,348,563
Earnings per share before noncontrolling interest	$	0.55		$	0.82		$	0.89		$	1.55
Earnings per share attributable to controlling interest	$	0.55		$	0.82		$	0.89		$	1.47
Earnings per share attributable to noncontrolling interest	$	-		$	-		$	-		$	(0.08	)

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

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

	Common stock				Additional			Retained earnings					Accumulated other
			Par		paid-in			Unrestricted			Statutory		comprehensive		Noncontrolling
	Shares		value		capital			earnings			reserves		income		interest			Total

BALANCE, January 1, 2010		31,067,471	$	310	$	218,094,374		$	69,594,111		$	22,869,423	$	18,638,299	$	21,299,841		$	350,496,358

Amortization of stock compensation						509,338													509,338
Net income									46,228,492							2,353,123			48,581,615
Adjustment to statutory reserve									(5,044,288	)		5,044,288							-
Deconsolidation of subsidiaries														23		(1,604,613	)		(1,604,590	)
Acquisition of noncontrolling interest						(5,387,208	)							711		(22,134,423	)		(27,520,920	)
Foreign currency translation gain														1,412,069		(191	)		1,411,878

BALANCE, June 30, 2010 (Unaudited)		31,067,471		310		213,216,504			110,778,315			27,913,711		20,051,102		(86,263	)		371,873,679

Amortization of stock compensation						485,441													485,441
Exercise of stock warrants at $10.84		183,349		2		4,510,398													4,510,400
Noncontrolling interest in acquiree																			-
Net income									30,586,854							79,288			30,666,142
Adjustment to statutory reserve									(5,215,656	)		5,215,656							-
Increase in noncontrolling interest																2,882,353			2,882,353
Foreign currency translation gain														12,309,413		(22,635	)		12,286,778

BALANCE, December 31, 2010		31,250,820		312		218,212,343			136,149,513			33,129,367		32,360,515		2,852,743			422,704,793

Amortization of stock compensation						222,594													222,594
Net income									27,967,610							20,135			27,987,745
Adjustment to statutory reserve									(3,736,713	)		3,736,713							-
Foreign currency translation gain														9,472,884		(30	)		9,472,854

BALANCE, June 30, 2011 (Unaudited)		31,250,820	$	312	$	218,434,937		$	160,380,410		$	36,866,080	$	41,833,399	$	2,872,848		$	460,387,986

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

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30, 2011 AND 2010

(Unaudited)

	Six Months Ended June 30,
	2011			2010
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income attibutable to noncontrolling interest	$	20,135		$	2,353,123
Net income attibutable to controlling interest		27,967,610			46,228,492
Consolidated net income		27,987,745			48,581,615
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Depreciation		5,061,037			3,829,181
Amortization of intangible assets		897,937			753,764
Amortization of debt issuance costs		83,334			281,936
Amortization of debt discount		-			1,223,276
Provision for (recovery of) receivables		1,915,982			(29,116	)
Write off of advances on inventory purchases		2,478,661			-
Provision for (recovery of) inventory reserve		695,277			(387,200	)
Share-based compensation		222,594			509,338
Loss on disposal of equipment		45,418			69,119
Change in fair value of warrants		(132,112	)		(1,423,379	)
Loss on sale of discontinued operations		-			623,158
Foreign exchange loss		400,000			-

Change in operating assets and liabilities
Notes receivable		(3,531,852	)		770,358
Accounts receivable, net		(14,356,056	)		(2,750,252	)
Inventories, net		1,632,996			(6,358,437	)
Advances on inventory purchases		(7,232,161	)		(1,498,028	)
Other assets, current		(1,086,402	)		2,328,104
Other assets, non-current		(2,011,882	)		125,988
Accounts payable		7,301,489			9,370,961
Customer deposits		(2,431,625	)		(2,803,473	)
Accrued liabilities and other payables		(1,836,200	)		(4,798,093	)
Taxes payable		2,325,131			719,344
Net cash provided by operating activities		18,429,317			49,138,164

CASH FLOWS FROM INVESTING ACTIVITIES:
Payment for advances on intangible assets		(23,208,049	)		-
Payment for advances on equipment purchases		(5,692,232	)		(10,386,470	)
Purchase of intangible assets		(10,634	)		(110,507	)
Purchase of plant and equipment		(3,604,343	)		(1,637,564	)
Disposal of plant and equipment		77,931			90,892
Additions to construction-in-progress		(8,444,793	)		(28,558,099	)
Payment to original shareholders for acquisition		-			(27,946,571	)
Payment to acquire noncontrolling interests		-			(26,550,890	)
Deconsolidation of cash held in disposed subdivisions		-			(602,948	)
Proceeds from sale of controlling interests in subsidiaries		-			718,781
Net cash used in investing activities		(40,882,120	)		(94,983,376	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Increase in restricted cash		(16,291,495	)		(1,543,179	)
Payment on notes payable		(611,600	)		(3,800,000	)
Proceeds from notes payable-short term		21,263,770			4,271,647
Payment on notes payable-short term		(2,140,600	)		(3,080,524	)
Proceeds from short term loans-bank		26,451,700			6,307,670
Repayment of short term loans-bank		(19,571,200	)		(9,094,780	)
Net cash provided by (used in) financing activities		9,100,575			(6,939,166	)

EFFECTS OF EXCHANGE RATE CHANGE ON CASH		2,177,278			157,179

DECREASE IN CASH		(11,174,950	)		(52,627,199	)

Cash and cash equivalents, beginning of period		98,753,870			92,902,400

Cash and cash equivalents, end of period	$	87,578,920		$	40,275,201

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

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Note 1 - Nature of Business

Harbin Electric, Inc. (the “Company” or “Harbin Electric”) is a Nevada Corporation, incorporated on July 9, 2003. Through its subsidiaries, the Company designs, develops, engineers, manufactures, sells and services a wide array of electric motors including linear motors, specialty micro-motors, and industrial rotary motors, with focus on innovation, creativity, and value-added products. Products are sold in China and to certain international markets.

Recent development

On June 19, 2011, the Company entered into an Agreement and Plan of Merger, dated June 19, 2011 (“Merger Agreement”), with Tech Full Electric Company Limited, a Cayman Islands exempted company with limited liability, wholly owned indirectly by Mr. Tianfu Yang, the Company’s Chairman and Chief Executive Officer (“Parent”) and Tech Full Electric Acquisition, Inc., a Nevada corporation and a wholly-owned subsidiary of Parent (“Merger Sub”).

Pursuant to the Merger Agreement, upon the terms and subject to the conditions thereof, at the effective time of the merger, Merger Sub will be merged with and into the Company, the Company will become a wholly-owned subsidiary of the Parent and each of the Company’s shares of common stock issued and outstanding immediately prior to the effective time of the merger (the “Shares”) will be converted into the right to receive $24.00 in cash without interest, except for Shares owned by Parent and Merger Sub (including shares to be contributed to Parent by Mr. Tianfu Yang, affiliates of Abax Global Capital (“Abax”) and certain of the Company’s employees and officers (collectively, the “Purchasing Group”) prior to the effective time of the merger pursuant to a contribution agreement between Parent, each member of the Purchasing Group and Tianfu Investments Limited, a Cayman Islands company directly owning 100% of the equity interest in Parent).

The Merger Agreement contains customary termination provisions for both the Company and Parent. If the Merger Agreement is terminated under certain circumstances, the Company will be required to pay Parent a termination fee of $22,500,000. If the Merger Agreement is terminated under certain other circumstances, Parent will be required to pay the Company a termination fee equal to $30,000,000.

The merger is currently expected to close in the fourth quarter of this year, and is subject to customary closing conditions as well as approval and adoption of the Merger Agreement by the Company’s shareholders (including the affirmative approval of the holders of a majority in combined voting power of the outstanding Shares not owned by the Purchasing Group). If completed, the merger will result in the Company becoming a privately-held company, and the Shares will no longer be listed on any public market. Accordingly, no assurance can be given that the merger will be completed.

Note 2 - Summary of Significant Accounting Policies

Basis of presentation

The consolidated financial statements of Harbin Electric Inc. reflect the activities of the following subsidiaries. All material intercompany transactions have been eliminated.

	Place incorporated	Ownership percentage
Advanced Electric Motors, Inc. (“AEM”)	Delaware, USA	100	%
Harbin Tech Full Electric Co., Ltd. (“HTFE”)	Harbin, China	100	%
Advanced Automation Group, LLC (“AAG”)	Delaware, USA	51	%
Advanced Automation Group Shanghai Co., Ltd. (“SAAG”)	Shanghai, China	51	%
Shanghai Tech Full Electric Co., Ltd. (“STFE”)	Shanghai, China	100	%
Weihai Tech Full Simo Motor Co., Ltd. (“Weihai”)	Weihai, China	100	%
Xi’an Tech Full Simo Motor Co., Ltd. (“Simo Motor”)	Xi’an, China	100	%

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

The accompanying consolidated financial statements include the accounts of all directly and indirectly owned subsidiaries listed above.

The interim unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP, for interim financial information and with the instructions to Securities and Exchange Commission, or SEC, Form 10-Q and Article 10 of SEC Regulation S-X and consistent with the accounting policies stated in the Company’s 2010 Annual Report on Form 10-K. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these financial statements should be read in conjunction with our audited consolidated financial statements and notes thereto for the year ended December 31, 2010, included in our Annual Report on Form 10-K filed with the SEC.

The interim consolidated financial statements included herein are unaudited; however, they contain all normal recurring accruals and adjustments that, in the opinion of management, are necessary to present fairly our consolidated financial position as of June 30, 2011 and December 31, 2010, and our consolidated results of operations for the three months and six months ended June 30, 2011 and 2010 and cash flows for the six months ended June 30, 2011 and 2010. The results of operations for the three months and six months ended June 30, 2011 are not necessarily indicative of the results to be expected for future quarters or the full year.

Use of estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the reported amounts of assets, liabilities, revenue and expenses, and disclosures about contingent assets and liabilities. Such estimates and assumptions by management affect accrued expenses, the valuation of accounts receivable, inventories, and long-lived assets, legal contingencies, lives of plant and equipment, lives of intangible assets, business combinations, goodwill, calculation of warranty accruals, taxes, share-based compensation and others.

Although the Company regularly assesses these estimates, actual results could materially differ. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances.

Foreign currency transactions

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

Translation adjustments resulting from this process amounted to a gain of $7,024,063 and $1,320,473 for the three months ended June 30, 2011 and 2010, respectively. Translation adjustments resulting from this process amounted to a gain of $9,472,884 and $1,412,069 for the six months ended June 30, 2011 and 2010, respectively. The balance sheet amounts with the exception of equity at June 30, 2011 and December 31, 2010 were translated at 6.46 RMB to $1.00 and 6.59 RMB to $1.00, respectively. The equity accounts were stated at their historical exchange rate. The average translation rates applied to the revenues, expenses and cash flows statement amounts for the six months ended June 30, 2011 and 2010 were 6.54 RMB to $1.00, and 6.82 RMB to $1.00, respectively.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Transaction loss of $272,808 and $35,796 were recognized which were included in the other income for the three months ended June 30, 2011 and 2010, respectively. Transaction loss of $465,541 and $38,478 were recognized which were included in the other income for the six months ended June 30, 2011 and 2010, respectively.

Concentration of risks

The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents, for cash flow statement purposes. Cash includes cash on hand and demand deposits in accounts maintained with state owned banks within the PRC and with banks in the United States. The Company maintains balances at financial institutions which typically exceed Federal Deposit Insurance Corporation insured limits for the banks located in the United States. Balances at financial institutions or state owned banks within the PRC are not insured. As of June 30, 2011 and December 31, 2010, the Company had deposits in excess of federally insured limits totaling $87,005,250 and $98,989,404, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.

No customer accounted for more than 10% of the net revenue for the three months and six months ended June 30, 2011 and 2010.

No vendor accounted for more than 10% of the raw material purchases for the three months and six months ended June 30, 2011 and 2010.

The Company's operations are carried out in the PRC. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC's economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in the North America and Western Europe. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. The Company's results may be adversely affected by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things.

Restricted cash

Restricted cash represents amounts set aside by the Company in accordance with the Company’s debt agreements with certain financial institutions. These cash amounts are designated for the purpose of paying down the principal amounts owed to the financial institutions, and these amounts are held at the same financial institutions with which the Company has debt agreements in the PRC. Due to the short-term nature of the Company’s debt obligations to these banks, the corresponding restricted cash balances have been classified as current in the consolidated balance sheets.

Notes receivable

Notes receivable arose from sale of goods and represent commercial drafts issued by customers to the Company and were guaranteed by banks of the customers. Notes receivables are interest-free with maturity dates of three or six months from date of issuance. The Company has the ability to submit a request for payment to the customer’s bank earlier than the scheduled payment date, but in such a case will incur an interest charge and a processing fee.

Accounts receivable, net

Accounts receivable are presented net of an allowance for bad debts account. The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves. The estimated loss rate is based on the Comany’s historical loss experience and also contemplates current market conditions. Delinquent account balances are written-off after management has determined that the likelihood of collection is not probable, and known bad debts are written off against allowance for doubtful accounts when identified.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Inventories, net

Inventories are valued at the lower of cost or market value, as determined on a first-in, first-out basis, using the weighted average method. Management compares the cost of inventories with the market value and an allowance is made for writing down the inventories to its market value, if lower than cost. On an ongoing basis, inventories are reviewed for potential write-down for estimated obsolescence or unmarketable inventories equal to the difference between the costs of inventories and the estimated net realizable value based upon forecasts for future demand and market conditions. When inventories are written-down to the lower of cost or market, they are not marked up subsequently based on changes in underlying facts and circumstances. Inventories are composed of raw material for manufacturing electrical motors, work in process and finished goods within the Company’s warehouse premise or consigned at a customer site. The inventory allowance is made when the inventory’s market value is lower than the cost. The recovery of the reserve is only made through sale or disposition of such inventory items.

Plant and equipment, net

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

		Estimated Useful Life
Buildings		20-40 years
Vehicle		5-10 years
Office equipment		5-6 years
Production equipment		10-12 years

Construction in progress represents the costs incurred in connection with the construction of buildings or new additions to the Company’s plant facilities. No depreciation is provided for construction in progress until such time as the assets are completed and placed into service. Maintenance, repairs and minor renewals are charged directly to expense as incurred. Major additions and betterment to buildings and equipment are capitalized. Interest incurred during construction is capitalized into construction in progress. All other interest is expensed as incurred.

The Company recognizes an impairment loss when estimated cash flows generated by those assets are less than the carrying amounts of the asset. Based on management review, the Company believes that there were no impairments as of June 30, 2011.

Goodwill and other intangible assets

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

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

General intangibles other than goodwill

Intangible assets that are acquired individually or as part of a group of assets, other than those acquired in a business combination are initially recorded at their fair value. The cost of a group of assets acquired in a transaction is allocated to the individual assets based on their relative fair values. Goodwill does not arise in such a transaction. Intangible assets that are acquired in a business combination are accounted for in accordance with ASC Topic 805, Business Combinations. The costs of intangible assets that are developed internally, as well as the costs of maintaining or restoring intangible assets that have indeterminate lives or that are inherent in a continuing business and related to the entity as a whole, are expensed as incurred.

The accounting for intangible assets, other than goodwill, subsequent to acquisition is based on the asset’s useful life. The useful life of the intangible asset is the period over which the asset is expected to contribute directly or indirectly to the entity’s future cash flows. An asset for which no legal, regulatory, contractual, competitive, economic, or other factors limit its useful life is considered to have an indefinite useful life.

The Company evaluates intangible assets for impairment, at least annually and whenever events or changes in circumstances indicate that the assets might be impaired. We perform our annual impairment test in the fourth quarter.

The Company’s impairment test consists of a comparison of the fair value of the intangible asset with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to the excess. As of June 30, 2011, management believes there was no impairment.

Accounting for long-lived assets

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We assess the recoverability of the assets based on the undiscounted future cash flow the assets are expected to generate and recognize an impairment loss when estimated undiscounted future cash flow expected to result from the use of the asset plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the asset. When we identify an impairment, we reduce the carrying amount of the asset to its estimated fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values. As of June 30, 2011, management believes there was no impairment.

Notes payable

In general, the short term notes are bank acceptance notes payable issued by local banks in China that entitle the Company’s suppliers to receive the full face amount from the issuing banks. In China, this is a very common low cost financial instrument used to pay suppliers.

Our bank acceptance notes payable represent short-term notes payable issued by Chinese banks in connection with the Company’s purchases that entitle the Company’s suppliers to receive the full face amount from the financial institutions at maturity, which range six to twelve months from the date of issuance. The notes payable were secured by the Company’s restricted cash deposited with issuing banks. All the bank acceptance notes are subject to bank charges of 0.05% of the principal as a commission on each loan transaction. The amount borrowed is entered in the accounting records by increasing cash or as payments to vendors and increasing notes payable. When the note is repaid, the difference between the carrying amount of the note and the cash necessary to repay that note is reported as interest expense.

Stock-based compensation

We record share-based compensation expense based upon the grant date fair value of share-based awards. The value of the award is principally recognized as expense ratably over the requisite service periods. We use the Black-Scholes Merton (“BSM”) option-pricing model, which incorporates various assumptions including volatility, expected life and interest rates to determine fair value. The Company’s expected volatility assumption is based on the historical volatility of Company’s stock. The expected life assumption is primarily based on the simplified method of the terms of the options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

The Company is required to measure the cost of the equity instruments issued in exchange for the receipt of goods or services from other than employees at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably determinable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services.

Stock compensation expense is recognized based on awards expected to vest. GAAP requires forfeitures to be estimated at the time of grant and revised in subsequent periods, if necessary, when actual forfeitures differ from those estimates. There were no estimated forfeitures as the Company has a short history of issuing options and the actual forfeitures during the history of issuing options were minimal.

Revenue recognition

The Company recognizes sales when title and risk of ownership are passed to the customer (which is at the date of shipment), when a formal arrangement exists, the price is fixed or determinable, no other significant obligations exist and collectability is reasonably assured. For products that are required to be examined by customers, sales revenue is recognized after the customer examination period has passed. Payments received before all of the relevant criteria for revenue recognition are satisfied, are recorded as customer deposits.

In addition, revenue recognition could be negatively impacted by returns. For our linear motor and specialty micro-motor businesses, our products are custom products which are customer specific, and no returns are allowed. We warrant our product for repair, only in the event of defects for two years from the date of shipment. We charge such costs to cost of goods sold. For our industrial rotary motor business, our products are standardized products and returns are allowed within three days upon receipt of products by customers. We provide product warranty for repair one year from the date of shipment. Historically, the returns and defects have not been material. Should returns increase in the future it would be necessary to adjust the estimates, in which case recognition of revenues could be delayed.

The Company also provides after-sale services to our customers. Service revenue is recognized as services are rendered, the customers have approved the completion of the services and invoices have been issued and collectability is reasonably assured. Customer billings for services not yet rendered are deferred and recognized as revenue as the services are rendered and the associated deferred revenue is included in current liabilities or long-term liabilities, as appropriate.

The Company recognizes revenues with regards to the sales of consigned inventories when the title and risks of ownership have been transferred to customers, customers provide persuasive evidence to notify the Company, and upon receipt of the notification form from customers. The Company also performs periodic inventory counts to confirm the inventory quantities held on consignment.

Customers who purchase industrial rotary motors are divided into two major categories: distributors and non-distributors. Non-distributors consist of OEM users, traders and end users. Except for the annual sales target for distributors, the sales arrangements are the same with distributors and non-distributors.

Distributors are committed to annual purchase targets and may be entitled to a sales rebate. The Company periodically provides incentive offers to its distributors to encourage purchases. Such offers include inducement offers (e.g., offers of future discounts subject to meeting the customer’s annual purchase target), and other similar offers. Inducement offers, when accepted by customers, are treated as a reduction to purchase price based on estimated future redemption rates. Redemption rates are estimated using the Company’s historical experience for similar inducement offers. Inducement offers are presented as a net amount in “net sales.”

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Shipping and handling costs are included in selling, general and administrative costs and totaled $1,294,825 and $1,212,761 for the three months ended June 30, 2011 and 2010, respectively. Shipping and handling costs totaled $2,754,193 and $2,045,176 for the six months ended June 30, 2011 and 2010, respectively.

Income taxes

The Company utilizes the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. GAAP also requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. As of January 1, 2007, income tax positions must meet a more-likely-than-not recognition threshold to be recognized. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.

Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets of $314,935 and $377,727 mainly due to the temporary differences of commission expenses between the financial statement and tax basis were recorded at June 30, 2011 and December 31, 2010, respectively. The deferred tax assets (see Note 12 for more discussion) were included in the Consolidated Balance Sheets under other assets, net. The deferred tax activity consisted of the following:

	Amount
Deferred tax assets at January 1, 2010	$	-
Additions to deferred tax assets		-
Decrease of deferred tax assets		-
Effect of foreign currency translation		-
Deferred tax assets at June 30, 2010 (unaudited)		-
Additions to deferred tax assets		368,365
Decrease of deferred tax assets		-
Effect of foreign currency translation		9,362
Deferred tax assets at December 31, 2010		377,727
Additions to deferred tax assets		112,410
Decrease of deferred tax assets		(182,672	)
Effect of foreign currency translation		7,470
Deferred tax assets at June 30, 2011 (unaudited)	$	314,935

Penalties and interest incurred related to underpayment of income tax are classified as income tax expense in the year incurred. No significant penalties or interest relating to income taxes have been incurred during the three and six months ended June 30, 2011 and 2010. GAAP also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures and transition.

The charge for taxation is based on the results for the reporting period as adjusted for items, which are non-assessable or non-deductible. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

The Company’s operating subsidiaries located in PRC are subject to PRC income tax. Under the Income Tax Laws of PRC, a company is generally subject to income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriated tax adjustments. The PRC government provides reduced tax rates for productive foreign investment enterprises in the Economic and Technological Development Zones and for enterprises engaged in production or business operations in the Special Economic Zones or in certain industries. These preferential tax rates are generally graduated, starting at 0% and increasing to the standard EIT rate of 25% over time. HTFE was granted a 10% preferential tax rate from 2008 to 2010 due to its location in a specially designated economic region. This 10% preferential tax rate expired on December 31, 2010. While applying for the next level of 15% preferential tax treatment, HTFE is currently using 25% standard income tax rate until the application is approved. STFE was income tax exempt in 2008 and 2009 and was granted a preferential income tax rates of 11% in 2010 and 12% in 2011 due to its location in an economic development zone. Simo Motor enjoyed a 15% preferential tax rate in 2009 and 2010 due to its location in the Province of Shaanxi which is in the mid-west region of China, and qualified for the government’s “Go-West” program. This “Go-West” preferential tax rate expired on December 31, 2010. However, in 2011 Simo Motor also qualifies for a 15% preferential tax rate applying to enterprises in high/new technology industries designated for special support by the State. Weihai has been subject to 25% standard income tax rate.

The Company’s subsidiaries were subject to the following tax rates for the three and six months ended June 30:

	2011 (Unaudited)						2010 (Unaudited)
Subsidiaries	Income Tax Exemption			Effective Income Tax Rate			Income Tax Exemption			Effective Income Tax Rate
HTFE		-			25	%		15	%		10	%

Weihai		-			25	%		-			25	%

STFE		13	%		12	%		14	%		11	%

Simo Motor		10	%		15	%		10	%		15	%

The following table reconciles the U.S. statutory rates to the Company’s effective tax rate for the three months ended June 30:

	2011 (Unaudited)			2010 (Unaudited)
U.S. Statutory rates		34.0	%		34.0	%
Foreign income not recognized in USA		-34.0			-34.0
China income taxes		25.0			25.0
Tax exemption		-3.4			-9.4
Other items (a)		4.3			-2.7
Effective income taxes		25.9	%		12.9	%

(a) The 4.3% represents the $4,600,793 of expenses incurred by the Company, and its US subsidiaries AEM and AAG that are not subject to PRC income tax for the three months ended June 30, 2011.

The (2.7%) represents the $787,587 of gain incurred by the Company, and its US subsidiaries AEM and AAG that are not subject to PRC income tax for the three months ended June 30, 2010.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

The following table reconciles the U.S. statutory rates to the Company’s effective tax rate for the six months ended June 30:

	2011 (Unaudited)			2010 (Unaudited)
U.S. Statutory rates		34.0	%		34.0	%
Foreign income not recognized in USA		-34.0			-34.0
China income taxes		25.0			25.0
Tax exemption		-2.6			-11.6
Other items (a)		4.3			0.5
Effective income taxes		26.7	%		13.9	%

(a) The 4.3% represents the $7,243,461 of expenses incurred by the Company, and its US subsidiaries AEM and AAG that are not subject to PRC income tax for the six months ended June 30, 2011.

The 0.5% represents the $279,410 of expenses incurred by the Company, and its US subsidiaries AEM and AAG that are not subject to PRC income tax for the six months ended June 30, 2010.

The estimated tax savings for the three months ended June 30, 2011 and 2010 amounted to $950,737 and $3,686,283, respectively. The net effect on earnings per share attributable to controlling interest had the income tax been applied would decrease earnings per share from $0.55 to $0.52 for the three months ended June 30, 2011, $0.83 to $0.71 for the three months ended June 30, 2010.

The estimated tax savings for the six months ended June 30, 2011 and 2010 amounted to $1,159,500 and $6,806,723, respectively. The net effect on earnings per share attributable to controlling interest had the income tax been applied would decrease earnings per share from $0.89 to $0.86 for the six months ended June 30, 2011, $1.49 to $1.27 for the six months ended June 30, 2010.

Harbin Electric, AEM and AAG were organized in the United States and have incurred net operating losses for income tax purposes for the three months and six months ended June 30, 2011. The net operating loss carry forwards for United States income taxes for Harbin Electric and AEM amounted to approximately $42.0 million which may be available to reduce future years’ taxable income. Management believes that the realization of the benefits from these losses appears uncertain due to the Company’s limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero. The net change in the valuation allowance for the three months ended June 30, 2011 was an increase of approximately $2.3 million. Management will review this valuation allowance periodically and make adjustments accordingly. AAG started to use the net operating loss carry forwards from previous years in the amount of $168,421 to reduce its taxable income generated in 2011. The remaining carry forwards will expire, if not utilized, in years 2027 through 2030.

The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $298 million as of June 30, 2011, which is included in consolidated retained earnings and will continue to be indefinitely reinvested in international operations. Accordingly, no provision has been made for U.S. deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if we concluded that such earnings will be remitted in the future.

Value added tax

Sales revenue represents the invoiced value of goods, net of a value-added tax (“VAT”). All of the Company’s products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing their finished product. The Company recorded VAT Payable and VAT receivable net of payments in the financial statements. The VAT tax return is filed offsetting the payables against the receivables.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

VAT on sales and VAT on purchases amounted to $23,859,349 and $19,588,639 for the three months ended June 30, 2011, respectively. VAT on sales and VAT on purchases amounted to $20,075,916 and $13,653,918 for the three months ended June 30, 2010, respectively. Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government.

VAT on sales and VAT on purchases amounted to $43,147,929 and $32,438,524 for the six months ended June 30, 2011, respectively. VAT on sales and VAT on purchases amounted to $38,059,087 and $24,967,631 for the six months ended June 30, 2010, respectively. Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government.

Advertising expenses

The Company expenses the cost of advertising as incurred in selling, general and administrative expenses. The Company incurred $117,268 and $23,662 for the three months ended June 30, 2011 and 2010, respectively.

The Company expenses the cost of advertising as incurred in selling, general and administrative expenses. The Company incurred $149,552 and $56,111 for the six months ended June 30, 2011 and 2010, respectively.

Research and development expenses

Research and development costs are expensed as incurred. The costs of material and equipment that are acquired or constructed for research and development activities and have alternative future uses are classified as plant and equipment and depreciated over their estimated useful lives. The Company’s total research and development expenses for the three months ended June 30, 2011 and 2010 are $947,674 and $362,783, respectively. The Company’s total research and development expenses for the six months ended June 30, 2011 and 2010 are $4,826,202 and $956,978, respectively.

In March 2010, the Company entered into a research and development contract with a research institute to develop the linear motor automated control system. The total contracted amount was $4.8 million with a 3-year term. For the six months ended June 30, 2011, $3,544,149 was incurred and expensed as research and development costs.

Noncontrolling interest

The Company owns 100% of Simo Motor. The 0.05% of noncontrolling interest was acquired indirectly from Simo Motor’s subsidiary Qishan Simo Moulding Co, Ltd. Effective July 1, 2010, 49% of AAG and SAAG was owned by noncontrolling interests, Shelton Technology, LLC, a Michigan limited liability company.

Fair value of financial instruments

The Company measures and reports its financial assets and liabilities on a fair value basis in accordance with ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC 820”). ASC 820 defines fair value as the price that would be received to sell an asset or the price paid to transfer a liability (the exit price) in the principal and most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 requires the classification of assets and liabilities carried at fair value using a three-tier hierarchy based upon observable and unobservable inputs as follows:

Level 1: Quoted market prices in active markets for identical assets or liabilities

Level 2: Observable market based inputs that are corroborated by market data

Level 3: Unobservable inputs that are not corroborated by market data

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

As of June 30, 2011 and December 31, 2010, the Company has 183,348 warrants outstanding. The fair value of the outstanding warrants was approximately $1.39 million and $1.53 million, respectively. The Company recognized a total of $565,867 gain and a total of $1,657,457 gain from the change in fair value of the warrants for the three months ended June 30, 2011 and 2010, respectively. The Company recognized a total of $132,112 gain and a total of $1,423,379 gain from the change in fair value of the warrants for the six months ended June 30, 2011 and 2010, respectively.

These common stock purchase warrants do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the BSM using the following assumptions:

	June 30, 2011			December 31, 2010
	(Unaudited)
Annual dividend yield		-			-
Expected life (years)		1.17			1.67
Risk-free interest rate		0.22	%		0.51	%
Expected volatility		97	%		61	%

Expected volatility is based primarily on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the term of the warrants. We believe this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. We have no reason to believe future volatility over the expected remaining life of these warrants likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is based on U.S. Treasury securities according to the remaining term of the warrants.

	Carrying Value as of June 30, 2011		Fair Value Measurements at June 30, 2011 Using Fair Value Hierarchy
	(Unaudited)		Level 1	Level 2		Level 3

Fair value of warrant liabilities	$	1,394,418		$	1,394,418

Other than the warranty liabilities, the Company did not identify any financial assets or liabilities that are required to be presented on the balance sheet at fair value.

Recent accounting pronouncements

In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update No. 2011-02, Receivables (Topic 310) – A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, which clarify when a modification or restructuring of a receivable constitutes a troubled debt restructuring. In evaluating whether such a modification or restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that two conditions exist: (1) the modification or restructuring constitutes a concession and (2) the debtor is experiencing financial difficulties. The guidance will be effective for our interim and annual reporting periods beginning after June 15, 2011 and will be applied retrospectively to the beginning of the annual period of adoption. The adoption of this newly issued guidance is not expected to have a material impact on our consolidated financial statements.

In May 2011, FASB issued Fair Value Measurement (Topic 820) — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs No. 2011-0, which provides additional guidance for fair value measurements. These updates to the ASC or Codification include clarifications regarding existing fair value measurement principles and disclosure requirements, and also specific new guidance for items such as measurement of instruments classified within stockholders’ equity and disclosures regarding the sensitivity of Level 3 measurements to changes in valuation model inputs. These updates to the Codification are effective for interim and annual periods beginning after December 15, 2011. We do not expect the implementation of this guidance to have a material impact on its consolidated financial statements.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

In June 2011, the FASB issued Comprehensive Income (Topic 220) — Presentation of Comprehensive Income (ASU No. 2011-05), which updates the Codification to require the presentation of the components of net income, the components of other comprehensive income (OCI) and total comprehensive income in either a single continuous statement of comprehensive income or in two separate, but consecutive statements of net income and comprehensive income. These updates do not affect the items reported in OCI or the guidance for reclassifying such items to net income. These updates to the Codification are effective for interim and annual periods beginning after December 15, 2011. We do not expect the implementation of this guidance to have a material impact on its consolidated financial statements.

Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications have no effect on net income or cash flows.

Note 3 – Disposal of subsidiaries

Effective April 1, 2010, Simo Motor, a PRC subsidiary of the Company, sold its equity interests in its three subsidiaries, Tianjin Simo Electric Co., Ltd. (“Tianjin Simo”), Xi’an Simo Science and Technology Development Co., Ltd. (“Science and Technology”) and Xi’an Simo Imports and Exports Co., Ltd. (“Imports and Exports”), to certain shareholders of these three subsidiaries. As a result of the foregoing dispositions, Simo Motor no longer owns any of the outstanding equity of these three subsidiaries.

Note 4 – Acquisition of the noncontrolling interests

Effective April 1, 2010, Simo Motor, a PRC subsidiary of the Company, acquired all of the equity interests in its four subsidiaries, Tech Full Lamination Co., Ltd. (“Lamination”), Xi’an Simo A’Da Motor Co., Ltd. (“A’Da Motor”), Xi’an Tech Full Simo Moulds Co., Ltd. (“Moulds”) and Xi’an Tech Full Simo Transportation Co., Ltd. (“Transportation”). As a result of the above acquisitions, Simo Motor now owns 100% of the outstanding equity of these four subsidiaries.

Note 5 – Supplemental disclosure of cash flows

The Company prepares its statements of cash flows using the indirect method as defined under the ASC Topic 230. The following information relates to non-cash investing and financing activities for the three months ended March 31, 2011 and 2010.

Total interest paid amounted to $2,018,579 and $1,513,782 for the six months ended June 30, 2011 and 2010, respectively.

Total income tax paid amounted to $9,021,468 and $7,089,794 for the six months ended June 30, 2011 and 2010, respectively.

For six months ended June 30, 2011, notes receivable in the amount of $16,847, and other receivable in the amount of $664 were used for plant and equipment purchases. Other receivables in the amount of $98,758 were used to increase construction-in-progress. Accounts payables in the amount of $2,028 were reduced against proceeds from disposal of equipment.

For the six months ended June 20, 2011, $12,548,166 was transferred from advanced on equipment purchases to plant and equipment upon the receipt and installation of equipment.

For the six months ended June 30, 2011, $6,060,344 was transferred from advanced on equipment purchases to construction in progress after the equipment was received.

For the six months ended June 30, 2010, equipment in the amount of $322,027 was transferred as a reduction to accounts payable for $171,279 and as a reduction to other payables in the amount of $150,748.

For the six months ended June 30, 2011, $10,783,230 of notes payable – short term were transferred to accounts payable vendors for the purchase of raw materials. For the six months ended June 30, 2011, $4,408,950 of notes payable – short term was offset against notes receivable.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Note 6 – Accounts receivable, net

Accounts receivable consisted of the following:

	June 30,			December 31,
	2011			2010
	(Unaudited)

Accounts receivable	$	109,602,042		$	93,392,999
Less: allowance for bad debts		(9,443,358	)		(7,493,667	)
Accounts receivable, net	$	100,158,684		$	85,899,332

The following table consists of allowance for bad debts:

Allowance for bad debts at January 1, 2010	$	114,475
Increase in allowance		-
Negative provisions for allowance		(29,116)
Accounts receivable write off		-
Effect of foreign currency translation		3,447
Allowance for bad debts at June 30, 2010 (Unaudited)		88,806
Increase in allowance		7,686,302
Negative provisions for allowance		(204,544)
Accounts receivable write off		-
Effect of foreign currency translation		(76,897	)
Allowance for bad debts at December 31, 2010	$	7,493,667
Increase in allowance		1,961,100
Negative provisions for allowance		(45,118)
Accounts receivable write off		(2,702)
Effect of foreign currency translation		36,411
Allowance for bad debts at June 30, 2011 (Unaudited)	$	9,443,358

For the Simo Motor acquisition, the Company recorded acquired accounts receivables at the acquisition-date fair value. However, the fair value was disclosed on the Company’s Form 10K filing of 2009 with the original book value, reduced by a separate valuation allowance. Based on accounting guidance related to Business Combination, Paragraphs 805-20-30-1, a separate valuation allowances is not recognized for assets that are recorded at fair value at the acquisition date. Topic 805 requires assets, which include receivables and loans, to be measured at their acquisition-date fair value without a separate valuation allowance. As a result, the Company made a reclassification as follows as of December 31, 2009. No financial statement captions were impacted as only net numbers were stated on the balance sheet.

	December 31, 2009			Reclassification			December 31, 2009
							(Revised)
Accounts receivable	$	97,302,153		$	(3,864,793	)	$	93,437,360

Less: allowance for bad debts		(3,979,268	)		3,864,793			(114,475	)

Accounts receivable, net	$	93,322,885		$	-		$	93,322,885

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Note 7 – Inventories, net

The following is a summary of inventories by major category:

	June 30,			December 31,
	2011			2010
	(Unaudited)
Raw and packing materials	$	8,818,592		$	8,673,719
Work in process		22,239,299			20,819,664
Finished goods		33,735,144			29,252,978
Finished goods - consignment		76,097			6,421,301
Inventory valuation allowance		(3,073,528	)		(2,324,106	)
Total inventories, net	$	61,795,604		$	62,843,556

Allowance for inventory valuation at January 1, 2010	$	710,611
Additional reserves		-
Recovery of reserves		-
Effect of foreign currency translation		-
Allowance for inventory valuation at June 30, 2010 (Unaudited)		710,611
Additional reserves		3,940,870
Recovery of reserves		(2,340,118	)
Effect of foreign currency translation		12,743
Allowance for inventory valuation at December 31, 2010	$	2,324,106
Additional reserves		878,988
Recovery of reserves		(183,711	)
Effect of foreign currency translation		54,145
Allowance for inventory valuation at June 30, 2011 (Unaudited)	$	3,073,528

For the Simo Motor acquisition, the Company recorded acquired inventory at the acquisition-date fair value. However, the fair value was disclosed on the Company’s Form 10K filing of 2009 with the original book value, reduced by a separate valuation allowance. Based on accounting guidance related to Business Combination, Paragraphs 805-20-30-1, a separate valuation allowances are not recognized for assets that are recorded at fair value at the acquisition date. Topic 805 requires assets, which include receivables and loans, to be measured at their acquisition-date fair value without a separate valuation allowance. As a result, the Company made a reclassification as follows as of December 31, 2009. No financial statement captions were impacted as only net numbers were stated on the balance sheet.

	December 31, 2009			Reclassification			December 31, 2009
							(Revised)
Raw and packing materials	$	11,826,804		$	(2,903,706	)	$	8,923,098
Work in process		28,434,522			(3,258,327	)		25,176,195
Finished goods		25,471,544			(2,024,219	)		23,447,325
Finished goods - consignment		18,077,870			-			18,077,870
Inventory valuation allowance		(8,896,863	)		8,186,252		$	(710,611	)
Total inventory, net	$	74,913,877		$	-		$	74,913,877

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Note 8 – Advances on inventory purchases

The Company makes advances to certain vendors for inventory purchases. The advances on inventory purchases were $20,986,377 and $15,893,866 as of June 30, 2011 and December 31, 2010, respectively. For the three months ended June 30, 2011 and 2010, advances on inventory purchases amounted to $2,478,661 and $0, respectively, were directly written off due to vendors business failures. For the six months ended June 30, 2011 and 2010, $2,478,661 and $0 were directly written off from advances on inventory purchases.

Note 9 – Plant and equipment, net

The following table presents details of our property and equipment:

	June 30,			December 31,
	2011			2010
	(Unaudited)
Buildings	$	93,638,488		$	90,434,596
Office equipment		3,421,862			3,380,045
Production equipment		61,437,436			45,564,179
Vehicles		2,423,088			2,335,906
Assets held for sale		46,263			46,071
Construction in progress		57,651,085			43,172,049
Total		218,618,222			184,932,846
Less: accumulated depreciation		(16,739,593	)		(11,858,708	)
Property and equipment, net	$	201,878,629		$	173,074,138

Construction in progress represents labor costs, material, capitalized interest incurred in connection with the construction of the new plant facility in Shanghai and the construction and installation of manufacturing equipment in HTFE, Weihai, and Simo Motor. Construction in progress as of June 30, 2011, consisted of the following:

No.	Project Description	June 30, 2011		Commencement Date	Expected completion date
		(Unaudited)
1	Building construction for STFE facility	$	6,645,071	5/13/2009	12/31/2011
2	Manufacturing machinery and equipment for STFE		35,544,893	12/12/2008	9/30/2011
3	Building construction and manufacturing machinery and equipment for Weihai facility		15,267,358	8/20/2010	12/31/2011
4	Building construction and manufacturing machinery and equipment for Simo facility		169,651	11/30/2010 & 12/29/2010	12/31/2011
5	Others		24,112	Various	Various

	Total	$	57,651,085

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Depreciation expense for the three months ended June 30, 2011 and 2010, amounted to $2,673,138 and $1,941,073, respectively. Depreciation expense for the six months ended June 30, 2011 and 2010, amounted to $5,061,037 and $3,829,181, respectively.

For the six months ended June 30, 2011 and 2010, a total of $0 and $127,751 of interest were capitalized into construction in progress, respectively.

Note 10 – Advances on non-current assets

Advance for intangible assets

The advances for intangible assets consisted of land use right prepayment. As of June 30, 2011 and December 31, 2010, advances for intangible assets amounted to $27,198,715 and $3,645,361, respectively.

On September 8, 2006, HTFE entered into an agreement ("HTFE Land Use Agreement") with Shanghai Lingang Investment and Development Company Limited ("Shanghai Lingang") with respect to HTFE’s use of 40,800 square meters (approximately 10.1 acres) of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the "Site"). The size of the land used by HTFE was later revised to a total of approximately 53,000 square meters (approximately 13.1 acres). The term of the HTFE Land Use Agreement is 50 years and the aggregate amount HTFE shall pay to Shanghai Lingang is approximately $6.28 million (RMB 42,840,000) ("Fee"), approximately 96.8% or $6.08 million (RMB 41,452,020) has been paid, as of June 30, 2011. HTFE shall register a Sino-foreign joint venture company at the location of Shanghai Lingang, with taxes payable at the same location. HTFE has agreed to compensate Shanghai Lingang for certain local taxes due to the local tax authority in connection with applicable tax generation requirements.

On June 10, 2011, Simo Motor entered into a land use agreement (the “Simo Land Use Agreement”) with Xi’an Lintong Tourism and Business Development Management Commission (“Xi’an Lintong”) with respect to Simo Motor’s use of 500 Chinese Mu of land (approximately 82.4 acres or 333,500 square meters) located at Daixin Industrial Development Zone in Xi’an Lintong (the “New Site”). Pursuant to the Simo Land Use Agreement, the New Site will be used for construction of a new manufacturing facility that will produce electric equipment and machinery and related products as part of a capacity expansion project at Xi’an Simo. The term of the Simo Land Use Agreement is 50 years and the aggregate amount that Simo Motor shall pay to Xi’an Lintong is approximately $38.8 million (RMB 250 million). The Company made a pre-payment of $23.0 million (RMB 150 million) as of June 30, 2011 and will pay in full upon receipt of the land use license to be issued by the government.

Advance on plant and equipment purchases

The Company makes advances to certain vendors for equipments and construction projects. The advances on equipment and construction amounted to $36,624,941 and $48,830,831 as of June 30, 2011 and December 31, 2010, respectively.

Note 11 – Goodwill and other intangible assets

Net intangible assets consist of the following at:

	June 30, 2011			December 31, 2010
	(Unaudited)
Goodwill on 2008 Acquisition of Weihai	$	12,943,105		$	12,692,107
Goodwill on 2009 Acquisition of Simo Motor		43,062,719			42,227,631
Total goodwill		56,005,824			54,919,738
Land use rights		18,147,584			17,794,376
Patents		7,087,356			6,940,543
Software		16,871			16,648
Intellectual property		2,594,118			2,594,118
Customer lists		288,235			288,235
Total goodwill and other intangible assets		84,139,988			82,553,658
Less: accumulated amortization		(5,478,169	)		(4,486,841	)
Intangible assets, net	$	78,661,819		$	78,066,817

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Amortization expense for the three months ended June 30, 2011 and 2010 amounted to $440,676 and $387,916, respectively. Amortization expense for the six months ended June 30, 2011 and 2010 amounted to $897,937 and $753,764, respectively.

The Company uses the purchase method of accounting for business combinations. Annual testing for impairment of goodwill is performed during the fourth quarter of each year unless events or circumstances indicate earlier impairment testing is required. No impairment loss was recognized for the three months and six months ended June 30, 2011 and 2010. As a result of the disposition of three subsidiaries, effective April 1, 2010, Simo Motor no longer owns any of the outstanding equity of Tianjin Simo, Science and Technology, and Imports and Exports (see Note 3 for more discussion). Goodwill of these three former subsidiaries in the amount of $964,159 was included in the carrying amount of the reporting unit in determining the gain or loss on disposal.

	Weihai		Simo Motor			Total

Goodwill, as of January 1, 2010	$	12,273,778	$	41,799,976		$	54,073,754

Disposal of subsidiaries		-		(964,159	)		(964,159	)
Effect of foreign currency translation		-		-			-
Goodwill, as of June 30, 2010 (unaudited)		12,273,778		40,835,817			53,109,595

Disposal of subsidiaries		-		-			-

Effect of foreign currency, translation		418,329		1,391,814			1,810,143

Goodwill, as of December 31, 2010		12,692,107		42,227,631			54,919,738

Effect of foreign currency translation		250,998		835,088			1,086,086
Goodwill, as of June 30, 2011 (unaudited)	$	12,943,105	$	43,062,719		$	56,005,824

Note 12 – Other assets

Other assets, current, consisted of the following:

	June 30, 2011		December 31, 2010
	(Unaudited)
Other receivable, net	$	1,956,311	$	1,620,638
Prepaid expenses		1,044,745		503,330
Prepaid consulting service fee, current		600,000		-
Deferred tax assets		314,935		377,727
Total	$	3,915,991	$	2,501,695

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Other assets, non-current, consisted of the following:

	June 30, 2011		December 31, 2010
	(Unaudited)
Security deposit	$	1,500	$	1,500
Long term deferred expenses		340,176		677,491
Prepaid consulting service fee, non-current		3,397,279		724,335
Total	$	3,738,955	$	1,403,326

Prepaid consulting service fee, non-current represent retainer fee or prepaid consulting fees to third parties. In February 2011, the Company entered into a consulting service agreement with a third party which agreed to provide advisory and consulting services to obtain financing in Chinese Capital Market for a period of 5 years from 2011 to 2015. The service fee is non-refundable and amounted to $3 million. For the three month and six month ended June 30, 2011, $139,052 and $200,000 was amortized as professional fees. As of June 30, 2011, prepayment of $600,000 and $2,200,000 were included in current and non-current prepaid consulting service fee, respectively.

Note 13 – Taxes payable

Taxes payable consisted of the following:

	June 30, 2011			December 31, 2010
	(Unaudited)
VAT tax payable		$	1,645,155	$	1,930,544
Individual income tax withholding payable			98,733		84,965
Corporation income tax payable			5,902,207		3,672,511
Other miscellaneous tax payable			3,074,492		2,517,787
Total		$	10,720,587	$	8,205,807

Note 14 – Financing

On November 22, 2010, the Company entered into a Term Loan Facility Agreement, dated November 22, 2010 (the “CDB Agreement”) with China Development Bank Corporation, Hong Kong Branch (“CDB”) pursuant to which CDB has agreed to provide a USD$35,000,000 loan facility (“Facility A”) and an RMB100,000,000 loan facility (“Facility B,” and collectively with Facility A, the “Facilities”) to the Company (the loans made under Facility A shall be referred to herein as “Facility A Loans” and the loans made under Facility B shall be referred to herein as “Facility B Loans”). The Facility A Loans and the Facility B Loans shall be made pursuant to one or more borrowings from time to time during the period of time from the date of the CDB Agreement to the date falling on the expiration of six (6) months after the date of the CDB Agreement upon delivering a utilization request from the Company to CDB. Interest on Facility A Loans shall be 3% per annum plus LIBOR (as defined in the CDB Agreement). Interest on Facility B Loans shall be 2.5% per annum plus SHIBOR (as defined in the CDB Agreement). The Company is required to repay the Facility A Loans in two (2) equal installments on (i) the date which falls twenty four (24) months after the first utilization date of any loan and (ii) the date which falls thirty six (36) months after the first utilization date of any loan. The Company is required to repay the Facility B Loans in two (2) equal installments on (i) the date which falls twenty four (24) months after the first utilization date of any loan and (ii) the date which falls thirty six (36) months after the first utilization date of any loan.

The CDB Agreement provides that the Company may, upon not less than one month’s prior notice prepay on an Interest Payment Date (as defined in the CDB Agreement) or a Repayment Date (as defined in the CDB Agreement) all or part of any loan (but if in part, in an amount that is an integral multiple of UDS$500,000 in the case of a Facility A Loan or RMB 2,000,000 in the case of Facility B Loan). The CDB Agreement also provides that upon a Change of Control (as defined in the CDB Agreement) of the Company, CDB may, by not less than 30 days notice to the Company, cancel the Facilities and declare all outstanding loans, together with accrued interest and all other amounts to be immediately due and payable.

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

The Company’s obligations under the CDB Agreement are secured by a pledge of shares of common stock of the Company owned by its Chairman and Chief Executive Officer, Tianfu Yang. On November 22, 2010, Mr. Yang entered into a Security and Pledge Agreement (the “Pledge Agreement”) with CDB, pursuant to which, Mr. Yang has agreed to pledge 7,000,000 shares of common stock to CDB to secure the loans. Under the Pledge Agreement, Mr. Yang may also be obliged to pledge to CDB, under certain circumstances, additional shares of common stock owned by him and, to the extent such additional shares are not sufficient, cash.

Debt issuance costs of $500,000, resulting from the Term Loan Facility Agreement the Company entered into with CDB, are carried in other assets and are amortized over the life of the loan using the straight-line amortization method. A total of $41,667 was amortized to interest expense for the three months ended June 30, 2011. A total of $83,334 was amortized to interest expense for the six months ended June 30, 2011. As of June 30, 2011, unamortized debt issuance costs totaled $413,470.

Note 15 -Short and long term loans

The Company’s short term loans are comprised of the following:

	June 30, 2011		December 31, 2010
	(Unaudited)
Short term loans – bank	$	36,911,420	$	29,369,120
Short term loans – others		24,752		121,360
Total short term loans	$	36,936,172	$	29,490,480

HARBIN ELECTRIC, INC. AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2011

(UNAUDITED)

Short term loans – bank

	June 30, 2011			December 31, 2010
	(Unaudited)
Loan from Citic Bank in city of Wendeng, due from various dates from May to June 2011. Monthly interest-only payments at 5.310% per annum, secured by assets	$	-	$	3,185,700

Commercial bank in Weihai, due June June 3, 2012 monthly interest rate at 7.57% per annum, secured by assets and land use right		3,248,700		-

Loan from Commercial Bank in city of Weihai, due from various dates from August to September 2011. Monthly interest-only payments at 0.509% per annum, secured by assets		1,237,600		1,213,600

Loan from Bank of Communications, due in December 2011 to June 2012. Benchmark interest rate up by 10%, approximate rate of 6.116% to 6.94% per annum, guaranteed loan		3,094,000		3,034,000

Loan from Citic Bank, due in December 2011 through February 2012. Average interest from 5.31% to 8.48% per annum, secured by assets and guaranteed loan		7,735,000		6,523,100

Loan from China Merchant Bank, due various dates in June through June 2012. Monthly interest-only payments from 6.37% to 6.97% per annum, secured by assets and guaranteed by third party		3,403,400		8,495,200

Loan from Bank of China. Monthly interest-only payment at 4% per annum, unsecured, and due upon demand.		866,320		849,520

Loan from Bank of China, due in March through April 2012, Benchmark interest rate up, approximately 6.19% per annum, secured by assets guaranteed loan.		11,602,500		-

Loan from China Commercial Bank, due in November 2011. Monthly interest-only payment at 6.0% per annum, guaranteed loan		1,547,000		1,517,000

Loan from Shanghai Pudong Development Bank in city of Xi’an, due October 2011. Interest-only payments at 6.1% per annum, secured by Notes.		4,176,900

Loan from Huaxia Bank in city of Xi’an, due various dates from February to March 2011. Interest-only payments at 6.12% per annum, secured by assets.		-		4,551,000

Short term loans – bank	$

Nevada	98-0403396
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

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

		Page
Part I. Financial Information

Item 1. Financial Statements		3

Consolidated Balance Sheets As of June 30, 2011 (Unaudited) and December 31, 2010		3

Consolidated Statements of Operations and Other Comprehensive Income (Loss) For the Three Months and Six Months Ended June 30, 2011 and 2010 (Unaudited)		4

Consolidated Statements of Changes in Equity (Unaudited)		5

Consolidated Statements of Cash Flows For the Six Months Ended June 30, 2011 and 2010 (Unaudited)		6

Notes to the Consolidated Financial Statements (Unaudited)		7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		35

Item 3. Quantitative and Qualitative Disclosures About Market Risk		45

Item 4. Controls and Procedures		45

Part II. Other Information

Item 1. Legal Proceedings		46

Item 1A. Risk Factors		47

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		54

Item 3. Defaults Upon Senior Securities		54

Item 4. (Removed and Reserved)		54

Item 5. Other Information		54

Item 6. Exhibits		54

Signatures		55

Index to Exhibits		56