China Xuefeng Environmental Earnings 2018-11-30

Form 10-Q

or

Commission File Number: 333-175483

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

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

Large accelerated filer	☐		Accelerated filer	☐
Non-accelerated filer	☐	(Do not check if a smaller reporting company)	Smaller reporting company	☒
			Emerging growth company	☐

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION
	Page
Item 1. Financial Statements.	1
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.	27
Item 3. Quantitative and Qualitative Disclosures About Market Risk.	34
Item 4. Controls and Procedures.	35
PART II – OTHER INFORMATION
Item 1. Legal Proceedings.	36
Item 1A. Risk Factors.	36
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds.	36
Item 3 Defaults Upon Senior Securities.	36
Item 4. Mine Safety Disclosures.	36
Item 5. Other Information.	36
Item 6. Exhibits.	37
Signatures	38

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See accompanying notes to the consolidated financial statements.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES

 

See accompanying notes to the consolidated financial statements.

	Three Months Ended, November 30,									Six Months Ended, November 30,
	2018				2017					2018			2017
Revenue:
Sales		$	2,781,860			$	1,811,796			$	5,554,445			$	3,144,732
Lease income			999,127				948,442				2,033,590				1,834,534
Total revenue			3,780,987				2,760,238				7,588,035				4,979,266
Cost of goods sold:
Cost of sales			1,136,888				126,987				2,307,568				267,435
Depreciation expense - leased equipment			479,082				458,868				975,109				887,659
Total cost of goods sold			1,615,970				585,855				3,282,677				1,155,094
Gross profit	2,165,017				2,174,383						4,305,358				3,824,172
Operating expenses:
Selling and marketing			278,968				252,662				574,575				429,568
General and administrative	280,714				281,625						570,489				522,286
R&D Expense	-				374,841										374,841
Total operating expenses	559,682				909,128						1,145,064				1,326,695

See accompanying notes to the consolidated financial statements.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES

 

See accompanying notes to the consolidated financial statements.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES

 

See accompanying notes to the consolidated financial statements.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES

		For the Six Months Ended November 30,
		2018				2017
Net increase in cash			5,220,449				9,101,672
Cash, beginning			17,559,007				10,343,963
Cash, end		$	22,779,456			$	19,445,635
Supplemental disclosure of cash flow information
Income taxes paid		$	846,554			$	935,701
Land appreciation tax paid		$	2,949			$	2,995
Supplemental disclosure of non-cash activities
Property, equipment, equipment construction in process		$	-			$	9,120,991
Payment of accrued liabilities by shareholder		$	28,890			$	29,826

 

See accompanying notes to the consolidated financial statements.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES

China Xuefeng Environmental Engineering Inc. (the "Company"), formerly known as NYC Moda Inc., was incorporated under the laws of the State of Nevada on March 30, 2011.  Since its inception until the closing of the Exchange Agreement, the Company was a development-stage company.

On November 27, 2012, the Company completed a reverse acquisition transaction through a share exchange with the stockholders of Inclusion Business Limited ("Inclusion"), whereby the Company acquired 100% of the outstanding shares of Inclusion in exchange for 7,895,000 shares of its common stock, representing 76.65% of the issued and outstanding shares of common stock.  As a result of the reverse acquisition, Inclusion became the Company's wholly-owned subsidiary and the former Inclusion Stockholders became our controlling stockholders.  The share exchange transaction was treated as a reverse acquisition, with Inclusion as the acquirer and the Company as the acquired party for accounting purposes.

In November, 2012, the Company filed a certificate of amendment to its articles of incorporation to change its name from "NYC Moda, Inc." to "China Xuefeng Environmental Engineering Inc." (the "Name Change") and to initiate a 4-for-1 forward stock split (the "Forward Split") of its outstanding shares of common stock. The Name Change and the Forward Split were effective in December, 2012. Upon the effectiveness of the Forward Split, the number of outstanding shares of the Company's common stock increased from 10,300,000 to 41,200,000 shares. In March, 2013, the Company sold 14,000,000 shares of common stock to 12 unrelated individuals in a private offering, generating $7,000,000 in net proceeds.

As a result of the transaction with Inclusion, the Company owns all of the issued and outstanding common stock of Lotus International Holdings Limited ("Lotus"), a wholly-owned subsidiary of Inclusion, which in turn owns all of the issued and outstanding capital stock of Baichuang Information Consulting (Shenzhen) Co. Ltd ("Baichuang Consulting"). In addition, the Company effectively and substantially controls Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng") through a series of captive agreements with Baichuang Consulting.

The Company conducts its operations through its controlled consolidated variable interest entity ("VIE"), Jiangsu Xuefeng.  Jiangsu Xuefeng, incorporated under the laws of the People's Republic of China ("PRC") in December, 2007, is primarily engaged in the sale, lease and installation of garbage recycling equipment and provides improvement and upgrading services of garbage recycling processing technology and equipment. 

In October 2012, Baichuang Consulting (the "WFOE"), a wholly-owned subsidiary of Lotus, entered into a series of contractual arrangements (the "VIE Agreements"). The VIE Agreements include (i) an Exclusive Technical Service and Business Consulting Agreement; (ii) a Proxy Agreement, (iii) Share Pledge Agreement and, (iv) Call Option Agreement with the stockholders of Jiangsu Xuefeng

Exclusive Technical Service and Business Consulting Agreement: Pursuant to the Exclusive Technical Service and Business Consulting Agreement, the WFOE provides technical support, consulting, training, marketing and operational consulting services to Jiangsu Xuefeng. In consideration for such services, Jiangsu Xuefeng has agreed to pay an annual service fee to the WFOE of 95% of Jiangsu Xuefeng's annual net income and an additional payment of approximately US$15,910 (RMB100,000) each month. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.

NOTE 1.   ORGANIZATION (CONTINUED)

Proxy Agreement: Pursuant to the Proxy Agreement, the stockholders of Jiangsu Xuefeng agreed to irrevocably entrust the WFOE to designate a qualified person acceptable under PRC law and foreign investment policies, to oversee all of the equity interests in Jiangsu Xuefeng held by the stockholders of Jiangsu Xuefeng. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.

Call Option Agreement: Pursuant to the Call Option agreement, the WFOE has an exclusive option to purchase, or to designate a purchaser, to the extent permitted by PRC law and foreign investment policies, part or all of the equity interests in Jiangsu Xuefeng held by each of the stockholders. To the extent permitted by PRC laws, the purchase price for the entire equity interest is approximately US$0.16 (RMB1.00) or the minimum amount required by PRC law or government practice. This Agreement remains effective until all the call options under the Agreement have been exercised by Baichuang Consulting or its designated entities or natural persons.

Share Pledge Agreement: Pursuant to the Share Pledge agreement, each of the stockholders pledged their shares in Jiangsu Xuefeng to the WFOE, to secure their obligations under the Exclusive Technical Service and Business Consulting Agreement. In addition, the stockholders of Jiangsu Xuefeng agreed not to transfer, sell, pledge, dispose of or create any encumbrance on their interests in Jiangsu Xuefeng that would affect the WFOE's interests. This Agreement remains effective until the obligations under the Exclusive Technical Service and Business Consulting Agreement, Call Option Agreement and Proxy Agreement have been fulfilled or terminated.

On January 19, 2016, the VIE structure was terminated upon Baichuang Consulting exercising its option to purchase all of the registered equity of Jiangsu Xuefeng.  Baichuang Consulting became the sole owner of Jiangsu Xuefeng.

On August 4, 2016, Baichuang Information Consulting Co., Ltd ("Baichuang Information") entered into an agreement with Mr. Li Yuan, the sole shareholder of Linyi County Xuefeng Renewable Resources Utilization Technology Co., Ltd ("Linyi Xuefeng"), to purchase his 100% ownership of Linyi Xuefeng. Mr. Li Yuan is the Chief Executive Officer and main shareholder of the Company. The purchase price was determined by the audited net assets of Linyi Xuefeng as of May 31, 2016, initially with a payment of RMB10,000,000 ($1,500,000 US) in cash and the balance to be paid in common shares of China Xuefeng at 75% of the closing price on August 4, 2016. On October 7, 2016, a supplementary agreement was entered between both parties to finalize the purchase based upon the audited net asset value of $ 23,462,612 on May 31, 2016. The supplementary agreement eliminated the cash payment making the entire purchase with stock of the Company. The price utilized was $3 per share and 7,820,871 shares were issued to Mr. Li Yuan.

 

NOTE 1.   ORGANIZATION (CONTINUED)

     

Linyi Xuefeng was officially approved and incorporated under the laws of the People's Republic of China ("PRC") in June 2013. Mr. Yuan Li was the sole owner since inception. Linyi Xuefeng constructed a garbage processing plant which commenced operations in February 2018. Previously Linyi Xufeng received non-operating revenue, which was a subsidy received from the government for the city pollution garbage processing plant construction.

On October 30, 2017, the Company completed a closing of a private placement offering (the "Offering") of shares of the Company's common stock, par value $0.001 per share (the "Shares"), at a purchase price of RMB 13.275, or US$2.00 per share, based on the currency exchange rate of 6.6375 on October 27, 2017, for an aggregate purchase price of RMB 46,462,500, or approximately $7,000,000. Upon the closing, the Company issued a total of 3,500,000 shares of its common stock to the subscribers in the Offering.

As a result of the entry into the foregoing agreements, the Company has a corporate structure which is set forth as follows:

BASIS OF ACCOUNTING AND PRESENTATION

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (CONTINUED)

BASIS OF ACCOUNTING AND PRESENTATION  (CONTINUED)

The acquisition of Linyi Xuefeng was treated as a combination of entities under common control as Mr. Li Yuan was the chief executive officer, a major shareholder and had voting control of both companies. An acquisition of an entity under common control is treated similar to a "pooling of interest." Accordingly, the financial statements of the Company have been restated and include the historical balances of Linyi Xuefeng as if the acquisition occurred on the first day of the earliest period presented.

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.

FOREIGN CURRENCY TRANSLATION

The exchange rates used to translate amounts in RMB into US dollars for the purposes of preparing the financial statements are as follows:

 

		November 30, 2018				May 31, 2018				November 30, 2017
		(Unaudited)								(Unaudited)
Balance sheet items, except for stockholders' equity, as of periods end			0.1437				0.1560				0.1512
Amounts included in the statements of income, statements of changes in stockholders' equity and statements of cash flows for three months			0.1500				N/A				0.1514
Amounts included in the statements of income, statements of changes in stockholders' equity and statements of cash flows for six months			0.1474				N/A				0.1497

 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

FOREIGN CURRENCY TRANSLATION (CONTINUED)

For the three months ended November 30, 2018 and 2017, foreign currency translation adjustments of $(1,267,390) and $(162,023), respectively, and for the six months ended November 30, 2018 and 2017, foreign currency translation adjustments of $(5,706,904) and $1,748,560, respectively, have been reported as other comprehensive (loss) income. Other comprehensive (loss) income of the Company consists entirely of foreign currency translation adjustments.  Pursuant to ASC 740-30-25-17, "Exceptions to Comprehensive Recognition of Deferred Income Taxes," the Company does not recognize deferred U.S. taxes related to the undistributed earnings of its foreign subsidiaries and, accordingly, recognizes no income tax expense or benefit from foreign currency translation adjustments.

Although government regulations now allow convertibility of the RMB for current account transactions, significant restrictions still remain.  Hence, such translations should not be construed as representations that the RMB could be converted into US dollars at that rate or any other rate.

The value of the RMB against the US dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC's political and economic conditions.  Any significant revaluation of the RMB may materially affect the Company's financial condition in terms of US dollar reporting.

REVENUE RECOGNITION

The ASU requires the use of a new five-step model to recognize revenue from customer contracts.  The five-step model requires that the Company (i) identify the contract with the customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, including variable consideration to the extent that it is probable that a significant future reversal will not occur, (iv) allocate the transaction price to the respective performance obligations in the contract, and (v) recognize revenue when (or as) the Company satisfies the performance obligation.  The application of the five-step model to the revenue streams compared to the prior guidance should not result in significant changes in the way the Company records its revenue.  Upon adoption, the Company evaluated its revenue recognition policy for all revenue streams within the scope of the ASU under previous standards and using the five-step model under the new guidance and confirmed that there were no material differences in the pattern of revenue recognition.

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

        

REVENUE RECOGNITION (CONTINUED)

Revenues are primarily derived from the operation of a garbage processing plant, selling and leasing garbage processing equipment, providing garbage recycling processing system technology support, renovation and upgrade services and patent licensing to customers.  The Company's revenue recognition policies comply with FASB ASC 605 "Revenue Recognition."  In general, the Company recognizes revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the products or services have been delivered or performed and collectability of the resulting receivable is reasonably assured.

Improvement and upgrading service is a one-time service provided to upgrade customer's existing equipment before they opt to license and use our patented technology. The fee for the service would be paid within thirty (30) days upon execution of the contract.

Inspection would be conducted by the customers according to industry standards within three days upon completion of the improvement and upgrading service. Performance testing would then be conducted on the upgraded equipment, which typically can be done within a month. A final inspection assessment report would be provided to the customers within five days upon completion of the testing and Customers would provide the Company with a signed acceptance form if they are satisfied. The Company will recognize the revenue for the improvement and upgrading service once the performance testing is passed and the final evaluation report is provided by the customer.

Patent licensing is limited to five (5) years with payments due annually in advance and recognized as revenue monthly. We are responsible to provide repairing service when necessary, but customers would bear any out of pocket expense relating to the repairing service.

We believe that lease receivables have four potential risks: operation risk, credit risk, accident risk and natural disasters risk.

First, there is no guarantee that the licensee of our patent will have sufficient capital resources to perform the licensing agreement and pay the licensing fee on time or at all. The length of the agreement is up to five (5) years and therefore the Company may not able to collect fees for the entire agreement. Second, there is a potential credit risk for which the licensee may unilaterally terminate the agreement and thus affect the payout of the licensing agreement. Third, an accident involving the equipment caused by employees of the licensee may have material adverse effect on the operation of the licensee. This unforeseeable risk could impact the licensee's ability to perform throughout the length of the agreement. Lastly, unforeseeable natural disasters could have a material adverse effect on the production and operation of the Company's licensees. If their operation is impacted by events such as fire, flood or earthquakes, they may need to cease their operation and therefore may be unable to perform their obligations under the agreement.

Linyi Xuefeng's revenues are primarily derived from selling organic manure, hollow brick, wood plastic tray and ferrous metal. It's income also relates to government for city pollution garbage processing system constructions.  Government subsidies are recognized as earned when grant expenses are incurred up to the maximum amount allowed for each grant award.

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

       

REVENUE RECOGNITION (CONTINUED)

Sales-Type Leases

The Company entered into three sales-type lease arrangements during the three months ended November 30 2015, with two customers for financing of their purchase of garbage processing equipment. The arrangements with the customers have a fixed term of three years.  Revenue from the sale of the equipment is recognized at the inception of the lease.  The payments have been present valued with an annual interest rate of 5.25%.  In connection with these arrangements, the Company recognized no revenue for the three and six months ended November 30, 2018 and 2017.  No residual collections balance as of November 31, 2018.

Operating Leases

The Company entered into multiplelease arrangements with customers for garbage processing equipment. The arrangements with a fixed term of five years with payments due quarterly with deposit payments equivalent to one year leasing fee. Revenue from the leasing of the equipment is recognized monthly. At the end of each of the five year lease terms, it will be determined whether the lease will be extended, leased to a new customer or returned to the Company. Future minimum payments for the years ending May 31 are as follows:

     

Multiple-Element Arrangements

 

In October 2009, the FASB issued Accounting Standards Update ("ASU") No. 2009-13, "Multiple Deliverable Revenue Arrangements." ASU No. 2009-13 amended the guidance on arrangements with multiple deliverables under ASC 605-25, "Revenue Recognition—Multiple-Element Arrangements."  To qualify as a separate unit of accounting under ASC 605-25, the delivered item must have value to the customer on a standalone basis.  The significant deliverables under the Company's multiple-element arrangements are improvement and upgrade services and patent licensing.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Multiple-Element Arrangements (Continued)

Improvement and Upgrade Service

The improvement and upgrade service is a one-time service.  By the end of improvement and upgrading services, there is persuasive evidence that an arrangement exists since the Company has a signed contract with a customer; delivery has occurred and a customer has completed inspection and accepted the improvement and upgrading services then delivered; the fee is fixed and become due within 30 days upon the signing of the contract; and collectability is probable. An inspection is conducted by the customer according to industry standards within three days of the completion of the improvement and upgrade.  An acceptance form is provided by the customer if the inspection is satisfactory.  Performance testing is conducted on the upgraded equipment within one month. A final evaluation report is provided within five days of the completion of the performance testing.  The fee for improvement and upgrade services is fixed and becomes due within 30 days, upon the signing of the contract.  The fees for the improvement and upgrading services are not subject to refund, forfeiture or any other concession if patent licensing is not completed.

The Company has met the agreed upon specifications and has not been required to make any refunds for its services.  No warranty is provided by the Company.

The customer is responsible for repair services when necessary.  The out of pocket expenses for the repair services will be charged separately to the customer by the Company.

Patent Licensing

Patent licensing is limited to 5 years with payments due annually in advance.  The patent technology of "harmless and comprehensive garbage processing equipment" provided by the Company to its customers has high garbage processing capacity and stable operation capacity.  It is the first modern system equipment in China to use DCS (Distributed Control System) centralized control, by which mechanical automation will be realized for the comprehensive treatment of life garbage.  Its core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization, with a utilization rate approaching 100%.  The resource recovery products, biogas, not only can be used for meeting the needs of the plant itself, but also can be sold as a separate product, which greatly improves the efficiency of garbage processing of the customer's equipment, decreases production cost, and increases the recovery return of garbage processing.

The Company's customer who pays for an upgrade and improvement fee is not required to enter into a licensing agreement to continue to use the patented technology.  If the customer does not require the garbage processing equipment to reach the level of the patented technology which can process 500 tons to 1,000 tons of garbage per day, then the customer does not need to enter into the patent licensing agreement.

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION (CONTINUED)

Multiple-Element Arrangements (Continued)

Multiple Elements

The Company determined that its improvement and upgrade services are individually a separate unit of accounting.  In determining whether the improvement and upgrade services has standalone value, the Company considered factors including the availability of similar services from other vendors, its fee structure based on inclusion and exclusion of the service, and its marketing and delivery of the services.  The Company uses the vendor-specific objective evidence to determine the selling price for its improvement and upgrade services when sold in multiple-element arrangements.  Although not yet being sold separately, the price established by the management has the relevant authority.

The Company also determined that the patent licensing has standalone value because the patent can be licensed separately. The Company uses the vendor-specific objective evidence to determine the price for patent licensing when sold in multiple-element arrangements.  Although not yet being licensed separately, the price established by the management has the relevant authority.  The Company establishes the price of upgrading and improvement service and the price of patent licensing is determined based on the following method:

Since equipment improvement and upgrade services and patent leasing services are derived from the Company's patented technology, which the Company has the exclusive right to while others must obtain licensing rights to use the technology, the Company has a strong bargaining power in the market to undertake the promotion of its brand and corporate image. Furthermore, the Company uses a profit cost pricing method to determine the price of its product. The Company calculates the price by adding its target profit, or a 90% gross profit margin, to the base product cost to derive the final sale price of its services.

The Company allocates the arrangement consideration based on their relative selling prices.  Revenues for the improvement and upgrade services are recognized when completed, the performance testing is passed and the final evaluation report is provided by the customer, which generally is within 30 days, assuming all other revenue recognition criteria are met.  Revenues for patent licensing are recognized monthly over the licensing period.

The Company believes the effect of changes in the selling price for improvement and upgrade services and patent licensing will not have significant effect on the allocation of the arrangement.

  

CASH AND CASH EQUIVALENTS

The Company considers all demand and time deposits and all highly liquid investments with an original maturity of three months or less to be cash equivalents.

 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

FAIR VALUE OF FINANCIAL INSTRUMENTS

FASB ASC 820, "Fair Value Measurement," defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability.  The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity.

ASC 820 requires the use of observable market data, when available, in making fair value measurements.  When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement. Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.  As of November 30, 2018 and May 31, 2018, none of the Company's assets and liabilities were required to be reported at fair value on a recurring basis.  Carrying values of non-derivative financial instruments, including cash, accounts receivable, prepaid VAT, accounts payable and accrued expenses, and deferred revenue approximate their fair values due to the short term nature of these financial instruments.  There were no changes in methods or assumptions during the periods presented.

FIXED ASSETS AND LEASE EQUIPMENT

Fixed assets are recorded at cost, less accumulated depreciation.  Cost includes the price paid to acquire the asset, and any expenditures that substantially increase the asset's value or extends the useful life of an existing asset.  Depreciation is computed using the straight-line method over the estimated useful lives of the assets.  Major repairs and betterments that significantly extend the original useful life or improve productivity are capitalized and depreciated over the periods benefited.  Maintenance and repairs are generally expensed as incurred.  The estimated useful lives for fixed asset categories are as follows:

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

    

IMPAIRMENT OF LONG-LIVED ASSETS

The Company applies FASB ASC 360, "Property, Plant and Equipment," which addresses the financial accounting and reporting for the recognition and measurement of impairment losses for long-lived assets.  In accordance with ASC 360, long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  The Company may recognize the impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to those assets.  No impairment of long-lived assets was recognized for the periods presented.

DEFERRED REVENUE

Deferred revenue is advance payments received for patent licensing fees and received from the government for city pollution garbage processing system constructions.  These payments received, but not yet earned, are recognized as deferred revenue in the consolidated balance sheets.

INCOME TAXES

The Company accounts for income taxes in accordance with FASB ASC 740, "Income Taxes" ("ASC 740"), which requires the recognition of deferred income taxes for differences between the basis of assets and liabilities for financial statement and income tax purposes.  Deferred tax assets and liabilities represent the future tax consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. During the year ended May 31, 2015, as permitted by the PRC tax law, the Company began recognizing revenue from patent licensing fees for income tax purposes, based on when it is earned rather than when it is collected, consistent with the financial statement recognition.  As a result, there are no differences between the basis of assets and liabilities for financial statements and income tax purposes for deferred revenue and, as a result, deferred income taxes are no longer required to be recognized. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized.

ASC 740 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements.  Under ASC 740, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position would be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.  ASC 740 also provides guidance on de-recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, and accounting for interest and penalties associated with tax positions.  As of November 30, 2018 and May 31, 2018, the Company does not have a liability for any unrecognized tax benefits.

 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

INCOME TAXES(CONTINUED)

The income tax laws of various jurisdictions in which the Company and its subsidiaries operate are summarized as follows:

United States

On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the "Act") was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a U.S. corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017. On December 22, 2017, Staff Accounting Bulletin No. 118 ("SAB 118") was issued to address the application of US GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Act.  The Company believes there is no tax due under the Act as of November 30, 2018.

PRC

Jiangsu Xuefeng and Baichuang Consulting are subject to an Enterprise Income Tax at 25% and file their own tax returns.  Consolidated tax returns are not permitted in China.

BVI

Inclusion is incorporated in the BVI and is governed by their income tax laws.  According to current BVI income tax law, the applicable income tax rate for the Company is 0%.

Hong Kong

Lotus is incorporated in Hong Kong.  Pursuant to the income tax laws of Hong Kong, the Company is not subject to tax on non-Hong Kong source income.

ADVERTISING COSTS

Advertising costs are charged to operations when incurred.  For the three months ended November 30, 2018 and 2017, advertising expense was $130,386 and $136,255 respectively. For the six months ended November 30, 2018 and 2017, advertising expense was $265,384 and $269,549, respectively.

STATUTORY RESERVE FUND

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

VALUE ADDED TAX ("VAT")

All China-based enterprises are subject to a VAT imposed by the PRC government on their domestic product sales.  The output VAT is charged to customers who purchase goods from the Company and the input VAT is paid when the Company purchases goods from its vendors. Input VAT rates are 16% for the purchasing activities conducted by the Company. Output VAT rate is 16% for all products.  The input VAT can be offset against the output VAT.  The VAT payable will be presented on the balance sheets when input VAT is less than the output VAT.  Recoverable balance will be presented on the balance sheets when input VAT is larger than the output VAT.

In September 2017, the FASB issued ASU 2017-13, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842). The main objective of this pronouncement is to clarify the effective date of the adoption of ASC Topic 606 and ASC Topic 842 and the definition of public business entity as stipulated in ASU 2014-09 and ASU 2016-02. ASU 2014-09 provides that a public business entity and certain other specified entities adopt ASC Topic 606 for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. All other entities are required to adopt ASC Topic 606 for annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019. ASU 2016-12 requires that "a public business entity and certain other specified entities adopt ASC Topic 842 for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. All other entities are required to adopt ASC Topic 842 for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020". ASU 2017-13 clarifies that the SEC would not object to certain public business entities electing to use the non-public business entities effective dates for applying ASC 606 and ASC 842. ASU 2017-13, however, limits such election to certain public business entities that "otherwise would not meet the definition of a public business entity except for a requirement to include or inclusion of its financial statements or financial information in another entity's filings with the SEC". The Company expects that the adoption of this ASU will not have a material impact on its financial statements.

NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS  (CONTINUED)

In February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220). The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. Consequently, the amendments eliminate the stranded tax effects resulting from the Tax Cuts and Jobs Act and will improve the usefulness of information reported to financial statement users. However, because the amendments only relate to the reclassification of the income tax effects of the Tax Cuts and Jobs Act, the underlying guidance that requires that the effect of a change in tax laws or rates be included in income from continuing operations is not affected. The amendments in this update also require certain disclosures about stranded tax effects. The guidance is effective for fiscal years beginning after December 15, 2018 with early adoption permitted, including interim periods within those years. The Company expects that the adoption of this ASU will not have a material impact on its financial statements.

In June 2018, the FASB issued ASU No. 2018-07, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, or ASU 2018-07. ASU 2018-07 simplifies the accounting for share-based payments made to nonemployees so the accounting for such payments is substantially the same as those made to employees. Under this ASU, share based awards to nonemployees will be measured at fair value on the grant date of the awards, entities will need to assess the probability of satisfying performance conditions if any are present, and awards will continue to be classified according to Accounting Standards Codification ("ASC") 718 upon vesting which eliminates the need to reassess classification upon vesting, consistent with awards granted to employees. This ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company expects that the adoption of this ASU will not have a material impact on its financial statements.

The Company believes that other recent accounting pronouncement updates will not have a material effect on the Company's consolidated financial statements.

Fixed assets are summarized as follows:

 

NOTE 4.   FIXED ASSETS (CONTINUED)

For the three months ended November 30, 2018 and 2017, depreciation expense was $597,104  and $27,005  respectively. For the six months ended November 30, 2018 and 2017, depreciation expense was $1,216,610  and $53,711 respectively.

Building and improvements and production facilities include approximately $34 million relating to construction of the garbage recycling processing plant and production facilities purchase (see note 1).

 

For the three months ended November 30, 2018 and 2017, depreciation expense was $479,082 and $458,868 respectively.  For the six months ended November 30, 2018 and 2017, depreciation expense was $975,109 and $887,659 respectively.

Before leasing the equipment to their client, the Company will upgrade the equipment to meet the client's requirement. The Company records the equipment as equipment construction in process before it finishes the upgrading process. As of November 30, 2018, no equipment construction in process was included in lease equipment.

The Company is required to file income tax returns in both the United States and the PRC.  Its operations in the United States have been insignificant and income taxes have not been accrued.  In the PRC, the Company files tax returns for Jiangsu Xuefeng.

The provision for (benefit from) income taxes consists of the following for the three and six months ended November 30, 2018 and 2017:

		For the Three Months Ended November 30，								For the Six Months Ended November 30，
		2018				2017				2018				2017
		(Unaudited)				(Unaudited)				(Unaudited)				(Unaudited)
Current		$	357,404			$	482,640			$	732,240				894,319
Deferred			43,162				(186,360	)			56,271				(279,472	)
Total		$	400,566				296,280				788,511				614,847

NOTE 6.   INCOME TAXES (CONTINUED)

As of November 30, 2018, the Company had unused operating loss carry-forwards of approximately $3,109,496  expiring in various years through 2023.  

The expected tax rate for income in the PRC is 25%.  The following table reconciles the effective income tax rates with the statutory rates for the periods ended November 30:

The Company is currently leasing the patent rights on garbage recycling processing technology from Li Yuan, one of the Company's stockholders under an agreement expiring August 2022. The Company is required to pay a fee of $11,795 (RMB80,000) each month during the agreement term. The related prepaid patent leasing fees of $11,496 and $87,354 are included in prepaid expenses on the consolidated balance sheets as of November 30, 2018 and May 31, 2018, respectively.

 

NOTE 7.   RELATED PARTY TRANSACTIONS (CONTINUED)

The remaining payments for the patent rights are as follows:

Year Ending
May 31,		Amount
2019		$	68,976
2020			137,952
2021			137,952
2022			137,952
2023			34,488
Total		$	517,320

The Company obtained a demand loan from Li Yuan, a stockholder which is non-interest bearing.  The total loan of approximately $752,473 represents $673,473 of expenses paid by the stockholder and payments of approximately $79,000 representing the registered capital and operating expenses of Baichuang Information Consulting (Shenzhen) Co., Ltd. The balance is reflected as loan from stockholder as of November 30, 2018.

On September 6, 2013, the Company signed with Linyi Yanjiazhuang Beizhi Village government to obtain a land use right 66,667 square meters of land at total $5,870,120 (RMB40,000,000). In addition, the Company was required to subject a deed tax of $176,104 (RMB1,200,000 ). The purchase of the land was approved by local government on September 9, 2013. The Company fully paid the deed tax of $176,104 when the purchase agreement was signed. The Company paid $3,668,825 (RMB25,000,000) on September 25, 2013 and $2,201,295 (RMB15,000,000) on November 12, 2013 to local government for the land purchase. The land use right started on September 9, 2013 and ends on September 8, 2063.

The amortization for the land use right for the three months ended November 30, 2018 and 2017 was $29,844 and $31,188 respectively. The amortization for the land use right for the six months ended November 30, 2018 and 2017 was $60,743 and $61,697 respectively.

 

 

NOTE 10.   LEASES

The Company leases office space from an unrelated third party, which commenced on April 1, 2016 and expires on March 31, 2019.  The lease requires the Company to prepay the semi-annual rental of $3,538  (RMB24,000). The lease provides for renewal options.

The Company also leases office space for Linyi Xuefeng under a three-year operating lease from an unrelated third party, which expired on May 31, 2016 and the lease was renewed until May 31, 2019. The lease required the Company to prepay the semi-annual rental.

Future minimum payments for the years ending May 31 are as follows:

The Company's operations may be adversely affected by significant political, economic and social uncertainties in the PRC. The different cultures, business preferences, corruption, diverse uncertain government regulations, tax systems and currency regulations are risks impacting the Company's current operations.  Although the PRC government has been pursuing economic reform policies for more than twenty years, no assurance can be given that the PRC government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption or unforeseen circumstances affecting the PRC's political, economic and social conditions.  There is also no guarantee that the PRC government's pursuit of economic reforms will be consistent, effective or continue.

Cash and cash equivalents

Substantially all of the Company's bank accounts are in banks located in the PRC and are covered by protection similar to that provided by the Federal Deposit Insurance Corporation ("FDIC") on funds held in United States banks.  The Insurance covers $71,850 for all depository accounts at each bank.  The amount in excess of insured limits at November 30, 2018 was approximately $22,707,606.

Major customers

Management's Discussion and Analysis of Financial Condition and Results of Operations.

		Three Months Ended November 30,
		2018				2017				Percentage Change
		(U.S. $)				(U.S. $)
Revenue		$	3,780,987			$	2,760,238				37	%
Cost of revenue			(1,615,970	)			(585,855	)			176	%
Gross profit			2,165,017				2,174,383				(0	%)
Selling expenses			278,968				252,662				10	%
General and administrative expenses			280,714				281,625				(0	%)
R&D expenses			-				374,841				(100	%)
Total operating expenses			559,682				909,128				(38	%)
Operating income			1,605,335				1,265,255				27	%
Non-operating income			230,990				296,653				(22	%)
Income before provision for income taxes			1,836,325				1,561,908				18	%
Provision for income taxes			400,566				296,280				35	%
Net income			1,435,759				1,265,628				13	%
Noncontrolling interests			-				-				0	%
Net income attributable to common  stockholders		$	1,435,759			$	1,265,628				13	%

Revenue

	Quarters Ended November 30,
	2018				2017				Percentage Change
	(U.S. $)				(U.S. $)
Improvements and Upgrading Services		$	-			$	449,248		(100	%)
Patent Leasing	1,369,052				1,362,549				0	%
Operating lease	999,126				948,441				5	%
Sales of garbage related products			1,412,809				-
Total		$	3,780,987			$	2,760,238		37	%

		Six Months Ended November 30,
		2018				2017				Percentage Change
		(U.S. $)				(U.S. $)
Revenue		$	7,588,035			$	4,979,266			52		%
Cost of revenue			(3,282,677	)			(1,155,094	)			184	%
Gross profit			4,305,358				3,824,172				13	%
Selling expenses			574,575				429,568				34	%
General and administrative expenses			570,489				522,286				9	%
R&D expenses			-				374,841				(100	%)
Total operating expenses			1,145,064				1,326,695				(14	%)
Operating income			3,160,294				2,497,477				27	%
Non-operating income			481,929				601,495				(20	%)
Income before provision for income taxes			3,642,223				3,098,972				18	%
Provision for income taxes			788,511				614,847				28	%
Net income			2,853,712				2,484,125				15	%
Noncontrolling interests			-				-				0	%
Net income attributable to common  stockholders		$	2,853,712			$	2,484,125				15	%

	Six Months Ended November 30,
	2018				2017					Percentage Change
	(U.S. $)				(U.S. $)
Improvements and Upgrading Services		$	-			$	449,248			(100		%)
Patent Leasing		2,786,526				2,695,485				3		%
Operating lease		2,033,590				1,834,533				11		%
Sales of garbage related products			2,767,919				-				100	%
Total		$	7,588,035			$	4,979,266				52	%

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Risk

Changes in interest rates may affect the interest earned and therefore affect our cash flows and results of operations. However, we do not believe that this interest rate change risk is significant.

A substantial portion of our assets and operations are located and conducted in PRC. While the PRC economy has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall economy of China, but may also have a negative effect on us. For example, our operating results and financial condition may be adversely affected by government control over capital investments or changes in tax regulations applicable to us.  If there are any changes in any policies by the Chinese government and our business is negatively affected as a result, then our financial results, including our ability to generate revenue and profits, will also be negatively affected. Economic growth in the PRC has recently begun to slow.

Evaluation of Disclosure Controls and Procedures

Our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of November 30, 2018.

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis. In its assessment of the effectiveness of internal control over financial reporting as of November 30, 2018, the Company determined that there were control deficiencies that constituted the following material weaknesses:

Changes in Internal Control over Financial Reporting

No change in our system of internal control over financial reporting occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.  

Item 1.  Legal Proceedings.

Item 1A. Risk Factors.

Item 3.  Defaults Upon Senior Securities.

Item 4.  Mine Safety Disclosures.

Item 5.  Other Information.

None.

Item 6. Exhibits.

Exhibit No.		Description
31.1*		Certification of Principal Executive Officer and Principal Accounting Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of 2002
32.1+		Certification of Principal Executive Officer and Principal Accounting Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002+
101.INS**		XBRL Instance Document
101.SCH**		XBRL Taxonomy Extension Schema Document
101.CAL**		XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF**		XBRL Taxonomy Extension Definition Linkbase Document
101.LAB**		XBRL Taxonomy Extension Label Linkbase Document
101.PRE**		XBRL Taxonomy Extension Presentation Linkbase Document

*	Filed herewith

**	In accordance with Regulation S-T, the XBRL related information on Exhibit No. 101 to this Quarterly Report on Form 10-Q shall be deemed "furnished" herewith not "filed".

+	In accordance with SEC Release 33-8238, Exhibit 32.1 is being furnished and not filed".

SIGNATURES

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