NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Basis of Presentation

The accompanying audited consolidated financial statements have been prepared by Gulf Resources, Inc. a Delaware corporation and its subsidiaries (collectively, the “Company”).

Upper Class Group Limited was incorporated with limited liability in the British Virgin Islands on July 28, 2006 and was inactive until October 9, 2006 when Upper Class Group Limited acquired all the issued and outstanding stock of Shouguang City Haoyuan Chemical Company Limited (“SCHC”). SCHC is an operating company incorporated in Shouguang City, Shangdong Province, the People’s Republic of China (the “PRC”) on May 18, 2005. SCHC is engaged in manufacturing and trading bromine and crude salt in China. Since the ownership of Upper Class Group Limited and SCHC were the same, the merger was accounted for as a transaction between entities under common control, whereby Upper Class Group Limited recognized the assets and liabilities transferred at their carrying amounts.

On December 12, 2006, Gulf Resources, Inc. (formerly Diversifax, Inc.), a public “shell” company, acquired Upper Class Group Limited and its wholly-owned subsidiary, SCHC (together “Upper Class”). Under the terms of the agreement, all stockholders of Upper Class received a total amount of 13,250,000 (restated for the 2-for-1 stock split in 2007 and the 1-for-4 stock split in 2009) shares of voting common stock of Gulf Resources, Inc. in exchange for all shares of Upper Class’ common stock held by all stockholders. Under accounting principles generally accepted in the United States, the share exchange is considered to be a capital transaction in substance, rather than a business combination. That is, the share exchange is equivalent to the issuance of stock by Upper Class for the net monetary assets of Gulf Resources, Inc., accompanied by a recapitalization, and is accounted for as a change in capital structure. Accordingly, the accounting for the share exchange will be identical to that resulting from a reverse acquisition, except no goodwill will be recorded. Under reverse takeover accounting, the post reverse acquisition comparative historical financial statements of the legal acquirer, Gulf Resources, Inc., are those of the legal acquiree, Upper Class, which is considered to be the accounting acquirer. Share and per share amounts stated have been retroactively adjusted to reflect the merger.

On February 5, 2007, SCHC acquired Shouguang Yuxin Chemical Industry Co., Limited (“SYCI”), a company incorporated in PRC on October 30, 2000. SYCI manufactures chemical products utilized in oil and gas field explorations and as papermaking chemical agents. Under the terms of the merger agreement, all stockholders of SYCI received a total amount of 8,094,059 (restated for the 2-for-1 stock split in 2007 and the 1-for-4 stock split in 2009) shares of voting common stock of Gulf Resources, Inc. in exchange for all shares of SYCI’s common stock held by all stockholders. Also, upon the completion of the merger, Gulf Resources, Inc. paid a $2,550,000 dividend to the original stockholders of SYCI. Since the ownership of Gulf Resources, Inc. and SYCI are substantially the same, the merger was accounted for as a transaction between entities under common control, whereby Gulf Resources, Inc. recognized the assets and liabilities of the Company transferred at their carrying amounts. Share and per share amounts stated have been retroactively adjusted to reflect the merger.

On November 11, 2007, Upper Class formed Hong Kong Jiaxing Industrial Limited (formerly known as Jiaxing Technology Limited) (“HKJI”), a wholly-owned subsidiary of Upper Class, in Hong Kong. Upper Class transferred its equity interest in SCHC to HKJI.

The adoption of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC” or “Codification”) did not result in significant effect in the accounting policies adopted by the Company.

All relevant share data have been adjusted retrospectively to reflect a 1-for-4 stock split effective on October 12, 2009.

(b) Nature of the Business

The Company manufactures and trades bromine and crude salt through SCHC, and manufactures chemical products for use in the oil industry and paper manufacturing industry through SYCI.

The consolidated financial statements include the accounts of Gulf Resources, Inc. and its wholly-owned subsidiaries, Upper Class, a company incorporated in the British Virgin Islands, which owns 100% of HKJI, a company incorporated in Hong Kong, which owns 100% of SCHC and SYCI, which is 100% owned by SCHC. All material intercompany transactions have been eliminated on consolidation.

The consolidated financial statements have been restated for all periods prior to the mergers to include the financial position, results of operations and cash flows of the commonly controlled companies.

(d) Use of Estimates

The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and this requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The most significant accounting estimates with regard to these consolidated financial statements that require the most significant and subjective judgments include, but are not limited to, useful lives of property, plant and equipment, recoverability of long-lived assets, determination of impairment losses, assessment of market value of inventories and provision for inventory obsolescence, allowance for doubtful accounts, recognition and measurement of current and deferred income taxes, valuation allowance for deferred tax assets, and assumptions used for the valuation of share based payments. Accordingly, actual results may differ significantly from these estimates under different assumptions or conditions.

(e) Cash and Cash Equivalents

Cash and cash equivalents consist of all cash balances and highly liquid investments with original maturities of three months or less. Because of short maturity of these investments, the carrying amounts approximate their fair values.

(f) Accounts Receivable and Allowance of Doubtful Accounts

Accounts receivable is stated at cost, net of allowance for doubtful accounts. The Company establishes an allowance for doubtful accounts based on management’s assessment of the collectability of trade and other receivables. A considerable amount of judgment is required in assessing the amount of allowance and the Company considers the historical level of credit losses and applies certain percentage to accounts receivable balance. The Company makes judgments about the credit worthiness of each customer based on ongoing credit evaluations, and monitors current economic trends that might impact the level of credit losses in the future. If the financial condition of the customer begins to deteriorate, resulting in their inability to make payments, a larger allowance may be required.

As of December 31, 2011 and 2010, allowance for doubtful accounts were nil. No allowances for doubtful accounts were charged to the income statement for the years ended December 31, 2011, 2010 and 2009.

(g) Concentration of Credit Risk

The Company is exposed to credit risk in the normal course of business, primarily related to accounts receivable and cash and cash equivalents. Substantially all of the Company’s cash and cash equivalents are maintained with financial institutions in the PRC, namely, Industrial and Commercial Bank of China Limited and China Merchants Bank Company Limited, which are not insured or otherwise protected. The Company placed $78,526,060 and $68,444,480 with these institutions as of December 31, 2011 and 2010, respectively. The Company has not experienced any losses in such accounts in the PRC.

Concentrations of credit risk with respect to accounts receivable exists as the Company sells a substantial portion of its products to a limited number of customers. However, such concentrations of credit risks are limited since the Company performs ongoing credit evaluations of its customers’ financial condition and due to the generally short payment terms. The balances of accounts receivable as of December 31, 2011 and 2010 are all amounts outstanding for less than three months.

(h) Inventories

Inventories are stated at the lower of cost, determined on a first-in first-out cost basis, or market. Costs of work-in-progress and finished goods comprise direct materials, direct labor and an attributable portion of manufacturing overhead. Net realizable value is based on estimated selling price less costs to complete and selling expenses.

(i) Property, Plant and Equipment

Property, plant and equipment are stated at cost less accumulated depreciation and any impairment losses. Expenditures for new facilities or equipment, and major expenditures for betterment of existing facilities or equipment are capitalized and depreciated using the straight-line method at rates sufficient to depreciate such costs over the estimated productive lives. All other ordinary repair and maintenance costs are expensed as incurred.

Mineral rights are recorded at cost less accumulated depreciation and any impairment losses. Mineral rights are amortized ratably over the term of the lease, or the equivalent term under the units (in tonnes) of production method, whichever is shorter.

Construction in progress primarily represents direct costs of construction of property, plant and equipment. Costs incurred are capitalized and transferred to property, plant and equipment upon completion, at which time depreciation commences.

The Company’s depreciation and amortization policies on property, plant and equipment other than mineral rights and construction in progress are as follows:

	Useful life (in years)
Buildings (including salt pans)		8 - 20
Plant and machinery (including protective shells, transmission channels and ducts)		5 - 8
Motor vehicles		5
Furniture, fixtures and equipment		8

In April 2011, the Company changed the estimated useful life of certain protective shells and transmission channels and ducts that included in plant and machinery from 8 years to 5 years. Initially, the Company expected the protective shells’ useful lives would be 8 years with reference to the past wear and tear experienced in 2005. In view of the increased rate of erosion experienced in last 2 years, which reduced the volume of brine water flowing into the bromine production process and adversely affected the annual bromine and crude salt production capacities and efficiencies; and the recent directional information from the Crude Salt Institutional Association in Shandong Province, PRC, which indicated that the latest erosion rate would be 20% per annum, the Company reduced the useful lives of such protective shells to 5 years to reflect the most productive cycle. Changes in estimates are accounted for on a prospective basis, by depreciating those plant and machinery current carrying values over their revised remaining useful lives. The effect of this change in estimate, compared to the original depreciation, for fiscal year 2011 was a pre-tax increment in depreciation expense of $975,517. The pre-tax increase (decrease) to depreciation expense in future periods is expected to be $1,115,252, $836,863, $219,197, ($380,464), ($1,225,851), ($927,600), ($566,456) and ($46,457) in the eight years ending December 31, 2019.

Property, plant and equipment under capital leases are depreciated over their expected useful lives on the same basis as owned assets, or where shorter, the term of the lease, which is 20 years.

(j) Asset Retirement Obligation

The Company follows FASB ASC 410, which established a uniform methodology for accounting for estimated reclamation and abandonment costs. FASB ASC 410 requires the fair value of a liability for an asset retirement obligation to be recognized in the period in which the legal obligation associated with the retirement of the long-lived asset is incurred. When the liability is initially recorded, the offset is capitalized by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. To settle the liability, the obligation is paid, and to the extent there is a difference between the liability and the amount of cash paid, a gain or loss upon settlement is recorded.

Currently, there are no reclamation or abandonment obligations associated with the land being utilized for exploitation.

(k) Recoverability of Long Lived Assets

In accordance with ASC 360-10-35 “Impairment or Disposal of Long-lived Assets”, long-lived assets to be held and used are analyzed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable or that the useful lives of those assets are no longer appropriate. The Company evaluates at each balance sheet date whether events and circumstances have occurred that indicate possible impairment.

The Company determines the existence of such impairment by measuring the expected future cash flows (undiscounted and without interest charges) and comparing such amount to the carrying amount of the assets. An impairment loss, if one exists, is then measured as the amount by which the carrying amount of the asset exceeds the discounted estimated future cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value of such assets less costs to sell. Asset impairment charges are recorded to reduce the carrying amount of the long-lived asset that will be sold or disposed of to their estimated fair values. Charges for the asset impairment reduce the carrying amount of the long-lived assets to their estimated salvage value in connection with the decision to dispose of such assets.

In accordance with the provisions of the FASB ASC 360-10 “Impairment or Disposal of Long-lived Assets” subsections, (i) owned long-lived assets held and used with a carrying amount of $9,421,857 were written down to their fair value of $7,616,259, resulting in an impairment charge of $1,805,598, which was included in earnings for the year ended December 31, 2011; and (ii) long-lived assets held and used under capital lease with a carrying amount of $3,051,054 were written down to their fair value of $2,368,008, resulting in an impairment charge of $683,046, which was included in earnings for the year ended December 31, 2011. The following table sets forth the fair value and related impairment charges for the year ended December 31, 2011:

			Fair Value Measurements Using
Description	Year ended December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Gains (Losses)
Owned long-lived assets (plant and machinery) held and used	$	7,616,259	$	-	$	-	$	7,616,259	$	(1,805,598	)
Long-lived assets (plant and machinery) held under capital lease and used	$	2,368,008	$	-	$	2,368,008		-	$	(683,046	)
									$	(2,488,644	)

The above owned long-lived assets, which is classified as Level 3 in the fair value hierarchy, was valued using a discounted cash flow model incorporating assumptions that, in management’s judgment, reflect the assumptions marketplace participants would use at December 31, 2011. Such assumptions included an estimate of future cash flows and a discount rate based on the 5-year PRC Treasury bill rate.

The long-lived assets held under capital lease, which is classified as Level 2 in the fair value hierarchy, was valued by an independent appraiser using the market approach, which included mainly quoted prices for similar assets.

The Company determined that no impairment was required after going through the impairment testing to the operating long-lived assets as of December 31, 2010.

(l) Retirement Benefits

Pursuant to the relevant laws and regulations in the PRC, the Company participates in a defined contribution retirement plan for its employees arranged by a governmental organization. The Company makes contributions to the retirement scheme at the applicable rate based on the employees’ salaries. The required contributions under the retirement plans are charged to the consolidated income statement on an accrual basis when they are due. The Company’s contributions totaled $431,428, $457,805 and $270,324 for the years ended December 31, 2011, 2010 and 2009, respectively.

(m) Mineral Rights

The Company follows FASB ASC 805 “Business Combinations” that certain mineral rights are considered tangible assets and that mineral rights should be accounted for based on their substance. Mineral rights are included in property, plant and equipment.

(n) Leasing arrangements

Rentals payable under operating leases are charged to the statements of income on a straight line basis over the term of the relevant lease. For capital leases, the present value of future minimum lease payments at the inception of the lease is reflected as an asset and a liability in the statement of financial position. Amounts due within one year are classified as short-term liabilities and the remaining balance as long-term liabilities.

(o) Reporting Currency and Translation

The financial statements of the Company’s foreign subsidiaries are measured using the local currency, Renminbi (“RMB”), as the functional currency; whereas the functional currency and reporting currency of the Company is the United States dollar (“USD” or “$”).

As such, the Company uses the “current rate method” to translate its PRC operations from RMB into USD, as required under ASC 830 “Foreign Currency Matters”. The assets and liabilities of its PRC operations are translated into USD using the rate of exchange prevailing at the balance sheet date. The capital accounts are translated at the historical rate. Adjustments resulting from the translation of the balance sheets of the Company’s PRC subsidiaries are recorded in stockholders’ equity as part of accumulated comprehensive income. The statement of income and comprehensive income is translated at average rates during the reporting period. Gains or losses resulting from transactions in currencies other than the functional currencies are recognized in net income for the reporting periods as part of general and administrative expense. The statement of cash flows is translated at average rates during the reporting period, with the exception of issuance of shares and payment of dividends which are translated at historical rates.

(p) Foreign Operations

All of the Company’s operations and assets are located in PRC. The Company may be adversely affected by possible political or economic events in this country. The effect of these factors cannot be accurately predicted.

(q) Revenue Recognition

The Company recognizes revenue, net of value-added tax, when persuasive evidence of an arrangement exists, delivery of the goods has occurred, customer acceptance has been obtained, which means the significant risks and ownership have been transferred to the customer, the price is fixed or determinable and collectability is reasonably assured.

(r) Income Taxes

The Company accounts for income taxes in accordance with the Income Taxes Topic of the FASB ASC, which requires the use of the liability method of accounting for deferred income taxes. Under this method, deferred income taxes are recorded to reflect the tax consequences on future years of temporary differences between the tax basis of assets and liabilities and their reported amounts at each period end. If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is recognized. The guidance also provides criteria for the recognition, measurement, presentation and disclosures of uncertain tax positions. A tax benefit from an uncertain tax position may be recognized if it is “more likely than not” that the position is sustainable based solely on its technical merits.

(s) Exploration Costs

Exploration costs, which included the cost of researching appropriate places to drill wells and the cost of actual drilling of potential natural brine resources, were charged to the income statement as incurred. For the year ended December 31, 2011, the Company incurred exploration costs in the amount of $7,034,153, in Sichuan province, PRC, for the drilling of exploratory wells and their associated facilities in order to confirm and measure the natural brine resources in the area of drilling. The Company completed the drilling of exploratory wells in December 2011 and received a testing report in mid-January 2012 which confirmed the underground brine water resources.

(t) Shipping and Handling Fees and Costs

The Company does not charge its customers for shipping and handling as all customers arrange their own transportation of finished goods. The Company classifies shipping and handling costs for purchase of raw materials as part of the cost of net revenue, which amounted to $506,331, $567,686 and $492,582 for the years ended December 31, 2011, 2010 and 2009, respectively.

(u) Contingencies

The Company accrues for costs relating to litigation, including litigation defense costs, claims and other contingent matters, including liquidated damage liabilities, when such liabilities become probable and reasonably estimable. Such estimates may be based on advice from third parties or on management’s judgment, as appropriate. Revisions to accruals are reflected in earnings (loss) in the period in which different facts or information become known or circumstances change that affect the Company’s previous assumptions with respect to the likelihood or amount of loss. Amounts paid upon the ultimate resolution of such liabilities may be materially different from previous estimates.

(v) Stock-based Compensation

Common stock, stock options and stock warrants issued to employees or directors are recorded at their fair values estimated at grant date using the Black-Scholes model and the portion that is ultimately expected to vest is recognized as compensation cost over the requisite service period.

Common stock, stock options and stock warrants issued to other than employees or directors are recorded on the basis of their fair value using the Black-Scholes model on the basis of the market price of the underlying common stock on the “valuation date,” which for options and warrants related to contracts that have substantial disincentives to non-performance is the date of the contract, and for all other contracts the measurement date is the date that the service is complete. Expense related to the options and warrants is recognized on a straight-line basis over the shorter of the period over which services are to be received or the vesting period. Where expense must be recognized prior to a valuation date, the expense is computed under the Black-Scholes model on the basis of the market price of the underlying common stock at the end of the period, and any subsequent changes in the market price of the underlying common stock up through the valuation date is reflected in the expense recorded in the subsequent period in which that change occurs.

(w) Basic and Diluted Net Income per Share of Common Stock

Basic earnings per common share are based on the weighted average number of shares outstanding during the periods presented. Diluted earnings per share are computed using weighted average number of common shares plus dilutive common share equivalents outstanding during the period. Anti-dilutive common stock equivalents which were excluded from the calculation of number of dilutive common stock equivalents amounted to 535,449, 14,250 and 305,449 shares for the years ended December 31, 2011, 2010 and 2009, respectively.

The following table sets forth the computation of basic and diluted earnings per share:

	Years ended December 31,
	2011		2010		2009
Numerator
Net income	$	30,952,760	$	51,283,320	$	30,591,415

Denominator
Basic: Weighted-average common shares outstanding during the year		34,660,866		34,614,667		30,698,824
Add: Dilutive effect of stock options		12,749		60,662		2,873
Diluted		34,673,615		34,675,329		30,701,697

Net income per share
Basic	$	0.89	$	1.48	$	1.00
Diluted	$	0.89	$	1.48	$	1.00

(x) Reclassification

The Company reclassified mineral resources compensation fees, previously included in “General and administrative expenses”, for year ended December 31, 2009 into “Cost of net revenue” and sales of wastewater and gain or loss on disposal of property, plant and equipment, previously included in “Other Income (Expense)” after “Income from Operations”, for the years ended December 31, 2010 and 2009 into “Other operating income” for sales of wastewater and gain on disposal of property, plant and equipment and “General and administrative expenses” for loss on disposal of property, plant and equipment to conform to the current year presentation. The above reclassifications had no impact on previously reported net income for the years ended December 31, 2010 and 2009.

(y) Recently adopted accounting pronouncements

In October 2009, the FASB issued Accounting Standard Update (“ASU”) No. 2009-13, “Multiple-Delivery Revenue Arrangements” (“ASU 2009-13”), which establishes the accounting and reporting guidance for arrangements including multiple deliverable revenue-generating activities, and provides amendments to the criteria for separating deliverables, and measuring and allocating arrangement consideration to one or more units of accounting.

(y) Recently adopted accounting pronouncements – Continued

The amendments of ASU 2009-13 also establish a hierarchy for determining the selling price of a deliverable, and require significantly enhanced disclosures to provide information about a vendor’s multiple-deliverable revenue arrangements, including information about their nature and terms, significant deliverables, and the general timing of delivery. The amendments also require disclosure of information about the significant judgments made and changes to those judgments, and about how the application of the relative selling price method affects the timing or amount of revenue recognition. The amendments of ASU 2009-13 are effective prospectively for revenue arrangements entered into or materially modified in annual reporting periods beginning on or after June 15, 2010. On January 1, 2011, the Company adopted ASU 2009-13 on a prospective basis. The adoption did not have a material impact on the Company’s financial position or results of operations, but could have an impact on how the Company accounts for any future collaboration agreements, should the Company enter into any such agreements in the future.

In January 2010, FASB issued ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820) – Improving Disclosures about Fair Value Measurements” (“ASU2010-06”). This update provides amendments to ASC Topic 820 that provide disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company adopted the disclosure requirements effective January 1, 2011. The adoption of this update did not have a material impact to the Company’s financial position.

(z) Recently issued accounting pronouncements not yet adopted

In May 2011, FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 82) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs” (“ASU 2011-04”). The amendments in this update will ensure that fair value has the same meaning in U.S. GAAP and in IFRS and that their respective fair value measurement and disclosure requirements are the same. This update is effective prospectively for interim and annual periods beginning after December 15, 2011. Early adoption by public entities is not permitted, and the Company is therefore required to adopt this ASU on January 1, 2012. The Company is evaluating the guidance and does not expect its adoption to have a material impact on the Company’s results of operations, financial position or cash flows.

In June 2011, FASB issued ASU No. 2011-05, Comprehensive Income (“ASU 2011-05”), which will require companies to present the components of net income and other comprehensive income (“OCI”) either as one continuous statement or as two consecutive statements. ASU 2011-05 eliminates the option to present components of OCI as part of the statement of changes in stockholders’ equity. The update does not change the items which must be reported in OCI, how such items are measured or when they must be reclassified to net income. In December 2011, FASB issued ASU No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in ASU 2011-05” (“ASU 2011-12”), which defers the requirement in ASU 2011-05 that companies present reclassification adjustments for each component of accumulated OCI and OCI. ASU 2011-05 was set to be effective for interim and annual periods beginning after December 15, 2011, but is deferred by ASU 2011-12. The Company does not expect ASU 2011-05 or ASU 2011-12 to have a material impact on its financial statements or results of operations.

In December 2011, FASB issued ASU No. 2011-11, “Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”), which will require disclosures for entities with financial instruments and derivatives that are either offset on the balance sheet in accordance with ASC 210-20-45 or ASC 815-10-45, or subject to a master netting arrangement. ASU 2011-11 is effective for interim and annual periods beginning on or after January 1, 2013. The Company has not completed its review of ASU 2011-11, but it does not expect its adoption to have a material impact on the Company’s results of operations, financial position or cash flows.

The Company does not believe that any other accounting standards and guidance with an effective date during year ended December 31, 2011 or issued during 2011 had or are expected to have a significant impact on the Company’s consolidated financial statements and the disclosures presented in the consolidated financial statements.