NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

For the nine months ended June 30, 2010 and 2009, respectively

NOTE 1.  BASIS OF PRESENTATION

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 the management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended June 30, 2010 and 2009 are not necessarily indicative of the results that may be expected for the full years. 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, 2009.

The condensed consolidated balance sheet information as of September 30, 2009 was derived from the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2009. 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation

 

The consolidated financial statements include the financial statements of China HGS Real Estate Inc. (the “Company” or “China HGS”), China HGS Investment Inc. (“HGS Investment”), Shaanxi HGS Management and Consulting Co., Ltd. (“Shaanxi HGS”) and its variable interest entity (“VIE”), Shaanxi Guangsha Investment and Development Group Co., Ltd. (“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 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 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 then quoted prices that are observable, and inputs derived from or corroborated by observable market data.

Level 3-Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

The carrying amounts reported in the accompanying condensed consolidated balance sheets for cash and cash equivalents, restricted cash, other current assets, short-term loans, accounts payable, customer deposits, other payables, accrued expenses, and taxes payable, approximate their fair value based on the short-term maturity of these instruments.

 

 

 

 

Revenue recognition

 

Real estate sales are reported 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 of 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, and the buyer’s receivable, if any, is not subject to future subordination. Sales transactions not meeting all the conditions of the full accrual method are accounted for using the deposit method in which all costs are capitalized as incurred, and payments received from the buyer are recorded as a deposit liability.

 

Foreign currency translation

 

The Company’s financial information is presented in US dollars. The functional currency of the Company’s operating subsidiaries is Renminbi (“RMB”), the currency of the PRC. Transactions at the Company which are denominated in currencies other than RMB are translated into RMB at the exchange rate quoted by the People’s Bank of China prevailing at the dates of the transactions. Exchange gains and losses resulting from transactions denominated in a currency other than that RMB are included in statements of operations as exchange gains.

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 period-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.

 

 

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 US dollars at the rates used in translation.

Cash and cash equivalents

 

Cash includes cash on hand and demand deposits in accounts maintained with state-owned and private 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. Total cash at June 30, 2010 and September 30, 2009 amounted to $9,214,964 and $820,783, respectively, of which no deposits are covered by insurance. The Company has not experienced any losses to date as a result of this policy.

Loans to outside parties

 

Loans to outside parties consist of various cash advances to unrelated companies and individuals with which the Company has good business relationships. Loans to outside parties are reviewed periodically as to whether their carrying value has become impaired. The Company considers the assets to be impaired if the collectability of the balances becomes doubtful. As of June 30, 2010 and September 30, 2009, there was no allowance for doubtful accounts.

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 government of China. 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 times the total project costs.

 

Costs of amenities transferred to buyers are allocated as common costs of the project that are allocated to specific units as a component of total construction costs.

In accordance to ASC 360-10, real estate property development completed and under development are subject to valuation adjustments 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.

 

Management evaluates, on a yearly basis, the impairment of the Company’s real estate developments based on a community level. Each community is assessed as an individual project. The evaluation takes into account several factors including, but not limited to, physical condition, inventory holding period, management’s plans for future operations, prevailing market prices for similar properties and projected cash flows.  There were no impairment losses as of June 30, 2010 and September 30, 2009, respectively.

Property and equipment

 

Property and equipment are recorded at cost less accumulated depreciation and any impairment losses.  The cost of an asset comprises its purchase price and any directly attributable costs of bringing the asset to its working condition and location for its intended use.  Expenditures incurred after the fixed assets have been put into operation, such as repairs and maintenance and overhaul costs, is normally charged to the profit and loss account in the year in which it is incurred.

 

In situations where it can be clearly demonstrated that the expenditure has resulted in an increase in the future economic benefits expected to be obtained from the use of the asset beyond its originally assessed standard of performances, the expenditure is capitalized as an additional cost of the asset.

Depreciation is computed using the straight-line method over the estimated useful lives of the assets, less any estimated residual value.  Estimated useful lives of the assets are as follows:

 

 

Any gain or loss on disposal or retirement of a fixed asset is recognized in the profit and loss account and is the difference between the net sales proceeds and the carrying amount of the relevant asset. When property and equipment are retired or otherwise disposed of, the asset and accumulated depreciation are removed from the accounts and the resulting profit or loss is reflected in income.

 

Maintenance, repairs and minor renewals are charged directly to expense as incurred unless such expenditures extend the useful life or represent a betterment, in which case they are capitalized.

Impairment of long-lived assets

 

Long-lived assets, which include property, plant and equipment and intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

Recoverability of long-lived assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the assets. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the assets.  Fair value is generally determined using the asset’s expected future discounted cash flows or market value, if readily determinable. No impairment loss is recorded as of June 30, 2010 and September 30, 2009.

 

 

 

Capitalized interest

 

Capitalized interest is accounted for in accordance with ASC 835-20 “Capitalization of Interest Cost”.

 

For loans to finance projects and provide for working capital, the Company charges the borrowing costs related to working capital loans to interest expense when incurred and capitalize interest costs related to project developments as a component of the project costs.

The interest to be capitalized for a project is based on the amount of borrowings related specifically to such project. Interest for any period is capitalized based on the amounts of accumulated expenditures and the interest rate of the loans. Payments received from the pre-sales of units in the project are deducted in the computation of the amount of accumulated expenditures during a period. The interest capitalization period begins when expenditures have been incurred and activities necessary to prepare the asset (including administrative activities before construction) have begun, and ends when the project is substantially completed. Interest Capitalized is limited to the amount of interest incurred.

 

The interest rate used in determining the amount of interest capitalized is the weighted average rate applicable to the project-specific borrowings. However, when accumulated expenditures exceed the principal amount of project-specific borrowings, the Company also capitalizes interest on borrowings that are not specifically related to the project, at a weighted average rate of such borrowings.

 

The Company’s significant judgments and estimates related to interest capitalization include the determination of the appropriate borrowing rates for the calculation, and the point at which capitalization is started and discontinued. Changes in the rates used or the timing of the capitalization period may affect the balance of property under development and the costs of sales recorded. There was no capitalized interest as of June 30, 2010 and September 30, 2009.

 

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 current liability until the revenue can be recognized.

Stock-based compensation

The Company accounted for share-based compensation in accordance with ASC Topic 718, 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.

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 of the terms of the options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

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

 
 

 

 

Property warranty

 

The Company provides 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 constantly 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 constantly 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 current liabilities, 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. As of June 30, 2010 and September 30, 2009, the Company had not recognized any warranty liability or incurred any warranty costs in excess of the amount retained from subcontractors.

 

Income taxes

 

The Company accounts for income taxes in accordance with ASC 740 “ Income Taxes ”. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been included in the financial statements or income tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted rates expected to apply to taxable income in the years in which those differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. There are no deferred tax amounts for the nine months ended June 30, 2010 and 2009.

Land appreciation tax (“LAT”)

 

LAT is prepaid on customer deposits and is expensed when the related revenue is recognized. 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.

 

Comprehensive income

 

In accordance with ASC 220-10-55, comprehensive income is defined to include 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 nine months ended June 30, 2010 and 2009 were net income and the foreign currency translation adjustment.

 

Basic and diluted earnings per share

 

The Company computes earnings per share (“EPS”) in accordance with the ASC 260, “ Earnings per share ”, which requires companies with complex capital structures to present basic and diluted EPS.  Basic EPS is measured as net income divided by the weighted average common shares outstanding for the period.  Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (e.g., convertible securities, options and warrants) as if they had been converted at the beginning of the periods presented, or issuance date, if later.  Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS.

 

Advertising expenses

 

Advertising costs are expensed as incurred, or the first time the advertising takes place, in accordance with ASC 340-20 “Capitalized advertising costs”. For the three and nine months ended June 30, 2010 and 2009, the Company recorded advertising expenses of $34,164, $83,007 and $35,150, $58,479, respectively.

Concentration of credit risk

 

Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of accounts receivables and other receivables.  The Company does not require collateral or other security to support these receivables.  The Company conducts periodic reviews of its clients' financial condition and customer payment practices to minimize collection risk on accounts receivables.

 

 

 

 

Risks and uncertainties

 

The operations of the Company are located in the PRC. Accordingly, the Company’s operations are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company’s results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation, among other things.

 

The Company uses various suppliers and sells to a wide range of customers. No single supplier or customer accounted for more than 10% of revenue or project expenditures for the three and nine months ended June 30, 2010 and 2009, respectively.

Recent accounting pronouncements

In January 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-06 Improving Disclosures About Fair Value Measurements. This amendment clarifies existing disclosures, require new disclosures, and include conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. This disclosure is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  The Company has determined the adoption of this rule will not have a material impact on its consolidated financial statements.

 
 

NOTE 3. RESTRICTED CASH

 

Restricted cash is cash set aside for a particular use or event and is subject to withdrawal restrictions. The Company is required to maintain certain deposits, as restricted cash, with banks that provide mortgage loans to the Company’s customers. These deposits are guarantees for the mortgage loans and are normally equivalent to 5% of the mortgage proceeds paid to the Company. As of June 30, 2010 and September 30, 2009, the balances of restricted cash totaled $414,131 and $412,373, respectively. These deposits are not covered by insurance. The Company has not experienced any losses to date as a result of this policy.

NOTE 4. LOANS TO OUTSIDE PARTIES

 

In order to control the development costs and maintain good relationships with suppliers, the Company makes cash advances to its long-term contractors to support their occasional short-term working capital needs. These advances bear no interest and they are due on demand. As of June 30, 2010 and September 30, 2009, the Company had outstanding loans to outside parties in the amount of $5,328,937 and $1,762,022, respectively.  All these loans are considered collectible based on the Company’s past experiences. 

NOTE 5. REAL ESTATE PROPERTY DEVELOPMENT COMPLETED AND UNDER DEVELOPMENT

 

The following summarizes the components of real estate property development completed and under development as of June 30, 2010 and September 30, 2009, respectively:

 

 

As of June 30, 2010 and September 30, 2009, land use rights included in the real estate property under development totaled $11,812,124 and $14,261,781, respectively. The management determined that no impairment was necessary for the three and nine months ended June 30, 2010 and 2009.

 

Depreciation expenses for the three and nine months ended June 30, 2010 and 2009 were $16,329, $47,720 and $16,268, $43,905, respectively.

Customer deposits are typically funded up to 70%~80% by mortgage loans made by banks to the customers. Until the customer obtains legal title to the property, the banks have a right to seek reimbursement from the Company for any defaults by the customers. The Company, in turn, has a right to withhold transfer of title to the customer until outstanding amounts are fully settled.

 

 

 

 

 

 

The total of interest expense for short term loans totaled $13,968, $41,962 and $27,253, $95,926 for the three and nine months ended June 30 2010 and 2009, respectively.

 

A related party of the Company pledged a land use right in the amount of RMB 7,757,300 (approximately $1.2 million) as collateral for the loan b) shown above.  This loan, which would have matured on August 13, 2010 has been repaid in full on August 11, 2010.

NOTE 9. OTHER PAYABLES

 

Other payables represent contract deposits and bidding deposits that are to be refunded upon completion of the projects or satisfaction of claim-free warranty.

NOTE 10. STOCK OPTIONS

In January 2010, the Board of Directors of the Company approved the issuance of stock options to three newly appointed independent directors to purchase up to 34,000 shares of the Company’s common stock. These stock options will become exercisable as to 20% of the original number of shares on the grant date and 10% of the shares at the end of every quarter thereafter until 100% exercisable. The exercise price of such options is $2.60 per share and the options expire on January 6, 2015.

 

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.

The assumptions used in calculating the fair value of options granted using the Black-Scholes option pricing model are as follows:

Total stock-based compensation expense recognized in the accompanying condensed consolidated statement of income for the three and nine month period ended June 30, 2010 and 2009, was $7,716, $30,863 and $-0-, respectively. As of June 30, 2010, there was approximately $46,294 of unrecognized compensation cost related to stock option awards that is expected to be recognized as expense when vested.

 

 

 

 

NOTE 11. TAXES

 

(A) Business sales tax

 

The Company is subject to 5% business sales tax on actual revenue.  It is the Company’s continuing practice to recognize 5% of the sales tax on estimated revenue, and file tax return based on the actual result, as the local tax authority may exercise broad discretion in applying the tax amount.  As a result, the Company’s accrual sales tax may differ from the actual tax clearance.

 

(B) Corporate income taxes (“CIT”)

 

The Company is governed by the Income Tax Law of the People’s Republic of China concerning the private-run enterprises, which are generally subject to income tax at a new statutory rate of 25%, effective January 1, 2008, 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 local economy and encourage entrepreneurship. The Company incurred $133,107, $534,583 and $50,329, $195,647 income taxes for the three and nine months ended June 30, 2010 and 2009, 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. Management believes that the possibility of any reevaluation of income taxes is remote based on the fact that the Company has obtained the written tax clearance from the local tax authority. Thus, no additional taxes payable has been recorded for the difference between the taxes due based on taxable income calculated according to statutory taxable income method and the taxes due based on the fixed rate method. It is the Company’s policy that if such reevaluation of income taxes becomes probable and the amount of additional taxes due can be reasonably estimated, additional taxes shall be recorded in the period which the amount can be reasonably estimated.

(C) LAT (Land Appreciation Tax)

 

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 June 30, 2010 and September 30, 2009, the Company has made full payment for LAT with respect to properties sold in accordance with the requirements of the local tax authorities.

(D) Tax payables consisted of the following:

NOTE 12.  STOCKHOLDERS’ EQUITY

 

Surplus reserves

 

The Company is required to make appropriations to reserve funds, comprising the statutory surplus reserve and discretionary surplus reserve, based on after-tax net income determined in accordance with generally accepted accounting principles of the PRC (“PRC GAAP”). Appropriations to the statutory surplus reserve is required to be at least 10% of after tax net income determined in accordance with PRC GAAP until the reserve is equal to 50% of the entities’ registered capital. Appropriations to the discretionary surplus reserve are made at the discretion of the Board of Directors.

  

The statutory surplus reserve fund is non-discretionary other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of shares currently held by them, provided that the remaining statutory surplus reserve balance after such issue is not less than 25% of the registered capital before the conversion. Pursuant to the Company’s articles of incorporation, the Company has appropriated 10% of its net profits as statutory surplus reserve.

The discretionary surplus reserve may be used to acquire fixed assets or to increase working capital. The Company’s Board of Directors decided not to make an appropriation to this reserve for the nine months ended June 30, 2010.

NOTE 13. WEIGHTED AVERAGE NUMBER OF SHARES

 

In August 2009, the Company entered into a share exchange transaction which was accounted for as a reverse merger under the purchase method of accounting, since there was a change of control. The Company computes the weighted-average number of common shares outstanding in accordance with ASC 805, which states that in calculating the weighted average shares when a reverse merger takes place in the middle of the year, the number of common shares outstanding from the beginning of that period to the acquisition date shall be computed on the basis of the weighted-average number of common shares of the legal acquiree (the accounting acquirer) outstanding during the period multiplied by the exchange ratio established in the merger agreement. The number of common shares outstanding from the acquisition date to the end of that period shall be the actual number of common shares of the legal acquirer (the accounting acquiree) outstanding during that period.

NOTE 14. CONTINGENCY

 

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 the registration of the mortgage with the relevant mortgage registration authorities, which generally occurs within six to twelve months after the purchasers take possession of the relevant properties. 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 default as required by the mortgage lenders. The Company has not experienced any losses related to this guarantee and believes that such reserves are sufficient.

 

 

 

 

 

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

Special Note Regarding Forward Looking Statements

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included in this Quarterly Report on Form 10-Q, or this Quarterly Report, and in conjunction with our Annual Report on Form 10-K for the fiscal year ended September 30, 2009. Certain of these statements, including, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, statements regarding the deployment of our products, statements regarding our reliance on third parties and other statements using words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,”“should,” “will” and “would,” and words of similar import and the negatives thereof, constitute forward-looking statements. These statements are predictions based upon our current expectations about future events. Actual results could vary materially as a result of certain factors, including but not limited to, those expressed in these statements. We refer you to the “Risk Factors,” “Results of Operations,” “Disclosures About Market Risk,” and “Liquidity and Capital Resources” sections contained in this Quarterly Report, and the risks discussed in our other Securities Exchange Commission, or SEC, filings, which identify important risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements.

We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report. All subsequent written or oral forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements included in this Quarterly Report are made only as of the date of this Quarterly Report. We do not intend, and undertake no obligation, to update these forward-looking statements.

Overview of Our Business

Overview

We conduct substantially all of our business through Shaanxi Guangsha Investment and Development Group Co., Ltd., in Hanzhong, Shaanxi Province. All of our businesses are conducted in mainland China. We were founded by Mr. Xiaojun Zhu, our Chairman and Chief Executive Officer and commenced operations in 1995 in Hanzhong, a prefecture-level city of Shaanxi Province. Since the initiation of our business, we have been focused on expanding our business in certain Tier 2 cities in China which we strategically selected based on a set of criteria. Our selection criteria includes population and urbanization growth rate, general economic condition and growth rate, income and purchasing power of resident consumers, anticipated demand for private residential properties, availability of future land supply and land prices and governmental urban planning and development policies. As of June 30, 2010, we have established operations in two Tier 2 cities and one county in Hanzhong City, Shaanxi Province, comprising of downtown area and west ring road in the city of Hanzhong, city of Weinan, a municipality in Shaanxi Province, and Yang County.

We intend to continue our expansion into additional selected Tier 2 cities and counties as suitable opportunities arise. We will expand to more select targeted Tier 2 cities including cities in Sichuan Province and other Tier 2 cities in Shaanxi Province which we are surveying for expansion in the near future.

 

 

 

 

Our Current Organizational Structure

The following chart reflects our current organizational structure:

 

 

 

(1) Calculated by square meters (1 square meter = 10.7 square feet).

(2) The amounts for ‘‘Total GFA’’ in this table and elsewhere in this statement are the amounts of total saleable residential GFA and are derived on the following basis:

 

 

 

 

 

Suppliers

In China, the supply of land is controlled by the government. Since the early 2000s, the real estate industry in China has been transitioning from an arranged system controlled by the PRC government to a more market-oriented system. At present, although the Chinese government still owns all urban land in China, land use rights with terms up to 70 years can be granted to, and owned or leased by, private individuals and companies. Generally, there are two ways the Company usually applies to acquire land use rights.

In 2005, the Company acquired a land lease from a bankrupt company, Weinan Chemical Company, which covers an area of 80 acres. After the acquisition, the Company started the construction of the Lijing Garden Projects and finished all three projects of the Lijing Garden in June 2008.

In May 2008, the Company successfully acquired a land lease covering 236 acres through bidding on an auction held by the local Land Consolidation and Rehabilitation Center of Yang County. After the acquisition, the Company started the construction of Yangzhou Pearl Garden Projects on the acquired land lease, with a total construction Gross Floor Area of 318,947 square meters. As of June 30, 2010, 43.1% of the projects of Yangzhou Pearl Garden have been completed, 48.8% were still under construction and the remaining 8.1% is under planning and is expected to be completed before December 2011.

 

In July 2008, the Company acquired the land lease of another bankrupt company, Hanzhong Energy Company, which covers an area of 30 acres in Hanzhong City. After the acquisition, the Company started the construction of Mingzhu Qinju Garden Projects on the acquired land lease, with a total construction Gross Floor Area of 42,476 square meters. As of June 30, 2010, 75% of Mingzhu Qinju Garden was completed and expected to be delivered to buyers in September 2010. The remaining 25% of this project is expected to be completed by the end of June 2011.

In 2009, the Company successfully acquired another land lease covering 180 acres through bidding on an auction held by the local Land Consolidation and Rehabilitation Center of Hanzhong City. After the acquisition, the Company started the construction of Mingzhu Garden Projects (Phase Five) on the acquired land lease, and as of June 30, 2010, 26.7% of the project of Mingzhu Garden (Phase Five) has been completed and the remaining 73.3% of the project is still under construction and is expected to be completed by the end of September, 2011.

All such land transactions are required to be reported to and authorized by the Xi’an Bureau of Land and Natural Resources. As to real estate project design and construction services, the Company typically selects the lowest-cost provider based on quality ensured through an open bidding process. Such service providers are numerous in China and the Company foresees no difficulties in securing alternative sources of services as needed.

Competition

The real estate industry in China is highly competitive. In Tier 2 cities that we focus on the markets are relatively more fragmented than Tier 1 cities. We compete primarily with local and regional property developers and an increasing number of large national property developers who have also started to enter these markets. Competitive factors include the geographical location of the projects, the types of products offered, brand recognition, price, designing and quality. In the regional markets which we operate, our major competitors include Wanbang Real Estate Development Co. Ltd., and other national real estate developers who have also started their projects in the local markets.

Nationally, there are numerous companies that have real estate projects across China. There are 55 housing and land development companies listed on the Shanghai and Shenzhen Stock Exchanges. However, such companies usually undertake large scale projects and are unlikely to compete with Guangsha for business as the Company targets small to medium sized projects in Tier 2 cities and counties.

In the regional market, the Company’s only direct competitor with meaningful market shares in the market is Wanbang Real Estate Development Co. Ltd. This company generally undertakes medium and small scale projects and focuses on development of commercial real estate properties, such as hotels and shopping centers. By the end of December, 2009, Wanbang had developed realty of about 600 acres across Hangzhong City and other counties surrounding. As of March 31, 2010, Wanbang has completed the construction of about 200,000 square meters of commercial properties. Since April 2010 to present, Weibang is undertaking some government supported small projects such as construction of some economic and lower priced residential apartments to target certain lower income customers.

 

 

 

 

Quality Control

We emphasize quality control to ensure that our buildings and residential units meet our standards and provide high quality service. We select only experienced design and construction companies. We, through our contracts with construction contractors, provide customers with warranties covering the building structure and certain fittings and facilities of our property developments in accordance with the relevant regulations. To ensure construction quality, our construction contracts contain quality warranties and penalty provisions for poor work quality. In the event of delay or poor work quality, the contractor may be required to pay pre-agreed damages under our construction contracts. Our construction contracts do not allow our contractors to subcontract or transfer their contractual arrangements with us to third parties. We typically withhold 2% of the agreed construction fees for two to five years after completion of the construction as a deposit to guarantee quality, which provides us assurance for our contractors’ work quality.

Our contractors are also subject to our quality control procedures, including examination of materials and supplies, on-site inspection and production of progress reports. We require our contractors to comply with relevant PRC laws and regulations, as well as our own standards and specifications. We set up a profile for each and every unit constructed and monitor the quality of such unit throughout its construction period until its delivery. We also employ independent surveyors to supervise the construction progress. In addition, the construction of real estate projects is regularly inspected and supervised by the PRC governmental authorities.

Environmental Matters

As a developer of property in the PRC, we are subject to various environmental laws and regulations set by the PRC national, provincial and municipal governments. These include regulations on air pollution, noise emissions, as well as water and waste discharge. We, as of June 30, 2010, have never paid any penalties associated with the breach of any such laws and regulations. Compliance with existing environmental laws and regulations has not had a material adverse effect on our financial condition and results of operations, and we do not believe it will have such an impact in the future.

Our projects are normally required to undergo an environmental impact assessment by government-appointed third parties, and a report of such assessment needs to be submitted to the relevant environmental authorities in order to obtain their approval before commencing construction.

Upon completion of each project, the relevant environmental authorities inspect the site to ensure the applicable environmental standards have been complied with, and the resulting report is presented together with other specified documents to the relevant construction administration authorities for their approval and record. Approval from the environmental authorities on such report is required before we can deliver our completed work to our customers. As of June 30, 2010, we have not experienced any difficulties in obtaining those approvals for commencement of construction and delivery of completed projects.

 

 

 

 

 

 

Marketing and Distribution Channel

As of June 30, 2010, we maintain a marketing and sales force for our development projects with 60 personnel specializing in marketing and sales. We also train and use outside real estate agents to market and increase the public awareness of our products, and spread the acceptance and influence of our brand. However, we still majorly let our own sales force represent our brand and project rather than rely on third party brokers or agents, for the reason that we believe our own dedicated sales representatives are better motivated to serve our customers and to control our property pricing and selling expenses.

Our marketing and sales teams work closely with each other in order to determine the appropriate advertising and selling plans for a particular project. We develop public awareness through our marketing and advertising efforts and also referrals from our satisfied customers. We utilize our customer relationship management system to track customer profiles to forecast future individual requirements and general demand for our products. This allows us to have real-time information on the status of individual customer transactions and the vacancy of product types for each project, and to anticipate the product preferences of current and future customers. We mainly develop customer awareness through advertising.

As for advertisement, we use various advertising media to market our property developments, including newspapers, magazines, television, radio, e-marketing and outdoor billboards. We also participate in real estate exhibitions to enhance our brand name and promote our property developments.

The majority of our customers purchase our properties using mortgage financing. Under current PRC laws, the minimum down payment is 30% of the total purchase price for the purchase of the first self-use residential unit with total GFA of 90 square meters or more on all existing units and those yet to be completed, and a down payment of 20% on the first residential units for self use with total GFA of under 90 square meters. The loan-to-value of the mortgage loan is also subject to change according to the economic policies of the central and local governments and banks in China of where the applicants apply for the mortgage loan.

A typical sales transaction usually consists of three steps. First, the customer pays a deposit to us. Within seven days after paying the deposit, the customer will sign a purchase contract with us and make down payment to us in cash. After making the down payment, the customer arranges for a mortgage loan for the balance of the purchase price. Once the loan is approved, the mortgage loan proceeds are paid to us directly by the bank. Finally, we deliver the property to the customer. Legal title, as evidenced by a property ownership certificate issued by local land and construction bureaus, will be delivered to the customer in 12 months from the property delivery date.

As is customary in the property industry in China, we provide guarantees to mortgagee banks in respect of the mortgage loans provided to the purchasers of our properties up until completion of the registration of the mortgage with the relevant mortgage registration authorities. Guarantees for mortgages on residential properties are typically discharged when the individual property ownership certificates are issued. In our experience, the issuance of the individual property ownership certificates typically takes six to twelve months, so our mortgage guarantees typically remain outstanding for up to twelve months after we deliver the underlying property.

 

 

 

 

 

 

 

Our revenues are all derived from our sale of real estate. Real estate sales represent revenues from the sales of properties we developed. Sales tax is a one-time tariff which consists of a business tax at the rate of 5% on actual revenue. Our continuing practice is to recognize the sales tax on estimated revenue, and file tax return based on the actual result, as the local tax authority may exercise broad discretion in applying the tax amount. As a result, our accrual sales tax may differ from the actual tax clearance.

Total sales tax amounted to $503,158 and $39,944 for the three months ended June 30, 2010 and 2009, respectively, representing an increase of  1,159.6% from year to year, mainly because of the large increase of our revenue for the three months ended June 30, 2010 than in prior comparative period. Revenues increased by 2,144.9% to approximately $7.67 million for the three months ended June 30, 2010 from approximately $0.34 million for the three months ended June 30, 2009. The $7.33 million increase was mainly attributable to several reasons, including (1) the Company strengthened its advertising and sales promotion activities during the quarter ended June 30,  2010 than in prior comparative period; (2) the Company’s enhanced brand name and high quality product has won consumers’ confidence and trust; (3) the increase in local residents’ disposal income has stimulated the great market demand for new residential units in China’s Tier 2 and Tier 3 cities, where the Company is competing and focusing; (4) the Company has developed several new projects and sold to a wider variety of customers during the quarter, which has broadened the sales touch point with the buyers and exposed the Company to more sales opportunities. Among these new projects, sales of residential units in Yangzhou Pearl Garden continued to climb as this community became mature. For the three months ended June 30, 2010, total of 189 units of residential apartments, commercial shop-fronts as well as car parks from Yangzhou Pearl Garden were sold, generating 69.83% of the total revenue for the quarter ended June 30, 2010.  In addition, 68 units of commercial shop-fronts, car parks as well as residential apartments from Mingzhu Garden phase V has been sold which contributed 16% of the total sales revenue for the quarter ended June 30, 2010. Also, 31 units of car parks and commercial shop-fronts from Hanzhong Mingpin Project have been sold, which accounted for more than 14% of the total sales revenue for the quarter ended June 30, 2010; and (5) Revenue was much lower for the quarter ended June 30, 2009. This was because only 14 units of residential property in Mingzhu Garden phase IV were sold to customers at lower price (at approximately $221/per square meter). However, for the three months ended June 30, 2010, there were total of 288 units of residential and commercial property as well as car parks from Yangzhou Pearl Garden, Mingzhu Garden phase V  and Hanzhong Mingpin Project sold to customers at higher sales price (at approximately $448/per square meter for residential apartment and $593/per square meter for commercial shop-front).  Accordingly, sales revenue for the three months ended June 30, 2010 was much higher than prior comparative period.

 

 

 

 

 

 

Our cost of real estate sales consists primarily of the cost of land use rights and construction costs. Costs of real estate sales are capitalized and allocated to development projects using the specific identification method. Costs are recorded based on the ratio of the sales value of the relevant units completed and sold to the estimated total project sales value, multiplied by the total project costs.

Cost of sales was approximately $4.0 million for the three months ended June 30, 2010 compared to $0.15 million for the three months ended June 30, 2009. The $3.86 million increase in cost of sales was mainly attributable to the increased sales of our real estate property, especially the costs associated with the increased sales in Yangzhou Pearl Garden, Mingzhu Garden phase V and Hanzhong Mingpin Project. For the three months ended June 30, 2010, costs of sales was allocated based on sales of 288 residential or commercial units.  Cost of sales was much lower in the prior period due to much lower revenue recognized for the period because only 14 residential apartments were sold, and accordingly lower amount of costs has been allocated.

Land use rights costs

Land use rights costs include the premium we pay to acquire land use rights for our property development sites, plus taxes. Our land use rights costs vary 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. Our land use rights costs for the three months ended June 30, 2010 are $1,124,417, representing an increase of $1.1 million or 4,585% compared to the three months ended June 30, 2009. The increase in our land use rights costs was primarily because we allocated more of such costs to our cost of sales account based on our large increase of sales revenue for the three months ended June 30, 2010. For the three months ended June 30, 2010, we reported sales revenue from three projects, i.e. Yangzhou Pearl Garden, Mingzhu Garden Phase V, and Hanzhong Mingpin Project. However, for the same period in 2009, our revenue only came from the sales of 14 residential apartment at Mingzhu Garden Phase IV. Our land use rights costs was much lower in the three months ended June 30, 2009 because our sales revenue was lower for that period. For the past several years, our land use rights costs have been steadily increasing due to rising property prices in Hanzhong City and increased competition from other bidders at government land auctions. In order to control our costs and maintain our competitive advantage, we have been trying to acquire land use leases at favorable prices and keep as much the land reserve as we can whenever such opportunities emerge.

Construction costs

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, 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 ended June 30, 2010 were $2.89 million, representing an increase of $2.76 million or 2,088.1% compared to that of the three months ended June 30, 2009. The increase in our construction costs for the three months ended June 30, 2010 was primarily due to our increased sales revenue as well as increased raw material prices and direct labor costs as compared to the same period in 2009.

 

 

 

 

As a result of the above factors, the total cost of real estate sales increased by 2,471.6% or $3,861,964 to $4,018,218 for the three months ended June 30, 2010, compared to $156,254 of the three months ended June 30, 2009.  The total cost of sales as a percentage of revenue for the three months ended June 30, 2010 basically remains within a normal stable range as compared to that of the prior comparative period.

Gross Profit

Gross profit was approximately $3.65 million for the three months ended June 30, 2010 compared to $0.18 million for the three months ended June 30, 2009, an increase of $3.86 million attributed to our increased sales revenue. Our overall gross profit as a percentage of revenues decreased to 47.65% in the three months ended June 30, 2010 compared to 54.31% in the comparable period in prior year mainly due to our higher cost of sales incurred in line with the climbing revenue. The gross margin of our projects is normally in the range of 40% to 55%.

The following table sets forth the gross margin of each of our Projects for the indicated period: