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EX-31.1 - Cleantech Solutions International, Inc.,v222580_ex31-1.htm
EX-31.2 - Cleantech Solutions International, Inc.,v222580_ex31-2.htm
EX-32.1 - Cleantech Solutions International, Inc.,v222580_ex32-1.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2011
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT  OF 1934

For the transition period from __________ to __________

COMMISSION FILE NUMBER: 001-34591

CHINA WIND SYSTEMS, INC.
 (Name of Registrant as specified in its charter)
 
DELAWARE
74-2235008
(State or other jurisdiction of
(I.R.S. Employer
incorporation of organization)
Identification No.)
 
No. 9 Yanyu Middle Road
Qianzhou Township, Huishan District, Wuxi City
Jiangsu Province, China 150090
 (Address of principal executive office)

(86) 51083397559
 (Registrant’s telephone number)

Not applicable
(Former name, former address and former fiscal year, if changed since last report)

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

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

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.  19,147,642 shares of common stock are issued and outstanding as of May 13, 2011.
 
 
 

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
March 31, 2011

TABLE OF CONTENTS
 
     
Page
 
     
No.
 
PART I. - FINANCIAL INFORMATION
         
Item 1.
Financial Statements
     
           
 
Consolidated Balance Sheets as of March 31, 2011 (Unaudited) and December 31, 2010 (Audited)
    3  
           
 
Consolidated Statements of Income and Comprehensive Income for the Three Months Ended March 31, 2011 and 2010 (unaudited)
    4  
           
 
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010 (unaudited)
    5  
           
 
Notes to Unaudited Consolidated Financial Statements.
    6  
           
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations.
    22  
           
Item 3
Quantitative and Qualitative Disclosures About Market Risk.
    32  
           
Item 4
Controls and Procedures.
    33  
           
PART II - OTHER INFORMATION
           
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.
    34  
           
Item 6.
Exhibits.
    34  
 
FORWARD LOOKING STATEMENTS
 
This report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not deemed to represent an all-inclusive means of identifying forward-looking statements as denoted in this report. Additionally, statements concerning future matters are forward-looking statements.
 
Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed under the headings “Risks Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-Q and in other reports that we file with the SEC. You are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report.
 
We file reports with the SEC. The SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including us. You can also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
 
We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report, except as required by law. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this quarterly report, which are designed to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.
 
 
2

 

PART 1 - FINANCIAL INFORMATION

Item 1. Financial Statements.
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

   
March 31,
2011
   
December 31,
2010
 
   
(Unaudited)
   
(Audited)
 
ASSETS
           
             
CURRENT ASSETS:
           
    Cash and cash equivalents
  $ 1,252,597     $ 947,177  
    Notes receivable
    213,087       50,593  
    Accounts receivable, net of allowance for doubtful accounts
    6,175,107       8,207,797  
    Inventories, net of reserve for obsolete inventory
    4,577,077       3,371,128  
    Advances to suppliers
    625,902       333,923  
    Prepaid VAT on purchases
    2,521,987       2,759,763  
    Prepaid expenses and other
    140,325       36,338  
                 
        Total Current Assets
    15,506,082       15,706,719  
                 
PROPERTY AND EQUIPMENT - net
    56,764,932       54,742,993  
                 
OTHER ASSETS:
               
   Land use rights, net
    3,768,575       3,767,159  
                 
        Total Assets
  $ 76,039,589     $ 74,216,871  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
CURRENT LIABILITIES:
               
    Loans payable
  $ 1,217,637     $ 1,814,937  
    Accounts payable
    6,640,657       7,660,768  
    Accrued expenses
    662,519       526,006  
    VAT and service taxes payable
    -       81,614  
    Advances from customers
    314,468       236,004  
    Income taxes payable
    1,157,599       1,331,713  
 
               
        Total Current Liabilities
    9,992,880       11,651,042  
                 
STOCKHOLDERS' EQUITY:
               
    Preferred stock $0.001 par value (60,000,000 shares authorized, all of which  were designated
               
       as series A convertible preferred, 15,622,625 and 16,205,268 shares issued and outstanding
               
       at March 31, 2011 and December 31, 2010, respectively)
    15,622       16,205  
    Common stock ($0.001 par value; 150,000,000 shares authorized;
               
       19,123,392 and 18,751,128 shares issued and outstanding
               
       at March 31, 2011 and December 31, 2010, respectively)
    19,123       18,751  
    Additional paid-in capital
    26,989,156       26,579,053  
    Retained earnings
    31,736,903       29,264,152  
    Statutory reserve
    1,850,606       1,658,197  
    Accumulated other comprehensive gain - foreign currency translation adjustment
    5,435,299       5,029,471  
                 
        Total Stockholders' Equity
    66,046,709       62,565,829  
                 
        Total Liabilities and Stockholders' Equity
  $ 76,039,589     $ 74,216,871  
 
See notes to unaudited consolidated financial statements
 
 
3

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
 
`
 
For the Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
   
(Unaudited)
   
(Unaudited)
 
REVENUES
  $ 17,566,380     $ 16,840,682  
                 
COST OF REVENUES
    13,013,774       12,423,987  
                 
GROSS PROFIT
    4,552,606       4,416,695  
                 
OPERATING EXPENSES:
               
     Depreciation
    80,587       82,955  
     Selling, general and administrative
    831,801       1,401,376  
                 
        Total Operating Expenses
    912,388       1,484,331  
                 
INCOME FROM OPERATIONS
    3,640,218       2,932,364  
                 
OTHER INCOME (EXPENSE):
               
     Interest income
    712       1,244  
     Interest expense
    (29,702 )     (74,919 )
     Foreign currency loss
    (1,457 )     (1,859 )
     Other income
    8,650       -  
                 
        Total Other Income (Expense)
    (21,797 )     (75,534 )
                 
INCOME BEFORE INCOME TAXES
    3,618,421       2,856,830  
                 
INCOME TAXES
    953,261       910,293  
                 
NET INCOME
  $ 2,665,160     $ 1,946,537  
                 
COMPREHENSIVE INCOME:
               
      NET INCOME
  $ 2,665,160     $ 1,946,537  
                 
      OTHER COMPREHENSIVE INCOME:
               
           Unrealized foreign currency translation gain
    405,828       7,270  
                 
      COMPREHENSIVE INCOME
  $ 3,070,988     $ 1,953,807  
                 
NET INCOME PER COMMON SHARE:
               
    Basic
  $ 0.14     $ 0.11  
    Diluted
  $ 0.10     $ 0.08  
                 
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
               
    Basic
    18,925,959       17,252,799  
    Diluted
    25,655,436       25,395,026  
 
See notes to unaudited consolidated financial statements
 
 
4

 

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

   
For the Three Months Ended
 
   
March 31,
   
2011
   
2010
 
   
(Unaudited)
   
(Unaudited)
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 2,665,160     $ 1,946,537  
Adjustments to reconcile net income from operations to net cash
               
provided by operating activities:
               
Depreciation
    1,177,002       584,646  
Amortization of debt discount to interest expense
    -       44,993  
Amortization of land use rights
    22,428       21,618  
(Decrease) Increase in allowance for doubtful accounts
    (7,145 )     251,496  
Stock-based compensation expense
    84,892       286,320  
Changes in assets and liabilities:
               
Notes receivable
    (161,698 )     102,808  
Accounts receivable
    2,085,825       (1,075,263 )
Inventories
    (1,181,083 )     (1,095,615 )
Prepaid value-added taxes on purchases
    254,544       (489,189 )
Prepaid and other current assets
    (103,842 )     137,756  
Advances to suppliers
    (289,011 )     (110,779 )
Accounts payable
    (1,065,108 )     1,141,572  
Accrued expenses
    133,298       (212,230 )
VAT and service taxes payable
    (81,892 )     78,994  
Income taxes payable
    (182,032 )     (67,074 )
Advances from customers
    76,741       185,517  
                 
NET CASH PROVIDED BY OPERATING ACTIVITIES
    3,428,079       1,732,107  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Purchase of property and equipment
    (2,846,586 )     (2,810,860 )
                 
NET CASH USED IN INVESTING ACTIVITIES
    (2,846,586 )     (2,810,860 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from loans payable
    758,794       -  
Repayment of loans payable
    (1,365,830 )     (330,000 )
Proceeds from sale of common stock
    125,000       -  
Proceeds from exercise of warrants
    200,000       1,600,000  
                 
NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES
    (282,036 )     1,270,000  
                 
EFFECT OF EXCHANGE RATE ON CASH AND CASH EQUIVALENTS
    5,963       360  
                 
NET INCREASE IN CASH AND CASH EQUIVALENTS
    305,420       191,607  
                 
CASH AND CASH EQUIVALENTS - beginning of year
    947,177       2,278,638  
                 
CASH AND CASH EQUIVALENTS - end of period
  $ 1,252,597     $ 2,470,245  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Cash paid for:
               
Interest
  $ 29,702     $ 32,069  
Income taxes
  $ 1,135,294     $ 977,367  
                 
NON-CASH INVESTING AND FINANCING ACTIVITIES:
               
Series A preferred converted to common shares
  $ 936     $ -  
Common stock issued for prior and future service
  $ -     $ 7,470  
 
See notes to unaudited consolidated financial statements.
 
 
5

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

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

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

Electrical was formed on May 21, 2004, and Fulland Wind Energy was formed on August 27, 2008.  Beginning in April 2007, Electrical began to produce large-scaled forged rolled rings that are up to three meters in diameter for the wind-power and other industries.  In 2009, the Company began to produce and sell forged products through Fulland Wind Energy. The Company manufactures and machines all forged products, including wind products such as shafts, rolled rings, gear rims, gearboxes, bearings and other components and finished products and assemblies for the wind power industry, ESR products used in the wind industry, steel industry, and other sectors, and solar products, including any type of large-scale equipment used in the manufacturing process for the solar industry, through Fulland Wind Energy.  The Company refers to this segment of its business as the forged rolled rings and related components division.  

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

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

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

These consolidated financial statements should be read in conjunction with the summary of significant accounting policies and notes to consolidated financial statements included in the Company’s Form 10-K annual report for the year ended December 31, 2010.
 
 
6

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

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

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

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

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

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

 
7

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011

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

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

Option Agreement. Under the option agreement between the Huayang Companies’ shareholders and Green Power, the Huayang Companies’ shareholders irrevocably granted Green Power or its designated person an exclusive option to purchase, to the extent permitted under PRC law, all or part of the equity interests in the Huayang Companies for the cost of the initial contributions to the registered capital or the minimum amount of consideration permitted by applicable PRC law. Green Power or its designated person has sole discretion to decide when to exercise the option, whether in part or in full. The term of this agreement, as amended on November 1, 2008, is 20 years from October 12, 2007 and may be extended prior to its expiration by written agreement of the parties.

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

Use of estimates

The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosures at the date of the financial statements and during the reporting period. Actual results could materially differ from these estimates. Significant estimates in 2011 and 2010 include the allowance for doubtful accounts, the allowance for obsolete inventory, the useful life of property and equipment and intangible assets, assumptions used in assessing impairment of long-term assets and valuation of deferred tax assets, accruals for taxes due, the calculation of the value of any beneficial conversion feature related to preferred stock, and the value of stock-based compensation.

Cash and cash equivalents

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

 
8

 

CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011

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

Fair value of financial instruments

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

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

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

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

Concentrations of credit risk

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

Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially all of the Company’s cash is maintained with state-owned banks within the PRC, and no deposits are covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any risks on its cash in bank accounts. A significant portion of the Company’s sales are credit sales which are primarily to customers whose ability to pay is dependent upon the industry economics prevailing in these areas; however, concentrations of credit risk with respect to trade accounts receivables is limited due to generally short payment terms.  The Company also performs ongoing credit evaluations of its customers to help further reduce credit risk. At March 31, 2011 and December 31, 2010, the Company’s cash balances by geographic area were as follows:

   
March 31, 2011
   
December 31, 2010
 
Country:
                       
United States
  $ 267,830       21.4 %   $ 97,188       10.3 %
China
    984,767       78.6 %     849,989       89.7 %
Total cash and cash equivalents
  $ 1,252,597       100.0 %   $ 947,177       100.0 %
 
 
9

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Notes receivable

Notes receivable represents trade accounts receivable due from various customers where the customers’ bank has guaranteed the payment of the receivable. This amount is non-interest bearing and is normally paid within three to six months.   Historically, the Company has experienced no losses on notes receivable. The Company‘s notes receivable totaled $213,087 and $50,593 at March 31, 2011 and December 31, 2010, respectively.

Accounts receivable

Accounts receivable are presented net of an allowance for doubtful accounts. The Company maintains allowances for doubtful accounts for estimated losses. The Company reviews the accounts receivable on a periodic basis and makes general and specific allowances when there is doubt as to the collectability of individual balances. In evaluating the collectability of individual receivable balances, the Company considers many factors, including the age of the balance, a customer’s historical payment history, its current credit-worthiness and current economic trends. Accounts are written off after exhaustive efforts at collection. At March 31, 2011 and December 31, 2010, the Company has established, based on a review of its outstanding balances, an allowance for doubtful accounts in the amounts of $1,819,864 and $1,815,508, respectively.

Inventories

Inventories, consisting of raw materials, work in process and finished goods related to the Company’s products are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, the Company will record reserves for the difference between the cost and the market value. These reserves are recorded based on estimates.  The Company recorded an inventory reserve of $167,162 and $166,108 at March 31, 2011 and December 31, 2010, respectively.

Advances to suppliers
 
Advances to suppliers represent the cash paid in advance for the purchase of raw material from suppliers. The advance payments are intended to ensure preferential pricing and delivery. The amounts advanced under such arrangements totaled $625,902 and $333,923 as of March 31, 2011 and December 31, 2010, respectively.

Property and equipment

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

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

 
10

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011

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

Impairment of long-lived assets

In accordance with ASC Topic 360, the Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable, or at least annually. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value. The Company did not record any impairment charges for the three months ended March 31, 2011 and 2010.
 
Advances from customers

Advances from customers at March 31, 2011 and December 31, 2010 amounted to $314,468 and $236,004, respectively, and consist of prepayments from customers for merchandise that had not yet been shipped. The Company will recognize the deposits as revenue as customers take delivery of the goods, in accordance with its revenue recognition policy.

Revenue recognition

Pursuant to the guidance of ASC Topic 605 and ASC Topic 360, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. The Company accounts for the product sale as a multiple element arrangement. Revenue from multiple element arrangements is allocated among the separate accounting units based on the residual method. Under the residual method, the revenue is allocated to undelivered elements based on fair value of such undelivered elements and the residual amounts of revenue allocated to delivered elements. The Company recognizes revenues from the sale of dyeing equipment, forged rolled rings and other components upon shipment and transfer of title. The other elements may include installation and, generally, a one-year warranty. Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally within a couple days of the delivery of the equipment. Grant income is recognized when funds have been received and all significant terms of the grant have been fulfilled by the Company. Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period.  For the three months ended March 31, 2011 and 2010, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal.
 
All other product sales with customer specific acceptance provisions, including the forged rolled rings, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.

Income taxes

The Company is governed by the Income Tax Law of the PRC and the U.S. The Company accounts for income taxes using the liability method prescribed by ASC 740, “Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the year in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rates is recognized as income or loss in the period that includes the enactment date.
 
 
11

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011

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

Income taxes (continued)

The Company applied the provisions of ASC 740-10-50, ”Accounting For Uncertainty in Income Taxes,” which provides clarification related to the process associated with accounting for uncertain tax positions recognized in our financial statements. Audit periods remain open for review until the statute of limitations has passed. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the Company’s liability for income taxes. Any such adjustment could be material to the Company’s results of operations for any given quarterly or annual period based, in part, upon the results of operations for the given period. As of March 31, 2011 and December 31, 2010, the Company had no uncertain tax positions, and will continue to evaluate for uncertain positions in the future.

Stock-based compensation

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

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

Shipping costs

Shipping costs are included in selling expenses and totaled $358,622 and $398,091 for the three months ended March 31, 2011 and 2010, respectively.

Employee benefits

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

Advertising

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

Research and development

Research and development costs are expensed as incurred. For the three months ended March 31, 2011 and 2010, research and development costs were not material.

 
12

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Foreign currency translation

The reporting currency of the Company is the U.S. dollar. The functional currency of the parent company is the U.S. dollar and the functional currency of the Company’s operating subsidiaries is the Chinese Renminbi (“RMB”). For the subsidiaries and affiliates whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the unified exchange rate at the end of the period, and equity is translated at historical exchange rates. As a result, amounts relating to assets and liabilities reported on the statements of cash flows may not necessarily agree with the changes in the corresponding balances on the balance sheets.  Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income.  The cumulative translation adjustment and effect of exchange rate changes on cash for the three months ended March 31, 2011 and 2010 was $5,963 and $360, respectively. Transactions denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing on the transaction dates. Assets and liabilities denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing at the balance sheet date with any transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.

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

Asset and liability accounts at March 31, 2011 and December 31, 2010 were translated at 6.5701 RMB to $1.00 and at 6.6118 RMB to $1.00, respectively, which were the exchange rates on the balance sheet dates. Equity accounts were stated at their historical rate. The average translation rates applied to the statements of income for the three months ended March 31, 2011 and 2010 were 6.5894 RMB and 6.83603 RMB to $1.00, respectively.  Cash flows from the Company’s operations are calculated based upon the local currencies using the average translation rate. As a result, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the consolidated balance sheets.

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

 
13

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011

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

Income per share of common stock (continued)

The following table presents a reconciliation of basic and diluted net income per share:

   
Three Months Ended
March 31,
 
   
2011
   
2010
 
Net income available to common stockholders for basic and diluted net income per share of common stock
  $ 2,665,160     $ 1,946,537  
Weighted average common stock outstanding - basic
    18,925,959       17,252,799  
Effect of dilutive securities:
               
Series A convertible preferred stock
    5,304,050       5,178,088  
Warrants
    1,425,427       2,964,139  
Weighted average common stock outstanding - diluted
    25,655,436       25,395,026  
Net income per common share – basic
  $ 0.14     $ 0.11  
Net income per common share - diluted
  $ 0.10     $ 0.08  
 
The Company's total common stock equivalents at March 31, 2011 and December 31, 2010 include the following:

   
March 31,
2011
   
December 31,
2010
 
Warrants
    2,406,869       2,524,654  
Series A convertible preferred stock
    5,207,543       5,401,756  
Total
    7,614,412       7,926,410  

Deemed preferred stock dividend

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

Accumulated other comprehensive income
 
Comprehensive income is comprised of net income and all changes to the statements of stockholders' equity, except those due to investments by stockholders, changes in paid-in capital and distributions to stockholders. For the Company, comprehensive income for the three months ended March 31, 2011 and 2010 included net income and unrealized gains from foreign currency translation adjustments.

 
14

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Related parties

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

Recent accounting pronouncements

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

NOTE 2 – ACCOUNTS RECEIVABLE

At March 31, 2011 and December 31, 2010, accounts receivable consisted of the following:
 
   
March 31,
2011
   
December 31,
2010
 
Accounts receivable
  $ 7,994,971     $ 10,023,305  
Less: allowance for doubtful accounts
    (1,819,864 )     (1,815,508 )
    $ 6,175,107     $ 8,207,797  
 
NOTE 3 - INVENTORIES

At March 31, 2011 and December 31, 2010, inventories consisted of the following:

   
March 31,
2011
   
December 31,
2010
 
Raw materials
  $ 2,367,892     $ 1,573,841  
Work in process
    1,481,607       1,302,015  
Finished goods
    894,740       661,380  
      4,744,239       3,537,236  
Less: reserve for obsolete inventory
    (167,162 )     (166,108 )
    $ 4,577,077     $ 3,371,128  

NOTE 4 - PROPERTY AND EQUIPMENT

At March 31, 2011 and December 31, 2010, property and equipment consist of the following:

   
Useful Life
   
March 31,
2011
   
December 31,
2010
 
Office equipment and furniture
 
5 Years
    $ 173,357     $ 127,522  
Manufacturing equipment
 
5 – 10 Years
      45,087,994       42,473,873  
Vehicles
 
5 Years
      120,328       119,569  
Construction in progress
  -       4,327,714       3,837,975  
Building and building improvements
 
20 Years
      17,106,537       16,998,647  
              66,815,930       63,557,586  
Less: accumulated depreciation
            (10,050,998 )     (8,814,593 )
                         
            $ 56,764,932     $ 54,742,993  

 
15

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 4 - PROPERTY AND EQUIPMENT (continued)

For the three months ended March 31, 2011 and 2010, depreciation expense amounted to $1,177,002 and $584,646, of which $1,096,415 and $501,691 is included in cost of sales, respectively.  Upon completion of the construction in progress, the assets will be classified to its respective property and equipment category.
 
NOTE 5 – LAND USE RIGHTS

There is no private ownership of land in China. Land is owned by the government and the government grants land use rights for specified terms.   The Company’s land use rights have terms of 45 and 50 years and expire on January 1, 2053 and October 30, 2053.  The Company amortizes the land use rights over the term of the respective land use right. For the three months ended March 31, 2011 and 2010, amortization of land use rights amounted to $22,428 and $21,618, respectively.

At March 31, 2011 and December 31, 2010, land use rights consist of the following:
 
 
Useful Life
 
March 31,
2011
   
December 31,
2010
 
Land use rights
45 - 50 years
  $ 4,109,647     $ 4,083,728  
Less: accumulated amortization
      (341,072 )     (316,569 )
      $ 3,768,575     $ 3,767,159  
                   
Amortization of land use rights attributable to future periods is as follows:

Twelve-month periods ending March 31,:
     
2012
  $ 89,974  
2013
    89,974  
2014
    89,974  
2015
    89,974  
2016
    89,974  
Thereafter
    3,318,705  
    $ 3,768,575  

NOTE 6 – STOCKHOLDERS’ EQUITY

(a) Common stock issued for services

On January 1, 2011, the Company issued 2,500 shares of its common stock to a director pursuant to an amended director’s agreement. The shares are valued at the fair value on the grant date and the Company recorded stock-based compensation of $8,824.

On January 1, 2011, the Company issued 7,500 shares of its common stock to its chief financial officer pursuant to the employment agreement between the Company and the chief financial officer. The shares are valued at the fair value on the grant date and the Company recorded stock-based compensation of $26,475.

In March 2011, the Company issued an aggregate of 15,250 shares of its common stock to employees pursuant to the Company’s 2010 long-term incentive plan, of which 7,000 shares were granted to the Company’s chief executive officer.  None of the other share were issued to executive officers or directors.  The shares are valued at the fair value on the grant date and the Company recorded stock-based compensation of $49,598.

 
16

 
\
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
  
NOTE 6 – STOCKHOLDERS’ EQUITY (continued)

(b) Common stock issued for preferred share conversions

In February, the Company issued 312,000 shares of its common stock upon the conversion of series A preferred stock.

(c)  Common stock sold for cash

On January 18, 2011, the Company sold 35,014 shares of its common stock to its chief financial officer for $125,000, representing the market price on January 18, 2011, the date of the stock purchase agreement.

(d)  Series A preferred stock issued for warrants exercise

In February and March 2011, the Company issued a total of 353,357 shares of series A preferred stock upon the exercise of warrants, for which the Company received total cash proceeds of $200,000.

(e) Warrants

Warrant activities for the three months ended March 31, 2011 are summarized as follows:

   
Three Months Ended
March 31, 2011
   
Number of Warrants
   
Weighted Average Exercise Price
 
Balance at beginning of year
    2,524,654     $ 1.57  
Granted
    -       -  
Exercised
    (117,785 )     1.698  
Forfeited
    -       -  
Balance at end of period
    2,406,869     $ 1.57  
                 
Warrants exercisable at end of period
    2,406,869     $ 1.57  

The following table summarizes the shares of the Company's common stock issuable upon exercise of warrants outstanding at March 31, 2011:
 
Warrants Outstanding
   
Warrants Exercisable
 
Range of Exercise Price
 
Number Outstanding at March 31, 2011
   
Weighted Average Remaining Contractual Life (Years)
   
Weighted Average Exercise Price
   
Number
Exercisable at
March 31, 2011
   
Weighted Average Exercise Price
 
$1.698     1,767,778       1.62     $ 1.698       1,767,778     $ 1.698  
$1.200     639,091       1.81       1.200       639,091       1.200  
      2,406,869       1.68     $ 1.57       2, 406,869     $ 1.57  

 
17

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 7 – INCOME TAXES

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

Accordingly, the net deferred tax asset related to the U.S. net operating loss carryforward has been fully offset by a valuation allowance. The Company is governed by the Income Tax Law of the PRC and the U.S.  In 2011 and 2010, under the Income Tax Laws of PRC, Chinese companies are generally subject to an income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments. The Company’s VIEs (Dyeing and Electric) and the Company’s subsidiary, Fulland Wind Energy, are subject to these statutory rates. The Company’s wholly-owned subsidiary, Fulland Limited was incorporated in the Cayman Islands. Under the current laws of the Cayman Islands, this entity is not subject to income taxes.

NOTE 8 – LOANS PAYABLE

At March 31, 2011 and December 31, 2010, loans payable consisted of the following:
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Loan payable to Bank of Communications, due on February 1, 2011 with annual interest at December 31, 2010 of 4.86%, the rate being adjusted quarterly based on People’s Bank of China’s base rate times 120% and repaid on due date
    -       756,224  
                 
Loan payable to Agricultural and Commercial Bank, due on March 31, 2011 with annual interest at March 31, 2011 and December 31, 2010 of 5.75% and 5.75%, respectively, secured by certain assets of the Company and repaid on due date
    -       604,979  
                 
Loan payable to Agricultural and Commercial Bank, due on October 10, 2011 with annual interest at March 31, 2011 and December 31, 2010 of 5.75% and 5.75%, respectively, secured by certain assets of the Company
    456,614       453,734  
                 
Loan payable to Bank of Communications, due on July 4, 2011 with annual interest at March 31, 2011 of 6.72%, the rate being adjusted quarterly based on People’s Bank of China’s base rate times 120%
    304,409       -  
                 
Loan payable to Bank of Communications, due on July 6, 2011 with annual interest at March 31, 2011 of 6.72%, the rate being adjusted quarterly based on People’s Bank of China’s base rate times 120%
    456,614       -  
                 
Total loans payable (current)
  $ 1,217,637     $ 1,814,937  

NOTE 9 - SEGMENT INFORMATION

For the three months ended March 31, 2011 and 2010, the Company operated in two reportable business segments - (1) the manufacture of dyeing and finishing equipment segment and (2) the manufacture of forged rolled rings and related components for the wind power and other industries segment. The Company's reportable segments are strategic business units that offer different products. They are managed separately based on the fundamental differences in their operations.  All of the Company’s operations are conducted in the PRC.
 
 
18

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 9 - SEGMENT INFORMATION (continued)

Information with respect to these reportable business segments for the three months ended March 31, 2011 and 2010 is as follows:

   
2011
   
2010
 
Revenues:
           
Dyeing and finishing equipment
  $ 4,149,023     $ 4,993,233  
Forged rolled rings and related components
    13,417,357       11,847,449  
      17,566,380       16,840,682  
Depreciation:
               
Dyeing and finishing equipment
    163,256       110,210  
Forged rolled rings and related components
    1,013,746       474,436  
      1,177,002       584,646  
Interest expense:
               
Dyeing and finishing equipment
    -       -  
Forged rolled rings and related components
    29,702       26,976  
Other (a)
    -       47,943  
      29,702       74,919  
Net income (loss):
               
Dyeing and finishing equipment
    423,442       499,978  
Forged rolled rings and related components
    2,441,673       1,971,425  
Other (a)
    (199,955 )     (524,866 )
      2,665,160       1,946,537  
Identifiable long-lived tangible assets at March 31, 2011 and December 31, 2010 by segment:
               
Dyeing and finishing equipment
  $ 8,246,250     $ 6,033,004  
Forged rolled rings and related components
    48,518,682       48,709,989  
    $ 56,764,932     $ 54,742,993  
Identifiable long-lived tangible assets at March 31, 2011 and December 31, 2010 by geographical location:
               
China
  $ 56,764,932     $ 54,742,993  
United States
    -       -  
    $ 56,764,932     $ 54,742,993  
 

(a) 
The Company does not allocate any general and administrative expenses of its U.S. activities to its reportable segments because these activities are managed at a corporate level and not allocable to any segment.
 
NOTE 10 – STATUTORY RESERVES

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

 
19

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
 
NOTE 10 – STATUTORY RESERVES (continued)

For the three months ended March 31, 2011, statutory reserve activity is as follows:

   
Dyeing
   
Electric
   
Wuxi Fulland
   
Total
 
Balance – December 31, 2010
  $ 72,407     $ 1,168,796     $ 416,994     $ 1,658,197  
Additional to statutory reserves
    -       -       192,409       192,409  
Balance – March 31, 2011
  $ 72,407     $ 1,168,796     $ 609,403     $ 1,850,606  

NOTE 11 – CONCENTRATIONS

Customers

One customer accounted for 10% or more of the Company’s revenues during the three months ended March 31, 2011 and the three months ended March 31, 2010.  Each of these customers was a customer of the forged rolled rings and related components segment.  The following table sets forth sales to these customers.

   
Three Months Ended
March 31,
 
Customer
 
2011
   
2010
 
A
    10 %     0 %
B
    0 %     23 %

Suppliers

The following table sets forth information as to each supplier that accounted for 10% or more of the Company’s purchases for the three months ended March 31, 2011 and the three months ended March 31, 2010.

   
Three Months Ended
 March 31,
 
Supplier
 
2011
   
2010
 
A
    12 %     *  
B
    11 %     *  
C
    16 %     40 %
D
    *       27 %
 

*
less than 10%.

NOTE 12 – RESTRICTED NET ASSETS

Regulations in the PRC permit payments of dividends by the Company’s PRC VIEs only out of their retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. Subject to certain cumulative limit, a statutory reserve fund requires annual appropriations of at least 10% of after-tax profit, if any, of the relevant PRC VIE’s and subsidiary. The statutory reserve funds are not distributable as cash dividends. As a result of these PRC laws and regulations, the Company’s PRC VIE’s and its subsidiary are restricted in their abilities to transfer a portion of their net assets to the Company. Foreign exchange and other regulations in PRC may further restrict the Company’s PRC VIEs and its subsidiary from transferring funds to the Company in the form of loans and/or advances.

As of March 31, 2011 and December 31, 2010, substantially all of the Company’s net assets are attributable to the PRC VIE’s and its subsidiary located in the PRC. Accordingly, the Company’s restricted net assets were approximately $65,331,000 and $62,056,000, respectively.

 
20

 
 
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
 
NOTE 13 – SUBSEQUENT EVENTS

On April 1, 2011, the Company issued 2,500 shares of its common stock to a director pursuant to an amended director’s agreement. The shares are valued at the fair value on the grant date and the Company recorded stock-based compensation of $7,850.

On April 1, 2011, the Company issued 7,500 shares of its common stock to its chief financial officer pursuant to the employment agreement between the Company and the chief financial officer. The shares are valued at the fair value on the grant date and the Company recorded stock-based compensation of $23,550.

On April 1, 2011, the Company issued 1,250 shares of its common stock to an employee pursuant to the engagement agreement between the Company and the employee. The shares are valued at the fair value on the grant date and the Company recorded stock-based compensation of $3,925.

On April 14, 2011, the Company issued 13,000 shares of common stock to an investor relations firm pursuant to an agreement with the firm.  The shares are valued at the fair value on the grant date and the Company recorded stock-based compensation of $37,440. 
 
 
21

 

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

We are engaged in two business segments – the forged rolled rings and related components segment, in which we manufacture and sell high precision forged rolled rings, shafts, flanges, and other forged components for the wind power and other industries, and the dyeing and finishing equipment segment, in which we manufacture and sell textile dyeing and finishing machines.

The following table sets forth information as to revenue of our forged rolled rings and related components and dyeing and finishing equipment segments in dollars and as a percent of revenue (dollars in thousands):

   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
Dollars
   
%
   
Dollars
   
%
 
Forged rolled rings - wind power industry
  $ 10,182       58.0 %   $ 6,953       41.3 %
Forged rolled rings – other industries
    3,235       18.4 %     4,895       29.1 %
Dyeing and finishing equipment
    4,149       23.6 %     4,993       29.6 %
Total
  $ 17,566       100.0 %   $ 16,841       100.0 %

Forged rolled rings and related components segment

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

Through our forged rolled rings and other related products division, we supply precision forged rolled rings and other forged components to the wind and other industries.  These components are used in wind turbines, which are used to generate wind power.  The government of the PRC has announced its desire to expand significantly its goal for installed wind energy capacity.  We began to manufacture shafts and forged rolled rings for gear rims, flanges and other applications in our new 108,000 square foot manufacturing facility which became operational in March 2009.

We produce precision forgings using axial close-die forging technology, which is a new technology for producing rotary precision forgings, using forging equipment which we manufactured for our own use. The axial close-die forging technology reduces the use of raw materials by as much as 35%, provides a high precision and surface flatness, reduces the cutting output, has excellent mechanical strength and high flexibility, and is a fully automatic operation. We believe that our forging capabilities will continue to increase as we implement our expansion plans.

In October 2009, we ordered the initial machinery to expand our completed state-of-the-art forged product facility with a new production line, enabling us to manufacture ESR forged products for the high performance components market of the wind power industry.  We believe that ESR forged products will be important components in the next generation of larger wind turbines, which will require stronger steel alloy precision forged components than the smaller turbines.  ESR technology is used to increase the durability and quality of steel and to blend specific alloys that are required to meet the anticipated strength requirements of the next generation of wind turbines.  We delivered the initial units from this production line in July 2010.

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

The forged rolled rings segment has become a more significant percentage of our total revenues since we expanded our manufacturing facilities to enable us to manufacture forged rolled rings with a larger diameter in order to meet the perceived needs of the wind power industry.

 
22

 

During the first quarter of 2011, we manufactured and delivered test subassemblies for solar cell manufacturing equipment, which marked our entry into the solar products market.  We have since received follow-on orders for this product in the amount of $1.1 million. This equipment is being marketed and manufactured in our forged rolled rings segment.

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

Dyeing and finishing equipment segment

In connection with our Dyeing and finishing equipment segment, despite the world economic slowdown, for the year 2009, China’s gross output value for textiles rose by 10.3% year on year to RMB 3.8 trillion (approximately $576 billion), while the amount of clothes produced increased by 6.9% year on year to 23.75 billion units (source: China National Textile and Apparel Council, Ministry and Industry Information Technology). We believe weak overseas demand has been more than offset by strong demand within China. If the local demand for textile machinery deteriorates or if we cannot generate acceptable margins, we will discontinue this business to focus on the sale of forged rolled rings and related products.

Raw materials
 
A major element of our cost of revenues is raw materials, principally steel and other metals. These metals are subject to price fluctuations, and recently these fluctuations have been significant.  In times of increasing prices, we need to try to fix the price at which we purchase raw materials in order to avoid increases in costs which we cannot recoup through increases in sales prices.  Similarly, in times of decreasing prices, we may have purchased metals at prices which are high in terms of the price at which we can sell our products, which also can impair our margins. Three major suppliers provided approximately 39% (12%, 11% and 16%, respectively) of our purchases of raw materials for the three months ended March 31, 2011 primarily consisting of steel for the forged rolled rings and related components segment.

Critical accounting policies and estimates

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

Variable interest entities

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

 
23

 

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

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

Accounts receivable

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

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

Inventories

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

Property and equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are as follows:

   
Useful Life
Building and building improvements
 
20
Years
Manufacturing equipment
 
5 – 10
Years
Office equipment and furniture
 
5
Years
Vehicle
 
5
Years
 
The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition.

 
24

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

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

Land use rights

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

Revenue recognition

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

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

Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period. For the three months ended March 31, 2011 and 2010, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal.
 
All other product sales, including the forged rolled rings, with customer specific acceptance provisions, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.

Research and development

Research and development costs are expensed as incurred.  We incurred minimal research and development expenses in the three months ended March 31, 2011 and 2010.  Product development expenses, which primarily consist of cost of material used and salaries paid for the development of our products and fees paid to third parties, are included in general and administrative expenses.

Income taxes

We are governed by the Income Tax Law of the PRC and the United States. Income taxes are accounted for pursuant to accounting standards, which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. The charge for taxes is based on the results for the year as adjusted for items, which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.
 
 
25

 

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

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

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

Stock-based compensation

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

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

Recent accounting pronouncements 

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

Currency exchange rates

All of our sales are denominated in RMB. As a result, changes in the relative values of U.S. dollars and RMB affect our reported levels of revenues and profitability as the results of our operations are translated into U.S. dollars for reporting purposes. In particular, fluctuations in currency exchange rates could have a significant impact on our financial stability due to a mismatch among various foreign currency-denominated sales and costs. Fluctuations in exchange rates between the U.S. dollar and RMB affect our gross and net profit margins and could result in foreign exchange and operating losses.

Our exposure to foreign exchange risk primarily relates to currency gains or losses resulting from timing differences between signing of sales contracts and settling of these contracts. Furthermore, we translate monetary assets and liabilities denominated in other currencies into RMB, the functional currency of our operating subsidiaries. Our results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate at the end of the period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in our statement of shareholders’ equity. We have not used any forward contracts, currency options or borrowings to hedge our exposure to foreign currency exchange risk. We cannot predict the impact of future exchange rate fluctuations on our results of operations and may incur net foreign currency losses in the future.

Our financial statements are expressed in U.S. dollars and the functional currency of our parent company is U.S. dollars. The functional currency of our operating subsidiaries and affiliates is RMB.  To the extent we hold assets denominated in U.S. dollars, any appreciation of the RMB against the U.S. dollar could result in a charge in our statement of operations and a reduction in the value of our U.S. dollar denominated assets. On the other hand, a decline in the value of RMB against the U.S. dollar could reduce the U.S. dollar equivalent amounts of our financial results.

 
26

 
 
RESULTS OF OPERATIONS

The following table sets forth the results of our operations for the periods indicated as a percentage of net revenues (dollars in thousands):
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
Dollars
   
Percent
   
Dollars
   
Percent
 
Net revenues
  $ 17,566       100.0 %   $ 16,841       100.0 %
Cost of revenues
    13,013       74.1 %     12,424       73.8 %
Gross profit
    4,553       25.9 %     4,417       26.2 %
Operating expenses
    913       5.2 %     1,484       8.8 %
Income from operations
    3,640       20.7 %     2,933       17.4 %
Other income (expenses)
    (22 )     (0.1 )%     (76 )     (0.4 )%
Income before provision for income taxes
    3,618       20.6 %     2,857       17.0 %
Provision for income taxes
    953       5.4 %     910       5.4 %
Net income
    2,665       15.2 %     1,947       11.6 %
Other comprehensive income:
                               
Foreign currency translation adjustment
    406       2.3 %     7       0.0 %
                                 
Comprehensive income
  $ 3,071       17.5 %   $ 1,954       11.6 %
 
The following table sets forth information as to the gross margin for our two business segments for the three months ended March 31, 2011 (dollars in thousands).

   
Forged rolled rings and related products
   
Dyeing and finishing equipment
   
Total
 
   
Three Months ended March 31, 2011
 
Revenues
  $ 13,417     $ 4,149     $ 17,566  
Cost of revenues
  $ 9,739     $ 3,274     $ 13,013  
Gross profit
  $ 3,678     $ 875     $ 4,553  
Gross margin %
    27.4 %     21.1 %     25.9 %
 
The following table sets forth information as to the gross margin for our two business segments for the three months ended March 31, 2010 (dollars in thousands).

   
Forged rolled rings and related products
   
Dyeing and finishing equipment
   
Total
 
   
Three Months ended March 31, 2010
 
Revenues
  $ 11,848     $ 4,993     $ 16,841  
Cost of revenues
  $ 8,440     $ 3,984     $ 12,424  
Gross profit
  $ 3,408     $ 1,009     $ 4,417  
Gross margin %
    28.8 %     20.2 %     26.2 %

 
27

 
 
Revenues. For the three months ended March 31, 2011, we had revenues of $17,566,000, as compared to revenues of $16,841,000 for the three months ended March 31, 2010, an increase of approximately 4.3%. The increase in revenue was attributable to the increase in revenue from our forged rolled rings and related products segment and offset by a decrease in revenue from our dyeing and finishing equipment segment, and is summarized as follows (dollars in thousands):

   
For the Three Months Ended March 31, 2011
   
For the Three Months Ended March 31, 2010
   
Increase
(Decrease)
   
Percentage
Change
 
Forged rolled rings and related products - wind power industry
  $ 10,182     $ 6,953     $ 3,229       46.5 %
Forged rolled rings and related products – other industries
    3,235       4,895       (1,660 )     (33.9 )%
Dyeing and finishing equipment
    4,149       4,993       (844 )     (16.9 )%
Total net revenues
  $ 17,566     $ 16,841     $ 725       4.3 %

The decrease in revenue from the sale of dyeing and finishing equipment reflects the business cycle as well as delays in purchasing new equipment designed to meet stricter environmental standards imposed by the Chinese government as textile manufacturers evaluate both their projected business in uncertain economic times and new equipment designed to meet the new standards.  We believe that our newest equipment meets the new standards.
 
Revenue from forging of rolled rings and related products totaled $13,417,000 for the three months ended March 31, 2011, with revenues of $10,182,000 from the wind power industry and revenues of $3,235,000 from other forging operations.  Due to the shift in focus of our sales effort to the wind segment, for the three months ended March 31, 2011, we increased sales of forged rolled rings to the wind power industry by 46.5% as compared to the comparable 2010 period. We experienced a 33.9% decrease in forging revenues from other industries, such as the railway, heavy machinery manufacturing, petrochemical, metallurgical, sea port machinery, and defense and radar industries.  We believe that the increase in forging revenues from the wind industry reflects both the Chinese government’s stated desire to increase the use of wind power as an energy source and the shift in focus of our sales effort and the allocation of our resources to the wind market.

Cost of revenues. For the three months ended March 31, 2011, cost of revenues totaled $13,013,000 as compared to $12,424,000 for comparable 2010 period, an increase of $589,000, or 4.7%. Cost of revenues for the dyeing segment was $3,274,000 for the three months ended March 31, 2011, as compared to $3,984,000 for the comparable 2010 period. Cost of revenues related to the manufacture of forged rolled rings and related products was $9,739,000 for the three months ended March 31, 2011 as compared to $8,440,000 for the comparable 2010 period.

Gross profit and gross margin. Our gross profit was $4,553,000 for the three months ended March 31, 2011 as compared to $4,417,000 for the comparable 2010 period, representing gross margins of 25.9% and 26.2%, respectively. Gross profit for the dyeing segment was $875,000 for the three months ended March 31, 2011 as compared to $1,009,000 for the three months ended March 31, 2010, representing gross margins of approximately 21.1% and 20.2%, respectively. The increase in our gross margin for the dyeing segment was attributable to the decrease in the related miscellaneous sales taxes for which we received a credit in the 2011 quarter. Gross profit from forged rolled rings and related products segment was $3,678,000 for the three months ended March 31, 2011 as compared to $3,408,000 for the three months ended March 31, 2010, representing gross margins of approximately 27.4% and 28.8%, respectively. The decrease in our gross margin was mainly attributed to an increase in the cost of raw materials and an increase in labor costs in the three months ended March 31, 2011 as compared to the three months ended March 31, 2010, which could not be passed on to our customers.

Depreciation. Depreciation was $1,177,000 for the three months ended March 31, 2011 and $585,000 for the three months ended March 31, 2010, of which $1,096,000 for the three months ended March 31, 2011 and $502,000 for the three months ended March 31, 2010 is included in cost of sales and $81,000 for the three months ended March 31, 2011 and $83,000 for the three months ended March 31, 2010 is included in operating expenses. The overall increase in depreciation is attributable to the increase in our depreciable production equipment, primarily relating to our forged rolled rings and other related products segment.  We expect depreciation to increase in future periods, as we install and place in service new equipment and facilities related to our production line.

 
28

 

Selling, general and administrative expenses. Selling, general and administrative expenses totaled $832,000 for the three months ended March 31, 2011, as compared to $1,401,000 for the three months ended March 31, 2010, a decrease of $569,000 or approximately 40.6%. Selling, general and administrative expenses consisted of the following (dollars in thousands):

   
Three Months Ended
March 31,
2011
   
Three Months Ended
March 31,
2010
 
Professional fees
  $ 61     $ 76  
Bad debt (recovery) expense
    (7 )     251  
Payroll and related benefits
    186       427  
Travel
    41       90  
Shipping
    359       398  
Other
    192       159  
    $ 832     $ 1,401  

 
Professional fees decreased for the three months ended March 31, 2011 by $15,000, or 19.7%, as compared to the three months ended March 31, 2010. The decrease is primarily attributed to a decrease in stock transfer fee of approximately $11,000 and a decrease in other professional fees of approximately $4,000.
 
 
For the three months ended March 31, 2011, we had a bad debt recovery of approximately $7,000 as compared to bad debt expense of approximately $251,000 for the three months ended March 31, 2010. Based on our periodic review of accounts receivable balances, we adjusted the allowance for doubtful accounts after considering management’s evaluation of the collectability of individual receivable balances, including the analysis of subsequent collections, the customers’ collection history, and recent economic events.
 
 
Payroll and related benefits decreased for the three months ended March 31, 2011 by $241,000, or 56.4%, as compared to the three months ended March 31, 2010. The decrease was mainly attributable to a decrease in stock-based compensation of $276,000 offset by an increase in compensation and related benefits of approximately $35,000 in our dyeing and finishing segment and forged rolled rings and related products segment resulting from increased operations.
 
 
Travel expense for the three months ended March 31, 2011 decreased by $49,000, or 54.4%, as compared to the three months ended March 31, 2010. The decrease is primarily related to the decrease in travel for investor road shows and conferences.
 
 
Shipping expense for the three months ended March 31, 2011 decreased by $39,000, or 9.8%, as compared to the three months ended March 31, 2010. The decrease was primarily attributable to a slight decrease in our sales quantity and we only paid partial shipping fees for some customers in the three months ended March 31, 2011.
 
 
 
Other selling, general and administrative expenses for the three months ended March 31, 2010 increased by $33,000, or 20.8%, as compared with the three months ended March 31, 2010. The increase was primarily attributed to an increase in maintenance expense of approximately $13,000, an increase in insurance expense of approximately $16,000 and an increase in other miscellaneous expenses of approximately $4,000.
 
Income from operations. For the three months ended March 31, 2011, income from operations amounted to $3,640,000, as compared to $2,932,000 for the three months ended March 31, 2010, an increase of $708,000 or 24.1%.
 
 
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Other income (expenses). For the three months ended March 31, 2011, other expenses amounted to $22,000 as compared to $76,000 for the three months ended March 31, 2010.
 
For the three months ended March 31, 2011, other income (expense) included:
 
 
interest expense of $30,000, which reflecting an increase in our interest rates;
 
 
foreign currency losses of $1,000;
 
 
interest income of $1,000;
 
 
other income of $9,000. In the 2011 period, we rented out a portion of our office space and generated rent revenue of approximately $4,000. Additionally, during the 2011 period, we recognized grant income of $5,000 for grants received from the local government. We used the grant for working capital purposes.
 
For the three months ended March 31, 2010, other income (expense) included:
 
 
interest expense of $75,000, consisting of non-cash interest expense of $45,000 from the amortization of debt discount arising from our March 2009 financing and interest expense of $30,000 incurred on our outstanding loans;
 
 
foreign currency losses of $2,000; and
 
 
interest income of $1,000.
 
Income tax expense. Income tax expense totaled $953,000 for the three months ended March 31, 2011, as compared to $910,000 for the three months ended March 31, 2010, an increase of $43,000, or approximately 4.7% which was primarily attributable to the increase in taxable income generated by our operating entities.
 
Net income. As a result of the foregoing, our net income was $2,665,000 for the three months ended March 31, 2011, as compared with $1,947,000 for the three months ended March 31, 2010. This translates to basic net income per common share of $0.14 and $0.11, and diluted net income per common share of $0.10 and $0.08, for the three months ended March 31, 2011 and 2010, respectively.
 
Foreign currency translation gain. The functional currency of our subsidiaries and variable interest entities operating in the PRC is the Chinese Yuan or Renminbi (“RMB”). The financial statements of our subsidiaries are translated to U.S. dollars using period end rates of exchange for assets and liabilities, and average rates of exchange (for the period) for revenues, costs, and expenses. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations. As a result of these translations, which are a non-cash adjustment, we reported a foreign currency translation gain of $406,000 for the three months ended March 31, 2011 as compared to $7,000 for the three months ended March 31, 2010. This non-cash gain had the effect of increasing our reported comprehensive income.
 
Comprehensive income. As a result of our foreign currency translation gains, we had comprehensive income for the three months ended March 31, 2011 of $3,071,000, compared with $1,954,000 for the three months ended March 31, 2010.

 
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Liquidity and Capital Resources

Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations and otherwise operate on an ongoing basis.  At March 31, 2011 and December 31, 2010, we had cash balances of $1,252,597 and $947,177, respectively. These funds are located in financial institutions located as follows (dollars in thousands):

   
March 31, 2011
   
December 31, 2010
 
Country:
                       
United States
  $ 268       21.4 %   $ 97       10.3 %
China
    985       78.6 %     850       89.7 %
Total cash and cash equivalents
  $ 1,253       100.0 %   $ 947       100.0 %

The following table sets forth information as to the principal changes in the components of our working capital from December 31, 2010 to March 31, 2011 (dollars in thousands):

         
December 31, 2010
to March 31, 2011
 
Category
 
2011
   
2010
   
Change
   
Percentage Change
 
Current assets:
                       
Cash and cash equivalents
  $ 1,253     $ 947       306       32.2 %
Notes receivable
    213       51       162       321.2 %
Accounts receivable, net of allowance for doubtful accounts
    6,175       8,208       (2,033 )     (24.8 )%
Inventories, net of reserve for obsolete inventory
    4,577       3,371       1,206       35.8 %
Advances to suppliers
    626       334       292       87.4 %
Prepaid value-added taxes on purchase
    2,522       2,760       (238 )     (8.6 )%
Prepaid expenses and other current assets
    140       36       104       286.2 %
Current liabilities:
                               
Loans payable
    1,218       1,815       (597 )     (32.9 )%
Accounts payable
    6,641       7,661       (1,020 )     (13.3 )%
Accrued expenses
    662       526       136       26.0 %
VAT and service taxes payable
    -       81       (81 )     (100.0 ) %
Advances from customers
    314       236       78       33.2 %
Income tax payable
    1,158       1,332       (174 )     (13.1 )%
Working capital:
                               
Total current assets
    15,506       15,707       (201 )     (1.3 ) %
Total current liabilities
    9,993       11,651       (1,658 )     (14.2 )%
Working capital
    5,513       4,056       1,457       35.9 %

Our working capital increased $1,457,000 to $5,513,000 at March 31, 2011 from working capital of $4,056,000 at December 31, 2010. This increase in working capital is primarily attributable to an increase in cash and cash equivalents of $306,000, an increase in notes receivable of $162,000, an increase in inventories, net of reserve for obsolete inventory, of $1,206,000, an increase in advances to suppliers of $292,000, an increase in prepaid expenses and other current assets of $104,000, a decrease in loans payable of $597,000, a decrease in accounts payable of $1,020,000, a decrease in VAT and service taxes payable of $81,000 and a decrease in income taxes payable of $174,000, offset by a decrease in accounts receivable, net of allowance for doubtful accounts, of $2,033,000, a decrease in prepaid VAT on purchases of $238,000, an increase in accrued expenses of $136,000, and an increase in advance from customers of $78,000.

Net cash flow provided by operating activities was $3,428,000 for the three months ended March 31, 2011 as compared to $1,732,000 for the three months ended March 31, 2010, an increase of $1,696,000.

 
·
Net cash flow provided by operating activities for the three months ended March 31, 2011 was primarily due to net income of $2,665,000, a decrease in accounts receivable of $2,086,000 and increase in depreciation of $1,177,000, offset primarily by an increase in inventory of $1,181,000 and a decrease in accounts payable of $1,065,000.

 
·
Net cash flow provided by operating activities for the three months ended March 31, 2010 was primarily due to net income of $1,947,000, increases in accounts payable of $1,412,000 and depreciation of $585,000, offset primarily by increases in inventory of $1,096,000 and accounts receivable of $1,075,000.

 
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Net cash flow used in investing activities, which reflected the purchase of property and equipment, was $2,847,000 for the three months ended March 31, 2011 as compared to $2,811,000 for the three months ended March 31, 2010.

Net cash flow used in financing activities was $282,000 for the three months ended March 31, 2011 as compared to net cash flow provided by financing activities of $1,270,000 for the three months ended March 31, 2010. During the three months ended March 31, 2011, we received proceeds from loans of $759,000, proceeds from the sale of common stock of $125,000, proceeds from exercise of common stock warrants of $200,000 offset by the repayment of loans of $1,366,000. For the three months ended March 31, 2010, we received $1,600,000 from the exercise of warrants offset by the repayment of loans of $330,000.

Our capital requirements for the next twelve months relate to purchasing machinery for the manufacture of products for the solar industry as well as additional investment in our forged rolled rings division.  We also expect to incur modest expenses in maintaining our dyeing business.  We believe that our cash flow from operations will be sufficient to meet our anticipated cash requirements for the next twelve months.

Contractual Obligations and Off-Balance Sheet Arrangements

We have certain fixed contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our determination of amounts presented in the tables, in order to assist in the review of this information within the context of our consolidated financial position, results of operations, and cash flows. The following tables summarize our contractual obligations as of March 31, 2011 (dollars in thousands), and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

   
Payments Due by Period
 
   
Total
   
Less than
1 year
   
1-3 
Years
   
3-5
Years
   
5 Years
+
 
Contractual obligations:
                             
Bank loans (1)
  $ 1,218     $ 1,218     $ -     $ -     $ -  
                                         
Total
  $ 1,218     $ 1,218     $ -     $ -     $ -  
 

(1)
Bank loans consists of short term bank loans. Historically, we have refinanced these bank loans for an additional term of one year and we expect to continue to refinance these loans upon expiration.

Off-balance Sheet Arrangements
 
We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

Foreign Currency Exchange Rate Risk

We produce and sell almost all of our products in China. Thus, most of our revenues and operating results may be impacted by exchange rate fluctuations between RMB and US dollars.  For the three months ended March 31, 2011, we had unrealized foreign currency translation gain of $405,828, because of the change in the exchange rate.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Not required for smaller reporting companies.

 
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ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As required by Rule 13a-15 under the Exchange Act, our management, including Jianhua Wu, our chief executive officer, and Fernando Liu, our chief financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2011.
 
Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating and implementing possible controls and procedures.
 
Management conducted its evaluation of disclosure controls and procedures under the supervision of our chief executive officer and our chief financial officer. Based on that evaluation, Mr. Wu and Mr. Liu concluded that our disclosure controls and procedures were not effective as of March 31, 2011.
 
Management’s Report on Internal Control over Financial Reporting
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act.  Our management is also required to assess and report on the effectiveness of our internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”).   As previously reported in our Form 10-K for the year ended December 31, 2010, management assessed the effectiveness of our internal control over financial reporting as of December 31, 2010 and, during our assessment, management identified significant deficiencies related to (i) the U.S. GAAP expertise of our internal accounting staff, (ii) our internal audit functions and (iii) a lack of segregation of duties within accounting functions. Although management believes that these deficiencies do not amount to a material weakness, our internal controls over financial reporting were not effective at December 31, 2010.
 
In order to correct the foregoing deficiencies, we have taken the following remediation measures during the first quarter of 2011:

 
In January 2011, we hired a chief financial officer with experience in internal control and U.S. GAAP reporting compliance, and, together with our vice president of financial reporting and our chief executive officer oversee and manage our financial reporting process and the required training of the accounting staff.

 
We have committed to the establishment of effective internal audit functions and, during the first quarter of 2011,  we hired a Sarbanes-Oxley consulting firm to assist us with implementation of stronger internal controls and procedures.

 
We have adopted a formal plan and we expect to take significant steps to implement this plan during the next few months.   To the extent possible, we are implementing procedures to assure that the initiation of transactions, the custody of assets and the recording of transactions will be performed by separate individuals.

A material weakness (within the meaning of PCAOB Auditing Standard No. 5) is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.
  
 
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Changes in Internal Controls over Financial Reporting
 
There were no changes in our internal controls over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
During the three months ended March 31, 2011, we did not make any sales of unregistered securities that were not reported on a Form 8-K, except as follows.

In February, we issued 312,000 shares of its common stock upon the conversion of series A preferred stock. The issuance of such shares was exempt from the registration requirement of the Securities Act by virtue of Section 3(a) (9) of such Act.

In February and March 2011, we issued a total of 353,357 shares of series A preferred stock upon the exercise of warrants, for which the Company received total cash proceeds of $200,000.  The issuance of such shares was exempt from registration pursuant to Section 4(2) of the Securities Act as a transaction not involving a public offering.  The purchaser was an accredited investor who acquired the shares for its own account and not with a view to the sale or distribution thereof.  The certificates for the shares bear a restricted stock legend.

ITEM 6. EXHIBITS

31.1           Rule 13a-14(a)/15d-14(a) certification of Chief Executive Officer
 
31.2           Rule 13a-14(a)/15d-14(a) certification of Principal Financial Officer
 
32.1           Section 1350 certification of Chief Executive Officer and Chief Financial Officer

 
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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
CHINA WIND SYSTEMS, INC.
 
       
Date: May 16, 2011
By:
/s/ Jianhua Wu  
   
Jianhua Wu,
Chief Executive Officer
 
       
Date: May 16, 2011
By:
/s/ Fernando Liu  
   
Fernando Liu,
Chief Financial Officer
and Principal Accounting Officer
 
 
 
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