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EXCEL - IDEA: XBRL DOCUMENT - CHINA HGS REAL ESTATE INC.Financial_Report.xls
EX-31.2 - EXHIBIT 31.2 - CHINA HGS REAL ESTATE INC.v342994_ex31-2.htm
EX-32.1 - EXHIBIT 32.1 - CHINA HGS REAL ESTATE INC.v342994_ex32-1.htm
EX-31.1 - EXHIBIT 31.1 - CHINA HGS REAL ESTATE INC.v342994_ex31-1.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, 2013

 

¨ 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: 001-34864

 

CHINA HGS REAL ESTATE, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 Florida    33-0961490
(State or Other Jurisdiction of Incorporation)   (I.R.S. Employer Identification Number)

 

6 Xinghan Road, 19th Floor, Hanzhong City

Shaanxi Province, PRC 723000

 (Address of Principal Executive Offices, Zip Code)

 

+(86) 091 - 62622612

(Registrant’s Telephone Number, including Area Code)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No ¨

 

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

 

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

 

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

 

The number of shares outstanding of each of the issuer’s classes of common equity, as of May 13, 2013 is as follows:

 

Class of Securities   Shares Outstanding
Common Stock, $0.001 par value   45,050,000

 

 
 

 

TABLE OF CONTENTS

 

    Page
PART I FINANCIAL INFORMATION  
     
Item 1. Interim Financial Statements (unaudited)  
  Condensed Consolidated Balance Sheets at March 31, 2013 and September 30, 2012 1
  Condensed Consolidated Statements of Income and Comprehensive Income for the Three and Six Months Ended March 31, 2013 and 2012 2
  Condensed Consolidated Statements of Cash Flows for the Three and Six Months Ended March 31, 2013 and 2012 3
  Notes to Condensed Consolidated Financial Statements 4-17
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 18-33
Item 3. Quantitative and Qualitative Disclosures about Market Risk 34
Item 4. Controls and Procedures 34
     
PART II OTHER INFORMATION  
     
Item 1. Legal Proceedings 35
Item 1A. Risk Factors 35
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 35
Item 3. Defaults upon Senior Securities 35
Item 4. Mine Safety Disclosures 35
Item 5. Other Information 35
Item 6 Exhibits 35
  Signatures 36

 

 
 

 

PART I: FINANCIAL INFORMATION

ITEM 1. INTERIM FINANCIAL STATEMENTS

CHINA HGS REAL ESTATE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

   March  31,   September 30, 
   2013   2012 
ASSETS          
Current assets:          
Cash  $712,193   $1,104,686 
Restricted cash   1,217,523    1,080,985 
Accounts receivable   4,040,848    - 
Advances to vendors   4,066,690    2,566,422 
Loans to outside parties, net   5,174    20,957 
Real estate property development completed   12,803,437    19,534,088 
Real estate property under development   5,444,570    8,590,275 
Other current assets   230,206    171,863 
           
Total current assets   28,520,641    33,069,276 
           
Property, plant and equipment, net   1,000,968    1,037,080 
Real estate property development completed, net of current portion   5,787,356    6,691,813 
Security deposits for land use right   23,485,479    22,894,698 
Real estate property under development, net of current portion   76,734,184    56,021,787 
Total Assets  $135,528,628   $119,714,654 
           
LIABILITIES AND STOCKHOLDERS' EQUITY          
Current liabilities:          
Accounts payable  $5,167,190   $3,828,880 
Other payables   1,877,500    1,213,394 
Construction deposits   297,409    301,318 
Customer deposits   9,404,479    11,597,422 
Shareholder loan   1,810,000    1,810,000 
Accrued expenses   2,508,137    2,305,086 
Taxes payable   5,232,511    4,336,458 
Total current liabilities   26,297,226    25,392,558 
Construction deposits, net of current portion   973,761    864,259 
Customer deposits, net of current portion   20,584,780    17,743,993 
Total liabilities   47,855,767    44,000,810 
Commitments and Contingencies          
Stockholders' equity          
Common stock, $0.001 par value, 100,000,000 shares authorized, 45,050,000 shares issued and outstanding March 31, 2013 and September 30, 2012  $45,050   $45,050 
Additional paid-in capital   17,755,849    17,750,337 
Statutory surplus   6,549,354    6,549,354 
Retained earnings   56,170,026    44,894,229 
Accumulated other comprehensive income   7,152,582    6,474,874 
Total stockholders' equity   87,672,861    75,713,844 
           
Total Liabilities and Stockholders' Equity  $135,528,628   $119,714,654 

 

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

 

1
 

 

CHINA HGS REAL ESTATE INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(Unaudited)

 

   Three months ended March 31,   Six months ended March 31, 
   2013   2012   2013   2012 
                 
Real estate sales  $19,382,960   $2,878,446   $30,386,375   $5,380,427 
Sales tax   (1,148,725)   (193,579)   (1,859,442)   (369,484)
Cost of real estate sales   (10,678,011)   (1,139,329)   (14,508,255)   (2,021,229)
Gross profit   7,556,224    1,545,538    14,018,678    2,989,714 
                     
Operating expenses                    
Selling and distribution expenses   297,914    39,432    459,008    81,873 
General and administrative expenses   1,117,545    494,873    1,678,516    813,645 
Total operating expenses   1,415,459    534,305    2,137,524    895,518 
                     
Operating income   6,140,765    1,011,233    11,881,154    2,094,196 
                     
Interest income   -    63    -    14,000 
Interest (expense)   (18,100)   (18,100)   (36,200)   (36,200)
Other income (expenses) - net   7    -    7,959    - 
Income before income taxes   6,122,672    993,196    11,852,913    2,071,996 
                     
Provision for income taxes   355,952    47,945    577,116    96,283 
Net income  $5,766,720   $945,251   $11,275,797   $1,975,713 
                     
Other comprehensive income                    
Foreign currency translation adjustment  $468,723   $459,860   $677,708   $804,449 
                     
Comprehensive income  $6,235,443   $1,405,111   $11,953,505   $2,780,162 
                     
Basic and diluted income per common share                    
Basic  $0.13   $0.02   $0.25   $0.04 
Diluted  $0.13   $0.02   $0.25   $0.04 
                     
Weighted average common shares outstanding                    
Basic   45,050,000    45,050,000    45,050,000    45,050,000 
Diluted   45,116,695    45,050,000    45,090,074    45,050,000 

  

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

 

2
 

 

CHINA HGS REAL ESTATE INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

   Six months ended
March 31,
 
   2013   2012 
Cash flows from operating activities          
Net  income  $11,275,797   $1,975,713 
Adjustments to reconcile net income to net cash (used in ) provided by operating activities:          
Depreciation   44,671    44,416 
Stock Based Compensation   5,512    16,634 
Provision for losses on loans to outside parties   -    7,830 
Changes in assets and liabilities:          
Restricted cash   (127,177)   (159,548)
Advances to vendors   (1,475,065)   2,017,926 
Loans to outside parties   15,917    863,917 
Security deposits for land use rights   (398,329)   (11,682,885)
Accounts receivable   (4,030,621)   - 
Real estate property development completed   7,834,524    1,712,880 
Real estate property under development   (16,983,329)   (5,305,964)
Other current assets   (56,762)   (57,933)
Accounts payables   1,302,987    (4,517,307)
Other payables   652,305    441,900 
Customer deposits   401,479    6,926,080 
Construction Deposits   95,605    (152,238)
Accrued expenses   184,157    (46,889)
Taxes payable   857,617    62,413 
Net cash used in operating activities   (400,712)   (7,853,055)
           
Cash flow from financing activities          
Proceeds from shareholder loan   -    3,142,332 
Repayment of shareholder loan   -    (3,142,332)
Net cash provided by financing activities   -    - 
           
Effect of changes of foreign exchange rate on cash   8,219    68,664 
           
Net decrease  increase in cash   (392,493)   (7,784,391)
           
Cash, beginning of period   1,104,686    8,837,795 
           
Cash, end of period  $712,193   $1,053,404 
           
Supplemental disclosures of cash flow information:          
Interest paid  $-   $- 
Income taxes paid  $37,408   $59,368 

 

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

 

3
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION

 

China HGS Real Estate, Inc. (“China HGS” or the “Company” or “we”, “us”, “our”), through its subsidiaries and variable interest entity (“VIE”), engages in real estate development, and the construction and sales of residential apartments, parking space and commercial properties in Tier 3 and Tier 4 cities and counties in China.

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the U.S. generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six moths ended March 31, 2013 and 2012 are not necessarily indicative of the results that may be expected for the full year. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2012.

 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Principles of consolidation

 

The unaudited condensed consolidated financial statements include the financial statements of China HGS Real Estate Inc. (the “Company” or “China HGS”), China HGS Investment Inc. (the “HGS Investment”), Shaanxi HGS Management and Consulting Co., Ltd. (the “Shaanxi HGS”) and its variable interest entity (“VIE”), Shaanxi Guangsha Investment and Development Group Co., Ltd. (the “Guangsha”). All inter-company transactions and balances between the Company and its subsidiaries have been eliminated upon consolidation.

 

Use of estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes, and disclosure of contingent liabilities at the date of the condensed consolidated financial statements. Estimates are used for, but not limited to, the selection of the useful lives of property and equipment, provision necessary for contingent liabilities, fair values, revenue recognition, taxes, budgeted costs and other similar charges. Management believes that the estimates utilized in preparing its condensed consolidated financial statements are reasonable and prudent. Actual results could differ from these estimates.

 

Fair value of financial instruments

 

The Company follows the provisions of Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures. It 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.

 

4
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Fair value of financial instruments (continued)

 

Level 3-Inputs are unobservable inputs which reflect the reporting entity’s own assumptions or 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 accompanying condensed consolidated balance sheets for cash, restricted cash, advance to vendors, loans to outside parties, security deposits for land use rights, other current assets, accounts payable, customer deposits, other payables, accrued expenses, and taxes payable, approximate their fair value based on the short-term maturity of these instruments. The fair value of the long term customer and construction deposits approximate their carrying amounts because the deposits are received in cash.

 

Revenue recognition

 

Real estate sales are recognized in accordance with the ASC 360-20 “Real Estate Sales”.

 

Revenue from the sales of development properties is recognized by the full accrual method at the time of the closing of an individual unit sale. This occurs when title to or possession of the property is transferred to the buyer. A sale is not considered consummated until (a) the parties are bound by the terms of a contract, (b) all consideration has been exchanged, (c) any permanent financing for which the seller is responsible has been arranged, (d) all conditions precedent to closing have been performed, (e) the seller does not have substantial continuing involvement with the property, and (f) the usual risks and rewards of ownership have been transferred to the buyer. Further, the buyer’s initial and continuing investment is adequate to demonstrate a commitment to pay for the property.

 

The Company provides “mortgage loan guarantees” only with respect to buyers who make down-payments of 30%-50% of the total purchase price of the property. The period of the mortgage loan guarantee begins on the date the bank approves the buyer’s mortgage and we receives the loan proceeds in our bank account and ends on the date the “Certificate of Ownership” evidencing that title to the property has been transferred to the buyer. The procedures to obtain the Certificate of Ownership take six to twelve months (the “Mortgage Loan Guarantee Period”).  If, after investigation of the buyer’s income and other relevant factors, the bank decides not to grant the mortgage loan, our mortgage-loan based sales contract terminates and there will be no guarantee obligation.  If, during the Mortgage Loan Guarantee Period, the buyer defaults on his or her monthly mortgage payment for three consecutive months, we are required to refund the loan proceeds back to the bank, although we have the right to keep the customer's deposit and resell the property to a third party.  Once the Certificate of Property has been issued by the relevant government authority, our loan guarantee terminates.  If the buyer then defaults on his or her mortgage loan, the bank has the right to take the property back and sell it and use the proceeds to pay off the loan.  The Company is not liable for any shortfall that the bank may incur in this event. To date, no buyer has defaulted on his or her mortgage payments during the Mortgage Loan Guarantee Period and the Company has not had to refund any loan proceeds pursuant to its mortgage loan guarantees.

 

For municipal road construction projects, fees are generally recognized by the full accrual method at the time the projects are completed.

 

5
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Revenue recognition (continued)

 

On October 23, 2012, the Company entered into a sales agreement to sell the remaining commercial units in Nan Dajie (Mingzhu Xinju) project with a total GFA of 4,545.88 square meters located in Hanzhong City for a total contract amount of $5,393,038 (RMB 33,911,426). The purchaser is related to one of the Company’s concrete suppliers for our Hanzhong City Oriental Pearl Garden project and Mingzhu Beiyuan project. The purchaser’s payments are guaranteed by third parties. The ownership certificate of the related property was issued to the purchaser on November 22, 2012. The Company expects to collect the full proceeds by July 31, 2013. As of March 31, 2013, total accounts receivable balance of $4,040,848 was due from the purchaser.

 

Foreign currency translation

 

The Company’s financial information is presented in U.S. dollars. The functional currency of the Company’s operating subsidiaries is Renminbi (“RMB”), the currency of the PRC. The financial statements of the Company have been translated into U.S. dollars in accordance with ASC 830-30 “Translation of Financial Statements”. The financial information is first prepared in RMB and then is translated into U.S. dollars at year-end exchange rates as to assets and liabilities and average exchange rates as to revenue and expenses. Capital accounts are translated at their historical exchange rates when the capital transactions occurred. The effects of foreign currency translation adjustments are included as a component of accumulated other comprehensive income in stockholders’ equity.

 

   For six months
ended March  31,
   September 30, 
   2013   2012   2012 
Period end RMB : USD exchange rate   6.2666    6.3247    6.3190 
Six months average RMB : USD exchange rate   6.2825    6.3487      

 

The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that the RMB amounts could have been, or could be, converted into U.S. dollars at the rates used in translation.

 

Cash

 

Cash includes cash on hand and demand deposits in accounts maintained with commercial banks within the PRC. The Company considers all highly liquid investments with original maturities of three months or less when purchased to be cash equivalents. The Company maintains bank accounts in the PRC. Cash balances in bank accounts in PRC are not insured.

 

6
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Restricted Cash

 

The restricted cash is required by the banks as collateral for mortgage loans given to the home buyers before obtaining the certificates of ownership of the properties as collateral. In order to provide the banks with the certificates of ownership, the Company is required to complete certain procedures with the Chinese government, which normally takes six to twelve months. Because the banks provide the loan proceeds to the Company without obtaining certificates of ownership as loan collateral during this six to twelve months’ period, the mortgage banks require the Company to maintain, as restricted cash, 5% to 10% of the mortgage proceeds as security for the Company’s obligations under such guarantees. The restricted cash is released by the banks once they receive the certificates of ownership. As of March 31, 2013 and September 30, 2012, the balances of restricted cash totaled $1,217,523 and $1,080,985, respectively. These deposits are not covered by insurance. The Company has not experienced any losses in such accounts and management believes its restricted cash account is not exposed to any risks.

 

Accounts receivable and allowance for doubtful accounts

 

Accounts receivable include trade accounts due from customers. An allowance for doubtful accounts is established and recorded based on managements’ assessment of potential losses bases on the credit history and relationships with the customers. Management reviews its receivables on a regular basis to determine if the bad debt allowance is adequate and adjusts the allowance when necessary. Delinquent account balances are written-off against allowance for doubtful accounts after management has determined that the likelihood of collection is not probable.

 

Advances to vendors

 

Advances to vendors consist of balances paid to contractors and vendors for services and materials that have not been provided or received and generally relate to the development and construction of residential and commercial units in the PRC. Advances to vendors are reviewed periodically to determine whether their carrying value has become impaired. Historically, the Company has not experienced any losses as a result of these advances. As of March 31, 2013 and September 30, 2012, the Company had outstanding balance of advance to vendors in the amount of $4,066,690 and $2,566,422, respectively. 

 

Loans to outside parties

 

Loans to outside parties consist of various cash advances to unrelated companies and individuals with which the Company has business relationships. Loans to outside parties are reviewed periodically as to whether their carrying value has become impaired. These loans bear no interest and they are due on demand. The Company considers the assets to be impaired if the collectability of the balances becomes doubtful. All these loans are considered collectible within the next twelve months based on the Company’s past experience.

 

Security deposits for land use rights

 

Security deposits for land use rights consist of the deposit held by the PRC government for the purchase of land use rights in Hanzhong City and the deposit held by an unrelated party to transfer its land use rights in Hanzhong City to the Company. The deposits will be reclassified to real estate property under development upon the transfers of legal title.

 

7
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Real estate property development completed and under development

 

Real estate property consists of finished residential unit sites, commercial offices and residential unit sites under development. The Company leases the land for the residential unit sites under land use right leases with various terms from the PRC government. The cost of land use rights is included in the development cost and allocated to each project. Real estate property development completed and real estate property under development are stated at the lower of cost or fair value.

 

Expenditures for land development, including cost of land use rights, deed tax, pre-development costs, and engineering costs, exclusive of depreciation, are capitalized and allocated to development projects by the specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project (or phase of the project) multiplied by the total cost of the project (or phase of the project).

 

Cost of amenities transferred to buyers is allocated to specific units as a component of total construction cost. The amenity cost includes landscaping, road paving, etc. Once the projects are completed, the amenities are under control of the property management companies. In accordance to GAAP, real estate property development completed and under development are subject to impairment when the carrying amount exceeds fair value. An impairment loss shall be recognized only if the carrying amount of the assets is not recoverable and exceeds fair value. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows expected to be generated by the assets.

 

Impairment of long-lived assets

 

In accordance with ASC 360, "Accounting for the Impairment or Disposal of Long-Lived Assets", the Company is required to review its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets. Whenever any such impairment exists, an impairment loss will be recognized for the amount by which the carrying value exceeds the fair value.

 

Assets are grouped and evaluated at the lowest level for their identifiable cash flows that are largely independent of the cash flows of other groups of assets. The Company considers historical performance and future estimated results in its evaluation of potential impairment and then compares the carrying amount of the asset to the future estimated cash flows expected to result from the use of the asset. If the carrying amount of the asset exceeds estimated expected undiscounted future cash flows, the Company measures the amount of impairment by comparing the carrying amount of the asset to its fair value. The estimation of fair value is generally determined by using the asset's expected future discounted cash flows or market value. The Company estimates fair value of the assets based on certain assumptions such as budgets, internal projections, and other available information as considered necessary. There is no impairment of long-lived assets during the three and six months ended March 31, 2013 and 2012, respectively.

 

Customer deposits

 

Customer deposits consist of amounts received from customers relating to the sale of residential units in the PRC. In the PRC, customers will generally obtain permanent financing for the purchase of their residential unit prior to the completion of the project. The lending institution will provide the funding to the Company upon the completion of the financing rather than the completion of the project. The Company receives these funds and recognizes them as a liability until the revenue can be recognized.

 

8
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Property warranty

 

The Company provides its customers with warranties which cover major defects of building structure and certain fittings and facilities of properties sold. The warranty period varies from two years to five years, depending on different property components the warranty covers. The Company continually estimates potential costs for materials and labor with regard to warranty-type claims expected to be incurred subsequent to the delivery of a property. Reserves are determined based on historical data and trends with respect to similar property types and geographical areas. The Company continually monitors the warranty reserve and makes adjustments to its pre-existing warranties, if any, in order to reflect changes in trends and historical data as information becomes available. The Company may seek further recourse against its contractors or any related third parties if it can be proved that the faults are caused by them. In addition, the Company also withholds up to 2% of the contract cost from sub-contractors for periods of two to five years. These amounts are included in construction deposits, and are only paid to the extent that there has been no warranty claim against the Company relating to the work performed or materials supplied by the subcontractors. For the period ended March 31, 2013 and September 30, 2012, the Company had not recognized any warranty liability or incurred any warranty costs in excess of the amount retained from subcontractors.

 

Construction Deposits

 

Construction deposits are the warranty deposits the real estate contractors provide to the Company upon signing the construction contracts. The Company can use such deposits to reimburse customers in the event of customer claims due to construction defects.  The remaining balance of the deposits are returned to the contractors when the terms of the after-sale property warranty expires, which normally occurs within two to five years after the date of the deposit.

 

Stock-based compensation

 

The Company accounted for share-based compensation in accordance with ASC Topic 718, Compensation - Stock compensation, which requires that share-based payment transactions be measured based on the grant-date fair value of the equity instrument issued and recognized as compensation expense over the requisite service period, or vesting period.

 

ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in the subsequent period if actual forfeitures differ from initial estimates. Forfeiture rate is estimated based on historical and future expectation of employee turnover rate and are adjusted to reflect future change in circumstances and facts, if any. Share-based compensation expense is recorded net of estimated forfeitures such that expense was recorded only for those stock options and common stock awards that are expected to vest. 

 

9
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

 

Income taxes

 

The Company utilizes ASC 740, “Income Taxes,” which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

 

ASC 740-10-25 prescribes a more-likely-than-not threshold for consolidated financial statement recognition and measurement of a tax position taken (or expected to be taken) in a tax return. It also provides guidance on the recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, years open for tax examination, accounting for income taxes in interim periods and income tax disclosures. There are no material uncertain tax positions as of March 31, 2013 and September 30, 2012.

 

The Company is a corporation organized under the laws of the State of Florida. However, all of the Company’s operations are conducted solely by its subsidiaries in the PRC.  No income is earned in the United States and the management does not repatriate any earnings outside the PRC.  As a result, the Company did not generate any U.S. taxable income for the three and six months ended March 31, 2013, and 2012, respectively.

 

As of March 31, 2013, the tax years ended September 30, 2006 through March 31, 2013 for the Company’s PRC entities remain open for statutory examination by PRC tax authorities. The parent Company China HGS Real Estate Inc.’s tax years ended September 30, 2009 through March 31, 2013 remains open for statutory examination by U.S. tax authorities.

 

Land appreciation tax (“LAT”)

 

In accordance with the relevant taxation laws in the PRC, the Company is subject to LAT based on progressive rates ranging from 30% to 60% on the appreciation of land value, which is calculated as the proceeds of sales of properties less deductible expenditures including borrowing costs and all property development expenditures. LAT is exempted if the appreciation values do not exceed certain thresholds specified in the relevant tax laws.

 

The whole project must be completed before the LAT obligation can be assessed. Accordingly, the Company should record the liability and the total related expense at the completion of a project unless the tax authorities impose an assessment at an earlier date.  The methods to implement this tax law vary among different geographic areas. Hanzhong, where the project Mingzhu Garden, NanDajie and Central Plaza are located, implements this tax rule by requiring real estate companies prepay the LAT based upon customer deposits received. The tax rate in Hanzhong is 1%. Yang County, where the project Yangzhou Pearl Garden is located, requires a tax rate of 0.5%.

 

Comprehensive income

 

In accordance with ASC 220-10-55, comprehensive income is defined as all changes in equity except those resulting from investments by owners and distributions to owners. The Company’s only components of comprehensive income during the three and six months ended March 31, 2013 and 2012 were net income and foreign currency translation adjustments.

 

10
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 3. SECURITY DEPOSITS FOR LAND USE RIGHTS

 

In May 2011, the Company entered into a development agreement with the local government. Pursuant to the agreement, the Company will prepay the development cost of $19,101,267 (RMB119, 700,000) and the Company has the right to acquire the land use rights through public bidding. The prepaid development cost will be deducted from the final purchase price of the land use rights. As of March 31, 2013, a deposit of $3,191,523 (RMB20,000,000) (September 30, 2012 - $3,165,058 or RMB 20,000,000) was paid by the Company. The Company currently expects to make payment of the remaining development cost within the next twelve months based on government’s current work progress.

 

In August 2011, the Company entered into a land transfer agreement with Hanzhong Shijin Real Estate Development Limited (“Shijin”). Pursuant to the agreement, Shijin agreed to transfer certain land use rights to the Company for the total price of $7,260,716 (RMB45, 500,000). As of March 31, 2013, a deposit of $7,725,482 (consisting of the full contract amount of RMB45, 500,000, a commission of RMB410,000 and a deposit of RMB2,502,500 related to application of land use rights certificate) was paid by the Company. The Company is in the process of applying for the land use rights certificate. As of September 30, 2012, the deposit balance was $7,265,390 (RMB45,910,000).

 

On November 18, 2011, the Company won two bids for the land use rights by auction to obtain two parcels of land in Yang County for total consideration and the bidding commission of $12,703,259 (RMB79,606,242). As of March 31, 2013, the Company has paid $12,568,474(RMB78,761,600). The remaining balance of $134,785 is expected to be paid when the Company receives the land use rights certificate. As of March 31, 2013, the deposit balance was $12,568,474 (RMB78, 761,600).

 

11
 

 

NOTE 4. REAL ESTATE PROPERTY DEVELOPMENT COMPLETED AND UNDER DEVELOPMENT

 

The following summarizes the components of real estate property development completed and under development as of March 31, 2013 and September 30, 2012:

 

   March 31, 2013   September 30, 2012 
Development completed          
Hanzhong City Mingzhu Garden (Mingzhu Nanyuan & Mingzhu Beiyuan)  $6,742,044   $10,957,861 
Hanzhong City Nan Dajie (Mingzhu Xinju)   1,893,493    3,651,828 
Yang County Yangzhou Pearl Garden   9,353,911    11,019,854 
Hanzhong City Central Plaza   601,345    596,358 
Real estate property development completed  $18,590,793   $26,225,901 
Less:  Real estate property completed –short-term  $12,803,437   $19,534,088 
Real estate property completed –long-term  $5,787,356   $6,691,813 
Under development:          
Hanzhong City Oriental Pearl Garden   35,126,577    30,964,847 
Hanzhong City Mingzhu Garden (Mingzhu Nanyuan & Mingzhu Beiyuan)   27,510,851    21,102,925 
Yang County Yangzhou Pearl Garden   18,120,550    11,620,714 
Hanzhong City Mingzhu Road West (a)   1,199,362    732,571 
Hanzhong City Liuhou Road (a)   221,414    191,005 
Real estate property under development  $82,178,754   $64,612,062 
           
Less:  Short-term portion  $5,444,570   $8,590,275 
Real estate property under development –long-term  $76,734,184   $56,021,787 

 

(a)In June 2012, the Company was approved by Hanzhong local government to construct two municipal roads with a total length of 1,064.09 meters. The budgeted price for these two municipal roads is approximately $3.0 million (RMB18,716,489) which was approved by Hanzhong Ministry of Finance. The related construction has been substantially completed as of March 31, 2013 and is expected to be delivered to local government in short term. For these construction projects, the Company recognizes the fee as other revenue using the full accrual method when the project is completed.

 

As of March 31, 2013 and September 30, 2012, land use rights included in real estate property under development totaled $42,214,850 and $41,902,111, respectively.

 

12
 

 

NOTE 5. CUSTOMER DEPOSITS

 

Customer deposits consist of amounts received from customers for the pre-sale of residential units in the PRC. The detail of customer deposits is as follows:

 

   March 31, 2013   September 30, 2012 
         
Customer deposits by real estate projects          
           
Mingzhu Garden (Mingzhu Nanyuan & Mingzhu Beiyuan)  $22,308,961   $16,900,566 
Hanzhong City Oriental Pearl Garden   1,792,839    - 
Yangzhou Pearl Garden   5,887,459    12,440,849 
Total  $29,989,259   $29,341,415 
           
Less:  Customer deposits -short-term  $9,404,479   $11,597,422 
Customer deposits - long-term  $20,584,780   $17,743,993 

 

Customers are required to make initial customer deposits. The initial customer deposits are typically 10%-20% of the unit price for those customers who purchase properties in cash and 30%-50% of the unit price for those customers who purchase properties with mortgages. The banks provide the balance of the funding to the Company upon consummation of the sales. The banks hold the properties as collateral for customers’ mortgage loans. If the customers default, the bank will repossess the collateral properties. Except during the Mortgage Loan Guarantee Period of approximately six to twelve months, the banks have no recourse to the Company for customers’ defaults.

 

NOTE 6. SHAREHOLDER LOAN

 

On June 28, 2011, the Company entered into a one-year loan agreement (“USD Loan Agreement”) with Mr. Xiaojun Zhu, pursuant to which the Company borrowed $1,810,000 from Mr. Xiaojun Zhu to make a capital injection into Shaanxi HGS, the Company’s subsidiary. The interest rate for the loan is 4% per annum. The Company recorded an interest expense of $18,100 and $36,200 for the three and six months ended March 31, 2013 and 2012, respectively. On July 19, 2012, the Company entered into an amendment to the USD Loan Agreement to extend the term until June 28, 2013.

 

13
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 7. STOCK OPTIONS

 

Under the fair value recognition provisions of ASC Topic 718, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized on a straight-line basis as expense over the vesting period. Additionally, the Company is required to use judgment in estimating the amount of stock-based awards that are expected to be forfeited. If actual forfeitures differ significantly from the original estimate, stock-based compensation expense and the results of operations could be impacted.

 

In January 2010, the Company’s Board of Directors granted stock options to three independent directors to purchase up to 34,000 shares of the Company’s common stock (“2010 Stock Options).  20% of the shares underlying the options were exercisable on the grant date and the remaining 80% of the shares underlying the options become exercisable over the next eight quarters at the rate of 10% at the end of every quarter. The exercise price of the options is $2.60 per share and the options expire on January 6, 2015.  As of March 31, 2013 and September 30, 2012, 100% of the option awards have vested, respectively. During the three months ended March 31, 2013 and 2012, a total of Nil shares underlying the 2010 Stock Options were forfeited. During the six months ended March 31, 2013 and 2012, a total of 24,000 shares and Nil share underlying the 2010 Stock Options were forfeited, respectively.

 

On March 16, 2011, the Company’s Board of Directors granted stock options to three independent directors to purchase up to an aggregate of 34,000 shares of the Company’s common stock (“2011 Stock Options).  Twenty percent (20%) of the shares underlying the options were exercisable on the grant date and the remaining 80% of the shares underlying the options become vested over the next eight quarters at the rate of 10% at the end of every quarter. The exercise price of the options is $2.37 per share and the options expire on March 16, 2016. As of March 31, 2013 and September 30, 2012, 100% and 90% of the option awards have vested, respectively.  During the three months ended March 31, 2013 and 2012, a total of Nil shares underlying the 2011 Stock Options were forfeited. During the six months ended March 31, 2013 and 2012, a total of 24,000 shares and Nil share underlying the 2011 Stock Options were forfeited, respectively.

 

On August 22, 2012, the Company’s Board of Directors granted stock options to two newly appointed independent directors to purchase up to an aggregate of 120,000 shares of the Company’s common stock (“2012 Stock Options).  The shares underlying the options become vested during the following 12 months period at the end of each quarter. The exercise price of the options is $2.37 per share. As of March 31, 2013 and September 30, 2012, 58.3% and 8.3% of the option awards have vested, respectively. 

 

The assumptions used in calculating the fair
value of options granted using the Black-Scholes
option pricing model are as follows:
  Options
granted in
August 2012
   Options
granted in
March 2011
 
Risk-free interest rate   0.19%   1.87%
Expected life of the options   1 year    5 years 
Expected volatility   148%   65%
Expected dividend yield   0%   0%
Fair value  $8,400   $44,590 

 

The Company uses the Black-Scholes option-pricing model, which incorporates various assumptions including volatility, expected life and interest rates to determine fair value. The Company’s expected volatility assumption is based on the historical volatility of Company’s stock. The expected life assumption is primarily based on the simplified method due to the Company’s limited option exercise behavior. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

 

14
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 7. STOCK OPTIONS (continued)

 

The following table summarizes the stock option activities of the Company:  

 

   Number of
options
   Weighted
Average
Exercise Price
   Weighted
Average
Remaining
Life in Years
   Grant Date
Fair Value
 
Outstanding, September 30, 2012   188,000   $2.41    1.60   $130,147 
Granted   -    -    -    - 
Forfeited   48,000    2.49    2.61    85,940 
Exercised   -    -    -    - 
Outstanding, March 31, 2013   140,000   $2.39    0.67   $44,207 
Exercisable, March  31, 2013   90,000   $2.40    0.83   $40,708 

 

Total stock-based compensation expense recognized in the three months ended March 31, 2013 and 2012, was $2,100 and $4,459, respectively. Total stock-based compensation expense recognized in the six months ended March 31, 2013 and 2012, was $5,512 and $16,634, respectively. As of March 31, 2013 and September 30, 2012, there was $3,500 and $9,012 of unrecognized compensation cost related to stock option awards that are expected to be recognized, respectively.

 

NOTE 8. TAXES

 

(A) Business sales tax

 

The Company is subject to a 5% business sales tax on revenue.  It is the Company’s continuing practice to recognize the 5% business sales tax based on revenue as a cost of sales as the revenue is recognized. As of March 31, 2013, the Company had business sales tax payable of $3,970,000 (September 30, 2012- $3,366,130), which is expected to be paid when the projects are completed and assessed by the local tax authority.

 

B) Corporate income taxes (“CIT”)

 

The Company’s PRC subsidiaries and VIE are governed by the Income Tax Law of the People’s Republic of China concerning the privately run enterprises, which are generally subject to income tax at a statutory rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments.

 

However, as approved by the local tax authority of Hanzhong City, the Company’s CIT was assessed annually at a pre-determined fixed rate as an incentive to stimulate the local economy and encourage entrepreneurship. The local income tax rate in Hanzhong is 2.5% and in Yang County is 1.25% on revenue. For the three months ended March 31, 2013 and 2012, the Company’s assessed income taxes were $355,952 and $47,945 respectively. For the six months ended March 31, 2013 and 2012, the Company’s assessed income taxes were $577,116 and $96,283, respectively.

 

Although the possibility exists for reinterpretation of the application of the tax regulations by higher tax authorities in the PRC, potentially overturning the decision made by the local tax authority, the Company has not experienced any reevaluation of the income taxes for prior years. The PRC tax rules are different from the local tax rules and the Company is required to comply with local tax rules.  The difference between the two tax rules will not be a liability of the Company.  There will be no further tax payments for the difference.

 

15
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 8. TAXES (continued)

 

B) Corporate income taxes (“CIT”)

 

The following table reconciles the statutory rates to the Company’s effective tax rate for the three and six months ended March 31, 2013 and 2012: 

 

   Three months ended
March 31,
   Six months ended March
31,
 
   2013   2012   2013   2012 
Chinese statutory tax rate   25.0%   25.0%   25.0%   25.0%
Exemption rendered by local tax authorities   (19.2)%   (20.2)%   (20.1)%   (20.4)%
Effective tax rate   5.8%   4.8%   4.9%   4.6%

 

The parent Company China HGS Real Estate, Inc. is incorporated in the United States. Net operating loss carry forwards for United States income tax purposes amounted to $211,692 and $169,980 as of March 31, 2013 and September 30, 2012, respectively, which are available to reduce future years’ taxable income. These carry forwards will expire in 2032. However, the change in control resulting from the reverse merger in 2009 limits the amount of loss to be utilized each year. Management doesn’t expect to remit any of its net income back to the United States in the foreseeable future. Accordingly, the Company recorded a full valuation allowance as of March 31, 2013 and September 30, 2012. The components of deferred taxes as of March 31, 2013 and September 30, 2012 consist of the following:

 

   As of 
   March 31
2013
   September 30,
2012
 
 Net operating loss carry-forwards for parent company  $71,975   $57,793 
Valuation allowance   (71,975)   (57,793)
Net deferred tax asset  $-   $- 

 

The valuation allowance increased $6,868 and $7,660 for the three months ended March 31, 2013 and 2012, respectively. The valuation allowance increased $14,182 and $17,963 for the six months ended March 31, 2013 and 2012, respectively.

 

(C) LAT

 

Since January 1, 1994, LAT has been applicable at progressive tax rates ranging from 30% to 60% on the appreciation of land values, with an exemption provided for the sales of ordinary residential properties if the appreciation values do not exceed certain thresholds specified in the relevant tax laws. However, the Company’s local tax authority in Hanzhong City has not imposed the regulation on real estate companies in its area of administration. Instead, the local tax authority has levied the LAT at the rate of 0.8% or 1.0% against total cash receipts from sales of real estate properties, rather than according to the progressive rates.  As of March 31, 2013, the prepaid LAT balance is $166,798 with respect to properties sold up to March 31, 2013. As of September 30, 2012, the outstanding LAT payable balance is $22,650 with respect to properties sold up to September 30, 2012.

 

16
 

 

CHINA HGS REAL ESTATE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 8. TAXES (continued)

 

(D) Taxes payable consisted of the following:

   March 31, 2013   September 30, 2012 
         
CIT  $905,300   $765,206 
Business tax   3,970,000    3,366,130 
Other tax and fees   357,211    205,122 
Total taxes payable  $5,232,511   $4,336,458 

 

NOTE 9. CONTINGENCY AND COMMITMENTS

 

As an industry practice, the Company provides guarantees to PRC banks with respect to loans procured by the purchasers of the Company’s real estate properties for the total mortgage loan amount until the completion of obtaining the “Certificate of Ownership” of the properties from the government, which generally takes six to twelve months. Because the banks provide loan proceeds without getting the “Certificate of Ownership” as loan collateral during this six to twelve months’ period, the mortgage banks require the Company to maintain, as restricted cash, 5% to 10% of the mortgage proceeds as security for the Company’s obligations under such guarantees. If a purchaser defaults on its payment obligations, the mortgage bank may deduct the delinquent mortgage payment from the security deposit and require the Company to pay the excess amount if the delinquent mortgage payments exceed the security deposit. The Company has made necessary reserves in its restricted cash account to cover any potential mortgage defaults as required by the mortgage lenders. The Company has not experienced any losses related to this guarantee and believes that such reserves are sufficient.

 

In May 2011, the Company entered into a development agreement with the local government. Pursuant to the agreement, the Company will prepay the development cost of $18,942,871 (RMB119,700,000) and the Company has the right to acquire the land use rights through public bidding unless another company wins the bidding. The prepaid development cost will be deducted from the final purchase price of the land use rights or refunded to the Company plus profit earned if the Company does not win the bidding. As of March 31, 2013, a deposit of $3,191,523 (RMB20, 000,000) (September 30, 2012 - $3,165,058 or RMB 20,000,000) was paid by the Company. The Company currently expects to make payment of the remaining development cost within the next twelve months based on government’s current work progress.

 

On November 18, 2011, the Company won two bids for the land use rights by auction to obtain two parcels of land in Yang County for total consideration and the bidding commission of $12,703,259 (RMB79,606,242). As of March 31, 2013, the Company has paid $12,568,474(RMB78, 761,600). The remaining balance of $134,785 is expected to be paid when the Company receives the land use rights certificate.

 

17
 

 

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

 

The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in the unaudited condensed consolidated financial statements of China HGS Real Estate, Inc. for the three and six months ended March 31, 2013 and 2012 and should be read in conjunction with such financial statements and related notes included in this report.

 

As used in this report, the terms “Company,” “we,” “our,” “us” and “HGS” refer to China HGS Real Estate, Inc. and its subsidiaries.

 

Preliminary Note Regarding Forward-Looking Statements.

 

We make forward-looking statements in Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report based on the beliefs and assumptions of our management and on information currently available to us. Forward-looking statements include information about our possible or assumed future results of operations which follow under the headings “Business Overview,” “Liquidity and Capital Resources,” and other statements throughout this report preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates” or similar expressions.

 

Forward-looking statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed in these forward-looking statements, including the risks and uncertainties described below and other factors we describe from time to time in our periodic filings with the U.S. Securities and Exchange Commission (the “SEC”). We therefore caution you not to rely unduly on any forward-looking statements. The forward-looking statements in this report speak only as of the date of this report, and we undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise. These forward-looking statements include, among other things, statements relating to:

 

our ability to sustain our project development

 

our ability to obtain additional land use rights at favorable prices;

 

the market for real estate in Tier 3 and 4 cities and counties;

 

our ability to obtain additional capital in future years to fund our planned expansion; or

 

economic, political, regulatory, legal and foreign exchange risks associated with our operations.

 

Business Overview

 

We conduct substantially all of our business through Shaanxi Guangsha Investment and Development Group Co., Ltd, in Hanzhong, Shaanxi Province. Since the initiation of our business, we have been focused on expanding our business in certain Tier 3 and Tier 4 cities and counties in China.

 

The restrictive real estate policy and tightened liquidity policy left a profound negative impact on the residential housing transaction volume in 2011 and 2012. These policies also negatively affected buyers’ confidence and consumption psychology. Some buyers are taking a wait-and-see attitude and may delay their purchasing decision.

 

On March 1 2013, China’s State Council announced five general curbing principles to regulate the real estate market, including new initiatives aimed at streamlining the work responsibility system for property prices, control speculative property investments, increasing commodity housing and land supply, step up construction of affordable housing, as well as tightening controls of the market. The detail measures include a 20 percent tax on profits from selling a home, a capital gains tax that is on the books but has not been widely enforced. Additionally, down payments and mortgage rates will be increased for second homes in certain cities. Cities and local governments are instructed to institute “property control targets and detailed implementation plans” by the end of March 2013. The Council pointed out that China is in the progress of rapid urbanization and housing supply in major cities will not be able to meet demands in the short term. The State Council will maintain its control on speculative property investment and make efforts to meet the demands of home buyers.

 

18
 

 

While the government’s broad policy direction is likely to remain unchanged and the restrictive real estate policies have created a ‘wait-and-see’ mentality among real estate buyers, the cumulative downward price adjustment has triggered the partial release of demand, creating a rise in transaction volumes in the late period of 2012. Developers generally have been reducing inventory by adopting more aggressive sales tactics.

 

For the three and six months ended March 31, 2013, our sales volume significantly increased comparing to the same periods last year. Our sales, gross profit and net income for the three months ended March 31, 2013 were $19,382,960, $7,556,224 and $5,766,720, respectively, representing an approximately 573.4%, 388.9% and 510.1% increase from the three months ended March 31, 2012, respectively. Our sales, gross profit and net income for the six months ended March 31, 2013 were $30,386,375, $14,018,678 and $11,275,797, respectively, representing an approximately 464.8%, 368.9% and 470.7% increase from the six months ended March 31, 2012, respectively.

 

We are using full accrual method to recognize revenue and only recognize sales revenue upon delivery of sold properties to buyers instead of upon pre-sale of the properties. This accounting method adds uncertainties in our future sales trend and causes uneven sales revenue from period to period as our sales revenue depends upon the number of units delivered during the year. Currently, most of our real estate projects under construction are high-rise buildings with planned GFA over 709,038 square meters, which generally take about 2- 3 years for the construction, while our completed projects in the past were mostly multi-layer or sub-high-rise buildings and took 1-1.5 years for construction. It might indicate that in certain future reporting periods, even we have pre-sale contracts, we may not record any revenue because we have no new construction work completed and delivered to buyers in those periods. This is a typical characteristic of our business and the uneven sales revenues from period to period are due in part to the rate at which units are completed and delivered to buyers under the current full accrual method of revenue recognition policy.

 

The housing prices in Tier 3 and Tier 4 cities and counties are stable from last year. While short-term market correction is a process that the property sector is bound to undergo, the fundamental demand for residential housing will remain given the rising per capita income, accelerating urbanization and increasing demand for better living environment. For the six months ended March 31, 2013, our average selling price (“ASP”) for real estate projects (excluding sales of parking spaces) located in Yang County was approximately $436.7 per square meter, a slight increase from the ASP of $422 per square meter for the six months ended March 31, 2012. The ASP of our Hanzhong real estate projects (excluding sales of parking spaces) was approximately $759.2 per square meter for the six month ended March 31, 2013, a decrease of 18.5% from the ASP of $932 per square meter for the six months ended March 31, 2012, because the Company sold more commercial properties during the same period last year. Generally, the ASP of commercial units is more than doubled from the ASP of residential units.

 

With respect to capital funding requirements, while many property developers must now worry about their debt leverage and working capital needs for debt repayment, in contrast, the Company does not have any external bank loan outstanding at March 31, 2013. The Company’s cash flows from pre-sales and sales and, if necessary, shareholder loans should provide financial support for the current development and operations. In order to fully implement our business plan, however, we may need to raise capital in the future to sustain our expansion. Therefore, we might seek to access the capital markets in both the U.S. and China to obtain the funds we require. At the present time, however, we do not have commitments of funds from any source.

 

Market Outlook

 

We believe the fundamentals underpinning real estate demand remain strong. We intend to remain focused on our existing construction projects in Hanzhong City and Yang County, deepen our institutional sales network, enhance our cost and operational synergies and improve cash flows and strengthen our balance sheet. In this respect, in late fiscal 2012, we began the construction of two large residential projects in Hanzhong City and additional high-rise residential buildings in Yang County.

 

19
 

 

Oriental Pearl Garden

 

The project is located in downtown Hanzhong City. It consists of 12 high-rise residential buildings with commercial shops on the first and second floors with an estimated GFA of 260,000 square meters. The Company started construction in the third quarter of fiscal 2012 and expects to complete the whole construction in 2-3 years. The pre-sale license is expected to be obtained by the third or fourth quarter of fiscal 2013. As of March 31, 2013, the customer deposit balance was $1,792,839 for the project.

 

 

Mingzhu Beiyuan

 

The project is located in the south west part of Hanzhong City. It includes 17 high-rise residential buildings with an estimated GFA of 350,000 square meters. The Company started construction in the third quarter of fiscal 2012 and expect to complete the whole construction in 2-3 years. The Company received the presale license on April 25, 2013. During fiscal 2011, we signed a series of residential-apartment bulk-purchase agreements with Hanzhong Municipal Public Security Bureau, Hanzhong Municipal Bureau of Justice, Hanzhong Local Tax Bureau and the Hanzhong Social Insurance Center. The total residential units to be delivered in Mingzhu Beiyuan under these residential-apartment bulk-purchase agreements are 518 units with a total GFA of 68,752 square meters. As of March 31, 2013, the customer deposit balance related to these bulk-purchase agreements amounted to $16,100,924 (RMB100,898,050). None of the revenue has been recognized during the three months and six months ended March 31, 2013.

 

 

Yangzhou Pearl Garden

 

During fiscal 2012, the Company also started the construction of 8 high-rise residential buildings and 1 sub-high-rise residential building with a total GFA of 99,038 square meters in Yangzhou Pearl Garden located in Yang County. We have obtained a pre-sale license for 3 residential buildings. The rest of pre-sale licenses are expected to be obtained by September 30, 2013. During fiscal 2011, the Company entered into a preliminary contract with Yang County to develop affordable apartment buildings with a total GFA of 40,000 square meters. These units are mainly located in 4 of 8 high-rise residential buildings. For the three and six months ended March 31, 2013, the Company completed and delivered 2 high-rise residential buildings with revenue of $8,177,167 (RMB51, 373,053) recognized and expect 1 more high-rise residential building to be completed in the third quarter of fiscal 2013. The construction for the balance of the buildings is expected to be completed in approximately 2 years. As of March 31, 2013, the customer deposit balance related to this preliminary contract amounted to $2,804,509 (RMB17,574,737).

 

 

In addition to the above residential projects, the Company was approved by the Hanzhong local government to construct two municipal roads with a total length of 1,064.09 meters. The budgeted price for these two municipal roads is RMB18,716,489.34 (equivalent to $3.0 million), which was approved by the Hanzhong Ministry of Finance. The related construction was substantially completed by December 31, 2012 but required the government’s quality approval before delivery for its intended use. For these construction projects, the Company recognizes the fee as other revenue using the full accrual method when the project is completed. None of the revenue has been recognized during the three months and six months ended March 31, 2013 .

 

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 CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis and use them on historical experience and various other assumptions that are believed to be reasonable under the circumstances as the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates because of different assumptions or conditions.

 

We believe the following critical accounting policies affect our significant estimates and judgments used in the preparation of our condensed consolidated financial statements. These policies should be read in conjunction with Note 2 of the notes to unaudited condensed consolidated financial statements.

 

Principles of Consolidation

 

The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).

 

The consolidated financial statements include the financial statements of China HGS Real Estate, Inc. (the “Company” or “China HGS”), China HGS Investment Inc. (the “HGS Investment”), Shaanxi HGS Management and Consulting Co., Ltd. (the “Shaanxi HGS”) and its variable interest entity (“VIE”), Shaanxi Guangsha Investment and Development Group Co., Ltd. (the “Guangsha”). All inter-company transactions and balances between the Company and its subsidiaries have been eliminated upon consolidation.

 

Use of estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes, and disclosure of contingent liabilities at the date of the condensed consolidated financial statements. Estimates are used for, but not limited to, the selection of the useful lives of property and equipment, provision necessary for contingent liabilities, fair values, revenue recognition, taxes, budgeted costs and other similar charges. Management believes that the estimates utilized in preparing its condensed consolidated financial statements are reasonable and prudent. Actual results could differ from these estimates.

 

Fair value of financial instruments

 

The Company follows the provisions of Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures. It 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 or what assumptions the market participants would use in pricing the asset or liability based on the best available information.

 

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The carrying amounts reported in the accompanying condensed consolidated balance sheets for cash, restricted cash, advance to vendors, loans to outside parties, security deposits for land use rights, other current assets, accounts payable, customer deposits, other payables, accrued expenses, and taxes payable, approximate their fair value based on the short-term maturity of these instruments. The fair value of the long term customer and construction deposits approximate their carrying amounts because the deposits are received in cash.

 

Revenue recognition

 

Real estate sales are recognized in accordance with the ASC 360-20 “Real Estate Sales”.

 

Revenue from the sales of development properties is recognized by the full accrual method at the time of the closing of an individual unit sale. This occurs when title to or possession of the property is transferred to the buyer. A sale is not considered consummated until (a) the parties are bound by the terms of a contract, (b) all consideration has been exchanged, (c) any permanent financing for which the seller is responsible has been arranged, (d) all conditions precedent to closing have been performed, (e) the seller does not have substantial continuing involvement with the property, and (f) the usual risks and rewards of ownership have been transferred to the buyer. Further, the buyer’s initial and continuing investment is adequate to demonstrate a commitment to pay for the property.

 

The Company provides “mortgage loan guarantees” only with respect to buyers who make down-payments of 30%-50% of the total purchase price of the property. The period of the mortgage loan guarantee begins on the date the bank approves the buyer’s mortgage and we receives the loan proceeds in our bank account and ends on the date the “Certificate of Ownership” evidencing that title to the property has been transferred to the buyer. The procedures to obtain the Certificate of Ownership take six to twelve months (the “Mortgage Loan Guarantee Period”).  If, after investigation of the buyer’s income and other relevant factors, the bank decides not to grant the mortgage loan, our mortgage-loan based sales contract terminates and there will be no guarantee obligation.  If, during the Mortgage Loan Guarantee Period, the buyer defaults on his or her monthly mortgage payment for three consecutive months, we are required to refund the loan proceeds back to the bank, although we have the right to keep the customer's deposit and resell the property to a third party.  Once the Certificate of Property has been issued by the relevant government authority, our loan guarantee terminates.  If the buyer then defaults on his or her mortgage loan, the bank has the right to take the property back and sell it and use the proceeds to pay off the loan.  The Company is not liable for any shortfall that the bank may incur in this event. To date, no buyer has defaulted on his or her mortgage payments during the Mortgage Loan Guarantee Period and the Company has not had to refund any loan proceeds pursuant to its mortgage loan guarantees.

 

For municipal road construction projects, fees are generally recognized by the full accrual method at the time of the projects are completed.

 

Accounts receivable and allowance for doubtful accounts

 

Accounts receivable include trade accounts due from customers. An allowance for doubtful accounts is established and recorded based on managements’ assessment of potential losses bases on the credit history and relationships with the customers. Management reviews its receivables on a regular basis to determine if the bad debt allowance is adequate and adjusts the allowance when necessary. Delinquent account balances are written-off against allowance for doubtful accounts after management has determined that the likelihood of collection is not probable.

 

Customer Deposits

 

Customer deposits consist of prepayments received from customers relating to the sale of residential units in the PRC. The Company receives these funds and recognizes them as a liability until the revenue can be recognized. The classification of customer deposits as current liabilities or long term liabilities is subject to our estimation on whether we expect to be able to recognize these deposits as revenue within one year of the balance sheet date. We convert the customer deposits to revenue when the homebuyers or banks pay off the balance, and the certificates of the ownership are delivered to the homebuyers or the banks.

 

Advances to vendors

 

Advances to vendors consist of balances paid to contractors and vendors for services and materials that have not been provided or received and generally relate to the development and construction of residential and commercial units in the PRC. Advances to vendors are reviewed periodically to determine whether their carrying value has become impaired. Historically, the Company has not experienced any losses as a result of these advances.

 

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Loans to outside parties

 

Loans to outside parties consist of various cash advances to unrelated companies and individuals with which the Company has business relationships. Loans to outside parties are reviewed periodically as to whether their carrying value has become impaired. These loans bear no interest and they are due on demand. The Company considers the assets to be impaired if the collectability of the balances becomes doubtful.  All these loans are considered collectible based on the Company’s past experience.

 

Real estate property development completed and under development

 

Real estate property consists of finished residential unit sites, commercial offices and residential unit sites under development. The Company leases the land for the residential unit sites under land use right leases with various terms from the PRC government. The cost of land use rights is included in the development cost and allocated to each project. Real estate property development completed and real estate property under development are stated at the lower of cost or fair value.

 

Expenditures for land development, including cost of land use rights, deed tax, pre-development costs, and engineering costs, exclusive of depreciation, are capitalized and allocated to development projects by the specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project (or phase of the project) multiplied by the total cost of the project (or phase of the project).

 

Cost of amenities transferred to buyers is allocated to specific units as a component of total construction cost. The amenity cost includes landscaping, road paving, etc. Once the projects are completed, the amenities are under control of the property management companies. In accordance to GAAP, real estate property development completed and under development are subject to impairment when the carrying amount exceeds fair value. An impairment loss shall be recognized only if the carrying amount of the assets is not recoverable and exceeds fair value. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows expected to be generated by the assets.

 

Income taxes

 

The Company utilizes ASC 740, “Income Taxes,” which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

 

ASC 740-10-25 prescribes a more-likely-than-not threshold for consolidated financial statement recognition and measurement of a tax position taken (or expected to be taken) in a tax return. It also provides guidance on the recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, years open for tax examination, accounting for income taxes in interim periods and income tax disclosures.

 

The Company is a corporation organized under the laws of the State of Florida. However, all of the Company’s operations are conducted solely by its subsidiaries in the PRC.  No income is earned in the United States and the management does not repatriate any earnings outside the PRC.  As a result, the Company did not generate any U.S. taxable income.

 

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RESULTS OF OPERATIONS

Three Months Ended March 31, 2013 compared to Three Months Ended March 31, 2012

 

Revenues

 

The following table summarizes our revenue generated by different projects:

 

   For Three Months Ended March 31,     
   2013   2012   Variance 
   Revenue   %   Revenue   %   Amount   % 
                         
Mingzhu Garden (Mingzhu Nanyuan & Mingzhu Beiyuan)  $9,088,453    46.9%  $578,955    20.1%  $8,509,498    1,469.8%
Yangzhou Pearl Garden   10,289,763    53.1%   1,921,341    66.8%   8,368,422    435.6%
NanDajie (Mingzhu Xinju)   4,744    0.0%   357,113    12.4%   (352,369)   (98.7)%
Central Plaza   -         21,037    0.7%   (21,037)   (100)%
Total Real Estate Sales before Sales Tax  $19,382,960    100%  $2,878,446    100%  $16,504,514    573.4%
Sales Tax   (1,148,725)        (193,579)        (955,145)   493.4%
Revenue net of sales tax  $18,234,235        $2,684,867        $15,549,368    579.1%

 

Our revenues are derived from the sale of residential buildings, commercial front-stores and parking spaces in projects that we have developed. Revenues before sales tax increased by 573.4% to approximately $19.4 million for the three month ended March 31, 2013 from approximately $2.9 million for the same period in the last year. The total GFA sold during the three months ended March 31, 2013 was 41,474 square meters, representing an over three times increase from the 4,938 square meters completed and sold during the three months ended March 31, 2012. During the three months ended March 31, 2013, the Company completed and delivered two high-rise buildings in Yangzhou Pearl Garden project and recognized $8,177,167 (RMB51, 373,053) in revenue.

 

Sales taxes for the three months ended March 31, 2013 and 2012 consisted of a business tax, 5% of the revenue, an urban construction tax, 7% of business tax, an education surcharge tax, 3% of business tax, and a land appreciation tax. Land appreciation tax for the three months ended March 31, 2013 and 2012 was assessed at the rate of 0.5% of the customer deposits in Yang County and 1% of the customer deposits in Hanzhong. The sales taxes for the three months ended March 31, 2013 increased by 493.4% from the same period last year, primarily as a result of the increase in our revenue. 

 

We are developing more high-rise residential buildings, which requires longer construction periods. This indicates that in certain future reporting periods, we might not have any new construction work, completed and delivered to buyers, and the only available-for-sale properties would be from our inventories which were previously completed and unsold properties. Since we recognize revenue in accordance with the full accrual method at the time of the closing of an individual unit sale, the longer construction periods for high-rise residential building would have negative impact on our revenue recognition.

 

Cost of Sales

 

The following table sets forth a breakdown of our cost of sales:

 

   For Three Months Ended March  31,     
   2013   2012   Variance 
   Cost   %   Cost   %   Amount   % 
                         
Land use rights  $980,345    9%  $113,760    13%  $866,585    761.8%
Construction cost   9,697,666    91%   1,025,569    87%   8,672,097    845.6%
Total cost  $10,678,011    100%  $1,139,329    100%  $9,538,682    837.2%

 

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Our cost of sales consists primarily of costs associated with land use rights and construction costs. Cost of sales are capitalized and allocated to development projects using the specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project or phase of the project times the total cost of the project or phase of the project.

 

Cost of sales was approximately $10.7 million for the three months ended March 31, 2013. The $9.5 million increase in cost of sales was mainly attributable to the increase in the total GFA sold during this quarter.

 

Land use rights cost: The cost of land use rights includes the land premium we pay to acquire land use rights for our property development sites, plus taxes. Our land use rights cost varies for different projects according to the size and location of the site and the minimum land premium set for the site, all of which are influenced by government policies, as well as prevailing market conditions. Costs for land use rights for the three months ended March 31, 2013 were $980,345, as compared to $113,760 for the three months ended March 31, 2012, representing an increase of $866,585 from the same quarter last year. The increase was consistent with the fact that the total GFA sold during the three months ended March 31, 2013 was significantly higher than the same quarter of last year.

 

Construction cost: We outsource the construction of all of our projects to third party contractors, whom we select through a competitive tender process. Our construction contracts provide a fixed payment which covers substantially all labor, materials and equipment costs, subject to adjustments for some types of excess, such as design changes during construction or changes in government-suggested steel prices. Our construction costs consist primarily of the payments to our third-party contractors, which are paid over the construction period based on specified milestones. In addition, we purchase and supply a limited range of fittings and equipment, including elevators, window frames and door frames. Our construction costs for the three months ending March 31, 2013 were approximately $9.7 million as compared to approximately $1.0 million for the three months ended March 31, 2012, representing an increase of $8.7 million. The increase in construction cost was due to the additional units sold reflected in the increased revenue recognized.

 

The total cost of sales as a percentage of real estate sales before sales tax for the three months ended March 31, 2013 increased to 55.1% from 39.6% for the three months ended March 31, 2012, mainly attributable to lower sales of higher margin parking units during the quarter.

   

Gross Profit

 

Gross profit was approximately $7.6 million for the three months ended March 31, 2013 as compared to approximately $1.5 million for the three months ended March 31, 2012, representing an increase of $6.0 million, which was mainly attributable to the increase in sales. The overall gross profit as a percentage of real estate sales before sales tax decreased to 39.0% during the three months ended March 31, 2013 from 53.7% for the same quarter last year due to lower sales of higher margin parking units in the quarter. Generally the gross margin for the parking units ranges from 60% to over 90%.

 

The following table sets forth the gross margin of each of our projects:

 

   For Three Months Ended March 31, 
   2013   2012 
   Gross Profit   Percentage
of Revenue
   Gross Profit   Percentage
of Revenue
 
                 
Mingzhu Garden (Mingzhu Nanyuan & Mingzhu Beiyuan)  $5,289,839    58.2%  $506,764    87.5%
Yangzhou Pearl Garden   3,411,927    33.2%   1,131,567    58.9%
NanDajie (Mingzhu Xinju)   3,183    67.1%   87,215    24.4%
Central Plaza   -         13,571    58.9%
Sales Tax   (1,148,725)        (193,579)     
Total Gross Profit  $7,556,224    39.0%  $1,545,538    53.7%
Total Real Estate Sales before Sales Tax  $19,382,960        $2,878,446      

 

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Operating Expenses

 

Total operating expenses increased by 164.9% or $881,154 to $1,415,459 for the three months ended March 31, 2013 from $534,305 for the three months ended March 31, 2012 as a result of a 655.5% increase in selling expense of $258,482 and a 125.8% increase in general and administration expenses of $622,672.

 

The increase in selling expenses for the three months ended March 31, 2013 was primarily attributed to more promotions, sales and marketing activities. The increasing revenue also resulted in higher sales commission expense. The higher general administration expense for the three months ended March 31, 2013 was attributed to additional $0.6 million consulting fee incurred for our real estate developments and higher executive compensation, bonus, taxes and office expense.

 

However, as a percentage of total sales, the operating expenses decreased to 7.3% for the three months ended March 31, 2013 from 18.6% for the three months ended March 31, 2012, reflecting improved operating efficiency as real estate sales grow.

 

   For Three Months Ended
March 31,
 
   2013   2012 
         
Selling expenses  $297,914   $39,432 
General and administrative expenses   1,117,545    494,873 
Total operating expenses  $1,415,459   $534,305 
Percentage of Real Estate Sales before Sales Tax   7.3%   18.6%

  

Income Taxes

 

U.S. Taxes

 

China HGS is a Florida corporation. However, all of our operations are conducted solely by our subsidiaries in the PRC. No income is earned in the United States and we do not repatriate any earnings outside the PRC. As a result, we did not generate any U.S. taxable income for the three months ended March 31, 2013.

 

PRC Taxes

 

Our Company is governed by the Income Tax Law of the People’s Republic of China concerning private-run enterprises, which are generally subject to tax at a new statutory rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments.

 

However, the local tax authority of Hanzhong City has the power to assess corporate taxes annually on local enterprises at a pre-determined fixed rate as an incentive to stimulate the local economy and encourage entrepreneurship. The tax authority assessed us for income taxes at the rate of 1.25% on revenue in Yang County and 2.5% on our revenue in Hanzhong, instead of statutory rate of 25% on the income before income tax. Income tax expenses for the three months ended March 31, 2013 were $355,952 compared to $47,945 for the three months ended March 31, 2012 as a result of the increase in our revenue.

 

Net Income

 

We reported net income of $5,766,720 for the three months ended March 31, 2013, as compared to net income of $945,251 for the three months ended March 31, 2012. The increase of $4.8 million in our net income was primarily due to the increase in revenue and gross profit as further discussed above under Revenues and Gross Profit.

 

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Other Comprehensive Income

 

We operate primarily in the PRC and the functional currency of our operating subsidiary is the Chinese Renminbi (“RMB”).  The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that the RMB amounts could have been, or could be, converted into USD at the rates used in translation.

 

Translation adjustments resulting from this process amounted to $468,723 and $459,860 for the three months ended March 31, 2013 and 2012, respectively.  The balance sheet amounts with the exception of equity at March 31, 2013 were translated at RMB 6.2666 to USD 1.00 as compared to RMB 6.3190 to USD 1.00 at September 30, 2012. The equity accounts were stated at their historical rate. The average translation rates applied to the income statements accounts for the periods ended March 31, 2013 and 2012 were RMB 6.2825 and RMB 6.3487, respectively.

 

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Six Months Ended March 31, 2013 compared to Six Months Ended March 31, 2012

 

Revenues

 

The following table summarizes our revenue generated by different projects:

 

   For Six Months Ended March 31,     
   2013   2012   Variance 
   Revenue   %   Revenue   %   Amount   % 
                         
Mingzhu Garden (Mingzhu Nanyuan & Mingzhu Beiyuan)  $10,361,239    34.1%  $1,600,196    29.7%  $8,761,043    547.5%
Yangzhou Pearl Garden   14,603,500    48.1%   3,058,254    56.8%   11,545,246    377.5%
NanDajie (Mingzhu Xinju)   5,421,636    17.8%   700,940    13.0%   4,720,696    673.5%
Central Plaza   -         21,037    0.4%   (21,037)   (100)%
Total Real Estate Sales before Sales Tax  $30,386,375    100%  $5,380,427    100%  $25,005,948    464,8%
Sales Tax   (1,859,442)        (369,484)        (1,489,958)   403.3%
Revenue net of sales tax  $28,526,933        $5,010,943        $23,515,990    469.3%

 

Our revenues are derived from the sale of residential buildings, commercial front-stores and parking space in projects that we have developed. Revenues before sales tax increased by 464.8% to approximately $30.4 million for the six months ended March 31, 2013 from approximately $5.4 million for the same period in the last year. The total GFA sold during the six months ended March 31, 2013 was 54,502 square meters, representing an over five times increase from the 8,815 square meters completed and sold during the six months ended March 31, 2012. A significant portion of revenue during the six months ended March 31,2013 was from the sales of commercial units in NanDajie Project (Mingzhu Xinju) project. On October 23, 2012, the Company entered into a sales agreement to sell the remaining commercial units in Nan Dajie (Mingzhu Xinju) project with a total GFA of 4,545.88 square meters located in Hanzhong City for $5,411,455 (RMB 33,911,426). The purchaser is related to one of the Company’s concrete suppliers for our Hanzhong City Oriental Pearl Garden project and Mingzhu Beiyuan project. The purchaser’s payments are guaranteed by third parties. The ownership certificate of the related property was issued to the purchaser on November 22, 2012. The Company expects to collect the full proceeds by July 31, 2013. As of March 31, 2013, total accounts receivable of $4,040,848 was due from the purchaser.

 

Sales taxes for the six months ended March 31, 2013 and 2012 consisted of a business tax, 5% of the revenue, an urban construction tax, 7% of business tax, an education surcharge tax, 3% of business tax, and a land appreciation tax. Land appreciation tax for the six months ended December 31, 2013 and 2012 was assessed at the rate of 0.5% of the customer deposits in Yang County and 1% of the customer deposits in Hanzhong. The sales taxes for the six months ended March 31, 2013 increased by 403.3% from the same period last year, primarily as a result of the increase in our revenue. 

 

We are developing more high-rise residential buildings, which requires longer construction periods. This indicates that in certain future reporting periods, we might not have any new construction work, completed and delivered to buyers, and the only available-for-sale properties would be from our inventories which were previously completed and unsold properties. Since we recognize revenue in accordance with the full accrual method at the time of the closing of an individual unit sale, the longer construction periods for high-rise residential building would have negative impact on our revenue recognition.

 

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Cost of Sales

 

The following table sets forth a breakdown of our cost of sales:

 

   For Six Months Ended March  31,     
   2013   2012   Variance 
   Cost   %   Cost   %   Amount   % 
                         
Land use rights  $1,625,363    11%  $226,075    11.2%  $1,399,288    619.0%
Construction cost   12,882,892    89%   1,795,154    88.8%   11,087,738    617.7%
Total cost  $14,508,255    100%  $2,021,229    100%  $12,487,026    617.8%

  

Our cost of sales consists primarily of costs associated with land use rights and construction costs. Cost of sales are capitalized and allocated to development projects using the specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project (or phase of the project) times the total cost of the project (or phase of the project).

 

Cost of sales was approximately $14.5 million for the six months ended March 31, 2013 compared to $2.0 million for the six months ended March 31, 2012. The $12.5 million increase in cost of sales was mainly attributable to the increase in the total GFA sold during this period.

 

Land use rights cost: The cost of land use rights includes the land premium we pay to acquire land use rights for our property development sites, plus taxes. Our land use rights cost varies for different projects according to the size and location of the site and the minimum land premium set for the site, all of which are influenced by government policies, as well as prevailing market conditions. Costs for land use rights for the six months ended March 31, 2013 were approximately $1.6 million, as compared to $0.2 million for the six months ended March 31, 2012, representing an increase of $1.4 million from the same period last year. The increase was consistent with the fact that the total GFA sold during the six months ended March 31, 2013 was significantly higher than the same period of last year.

 

Construction cost: We outsource the construction of all of our projects to third party contractors, whom we select through a competitive tender process. Our construction contracts provide a fixed payment which covers substantially all labor, materials and equipment costs, subject to adjustments for some types of excess, such as design changes during construction or changes in government-suggested steel prices. Our construction costs consist primarily of the payments to our third-party contractors, which are paid over the construction period based on specified milestones. In addition, we purchase and supply a limited range of fittings and equipment, including elevators, window frames and door frames. Our construction costs for the six months ended March 31, 2013 were approximately $12.9 million as compared to approximately $1.8 million for the six months ended March 31, 2012, representing an increase of $11.1 million. The increase in construction cost was due to the additional units sold reflected in the increased revenue recognized.

 

The total cost of sales as a percentage of real estate sales before sales tax for the six months ended March 31, 2013 increased to 46.9% from 37.6% for the six months ended March 31, 2012, mainly attributable to lower revenue from sales of higher margin commercial properties and parking units in the current period.

   

Gross Profit

 

Gross profit was approximately $14.0 million for the six months ended March 31, 2013 as compared to approximately $3.0 million for the six months ended March 31, 2012, representing an increase of $11.0 million, which was mainly attributable to the increase in sales. The overall gross profit as a percentage of real estate sales before sales tax decreased to 46.1% during the six months ended March 31, 2013 from 55.6% for the same period last year, mainly due to lower sales of higher margin commercial units in Hanzhong City and Yang County during the current period.

 

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The following table sets forth the gross margin of each of our projects:

 

   For  Six Months Ended March 31, 
   2013   2012 
   Gross Profit   Percentage
of Revenue
   Gross Profit   Percentage
of Revenue
 
                 
Mingzhu Garden (Mingzhu Nanyuan & Mingzhu Beiyuan)  $6,064,690    58.5%  $1,265,930    79.1%
Yangzhou Pearl Garden   6,176,137    42.3%   1,761,462    57.6%
NanDajie (Mingzhu Xinju)   3,637,293    67.1%   318,235    45.4%
Central Plaza   -         13,571    64.5%
Sales Tax   (1,859,442)        (369,484)     
Total Gross Profit  $14,018,678    46.1%  $2,989,714    55.6%
Total Real Estate Sales before Sales Tax  $30,386,375        $5,380,427      

 

Operating Expenses

 

Total operating expenses increased by 138.7% or $1,242,006 to $2,137,524 for the six months ended March 31, 2012 from $895,518 for the six months ended March 31, 2012 as a result of a 460.6% increase in selling expense of $337,135 and a 106.3% increase in general and administration expenses of $864,871.

 

The increase in selling expenses for six months ended March 31, 2013 was primarily attributed to more promotions, sales and marketing activities. The increasing revenue also resulted in higher sales commission expense. The higher general administration expense for the six months ended March 31, 2012 was attributed to an additional $0.6 million consulting fee incurred for our real estate developments and higher executive compensation, bonus, taxes and office expense.

 

However, as a percentage of total sales, the operating expenses decreased to 7.0% for the six months ended March 31, 2013 from 16.6% for the six months ended March 31, 2012, reflecting improved operating efficiency as real estate sales grow.

 

   For Six Months Ended
March 31,
 
   2013   2012 
         
Selling expenses  $459,008   $81,873 
General and administrative expenses   1,678,516    813,645 
Total operating expenses  $2,137,524   $895,518 
Percentage of Real Estate Sales before Sales Tax   7.0%   16.6%

 

Income Taxes

 

U.S. Taxes

 

China HGS is a Florida corporation. However, all of our operations are conducted solely by our subsidiaries in the PRC. No income is earned in the United States and we do not repatriate any earnings outside the PRC. As a result, we did not generate any U.S. taxable income for the six months ended March 31, 2013.

 

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PRC Taxes

 

Our Company is governed by the Income Tax Law of the People’s Republic of China concerning private-run enterprises, which are generally subject to tax at a new statutory rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments.

 

However, the local tax authority of Hanzhong City has the power to assess corporate taxes annually on local enterprises at a pre-determined fixed rate as an incentive to stimulate the local economy and encourage entrepreneurship. The tax authority assessed us for income taxes at the rate of 1.25% on revenue in Yang County and 2.5% on our revenue in Hanzhong, instead of statutory rate of 25% on the income before income tax. Income tax expenses for the six months ended March 31, 2013 were $577,116 as compared to $96,283 for the six months ended March 31, 2012 as a result of the increase in our revenue.

 

Net Income

 

We reported net income of $11,275,797 for the six months ended March 31, 2013, as compared to net income of $1,975,713 for the six months ended March 31, 2012. The increase of $9.3 million in our net income was primarily due to the increase in revenue and gross profit as further discussed above under Revenues and Gross Profit.

 

Other Comprehensive Income

 

We operate primarily in the PRC and the functional currency of our operating subsidiary is the Chinese Renminbi (”RMB”).  The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that the RMB amounts could have been, or could be, converted into USD at the rates used in translation.

 

Translation adjustments resulting from this process amounted to $677,708 and $804,449 for the six months ended March 31, 2013 and 2012, respectively.  The balance sheet amounts with the exception of equity at March 31, 2013 were translated at RMB 6.2666 to USD 1.00 as compared to RMB 6.3190 to USD 1.00 at September 30, 2012. The equity accounts were stated at their historical rate. The average translation rates applied to the income statements accounts for the periods ended March 31, 2013 and 2012 were RMB 6.2825 and RMB 6.3487, respectively.

 

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Liquidity and Capital Resources

 

Current Assets and Liabilities

 

Our principal need for liquidity and capital resources is to maintain working capital sufficient to support our operations and to make capital expenditures to finance the growth of our business. To date, we have financed our operations primarily through cash flows from operations and borrowings from our principal shareholder.

 

We spent more on the new development projects under construction and provided a longer payment term for a certain major customer who made a bulk purchase of commercial units in Nan Dajie (Mingzhu Xinju) project. As a result, our total cash and restricted cash balance decreased to approximately $1.9 million as of March 31, 2013. Since most of our customers are first-time home buyers and our affordable housing units are in the pre-sales stage, we expect our cash flow will improve during the balance of fiscal 2013.

 

 As of March 31, 2013, the Company had approximately $2.2 million in working capital, a decrease of $5.5 million as compared to $7.7 million as of September 30, 2012. The decreases in working capital was mainly related to sales of the current portion of real estate property completed and an increase of accounts payable resulted from the progress on the construction of real estate property under development. The major changes in the working capital items include the decrease of the current portion of real estate property completed of $6.7 million, a decrease of the current portion of real estate property under development of $3.1 million, an increase of accounts payable of $1.3 million and an increase of tax liabilities of $0.9 million, offset by an increase from accounts receivable of $4.0 million, an increase of advance to venders of $1.5 million and a decrease of customer deposits of $2.2 million.

 

Current assets decreased by $4.5 million to approximately $28.5 million as of March 31, 2013 from $33.1 million as of September 30, 2012. The primary changes in our current assets during this period were increases in accounts receivable and advance to vendors, offsetting the decreases of current portion of real estate property completed and real estate property under development.

 

The decrease of cash from $1.1 million as of September 30, 2012 to $0.7 million as of March 31, 2013 was mainly due to the spending on the new projects under construction. The decrease in cash was partially offset by an increase in accounts payable of $1.3 million and customer deposits of $0.4 million. The increase of advance to venders from $2.6 million as of September 30, 2012 to $4.1 million as of March 31, 2013 was due to more prepayment made to the development and construction of residential and commercial units. The decrease of the current portion of real estate property development completed from $19.5 million as of September 30, 2012 to $12.8 million as of March 31, 2013 was attributable to higher sales from our continuous promotion efforts. The balance of real estate property under development current portion decreased by $3.1 million from $8.6 million as of September 30, 2012 to $5.4 million as of March 31, 2013 due to the completion of two high-rise buildings in Yangzhou Pear Garden project during the six months ended March 31, 2013.

 

Current liabilities as of March 31, 2013 totaled approximately $26.3 million, representing a 3.6% increase as compared to $25.4 million as of September 30, 2012. The increase in current liabilities was mainly due to the increase of $1.3 million in accounts payable and the increase of $0.9 million in tax payable, offset by a decrease of $2.2 million in customer deposits.

 

In order to fully implement our business plan and sustain continued growth, however, we may need to raise capital. Our expectation, therefore, is that we will seek to access the capital markets in both the U.S. and China to obtain the funds we require. At the present time, however, we do not have commitments of funds from any source.

 

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Cash Flow

 

Comparison of cash flows results is summarized as follows:

 

   Six months ended
March 31,
 
   2013   2012 
Net cash used in operating activities  $(400,712)  $(7,853,055)
Net cash used in investing activities        - 
Net cash provided by financing activities        - 
Effect of change of foreign exchange rate on cash   8,219    68,644 
Net cash decrease  in cash   (392,493)   (7,784,391)
Cash, beginning of period   1,104,686    8,837,795 
Cash, end of period  $712,193   $1,053,404 

 

Operating Activities

 

Net cash used in operating activities during the six months ended March 31, 2013 was $0.4 million, consisting of net income of $11.5 million, noncash adjustments of $0.05 million and net changes in our operating assets and liabilities, which mainly included an increase in advances to venders of $1.5 million due to more construction prepayments made on the projects under construction, an increase in account receivable of $4.0 million as we extended payment term for one major customer who made bulk purchase of commercial units in our Nan Dajie (Mingzhu Xinju) project located in Hanzhong City, an increase in real estate property under development of $17.0 million resulting from more progress on our real estate projects under development, a decrease in real estate property completed of $7.8 million due to sales and an increase in accounts payable of $1.3 million resulted from more construction progress. The negative cash provided by operating activities is mainly attributable to our significant spending on our new real estate property under development in Oriental Pearl Garden and Mingzhu Beiyuan projects located in Hanzhong city and Yangzhou Pearl Garden project located in Yang County.

 

Net cash used in operating activities during the six months ended March 31, 2012 was $7.9 million, consisting of net income of $2.0 million, noncash adjustments of $0.06 million and net changes in our operating assets and liabilities, which mainly included a decrease in advances to venders and loans to outside parties total of $2.9 million due to the repayment from these venders and outside parties, a decrease in real estate property development completed of $1.7 million resulted from sales and a decrease in account payable of $4.5 as we settled balances with our suppliers; an increase in security deposits for land use rights of $11.7 million, an increase in real estate property under development of $5.3 million attributable to our construction progress and an increase in customer deposits of $6.9 million resulted from our pre-sale efforts. The negative cash provided by operating activities is mainly attributable to our significant payment on security deposits on the land use rights, settlements of account payable with our suppliers and spending in the real estate property under development.

 

Inflation

 

Inflation has not had a material impact on our business and we do not expect inflation to have a material impact on our business in the near future.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 

Not applicable.

 

ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”). The evaluation of our disclosure controls and procedures included a review of our processes and the effect on the information generated for use in this Quarterly Report on Form 10-Q. In the course of this evaluation, we sought to identify any material weaknesses in our disclosure controls and procedures and to confirm that any necessary corrective action, including process improvements, was taken. The purpose of this evaluation is to determine if, as of the Evaluation Date, our disclosure controls and procedures were operating effectively such that the information, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) was recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) was accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Management conducted its evaluation of disclosure controls and procedures under the supervision of our chief executive officer and our chief financial officer. Based upon this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of March 31, 2013.

 

The management is committed to improving the internal controls over financial reporting and will undertake the consistent improvements or enhancements on an ongoing basis. To remediate the weakness in lack of internal audit function, the Company has employed an internal auditor to reinforce the function of the internal audit department. Currently, the internal audit department has two staffs.

 

The Company continued to engage the existing independent professional consulting firm to assist the Company’s Internal Control Evaluation Committee in evaluating the internal control effectiveness in fiscal 2013.

 

The remedial measures being undertaken may not be fully effectuated or may be insufficient to address the significant deficiencies we identified, and there can be no assurance that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified or occur in the future. If additional significant deficiencies (or if material weaknesses) in our internal controls are discovered or occur in the future, among other similar or related effects: (i) the Company may fail to meet future reporting obligations on a timely basis, (ii) the Company’s consolidated financial statements may contain material misstatements, and (iii) the Company’s business and operating results may be harmed.

 

Changes in Internal Control over Financial Reporting

 

Except for the matters described above to improve our internal controls over financial reporting, there were no changes in our internal control over financial reporting for the three and six months ended March 31, 2013 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, however the Company is in the process of designing and planning to change as described above.

 

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PART II: OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

We may be subject to, from time to time, various legal proceedings relating to claims arising out of our operations in the ordinary course of our business. We are not currently a party to any legal proceedings, the adverse outcome of which, individually or in the aggregate, would have a material adverse effect on the business, financial condition, or results of operations of the Company.

 

ITEM 1A. RISK FACTORS

 

As a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide information required by this item.

 

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

 

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None.  

 

ITEM 4. MINE SAFETY DISCLOSURES

 

None.

 

ITEM 5. OTHER INFORMATION

 

None.

 

ITEM 6. EXHIBITS

 

The exhibits listed on the Exhibit Index are provided as part of this report.

 

(a) Exhibits

  

Exhibit Number   Description of Exhibit
     
31.1*   Rule 13a-14(a) Certification of Chief Executive Officer
     
31.2*   Rule 13a-14(a) Certification of Chief Financial Officer
     
32.1*   Section 1350 Certification of Chief Executive Officer and Chief Financial Officer
     
101.INS*   XBRL Instance
     
101.SCH*   XBRL Taxonomy Extension Schema
     
101.CAL*   XBRL Taxonomy Extension Calculation
     
101.DEF*   XBRL Taxonomy Extension Definition
     
101.LAB*   XBRL Taxonomy Extension Labels
     
101.PRE*   XBRL Taxonomy Extension Presentation

 

* Furnished electronically herewith

 

35
 

 

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 HGS Real Estate, Inc.  
       
May 13, 2013 By: /s/ Xiaojun Zhu  
    Xiaojun Zhu  
    Chief Executive Officer  

  

  By: /s/ Wei Shen  
    Wei Shen  
    Chief Financial Officer  

 

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