Unassociated Document

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
   (Mark one)

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

For the quarterly period ended September 30, 2009
Or
¨ TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to _________
Commission file number: 000-33123
 
China Automotive Systems, Inc.
(Exact name of registrant as specified in its charter)

Delaware
33-0885775
(State or other jurisdiction of incorporation or
organization)
(I.R.S. employer identification number)
 

No. 1 Henglong Road, Yu Qiao Development Zone, Shashi District,
Jing Zhou City, Hubei Province, People’s Republic of China

(Address of principal executive offices)
 
Issuer’s telephone number: (86) 716- 832- 9196
 Issuer’s fax number: (86) 716-832-9298

Not Applicable
 (Former name, former address and former fiscal year, if changed since last report.)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨  

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 o No o

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

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

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

As of September 30, 2009, the Company had 26,984,744 shares of common stock issued and outstanding.
 

 
CHINA AUTOMOTIVE SYSTEMS, INC.
INDEX
 
   
Page
Part I — Financial Information
   
     
Item 1.  Financial Statements
 
   
Condensed Consolidated Statements of Operations (Unaudited) for the Three Months and Nine Months Ended September 30, 2009 and 2008
 
3
Condensed Consolidated Statements of Comprehensive Income  (Unaudited) for the Three Months and Nine Months Ended September 30, 2009 and 2008
 
5
Condensed Consolidated Balance Sheets at September 30, 2009 (Unaudited) and December 31, 2008
 
6
Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2009 (Unaudited) and December 31, 2008
 
7
Condensed Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2009 and 2008
 
8
Notes to Condensed Consolidated Financial Statements (Unaudited) for the Nine Months Ended September 30, 2009 and 2008
 
10
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
30
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
 
45
Item 4.  Controls and Procedures
 
46
     
Part II — Other Information
   
     
Item 1.  Legal Proceedings
 
46
Item 1A.  Risk Factors
 
46
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
 
51
Item 3.  Defaults Upon Senior Securities
 
51
Item 4.  Submission of Matters to a Vote of Security Holders
 
51
Item 5.  Other Information
 
51
Item 6.  Exhibits
 
51
Signatures
 
53
 
2

 
PART 1 — FINANCIAL INFORMATION
 
Item 1. Financial Statements
 
China Automotive Systems, Inc.
Condensed Consolidated Statements of Operations (Unaudited)

   
Three Months Ended September 30,
 
   
2009
   
2008
 
Net product sales, including $1,384,458 and $967,591 to related parties for the three months ended September 30, 2009 and 2008
 
$
64,654,369
   
$
36,936,755
 
Cost of product sold, including $3,477,109 and $1,783,822 purchased from related parties for the three months ended September 30, 2009 and 2008
   
47,015,047
     
27,058,532
 
Gross profit
   
17,639,322
     
9,878,223
 
Add: Gain on other sales
   
284,234
     
343,326
 
Less: Operating expenses-
               
Selling expenses
   
4,334,443
     
2,309,064
 
General and administrative expenses
   
2,739,886
     
2,060,675
 
R&D expenses
   
531,383
     
665,552
 
Depreciation and amortization
   
663,408
     
1,488,842
 
Total Operating expenses
   
8,269,120
     
6,524,133
 
Income from operations
   
9,654,436
     
3,697,416
 
Add: Other income, net (note 22)
   
-
     
123,167
 
Financial income (expenses) net (note 23)
   
(401,121
)
   
(446,261
)
Gain on change in fair value of derivative (note 24)
   
3,129,794
     
677,417
 
Income before income taxes
   
12,383,109
     
4,051,739
 
Less: Income taxes (note 25)
   
1,789,836
     
309,480
 
Net income
 
$
10,593,273
   
$
3,742,259
 
Net income attributable to noncontrolling interests
   
2,036,762
     
983,480
 
Net income attributable to common shareholders
 
$
8,556,511
   
$
2,758,779
 
Net income per common share attributable to common shareholders -
               
Basic (note 26)
 
$
0.32
   
$
0.10
 
Diluted (note 26)
 
$
0.28
   
$
0.09
 
Weighted average number of common shares outstanding –
               
Basic
   
26,983,717
     
26,983,244
 
Diluted
   
31,412,485
     
31,431,026
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
   
3

 
China Automotive Systems, Inc.
Condensed Consolidated Statements of Operations (Unaudited)

   
Nine Months Ended September 30,
 
   
2009
   
2008
 
Net product sales, including $3,257,716 and $3,766,078 to related parties for the nine months ended September 30, 2009 and 2008
 
$
171,836,094
   
$
124,912,138
 
Cost of product sold, including $8,463,331 and $6,387,212 purchased from related parties for the nine months ended September 30, 2009 and 2008
   
123,497,209
     
88,358,541
 
Gross profit
   
48,338,885
     
36,553,597
 
Add: Gain on other sales
   
523,860
     
595,226
 
Less: Operating expenses-
               
Selling expenses
   
10,509,910
     
7,721,240
 
General and administrative expenses
   
6,787,918
     
7,828,458
 
R&D expenses
   
1,415,531
     
1,404,525
 
Depreciation and amortization
   
1,742,162
     
4,234,633
 
Total Operating expenses
   
20,455,521
     
21,188,856
 
Income from operations
   
28,407,224
     
15,959,967
 
Add: Other income, net (note 22)
   
-
     
322,626
 
Financial income (expenses) net (note 23)
   
(1,318,829
)
   
(884,708
)
Gain on change in fair value of derivative (note 24)
   
591,511
     
1,672,570
 
Income before income taxes
   
27,679,906
     
17,070,455
 
Less: Income taxes (note 25)
   
4,714,124
     
718,417
 
Net income
 
$
22,965,782
   
$
16,352,038
 
Net income attributable to noncontrolling interests
   
6,074,110
     
4,418,730
 
Net income attributable to common shareholders
 
$
16,891,672
   
$
11,933,308
 
Net income per common share attributable to common shareholders -
               
Basic (note 26)
 
$
0.63
   
$
0.47
 
Diluted (note 26)
 
$
0.58
   
$
0.45
 
Weighted average number of common shares outstanding –
               
Basic
   
26,983,402
     
25,272,884
 
Diluted
   
31,627,696
     
28,734,809
 

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


China Automotive Systems, Inc.
Condensed Consolidated Statements of Comprehensive Income (Unaudited)

   
Three Months Ended September 30,
 
   
2009
   
2008
 
Net income
 
$
10,593,273
   
$
3,742,259
 
Other comprehensive income:
               
Foreign currency translation gain (loss)
   
38,176
     
781,552
 
Comprehensive income
 
$
10,631,449
   
$
4,523,811
 
Comprehensive income attributable to non-controlling interests
   
2,047,034
     
1,102,557
 
Comprehensive income attributable to common shareholders
 
$
8,584,415
   
$
3,421,254
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
China Automotive Systems, Inc.
Condensed Consolidated Statements of Comprehensive Income (Unaudited)

   
Nine Months Ended September 30,
 
   
2009
   
2008
 
Net income
 
$
22,965,782
   
$
16,352,038
 
Other comprehensive income:
               
Foreign currency translation gain (loss)
   
(164,153
)
   
6,878,591
 
Comprehensive income
 
$
22,801,629
   
$
23,230,629
 
Comprehensive income attributable to non-controlling interests
   
6,093,502
     
5,900,024
 
Comprehensive income attributable to common shareholders
 
$
16,708,127
   
$
17,330,605
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
5

 
China Automotive Systems, Inc.
Condensed Consolidated Balance Sheets

   
September 30, 2009
     
December 31, 2008
 
   
(Unaudited)
       
             
ASSETS
  
         
Current assets:
           
Cash and cash equivalents
 
$
45,894,475
   
$
37,113,375
 
Pledged cash deposits (note 3)
   
9,252,284
     
6,739,980
 
Accounts and notes receivable, net, including $2,940,878 and $1,285,110 from related parties at September 30, 2009 and December 31, 2008 (note 4)
   
131,518,363
     
96,424,856
 
Advance payments and other, including $256,880 and $9,374 to related parties at September 30, 2009 and December 31, 2008
   
2,038,161
     
1,442,614
 
Inventories (note 6)
   
29,388,926
     
26,571,755
 
Total current assets
 
$
218,092,209
   
$
168,292,580
 
Long-term Assets:
               
Property, plant and equipment, net (note 7)
 
$
58,226,765
   
$
51,978,905
 
Intangible assets, net (note 8)
   
673,054
     
504,339
 
Other receivables, net, including $869,318 and $903,674 from related parties at September 30, 2009 and December 31, 2008 (note 5)
   
1,214,876
     
1,349,527
 
Advance payments for property, plant and equipment, including $2,739,564 and $2,473,320 to related parties at September 30, 2009 and December 31, 2008
   
2,826,235
     
6,459,510
 
Long-term investments
   
79,075
     
79,010
 
Deferred income tax assets (note 9)
   
2,916,305
     
2,383,065
 
Total assets
 
$
284,028,519
   
$
231,046 ,936
 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Bank loans (note 10)
 
$
9,518,231
   
$
7,315,717
 
Accounts and notes payable, including $1,849,590 and $1,097,642 to related parties at September 30, 2009 and December 31, 2008 (note 11)
   
89,332,480
     
59,246,043
 
Convertible notes payable (note 12)
   
-
     
32,922,077
 
Derivative liabilities (note 13)
   
-
     
1,502,597
 
Customer deposits
   
552,519
     
236,018
 
Accrued payroll and related costs
   
3,064,192
     
2,715,116
 
Accrued expenses and other payables(note 14)
   
14,971,228
     
12,460,784
 
Accrued pension costs (note 15)
   
3,863,194
     
3,806,519
 
Taxes payable (note 16)
   
9,254,273
     
5,717,438
 
Amounts due to shareholders/directors (note 17)
   
50,034
     
337,370
 
Total current liabilities
 
$
130,606,151
   
$
126,259,679
 
Long-term liabilities:
               
Convertible notes payable (note 12)
   
28,534,712
     
-
 
Derivative liabilities (note 13)
   
913,063
     
-
 
Advances payable (note 18)
   
233,914
     
234,041
 
Total liabilities
 
$
160,287,840
   
$
126,493,720
 
Related Party Transactions and balances (note 28)
               
Commitments and contingencies (note 29)
   
  
     
  
 
Stockholders' equity:
               
Preferred stock, $0.0001 par value - Authorized - 20,000,000 shares Issued and outstanding – None
 
$
-
   
$
-
 
Common stock, $0.0001 par value - Authorized - 80,000,000 Shares Issued and Outstanding - 26,984,744 shares at September 30, 2009 and 26,983,244 shares at December 31, 2008 (note 19)
   
2,698
     
2,698
 
Additional paid-in capital (note 19)
   
27,353,646
     
27,148,206
 
Retained earnings-
               
Appropriated
   
8,324,533
     
7,525,777
 
Unappropriated
   
52,119,432
     
36,026,516
 
Deferred stock compensation (note 20)
 
(375,039
   
(500,052
)
Accumulated other comprehensive income
   
10,943,960
     
11,127,505
 
Non-controlling interests (note 21)
   
25,371,449
     
23,222,566
 
Total stockholders' equity
 
$
123,740,679
   
$
104,553,216
 
Total liabilities and stockholders' equity
 
$
284,028,519
   
$
231,046,936
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
6

 
China Automotive Systems, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity
Period Ended September 30, 2009 (unaudited) and December 31, 2008
 
                                 
Accumulated
             
   
Common Stock
   
Additional
               
Deferred
   
Other
             
          
Par
   
Paid-in
   
Retained Earnings
   
stock
   
Comprehensive
   
Non-controlling
       
    
Shares
   
Value
   
Capital
   
Appropriated
   
Unappropriated
   
Compensation
   
Income (Loss)
   
Interests
   
Total
 
Balance at January 1, 2008  
    23,959,702     $ 2,396     $ 30,125,951     $ 7,525,777     $ 23,591,275     $ -     $ 5,989,463     $ 23,166,270     $ 90,401,132  
Net income for the year ended December 31, 2008  
    -       -       -       -       12,435,241       -       -       5,071,408       17,506,649  
Foreign currency translation gain  
    -       -       -       -       -       -       5,138,042       1,432,977       6,571,019  
Capital contribution  
    -       -       -       -       -       -       -       745,723       745,723  
Issuance of common stock  
    3,023,542       302       22,089,698       -       -       -       -       -       22,090,000  
Issuance of stock options to independent directors and management  
    -       -       845,478       -       -       (500,052 )     -       -       345,426  
Payment for acquisition of 35.5% Henglongs equity  
    -       -       (25,912,921 )     -       -       -       -       (6,177,079 )     (32,090,000 )
Dividend distribution  
    -       -       -       -       -       -       -       (1,016,733 )     (1,016,733 )
Balance at December 31, 2008  
    26,983,244     $ 2,698     $ 27,148,206     $ 7,525,777     $ 36,026,516     $ (500,052 )   $ 11,127,505     $ 23,222,566     $ 104,553,216  
Net income for the nine months ended September 30, 2009  
    -       -       -       -       16,891,672       -       -       6,074,110       22,965,782  
Foreign currency translation gain (loss)  
    -       -       -       -       -       -       (183,545  )     19,392       (164,153  )
Exercise of stock options
    1,500               8,790                                               8,790  
Grant of stock options
                    196,650                                               196,650  
Amortization for stock-based compensation  
    -       -       -       -       -       125,013       -       -       125,013  
Dividend distribution  
    -       -       -       798,756       (798,756 )     -       -       (3,944,619  )     (3,944,619  )
Balance at September 30, 2009  
    26,984,744     $ 2,698     $ 27,353,646     $ 8,324,533     $ 52,119,432     $ (375,039 )   $ 10,943,960     $ 25,371,449     $ 123,740,679  
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

7

 
China Automotive Systems, Inc.
Condensed Consolidated Statements of Cash Flows (Unaudited)

   
Nine Months Ended September 30,
 
   
2009
   
2008
 
Cash flows from operating activities:
           
Net income
 
$
22,965,782
   
$
16,352,038
 
Adjustments to reconcile net income from continuing operations to net cash provided by operating activities:
               
Stock-based compensation
   
321,663
     
95,400
 
Depreciation and amortization
   
5,940,068
     
7,320,365
 
Allowance for doubtful accounts (Recovered)
   
(1,484,680
)
   
70,303
 
Deferred income taxes assets
   
(531,244
)
   
(582,746
)
Amortization for discount of convertible note payable
   
612,635
     
302,771
 
(Gain) loss on change in fair value of derivative
   
(591,511
)
   
(1,672,570
)
Other operating adjustments
   
(226,916
)
   
(11,054
)
Changes in operating assets and liabilities:
               
(Increase) decrease in:
               
Pledged deposits
   
(2,505,479
)
   
(4,188,067
Accounts and notes receivable
   
(33,727,451
)
   
(12,353,480
)
Advance payments and other
   
(593,563
)
   
(703,006
)
Inventories
   
(2,794,500
)
   
(8,253,097
)
Accounts and notes payable
   
30,025,373
     
8,678,459
 
Customer deposits
   
316,133
     
19,248
 
Accrued payroll and related costs
   
346,723
     
29,914
 
Accrued expenses and other payables
   
2,685,922
     
1,049,671
 
Accrued pension costs
   
53,613
     
(126,889
)
Taxes payable
   
3,528,700
     
(1,536,750
)
Advances payable
   
(317
)
   
(126,834
)
Net cash provided by operating activities
 
$
24,340,951
   
$
4,363,676
 
Cash flows from investing activities:
               
(Increase) decrease in other receivables
   
125,815
     
(385,893
)
Cash received from equipment sales
   
678,132
     
143,672
 
Cash paid to acquire property, plant and equipment
   
(8,814,876
)
   
(9,463,155
)
Cash paid to acquire intangible assets
   
(321,671
)
   
(117,064
)
Cash paid for the acquisition of 35.5% of Henglong
   
-
     
(10,000,000
)
Net cash (used in) investing activities
 
$
(8,332,600
)
 
$
(19,822,440
)
Cash flows from financing activities:
               
Proceeds from (repayment of) bank loans
   
2,197,177
     
(9,030,840
)
Dividends paid to the non-controlling interest holders of Joint-venture companies
   
(4,176,583
)
   
(5,159,657
)
(Decrease) in amounts due to shareholders/directors
   
(287,854
)
   
(78,857
)
Proceeds on exercise of stock options
   
8,790
     
-
 
Capital contribution from the non-controlling interest holders of Joint-venture companies
   
-
     
745,723
 
Proceeds on issuance of convertible note payable
   
-
     
35,000,000
 
Repayment of convertible note payable
   
(5,000,000
)
   
-
 
Net cash provided by (used in) financing activities
 
$
(7,258,470
)
 
$
21,476,369
 
Cash and cash equivalents effected by foreign currency
 
$
31,219
   
$
1,683,815
 
Net increase in cash and cash equivalents
   
8,781,100
     
7,701,420
 
Cash and cash equivalents at beginning of period
   
37,113,375
     
19,487,159
 
Cash and cash equivalents at end of period
 
$
45,894,475
   
$
27,188,579
 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
8

 
China Automotive Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Unaudited) (continued)
 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
 
   
Nine Months Ended September 30,
  
   
2009
   
2008
 
Cash paid for interest
 
$
1,217,604
   
$
1,169,852
 
Cash paid for income taxes
 
$
3,113,660
   
$
2,333,676
 

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
   
Nine Months Ended September 30,
 
   
2009
   
2008
 
             
Acquisition of 35.5% of Henglong from the minority shareholder on a cashless basis
 
$
-
   
$
(22,090,000
)
Liability resulting from issuance of common stock to acquire 35.5% of Henglong's equity
   
-
     
22,090,000
 
Issuance of warrants to purchase common stock
   
-
     
798,626
 
Derivative liabilities
   
-
     
1,703,962
 
Warrants and derivative liabilities for issuance of Convertible Debt are considered as discount of Convertible Debt.
 
$
-
   
(2,502,588
)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
9


China Automotive Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Unaudited)
Three Months and Nine Months Ended September 30, 2009 and 2008

1.  Organization and Business
 
China Automotive Systems, Inc., “China Automotive”, was incorporated in the State of Delaware on June 29, 1999 under the name Visions-In-Glass, Inc.  China Automotive, including, when the context so requires, its subsidiaries and the subsidiaries’ interests in the Sino-foreign joint ventures described below, is referred to herein as the “Company”. The Company is primarily engaged in the manufacture and sale of automotive systems and components, as described below.

Great Genesis Holdings Limited, a company incorporated on January 3, 2003 under The Companies Ordinance in Hong Kong as a limited liability company, “Genesis”, is a wholly-owned subsidiary of the Company.

Henglong USA Corporation, “HLUSA”, incorporated on January 8, 2007 in Troy, Michigan, is a wholly-owned subsidiary of the Company, and mainly engages in marketing of automotive parts in North America, and provides after sales service and research and development support accordingly.

 The Company owns the following aggregate net interests in eight Sino-foreign joint ventures organized in the PRC as of September 30, 2009 and 2008.
   
Name of Entity
 
Percentage Interest
  
  
September 30, 2009
     
September 30, 2008
 
Shashi Jiulong Power Steering Gears Co., Ltd., “Jiulong”
   
81.00
%   
   
81.00
%
Jingzhou Henglong Automotive Parts Co., Ltd.,  “Henglong”
   
80.00
%
   
80.00
%
Shenyang Jinbei Henglong Automotive Steering System Co., Ltd., “Shenyang”
   
70.00
%
   
70.00
%
Zhejiang Henglong & Vie Pump-Manu Co., Ltd., “Zhejiang”
   
51.00
%
   
51.00
%
Universal Sensor Application Inc., “USAI”
   
83.34
%
   
83.34
%
Wuhan Jielong Electric Power Steering Co., Ltd., “Jielong”
   
85.00
%
   
85.00
%
Wuhu HengLong Automotive Steering System Co., Ltd., “Wuhu”
   
77.33
%
   
77.33
%
Jingzhou Hengsheng Automotive System Co., Ltd., “Hengsheng”
   
100.00
%
   
100.00
%

Jiulong was established in 1993 and mainly engages in the production of integral power steering gear for heavy-duty vehicles.

Henglong was established in 1997 and mainly engages in the production of rack and pinion power steering gear for cars and light duty vehicles.

On March 31, 2008, the Company’s wholly-owned subsidiary, Genesis, and Wiselink Holdings Limited, “Wiselink”, both controlled by Hanlin Chen and his family, entered into an equity transfer agreement, the “Henglong Agreement”, pursuant to which Wiselink transferred and assigned its 35.5% equity interest in Jingzhou Henglong, one of the Company’s currently consolidated subsidiaries, to Genesis for a total consideration of US$32,090,000. The Company now holds an 80% equity interest in Jingzhou Henglong.

Under the terms of the Henglong Agreement, Genesis is deemed to be the owner of Jingzhou Henglong commencing from January 1, 2008. The Henglong Acquisition is considered as a business combination of companies under common control and is being accounted for in a manner of pooling of interests.

Shenyang was established in 2002 and focuses on power steering parts for light duty vehicles.
 
Zhejiang was established in 2002 to focus on power steering pumps.
 
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USAI was established in 2005 and mainly engages in production and sales of sensor modulars. In 2008, Genesis and Shanghai Hongxi Investment Inc., “Hongxi”, the other shareholder of USAI, agreed to increase USAI’s capital to $2,600,000 from $1,800,000. The increased capital was wholly funded by Genesis. Therefore, the capital contributed by Genesis in USAI increased to $2,166,900 from $1,366,900, accounting for 83.34% of the total capital; while the capital contributed by Hongxi remained unchanged, accounting for 16.66% of the total capital.

Jielong was established in 2006 and mainly engages in production and sales of electric power steering, “EPS”.

Wuhu was established in 2006 and mainly engages in production and sales of automobile steering systems.
 
Hengsheng was established in 2007 and mainly engages in production and sales of automobile steering systems.
 
2. Basis of Presentation and Significant Accounting Policies
 
(a) Basis of Presentation

Basis of Presentation - For the three months and nine months ended September 30, 2009 and 2008, the accompanying unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. The subsidiaries include eight Sino-foreign Joint-ventures mentioned in Note 1. Significant inter-company balances and transactions have been eliminated upon consolidation. The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America.

Comments - The accompanying interim condensed consolidated financial statements are unaudited, but in the opinion of the Company’s management, contain all adjustments, which include normal recurring adjustments, necessary to present fairly the financial position, the results of operations and cash flows for the nine months ended September 30, 2009 and 2008 respectively.

The consolidated balance sheet as of December 31, 2008 is derived from the Company’s audited financial statements.

Certain information and footnote disclosures normally included in financial statements that have been prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission, although the Company’s management believes that the disclosures contained in these financial statements are adequate to make the information presented therein not misleading. For further information, refer to the financial statements and the notes thereto included in the Company’s 2008 Annual Report on Form 10-K, as filed with the Securities and Exchange Commission.

The results of operations for the nine months ended September 30, 2009 are not necessarily indicative of the results of operations to be expected for the full fiscal year ending December 31, 2009.
 
Estimation -The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

(b) Significant Accounting Policies

Recent Accounting Pronouncements- In June 2009, the Financial Accounting Standards Board (FASB) approved the “FASB Accounting Standards Codification” (“Codification”, “FASB ASC”) as the single source of authoritative generally accepted accounting principles (GAAP) and created a new Topic 105, Generally Accepted Accounting Principles, in the General Principles and Objective Section of the Codification. Topic 105 is effective for interim and annual periods ending after September 15, 2009, and its adoption did not have an impact on our financial condition or results of operations.
 
FASB ASC Topic 855, “Subsequent Events” establishes general standards of accounting for disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and whether that date represents the date the financial statements were issued or were available to be issued. The adoption of Topic 855 did not have a material impact on the Company’s consolidated financial statements and disclosures.
 
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Foreign Currencies - The Company maintains its books and records in Renminbi, “RMB”, the currency of the PRC, its functional currency. In accordance with guidance now incorporated in ASC Topic 830 (formerly FAS 52), foreign currency transactions in RMB are reflected using the temporal method. Under this method, all monetary items are translated into the functional currency at the rate of exchange prevailing at the balance sheet date. Non-monetary items are translated at historical rates. Income and expenses are translated at the rate in effect on the transaction dates. Transaction gains and losses, if any, are included in the determination of net income for the period.

In translating the financial statements of the Company from its functional currency into its reporting currency in United States dollars, balance sheet accounts are translated using the closing exchange rate in effect at the balance sheet date and income and expense accounts are translated using an average exchange rate prevailing during the reporting period. Adjustments resulting from the translation, if any, are included in cumulative other comprehensive income (loss) in stockholders’ equity.

Stock-Based Compensation - The Company may periodically issue shares of common stock for services rendered or for financing costs. Such shares will be valued based on the market price on the transaction date. The Company may periodically issue stock options to employees and stock options or warrants to non-employees in non-capital raising transactions for services and for financing costs.

 In July 2004, the Company adopted a stock incentive plan. The maximum number of common shares for issuance under this plan is 2,200,000 with a period of 10 years. The stock incentive plan provides for the issuance, to the Company’s officers, directors, management and employees, of options to purchase shares of the Company’s common stock. Since the adoption of the stock incentive plan, the Company has issued 433,850 stock options under this plan, and there remain 1,766,150 stock options issuable in the future. As of September 30, 2009, the Company had 406,850 stock options outstanding.

The Company has adopted ASC Topic 718 (formerly SFAS 123R), “Accounting for Stock-Based Compensation”, which establishes a fair value method of accounting for stock-based compensation plans. In accordance with guidance now incorporated in ASC Topic 718, the cost of stock options and warrants issued to employees and non-employees is measured on the grant date based on the fair value. The fair value is determined using the Black-Scholes option pricing model. The resulting amount is charged to expense on the straight-line basis over the period in which the Company expects to receive benefit, which is generally the vesting period.
 
Comprehensive Income - The Company has adopted ASC Topic 220 (formerly SFAS No. 130), “Reporting Comprehensive Income”. ASC Topic 220 establishes standards for the reporting and display of comprehensive income, its components and accumulated balances in a full set of general purpose financial statements. ASC Topic 220 defines comprehensive income to include all changes in equity except those resulting from investments by owners and distributions to owners, including adjustments to minimum pension liabilities, accumulated foreign currency translation, and unrealized gains or losses on marketable securities.

Financial instruments - Derivative financial instruments, as defined in ASC Topic 815 (formerly FAS 133), Accounting for Derivative Financial Instruments and Hedging Activities (ASC Topic 815), consist of financial instruments or other contracts that contain a notional amount and one or more underlying, e.g. interest rate, security price or other variable, require no initial net investment and permit net settlement. Derivative financial instruments may be free-standing or embedded in other financial instruments. Further, derivative financial instruments are initially, and subsequently, measured at fair value and recorded as liabilities or, in rare instances, assets.

The Company generally does not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, the Company has entered into certain other financial instruments and contracts, such as debt financing arrangements that embody features that are either (i) not afforded equity classification, (ii) embody risks not clearly and closely related to host contracts, or (iii) may be net-cash settled by the counterparty. As required by ASC Topic 815 (formerly FAS 133), these instruments are required to be carried as derivative liabilities, at fair value, in the Company’s financial statements.

Registration Payment Arrangements - The Company has entered into registration payment arrangements with certain investors that provide for the payment of damages for failures to register common shares underlying the investor’s financial instruments. ASC Topic 825 (formerly FASB Staff Position 00-19-2), Accounting for Registration Payment Arrangements, provides for the exclusion of registration payments, such as the liquidated damages, from the consideration of classification of financial instruments. Rather, such registration payments would be accounted for pursuant to ASC Topic 450 (formerly FASB No. 5), “Accounting for Contingencies”, which is the Company’s current accounting practice. That is, all registration payments will require recognition when they are both probable and reasonably estimable. The Company does not currently believe that damages are probable.
 
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Fair Value Measurements - The Company has adopted the provisions of ASC Topic 820 (formerly SFAS 157), “Fair Value Measurements”, except as it applies to those nonfinancial assets and nonfinancial liabilities. ASC Topic 820 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. In February 2008, FASB Staff delayed the effective date of ASC Topic 820 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).
 
Noncontrolling Interests in Consolidated Financial Statements - In December 2007, the FASB issued guidance now incorporated in ASC Topic 810 “Consolidation” (formerly Statement of Financial Accounting Standards (“SFAS”) 160). The guidance clarifies the accounting for noncontrolling interests and establishes accounting and reporting standards for the noncontrolling interest in a subsidiary, including classification as a component of stockholders’ equity. This guidance was effective for the Company’s fiscal year beginning January 1, 2009. The Company has adopted this guidance in its consolidated financial statements for the period ended September 30, 2009.

3. Pledged cash deposits

Pledged as guarantee for its notes payable, the Company regularly pays some of its suppliers by bank notes. The Company has to deposit a cash deposit, equivalent to 10%- 40% of the face value of the relevant bank note, at a bank in order to obtain the bank note.

4. Accounts and notes receivable

The Company’s accounts receivable at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:
 
   
September 30, 2009
     
December 31, 2008
 
Accounts receivable
 
$
89,781,284
   
$
60,345,494
 
Notes receivable
   
45,378,494
     
40,989,840
 
     
135,159,778
     
101,335,334
 
Less: allowance for doubtful accounts
   
(3,641,415
)
   
(4,910,478
)
Balance at the end of the period
 
$
131,518,363
   
$
96,424,856
 
  
Notes receivable represent accounts receivable in the form of bills of exchange whose acceptances and settlements are handled by banks.

The activity in the Company’s allowance for doubtful accounts during the nine months ended September 30, 2009 (unaudited) and the year ended December 31, 2008 are summarized as follows:

   
September 30, 2009
     
December 31, 2008
 
Balance at beginning of period
 
$
4,910,478
   
$
3,827,838
 
Amounts provided (recovered) during the period
   
(1,272,113
)
   
841,078
 
Foreign currency translation gain
   
3,050
     
241,562
 
Balance at the end of the period
 
$
3,641,415
   
$
4,910,478
 
 
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5. Other receivables

The Company’s other receivables at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
     
December 31, 2008
 
Other receivables
 
$
1,885,305
   
$
2,009,364
 
Less: allowance for doubtful accounts
   
(670,429
)
   
(659,837
)
Balance at the end of the period
 
$
1,214,876
   
$
1,349,527
 
 
Other receivables consist of amounts advanced to both related and unrelated parties, primarily as unsecured demand loans, with no stated interest rate or due date.
 
The activity in the Company’s allowance for doubtful accounts of other receivable during the nine months ended September 30, 2009 (unaudited) and the year ended December 31, 2008 are summarized as follows:
   
   
September 30, 2009
     
December 31, 2008
 
Balance at beginning of the period
 
$
659,837
   
$
652,484
 
Amounts provided (recovered) during the period
   
10,024
     
(41,264
)
Foreign currency translation gain
   
568
     
48,617
 
Balance at the end of the period
 
$
670,429
   
$
659,837
 
  
6. Inventories

The Company’s inventories at September 30, 2009 (Unaudited) and December 31, 2008 consisted of the following:

   
September 30, 2009
     
December 31, 2008
 
Raw materials
 
$
10,589,303
   
$
8,354,397
 
Work in process
   
6,911,057
     
4,466,720
 
Finished goods
   
13,632,738
     
14,826,961
 
     
31,133,098
     
27,648,078
 
Less: provision for loss
   
(1,744,172
)
   
(1,076,323
)
Balance at the end of the period
 
$
29,388,926
   
$
26,571,755
 

7. Property, plant and equipment

The Company’s property, plant and equipment at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
     
December 31, 2008
 
Land use rights and buildings
 
$
29,515,540
   
$
27,416,977
 
Machinery and equipment
   
63,552,626
     
54,405,700
 
Electronic equipment
   
4,992,457
     
4,356,475
 
Motor vehicles
   
2,605,284
     
2,461,378
 
Construction in progress
   
660,238
     
1,007,415
 
     
101,326,145
     
89,647,945
 
Less: Accumulated depreciation
   
(43,099,380
)
   
(37,669,040
)
Balance at the end of the period
 
$
58,226,765
   
$
51,978,905
 

Depreciation charge for the nine months ended September 30, 2009 and the year ended December 31, 2008 are $5,786,463 and $9,672,948 respectively.
 
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8. Intangible assets
 
The activities in the Company’s intangible asset account at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
   
December 31, 2008
 
Balance at beginning of period
 
$
504,339
   
$
589,713
 
Add: additions during the period–
               
Patent technology
   
292,573
     
-
 
Management software license
   
29,098
     
125,550
 
Foreign currency translation gain
   
649
     
41,120
 
     
826,659
     
756,383
 
Less: Amortization at end of the period
   
(153,605
)
   
(252,044
)
Balance at the end of the period
 
$
673,054
   
$
504,339
 

9. Deferred Income Tax Assets

In accordance with the provisions of ASC Topic 740 “Income Taxes”(formerly SFAS 109), the Company assesses, on a quarterly basis, its ability to realize its deferred tax assets. Based on the more likely than not standard in the guidance and the weight of available evidence, the Company believes a valuation allowance against its deferred tax assets is necessary. In determining the need for a valuation allowance, the Company considered the following significant factors: an assessment of recent years’ profitability and losses; the Company’s expectation of profits based on margins and volumes expected to be realized (which are based on current pricing and volume trends); the long period - ten years or more in all significant operating jurisdictions — before the expiry of net operating losses, noting further that a portion of the deferred tax asset is composed of deductible temporary differences that are subject to an expiry period until realized under tax law. The Company will continue to evaluate the provision of valuation allowance in future periods.

The components of estimated deferred income tax assets at September 30, 2009 (unaudited) and December 31, 2008 were as follows:

   
September 30, 2009
   
December 31, 2008
 
Losses carryforward (U.S.)
 
$
3,411,308
   
$
2,300,322
 
Losses carryforward (PRC)
   
355,042
     
287,285
 
Product warranties and other reserves
   
2,111,248
     
1,737,052
 
Property, plant and equipment
   
2,580,914
     
2,471,716
 
Bonus accrual
   
217,714
     
297,208
 
Other
   
285,555
     
154,348
 
     
8,961,781
     
7,247,931
 
Valuation allowance *
   
(6,045,476
)
   
(4,864,866
)
Total deferred tax assets
 
$
2,916,305
   
$
2,383,065
 
 
*As of September 30, 2009, valuation allowance was $6,045,476, including $3,411,308 and $2,634,168 allowance for the Company’s deferred tax assets in the U.S. and allowance for the Company’s non-U.S. deferred tax assets. As of December 31, 2008, valuation allowance was $4,864,866, including $2,300,322 allowance for the Company’s deferred tax assets in the U.S. and $2,564,544 allowance for the Company’s non-U.S. deferred tax assets. Based on the Company’s current operations in the U.S., the management believes that the deferred tax assets in the U.S. are not likely to be realized in the future. For the non-U.S. deferred tax assets, pursuant to certain tax laws and regulations in China, the management believes such amount will not be utilized to offset future taxable income.

10. Bank loans

At September 30, 2009, the Company, through its Sino-foreign joint ventures, had outstanding fixed-rate short-term bank loans of $9,518,231, with weighted average interest rate at 5.57% per annum. These loans are secured with some of the property and equipment of the Company, and are repayable within one year.
 
15

 
At December 31, 2008, the Company, through its Sino-foreign joint ventures, had outstanding fixed-rate short-term bank loans of $7,315,717, with weighted average interest rate at 6.17% per annum. These loans are secured with some of the property and equipment of the Company and are repayable within one year.

11. Accounts and notes payable

The Company’s accounts and notes payable at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
   
December 31, 2008
 
Accounts payable
 
$
61,183,044
   
$
38,595,446
 
Notes payable
   
28,149,436
     
20,650,597
 
Balance at the end of the period
 
$
89,332,480
   
$
59,246,043
 

Notes payable represent accounts payable in the form of bills of exchange whose acceptances and settlements are handled by banks.

The Company has pledged cash deposits, notes receivable and certain property plant and machinery to secure trade financing granted by banks.
 
12. Convertible notes payable

In February 2008, the Company sold to two accredited institutional investors $35 million of convertible notes, the "Convertible Notes", with a scheduled maturity date of February 15, 2013. The Convertible Notes, including any accrued but unpaid interest, are convertible into common shares of the Company at a conversion price of $8.8527 per share, subject to adjustment upon the occurrence of certain events.

The Convertible Notes bear annual interest rates of 3%, 3.5%, 4%, 4.5% and 5% for each year of 2008, 2009, 2010, 2011 and 2012. The interest on the Convertible Notes shall be computed commencing from the issuance date and will be payable in cash in arrears semi-annually on January 15, and July 15 of each year with the first interest payable date being July 15, 2008. From and after the occurrence and during the continuance of an Event of Default defined in the relevant Convertible Note agreements, the interest rate then in effect shall be increased by two percent (2%) until the event of default is remedied.

The holders of the Convertible Notes will be entitled to convert any portion of the conversion amount into shares of common stock at the conversion price at any time or times on or after the thirtieth (30th) day after the issuance date and prior to the thirtieth (30th) Business Day prior to the expiry date of the Convertible Notes. A damage penalty will be paid if share certificates are not delivered timely after any conversion.

The Company will have the right to require the Convertible Note holders to convert all or any portion of the conversion amount then remaining under the Convertible Note obligation into shares of common stock, “ Mandatory Conversion”, if at any time during a six-month period, the beginning day of each such six-month period, a “Mandatory Conversion Period Start Date”, the arithmetic average of the weighted average price of the common stock for a period of at least thirty (30) consecutive trading days following the Mandatory Conversion Period Start Date equals or exceeds the percentage of $8.8527 set forth in the chart below as applicable to the indicated six month period:
 
0-6 months:
    125 %
6-12 months:
    125 %
12-18 months:
    135 %
18-24 months:
    135 %
24-30 months:
    145 %
30-36 months:
    145 %
36-42 months:
    155 %
42-48 months:
    155 %
 
 
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On each six month anniversary of the issuance date beginning August 15, 2008, the conversion price will be adjusted downward to the Reset Reference Price, as defined below, if the weighted average price for the twenty (20) consecutive trading days immediately prior to the applicable six month anniversary, the “Reset Reference Price”, is less than 95% of the conversion price in effect as of such applicable six month anniversary date. The foregoing notwithstanding, the conversion price will not be reduced via such reset provision to less than $7.0822. The conversion price is also subject to weighted-average antidilution adjustments, but in no event will the conversion price be reduced to less than $6.7417. If and whenever on or after the issuance date, the Company issues or sells its shares of Common Stock or other convertible securities, except for certain defined exempt issuances, for a consideration per share less than a price equal to the conversion price in effect on the issuance date immediately prior to such issue or sale, the original conversion price then in effect shall be adjusted by a weighted-average antidilution formula, but in no event to a new conversion price less than $6.4717.
 
The Company will not effect any conversion of the Convertible Notes, and each holder of the Convertible Notes will not have the right to convert any portion of the Convertible Notes to the extent that after giving effect to such conversion, such holders would beneficially own in excess of 4.99% of the number of shares of Common Stock outstanding immediately after giving effect to such conversion.

The Company will not effect a Mandatory Conversion of more than twelve percent (12%) of the original principal amount of the Convertible Notes, with the applicable accrued but unpaid interest, in any six month period or twenty-four percent (24%) of the original principal amount of the Convertible Notes, with the applicable accrued but unpaid interest, in any twelve (12) month period.

Upon the occurrence of an event of default with respect to the Convertible Notes, the Convertible Note holders may require the Company to redeem all or any portion of the Convertible Notes. Each portion of the Convertible Notes subject to redemption by the Company will be redeemed by the Company at a price equal to the sum of (i) the conversion amount to be redeemed and (ii) the Other Make Whole Amount. The “Other Make Whole Amount” will mean a premium to the conversion amount such that the total amount received by the Convertible Note holder upon redemption represents a gross yield to the Convertible Note holders on the original principal amount as of the redemption date equal to thirteen percent (13%), with interest computed on the basis of actual number of days elapsed over a 360-day year. The events of default includes the Company’s failure to cure a conversion failure by delivery of the required number of shares of Common Stock, the Company’s failure to pay to the Convertible Note holder any amount of principal, interest, late charges or other amounts when and as due under the Convertible Notes and other events as defined in the Convertible Note agreements.

Upon the consummation of a change of control as defined in the Convertible Note agreements, the Convertible Note holder may require the Company to redeem all or any portion of the Convertible Notes. The portion of the Convertible Notes subject to redemption shall be redeemed by the Company in cash at a price equal to the sum of the conversion amount of being redeemed and the Other Make Whole Amount as defined above.

On each of February 15, 2010 and February 15, 2011, the Convertible Note holders will have the right, in their sole discretion, to require that the Company redeem the Convertible Notes in whole but not in part, by delivering written notice thereof to the Company. The portion of this Convertible Note subject to redemption pursuant to this annual redemption right will be redeemed by the Company in cash at a price equal to the sum of the conversion amount being redeemed and the Annual Redemption Make Whole Amount. The “Annual Redemption Make Whole Amount” will mean a premium to the conversion amount such that the total amount received by the Convertible Note holder upon any annual redemption represents a gross yield on the original principal amount of eleven percent (11%), with interest computed on the basis of actual number of days elapsed over a 360-day year.

In the event that the Company has not completed the necessary filings to list the conversion shares on its principal market by the date that is ninety (90) days after the issuance date or has not so listed the conversion shares by the date that is ninety (90) days after the issuance date or the shares of the Company’s common stock are terminated from registration under the Securities Act of 1933, the Convertible Note holders will have the right, in its sole discretion, to require that the Company redeem all or any portion of the Convertible Notes. The portion of the Convertible Notes subject to redemption in connection with this listing default will be redeemed by the Company in cash at a price equal to the sum of the conversion amount being redeemed and the Other Make Whole Amount as mentioned above.

 
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At any time following February 15, 2009, if the Weighted Average Price (WAP) for twenty (20) consecutive trading days is less than 45% of the Conversion Price in effect on the Issuance Date, as adjusted, namely $3.187, the Convertible Note holder shall have the right, in its sole discretion, to require that the Company redeem all or any portion of the Convertible Notes. The portion of this Convertible Note subject to redemption in connection with the share price change of the underlying common stock will be redeemed by the Company in cash at a price equal to the sum of the conversion amount being redeemed and the Other Make Whole Amount as mentioned above.

Since the Company’s stock Weighted Average Price for twenty (20) consecutive trading days ended on March 16, 2009 was below $3.187, which is less than 45% of the Conversion Price in effect of the Issuance Date, as adjusted, the “ WAP Default” , each Convertible Note holder had the right, at its sole discretion, to require that the Company redeem all or any portion of the Convertible Notes by delivering written redemption notice to the Company within five (5) business days after the receipt of the Company’s notice of the WAP Default.  

On March 17, 2009, the Company delivered two WAP Default notices to the Convertible Note holders.  On March 27, 2009, the Company received a letter from YA Global, one of the Convertible Note holders, electing to require the Company to redeem all the three Convertible Notes it held in the total principal amount of $5,000,000, together with interest, late charges, if any, and the Other Make Whole Amount as defined in Section 5(d) of the Convertible Notes. After negotiation, the Company and YA Global reached a settlement agreement on April 8, 2009 and under the terms of the settlement agreement, the Company paid on April 15, 2009 a redemption amount of $5,041,667 to YA Global and YA Global waived its entitlement to the Other Make Whole Amount.

Following the WAP Default notices, the Company received a letter from the provisional liquidator acting on behalf of Lehman Brothers Commercial Corporation Asia Limited, the “LBCCA Liquidator”, the other Convertible Note holder, requesting an extension until April 24, 2009 to consider its rights under the Convertible Notes. The Company granted an extension to April 15, 2009. The LBCCA Liquidator further requested another extension to April 24, 2009.  On April 24, 2009, LBCCA’s lawyers sent three Holder Redemption Notices via fax electing to redeem the entire outstanding principal of $30,000,000, together with interest, late charges, if any, and the Other Make Whole Amount, to be paid on July 23, 2009. The Company discussed settlement with the LBCCA Liquidator, and on or about July 22, 2009, the Company and the LBCCA Liquidator agreed to extend the applicable holder mandatory redemption date for two months to September 23, 2009 to give more time to pursue settlement discussion. The Company received a letter dated September 22, 2009 from the LBCCA Liquidator stating that upon the Company’s acceptance of the revocation, all holder redemption notices dated April 24, 2009 shall be immediately revoked as if they were never issued, and the letter and the revocation did not purport to amend, restate or supplement any other terms and conditions under the three Notes and the Securities Purchase Agreement dated 1 February 2008 between the Company and LBCCA Liquidator. The Company accepted such revocation on September 23, 2009.

In connection with the Convertible Notes, the Company issued 1,317,864 detachable warrants, the “Warrants,” to purchase from the Company shares of common stock of the Company at the exercise price of $8.8527 per share. The Warrants are exercisable immediately and expired on February 15, 2009. The Warrants require net cash settlement in the event that there is a fundamental transaction, contractually defined as a merger, sale of substantially all assets, tender offer or share exchange. Due to this contingent redemption provision, in accordance with guidance now incorporated in ASC Topic 480 (formerly SFAS 150), the warrants require liability classification and must be recorded at fair value each reporting period. As of the issuance date, i.e., February 15, 2008, the fair value of warrants was $798,626, which was determined using the Black-Scholes option pricing model.
   
The Company has evaluated the convertible notes for terms and conditions that are not clearly and closely associated with the risks of the debt-type host instrument. Generally, such features require separation from the host contract and treatment as derivative financial instruments. Certain features, such as the conversion option, were found to be exempt. Other features, such as puts and redemption features, were found to require bifurcation and recognition as derivative liabilities. These derivative liabilities are recognized initially at fair value, using forward cash-flow valuation techniques. As of February 15, 2008, the compound derivative value amounted to $1,703,962. This derivative will be adjusted to its estimated fair value at the completion of each reporting period until the debt arrangement is ultimately settled, converted or paid.

When a financial instrument contains embedded derivatives that require bifurcation, such as the redemption put, and freestanding instruments that are recorded at fair value each period, such as the warrants, the accounting is to record the embedded derivative and the freestanding instruments at fair value on inception and the residual proceeds are allocated to the debt instrument. Based on this premise, upon inception of the debt instruments, the Company recorded the redemption put at fair value $1,703,962 and the Company recorded the warrants at fair value $798,626. The remaining proceeds were then allocated to the debt instrument.

As indicated above, according to the terms of the convertible notes, the conversion price was reset to $7.0822 as of August 15, 2008 based on the weighted average price of the stock on that date.  In accordance with ASC Topic 470 (formerly EITF 00-27), a contingency feature that cannot be measured at inception of the instrument, should be recorded when the contingent event occurs.  Therefore, on the date of the reset, the difference in the number of indexed shares prior to the reset was compared to the indexed shares subsequent to the reset and this incremental number of shares was multiplied by the commitment date stock price to determine the incremental intrinsic value that resulted from the adjustment to the conversion price.  This difference was recorded in equity as a beneficial conversion feature (“BCF”) and the related discount reduced the carrying value of the note and is being amortized over the remaining life of the instrument.

 
18

 

As of August 15, 2008, the number of indexed shares was 3,953,596 and 4,941,967 at the inception conversion price and reset conversion price, respectively. At the commitment date, the stock price was $6.09, and the “effective” conversion price was $6.93. Accordingly, since the effective conversion price is higher than the market value of the stock, the debt instruments are not considered "in the money" and no beneficial conversion feature is present.

On the date of inception, allocation of basis in the financing arrangement to the warrants and derivative liability has resulted in an original issue discount to the face value of the convertible notes in the amount of $2,502,588, which amount is subject to amortization over the Convertible Note’s term using the effective method. As of September 30, 2009, the amortization expense balance recorded by the Company was $1,037,300, including unamortized discount on the YA Global convertible note $276,448, which has been written off after its redemption. As the YA Global convertible note has been elected by its holder to be redeemed, the unamortized discount on the convertible note has been written off as expense on the redemption date.

13. Derivative liabilities

The Company has evaluated the convertible notes for terms and conditions that are not clearly and closely associated with the risks of the debt-type host instrument (see Note 12). Generally, such features require separation from the host contract and treatment as derivative financial instruments. Certain features, such as the conversion option, were found to be exempt. Other features, such as puts and redemption features were found to require bifurcation and recognition as derivative liabilities. These derivative liabilities are recognized initially at fair value, using forward cash-flow valuation techniques. As of February 15, 2008, the compound derivative value amounted to $1,703,962. This derivative will be adjusted to its estimated fair value at the completion of each reporting period until the debt arrangement is ultimately settled, converted or paid. As of September 30, 2009, the compound derivative value amounted to $913,063. The income from adjustment of fair value of compound derivative has been recorded in the income statement as gain or loss on change in fair value of derivative. (See note 12 and 24)

14. Accrued expenses and other payables

The Company’s accrued expenses and other payables at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
   
December 31, 2008
 
Accrued expenses
 
$
3,014,704
   
$
2,441,352
 
Other payables
   
1,841,950
     
1,690,046
 
Warranty reserves*
   
8,353,441
     
6,335,613
 
Dividend payable to non-controlling interest shareholders of Joint-ventures
   
1,761,133
     
1,991,796
 
Liabilities in connection with warrants**
   
-
     
1,977
 
Balance at the end of the period
 
$
14,971,228
   
$
12,460,784
 

*The Company provides for the estimated cost of product warranties when the products are sold. Such estimates of product warranties were based on, among other things, historical experience, product changes, material expenses, service and transportation expenses arising from the manufactured product. Estimates will be adjusted on the basis of actual claims and circumstances.

For the nine months ended September 30, 2009 (unaudited) and the year ended December 31, 2008, the warranties activities were as follows:

   
September 30, 2009
   
December 31, 2008
 
Balance at the beginning of period
 
$
6,335,613
   
$
4,919,491
 
Additions during the period-
   
5,807,096
     
5,861,782
 
Settlement within period, by cash or actual material
   
(3,795,373
)
   
(4,797,457
)
Foreign currency translation gain
   
6,105
     
351,797
 
Balance at end of period
 
$
8,353,441
   
$
6,335,613
 
 
 
19

 

**In connection with the Convertible Notes, the Company issued 1,317,864 of detachable warrants, “Warrants,” to purchase from the Company shares of common stock at the exercise price of $8.8527 per share, subject to adjustments upon certain events occurring. The Warrants are exercisable immediately and expired on February 15, 2009.

The exercise price or the number of shares to be converted by the Warrant will be adjusted in the event of no effective Registration Statement or delayed effectiveness of the Registration Statement. In addition, a damage penalty will be paid if the delivery of share certificates occurs upon the Warrants conversion.

The Company will not effect any conversion of a Warrant, and each holder of any Warrant will not have the right to convert any portion of such Warrant to the extent that after giving effect to such conversion, each of these two holders would beneficially own in excess of 4.99% of the number of shares of Common Stock outstanding immediately after giving effect to such conversion.

If and whenever on or after the issuance date, the Company issues or sells its shares of common stock or other convertible securities for a consideration per share less than a price equal to the exercise price of a Warrant in effect on the issuance date immediately prior to such issue or sale, the exercise price of such Warrant then in effect will be adjusted.

The warrants issued in connection with the financial arrangement were derivative instruments. The warrants require net cash settlement in the event that there is a fundamental transaction, contractually defined as a merger, sale of substantially all assets, tender offer or share exchange.
 
In accordance with guidance now incorporated in ASC Topic 480 (formerly SFAS 150), it appears that the warrants require liability classification due to the possible cash redemption upon the event of an all cash acquisition. The FSP clarifies that warrants that contain any redemption features, including contingent redemption features, must be recorded as liabilities and marked to fair value each reporting period. As of the issuance date, i.e., February 15, 2008, the fair value of warrants was $798,626. Such warrant liabilities will be adjusted to its estimated fair value at the completion of each reporting period until the maturity of February 15, 2009.

The warrant agreements contain strike price adjustment provisions. In accordance with Section 8(iii), if the rate at which any Convertible Instruments are convertible into changes at any time, the warrant exercise price in effect at the time of the change will be adjusted based on the formula provided in Section 8(a) of the warrant agreement.  Accordingly, the warrants will be valued at the exercise price of $8.55 as of August 15, 2008 and thereafter.

As of August 15, 2008, the Company valued the warrant using conversion price at inception and reset respectively.  The fair value of the warrant is $489,719 at the inception conversion price of $8.8527, and $551,131 at the reset conversion price of $8.5500, respectively. Such difference resulting from using the reset conversion price has increased warrant liabilities by $61,412.

As of September 30, 2009, the fair value of warrant was $0 because it was not exercised on its expiration date, February 15, 2009. The income from adjustment of fair value of liabilities in connection with warrants amount of gain has been recorded in the income statement as gain or loss on change in fair value of derivative. (see note 24)

15. Accrued pension costs
 
Since the Company’s operations are all located in China, all the employees are located in China. The Company records pension costs and various employment benefits in accordance with the relevant Chinese social security laws, which is substantially based on a total of 31% of base salary as required by local governments. Base salary levels are the average salary determined by the local governments.

The activities in the Company’s pension account during the nine months ended September 30, 2009 (unaudited) and the year ended December 31, 2008 are summarized as follows:

 
20

 

   
September 30, 2009
   
December 31, 2008
 
Balance at beginning of the period
 
$
3,806,519
   
$
3,622,729
 
Amounts provided during the period
   
2,521,716
     
2,311,049
 
Settlement during the period
   
(2,468,104
)
   
(2,381,047
)
Foreign currency translation gain
   
3,063
     
253,788
 
Balance at end of period
 
$
3,863,194
   
$
3,806,519
 
 
16. Taxes payable

The Company’s taxes payable at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
   
December 31, 2008
 
Value-added tax payable
 
$
7,263,389
   
$
6,279,089
 
Income tax payable
   
1,839,332
     
(652,865
)
Other tax payable
   
151,552
     
91,214
 
Balance at end of the period
 
$
9,254,273
   
$
5,717,438
 

17. Amounts due to shareholders/ directors

The activities in the amounts due to shareholders/directors at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
   
December 31, 2008
 
Balance at the beginning of period
 
$
337,370
   
$
304,601
 
Increase (decrease) during the period
   
(287,854
)
   
2,415
 
Foreign currency translation gain
   
518
     
30,354
 
Balance at end of period
 
$
50,034
   
$
337,370
 

The amounts due to shareholders/directors were unsecured, interest-free and repayable on demand.

18. Advances payable

The amounts mainly represent advances made by the Chinese government to the Company as subsidy on interest on loans related to production facilities expansion. 

The balances are unsecured, interest-free and will be repayable to the Chinese government if the usage of such advance does not continue to qualify for the subsidy (see notes 22).
 
19. Share Capital and Additional paid-in capital

The activities in the Company’s share capital and additional paid-in capital account during the nine months ended September 30, 2009 (unaudited) and the year ended December 31, 2008 are summarized as follows:

 
21

 
 
   
Share Capital
       
   
Shares
 
Par Value
   
Additional paid-in capital
 
Balance at January 1, 2008
 
23,959,702
 
$
2,396
   
$
30,125,951
 
Issuance of common stock*
 
3,023,542
   
302
     
22,089,698
 
Decrease in additional paid-in capital in connection with Henglong equity acquisition **
 
-
   
-
     
(25,912,921
)
Grant of stock options to independent directors and management***
 
-
   
-
     
845,478
 
Balance at December 31, 2008
 
26,983,244
 
$
2,698
   
$
27,148,206
 
Exercise of stock options by management****
 
1,500
   
-
     
8,790
 
Grant of stock options to independent directors *****
 
-
   
-
     
196,650
 
Balance at September 30, 2009
 
26,984,744
 
$
2,698
   
$
27,353,646
 

* On March 31, 2008, Wiselink Holdings Limited, “Wiselink”, Great Genesis Holdings Limited, “Genesis”, a wholly-owned subsidiary of China Automotive Systems, Inc., “the Company” and other parties entered into an equity transfer transaction, the “Acquisition”, documented by an Equity Transfer Agreement, the “Agreement”, pursuant to which Wiselink agreed to transfer and assign a 35.5% equity interest in Jingzhou Henglong Automotive Parts Co. Ltd., “Henglong” to Genesis for a total consideration of $32,090,000, the “Consideration”.

Under the terms of the Agreement, the Consideration is to be paid as follows: $10,000,000 cash was paid by Genesis to Wiselink on April 30, 2008, and the balance of the purchase price ($22,090,000) was paid by issuance of 3,023,542 shares of common stock of the Registrant, in its capacity as the 100% parent company of Genesis.

** Under the terms of the above agreement, Genesis is deemed to be the owner of the equity concerned commencing from January 1, 2008. In accordance with ASC Topic 805 (formerly FASB 141R) and Topic 470 (formerly APB 14), the above acquisition is considered as a business combination of companies under common control and is being accounted for in a manner similar to that of pooling of interests.

On April 22 and June 30, 2008, the Company issued 1,170,000 and 1,853,542 shares of common stock, respectively, at an issuance price of $7.3060, par value of $0.0001. The difference between issuance price and par value was credited into additional paid-in capital.

As of January 1, 2008, the net book value of 35.5% equity of Henglong was $6,177,079. The difference between the acquisition consideration of $32,090,000 and 35.5% equity of Henglong, which was $25,912,921, has been debited to additional paid-in capital.

*** In July 2004, the Company adopted a stock incentive plan. The maximum number of common shares for issuance under this plan is 2,200,000 with a period of 10 years. The stock incentive plan provides for the issuance, to the Company’s officers, directors, management and employees, of options to purchase shares of the Company’s common stock. Since the adoption of the stock incentive plan, the Company has issued 433,850 stock options under this plan, and there remain 1,766,150 stock options issuable in future. As of September 30, 2009, the Company had 406,850 stock options outstanding.
 
The Company issued 312,350 common stock options to independent directors and management, and the fair value of the options at the grant date was $845,478, for the year of 2008, which was calculated based on Black-Scholes option pricing model. The fair value was credited in additional paid-in capital, debited in operating expenses using straight line method over the expected beneficiary period. As of September 30, 2009, the Company has amortized $470,439 and the remaining $375,039, are reflected as deferred stock compensation under shareholders' equity in the balance sheet
.
**** As of September 2, 2009, certain option holders discontinued their service ahead of the schedule. 1,500 shares of their common stock options were exercised and 3,000 shares of their common stock options were canceled upon such dismissal.

***** In September 2009, the Company granted 22,500 common stock options to independent directors. The fair value of the options at the grant date was $196,650, which was calculated based on Black-Scholes option pricing model. The fair value was credited in additional paid-in capital, debited in operating expenses using straight line method over the expected beneficiary period.

 
22

 

20. Deferred stock compensation
 
The Company issued 312,350 common stock options to independent directors and management, and the fair value of the options at the grant date was $845,478, for the year of 2008, which was calculated based on Black-Scholes option pricing model.  As of September 30, 2009, the Company has amortized $470,439 and remaining $375,039 are reflected as deferred stock compensation under shareholders' equity in the balance sheet.

21. Non-controlling interests

The Company’s activities in respect of the amounts of the non-controlling interests’ equity at September 30, 2009 (unaudited) and December 31, 2008 are summarized as follows:

   
September 30, 2009
   
December 31, 2008
 
Balance at beginning of the period
 
$
23,222,566
   
$
23,166,270
 
Add: Additions during the period –
               
Income attributable to non-controlling interests
   
6,074,110
     
5,071,408
 
Capital Contribution from the non-controlling interest holders of Joint-venture companies
   
-
     
745,723
 
Less: Decreases during the period
               
Dividends declared to the non-controlling interest holders of Joint-venture companies
   
(3,944,619
)
   
(1,016,733
)
Transfer and assign equity interest in Henglong and USAI by non-controlling interest holders of Joint-venture companies*
   
-
     
(6,177,079
)
Foreign currency translation gain
   
19,392
     
1,432,977
 
Balance at end of period
 
$
25,371,449
   
$
23,222,566
 

* On March 31, 2008, the Company’s wholly-owned subsidiary, Genesis and Wiselink, both controlled by Hanlin Chen and his family, entered into an equity transfer agreement, pursuant to which Wiselink transferred and assigned its 35.5% equity interest in Jingzhou Henglong, one of the Company’s currently consolidated subsidiaries, to Genesis for a total consideration of $32,090,000.
 
Under the terms of the above agreement, Genesis is deemed to be the owner of the equity concerned commencing from January 1, 2008. In accordance with ASC Topic 805 (formerly SFAS 141(R)), the acquisition is considered as a business combination of companies under common control and is being accounted for in a manner of pooling of interests.

On January 1, 2008, the net book value of 35.5% equity of Henglong, which was transferred from non-controlling shareholders, was $6,177,079.

22. Other Income

During the three months and nine months ended September 30, 2009, there was no other income in the Company. During the three months and nine months ended September 30, 2008, other income was $123,167 and $322,626, mainly from Government subsidies.

Government subsidies represent refunds by the Chinese Government of interest paid to banks by companies entitled to such subsidies. This applies only to interest on loans related to production facilities expansion. The Company recorded the refunded interest on projects which achieved their goals into Other income, and refunded interest on projects which have not achieved their goals into advances payable.

23. Financial income (expenses)

During the three months and nine months ended September 30, 2009 (unaudited) and 2008, the Company recorded financial income (expenses) which is summarized as follows:

 
23