10-Q 1 v190651_10q.htm Unassociated Document
UNITED STATES
 
SECURITIES AND EXCHANGE COMMISSION
 
Washington, D.C. 20549
 
FORM 10-Q
 
x
Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 
for the fiscal quarter ended May 31, 2010
 
¨
Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 
for the transition period from ______ to______.
 
Commission file number: 000-52409
 
CHINA ENERGY CORPORATION
(Exact name of Registrant in its charter)
 
Nevada
98-0522950
(State or other jurisdiction of incorporation or
organization)
(IRS Employer Identification No.)
   
No. 57 Xinhua East Street
Hohhot, Inner Mongolia, PRC
010010
(Address of principal executive offices)
(Zip Code)
   
0471-466-8870
 
(Registrant’s 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 Exchange Act 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 ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes ¨ No x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated
filer ¨
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company
x
 
 
(Do not check if a smaller
 
 
 
reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.
¨ Yes      x No
 
State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:
 
Class
 
July 14, 2010
Common Stock, $0.001 par value
 
45,000,000 shares

 
 

 
 
TABLE OF CONTENTS
PART I.
FINANCIAL INFORMATION
 
   
 
ITEM 1.
Financial Statements
1
     
 
Consolidated Balance Sheets Income at May 31, 2010 and November 30, 2009
1
     
 
Consolidated Statements of Income For the Six Months Ended May 31, 2010 and May 31, 2009 (Unaudited)
2
     
 
Consolidated Statements of Changes For the Six Months Ended May 31, 2010 and May 31, 2009 (Unaudited)
3
     
 
Notes to Consolidated Financial Statements
5
     
ITEM 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
22
     
ITEM 3.
Quantitative And Qualitative Disclosure About Market Risk
32
     
ITEM 4T
Controls and Procedures
32
     
PART II.
OTHER INFORMATION
 
     
ITEM 1.
Legal Proceedings
32
     
ITEM 1A
Risk Factors
32
     
ITEM 2.
Unregistered Sales of Equity Securities and Use of Proceeds
32
     
ITEM 3.
Defaults Upon Senior Securities
33
     
ITEM 4.
(Removed and Reserved)
33
     
ITEM 5.
Other Information.
33
     
ITEM 6.
Exhibits and Reports on Form 8-K
33
     
 
Signatures
34

 
i

 

SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS
 
This report contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends affecting the financial condition of our business. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including, among other things:

 
·
general economic and business conditions, both nationally and in our markets,

 
·
government regulations on coal mining and heat power sectors,

 
·
our expectations and estimates concerning future financial performance, financing plans and the impact of competition,

 
·
our ability to implement our growth strategy,

 
·
anticipated trends in our business, and

 
·
advances in technologies

In addition, in this report, we use words such as “anticipates,” “believes,” “plans,” “expects,” “future,” “intends,” and similar expressions to identify forward-looking statements.
 
China Energy Corporation and its subsidiaries (the “Company”) undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this prospectus. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this prospectus may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements.

 
ii

 
 
ITEM 1. FINANCIAL STATEMENTS

CHINA ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

   
May 31,
   
November 30,
 
   
2010
   
2009
 
   
(Unaudited)
   
(Audited)
 
   
US$
   
US$
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 10,148,451     $ 5,073,645  
Term deposit-restricted
    7,320,108       -  
Accounts receivable, net of allowance for doubtful accounts of $120,782 and $120,853, respectively
    7,770,278       4,600,667  
Other receivables
    4,536,142       4,447,272  
Advance to suppliers
    6,000,416       5,511,630  
Inventories
    3,995,005       5,574,465  
Total current assets
    39,770,400       25,207,679  
                 
Fixed assets:
               
Property, plant and equipment
    51,058,566       50,546,862  
Construction in progress
    4,993,734       4,236,281  
      56,052,300       54,783,143  
Less: accumulated depreciation and depletion
    (9,344,274 )     (7,456,849 )
Net fixed assets
    46,708,026       47,326,294  
                 
Other assets:
               
Investment property, net of accumulated depreciation of $188,721 and $166,172, respectively
    1,912,498       1,936,278  
Intangible assets, net of amortization of $936,113 and $787,417, respectively
    3,476,360       3,627,642  
Restricted cash
    533,358       149,898  
Other long term assets
    486,077       450,021  
Notes receivable
    13,309,387       7,913,100  
Total other assets
    19,717,680       14,076,939  
                 
TOTAL ASSETS
  $ 106,196,106     $ 86,610,912  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Short term bank loans
  $ 16,104,238     $ 12,012,012  
Accounts payable
    10,673,206       11,489,568  
Notes payable
    5,856,087       -  
Advance from customers
    9,761,577       12,125,187  
Accrued liabilities
    651,448       325,539  
Other payables
    4,501,405       387,729  
Shareholder loans
    10,073,564       9,972,279  
Current portion of deferred income
    852,888       822,930  
Total current liabilities
    58,474,413       47,135,244  
                 
Deferred income, net of current portion
    6,067,091       6,224,033  
                 
Total liabilities
    64,541,504       53,359,277  
                 
Stockholders’ equity:
               
Common stock (authorized 200,000,000 shares of $0.001 par value; 45,000,000 shares issued and outstanding, respectively)
    45,000       45,000  
Additional paid-in capital
    8,655,805       8,655,805  
Paid-in capital – stock options
    315,000       315,000  
Retained earnings
    20,749,751       12,542,081  
Statutory reserves
    8,297,853       8,078,765  
Other comprehensive income
    3,591,193       3,614,984  
Total stockholders’ equity
    41,654,602       33,251,635  
                 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 106,196,106     $ 86,610,912  

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

 
1

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)

   
For the six months ended
May 31,
   
For the three months ended
May 31,
 
   
2010
   
2009
   
2010
   
2009
 
   
US$
   
US$
   
US$
   
US$
 
                         
Revenues
  $ 41,252,616     $ 9,298,621     $ 20,483,740     $ 4,283,675  
Cost of revenues
    (25,852,305 )     (8,924,191 )     (12,025,898 )     (4,236,939 )
Gross profit
    15,400,311       374,430       8,457,842       46,736  
                                 
Operating expenses:
                               
Selling and marketing
    (2,222,281 )     (238,153 )     (1,381,564 )     (195,516 )
General and administrative
    (1,731,846 )     (1,230,144 )     (628,194 )     (838,090 )
Total operating expenses
    (3,954,127 )     (1,468,297 )     (2,009,758 )     (1,033,606 )
                                 
Income (loss) from operations
    11,446,184       (1,093,867 )     6,448,084       (986,870 )
                                 
Investment income
    -       36,847       -       2,496  
Non-operating income
    682,678       325,173       569,215       164,772  
Finance expenses, net
    (771,001 )     (198,722 )     (555,652 )     (103,334 )
Government subsidies
    -       164,145       -       11,121  
Non-operating expenses
    (175,511 )     (757,083 )     (131,155 )     (56,418 )
Income (loss) before income taxes
    11,182,350       (1,523,507 )     6,330,492       (968,233 )
                                 
(Provision for) benefit from income taxes
    (2,755,592 )     24,590       (1,908,020 )     1,666  
                                 
Net income (loss)
  $ 8,426,758     $ (1,498,917 )   $ 4,422,472     $ (966,567 )
                                 
Other comprehensive income (loss)
                               
Foreign currency translation adjustment
    (23,791 )     79,005       (28,256 )     131,410  
Total comprehensive income (loss)
  $ 8,402,967     $ (1,419,912 )   $ 4,394,216     $ (835,157 )
                                 
Net income (loss) per common share basic
  $ 0.19     $ (0.03 )   $ 0.10     $ (0.02 )
                                 
Net income (loss) per common share diluted
  $ 0.17     $ (0.03 )   $ 0.09     $ (0.02 )
                                 
Weighted average common shares outstanding basic
    45,000,000       45,000,000       45,000,000       45,000,000  
                                 
Weighted average common shares outstanding diluted
    48,423,445       45,000,000       48,423,445       45,000,000  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
2

 
 
CHINA ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE SIX MONTHS ENDED MAY 31, 2010
(UNAUDITED)

               
Additional
   
Paid in
capital
               
Other
       
   
Shares
   
Amounts
   
Paid in
capital
   
Stock
options
   
Retained Earnings
   
Statutory
Reserves
   
Comprehensive
income
   
Total
 
Balance as of December 1, 2009
    45,000,000     $ 45,000     $ 8,655,805     $ 315,000     $ 12,542,081     $ 8,078,765     $ 3,614,984     $ 33,251,635  
Net income for the period
    -       -       -       -       8,426,758       -       -       8,426,758  
Other comprehensive (loss)
    -       -       -       -       -       -       (23,791 )     (23,791 )
Allocation of statutory reserve
    -       -       -       -       (219,088 )     219,088       -       -  
Balance as of May 31, 2010
    45,000,000     $ 45,000     $ 8,655,805     $ 315,000     $ 20,749,751     $ 8,297,853     $ 3,591,193     $ 41,654,602  

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

 
3

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
For the six months ended
May 31,
 
   
2010
   
2009
 
   
US$
   
US$
 
             
Cash flows from operating activities:
           
Net income (loss)
  $ 8,426,758     $ (1,498,917 )
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    2,108,233       1,441,566  
Interest accrued on shareholder loans
    109,348       106,433  
Loss on disposal of property, plant and equipment
    -       744,524  
Gain from short term investments
    -       (36,847 )
Changes in operating assets and liabilities:
               
(Increase) in term deposit
    (7,320,108 )     -  
(Increase) in restricted cash
    (383,460 )     -  
(Increase) in accounts receivable
    (3,048,758 )     (1,803,791 )
(Increase) in other receivables
    (88,870 )     (5,097,545 )
Decrease (increase) in advance to suppliers
    1,287,107       (770,088 )
Decrease (increase) in inventories
    1,579,460       (78,612 )
(Decrease) increase in deferred income
    (126,984 )     475,131  
Increase (decrease) in accounts payable
    198,588       (4,133,827 )
(Decrease) increase in advance from customers
    (2,363,610 )     838,514  
Increase in accrued liabilities and other payables
    4,439,585       415,551  
Net cash provided by (used in) operating activities
    4,817,289       (9,397,908 )
                 
Cash flows from investing activities:
               
Purchase of property, plant and equipment
    (3,093,625 )     (2,186,070 )
Increase in construction in progress
    (1,076,171 )     (698,877 )
(Increase) in notes receivable
    (5,396,287 )     (330,560 )
Payments received on notes receivable
    -       893,563  
Net cash (used in) investing activities
    (9,566,083 )     (2,321,944 )
                 
Cash flows from financing activities:
               
Proceeds from short term bank loans
    16,112,495       12,011,836  
Proceeds from notes payable
    5,856,087       -  
Principal payments made on short term bank loans
    (12,011,132 )     (2,929,716 )
Advance from shareholders
    513,711       4,439,636  
Repayments of shareholders loans
    (517,651 )     (594,000 )
Net cash provided by financing activities
    9,953,510       12,927,756  
                 
Effect of exchange rate changes on cash
    (129,910 )     33,140  
Net increase in cash and cash equivalents
    5,074,806       1,241,044  
 
               
Cash and cash equivalents, beginning of period
    5,073,645       456,802  
                 
Cash and cash equivalents, end of period
  $ 10,148,451     $ 1,697,846  
                 
Supplemental disclosure of cash flow information
               
                 
Cash paid for interest
  $ 554,554     $ 276,071  
Cash paid for income taxes
  $ 2,346,087     $ -  

The accompanying notes are an integral part of these consolidated financial statements.
 
 
4

 
 
CHINA ENERGY CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

1.
Organization and Business

Organization of the Company

China Energy Corporation (the “Company”) is a Nevada corporation, formed on October 11, 2002 under the name Omega Project Consultations, Inc.  The name was changed to China Energy Corporation on November 3, 2004.  On November 30, 2004, the Company entered into a share exchange agreement with Inner Mongolia Tehong Coal Group Co., Ltd. (“Coal Group”), and Inner Mongolia Zhunger Heat Power Co. Ltd. (“Heat Power”) and their respective shareholders. The transaction was accounted for as a reverse merger, a procedure that treats the transaction as though Coal Group had acquired the Company.  Under the accounting for a reverse merger, the assets and liabilities of the Company, which were nil at the time, were recorded on the books of Coal Group, the continuing company, and the stockholders’ equity accounts of Coal Group were reorganized to reflect the shares issued in this transaction.

The share exchange agreement, which resulted in the Company’s acquisition of the Coal Group and Heat Power, was governed by and valid under Nevada law and was not perfected under the then People’s Republic of China (“PRC”) law.  It was not until certain changes in PRC law, which became definitive in 2006, that the series of procedures of governmental approvals and corporate actions were clarified and the Company acknowleged the condition precedents to that perfection.

The Company does not believe the lack of perfection impairs its ability to exercise control over the Coal Group and Heat Power as it continues to exercise control over them, consistent with the intent of the original shareholders.

The Company is in the process of completing the necessary actions to meet the current PRC legal requirements related to the acquisition of Coal Group and Heat Power.  On July 13, 2009, the Company entered into a framework agreement which detailed the actions contemplated for the restructuring of the Company, Coal Group and Heat Power under a "variable interest entity" (“VIE”) structure to meet the current requirements of applicable PRC law.

The framework agreement provides that (i) the Company will establish a newly-formed, indirect subsidiary of the Company incorporated in the PRC (“CEC China”), (ii) CEC China will enter an exclusive service agreement and option agreement with each of Coal Group and Heat Power (collectively, the “Operating Companies”) and a share pledge agreement with each of the Operating Companies and certain of their respective PRC Shareholders (“PRC Shareholders”). The framework agreement also requires the PRC Shareholders to fully authorize CEC China to exercise all shareholders’ rights that the PRC Shareholders can exercise in the Operating Companies. By entering into the framework agreement and subsequently setting up the structure involving the use of VIEs, the Company will have the control and the economic benefits and costs of ownership of the Operating Companies consistent with PRC regulatory requirements.
 
 
5

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
The Company contemplates that the restructuring process will be completed during 2010.

Business:

The Company’s business is made up of two segments: Coal Group and Heat Power.

Coal Group: Coal Group was organized in China on August 8, 2000 as Inner Mongolia Zhunger Tehong Coal Co., Ltd. The name was changed in December 2003 to Inner Mongolia Tehong Coal Group Co. Ltd. Coal Group owns a coal mine in the Inner Mongolia District from which it produces coal. It also buys, sells, and transports coal, serving the Inner Mongolia District.  Coal Group has the capacity to produce approximately up to 800,000 metric tons per year based on enhancement of production lines, which was completed in August of 2009.

Heat Power: During 2003, Heat Power was granted a license, to supply heating to the entire XueJiaWan area.  To provide for this requirement, construction began in 2004 on a thermoelectric plant, which was completed in September 2006.  Heat Power supplies heating directly to users and supplies electricity within the XueJiaWan area through a government controlled intermediary, Inner Mongolia Electric Power Group Co., Ltd. (“Electric Power Group”).

Heat Power obtains its supply of powdered coal required to generate heat production from Zhunger County Guanbanwusu Coalmine (“Guanbanwusu”). It also obtains its supply through various other coal mines in the area.

2.
Summary of Significant Accounting Policies

Basis of Accounting and Presentation

The unaudited interim financial statements of the Company as of May 31, 2010 and for the three and six month periods ended May 31, 2010 and 2009, have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the Securities and Exchange Commission (the “SEC”) which apply to interim financial statements, including the accounts of China Energy Corporation and its subsidiaries, heat power and Coal Group.  In the opinion of management, such information contains all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for the periods presented.  The results of operations for the three and six months ended May 31, 2010 are not necessarily indicative of the results to be expected for future quarters or for the year ending November 30, 2010.

Certain information and disclosures normally included in the notes to financial statements have been condensed or omitted as permitted by the rules and regulations of the Securities and Exchange Commission, although the Company believes the disclosure is adequate to make the information presented not misleading. The accompanying unaudited financial statements should be read in conjunction with the audited financial statements of the Company for the year ended November 30, 2009.
 
 
6

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
Basis of Consolidation

The consolidated financial statements include the accounts of the Company and Coal Group and Heat Power.  All significant intercompany accounts and transactions have been eliminated in consolidation.

A subsidiary is an entity in which the Company, directly or indirectly, controls more than one half of the voting power; has the power to appoint or remove the majority of the members of the board of directors; to cast majority of votes at the meeting of the board of directors or to govern the financial and operating policies of the investee under a statute or agreement among the shareholders or equity holders.

Recently Issued Accounting Standards

In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2010-06, “Improving Disclosures about Fair Value Measurements (“ASU No. 2010-06”).  ASU No. 2010-06 amends FASB ASC Topic 820, “Fair Value Measurements and Disclosures”, to require additional information to be disclosed principally regarding Level 3 measurements and transfers to and from Level 1 and 2.  In addition, enhanced disclosure is required concerning inputs and valuation techniques used to determine Level 2 and Level 3 measurements.  This guidance is generally effective for interim and annual reporting periods beginning after December 15, 2009; however, requirements to disclose separately purchases, sales, issuances, and settlements in the Level 3 reconciliation are effective for fiscal years beginning after December 15, 2010 (and for interim periods within such years).  The update will not have a material impact on the Company’s consolidated results of operations or financial position.
 
In February 2010, the FASB issued Accounting Standards Update No. 2010-09, “Amendments to Certain Recognition and Disclosure Requirements” (“ASU No. 2010-09”).  ASU No. 2010-09 amends FASB ASC Topic 855-10, “Subsequent Events”, to remove the requirement for an SEC filer to disclose the date through which subsequent events have been evaluated in both issued and revised financial statements.  This change alleviates potential conflicts between ASC 855-10 and the SEC’s requirements.  The update did not have a material impact on the Company’s consolidated results of operations or financial position.

Foreign Currency Translations

Substantially all Company assets are located in China.  The functional currency for the majority of the Company’s operations is the Renminbi (“RMB”).  The Company uses the United States dollar (“US Dollar” or “US$” or “$”) for financial reporting purposes.  The financial statements of the Company’s foreign subsidiaries have been translated into US dollars in accordance with ASC 830, “Foreign Currency Matters.”   All asset and liability accounts have been translated using the exchange rate in effect at the balance sheet date.  Equity accounts have been translated at their historical exchange rates when the capital transaction occurred.  Statements of operations amounts have been translated using the average exchange rate for the period presented. Adjustments resulting from the translation of the Company’s financial statements are recorded as other comprehensive income.
 
 
7

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
The exchange rates used to translate amounts in RMB into US dollars for the purposes of preparing the consolidated financial statements were as follows:

   
May 31, 2010
 
May 31, 2009
 
November 30,
2009
 
Balance sheet items, except for the registered capital, additional paid-in capital, statutory reserves, retained earnings and other comprehensive income, as of period end
 
US$1=RMB 6.8305
 
US$1=RMB 6.8278
 
US$1=RMB 6.8265
 
   
 
         
Amounts included in the statements of operations, statements of changes in stockholders’ equity and statements of cash flows for the period
 
US$1=RMB 6.8270
 
US$1=RMB 6.8266
 
US$1=RMB 6.8330
 
 
For the six months ended May 31, 2010, a foreign currency translation adjustment of $23,791 has been reported as accumulated other comprehensive income in the consolidated statements of changes in stockholders’ equity.

Although government regulations now allow convertibility of RMB for current account transactions, significant restrictions still remain. Hence, such translations should not be construed as representations that RMB could be converted into US dollars at that rate or any other rate.

The value of RMB against the US dollars and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. Any significant revaluation of RMB may materially affect the Company’s consolidated financial condition in terms of US dollar reporting.

Cash and Cash equivalents

The Company considers all demand and time deposits and all highly liquid investments with an original maturity of three months or less as of the date of purchase to be cash equivalents.

Term Deposit

Term deposit represents amounts legally held by a bank which are not available for the Company’s general use.  These deposits are held as collateral for issuance of notes to vendors for purchase of coal which generally mature between three to six months.
 
Accounts Receivable

Accounts receivable is stated at cost, net of an allowance for doubtful accounts. The Company maintains an allowance for doubtful accounts for estimated losses resulting from the failure of customers to make required payments.  The Company reviews the accounts receivable on a periodic basis and makes allowances where there is doubt as to the collectibility of individual balances.  In evaluating the collectibility of individual receivable balances, the Company considers many factors, including the age of the balance, the customer’s payment history, its current credit-worthiness and current economic trends. As of May 31, 2010 and November 30, 2009, the balances of allowance for doubtful accounts were $120,782 and $120,853, respectively. For the periods presented, the Company did not write off any accounts receivable as bad debts.
 
 
8

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
Inventories

Inventories consisted of coal and operating supplies. Inventories are valued at the lower of cost or market, with cost being determined on the first in, first out basis.  Provisions are made for excess, slow moving and obsolete inventory as well as inventory whose carrying value is in excess of market. The Company did not make any inventory adjustments for the six months ended May 31, 2010 and 2009, and year ended November 30, 2009.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost, less accumulated depreciation. Cost includes the price paid to acquire or construct the asset, including capitalized interest during the construction period, and any expenditures that substantially increase the assets value or extend the useful life of an existing asset.  Depreciation is computed using the straight line method over the estimated useful lives of property, plant and equipment, which are approximately five years for electrical and office equipment, ten years for transportation equipment and pipelines, and 20 to 45 years for buildings.  Leasehold improvements are amortized over the lesser of their estimated useful lives or the term of the lease.  Capitalized costs related to assets under construction are not depreciated until construction is complete and the asset is ready for its intended use.  Major repairs and betterments that significantly extend original useful lives or improve productivity are capitalized and depreciated over the period benefited. Maintenance and repairs are generally expensed as incurred.  When property and equipment 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.

Costs of mine development, expansion of the capacity of or extending the life of the mine (“Mining Structures”) are capitalized and amortized using the units-of-production (“UOP”) method over the productive life of the mine based on proven and probable reserves.  Mining Structure includes the main and auxiliary mine shafts, underground tunnels, ramps, and other integrant mining infrastructure.

Investment Property

Investment property represents rental real estate purchased by the Company for investment purposes.  Depreciation is computed using the straight line method over the estimated useful life of 45 years.  The related rental income is included in non-operating income in the accompanying consolidated statements of operations.

Mining Right

All land in China belongs to the government.  To extract resources from land, the Company is required to obtain a mining right.  The Company’s Coal Group acquired its mining right from the Provincial Bureau of National Land and Resource in November of 2005.  The price of the mining right, which represents the acquisition cost of the mine, was assessed by the Bureau to be $3,656,731.  The mine acquisition cost is payable in instalments over a six year period from the date the mining right was granted.  The mine acquisition cost is amortized using the UOP method over the productive life of the mine based on proven and probable reserves.

 
9

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

Restricted Cash

Long-term restricted cash represents the bank deposits placed as guarantee for the future payments of rehabilitation costs as required by the PRC government. The long-term deposits carry an interest rate of 0.6% per annum.

Advance from Customers

Advance from customers primarily consists of payments received from customers by the Coal Group and Heat Power prior to the delivery of goods and services.

Deferred Income

Deferred income represents reimbursements received by Heat Power from various real estate development companies for the cost of constructing pipelines to connect to rural areas being developed.  The income is recognized on a straight line basis over the estimated useful life of the pipelines of ten years.

Impairment of Long-lived Assets

The Company utilizes FASB ASC 360, Property, Plant and Equipment” (“ASC 360”), which addresses the financial accounting and reporting for the recognition and measurement of impairment losses for long-lived assets. In accordance with ASC 360, long-lived assets are reviewed at least annually for impairment or, whenever events or changes in circumstances indicate that carrying amount of an asset may not be recoverable. The Company may recognize impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to these assets. If the total of the expected undiscounted future net cash flows is less than the carrying amount of the asset, a loss, if any, is recognized for the difference between the fair value of the asset and its carrying value. No impairment of long-lived assets was recognized for the six months ended May 31, 2010 and 2009.

Recognition of Revenue

Revenues from sales of products are recognized when the products are delivered and the title is transferred, the risks and rewards of ownership have been transferred to the customer, the price is fixed and determinable and collection of the related receivable is reasonably assured.

Revenue associated with sales of coal is recognized when the title to the goods has been passed to customers, which is the date when the goods are delivered to designated locations and accepted by the customers.
 
Heat Power supplies heat to users directly and supplies electricity through a government controlled intermediary. Revenue from sales of heat and electricity represents the amount of tariffs billed for heat and electricity generated and transmitted to the users and government controlled intermediary, respectively.
 
 
10

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
Resource Compensation Fees

In accordance with the relevant regulations, a company that is engaged in coal production business is required to pay a fee to the Inner Mongolia National Land and Resources Administration Bureau as the compensation for the depletion of coal resources. Coal Group was required to pay a resource compensation fee of $123,840 and $15,885 for the six months ended May 31, 2010 and 2009, respectively, which is included in cost of goods sold in the statements of operations.
 
Environmental Costs

The PRC has adopted extensive environmental laws and regulations that affect the operations of the coal mining industry. The potential of environmental liabilities under proposed or future environmental legislation cannot be reasonably estimated at present, and could be material. Under existing legislation, however, Company management believes that there are no probable liabilities that will have a material adverse effect on the consolidated balance sheets of the Company.

Fair Value of Financial Instruments

Financial instruments include accounts receivable, advance to suppliers and other receivables, short term bank loans, accounts payable, advance from customers, accrued liabilities, other payables and shareholder loans. As of May 31, 2010 and November 30, 2009, the carrying values of these financial instruments approximated their fair values.

Income Taxes

Coal Group and Heat Power generate their income in China where Value Added Tax, Income Tax, City Construction and Development Tax and Education Surcharge taxes are applicable. The Company, Coal Group and Heat Power do not conduct any operations in the U.S. and therefore, are not subject to U.S. taxes (see Note 13).

The Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes” (“ASC 740”), which requires the recognition of deferred income taxes for differences between the basis of assets and liabilities for financial statement and income tax purposes.  Deferred tax assets and liabilities represent the future tax consequence for those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.  Deferred taxes are also recognized for operating losses that are available to offset future taxable income.  Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.
 
 
11

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimated.

Net Income (Loss) Per Share

The Company computes net income (loss) per common share in accordance with FASB ASC 260, “Earnings Per Share” (“ASC 260”) and SEC Staff Accounting Bulletin No. 98 (“SAB 98”).  Under the provisions of ASC 260 and SAB 98, basic net income (loss) per common share is computed by dividing the amount available to common shareholders by the weighted average number of shares of common stock outstanding during the period.  Diluted income (loss) per common share is computed by dividing the amount available to common shareholders by the weighted average number of shares of common stock outstanding plus the effect of any dilutive shares outstanding during the period.  Accordingly, the number of weighted average shares outstanding as well as the amount of net income (loss) per share are presented for basic and diluted per share calculations for all periods reflected in the accompanying consolidated financial statements.

Statutory Reserves

Pursuant to corporate law of the PRC, the Company is required to maintain statutory reserves by appropriating from its after-tax profit before declaration or payment of dividends.  The statutory reserves, representing restricted retained earnings, consist of the following funds:
 
Surplus Reserve Fund: The Company is required to transfer 10% of its net income, as determined under PRC accounting rules and regulations, to a statutory surplus reserve fund until such reserve balance reaches 50% of the Company’s registered capital. The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of the shares currently held by them, provided that the remaining reserve balance after such issuance is not less than 25% of the registered capital.

Common Welfare Fund: The common welfare fund is a voluntary fund that the Company can elect to transfer 5% to 10% of its net income, as determined under PRC accounting rules and regulations, to this fund. This fund can only be utilized on capital items for the collective benefit of the Company’s employees, such as construction of dormitories, cafeteria facilities, and other staff welfare facilities. This fund is non-distributable other than upon liquidation.
 
 
12

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

Non-Surplus Reserve Fund (Safety and Maintenance): According to ruling No. 119 (2004) issued on May 21, 2004, and amended ruling No. 168 (2005) on April 8, 2005 by the PRC Ministry of Finance regarding Accrual and Utilization of Coal Production Safety Expense” and Criterion on Coal Mine Maintenance and Improvement,” the Company is required to set aside to a safety fund of RMB 6 per ton and RMB 10 per ton of raw coal mined for 2010 and 2009, respectively, and RMB 10.5 per ton for a maintenance fund.  As defined under US GAAP, a liability for safety and maintenance expenses does not exist at the balance sheet date because there is no present obligation to transfer assets or to provide services as a result of any past transactions. Therefore, for financial reporting purposes, this statutory reserve has been recorded as an appropriation of retained earnings.

The statutory reserves consist of the following:

   
May 31, 2010
   
November 30, 2009
 
             
Surplus Reserve and Common Welfare fund
  $ 2,447,598     $ 2,447,598  
Safety and Maintenance fund
    5,850,255       5,631,167  
Total statutory reserves
  $ 8,297,853     $ 8,078,765  

Stock Options

Stock options are accounted for upon issuance at fair market value.  Such value is determined at the date a commitment is made for issuance.  The value of options is included in a separate part of stockholders' equity.  Upon exercise or cancellation, the value of such options is transferred to additional paid-in capital.

Asset Retirement Cost and Obligation

The Company has adopted FASB ASC 410, Asset Retirement and Environmental Obligations” (“ASC 410”). ASC 410 generally requires that the Company’s legal obligations associated with the retirement of long-lived assets are recognized at fair value at the time the obligations are incurred. Obligations are incurred at the time development of a mine commences for underground mines or construction begins for support facilities, refuse areas and slurry ponds. The obligation’s fair value is determined using discounted cash flow techniques and is accreted over time to its expected settlement value. Upon initial recognition of a liability, a corresponding amount is capitalized as part of the carrying amount of the related long-lived asset.  The related asset is amortized using the UOP method over the productive life of the mine based on proven and probable reserves.  The Company did not incur and does not anticipate incurring any material dismantlement, restoration and abandonment costs given the nature of its producing activities and the current PRC regulations surrounding such activities.
 
Vulnerability Due to Operations in PRC

The Company’s operations may be adversely affected by significant political, economic and social uncertainties in the PRC. Although the PRC government has been pursuing economic reform policies for more than twenty years, no assurance can be given that the PRC 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 affecting the PRCs political, economic and social conditions. There is also no guarantee that the PRC government’s pursuit of economic reforms will be consistent or effective.
 
 
13

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

All of the Company’s businesses are transacted in RMB, which is not freely convertible. The People’s Bank of China or other banks are authorized to buy and sell foreign currencies at the exchange rates quoted by the Peoples 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 suppliers’ invoices, shipping documents and signed contracts.

Since the Company has its primary operations in the PRC, the majority of its revenues will be settled in RMB, not US dollars. Due to certain restrictions on currency exchanges that exist in the PRC, the Company’s ability to use revenue generated in RMB to pay any dividend payments to its shareholders outside of China will be limited.

All of the Company’s bank accounts are in banks located in PRC and are not covered by protection similar to that provided by the FDIC on funds held in United States banks.

The Company's mining operations are subject to extensive national and local governmental regulations in China, which regulations may be revised or expanded at any time.  Generally, compliance with these regulations requires the Company to obtain permits issued by government regulatory agencies.  Certain permits require periodic renewal or review of their conditions.  The Company cannot predict whether it will be able to obtain or renew such permits or whether material changes in permit conditions will be imposed. The inability to obtain or renew permits or the imposition of additional conditions could have a material adverse effect on the Company's ability to develop and operate its mines.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

3.   Segment Reporting

The Company is made up of two segments of business, Coal Group which derives its revenue from the mining and purchase and sale of coal, and Heat Power which derives its revenue by providing heating and electricity to residents and businesses of a local community.  Each of these segments is conducted in a separate corporation and each functions independently of the other.

Except for the loans made to Heat Power by Coal Group in the principal amount of RMB 94 million (equivalent to U.S. $13.7 million) as of May 31, 2010, during the periods reported herein, there were no other transactions between the two segments.  There also were no differences between the measurements used to report operations of the segments and those used to report the consolidated operations of the Company.  In addition, there were no differences between the measurements of the assets of the reported segments and the assets reported on the consolidated balance sheets.

 
14

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

 
   
Six Months Ended May 31,
 
   
2010
   
2009
 
   
Heat
   
Coal
         
Heat
   
Coal
       
   
Power
   
Group
   
Total
   
Power
   
Group
   
Total
 
   
US$
   
US$
   
US$
   
US$
   
US$
   
US$
 
Sales to external customers
    7,475,617       33,776,999       41,252,616       6,124,333       3,174,288       9,298,621  
Finance expense (income), net
    177,155       593,846       771,001       109,223       89,499       198,722  
Depreciation and depletion
    1,358,895       749,338       2,108,233       1,227,834       213,732       1,441,566  
Segment profit (loss)
    598,615       7,828,143       8,426,758       (1,646,181 )     147,264       (1,498,917 )
                                                 
   
Three Months Ended May 31,
 
   
2010
   
2009
 
   
Heat
   
Coal
           
Heat
   
Coal
         
   
Power
   
Group
   
Total
   
Power
   
Group
   
Total
 
   
US$
   
US$
   
US$
   
US$
   
US$
   
US$
 
Sales to external customers
    2,954,707       17,529,033       20,483,740       2,639,270       1,644,405       4,283,675  
Finance expense (income), net
    126,323       429,329       555,652       57,288       46,046       103,334  
Depreciation and depletion
    670,986       458,121       1,129,107       598,236       54,369       652,605  
Segment profit (loss)
    (47,877 )     4,470,349       4,422,472       (1,078,798 )     112,231       (966,567 )
 
   
May 31, 2010
   
November 31, 2009
 
   
Heat
   
Coal
         
Heat
   
Coal
       
   
Power
   
Group
   
Total
   
Power
   
Group
   
Total
 
   
US$
   
US$
   
US$
   
US$
   
US$
   
US$
 
Segment assets
    54,769,439       51,426,667       106,196,106       49,346,842       37,264,070       86,610,912  
Construction in progress
    4,300,766       692,968       4,993,734       3,514,152       722,129       4,236,281  
Investment property, net
    -       1,912,498       1,912,498       -       1,936,278       1,936,278  

4.
Shareholder Loans

Substantial portions of the cost of construction of the thermoelectric plant and of the costs of expansion projects at Heat Power and the coal mine were provided by shareholder loans. Balances are detailed below:

   
May 31, 2010
   
November 30, 2009
 
Ordos City YiYuan Investment Co., Ltd.
  $ 1,666,191     $ 1,634,404  
Hangzhou Dayuan Group, Ltd.
    4,979,281       5,428,963  
Xinghe County Haifu Coal Transportation & Sales Co., Ltd.
    1,841,749       1,807,686  
Wenxiang Ding
    -       28,565  
Yanhua Li
    1,539,126       1,025,416  
Yi Ding
    47,217       47,245  
Total
  $ 10,073,564     $ 9,972,279  
 
 
15

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
The shareholder loans are due on demand and part of shareholder loans bore interest at 5.310%.

   
May 31, 2010
   
November 30, 2009
 
   
Balance
   
Interest
rate
   
Balance
   
Interest
rate
 
Shareholder loans – interest free
  $ 1,586,343       0 %   $ 1,101,226       0 %
Shareholder loans – interest bearing
    6,470,976       5.310 %     6,964,156       3.155 %
Interest payable
    2,016,245               1,906,897          
Total
  $ 10,073,564             $ 9,972,279          

5.
Lease obligation

The Company leases an office under an operating lease expiring in the year ending December 31, 2011. The minimum future annual rent payments under the lease as of May 31, 2010 are approximated as follows:
  
Year Ending
   
Annual
 
November 30,
   
Amount
 
2010
    $ 43,921  
2011
      87,841  
2012
      7,320  
Total
    $ 139,082  

Rent expenses charged to operations for the six months ended May 31, 2010 and 2009 were $43,943 and $43,946, respectively.

6.    Advances to Suppliers

As is customary in China, the Company has made advances to its suppliers.  At May 31, 2010 and November 30, 2009, advances amounted to $6,000,416 and $5,511,630, respectively.  There is no interest due on these advances; the advances are offset against billings as they are made by the suppliers.

7.    Other Receivables

Other receivables consist of the following:

   
May 31, 2010
   
November 30, 2009
 
Loans to suppliers and other associated firms
  $ 1,439,773     $ 1,332,038  
Deposit funds to secure agreements
    510,558       509,392  
Employee expense advances
    199,011       217,643  
Government subsidies receivable
    1,464,022       1,464,880  
Heat network access fee receivable
    922,778       923,319  
Total
  $ 4,536,142     $ 4,447,272  
 
 
16

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)
 
On a periodic basis, management reviews the other receivable balances and establishes allowances where there is doubt as to the collectability of the individual balances.  In evaluating collectability of the individual balances, the Company considers factors such as the age of the balance, payment history, and credit-worthiness of the creditor.   The Company considers all other receivables at May 31, 2010 and November 30, 2009 to be fully collectible and, therefore, did not provide for an allowance for doubtful accounts.

8.    Fixed Assets

Fixed assets, consisting principally of buildings, machinery and equipment and construction in progress, are summarized as follows:
 
   
May 31, 2010
   
November 30, 2009
 
Buildings
  $ 10,302,813     $ 9,682,139  
Machinery & equipment
    39,041,597       39,322,399  
Automotive equipment
    984,474       919,922  
Office Equipment
    729,682       622,402  
Construction in progress
    4,993,734       4,236,281  
      56,052,300       54,783,143  
Accumulated depreciation and depletion
    (9,344,274 )     (7,456,849 )
Fixed assets, net
  $ 46,708,026     $ 47,326,294  

Depreciation expenses charged to operations for the six months ended May 31, 2010 and 2009 were $1,892,762 and $1,303,472, respectively.

9.    Notes Receivable

Certain loans were made for strategic purposes. Notes receivable, which are non-interest bearing except as noted below and payable on demand, consist of the following:

   
May 31, 2010
   
November 30, 2009
 
Inner Mongolia XiangRong Investment Management Co., Ltd.
  $ 1,378,092     $ 1,378,900  
Inner Mongolia Tehong Investment Co., Ltd.
    8,017,068       3,244,785  
Inner Mongolia Tehong Coal Chemical Co., Ltd.
    1,674,841       761,737  
QuanYing Coal Mine
    301,886       916,311  
Inner Mongolia XinKe Kaolin Fabrication Plant
    1,639,704       1,611,367  
Inner Mongolia Tehong Glass Co.,Ltd., with interest at11.16%
    297,796       -  
Total notes receivable
  $ 13,309,387     $ 7,913,100  
 
 
17

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

10. Short Term Bank Loans

The Company has bank loans collateralized by the investment property and guaranteed by a related party.  Relevant terms of these bank loans are as follows:

   
May 31,2010
   
November 30, 2009
 
Bank loan due 3/9/11, with interest at 6.372%
  $ 5,856,087     $ -  
Bank loan due 4/15/11, with interest at 6.372%
    7,320,108       -  
Bank loan due 4/22/11, with interest at 6.903%
    2,928,043       -  
Bank loan due 12/5/09, with interest at 6.696%
    -       1,757,855  
Bank loan due 3/15/10, with interest at 6.372%
    -       8,789,277  
Bank loan due 4/21/10, with interest at 6.372%
    -       1,464,880  
Total
  $ 16,104,238     $ 12,012,012  
 
11. Fair Value Measurement

FASB ASC 820 specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs).  In accordance with ASC 820, the following summarizes the fair value hierarchy:

Level 1 Inputs – Unadjusted quoted market prices for identical assets and liabilities in an active market that the Company has the ability to access.

Level 2 Inputs – Inputs, other than the quoted prices in active markets that are observable either directly or indirectly.

Level 3 Inputs – Inputs based on prices or valuation techniques that are both unobservable and significant to the overall fair value measurements.

ASC 820 requires the use of observable market data, when available, in making fair value measurements.  When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement.

Following is a description of the valuation methodologies used for assets measured at fair value.  There have been no changes in the methodologies used at May 31, 2010.

Notes receivable:  Valued at the net realizable value which approximates the fair value.

The method described above may produce a fair value calculation that may not be indicative of net realizable value or reflective of future values.  Furthermore, while the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date.
 
 
18

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

The following table presents the Company’s assets and related valuation inputs within the fair value hierarchy utilized to measure fair value on a recurring basis as of May 31, 2010:

   
Level 1
   
Level 2
   
Level 3
   
Total
 
Notes receivable
  $ -     $ -     $ 13,309,387     $ 13,309,387  
Total
  $ -     $ -     $ 13,309,387     $ 13,309,387  

The following table presents the Company’s assets and related valuation inputs within the fair value hierarchy utilized to measure fair value on a recurring basis as of November 30, 2009:

   
Level 1
   
Level 2
   
Level 3
   
Total
 
Notes receivable
  $ -     $ -     $ 7,913,100     $ 7,913,100  
Total
  $ -     $ -     $ 7,913,100     $ 7,913,100  

The following table presents a Level 3 reconciliation of the beginning and ending balances of the fair value measurements using significant unobservable inputs:
 
   
Notes Receivable
   
Total
 
Balance, December 1, 2009
  $ 7,913,100     $ 7,913,100  
Purchases, sales, issuance and settlements (net)
    5,396,287       5,396,287  
Balance, May 31, 2010
  $ 13,309,387     $ 13,309,387  

12. Government Subsidies

Government subsidies are primarily comprised of financial support provided by the local government to Heat Power to ensure supply of heat to the XueJiaWan area as the price for heat charged is regulated and approved by the government.  The financial support includes revenue subsidies to compensate for lower government regulated prices charged for heat and cost subsidies for purchase of coal used in providing heat.  Government subsidies are intended to be an incentive for Heat Power to supply heat at the government regulated prices.  Government subsidies amounted to zero and $164,145 for the six month periods ended May 31, 2010 and 2009, respectively, and are included in government subsidies in the accompanying consolidated statements of operations.

13. Income Taxes

The Company is required to file income tax returns in both the United States and China. Its operations in the United States have been insignificant and income taxes have not been accrued.  In China, the Company files tax returns for Heat Power and Coal Group and, although it is part of Coal Group, a separate tax return is required for the operations of the coal mine.  The laws of China permit the carryforward of net operating losses for a period of five years.  At May 31, 2010, the Chinese entities had no net operating losses available for future use as confirmed by the local tax authority.
 
 
19

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

Under ASC 740, recognition of deferred tax assets is permitted unless it is more likely than not that the assets will not be realized.  The Company has recorded deferred tax assets as follows:

   
May 31, 2010
   
November 30, 2009
 
Deferred tax assets
  $ -     $ 256,010  
Valuation allowance
    -       (256,010 )
Balance recognized
  $ -     $ -  

Deferred tax assets consist primarily of future tax benefits of net operating losses recognized for Heat Power.  A full valuation allowance has been established for the year ended November 30, 2009 since the Company is unable to determine if and when those benefits will be realized.

The following tables reconcile the effective income tax rate with the statutory rate for the period ended May 31, 2010:

Six months ended
May 31, 2010
 
Income Before
Income Taxes
   
Tax Provision
   
Rate of
Tax
 
As reported on the consolidated statements of operations
  $ 11,182,350     $ 2,755,592       24.6 %
Gain not used in calculation of taxable income on the tax returns
    (159,982 )     -       0.4 %
As calculated with statutory rate
  $ 11,022,368     $ 2,755,592       25 %
 
The Company has adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxesan interpretation of SFAS 109.” (“FIN 48”), as codified in ASC 740.  ASC 740 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under ASC 740, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position would be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement.  ASC 740 also provides guidance on de-recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, and accounting for interest and penalties associated with tax positions.

The Company did not file its U.S. federal income tax returns, including, without limitation, information returns on Internal Revenue Service (“IRS”) Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations” for the years ended November 30, 2002 through 2005, and 2008.  The Company was also late in filing for the years ended November 30, 2006 and 2007. Failure to furnish any information with respect to any foreign business entity required, within the time prescribed by the IRS, subjects the Company to certain civil penalties.  The Company is unable to determine the amount of any penalties that may be assessed at this time.  Management is of the opinion that penalties, if any, that may be assessed would not be material to the consolidated financial statements.
 
 
20

 

CHINA ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED MAY 31, 2010 AND 2009
(UNAUDITED)

In addition, because the Company did not generate any income in the United States or otherwise have any U.S. taxable income, the Company does not believe that it owes U.S. federal income taxes, or in respect to any transactions that the Company or any of its subsidiaries may have engaged in through May 31, 2010. However, there can be no assurance that the IRS will agree with this position, and therefore the Company ultimately could be held liable for U.S. federal income taxes, interest and penalties.

14. Contingency

As is customary in China, except for auto coverage, Coal Group and Heat Power do not carry sufficient insurance.  As a result the Company is effectively self-insuring risk of potential accidents that may occur in the workplace.  Given the nature of the industry, the Company may be exposed to risks that could have a material adverse impact on its consolidated financial statements.

China has enacted legislation which appears to restrict the ability of entities considered foreign to China, like the Company, to have ownership interest in operating companies located in China.  The Company has taken steps to avoid any potential adverse impact of this legislation.  (See Note 1)

The Company did not file the information reports for the years ended November 30, 2004 through 2009 concerning its interests in foreign bank accounts on TD F 90-22.1, “Report of Foreign Bank and Financial Accounts” (“FBARs”). For not complying with the FBAR reporting and recordkeeping requirements, the Company is subject to civil penalties up to $10,000 for each of its foreign bank accounts over the six year periods since November 30, 2004. The Company does not believe that the failure to file the FBARs was “willful” and intends to seek a waiver of any penalties. The Company is unable to determine the amount of any penalties that may be assessed at this time and believes that penalties, if any, that may be assessed would not be material to the consolidated financial statements.

 
21

 


Overview

Through Coal Group, we produce coal using the longwall method of mining at the LaiYeGou coal mine located in the Dongsheng coal field near the Dongsheng district of Ordos City, Inner Mongolia.  In addition to selling coal we produce at our mine, Coal Group also buys, sells and transports coal as part of its expanding proprietary coal trading business.  Each year the PRC government regulates the amount of coal we and other coal producers are able to sell by allocating space to coal mines in Inner Mongolia to ship their coal on rail cars to the port in Qinhuangdao, where regional users come to buy the coal on the open market. In order to capitalize on excess quota for rail space that we may have from time to time, commencing in 2008, we began to buy excess coal from other coal producers in Inner Mongolia and then pay to have that coal delivered by rail from the other companies’ mines to the Qinhuangdao port.  Our business of buying and re-selling coal on a proprietary basis expanded in 2009 as a result of our receipt of additional quota for space on trains from the local railway bureau.  Due to the increased quota, we were able to trade more coal.  Parties are awarded additional quotas based on their successful use of the quota in the previous year.  Our quota increased from 500,000 tons in 2009 to 840,000 tons in 2010.  We believe that, given the demand for coal and our past track record of successfully filling our extra quota, we will be able to grow our coal trading business through increased quotas granted to us by the local railway bureau; however, our ability to use any or all of our quota in 2010 will vary with market conditions and is dependent on our ability to source commercially acceptable coal purchases and subsequent trades.  Coal that we produce and sell directly to our customers is customarily transported at the buyer’s expense and therefore does not count against our quota.

Through Heat Power, we use our thermoelectric plant to generate and provide heating and electricity to residential and commercial customers throughout XueJiaWan, the administrative center of Zhunger, one of the seven counties of Ordos.

Coal Group is the major revenue and profit driver of the Company. While the sales prices of heat and electricity units generated by Heat Power are regulated by government, sales prices of coal are market driven. Therefore, Coal Group enjoys a higher gross margin compared to Heat Power.

Coal Group experiences lower sales volume in Q1 each year due to the Chinese New Year holidays. Heat Power provides heating from October 15th each year to April 15th of the next calendar year, resulting in higher sales and profit in Q1, lower sales in Q2 and Q4, and no sales from heating in Q3 each year.

History

On November 30, 2004, we entered into a Share Exchange Agreement with Coal Group and Heat Power, both Chinese corporations, whereby we acquired all the issued and outstanding stock of Coal Group and 49% of the issued and outstanding stock of Heat Power in consideration of 45,000,000 shares of our common stock. The offers and sales of the shares were exempt from registration under Regulation S of the Securities Act as they were made to off-shore, non US residents. The remaining 51% of the shares of Heat Power is owned by Coal Group.

The shareholders of both companies unanimously agreed to enter into the Share Exchange Agreement for the purposes of restructuring in anticipation of becoming listed on the OTC Bulletin Board. We were formed by the shareholders of Coal Group and Heat Power for this purpose and prior to entering into the Share Exchange Agreement we had no assets, liabilities or equity and had not issued any of our shares. As a result of entering into the Share Exchange Agreement; the shareholders of Coal Group and Heat Power became our shareholders. The 45,000,000 shares issued to the shareholders of Coal Group and Heat Power were allocated based on the capital contributions or ownership of such shareholders. The Agreement therefore was a non-arms length transaction.

 
22

 

As a result of new PRC merger and acquisition regulations, the Company was required to undergo an application process to convert each of Coal Group and Heat Power from a domestic PRC company to a Foreign Invested Enterprise (“FIE”) pursuant to which a FIE business license would be obtained.  The regulations required the Company, as a foreign investor, to invest cash equity interest into both operating companies. Accordingly, the Company formulated a plan pursuant to which it would be able to raise the funds to become an FIE.  As part of this plan, on December 30, 2007, the Company acquired PPI, a Nevada company with no assets, liabilities or equity. The Company holds 100% of the issued and outstanding shares of PPI, or 5,000 common shares with a par value of $ 0.001.On December 31, 2007, PPI entered into a Trust Agreement with all the registered shareholders of Coal Group and Heat Power, pursuant to which all the shareholders are obligated to hold their interests in Coal Group and Heat Power (represented by their registered paid up capital contributions to date) in trust for PPI, for an eight year term, extendable for another five years. In addition, prior to the execution of the PPI Trust Agreement, controlling shareholders of the Company, including Wenxiang Ding, Yanhua Li and members of their immediate family, transferred their shares of the Company to Georgia Pacific Investments Inc. (“GPI”) and Axim Holdings Ltd. (“Axim”) to be held in trust with the view that GPI and Axim would sell the shares in the open market in order to fund a plan to convert Coal Group and Heat Power into FIEs to raise the mandated cash equity investment under PRC rules for FIEs. The sole shareholder and director of each of GPI and Axim is Yi Ding, son of WenXiang Ding, our President and Chief Executive Officer. The Company has decided to forgo the FIE plan in favor of an alternative structure involving the use of “variable interest entities” or VIEs to reduce any regulatory risks relating to the foreign ownership structure of the Company.

Pursuant to a VIE restructuring as contemplated by a framework contract entered in June 2009, a newly-formed subsidiary of the Company (“CEC China”), will enter into a series of contractual arrangements with the registered shareholders of the operating companies so that the control and the economic benefits and costs of ownership of the operating companies would flow directly to CEC China through a series of management and business cooperation agreements. CEC China would also have the option to purchase the equity interests in Coal Group and Heat Power held by the registered shareholders. The registered shareholders will pledge their equity interests in Coal Group and Heat Power as security for their agreement to comply with provisions of the management and cooperation agreements and would provide CEC China with a power of attorney to exercise all their shareholder rights in Coal Group and Heat Power. The contractual arrangements under the VIE structure are intended to comply with, and be enforceable under, applicable PRC law, and would adequately reduce any PRC regulatory risk without the capital contributions necessary under the FIE plan initially proposed by the Company. In connection with the planned VIE restructuring, the Company and the registered shareholders have entered into a framework contract in July 2009 pursuant to which the Company and the registered shareholders have agreed to enter into the aforementioned agreements.

Operating Companies

Coal Group

Coal Group, organized in China on August 8, 2000, produces coal from the LaiYeGou coal mine located in Erdos City, Inner Mongolia, PRC.  Since the acquisition of LaiYeGou in 1999, Coal Group’s principal activities consist of the production of “Powered” coal and “lump” coal from raw coal and the sale of products to heating and power industries, distributors and coking factories for steel production.  Coal Group also buys, sells, and transports coal, as part of its proprietary coal trading activities.

Heat Power

Heat Power has two distinct operations servicing customers in the XueJiaWan district in Ordos City, Inner Mongolia.  Heat Power supplies (i) steam heating and (ii) electricity to end users.  In 2003, Heat Power was granted a license to supply heating to the entire XueJiaWan district. In order to have sufficient heating supply, in 2004 Heat Power began construction on a thermoelectric plant which was completed in September 2006. In conjunction with the thermoelectric plant, Heat Power also owns and operates 32 heat transfer stations.

 
23

 

Heat Power obtains its supply of powdered coal required to generate heat production principally from Zhunger County Guanbanwusu Coalmine (“Guanbanwusu”), an unrelated third party vendor. It also obtains coal from various other coal mines in the area. We do not supply Heat Power with coal for fuel.

In the XueJiaWan area, hardly anyone owns a domestic heating boiler.  Water is first heated in the Company’s thermoelectric plant by the high-temperature steam used for generating electricity, and then piped directly to homes and public buildings, including private dwellings, factories as well as municipal facilities, and lastly the water is piped back to the thermoelectric plant to repeat the process.

Results of Operations

Results of operations – Three Months Ended May 31, 2010

Revenues

The following is an analysis of our revenues and gross profit, details and analysis of components of expenses, and variance; for the three months ended May 31, 2010 compared to May 31, 2009:

Coal Group
 
Three Months Ended May 31,
 
         
% to total
         
% to total
 
   
2010
   
revenue
   
2009
   
revenue
 
Revenues
  $ 17,529,033       86       1,644,405       38  
Cost of revenues
  $ 9,041,968       44       965,883       22  
Gross Profit
  $ 8,487,065       42       678,522       16  
 
Heat Power 
 
Three Months Ended May 31,
 
         
% to total
         
% to total
 
   
2010
   
revenue
   
2009
   
revenue
 
Revenues
  $ 2,954,707       14       2,639,270       62  
Cost of revenues
  $ 2,983,930       15       3,271,056       77  
Gross Profit
  $ (29,223 )     (1 )     (631,786 )     (15 )

Coal Group
 
For the three months ended May 31, 2010, revenues for Coal Group were $17,529,033 compared to $1,644,405 in the comparable three months in 2009. The $15,884,628 increase was due to the fact that the production at LaiYeGou coal mine was partially shut down for the installation of the long wall automatic mining equipments and normal production resumed in the third quarter in 2009 with the completion of the installment and adjustment of the equipment.  The increase of the volume of proprietary trading of coal also contributed to the increase of revenue from Coal Group as compared to the prior comparable quarter in 2009.

Coal Trading
 
Three Months Ended May 31,
 
         
% to total
         
% to total
 
   
2010
   
revenue
   
2009
   
revenue
 
Revenues
  $ 7,699,181       38       1,141,455       26  
Cost of revenues
  $ 5,198,322       25       748,247       17  
Gross Profit
  $ 2,500,859       13       393,208       9  
 
Coal Production 
 
Three Months Ended May 31,
 
         
% to total
         
% to total
 
   
2010
   
revenue
   
2009
   
revenue
 
Revenues
  $ 9,829,852       48       502,950       12  
Cost of revenues
  $ 3,843,646       19       217,636       5  
Gross Profit
  $ 5,986,206       29       285,314       7  

 
24

 

Coal Group produced approximately 227,000 metric tons of coal during the three months ended May 31, 2010, compared to 12,000 metric tons in the comparable three months in 2009. Volume of coal sold by our proprietary trading business was approximately 183,000 metric tons during the three months ended May 31, 2010, compared to 16,000 metric tons in the comparable three months in 2009. We expect our 2010 annual production volume to be 800,000 metric tons.

Heat Power
 
For the three months ended May 31, 2010, revenues for Heat Power were $2,954,707 compared to $2,639,270 in the comparable three months in 2009.
 
For the three months ended May 31, 2010, revenues generated by Heat Power from its electricity operations were $1,158,751 compared to $1,033,782 in the comparable three month period in 2009.  Our revenue during the second quarter from our electricity operations was as follows:

Electricity Revenue for Quarter Ended May 31,
 
  
             
Units of
                   
  
             
power
                   
  
             
supplied
   
Revenue
 
   
Unit Price ($/KW.h)
   
(1000KW.h)
   
($)
 
Period
 
2010
   
2009
   
2010
   
2009
   
2010
   
2009
   
Variance
 
March
   
0.03
     
0.03
     
9,042
     
14,054
     
294,221
     
421,620
     
(127,399
April
   
0.03
     
0.03
     
15,605
     
11,171
     
502,567
     
335,136
     
167,431
 
May
   
0.03
     
0.03
     
11,523
     
9,235
     
361,963
     
277,026
     
84,937
 
                                                         
Total
                   
36,170
     
34,460
     
1,158,751
     
1,033,782
     
124,969
 
 
For the three months ended May 31, 2010, revenues generated by Heat Power from its heating supply operations were $1,795,956 compared to $1,532,403 in the comparable three month period in 2009. The $263,553 increase was due to the increase of heating area to 2.7 million square meters in the second quarter this year from 2.1 million square meters in the same period last year.  The heating area increased due to the continued development of the XueJiaWan area.  We are expecting this trend to continue for at least through the end of this fiscal year.  Our revenue during the second quarter from our heating supply operations were as follows:

Heating Revenue for Quarter Ended May 31,
 
  
 
Unit Price
   
Area (‘000)
       
  
 
($/sq meters
   
sq meters
   
Revenue
 
   
/month)
   
range)
   
($)
 
User
 
2010
   
2009
   
2010
   
2009
   
2010
   
2009
   
Variance
 
Residential
   
0.38*
     
0.34
     
2,039
     
1,440
     
1,156,772
     
923,380
     
233,392
 
Commercial
   
0.64
     
0.56
     
350
     
350
     
338,961
     
322,964
     
15,997
 
Municipal
   
0.64
     
0.56
     
310
     
310
     
300,223
     
286,059
     
14,164
 
                                                         
Total
                   
2,699
     
2,100
     
1,795,956
     
1,532,403
     
263,553
 
 
This price does not include subsidy received from government.

 
25

 
 
Cost of Sales

For the three months ended May 31, 2010, cost of sales increased by approximately $7,788,959 from the comparable three months in 2009, as a result of changes in the following expenses:
 
  
 
Three Months Ended May 31,
 
   
2010
   
2009
   
Variance
 
Coal & freight
  $ 9,557,244       2,526,981       7,030,263  
Heat resource rental
    439,518       252,528       186,990  
Depreciation & depletion
    1,078,589       604,141       474,448  
Salaries
    297,141       217,199       79,942  
Utilities
    429,795       243,488       186,307  
Operating supplies
    156,719       102,335       54,384  
Repairs
    27,397       15,537       11,860  
Others
    39,495       274,730       (235,235
                         
Total
  $ 12,025,898       4,236,939       7,788,959  
 
For the three months ended May 31, 2010 our gross margin was 41% compared with 1% in the 2009 comparable three month period. The increase reflected the fact that the production at LaiYeGou coal mine was partially shut down due to the installation of the new mining equipment, and normal production resumed in the third quarter of last year with the completion of the installation and adjustment of the equipment. Under normal production conditions, Coal Group has higher gross margins than Heat Power, and it also contributes more to the total gross profit of the Company. Gross margin from Heat Power also increased because of the expanded heating area.

Utilities, operating supplies and repairs expenses are expected to increase in line with revenue.
 
Selling Expenses

For the three months ended May 31, 2010, selling expenses increased by approximately $1,186,048 compared to the same period in 2009 as a result of the expandsion of our proprietary coal trading business. We were able to expand such business because we were allotted additional space on trains from the local railway bureau.  Selling expenses are expected to increase in line with revenue.
 
  
 
Three Months Ended May 31,
 
   
2010
   
2009
   
Variance
 
Transportation & Storage
  $ 864,642       159,745       704,897  
Sales tax and other expenses
    392,623       24,347       368,276  
Office
    82,511       5,780       76,731  
Salaries and wages
    37,665       5,644       32,021  
Depreciation
    4,123       -       4,123  
                         
Total
  $ 1,381,564       195,516       1,186,048  
 
General and Administrative Expenses

For the three months ended May 31, 2010, general and administrative expenses decreased by approximately $209,896 as a result of changes in the following expenses:
 
   
Six Months Ended May 31,
 
   
2010
   
2009
   
Variance
 
Office
  $ 166,134       154,891       11,243  
Professional and other fees
    171,274       377,780       (206,506
Salaries and wages
    122,210       152,108       (29,898
Travel
    70,203       46,831       23,372  
Depreciation
    76,109       74,807       1,302  
Repairs
    6,466       24,654       (18,188
Other
    15,798       7,019       8,779