NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1.
Organization and Basis of Presentation
Organization
China Industrial Steel inc. (“CIS”) was incorporated January 27, 2010 under the laws of the State of Maryland. On February 5, 2010, CIS formed a wholly-owned subsidiary, Northern Steel Inc. (“Northern”), under the laws of the State of Colorado to facilitate the Company’s operations in China.
On July 15, 2010, Northern formed its wholly owned foreign enterprise in Handan City, Hebei Province, China, Nuosen (Handan) Trading Co., Ltd (“Nuosen”), under the laws of China. Nuosen is a management company to manage operations in China.
Handan Hongri Metallurgy Co., Ltd. (“Hongri”) is a Chinese company located in Handan City, Hebei Province, China. Hongri was incorporated under the Chinese laws on March 7, 2007 with registered capital of Reminbi (“RMB”) 90,489,999 (approximately $12 million US dollars at historical exchange rate). Hongri is primarily engaged in the business of manufacturing and selling steel plates, steel bars, steel wires and steel billets for domestic customers and certain related parties.
Hebei Wu’an Yuanbaoshan Industry Group Co., Ltd (“YBS Group”) is an enterprise incorporated in Hebei province, China. YBS Group owns 70% equity interest of Hongri.
Fakei Investment (Hong Kong) Ltd (“Fakei”) is an enterprise incorporated in Hong Kong. Fakei owns 30% equity interest of Hongri.
On August 1, 2010, CIS, through Northern and its wholly owned foreign enterprise, Nuosen, entered into an Entrusted Management Agreement, an Exclusive Option Agreement, and a Covenants Agreement (collectively, the “Entrusted Agreements”) with Hongri and shareholders of Hongri, YBS Group and Fakei. The effect of the Entrusted Agreements is to cede control of management and economic benefits of Hongri to Nuosen. As consideration, CIS issued 44,083,529 restricted shares of its common stock, par value $0.0001, to Karen Prudente, a nominee and trustee of the shareholders of YBS Group for entering into the Entrusted Agreements with Nuosen. CIS also issued 17,493,463 restricted shares of its common stock to the shareholders of Fakei in consideration for Fakei entering into the Entrusted Agreements with Nuosen.
The Entrusted Agreements empower CIS, through Northern and Nuosen, with the ability to control and substantially influence Hongri’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholders’ approval. As a result of these Entrusted Agreements, which obligate CIS to absorb a majority of expected losses of Hongri and enable CIS to receive a majority of expected residual returns from Hongri and because CIS has the power to direct the activities of Hongri that most significantly impact Hongri’s economic performance, CIS, through its wholly-owned subsidiaries, accounts for Hongri as its Variable Interest Entity (“VIE”) under ASC 810-10-05-8A. Accordingly, CIS consolidates Hongri’s operating results, assets and liabilities.
On August 10, 2010, Mr. Shenghong Liu, the Chairman of the Board of Directors and one of the shareholders of YBS Group and several other shareholders of YBS Group (each of them, a “Purchaser”) have entered into call option agreements, (collectively, the “Call Option Agreements”), with the major shareholder, Karen Prudente, pursuant to which they are entitled to purchase up to 100% of the issued and outstanding shares from Karen Prudente at a price of $0.0001 per 100 shares for a period of five years as outlined in the Call Option Agreements: the options may be exercised, in whole or in part, in accordance with the following schedule: 34% of the option shares subject to the options shall vest and become exercisable on January 1, 2012; 33% of the option shares subject to the options shall vest and become exercisable on January 1, 2013 and 33% of the option shares subject to the options shall vest and become exercisable on January 1, 2014. The shareholders did not exercise these options as of the date of this report. According to the above mentioned Call Option Agreements, Karen Prudente would transfer all restricted shares of the Company’s common stock that she received to the shareholders of YBS Group subject to the terms and conditions thereunder and entrust the shareholders of YBS Group with her voting rights in the Company.
For accounting purposes, the above transactions were accounted for in a manner similar to a reverse merger or recapitalization, since the former equity shareholders of Hongri now effectively control a majority of CIS’ common stock immediately following the transactions. Consequently, the assets and liabilities and historical operations reflected in the consolidated financial statements prior to the transactions are those of Hongri and are recorded at the historical cost of Hongri, and the consolidated financial statements after completion of the transactions include the assets and liabilities of CIS, Northern, Nuosen, and Hongri (collectively, CIS or the “Company”), historical operations of Hongri, and operations of CIS, Northern, Nuosen and Hongri from the date of the transaction.
CIS through Hongri, its operating company in China, produces and sells steel plates, steel bars, steel wires and steel billets. The Company currently has an aggregate of 2.3 million metric tons steel making production capacity and 2.6 million metric tons of steel rolling production capacity per year from its headquarters on approximately 1,000 acres in Handan City, Hebei Province, China. Most of the Company’s products are domestically sold in China.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements include the accounts of the Company. All significant intercompany balances and transactions have been eliminated in consolidation.
The unaudited condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and reflect all adjustments (consisting of normal recurring adjustments unless otherwise indicated) which, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented.
Certain information in footnote disclosures normally included in the financial statements prepared in conformity with accounting principles generally accepted in the United States of America has been condensed or omitted pursuant to such principles and the financial results for the periods presented may not be indicative of the full year’s results. The Company believes the disclosures are adequate to make the information presented not misleading.
These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended December 31, 2012 included in the Company’s Annual Report on the Form 10K filed in April 2013.
2.
S
ummary
of Significant Accounting Policies
There have been no material changes during 2013 in the Companies’ significant accounting policies to these previously disclosed in the 2012 annual report. Only those policies considered to be most important to the reader have been disclosed in the quarterly Form 10-Q.
Accounts Receivable
Accounts receivable consists of balances due from customers for the sale of the Company’s steel products. Accounts receivable is recorded at the net realizable value consisting of the carrying amount less an allowance for uncollectible amounts.
The Company estimates the valuation allowance for anticipated uncollectible receivable balances after taking into consideration industry experience, the current economic climate and facts and circumstances specific to the applicable customer. Account balances are written-off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
Inventories
Inventories are stated at the lower of cost, as determined on a weighted average basis, or market. Costs of inventories include the purchase price and related manufacturing costs incurred in bringing the products to their present location and condition. Market value is determined by reference to selling prices or to management’s estimates based on prevailing market conditions. Management writes down the inventories to market value if it is below cost and also regularly evaluates the composition of its inventories to identify slow-moving and obsolete inventories to determine if a valuation allowance is required.
Advances to Suppliers and Related Parties
In order to ensure a steady supply of raw materials, the Company is required from time to time to make cash advances when placing its purchase orders. Management regularly evaluates the balance of advances and will record a reserve if necessary.
See Note 11 for advances to related parties in the normal course of business.
Advances from Customers
Customer advances consist of amounts received from customers relating to the sales of the Company’s steel products. The Company recognizes these funds as a current liability until the revenue can be recognized.
Foreign Currency Translation
The Company’s financial information is presented in U.S. dollars. The functional currency of the US parent company and US subsidiaries is the US dollar. The functional currency of the Company’s subsidiaries in the PRC is the RMB. Subsidiary transactions, 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 the RMB are included in statements of income as foreign currency transaction gain or loss.
The consolidated financial statements of the Company have been translated into U.S. dollars in accordance with ASC 830, “Foreign Currency Matters”. The financial information is first prepared in RMB and then is translated into U.S. dollars at period-end exchange rates for assets and liabilities and average exchange rates for 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 (loss) in stockholders’ equity.
The foreign exchange rates used in the translation were as follows:
|
|
|
Three Months Ended
|
|
|
Year Ended
|
|
|
|
|
March 31,
|
|
|
December 31,
|
|
|
|
|
2013
|
|
|
2012
|
|
|
2012
|
|
|
RMB/US$ exchange rate at the period end
|
|
|
0.1610
|
|
|
|
0.1588
|
|
|
|
0.1605
|
|
|
Average RMB/US$ exchange rate for the period
|
|
|
0.1607
|
|
|
|
0.1585
|
|
|
|
0.1585
|
|
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 flows from the Company’s operations are calculated based upon the local currencies using the average translation rate. As a result, amounts related to assets and liabilities reported on the statements of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheets.
Earnings Per Share
Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding during the period.
Diluted earnings per share is computed similarly to basic earnings per share except that it includes the dilutive securities (warrants) outstanding and potential dilution that could occur if dilutive securities were converted. Such securities (2,580,022 warrants at $4.50 per share and 1,000 warrants at $2.00 per share), had an anti-dilutive effect and, as such, were excluded from the calculation for all periods presented.
Risks and Uncertainties
The operations of the Company are located in the PRC. Accordingly, the Company’s business and financial condition may be influenced by the political, economic, and legal environments in the PRC, as well as by the general state of the PRC economy. The Company’s operations in the PRC 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, regulatory and social conditions in the PRC, and by changes in governmental policies or interpretations with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation. The current management team (specifically the CEO) of the Company and the majority owner of the Company through YBS are also the majority owners of the controlled variable interest entity in the PRC, Hongri. The US parent company (or CIS) only controls Hongri through certain agreements which obligated CIS to absorb a majority of expected losses of Hongri or enabled CIS to receive a majority residual returns from Hongri and granted CIS the power to direct the activities of Hongri that most significantly impact Hongri’s economic performance. As such, there is a risk that the majority shareholders of the Company and, or Hongri could cancel these agreements. If such action was to be taken, the Company would no longer retain control of Hongri, the operating subsidiary. Although the Company has not experienced losses from these risks and believes that they are in compliance with existing laws and regulations including the organization and structure disclosed in Note 1, this may not be indicative of future results.
The Company has significant exposure to the fluctuation of raw materials and energy. The Company does not enter into any commodity contracts or other financial derivatives to hedge these risks. In addition, the Company is subject to the cyclical nature of the steel industry and the current economic and political environment as it relates to steel production in China. There are many factors of the business which are impacted by prevailing market conditions, specifically, a change in the raw material and energy product pricing environment, rise or decline, will influence inventory levels, purchasing decisions and will, ultimately, all have an impact on the Company’s gross profit and operating results. Excessive steel production capacities, lack of demand for steel products and higher iron ore, coking coal and material costs are major challenges that the Chinese steel industry can occur and have begun to be encountered by the Company. In addition, a significant portion of the Company’s assets have been advanced to a related party supplier (see Note 11). These advances have been or are expected to be used to purchase raw materials for production of molten iron, which is a major raw material of the Company, equivalent to 11 weeks of cost of sales of the Company currently. In the event that the steel products market demand is lower, or there are further price reductions on raw materials already purchased, such asset could be impaired and/or the gross profit margin may be negatively impacted.
The Company provides credit in the normal course of business. Management continues to take appropriate actions to perform ongoing business and credit reviews of customers to reduce exposure to new and recurring customers who have been deemed to pose a high credit risk based on their commercial credit reports, the Company’s collection history, and perception of the risk posed by their geographic location. Concentration of credit risk with respect to accounts receivable is limited because a large number of geographically diverse customers make up the Company’s customer base.
The Company is potentially exposed to risks of losses that may result from business interruptions, injury to others (including employees) and damage to property. These losses may be uninsured, especially due to the fact that the Company’s operations are in China, where business insurance is not readily available. As of March 31, 2013, the Company has not experienced any uninsured losses from injury to others or other losses.
Recent Accounting Pronouncements
In February 2013, the FASB issued ASU 2013-02, Topic 220 – Comprehensive Income: Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“ASU 2013-02”). ASU 2013-02 changes the presentation requirements of significant reclassifications out of accumulated other comprehensive income in their entirety and their corresponding effect on net income. For other significant amounts that are not required to be reclassified in their entirety, the standard requires the company to cross-reference to related footnote disclosures. ASU 2013-02 became effective for the company on January 1, 2013. The adoption of this guidance did not have material effect on the Company’s consolidated financial statements.
In March 2013, the FASB issued ASU 2013-05 Topic 830 – Foreign Currency Matters (“ASU 2013-05”). ASU 2013-05 resolves the diversity in practice about whether Subtopic 810-10, Consolidation—Overall, or Subtopic 830-30, ASU 2013-05 applies to the release of the cumulative translation adjustment into net income when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business (other than a sale of in substance real estate or conveyance of oil and gas mineral rights)
within
a foreign entity. In addition, the amendments in this Update resolve the diversity in practice for the treatment of business combinations achieved in stages (sometimes also referred to as step acquisitions) involving a foreign entity. ASU 2013-02 became effective for the company prospectively for fiscal years (and interim reporting periods within those years) beginning after December 15, 2013. The Company does not expect the adoption of this guidance to have a material effect on the Company’s consolidated financial statements.
Bank notes receivable are highly liquid negotiable instruments issued by banks in the PRC on behalf of Hongri’s customers. These notes typically have maturities between one to six months. With these bank notes, The Company can: (a) redeem the notes for face value at maturity, (b) endorse the notes to the Company’s vendors as a form of payment instrument at full value, or (c) factor the notes to a bank. In the event that the Company factors these notes to a bank, it will record as interest expense the difference between cash received and the face value of the note. The Company believes all of the notes are fully realizable as of March 31, 2013 and December 31, 2012, respectively.
Accounts receivable at March 31, 2013 and December 31, 2012 consisted of the following:
|
|
|
2013
|
|
|
2012
|
|
|
Accounts receivable
|
|
$
|
16,536,687
|
|
|
$
|
9,880,791
|
|
|
Allowance for doubtful accounts
|
|
|
(778,067
|
)
|
|
|
(241,395
|
)
|
|
Accounts receivable, net
|
|
$
|
15,758,620
|
|
|
$
|
9,639,396
|
|
5.
Inventories
Inventories at March 31, 2013 and December 31, 2012 consisted of the following:
|
|
|
2013
|
|
|
2012
|
|
|
Raw materials
|
|
$
|
1,194,522
|
|
|
$
|
405,113
|
|
|
Finished products
|
|
|
12,213,227
|
|
|
|
5,919,991
|
|
|
Spare parts
|
|
|
5,359,576
|
|
|
|
5,260,173
|
|
|
Total
|
|
$
|
18,767,325
|
|
|
$
|
11,585,277
|
|
6.
Machinery and Equipment, Net
Machinery and equipment stated at cost less accumulated depreciation at March 31, 2013 and December 31, 2012 consisted of the following:
|
|
|
2013
|
|
|
2012
|
|
|
Machinery and equipment
|
|
$
|
275,733,264
|
|
|
$
|
262,788,674
|
|
|
Auxiliary facilities
|
|
|
3,068,638
|
|
|
|
3,059,109
|
|
|
Transportation equipment
|
|
|
571,995
|
|
|
|
570,219
|
|
|
Office equipment
|
|
|
43,563
|
|
|
|
43,428
|
|
|
Electronic equipment
|
|
|
58,885
|
|
|
|
58,702
|
|
|
Subtotal
|
|
|
279,476,345
|
|
|
|
266,520,132
|
|
|
Accumulated depreciation
|
|
|
(104,073,001
|
)
|
|
|
(96,960,996
|
)
|
|
Construction in progress
|
|
|
9,242,936
|
|
|
|
17,363,217
|
|
|
Total
|
|
$
|
184,646,280
|
|
|
$
|
186,922,353
|
|
7.
Restricted Cash
Restricted cash at March 31, 2013 and December 31, 2012 consisted of the following:
|
|
|
2013
|
|
|
2012
|
|
|
Bank deposit as part of collateral to bank notes payable
|
|
$
|
4,186,260
|
|
|
$
|
4,173,260
|
|
|
Bank deposit as part of collateral to working capital loan
|
|
|
1,610,100
|
|
|
|
1,605,100
|
|
|
Total
|
|
$
|
5,796,360
|
|
|
$
|
5,778,360
|
|
Restricted cash represents required cash deposits by the bank as a part of collateral to bank notes payable and working capital loan (see Note 9). The Company has to maintain 100% or 50% of the balance of the bank notes payable to ensure future credit availability. The Company earns interest at a variable rate per month on this restricted cash.
8.
Obligations Under Capital Leases – Related Parties
The Company accounts for its related party leases with YBS and its affiliates as capital leases under ASC 840 “Leases” because YBS has the ability to extend the length of the terms of all leases whenever they see fit. Therefore, the leases meet the requirement for capitalization of assets as the term is expected to be greater than 75% of the useful life of the asset. The terms of the leases were based on YBS’s costs and structured without significant built in profit. The value of the capitalized assets has been calculated to be the present value of all lease payments over the stated term using the Company’s bank borrowing rates. Should YBS extend any of the leases, the Company will re-calculate the value of the capitalized lease based on the renewed terms and record an additional asset upon the occurrence.
In December 2007, the Company entered into a lease agreement with YBS Group to lease 956 mu (approximately 157.5 acres) of land as its manufacturing site. The rent for the first three years was waived per lease agreement. The annual lease payment is $230,961 (RMB 1,434,450) which commenced in 2011. The average lease payment is $207,865 (RMB 1,291,005) per annum. The lease is set to expire on December 31, 2037. The present value of the total lease payments at inception was $2,045,334 (RMB 12,703,147 at the current exchange rate), which was calculated with a discount rate of 7.83%, a PRC long term borrowing rate in December 2007.
In November 2007, the Company entered into a lease agreement with YBS Group to lease the manufacturing building of Plate-Rolling I. The annual lease payment is $567,111 (RMB 3,522,211) commencing on January 1, 2008. The lease is set to expire on December 31, 2017. The present value of the total lease payments at inception was $3,834,714 (RMB 23,816,623 at the current exchange rate), which was calculated with a discount rate of 7.83%, a PRC long term borrowing rate in December 2007.
In November 2007, the Company entered into a lease agreement with Hongrong, a related party, to lease the manufacturing building of Steel-Making I. The annual lease payment is $194,937 (RMB 1,210,716) commencing on January 1, 2008. The lease is set to expire on December 31, 2017. The present value of the total lease payments at inception was $1,318,135 (RMB 8,186,666 at the current exchange rate), which was calculated with a discount rate of 7.83%, a PRC long term borrowing rate in December 2007.
In November 2009, the Company entered into a lease agreement with YBS Group to lease the manufacturing building of Steel-Making II. The annual lease payment is $17,304 (RMB 107,469) commencing on January 1, 2010. The lease is set to expire on December 31, 2019. The present value of the total lease payments at inception was $127,713 (RMB 793,198 at the current exchange rate), which was calculated with a discount rate of 5.94%, a PRC long term borrowing rate in December 2009.
In November 2009, the Company entered into a lease agreement with Hongrong to lease the manufacturing building of Bar-Rolling III. The annual lease payment is $122,127 (RMB 758,503) commencing on January 1, 2010. The lease is set to expire on December 31, 2019. The present value of the total lease payments at inception was $901,423 (RMB 5,598,552 at the current exchange rate), which was calculated with a discount rate of 5.94%, a PRC long term borrowing rate in December 2009.
As of March 31, 2013, future minimum rental payments applicable to the above non-cancelable capital leases with remaining terms in excess of one year were as follows:
|
March 31,
|
|
Capital Leases
|
|
|
2014
|
|
$
|
1,132,439
|
|
|
2015
|
|
|
1,132,439
|
|
|
2016
|
|
|
1,132,439
|
|
|
2017
|
|
|
1,132,439
|
|
|
2018
|
|
|
941,927
|
|
|
Thereafter
|
|
|
4,805,475
|
|
|
Total minimum lease payments
|
|
|
10,277,158
|
|
|
Less amount representing interest
|
|
|
(4,101,874
|
)
|
|
Present value of net minimum lease payments
|
|
|
6,175,284
|
|
|
Less current obligations
|
|
|
(663,216
|
)
|
|
Long-term obligations
|
|
$
|
5,512,068
|
|
9.
Bank Notes, Bank Loan Payable, Short Term Loan Payable – Related Party and Customer Financing
Bank Notes Payable
The bank notes payable do not carry a stated interest rate, but carry a specific due date usually within six months. These notes are negotiable documents issued by financial institutions on the Company’s behalf to vendors. These notes can either be endorsed by the vendor to other third parties as payment, or prior to becoming due, they can factor these notes to other financial institutions. These notes are short-term in nature, as such; the Company does not calculate imputed interest with respect to them. These notes are collateralized by the Company’s restricted bank deposits. The Company has to maintain 100% or 50% of the balance of the bank notes payable to ensure future credit availability.
Bank Loans Payable
Bank loans at March 31, 2013 and December 31, 2012 consisted of the following:
|
|
|
|
|
2013
|
|
|
2012
|
|
|
To Credit Union
|
|
|
|
|
|
|
|
|
|
Interest at 11.40%, payable September 24, 2013
|
|
(a)
|
|
$
|
3,059,190
|
|
|
$
|
3,049,690
|
|
|
Interest at 7.28%, payable April 7, 2013
|
|
(b)
|
|
|
3,059,190
|
|
|
|
3,049,690
|
|
|
To Raiffeisen Bank International AG Beijing Branch
|
|
|
|
|
|
|
|
|
|
|
|
Interest at 7.31%, due varied from January to February 2013
|
|
(c)
|
|
|
-
|
|
|
|
16,051,000
|
|
|
Interest at 7.31%, due varied from July to August 2013
|
|
(c)
|
|
|
16,101,000
|
|
|
|
-
|
|
|
To a ICBC Letter of Credit Loan
|
|
|
|
|
|
|
|
|
|
|
|
Interest at 0%, payable May 16, 2013
|
|
(d)
|
|
|
3,896,442
|
|
|
|
3,884,342
|
|
|
Interest at 6.44%, payable August 14, 2013
|
|
(e)
|
|
|
1,545,696
|
|
|
|
-
|
|
|
Total Short Term Bank Loans
|
|
|
|
$
|
27,661,518
|
|
|
$
|
26,034,722
|
|
|
|
(a) The Company borrowed $3,059,190 (RMB 19,000,000 translated at March 31, 2013 exchange rate) loan on September 25, 2012. The loan is a “working capital” loan that bears interest at 11.40% per annum and due on September 24, 2013. The loan is secured by the equipment of Hongrong, a related party.
|
|
|
(b) On October 8, 2012 the Company received a $3,059,190 (RMB 19,000,000 translated at March 31, 2013 exchange rate) short-term borrowing from Credit Union. The loan was a “working capital” loan that bears interest at 7.28% per annum and was due by April 7, 2013. The loan was secured by the equipment of Hongrong, a related party. On April 6, 2013, the Company repaid a $3,059,190 (RMB 19,000,000) short-term borrowing and borrowed same amount from Credit Union.
|
|
|
(c) On September 18, 2012, Hongri entered into a second amendment agreement (the “Amendment Agreement II”) with Raiffeisen Bank International AG Beijing Branch (“Raiffeisen”). The Amendment Agreement II provides for a revolving credit facility in an aggregate principal amount of $16,101,000 (RMB 100,000,000 translated at March 31, 2013 exchange rate) which is used as working capital only. Each borrowing could not exceed 180 days or days the Bank agreed during the Amendment Agreement period. The Amendment Agreement II is to be terminated on January 31, 2014.
|
Current loan balance of $16,101,000 (RMB 100,000,000 translated at March 31, 2013 exchange rate) was renewed from the end of January and the beginning of February 2013 and is due varied from July to August 2013.
Pursuant to the Amendment Agreement II, borrowings will bear interest at 130.6% of the benchmark rates of similar loans published by the People’s Bank of China. Current benchmark interest rate for a six months loan is 5.6% revised on July 6, 2012. The borrowing interest is 7.31% currently. The interest is calculated on the daily basis and shall be paid on the 20th of the last month of each quarter.
The borrowings are secured substantially by the following: all machinery and equipment of Hongri acquired before 2012. The net value of these machinery and equipment is approximately $159 million as of December 31, 2012, a security deposit of $1,610,100 (RMB 10,000,000) into the Raiffeisen bank as a collateral; corporate guaranty from YBS group, a majority shareholder of Hongri; and personal guaranty from Mr. Beifang Liu, Chairman of YBS group and Mr. Shenghong Liu, Chairman and Chief Executive Officer of the Company.
|
|
(d) On December 4, 2012, the Company borrowed a $3,896,442 (RMB 24,200,000 translated at March 31, 2013 exchange rate) short-term collateral loan from Industrial and Commercial Bank of China (“ICBC”). The loan is collaterated by a letter of credit in the same amount held by the Company, which is recorded as other assets in the balance sheet. The collateral loan is interest free and due by Mary 16, 2013.
|
|
|
(e) On February 26, 2013, the Company borrowed a $1,545,696 (RMB 9,600,000 translated at March 31, 2013 exchange rate) short-term loan from Industrial and Commercial Bank of China (“ICBC”). The loan is collaterated by a letter of credit in the same amount held by the Company, which is recorded as other assets in the balance sheet. The loan bears interest at 6.44% per annum and due by August 15, 2013.
|
Short Term Loan Payable – Related Party
On June 28, 2012, the Company borrowed $161,010 (RMB 1,000,000) from Mr. Beifang Liu, director of the Company, and $644,040 (RMB 4,000,000) from Mr. Maisheng Liu, brother of the CEO of the Company. These payables are interest free and due on demand.
The weighted average short term loan balance consisting of financial institution and Binchang Liu, Beifang Liu and Maisheng Liu loans was $5,589,548 and $9,084,274 for the three months ended March 31, 2013 and 2012, respectively. The weighted average interest rate for short term loan was 7.58% and 8.44% for the three months ended March 31, 2013 and 2012, respectively.
Customer financing
During 2012, the Company provided 100% credit guarantee to two major customers for them to get bank loans. These two customers then advanced cash receipt from the bank to the Company as a prepayment for the goods. The credit guarantee amounted to $31,718,970 (RMB 197,000,000 translated at March 31, 2013 exchange rate). The two customers’ bank loans are due in August 2013 but can be renewed upon mutual agreement.
Tax payables at March 31, 2013 and December 31, 2012 consisted of:
|
|
|
2013
|
|
|
2012
|
|
|
PRC corporation income tax
|
|
$
|
735,627
|
|
|
$
|
-
|
|
|
Other taxes payable
|
|
|
137,341
|
|
|
|
2,427
|
|
|
Total
|
|
$
|
872,968
|
|
|
$
|
2,427
|
|
See Note 13.
11.
Related Party Transactions
70% of the ownership interest of Hongri is owned by YBS Group, a major shareholder of certain other steel production related companies, mainly Hongrong Iron and Steel Co. Ltd. (“Hongrong”), Wu'an Baoye Coke Industrial Co. Ltd. (“Baoye”), Wu'an Yuanbaoshan Cement Plant (“Cement Plant”), Wu'an Yuanbaoshan Ore Treatment Plant (“Ore Treatment”), Wu'an Yuanbaoshan Industrial Group Go. Ltd - Gas Station and Wu’an Yeijin Iron Co. Ltd. (“Yeijin”). During the routine business process, Hongri purchases raw materials and supplies from these companies and advances to / or owes cash to these companies.
The relationships and the nature of related party transactions are summarized as follow:
|
Name of Related Party
|
|
Owned by YBS and
its major shareholders
|
|
Relationship
to Hongri
|
|
Nature of
Transactions
|
|
Hebei Wu'an Yuanbaoshan Industrial Group Co. Ltd. (“YBS Group”)
|
|
Self
|
|
70% parent
|
|
Services, information and public relationship, and coordination
|
|
Wu'an Yuanbaoshan Industrial Group Co. Ltd - Gas Station
|
|
|
100
|
%
|
Affiliated company
|
|
Supplier of gas
|
|
Wu'an Hongrong Iron & Steel Co. Ltd (“Hongrong”)
|
|
|
67
|
%
|
Affiliated company
|
|
Supplier of molten iron
|
|
Wu'an Baoye Coke Industrial Co. Ltd. (“Baoye”)
|
|
|
49
|
%
|
Affiliated company
|
|
Supplier of coke
|
|
Wu'an Yuanbaoshan Cement Plant
|
|
|
36
|
%
|
Affiliated company
|
|
Supplier of cement
|
|
Wu'an Yuanbaoshan Ore Treatment Plant
|
|
|
33
|
%
|
Affiliated company
|
|
Supplier of granular
|
|
Wu’an Yeijin Iron Co. Ltd
|
|
|
31
|
%
|
Affiliated company
|
|
Supplier of iron
|
Consolidation is required when an entity holds a controlling interest in another entity (often in the form of control through voting interests) or if the entity meets the requirements of a variable interest entity (“VIE”). The Company has no direct control of the affiliated companies, noted above, through voting interests. However, because the Company has a variable interest in some of these affiliated companies via the supply relationships noted above (i.e. implied relationships), the Company is required to determine whether such affiliates are VIE’s and, if so, whether the Company is the primary beneficiary so that consolidation must occur. A VIE has the following characteristics in accordance with ASC 810-10-15-14: insufficient equity investment at risk; equity lacking decision-making rights; equity with nonsubstantive voting rights; lacking the obligation to absorb an entity’s expected losses and lacking the right to receive an entity’s expected residual returns. The Company’s analysis concluded that such affiliates were not VIE’s because none of these characteristics are present.
As of March 31, 2013 and December 31, 2012, advances to related parties and accounts payable - related parties consisted of:
Advances to Related Parties
|
Name of related parties
|
|
2013
|
|
|
2012
|
|
|
Hongrong
|
|
$
|
138,301,241
|
|
|
$
|
183,633,559
|
|
|
Cement Plant
|
|
|
164,156
|
|
|
|
163,644
|
|
|
Total Advances to Related Parties
|
|
$
|
138,465,397
|
|
|
$
|
183,797,203
|
|
Accounts Payable - Related Parties
|
Name of related parties
|
|
2013
|
|
|
2012
|
|
|
Baoye
|
|
$
|
(2,533,605
|
)
|
|
$
|
(1,830,377
|
)
|
|
Ore Treatment
|
|
|
(3,191
|
)
|
|
|
(3,181
|
)
|
|
Total Accounts Payable - Related Parties
|
|
$
|
(2,536,796
|
)
|
|
$
|
(1,833,558
|
)
|
YBS Group is a parent company. It provides various services to the subsidiary companies, such as market and industrial information, public relationship, various government agents’ relationship, coordination of the production and purchase for subsidiaries and so on. YBS group charged a service fee based on applicable itemized expenses and fixed service fee. Commencing in 2010, YBS Group charged 0.1% of current year revenue of Hongri as a fixed service fee. Service fees consisted of management salaries, training, consultations, common areas charges and other fees. Management believes that 0.1% of revenue is a reasonable charge method. The Company estimated that this service fee would be similar or marginally higher if the same services had been provided by third parties. In addition to the fixed service fee, the Company will charge itemized services and expenses to the Company if such service and expenses are incurred. The total services fees were $260,674 and $177,083 for the three months ended March 31, 2013 and 2012, respectively. Among the 2013 services fees, $72,311 was an itemized expense in connection with the refinancing of $16 million loan from Raiffeisen Bank. Executive officers’ salaries were stand-alone expenses. Such expenses were $16,069 and $15,879 for three months ended March 31, 2013 and 2012, respectively.
Purchases from related parties
Hongri purchased raw materials from the above-mentioned related parties and had advances and accounts payable to these related parties in the routine business operations. It is a common practice in China that a vendor or supplier requires an advance payment before the shipment of merchandise. The Company’s advances to the related parties enable these related parties to pay partial amounts in advance to their vendors or suppliers. The Company is in favor of Hongrong as its primary molten iron supplier. It will reduce the transportation cost and steel making cost since Hongrong is located nearby Hongri. Hongrong has a new blast furnace with a capacity to supply all molten iron needs for the production of Hongri, However, due to that the new blast furnace is still in test stage and the quality of molten iron was not stable, the Company purchased partial of its irons from third parties in addition to purchase from Hongrong. The balance of advances to Hongrong was $138,301,241 and $183,633,559 as of March 31, 2013 and December 31, 2012, respectively. The amount advanced to Hongrong approximated to 11 weeks and 18 weeks purchase of molten iron used in production, respectively, as of March 31, 2013 and December 31, 2012.
Accounts payable to related parties represents an unsettled amount in the normal course of business. These payables were short term in nature. Total payable to related parties was $2,536,796 and $1,833,558 as of March 31, 2013 and December 31, 2012, respectively.
For the three months ended March 31, 2013, the Company purchased $106,125,715 (282,630 metric tons) molten iron and steel iron, $471,493 gas and $1,403,207 spare parts from Hongrong. For the three months ended March 31, 2012, the Company purchased $111,653,034 (257,896 metric tons) molten iron and steel iron and $4,986,606 gas and electricity from Hongrong.
The Company purchased $594,991 electricity from Baoye for the three months ended March 31, 2013.
Sales to related parties
During the three months ended in March 31, 2013 and 2012, the Company’s sales of its products to YBS Group amounted to $8,396,148 and $2,314,230, respectively. YBS acts as a distributor of steel products for the Company and all sales are final. The only right of return is for defective steel products and the Company has not experienced any returns in the past years of operations. The steel products are picked up directly by YBS’ customers at which time the Company recognizes the sale. The Company has determined these sales should be recorded on a gross basis based on the following analysis: upon shipment all risks of ownership transfer to YBS’ customers and the Company does not bare any additional risks and YBS has all of the collection risk from its customers.
During the three months ended March 31, 2013 and 2012, the Company sold $0 and $2,260,983, respectively, steel products to Hongrong, which were used in Hongrong’s blast furnace constructions. The Company also sold $1,796,158 and $1,005,580, respectively, by-products to Hongrong, which is to be re-used in manufacturing of molten iron.
Equipment purchased from related parties
See Note 12 Equipment Loans Payable – Related Parties.
Loan from related party
See Note 9 Bank Notes, Bank Loan Payable and Short Term Loan Payable – Related Party
Leases from related parties
See Note 8 Obligations Under Capital Lease – Related Parties
12.
Equipment Loans Payable – Related Parties
Equipment loan payables – related parties at March 31, 2013 and December 31, 2012 consisted of:
|
Equipment Loans Payable
|
|
2013
|
|
|
2012
|
|
|
Equipment loan - YBS Group payable
|
|
$
|
3,985,247
|
|
|
$
|
3,972,871
|
|
|
Less: current portion
|
|
|
(2,893,906
|
)
|
|
|
(2,884,919
|
)
|
|
Long-term payable
|
|
$
|
1,091,341
|
|
|
$
|
1,087,952
|
|
On November 30, 2007, the Company purchased Plate-Rolling I production line and related auxiliary equipment from YBS Group at a price of $26,208,524 (RMB 191,163,559 translated at the historical exchange rate), which was at cost, and carryover basis of YBS group. YBS Group provided a 10 year seller-financed loan to the Company to finance the purchase. The loan bears interest at 5% per annum, and has a fixed repayment schedule at $2,893,906 (RMB 17,973,455 at the March 31, 2013 exchange rate) per annum (payable at the end of the year). During 2012, the Company repaid $14,983,023 (RMB 94,518,192 translated at the 2012 average rate) equipment loan to YBS group by offsetting its previous advanced fund to YBS group. The remaining unpaid loan balance was $3,985,247 (RMB 24,751,549 translated at the March 31, 2013 exchange rate).
On November 30, 2009, the Company purchased Steel-Making II production line and related auxiliary equipment from YBS Group at a price of $35,718,399 (RMB 243,811,599 at the historical exchange rate), which was at cost, and carryover basis of YBS Group. YBS Group provided a 10 year seller-financed loan to the Company to finance the purchase. The loan bore interest at 5% per annum, and had a fixed repayment schedule at $3,913,233 (RMB 24,380,000 at the December 31, 2012 exchange rate) per annum (payable at the end of the year). During 2012, the Company repaid remaining balance of $27,054,862 (RMB 170,671,599 at the 2012 average exchange rate) in full by offsetting its previous advanced fund to YBS group.
On November 30, 2007, the Company purchased Steel-Making I production line and related auxiliary equipment from Hongrong at a price of $44,698,499 (RMB 326,028,440 translated at the historical exchange rate), which was at cost, and carryover basis of Hongrong. Hongrong provided a 10 year seller-financed loan to the Company to finance the purchase. The loan bore interest at 5% per annum, and had a fixed annual repayment schedule at $4,881,755 (RMB 30,414,021 at the December 31, 2012 exchange rate) per annum (payable at the end of the year). On March 31, 2012, the Company repaid the remaining $16,545,106 (RMB 104,372,354 at the 2012 average rate) by offsetting its current advanced fund to Hongrong.
Equipment loan interest paid to YBS group was $49,717 and $574,374 for the three months ended March 31, 2013 and 2012, respectively.
Equipment loan interest paid to Hongrong was $0 and $206,762 for the three months ended March 31, 2013 and 2012, respectively.
The provision for income tax arose from income tax incurred and or paid to the Chinese tax agent.
Hongri is subject to the PRC’s 25% standard enterprise income tax commencing on 2013. The income tax rate was 12.5%, 12.5%, 12.5%, 0% and 0% for 2012, 2011, 2010, 2009 and 2008, respectively, due to foreign investment enterprise exemption.
Nuosen is subject to the PRC’s 25% standard enterprise income tax.
Foreign pretax earnings were $2,237,204 and $5,990,494, respectively, for the three months ended March 31, 2013 and 2012. Pretax earnings of a foreign subsidiary are subject to U.S. taxation when effectively repatriated. The Company provides income taxes on the undistributed earnings of non-U.S. subsidiaries except to the extent that such earnings are indefinitely invested outside the United States. March 31, 2013, approximately $165,940,000 of accumulated unadjusted earnings of non-U.S. subsidiaries was indefinitely invested. At the existing U.S federal corporation income tax rate of 34%, an additional tax of $46,999,000 approximately would have to be provided if such earnings were remitted currently.
The following table reconciled the US statutory rates to the Company’s effective rate for the three months ended March 31, 2013 and 2012.
|
|
|
2013
|
|
|
2012
|
|
|
|
|
|
|
|
|
|
|
US statutory tax rate
|
|
|
34.0
|
%
|
|
|
34.0
|
%
|
|
Foreign income not recognized in US
|
|
|
-34.0
|
%
|
|
|
-34.0
|
%
|
|
China income tax rate
|
|
|
25.0
|
%
|
|
|
12.5
|
%
|
|
Non-deductible expenses
|
|
|
10.2
|
%
|
|
|
5.3
|
%
|
|
Effective rate
|
|
|
35.2
|
%
|
|
|
17.8
|
%
|
|
*
|
|
2013 Non-deductible expenses consists of:
|
|
|
|
|
|
|
|
|
a, 12.67% US GAAP adjustments not recognized by PRC tax authority;
|
|
|
|
|
b, 2.38% US operation loss;
|
|
|
|
|
|
|
|
|
|
|
|
c, 0.09% WOFE loss;
|
|
|
|
|
|
|
|
|
|
|
|
d, -4.94% recovered tax credit from previous loss
|
|
|
|
|
|
CIS and Northern were incorporated in the United States and have incurred net operating losses for income tax purposes in past years and the current period. As March 31, 2013, the Companies had loss carry forwards of approximately $1,932,000 for U.S. income tax purposes available for offset against future taxable U.S. income expiring in 2031 and 2032. Management believes that the realization of the benefits from these losses appears uncertain due to the Company's limited operating history. Accordingly, a full deferred tax asset valuation allowance has been provided and no deferred tax asset benefit has been recorded. The valuation allowance as of March 31, 2013 was approximately $657,000.
The Company did not have any significant temporary differences relating to deferred tax liabilities as of March 31, 2013 and December 31, 2012.
The Company files income tax returns with U.S. Federal Government and the states of Maryland and Colorado. With few exceptions, the Company is subject to U.S. federal and Maryland state income tax examinations by tax authorities for years on or after 2008 and for years on or after 2007 by Colorado tax authorities. The Company’s foreign subsidiaries also file income tax returns with the National Tax Bureau (with its branches in Handan) and other taxes and surcharges with the Local Tax Bureaus (Hebei Provincial Tax Bureau and Handan Municipal Tax Bureau). The Company is subject to tax examinations by these foreign tax authorities for years from 2008 to 2012.
The Company evaluated its tax positions, and as of March 31, 2013 and December 31, 2012. No uncertain tax position has been identified.
14.
Commitments and Contingencies
In the normal course of business, the Company is subject to contingencies, including legal proceedings and claims arising out of the normal course of businesses that relate to a wide range of matters, including among others, product liability. The Company records accruals for such contingencies based upon the assessment of the probability of occurrence and where determinable, an estimate of the liability. Management may consider many factors in making these assessments including past history, scientific evidence and the specifics of each matter.
During 2012, the Company provided 100% credit guarantee to two major customers for them to get bank loans. These two customers then advanced cash receipt from the bank to the Company as a prepayment for the goods. The credit guarantee amounted to $31,718,970 (RMB 197,000,000 translated at March 31, 2013 exchange rate). The two customers' bank loans will be due in August 2013 but can be renewed upon mutual agreement.
15.
Major Customers and Vendors
For three months ended March 31, 2013, 65% of the total Company’s purchase was from Hongrong, and 33% of the total purchase was from two unrelated parties (19% and 14%). For three months ended March 31, 2012, 75% of the total Company’s purchase was from Hongrong, and 24% of the total purchase was from an unrelated party.
For the three months ended March 31, 2013, there were two (2) major customers that accounted for approximately 40% of the Company’s total sales, 21% and 19%, respectively. For the three months ended March 31, 2012, there were two (2) major customers that accounted for approximately 42% of the Company’s total sales, 21% and 21%, respectively.
The Company operates in one industry segment and in one geographic region, which is the PRC. Revenues and costs of goods sold by major products for the three months ended March 31, 2013 and 2012 consisted of:
|
|
|
Three Months Ended March 31,
|
|
|
|
|
2013
|
|
|
2012
|
|
|
Revenues
|
|
Amount
|
|
|
Amount
|
|
|
Steel plates
|
|
$
|
94,496,510
|
|
|
$
|
64,296,735
|
|
|
Steel bars/steel wires
|
|
|
90,938,130
|
|
|
|
62,946,821
|
|
|
Steel billets
|
|
|
-
|
|
|
|
47,067,680
|
|
|
Byproducts and others
|
|
|
2,929,057
|
|
|
|
2,717,412
|
|
|
Total Revenues
|
|
$
|
188,363,697
|
|
|
$
|
177,028,648
|
|
|
Costs of Revenue
|
|
|
Amount
|
|
|
|
Amount
|
|
|
Steel plates
|
|
$
|
93,924,490
|
|
|
$
|
65,689,024
|
|
|
Steel bars/steel wires
|
|
|
88,627,570
|
|
|
|
59,609,340
|
|
|
Steel billets
|
|
|
-
|
|
|
|
42,308,554
|
|
|
Others
|
|
|
937,101
|
|
|
|
597,647
|
|
|
Total Cost of Revenue
|
|
$
|
183,489,161
|
|
|
$
|
168,204,565
|
|
|
Gross Profit Margin
|
|
|
%
|
|
|
|
%
|
|
|
Steel plates
|
|
|
0.61
|
%
|
|
|
-2.17
|
%
|
|
Steel bars/steel wires
|
|
|
2.54
|
%
|
|
|
5.30
|
%
|
|
Steel billets
|
|
|
-
|
|
|
|
10.11
|
%
|
|
Total Gross Profit Margin
|
|
|
2.59
|
%
|
|
|
4.98
|
%
|
|
Production Quantities
|
|
Metric Ton
|
|
|
Metric Ton
|
|
|
Steel plates
|
|
|
190,230
|
|
|
|
113,822
|
|
|
Steel bars/steel wires
|
|
|
185,788
|
|
|
|
110,635
|
|
|
Steel billets
|
|
|
-
|
|
|
|
85,602
|
|
|
Total Metric Tons
|
|
|
376,018
|
|
|
|
310,059
|
|
17. Subsequent Events
On April 6, 2013, the Company repaid a $3,059,190 (RMB 19,000,000) short-term borrowing and borrowed same amount from Credit Union.