UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





Form
10-Q





(Mark
One)




x
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
quarterly period ended March 31, 2009


or




o
              TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
      the transition period from __________________ to
      __________________________Commission
      file number: 000-32581





LOTUS PHARMACEUTICALS,
  INC.(Name
      of registrant as specified in its
charter)





NEVADA
                  
                  20-0507918(State
      or other jurisdiction of incorporation or organization)
                  
                  (I.R.S.
      Employer Identification
No.)





16
      Cheng Zhuang Road, Feng Tai District, Beijing100071
                  People’s Republic of China
                
                N/A(Address
      of principal executive offices)
                
                (Zip
      Code)





86-10-63899868(Registrant's
      telephone number, including area
code)




N/A(Former
      name, former address and former fiscal year, if changed since last
      report)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities 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 xNo o





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).


Yes oNo o





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





Large
      accelerated filer o
                Accelerated
      filer oNon-accelerated
      filer o
                  (Do
      not check if smaller reporting company)
                Smaller
      reporting company x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act)





Yes oNo x




Indicated
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date, 43,377,932 shares of common stock
are issued and outstanding as of May 15, 2009.





TABLE
OF CONTENTS





Page
                        No.PART
      I. - FINANCIAL INFORMATIONItem
      1.
                      Financial
      Statements.
                      
                      F-1Item
      2.
                      Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations.
                      
                      26Item
      3.
                      Quantitative
      and Qualitative Disclosures About Market Risk.
                      
                      37Item
      4T
                      Controls
      and Procedures.
                      
                      37PART
      II - OTHER INFORMATIONItem
      1.
                      Legal
      Proceedings.
                      
                      38Item
      1A.
                      Risk
      Factors.
                      
                      38Item
      2.
                      Unregistered
      Sales of Equity Securities and Use of Proceeds.
                      
                      38Item
      3.
                      Defaults
      Upon Senior Securities.
                      
                      38Item
      4.
                      Submission
      of Matters to a Vote of Security Holders.
                      
                      38Item
      5.
                      Other
      Information.
                      
                      38Item
      6.
                      Exhibits.
                      
                      39




CAUTIONARY
STATEMENT REGARDING FORWARD-LOOKING INFORMATION





Certain
statements in this report contain or may contain forward-looking statements that
are subject to known and unknown risks, uncertainties and other factors which
may cause actual results, performance or achievements to be materially different
from any future results, performance or achievements expressed or implied by
such forward-looking statements. These forward-looking statements were based on
various factors and were derived utilizing numerous assumptions and other
factors that could cause our actual results to differ materially from those in
the forward-looking statements. These factors include, but are not limited to,
our ability to enforce the Contractual Arrangements, Lotus East's strategic
initiatives, economic, political and market conditions and fluctuations, U.S.
and Chinese government and industry regulation, interest rate risk, U.S.,
Chinese and global competition, and other factors. Most of these factors are
difficult to predict accurately and are generally beyond our control. You should
consider the areas of risk described in connection with any forward-looking
statements that may be made herein. Readers are cautioned not to place
substantial reliance on these forward-looking statements and readers should
carefully review this report in its entirety together with our Annual Report on
Form 10-K for the year ended December 31, 2008 as filed with the SEC, including
the risks described in Item 1A. Risk Factors. Except for our ongoing obligations
to disclose material information under the Federal securities laws, we undertake
no obligation to release publicly any revisions to any forward-looking
statements, to report events or to report the occurrence of unanticipated
events. These forward-looking statements speak only as of the date of this
report, and you should not rely on these statements without also considering the
risks and uncertainties associated with these statements and our
business.


2




OTHER
PERTINENT INFORMATION





We
maintain a web site at www.lotuspharma.com. Information on this web site is not
a part of this report.





CERTAIN
DEFINED TERMS USED IN THIS REPORT





Unless
specifically set forth to the contrary, when used in this report the
terms:


·
              "Lotus," "we," "us," "our," the
      "Company," and
      similar terms refer to Lotus Pharmaceuticals, Inc., a Nevada corporation
      formerly known as S.E. Asia Trading Company, Inc., and its
      subsidiary,
  ·
              "Lotus
      International" refers to Lotus Pharmaceutical International, Inc.,
      a Nevada corporation and a subsidiary of
Lotus,
 
 ·
              "Lotus Century"
      refers to Lotus Century Pharmaceutical (Beijing) Technology co., Ltd., a
      wholly foreign-owned enterprise (WFOE) Chinese company which is a
      subsidiary of Lotus,
  ·
              "Liang Fang"
      refers to Beijing Liang Fang Pharmaceutical Co., Ltd., a Chinese limited
      liability company formed on June 21, 2000 and an affiliate of En Ze Jia
      Shi,
  ·
              "En Ze Jia Shi"
      refers to Beijing En Ze Jia Shi Pharmaceutical Co., Ltd., a Chinese
      limited liability company formed on September 17, 1999 and an affiliate of
      Liang Fang,
  ·
              "Lotus East"
      collectively refers to Liang Fang and En Ze Jia
  Shi,
  ·
              "Consulting Services
      Agreements" refers to the Consulting Services Agreements dated
      September 20, 2006 between Lotus and Lotus
East.
 
 ·
              "Operating
      Agreements" refers to the Operating Agreements dated September 20,
      2006 between Lotus, Lotus East and the stockholders of Lotus
      East,
 
 ·
              "Equity Pledge
      Agreements" refers to the Equity Pledge Agreements dated September
      20, 2006 between Lotus, Lotus East and the stockholders of Lotus
      East,
 
 ·
              "Option
      Agreements" refers to the Option Agreements dated September 20,
      2006 between Lotus, Lotus East and the stockholders of Lotus
      East,
 
 ·
              "Proxy
      Agreements" refers to the Proxy Agreements dated September 20, 2006
      between Lotus, Lotus East and the stockholders of Lotus
    East,
 
 ·
              "Contractual
      Arrangements" collectively refers to the Consulting Services
      Agreements, Operating Agreements, Equity Pledge Agreements, Option
      Agreements and the Proxy
Agreements,
 
 ·
              "China" or the
      "PRC"
      refers to the People's Republic of China,
and
 
 ·
              "RMB" refers to
      the renminbi which is the currency of mainland PRC of which the yuan is
      the principal currency.


3




PART
1. - FINANCIAL INFORMATION





Item 1.
Financial Statements.





LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS





March
      31,
                      
                      
                      December
      31,2009
                      
                      
                      2008(Unaudited)ASSETSCURRENT
      ASSETS:Cash
                      
                      $
                      1,228,769
                      
                      
                      $
                      1,278,808Accounts
      receivable, net of allowance for doubtful accounts
                      
                      
                      1,395,054
                      
                      
                      
                      6,132,912Other
      receivable
                      
                      
                      15,777
                      
                      
                      
                      15,757Other
      receivable-employee
                      
                      
                      730,396
                      
                      
                      
                      -Other
      receivable-related party
                      
                      
                      -
                      
                      
                      
                      2,027,954Inventories,
      net of reserve for obsolete inventory
                      
                      
                      3,726,128
                      
                      
                      
                      3,787,802Prepaid
      expenses and other assets
                      
                      
                      77,380
                      
                      
                      
                      121,274Deferred
      debt costs
                      
                      
                      364,894
                      
                      
                      
                      398,067Total
      Current Assets
                      
                      
                      7,538,398
                      
                      
                      
                      13,762,574PROPERTY
      AND EQUIPMENT - Net
                      
                      
                      9,591,554
                      
                      
                      
                      7,554,817OTHER
      ASSETSDeposit
      on patent license
                      
                      
                      2,921,585
                      
                      
                      
                      2,917,919Installments
      on intangible assets
                      
                      
                      35,301,508
                      
                      
                      
                      38,175,134Intangible
      assets, net of accumulated amortization
                      
                      
                      8,885,346
                      
                      
                      
                      1,231,730Deferred
      debt costs
                      
                      
                      -
                      
                      
                      
                      66,344Total
      Assets
                      
                      $
                      64,238,391
                      
                      
                      $
                      63,708,518LIABILITIES
      AND SHAREHOLDERS' EQUITYCURRENT
      LIABILITIES:Accounts
      payable and accrued expenses
                      
                      $
                      856,345
                      
                      
                      $
                      2,170,165Taxes
      Payable
                      
                      
                      1,994,388
                      
                      
                      
                      5,015,908Unearned
      revenue
                      
                      
                      794,516
                      
                      
                      
                      565,629Due
      to related parties
                      
                      
                      1,715,742
                      
                      
                      
                      1,588,689Series
      A convertible redeemable preferred stock, $.001 par value; 10,000,000
      sharesauthorized;
      6,206,890 and 5,747,118 shares issued and outstanding at March 31, 2009and
      December 31, 2008, respectively, net
                      
                      
                      4,341,124
                      
                      
                      
                      -Total
      Current Liabilities
                      
                      
                      9,702,115
                      
                      
                      
                      9,340,391LONG-TERM
      LIABILITIES:Due
      to related parties
                      
                      
                      460,150
                      
                      
                      
                      525,225Notes
      payable - related parties
                      
                      
                      5,062,803
                      
                      
                      
                      5,056,451Series
      A convertible redeemable preferred stock, $.001 par value; 10,000,000
      sharesauthorized;
      6,206,890 and 5,747,118 shares issued and outstanding at March 31, 2009and
      December 31, 2008, respectively, net
                      
                      
                      -
                      
                      
                      
                      3,652,341Total
      Liabilities
                      
                      
                      15,225,068
                      
                      
                      
                      18,574,408SHAREHOLDERS'
      EQUITY:Common
      stock ($.001 par value; 200,000,000 shares authorized;43,377,932
      and 42,420,239  shares issued and outstandingat
      March 31, 2009 and December 31, 2008, respectively)
                      
                      
                      43,378
                      
                      
                      
                      42,420Additional
      paid-in capital
                      
                      
                      11,802,423
                      
                      
                      
                      11,554,381Statutory
      reserves
                      
                      
                      4,167,174
                      
                      
                      
                      3,750,529Retained
      earnings
                      
                      
                      28,708,994
                      
                      
                      
                      25,557,537Other
      comprehensive gain - cumulative foreign currency translation
      adjustment
                      
                      
                      4,291,354
                      
                      
                      
                      4,229,243Total
      Shareholders' Equity
                      
                      
                      49,013,323
                      
                      
                      
                      45,134,110Total
      Liabilities and Shareholders' Equity
                      
                      $
                      64,238,391
                      
                      
                      $
                      63,708,518





See notes
to unaudited consolidated financial statements


F-1


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS


(UNAUDITED)





For
      the Three Months EndedMarch
      31,2009
                
                
                2008NET
      REVENUES:Wholesale
                
                $
                8,940,405
                
                
                $
                8,437,298Retail
                
                
                2,137,188
                
                
                
                2,016,547Other
      revenues
                
                
                746,694
                
                
                
                1,255,332Total
      Net Revenues
                
                
                11,824,287
                
                
                
                11,709,177COST
      OF SALES
                
                
                5,186,158
                
                
                
                7,768,425GROSS
      PROFIT
                
                
                6,638,129
                
                
                
                3,940,752OPERATING
      EXPENSES:Selling
      expenses
                
                
                1,701,799
                
                
                
                1,122,337Research
      and development
                
                
                -
                
                
                
                710,225General
      and administrative
                
                
                747,206
                
                
                
                626,417Total
      Operating Expenses
                
                
                2,449,005
                
                
                
                2,458,979INCOME
      FROM OPERATIONS
                
                
                4,189,124
                
                
                
                1,481,773OTHER
      INCOME (EXPENSE):Debt
      issuance costs
                
                
                (99,517
                )
                
                
                (62,886
                )Interest
      income
                
                
                1,319
                
                
                
                561Interest
      expense
                
                
                (448,097
                )
                
                
                (423,349
                )Total
      Other Income (Expense)
                
                
                (546,295
                )
                
                
                (485,674
                )INCOME
      BEFORE INCOME TAXES
                
                
                3,642,829
                
                
                
                996,099INCOME
      TAXES
                
                
                74,727
                
                
                
                -NET
      INCOME
                
                $
                3,568,102
                
                
                $
                996,099COMPREHENSIVE
      INCOME:NET
      INCOME
                
                
                3,568,102
                
                
                
                996,099OTHER
      COMPREHENSIVE INCOME:Unrealized
      foreign currency translation gain
                
                
                62,111
                
                
                
                1,454,203COMPREHENSIVE
      INCOME
                
                $
                3,630,213
                
                
                $
                2,450,302NET
      INCOME PER COMMON SHARE:Basic
                
                $
                0.08
                
                
                $
                0.02Diluted
                
                $
                0.07
                
                
                $
                0.02WEIGHTED
      AVERAGE COMMON SHARES OUTSTANDING:Basic
                
                
                43,048,060
                
                
                
                42,035,958Diluted
                
                
                49,254,950
                
                
                
                47,783,076





See notes
to unaudited consolidated financial statements


F-2





LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(UNAUDITED)





For
      the Three Months EndedMarch
      31,2009
                
                
                2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                
                $
                3,568,102
                
                
                $
                996,099Adjustments
      to reconcile net income from operations to net cash provided by (used in)
      operating activities:Depreciation
      and amortization
                
                
                362,467
                
                
                
                148,884Amortization
      of deferred debt issuance costs
                
                
                99,517
                
                
                
                62,512Amortization
      of debt discount
                
                
                -
                
                
                
                208,355Amortization
      of discount on convertible redeemable preferred stock
                
                
                288,783
                
                
                
                84,709Amortization
      of prepaid expense attributable to warrants
                
                
                14,849
                
                
                
                -Increase
      in allowance for doubtful accounts
                
                
                -
                
                
                
                53,305Changes
      in assets and liabilities:Accounts
      receivable
                
                
                4,744,877
                
                
                
                (115,927
                )Inventories
                
                
                66,423
                
                
                
                (3,161,360
                )Prepaid
      expenses and other current assets
                
                
                1,329,083
                
                
                
                (2,012,656
                )Accounts
      payable and accrued expenses
                
                
                (666,522
                )
                
                
                (98,515
                )Taxes
      payable
                
                
                (3,027,383
                )
                
                
                41,792Unearned
      revenue
                
                
                228,143
                
                
                
                217,749Advances
      from customers
                
                
                -
                
                
                
                (35,197
                )NET
      CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
                
                
                7,008,339
                
                
                
                (3,610,250
                )CASH
      FLOWS FROM INVESTING ACTIVITIES:Installments
      on intangible assets
                
                
                2,921,162
                
                
                
                -Purchase
      of intangible asset
                
                
                (7,887,138
                )
                
                
                -Purchase
      of property and equipment
                
                
                (2,153,243
                )
                
                
                -NET
      CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
                
                
                (7,119,219
                )
                
                
                -CASH
      FLOWS FROM FINANCING ACTIVITIES:repayment
      of convertible debt
                
                
                -
                
                
                
                (2,520,000
                )Proceeds
      from sale of convertible redeemable peferred stocks
                
                
                -
                
                
                
                5,000,000Payment
      of debt issuance costs
                
                
                -
                
                
                
                (468,568
                )Proceeds
      from related party advances
                
                
                59,314
                
                
                
                357,382NET
      CASH PROVIDED BY  FINANCING ACTIVITIES
                
                
                59,314
                
                
                
                2,368,814EFFECT
      OF EXCHANGE RATE ON CASH
                
                
                1,527
                
                
                
                272,856NET
      (DECREASE) INCREASE IN CASH
                
                
                (50,039
                )
                
                
                (968,580
                )CASH  -
      beginning of period
                
                
                1,278,808
                
                
                
                4,557,957CASH
      – end of period
                
                $
                1,228,769
                
                
                $
                3,589,377SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW  INFORMATION:Cash
      paid for:Interest
                
                $
                -
                
                
                $
                -Income
      taxes
                
                $
                -
                
                
                $
                -Non-cash
      investing and financing activities:Warrants
      issued for prepaid financing costs and consulting expense
                
                $
                -
                
                
                $
                505,752Common
      stock issued for prior compensation
                
                $
                249,000
                
                
                $
                -Common
      stock issued for conversion of convertible debt
                
                $
                -
                
                
                $
                250,000Debt
      discount for grant of warrants and beneficial conversion
      feature
                
                $
                -
                
                
                $
                2,033,025Preferred
      stock issued for dividend payable
                
                $
                400,000
                
                
                $
                -





See notes
to unaudited consolidated financial statements.


F-3




LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)





NOTE 1 -
ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Organization





Lotus
Pharmaceuticals, Inc. (“Lotus” or the “Company”), formerly S.E. Asia Trading
Company, Inc. (“SEAA”), was incorporated on January 28, 2004 under the laws of
the State of Nevada. SEAA operated as a retailer of jewelry, framed art and home
accessories. In December 2006, SEAA changed its name to Lotus Pharmaceuticals,
Inc.




On
September 28, 2006, pursuant to a Share Exchange Agreement with Lotus
Pharmaceutical International, Inc. (“Lotus International”), the Company acquired
all of the outstanding common stock of Lotus International from the Lotus
International shareholders in exchange for newly-issued stock of the Company.
Lotus International became a wholly-owned subsidiary of the Company and
Lotus International’s shareholders became the owners of the majority of the
Company’s voting stock. The acquisition of Lotus International by the
Company was accounted for as a reverse merger because on a post-merger basis,
the former shareholders of Lotus International hold a majority of the
outstanding common stock of the Company on a voting and fully-diluted basis. As
a result, Lotus International is deemed to be the acquirer for accounting
purposes.




Lotus
International was incorporated under the laws the State of Nevada on August
28, 2006 to develop and market pharmaceutical products in the People’s Republic
of China (“PRC” or “China”). PRC law currently has limits on foreign ownership
of certain companies. To comply with these foreign ownership restrictions, Lotus
operates its pharmaceutical business in China through Beijing Liang Fang
Pharmaceutical Co., Ltd. (“Liang Fang”) and an affiliate of Liang Fang,
Beijing En Ze Jia Shi Pharmaceutical Co., Ltd. (“En Ze Jia Shi”), both of
which are pharmaceutical companies headquartered in the PRC and organized under
the laws of the PRC (hereinafter, referred to together as “Lotus East”). Lotus
International has contractual arrangements with Lotus East and its shareholders
pursuant to which Lotus International will provide technology consulting and
other general business operation services to Lotus East. Through these
contractual arrangements, Lotus International also has the ability to
substantially influence Lotus East’s daily operations and financial affairs,
appoint its senior executives and approve all matters requiring shareholder
approval. As a result of these contractual arrangements, which enable Lotus
International to control Lotus East, Lotus International is considered
the primary beneficiary of Lotus East. Accordingly, the consolidated financial
statements include the accounts of Lotus Pharmaceuticals, Inc. and its
wholly-owned subsidiary, Lotus International and companies under its control
(Lotus East).




In
September 2006, Lotus International entered into the following contractual
arrangements:




Operating Agreement.
Pursuant to the operating agreement among Lotus, Lotus East and the shareholders
of Lotus East, (collectively “Lotus East’s Shareholders”), Lotus provides
guidance and instructions on Lotus East’s daily operations, financial management
and employment issues. The shareholders of Lotus East must designate the
candidates recommended by Lotus as their representatives on Lotus East’s Board
of Directors. Lotus has the right to appoint senior executives of Lotus East. In
addition, Lotus agreed to guarantee Lotus East’s performance under any
agreements or arrangements relating to Lotus East’s business arrangements with
any third party. Lotus East, in return, agreed to pledge its accounts receivable
and all of its assets to Lotus. Moreover, Lotus East agreed that without the
prior consent of Lotus, Lotus East would not engage in any transaction that
could materially affect the assets, liabilities, rights or operations of Lotus
East, including, without limitation, incurrence or assumption of any
indebtedness, sale or purchase of any assets or rights, incurrence of any
encumbrance on any of its assets or intellectual property rights in favor of a
third party or transfer of any agreements relating to its business operation to
any third party. The term of this agreement is ten (10) years from September 6,
2006 and may be extended only upon Lotus’s written confirmation prior to the
expiration of the this agreement, with the extended term to be mutually agreed
upon by the parties.


4


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 1 -
ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Consulting Services
Agreement. Pursuant to the exclusive consulting services agreements
between Lotus and Lotus East, Lotus has the exclusive right to provide to Lotus
East general pharmaceutical business operations services as well as consulting
services related to the technological research and development of pharmaceutical
products as well as general business operation advice and strategic planning
(the “Services”). Under this agreement, Lotus owns the intellectual property
rights developed or discovered through research and development, in the course
of providing the Services, or derived from the provision of the Services. Lotus
East is required to pay a quarterly consulting service fees in Renminbi (“RMB”),
the functional currency of the PRC, to Lotus that is equal to Lotus East’s
profits, as defined, for such quarter. To date, no consulting fees have been
paid by Lotus East.




Equity Pledge
Agreement.Under
the equity pledge agreement between the shareholders of Lotus East and Lotus,
the shareholders of Lotus East pledged all of their equity interests in Lotus
East to Lotus to guarantee Lotus East’s performance of its obligations under the
technology consulting agreement. If Lotus East or Lotus East’s Shareholders
breaches its respective contractual obligations, Lotus, as pledgee, will be
entitled to certain rights, including the right to sell the pledged equity
interests. Lotus East’s Shareholders also agreed that upon occurrence of any
event of default, Lotus shall be granted an exclusive, irrevocable power of
attorney to take actions in the place and stead of Lotus East’s
Shareholders to carry out the security provisions of the equity pledge agreement
and take any action and execute any instrument that Lotus may deem necessary or
advisable to accomplish the purposes of the equity pledge agreement. The
shareholders of Lotus East agreed not to dispose of the pledged equity interests
or take any actions that would prejudice Lotus’ interest. The equity pledge
agreement will expire two (2) years after Lotus East’s obligations under the
exclusive consulting services agreements have been fulfilled.




Option Agreement.Under the option agreement
between the shareholders of Lotus East and Lotus, the shareholders of Lotus East
irrevocably granted Lotus or its designated person an exclusive option to
purchase, to the extent permitted under PRC law, all or part of the equity
interests in Lotus East for the cost of the initial contributions to the
registered capital or the minimum amount of consideration permitted by
applicable PRC law. Lotus or its designated person has sole discretion to decide
when to exercise the option, whether in part or in full. The term of this
agreement is 10 years from September 6, 2006 and may be extended prior to its
expiration by written agreement of the parties.




Proxy Agreement. Pursuant to the proxy
agreement among Lotus and Lotus East’s Shareholders, Lotus East’s Shareholders
agreed to irrevocably grant a person to be designated by Lotus with the right to
exercise Lotus East’s Shareholders’ voting rights and their other rights,
including the attendance at and the voting of Lotus East’s Shareholders’ shares
at the shareholders’ meetings (or by written consent in lieu of such meetings)
in accordance with applicable laws and its Article of Association, including but
not limited to the rights to sell or transfer all or any of his equity interests
of Lotus East, and appoint and vote for the directors and Chairman as the
authorized representative of the shareholders of Lotus East. The term of this
Proxy Agreement is ten (10) years from September 6, 2006 and may be extended
prior to its expiration by written agreement of the parties.




Liang
Fang is a Chinese limited liability company and was formed under laws of the
People’s Republic of China on June 21, 2000. Liang Fang is engaged in the
production, trade and retailing of pharmaceuticals. Further, Liang Fang is
focused on development of innovative medicines and investing strategic growth to
address various medical needs for patients worldwide. Liang Fang’s operations
are based in Beijing, China.




As of
March 31, 2009, Liang Fang owns and operates 10 drug stores throughout Beijing,
China. These drugstores sell Western and traditional Chinese medicines, and
medical treatment accessories.





Liang
Fang’s affiliate, En Ze Jia Shi is a Chinese limited liability company and was
formed under laws of the People’s Republic of China on September 17, 1999. En Ze
Jia Shi is the sole manufacturer for Liang Fang and maintains facilities for the
production of medicines, patented Chinese medicine, as well as the research and
production of other new medicines.





As a
result of the management agreements between Lotus International and Lotus East,
Lotus East was deemed to be the acquirer of Lotus International for
accounting purposes. Accordingly, the financial statement data presented are
those of Lotus East for all periods prior to the Company’s acquisition of Lotus
International on September 28, 2006, and the financial statements of the
consolidated companies from the acquisition date forward.


5


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE
1 - ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





On May
29, 2007, the Company formed a new entity, Lotus Century Pharmaceutical
(Beijing) Technology Co., Ltd. (‘‘Lotus Century’’), a wholly foreign-owned
enterprise (“WFOE”) organized under the laws of the Peoples’ Republic of China.
Lotus Century is a Chinese limited liability company and a wholly-owned
subsidiary of Lotus Pharmaceutical International, Inc. Lotus Century intends to
be engaged in development of innovative medicines, medical technology consulting
and outsourcing services, and related training services.





Basis of
presentation




The
interim consolidated financial statements included herein have been prepared by
the Company, pursuant to the rules and regulations of the Securities and
Exchange Commission (the “SEC”). Certain information and footnote disclosures normally
included in an annual financial statement prepared in accordance with generally
accepted accounting principles in the United States (“GAAP”) have been condensed
or omitted pursuant to such rules and regulations. In the opinion of management,
the interim consolidated financial statements reflect all adjustments
(consisting only of normal recurring adjustments) necessary for a fair
presentation of the statement of the results for the interim periods presented.
These interim consolidated financial statements should be read in conjunction
with the audited consolidated financial statements and notes thereto, as well as
the accompanying Management’s Discussion and Analysis of Financial Condition and
Results of Operations for the year ended December 31, 2008 included in its
Annual Report on Form 10-K. Interim financial results are not necessarily
indicative of the results that may be expected for a full year.




The
Company has adopted FASB Interpretation No. 46R "Consolidation of Variable
Interest Entities" ("FIN 46R"), an Interpretation of Accounting Research
Bulletin No. 51. FIN 46R requires a Variable Interest Entity (VIE) to be
consolidated by a company if that company is subject to a majority of the risk
of loss for the VIE or is entitled to receive a majority of the VIE's residual
returns. VIEs are those entities in which the Company, through contractual
arrangements, bears the risks of, and enjoys the rewards normally associated
with ownership of the entities, and therefore the Company is the primary
beneficiary of these entities. As a VIE, Lotus East’s revenues are included
in the Company’s total revenues, its income from operations is consolidated with
the Company’s, and the Company’s net income includes all of Lotus East’s net
income.





The
accompanying unaudited consolidated financial statements are prepared in
accordance with generally accepted accounting principles in the United States of
America (“US GAAP”). The consolidated statements include the accounts of Lotus
Pharmaceuticals, Inc. and its wholly-owned subsidiaries, Lotus and Lotus Century
and variable interest entities under its control (Liang Fang and En Ze Jia Shi).
All significant inter-company balances and transactions have been
eliminated.




Use of
estimates




The
preparation of financial statements in conformity with US GAAP requires
management to make estimates and assumptions that affect certain reported
amounts and disclosures. Accordingly, actual results could differ from those
estimates. Significant estimates in 2009 and 2008 include the allowance for
doubtful accounts, the allowance for obsolete inventory, the useful life of
property and equipment and intangible assets, fair value of warrants and
beneficial conversion features related to the convertible notes, fair value of
warrants granted and accruals for taxes due.





Fair value of financial
instruments




The
carrying amounts reported in the balance sheet for cash, accounts receivable,
accounts payable and accrued expenses, convertible debt, customer advances, and
amounts due from related parties approximate their fair market value based on
the short-term maturity of these instruments.


6


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE
1 - ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Cash and cash
equivalents




For
purposes of the consolidated statements of cash flows, the Company considers all
highly liquid instruments purchased with a maturity of three months or less and
money market accounts to be cash equivalents. The Company maintains cash and
cash equivalents with various financial institutions mainly in the PRC and the
United States. Balances in the United States are insured up to $250,000 at each
bank. Balances at financial institutions or state-owned banks within the PRC are
not covered by insurance. Non-performance by these institutions could expose the
Company to losses for amounts in excess of insured balances. At March 31, 2009
and December 31, 2008, the Company’s China bank balances of approximately $1.2
million and $1.3 million, respectively, are uninsured. The Company has not
experienced, nor does it anticipate, non-performance by these
institutions.





Accounts
receivable





The
Company records accounts receivable, net of an allowance for doubtful accounts
and sales returns. The Company maintains allowances for doubtful accounts for
estimated losses. The Company reviews the accounts receivable on a periodic
basis and makes general and specific allowances when there is doubt as to the
collectability of individual balances. In evaluating the collectability of
individual receivable balances, the Company considers many factors, including
the age of the balance, customer’s historical payment history, its current
credit-worthiness and current economic trends. The amount of the provision, if
any is recognized in the consolidated statement of operations within “General
and administrative expenses”. Accounts are written off after exhaustive efforts
at collection. The Company policy regarding sales returns is discussed below.
The activity in the allowance for doubtful accounts and sales returns accounts
for accounts receivable at March 31, 2009 and December 31, 2008 is as
follows:





Allowance
      for
                    doubtful
      accounts
                  
                  
                  Allowance
      for
                    sales
      returns
                  
                  
                  TotalBalance-
      December 31, 2007
                  
                  $
                  548,083
                  
                  
                  
                  -
                  
                  
                  
                  548,083Additions
      (Reductions)
                  
                  
                  (575,781
                  )
                  
                  
                  -
                  
                  
                  
                  (575,781
                  )Foreign
      currency translation adjustments
                  
                  
                  27,698
                  
                  
                  
                  -
                  
                  
                  
                  27,698Balance-
      December 31, 2008
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Additions
      (Reductions)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Foreign
      currency translation adjustments
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Balance-
      March 31, 2009
                  
                  $
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -





Inventories





Inventories,
consisting of raw materials, work-in-process and finished goods related to the
Company’s products are stated at the lower of cost or market utilizing the
moving average method. An allowance is established when management determines
that certain inventories may not be saleable. If inventory costs exceed expected
market value due to obsolescence or quantities in excess of expected demand, the
Company will record reserves for the difference between the cost and the market
value. These reserves are recorded based on estimates and reflected in cost of
sales. The Company did not consider it necessary to record any inventory reserve
during the three months ended March 31, 2009 and the year ended December 31,
2008.


7


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE
1 - ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Property and
equipment





Property
and equipment are carried at cost and are depreciated on a straight-line basis
over the estimated useful lives of the assets. The cost of repairs and
maintenance is expensed as incurred; major replacements and improvements are
capitalized. When assets are retired or disposed of, the cost and accumulated
depreciation are removed from the accounts, and any resulting gains or losses
are included in income in the year of disposition. In accordance with
Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the
Impairment or Disposal of Long-Lived Assets”, the Company examines the
possibility of decreases in the value of fixed assets when events or changes in
circumstances reflect the fact that their recorded value may not be
recoverable.





Impairment of long-lived
assets





In
accordance with Statement of Financial Accounting Standards (SFAS) No. 144,
“Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company
periodically reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of the assets may not
be fully recoverable. The Company recognizes an impairment loss when the sum of
expected undiscounted future cash flows is less than the carrying amount of the
asset. The amount of impairment is measured as the difference between the
asset’s estimated fair value and its book value. The Company did not consider it
necessary to record any impairment charges during the three months ended March
31, 2009 and the year ended December 31, 2008.





Income
taxes





The
Company is governed by the Income Tax Law of the People’s Republic of China and
the United States. Income taxes are accounted for under Statement of Financial
Accounting Standards No. 109, “Accounting for Income Taxes,” which is an asset
and liability approach that requires the recognition of deferred tax assets and
liabilities for the expected future tax consequences of events that have been
recognized in the Company’s financial statements or tax returns.





Value added
tax





The
Company is subject to value added tax (“VAT”) for manufacturing products and
business tax for services provided. The applicable VAT rate is 17% for products
sold in the PRC. The amount of VAT liability is determined by applying the
applicable tax rate to the invoiced amount of goods sold (output VAT) less VAT
paid on purchases made with the relevant supporting invoices (input VAT). Under
the commercial practice of the PRC, the Company paid  VAT based on tax
invoices issued. The tax invoices may be issued subsequent to the date on which
revenue is recognized, and there may be a considerable delay between the date on
which the revenue is recognized and the date on which the tax invoice is issued.
In the event that the PRC tax authorities dispute the date on which revenue is
recognized for tax purposes, the PRC tax office has the right to assess a
penalty, which can range from zero to five times the amount of the taxes which
are determined to be late or deficient, and will be charged to operations in the
period if and when a determination is been made by the taxing authorities that a
penalty is due.


8


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE
1 - ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Earnings per common
share




Basic
earnings per share is computed by dividing net earnings by the weighted average
number of shares of common stock outstanding during the period. Diluted income
per share is computed by dividing net income by the weighted average number of
shares of common stock, common stock equivalents and potentially dilutive
securities outstanding during each period. Potentially dilutive common shares
consist of the common shares issuable upon the conversion of convertible debt
(using the if-converted method). The following table presents a reconciliation
of basic and diluted earnings per share:





For
      the Three months Ended
                    March
      31,2009
                  
                  
                  2008(Unaudited)
                  
                  
                  (Unaudited)Net
      income for basic and diluted earnings per share
                  
                  $
                  3,568,102
                  
                  
                  $
                  996,099Weighted
      average shares outstanding – basic
                  
                  
                  43,048,060
                  
                  
                  
                  42,035,958Effect
      of dilutive securities:Unexercised
      warrants
                  
                  
                  -
                  
                  
                  
                  -Convertible
      debentures
                  
                  
                  6,206,890
                  
                  
                  
                  5,747,118Weighted
      average shares outstanding– diluted
                  
                  
                  49,254,950
                  
                  
                  
                  47,783,076Earnings
      per share – basic
                  
                  $
                  0.08
                  
                  
                  $
                  0.02Earnings
      per share – diluted
                  
                  $
                  0.07
                  
                  
                  $
                  0.02





At March
31, 2009 and 2008, a total of 5,166,999 and 5,227,000 outstanding warrants have
not been included in the calculation of diluted earnings per shares as the
effect would be anti-dilutive. The closing market price of all outstanding
warrants of the Company on March 31, 2009 and 2008 was lower than the exercise
price of all outstanding warrants. Because of that, the Company assumes that
none of the outstanding warrants at that date would have been exercised and
therefore none were included in the computation of the diluted earnings per
share at March 31, 2009 and 2008. Accordingly, the Company has excluded any
effect of outstanding warrants as their effect would be
anti-dilutive.





Revenue
recognition





Product
sales




Product
sales are generally recognized when title to the product has transferred to
customers in accordance with the terms of the sale. The Company recognizes
revenue in accordance with the Securities and Exchange Commission’s (SEC) Staff
Accounting Bulletin (SAB) No. 101, “ Revenue Recognition in Financial
Statements “ as amended by SAB No. 104 (together, “SAB 104”), and
Statement of Financial Accounting Standards (SFAS) No. 48 “ Revenue
Recognition When Right of Return Exists. “ SAB 104 states that revenue
should not be recognized until it is realized or realizable and earned. In
general, the Company records revenue when persuasive evidence of an arrangement
exists, services have been rendered or product delivery has occurred, the sales
price to the customer is fixed or determinable, and collectability is reasonably
assured.




SFAS No. 48 states
that revenue from sales transactions where the buyer has the right to return the
product shall be recognized at the time of sale only if the seller’s price to
the buyer is substantially fixed or determinable at the date of sale, the buyer
has paid the seller, or the buyer is obligated to pay the seller and the
obligation is not contingent on resale of the product, the buyer’s obligation to
the seller would not be changed in the event of theft or physical destruction or
damage of the product, the buyer acquiring the product for resale has economic
substance apart from that provided by the seller, the seller does not have
significant obligations for future performance to directly bring about resale of
the product by the buyer, and the amount of future returns can be
reasonably estimated.




The
Company’s net product revenues represent total product revenues less allowances
for returns.


9


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 1 -
ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Allowance for
returns





The
Company accounts for sales returns in accordance with Statements of Financial
Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of
Return Exists, by establishing an accrual in an amount equal to its estimate of
sales recorded for which the related products are expected to be returned. The
Company determines the estimate of the sales return accrual primarily based on
historical experience regarding sales returns, but also by considering other
factors that could impact sales returns. These factors include levels of
inventory in the distribution channel, estimated shelf life, product
discontinuances, and price changes of competitive products, introductions of
generic products and introductions of competitive new products. In general, for
wholesale sales, the Company provides credit for product returns that are
returned six months prior to and up to six months after the product expiration
date. Upon sale, the Company estimates an allowance for future product returns.
The Company provides additional reserves for contemporaneous events that were
not known and knowable at the time of shipment. In order to reasonably estimate
future returns, the Company analyzed both quantitative and qualitative
information including, but not limited to, actual return rates, the level of
product manufactured by the Company, the level of product in the distribution
channel, expected shelf life of the product, current and projected product
demand, the introduction of new or generic products that may erode current
demand, and general economic and industry wide indicators. The Company also
utilizes the guidance provided in SAB 104 in establishing its return
estimates. Historically, approximately 49% of our total revenues consist of
sales of four principal products and product returns from these principal
products, as well as the Company’s other products, have been
immaterial.  Accordingly, based upon the Company’s experience, it
historically does not record a reserve at the time of sale and there have been
no accounting entries related to its product return policy which have reduced
its gross revenues or had any material impact on its financial
statements.





Other
revenues




Other
revenues consist of (i) leasing revenues received for the lease of retail space
to various retail merchants; (ii) advertising revenues from the lease of counter
space at the Company’s retail locations; (iii) leasing revenue from the lease of
retail space to licensed medical practitioners; (iv) revenues received by the
Company for research and development projects and lab testing jobs conducted on
behalf of third party companies, and; (v) revenues received for performing third
party contract manufacturing projects. In connection with third-party
manufacturing, the customer supplies the raw materials and we are paid a fee for
manufacturing their product and revenue is recognized at the completion of the
manufacturing job. The Company recognizes revenues from leasing of space and
advertising revenues as earned from contracting third parties. The Company
recognizes revenues upon performance of any research or lab testing jobs.
Revenues received in advance are reflected as deferred revenue on the
accompanying balance sheet. Additionally, the Company receives income from the
sale of developed drug formulas. Income from the sale of drug formulas are
recognized upon performance of all of the Company’s obligations under the
respective sales contract and are included in other income on the accompanying
consolidated statement of operations.




Concentrations of credit
risk




Financial
instruments which potentially subject the Company to concentrations of credit
risk consist principally of cash and trade accounts receivable. Substantially
all of the Company’s cash is maintained with state-owned banks within the
People’s Republic of China of which no deposits are covered by insurance. The
Company has not experienced any losses in such accounts and believes it is not
exposed to any risks on its cash in bank accounts. A significant portion of the
Company’s sales are credit sales which are primarily to customers whose ability
to pay is dependent upon the industry economics prevailing in these areas;
however, concentrations of credit risk with respect to trade accounts
receivables is limited due to generally short payment terms. The Company also
performs ongoing credit evaluations of its customers to help further reduce
credit risk.


10


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE
1 - ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Advertising





Advertising
is expensed as incurred. Advertising expenses were included in selling expenses
and amounted to $6,500 and $153,295 for the three months ended March 31, 2009
and 2008, respectively.





Research and
development





Research
and development costs are expensed as incurred. These costs primarily consist of
cost of material used and salaries paid for the development of the Company's
products and fees paid to third parties. For the three months ended March 31,
2009 and 2008, the Company expensed $0 and $710,225 as research and development
expense, respectively.





Foreign currency
translation





The
reporting currency of the Company is the U.S. dollar. The functional currency of
the Company is the local currency, the Chinese Renminbi (“RMB”). Results of
operations and cash flows are translated at average exchange rates during the
period, assets and liabilities are translated at the unified exchange rate at
the end of the period, and equity is translated at historical exchange rates.
Transaction gains and losses that arise from exchange rate fluctuations on
transactions denominated in a currency other than the functional currency are
included in the results of operations as incurred.





Asset and
liability accounts on March 31, 2009 and December 31, 2008 were translated at
6.8456 RMB to $1.00 USD and at 6.8542 RMB to $1.00 USD, respectively. Equity
accounts were stated at their historical rate. The average translation rates
applied to income statements for the three month ended March 31, 2009 and 2008
were 6.84659 RMB and 7.1757 RMB to $1.00 USD, respectively.  In
accordance with Statement of Financial Accounting Standards No. 95, "Statement
of Cash Flows," cash flows from the Company's operations is calculated based
upon the local currencies using the average translation rate. As a result,
amounts related to assets and liabilities reported on the statement of cash
flows will not necessarily agree with changes in the corresponding balances on
the balance sheet.





Accumulated other
comprehensive income




Accumulated
other comprehensive income consisted of unrealized gains on foreign currency
translation adjustments from the translation of financial statements from
Chinese RMB to US dollars. For the three months ended March 31, 2009 and 2008,
unrealized foreign currency translation gain was $62,111 and $1,454,203,
respectively.





Recent Accounting
Pronouncements





In March
2008, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 161, "Disclosures about Derivative Instruments and
Hedging Activities - an amendment of FASB Statement No. 133" (FAS


161). FAS
161 amends and expands disclosures about derivative instruments and hedging
activities. FAS 161 required qualitative disclosures about the objectives and
strategies of derivative instruments, quantitative disclosures about the fair
value amounts of and gains and losses on derivative instruments, and disclosures
of credit-risk-related contingent features in hedging activities. FAS 161 is
effective for fiscal years beginning after November 15, 2008 and will be
effective for the Company in fiscal year 2010. Early adoption is prohibited;
however, presentation and disclosure requirements must be retrospectively
applied to comparative financial statements. The Company has not yet determined
the effect, if any, that the adoption of this standard will have on its
financial position or results of operations.





In April
2008, FASB Staff Position No. 142-3, Determination of the Useful Life of
Intangible Assets (“FSP 142-3”) was issued. This standard amends the factors
that should be considered in developing renewal or extension assumptions used to
determine the useful life of a recognized intangible asset under FASB Statement
No. 142, Goodwill and Other Intangible Assets. FSP 142-3 is effective for
financial statements issued for fiscal years beginning after December 15,
2008, and interim periods within those fiscal years. Early adoption is
prohibited. The Company has not determined the impact on its financial
statements of this accounting standard.


11


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE
1 - ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Recent Accounting
Pronouncements(Continued)





In May
2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff
Position (“FSP”) APB 14-1,Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement). FSP APB 14-1 clarifies that convertible
debt instruments that may be settled in cash upon either mandatory or optional
conversion (including partial cash settlement) are not addressed by paragraph 12
of APB Opinion No. 14, Accounting for Convertible Debt and Debt issued with
Stock Purchase Warrants. Additionally, FSP APB 14-1 specifies that issuers of
such instruments should separately account for the liability and equity
components in a manner that will reflect the entity’s nonconvertible debt
borrowing rate when interest cost is recognized in subsequent periods. FSP APB
14-1 is effective for financial statements issued for fiscal years beginning
after December 15, 2008, and interim periods within those fiscal years. We will
adopt FSP APB 14-1 beginning in the first quarter of fiscal 2010, and this
standard must be applied on a retrospective basis. We are evaluating the impact
the adoption of FSP APB 14-1 will have on our consolidated financial position
and results of operations.




In May
2008, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No.
162, The Hierarchy of Generally Accepted Accounting Principles. This standard is
intended to improve financial reporting by identifying a consistent framework,
or hierarchy, for selecting accounting principles to be used in preparing
financial statements that are presented in conformity with generally accepted
accounting principles in the United States for non-governmental entities. SFAS
No. 162 is effective 60 days following approval by the U.S. Securities and
Exchange Commission (“SEC”) of the Public Company Accounting Oversight Board’s
amendments to AU Section 411, The Meaning of Present Fairly in Conformity with
Generally Accepted Accounting Principles. We do not expect SFAS No. 162 to have
a material impact on the preparation of our consolidated financial
statements.





In May
2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee
Insurance Contracts – an interpretation of FASB Statement No. 60.”  SFAS
163 requires that an insurance enterprise recognize a claim liability prior to
an event of default (insured event) when there is evidence that credit
deterioration has occurred in an insured financial obligation.  This
Statement also clarifies how Statement 60 applies to financial guarantee
insurance contracts, including the recognition and measurement to be used to
account for premium revenue and claim liabilities. Those clarifications will
increase comparability in financial reporting of financial guarantee insurance
contracts by insurance enterprises. This Statement requires expanded disclosures
about financial guarantee insurance contracts. The accounting and disclosure
requirements of the Statement will improve the quality of information provided
to users of financial statements.  SFAS 163 will be effective for financial
statements issued for fiscal years beginning after December 15, 2008.  The
Company does not expect the adoption of SFAS 163 will have a material impact on
its financial condition or results of operation.




In June
2008, the FASB ratified EITF 07-5, “Determining Whether an Instrument (or
Embedded Feature) is Indexed to an Entity’s Own Stock”. EITF 07-5 addresses
how an entity should evaluate whether an instrument or embedded feature is
indexed to its own stock, carrying forward the guidance in EITF 01-6 and
superseding EITF 01-6. Other issues addressed in EITF 07-5 include
addressing situations where the currency of the linked instrument differs from
the host instrument and how to account for market-based employee stock options.
EITF 07-5 is effective for fiscal years beginning
after December 15, 2008 and early adoption is not permitted. The
Company has evaluated this statement and estimated that it is not expected to
have an impact on its financial position and results of operations.





On June
16, 2008, the FASB issued Final Staff Position (“FSP”) No. EITF 03-6-1,
Determining Whether Instruments Granted in Share-Based Payment Transactions Are
Participating Securities” to address the question of whether instruments granted
in share-based payment transactions are participating securities prior to
vesting. The FSP determines that unvested share-based payment awards that
contain rights to dividend payments should be included in earnings per share
calculations. The guidance will be effective for fiscal years beginning after
December 15, 2008. The Company does not expect the adoption of EITF 03-6-1 will
have a material impact on its financial condition or results of
operation.


12


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 1 -
ORGANIZATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Recent Accounting
Pronouncements(continued)





On
October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” which clarifies
the application of SFAS 157 in a market that is not active and provides an
example to illustrate key considerations in determining the fair value of a
financial asset when the market for that financial asset is not active. FSP
157-3 became effective on October 10, 2008, and its adoption did not have a
material impact on our financial position or results.





In
January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment
Guidance of EITF Issue No. 99“Recognition of Interest Income and Impairment on
Purchased and Retained Beneficial Interests in Securitized Financial Assets”.
FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be
more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1
achieves this by amending the impairment model in EITF 99-20 to remove its
exclusive reliance on “market participant” estimates of future cash flows used
in determining fair value. Changing the cash flows used to analyze
other-than-temporary impairment from the “market participant” view to a holder’s
estimate of whether there has been a “probable” adverse change in estimated cash
flows allows companies to apply reasonable judgment in assessing whether an
other-than-temporary impairment has occurred. The adoption of FSP
EITF 99-20-1 did not have a material impact on our consolidated financial
statements.





Reclassifications





Certain
prior period amounts have been reclassified to conform to the current period
presentation. These reclassifications have no effect on net
income.





NOTE 2 -
ACCOUNTS
RECEIVABLE





At March
31, 2009 and December 31, 2008, accounts receivable consisted of the
following:





March
      31, 2009
                  
                  
                  December
      31, 2008Accounts
      receivable
                  
                  $
                  1,395,054
                  
                  
                  $
                  6,132,912Less:
      allowance for sales returns
                  
                  
                  -
                  
                  
                  
                  -Less:
      allowance for doubtful accounts
                  
                  
                  -
                  
                  
                  
                  -$
                  1,395,054
                  
                  
                  $
                  6,132,912





NOTE 3 -
OTHER
RECEIVABLE-EMPLOYEE





In
January 2009, an employee borrowed cash of $730,396 from The Company after she
got the board of directors approval and signed the loan contract. On May 9,
2009, she paid off the loan to The Company.





NOTE 4 –
INVENTORIES





At March
31, 2009 and December 31, 2008, inventories consisted of the
following:





March
      31, 2009
                  
                  
                  December
      31, 2008Raw
      materials
                  
                  $
                  2,294,695
                  
                  
                  $
                  2,884,092Work
      in process
                  
                  
                  -
                  
                  
                  
                  -Packaging
      materials
                  
                  
                  14,003
                  
                  
                  
                  16,100Finished
      goods
                  
                  
                  1,417,430
                  
                  
                  
                  887,6103,726,128
                  
                  
                  
                  3,787,802Less:
      reserve for obsolete inventory
                  
                  
                  -
                  
                  
                  
                  -$
                  3,726,128
                  
                  
                  $
                  3,787,802




13


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 5 -
PROPERTY AND
EQUIPMENT





At March
31, 2009 and December 31, 2008, property and equipment consist of the
following:





Useful
      Life
                      
                      March
      31, 2009
                      
                      
                      December
      31, 2008Office
      equipment and furniture
                      
                      3-8
      Years
                      
                      $
                      243,025
                      
                      
                      $
                      228,673Manufacturing
      equipment
                      
                      10
      – 15 Years
                      
                      
                      5,578,746
                      
                      
                      
                      5,585,793Building
      and building improvements
                      
                      20
      – 40 Years
                      
                      
                      3,140,104
                      
                      
                      
                      3,136,164Construction
      in progress
                      
                      
                      
                      
                      3,336,797
                      
                      
                      
                      1,181,75712,298,672
                      
                      
                      
                      10,132,387Less:
      accumulated depreciation
                      
                      
                      
                      
                      (2,707,118
                      )
                      
                      
                      (2,577,570
                      )$
                      9,591,554
                      
                      
                      $
                      7,554,817





At March
31, 2009, construction in progress amounted to $3,336,797, representing
construction for a new manufacturing plant located in Cha Ha Er Industrial
Garden District in Inner Mongolia, China. The amount included costs for road,
electrical, sewage, heating and water pipes constructions.




For the
three months ended March 31, 2009 and 2008, depreciation expense amounted to
$126,291 and $112,302 of which $119,775 and $91,058 is included in cost of
sales, respectively.





NOTE 6 –
DEPOSIT ON PATENT AND
INSTALLMENT ON INTANGIBLE ASSETS





Deposit
and Installments on a Chinese Class I drug patent-Laevo-Bambutero





Pursuant
to the technology transfer agreement the Company’ entered into in April 2008
(See note 13), the Company made a deposit to acquire a Chinese Class I drug
patent. Accordingly, the Company recorded $2,921,585 as deposit on patent as of
March 31, 2009.





Also, the
Company has made an installment on the Chinese Class I drug patent to obtain the
patent according to the signed contract. Therefore, the Company recorded
$2,629,426 as installment on intangible assets as of March 31, 2009. The Company
will need to make additional installments of approximately $4,382,000 to obtain
the patent.





In
addition, we expect to incur approximately $14.5 million expenses related to our
Laevo-Bambutero drug that was recently accepted by the Chinese SFDA for clinical
trial evaluations in the next 21 to 27 months.





Installments
on land use right




As of
March 31, 2009, the Company paid $32,672,082 (RMB 223.66 million) for land use
rights to property in the Cha Ha Er Industrial Park ( See note 13), located in
Inner Mongolia. The amount has reflected as an installment payment on intangible
assets on its balance sheet at March 31, 2009. The installment payment is
refundable if the Chinese local government would not grant it land use rights
certificate.


14


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 7 -
INTANGIBLE
ASSETS





The
Company purchased manufacturing rights for two approved drugs. The manufacturing
rights issued are in connection with the Company’s products Valsartan and
Brimonidine. The manufacturing rights for Valsartan became effective in November
2000 and had a life of 6.5 years, which expired in 2007. The manufacturing
rights for Brimonidine became effective on August 27, 2005 and will expire in
August 2009.





On
October 9, 2006, the Company entered into a five-year loan agreement and a
contract with Wu Lan Cha Bu Emergency Hospital (“Wu Lan”), whereby the Company
agreed to lend to Wu Lan approximately $4,382,000 for the construction of a
hospital ward in Inner Mongolia, China. In exchange for agreeing to lend to Wu
Lan the funds, Wu Lan agreed that the Company will be the exclusive provider for
all medicines and disposable medical treatment apparatus to Wu Lan for a period
of twenty (20) years. In October 2006, the Company’s chief executive officer,
Mr. Liu, lent these funds to Wu Lan on behalf of the Company. The Company
entered into an assignment agreement whereby the Company assigned all of its
rights, obligations, and receipts under the Loan Agreement to Mr. Liu,
except for the rights to revenues from the sale of medical and disposable
medical treatment apparatus which will remain with the Company. As compensation
to Mr. Liu for accepting the assignment under the loan agreement including
all of the risks and obligations and for Liu not accepting the rights to
revenues from the sale of medical and disposable medical treatment apparatus
which will remain with the Company, the Company agreed to pay Mr. Liu an
aggregate of approximately $1,315,000 in 5 equal annual installments of
approximately $263,000. Accordingly, the Company recorded an intangible asset of
approximately $1,315,000 related to exclusive rights to provide all medicines
and disposable medical treatment apparatus to Wu Lan for a period of twenty (20)
years. The Company will amortize this exclusive right over a term of 20
years.




The
Company entered into an intellectual rights transfer contract with Beijing
Yipuan Bio-Medical Technology Co., Ltd. in December 2008 to acquire the drug
Yipubishan, a highly effective and stable octreotide acetate injection solution,
according to a clinical research report issued by Beijing Union Medical College
Hospital Center for Clinical Pharmacology, used to treat the symptoms of gastric
ulcers and hemorrhages of the upper digestive tract since 2004. We have paid off
the new drug certificate and intellectual property right transfer fee to Yipuan
as of March 31, 2009.





At March
31, 2009 and December 31, 2008, intangible assets consist of the
following:





March
      31, 2009
                    
                    
                    December
      31, 2008Manufacturing
      rights
                    
                    $
                    1,265,923
                    
                    
                    $
                    1,264,334Revenue
      rights
                    
                    
                    1,314,713
                    
                    
                    
                    1,313,064Intellectual
      rights
                    
                    
                    7,888,278
                    
                    
                    
                    -Software
                    
                    
                    10,810
                    
                    
                    
                    10,79610,479,724
                    
                    
                    
                    2,588,194Less:  accumulated
      amortization
                    
                    
                    (1,594,378
                    )
                    
                    
                    (1,356,464
                    )$
                    8,885,346
                    
                    
                    $
                    1,231,730





Amortization
expense amounted to approximately $236,176and $36,582 for the three months ended
March 31, 2009 and 2008, respectively.





The
projected amortization expense attributed to future periods is as
follows:





Period
      ending March 31:
                  
                  Expense2010
                  
                  $
                  894,7882011
                  
                  
                  857,1932012
                  
                  
                  855,6102013
                  
                  
                  854,564Thereafter
                  
                  
                  5,423,191Total
                  
                  $
                  8,885,346


15


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 8 -
RELATED PARTY
TRANSACTIONS





Notes
payable – related parties





Notes
payable - related parties consisted of the following at March 31, 2009 and
December 31, 2008:





March
      31,
                        2009
                        (Unaudited)
                      
                      
                      December
      31,
                        2008Note
      to Song Guoan, father of Song Zheng Hong, director and spouse of Liu Zhong
      Yi, due on December 30, 2015 with variable annual interest at 80% of
      current bank rate (4.75% and 4.75%  at March 31, 2009 and
      December 31, 2008, respectively), and unsecured
                      
                      $
                      762,851
                      
                      
                      $
                      761,894Note
      to Zheng Gui Xin, employee, due on December 30, 2015 with with variable
      annual interest at 80% of current bank rate (4.75% and 4.75%  at
      March 31, 2009 and December 31, 2008, respectively), and
      unsecured
                      
                      
                      1,651,426
                      
                      
                      
                      1,649,354Note
      to Ma Zhao Zhao, employee, due on December 30, 2015 with variable annual
      interest at 80% of current bank rate (4.75% and 4.75%  at March
      31, 2009 and December 31, 2008, respectively), and
    unsecured
                      
                      
                      661,392
                      
                      
                      
                      660,562Note
      to Liu Zhong Yi, officer and director, due on December 30, 2015 with
      variable annual interest at 80% of current bank rate (4.75% and
      4.75%  at March 31, 2009 and December 31, 2008, respectively),
      and unsecured
                      
                      
                      1,407,860
                      
                      
                      
                      1,406,094Note
      to Song Zheng Hong, director and spouse of the Company chief executive
      officer, Liu Zhong Yi, due on December 30, 2015 with variable annual
      interest at 80% of current bank rate (4.75% and 4.75%  at March
      31, 2009 and December 31, 2008, respectively), and
    unsecured
                      
                      
                      579,274
                      
                      
                      
                      578,547Total
      notes payable – related parties, long term
                      
                      $
                      5,062,803
                      
                      
                      $
                      5,056,451





For the
three months ended March 31, 2009 and 2008, interest expense related to these
related loans amounted to $59,314 and $76,258, respectively.





Due
to related parties





The chief
executive officer of the Company and his spouse and several employees of the
Company, from time to time, provided advances to the Company for operating
expenses. During the three months ended March 31, 2009 and 2008, the Company did
not repay any of these advances. At March 31, 2009 and December 31, 2008, the
Company had a payable to the chief executive officer and his spouse and these
employees amounting to $719,439 and $718,536, respectively. These advances are
short-term in nature and non-interest bearing.





On
October 9, 2006, the Company entered into a five-year loan agreement and a
contract with Wu Lan Cha Bu Emergency Hospital ("Wu Lan"), whereby the Company
agreed to lend to Wu Lan approximately $4,382,000 for the construction of a
hospital ward in Inner Mongolia, China. In exchange for agreeing to lend to Wu
Lan the funds, Wu Lan agreed that the Company will be the exclusive provider for
all medicines and disposable medical treatment apparatus to Wu Lan for a period
of twenty (20) years. In October 2006, the Company's chief executive officer,
Mr. Liu, lent these funds to Wu Lan on behalf of the Company. Accordingly, the
Company entered into an assignment agreement whereby the Company assigned all of
its rights, obligations, and receipts under the Loan Agreement to Mr. Liu,
except for the rights to revenues from the sale of medical and disposable
medical treatment apparatus which will remain with the Company. As compensation
to Mr. Liu for accepting the assignment under the loan agreement including all
of the risks and obligations and for Liu not


16


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 8 -
RELATED PARTY
TRANSACTIONS (Continued)





Due
to related parties (continued)





accepting
the rights to revenues from the sale of medical and disposable medical treatment
apparatus which will remain with the Company, the Company agreed to pay Mr. Liu
an aggregate of approximately $1,315,000 to be paid in 5 equal


annual
installments of approximately $263,000. Accordingly, the Company recorded an
intangible asset of approximately $1,315,000 related to exclusive rights to
provide all medicines and disposable medical treatment apparatus to Wu Lan for a
period of twenty (20) years and a corresponding related party liability. For the
three months ended March 31, 2009 and for the year ended December 31, 2008, the
Company did not pay any of this related party liability. At March 31, 2009 and
December 31, 2008, amounts due under this assignment agreement amounted to
$1,032,323 and $1,031,028 of which $460,150 and $525,225 is included in
long-term liabilities and has been included in due to related parties on the
accompanying balance sheets, respectively.





At March
31, 2009 and December 31, 2008, the Company has recorded accrued interest
relating to notes payable - related parties of $424,130 and $364,350,
respectively, which have been included in due to related parties on the
accompanying balance sheets.





For the
three months ended March 31, 2009 and for the year ended December 31, 2008, a
summary of activities in due to related parties is as follows:





Assignment
      fee
                  payable
                
                
                Working
      capital
                  advances
                
                
                Accrued
                  interest
                
                
                TotalBalance  -
      December 31, 2007
                
                $
                966,198
                
                
                
                34,072
                
                
                
                61,208
                
                
                
                1,061,478Additions
                
                
                -
                
                
                
                682,179
                
                
                
                299,036
                
                
                
                981,215Payments
      made
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Foreign
      currency fluctuations
                
                
                64,830
                
                
                
                2,285
                
                
                
                4,106
                
                
                
                71,221Balance  -
      December 31, 2008
                
                $
                1,031,028
                
                
                
                718,536
                
                
                
                364,350
                
                
                
                2,113,914Additions
                
                
                -
                
                
                
                -
                
                
                
                59,322
                
                
                
                59,322Payments
      made
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Foreign
      currency fluctuations
                
                
                1,295
                
                
                
                903
                
                
                
                458
                
                
                
                2,656Balance  -
      March 31, 2009
                
                $
                1,032,323
                
                
                
                719,439
                
                
                
                424,130
                
                
                
                2,175,892





NOTE 9 -
CONVERTIBLE REDEEMABLE
PREFERRED STOCKS




On
February 25, 2008 (“Closing
Date”), the Company sold, pursuant to a Convertible Redeemable Preferred
Share and Warrant Purchase Agreement (the “Purchase Agreement”) by and among the
Company, Dr. Liu Zhongyi and Mrs. Song Zhenghong (the “Founders”), and
accredited investors (each a “Purchaser” and collectively, the “Purchasers”),
5,747,118 shares of the Company’s series A convertible redeemable preferred
stock (the “Preferred
Stock”) and warrants (the “Warrants”) to purchase
2,873,553 shares of the Company’s common stock, in a private placement (the
“February 2008 Private Placement”) pursuant to Regulation D under the Securities
Act of 1933, for the aggregate purchase price of $5 million (the “Transaction”).
Net proceeds, exclusive of expenses of the transaction were $4.6 million in
cash, after the Company paid fees of approximately $469,000 in cash of
which $400,000 was paid to Maxim Group, LLC, the placement agent for the
Transaction. The Company recorded the approximately $796,000 in fees, of which
$327,565 was related to value of the warrants granted to placement agent, as a
deferred debt cost and amortized approximately $ 99,517 and $33,172 of the
deferred cost during the three months ended at March 31, 2009 and 2008,
respectively. The convertible redeemable preferred stock is deemed debt due to
the mandatory redeemable feature of the preferred stocks.




The
Company used $2,576,556 of the net proceeds of the Transaction to repay in full
all of its outstanding principal obligations including accrued interest under
the 14% Secured Convertible Notes due February 2008 and the Company has at
contrary to use the remainder of the net proceeds for working capital and
general corporate purposes.


17


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE
9 - CONVERTIBLE
REDEEMABLE PREFERRED STOCKS (Continued)





Each of
these Preferred Shares is convertible  into one share of the Company’s
common stock (as adjusted for stock splits, stock dividends, reclassification
and the like), pays an 8% dividend annually, payable in additional Convertible
Preferred Shares and  also pays any dividend to be paid on the common
shares on an as-converted basis. Until May 25, 2010, the Preferred Shares may be
redeemed at the option of the Purchasers at the redemption price of $0.87 per
share (as adjusted for stock splits, stock dividends, reclassification and the
like), and no other capital stock of the Company may be redeemable prior to the
Preferred Shares. Holders of Preferred Shares may not convert Preferred Shares
to common shares if the conversion would result in the holder beneficially
owning more than 4.99% of the Company’s outstanding common shares. That
limitation may be waived by a holder of Preferred Shares on not less than 61
days written notice to the Company.





The
Warrants have an initial exercise price of $1.20 (subject to adjustment pursuant
to the terms of the warrants), are exercisable for a period of five (5) years
and may not be exercised  if exercise would result in the holder
beneficially owning more than 4.99% of the Company’s outstanding common shares.
That limitation may be waived by a holder of the warrants on not less than 61
days written notice to the Company.





Other key
provisions of the February 2008 Private Placement:




•
              The
      Preferred Shares vote with the common stock on an as converted basis,
      except that the Preferred Shares are not entitled to vote for directors.
      The Company is prohibited from taking certain corporate actions,
      including, without limitation, issuing securities senior to the Preferred
      Shares, selling substantially all assets, repurchasing securities and
      declaring or paying dividends, without the approval of the holders of a
      majority of the Preferred Shares then
  outstanding.
 
 •
              The
      Company agreed to undertake to file a resale registration statement within
      60 days following the Closing Date registering the maximum number of
      shares common stock issuable upon conversion of the Preferred Shares and
      exercise of  the warrants allowable under applicable federal
      securities regulations. If the Company was informed by the SEC that there
      were no comments to the registration statement, then the registration
      statement was required to be declared  effective within five (5)
      business days thereafter or on the 60th day after the filing date,
      whichever is sooner. If the SEC issued comments to the registration
      statement, then the registration statement was required to be declared
      effective by the 120th day after it was filed.  If the
      registration statement was not declared effective by the applicable date,
      the Company would be subject to liquidated damages, equal to 1% of the
      total conversion price and exercise price for the common stock being
      registered under the registration statement, for every 30-day period
      following the date that the registration statement should have been
      effective, prorated for any period less than 30 days, until either all of
      common shares registered under the registration statement have been sold
      or all such common shares may be sold in any three (3) month period
      pursuant to Rule 144 promulgated under the Securities Act, whichever is
      earlier. The Company must also pay the liquidated damages if sales cannot
      be made pursuant to the registration statement for any reason (excepting
      market conditions). The maximum amount of liquidated damages is
      $500,000.  The Company filed the resale registration statement
      on May 13, 2008 and received comments from the SEC.  The SEC
      declared the resale registration statement effective on July 25,
      2008.




18


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 9 -
CONVERTIBLE REDEEMABLE
PREFERRED STOCKS (Continued)




•
              The
      Founders delivered in the aggregate 7,500,000 shares of the Company’s
      common stock owned by them (the “Escrow Shares”) to an escrow account.
      Portions of the Escrow Shares are being held in escrow subject to the
      Company meeting certain net income targets in fiscal years 2007, 2008 and
      2009. The $8.5 million net income target for 2007 was achieved; as
      was   95% of $13.8 million in net income target for 2008.
      The net income target for 2009 is 95% of $17.5 million of net income, both
      after eliminating the effect of non-cash charges associated with the
      Transaction and adjusting for differences in the exchange rate between
      Chinese Renminbi and US dollars used in the Company’s financial statements
      and an exchange rate of RMB 7.30 to USD 1.00. A portion of the Escrow
      Shares will be transferred to the Purchasers if the Company does not meet
      the earning targets, and released back to the Founders if the Company
      does; another portion of the Escrow Shares is being held in escrow subject
      to the Company listing on the NASDAQ Stock Market within 18 months
      following the Closing Date. These Escrow Shares will be transferred to the
      Purchasers if the listing is not completed within that time period, and
      released back to the Founders if it is. In addition, two-thirds of the
      Escrow Shares are held in escrow to ensure that the Purchasers receive
      their full redemption payments if they choose to redeem their Preferred
      Shares. If a Purchaser receives less than the full redemption amount for
      each Preferred Share being redeemed, the Purchaser will receive a number
      of Escrow Shares to make up the difference, based on the then-current
      market price of the common shares. Following the end of the redemption
      period, these Escrow Shares, less those transferred to any Purchasers that
      redeemed their Preferred Shares, will be released back to the
      Founders.




In
connection with the issuance of the Preferred Shares and Warrants, the Company
recorded a total debt discount of $ 2,310,263 to be amortized over the term of
the Purchase Agreement. For the three months ended March 31, 2009 and 2008,
amortization of debt discount amounted to $ 288,783 and $84,709, respectively,
have been included in interest expense.




The
Company classified the series A Convertible redeemable preferred stock as
liability because of its mandatory redeemable feature according to SFAS
150.




On
February 25, 2009, the Company issued 459,772 additional shares of Series A
Preferred Stock to the holders of Series A Preferred Stock for the mandatory 8%
annual dividends.





The
series A convertible redeemable preferred stock on March 31, 2009 and December
31, 2008 is as follows:




March
      31, 2009
                  
                  
                  December
      31, 2008(Unaudited)Series
      A convertible redeemable preferred stock
                  
                  $
                  5,400,000
                  
                  
                  $
                  5,000,000Less:
      unamortized discount
                  
                  
                  (1,058,876
                  )
                  
                  
                  1,347,659Series
      A convertible redeemable preferred stock, net
                  
                  $
                  4,341,124
                  
                  
                  $
                  3,652,341





NOTE 10 – TAXES
PAYABLE




Value
Added Tax Payable





The
Company is subject to value added tax ("VAT") for manufacturing products. The
applicable VAT tax rate is 17% for products sold in the PRC. The amount of VAT
liability is determined by applying the applicable tax rate to the invoiced
amount of goods sold (output VAT) less VAT paid on purchases made with the
relevant supporting invoices (input VAT). Under the commercial practice of the
PRC, the Company paid value added taxes ("VAT") based on tax invoices issued.
The tax invoices may be issued subsequent to the date on which revenue is
recognized, and there may be a considerable delay between the date on which the
revenue is recognized and the date on which the tax invoice is issued. In the
event that the PRC tax authorities dispute the date of which revenue is
recognized for tax purposes, the PRC tax office has the right to assess a
penalty, which can range from zero to five times the amount of the taxes which
are determined to be late or


19


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 10 – TAXES PAYABLE
(Continued)




Value
Added Tax Payable (continued)





deficient.
According to the PRC tax laws, any potential tax penalty payable on late or
deficient payments of this tax could be between zero and five times the amount
of the late or deficient tax payable, and will be expensed as a period expense
if


and when
a determination has been made by the taxing authorities that a penalty is due.
At March 31, 2009 and December 31, 2008, the Company accrued $1,716,963 and
$5,015,908, respectively, of unpaid value-added taxes.





Income
tax payable





Prior to
January 1, 2008, companies established in the PRC were generally subject to an
enterprise income tax ("EIT") rate of 33.0%, which included a 30.0% state income
tax and a 3.0% local income tax. The PRC local government has provided various
incentives to companies in order to encourage economic development. Such
incentives include reduced tax rates and other measures. On March 16, 2007, the
National People's Congress of China passed the new Enterprise Income Tax Law
("EIT Law"), and on November 28, 2007, the State Council of China passed the
Implementing Rules for the EIT Law ("Implementing Rules") which took effect on
January 1, 2008. The EIT Law and Implementing Rules impose a unified EIT rate of
25.0% on all domestic-invested enterprises and Foreign Interest Enterprises
(“FIEs”), unless they qualify under certain limited exceptions. Therefore,
nearly all FIEs are subject to the new tax rate alongside other domestic
businesses rather than benefiting from the FEIT, and its associated preferential
tax treatments, beginning on January 1, 2008.





In
addition to the changes to the current tax structure, under the EIT Law, an
enterprise established outside of China with "de facto management bodies" within
China is considered a resident enterprise and will normally be subject to an EIT
of 25.0% on its global income. The Implementing Rules define the term "de facto
management bodies" as "an establishment that exercises, in substance, overall
management and control over the production, business, personnel, accounting,
etc., of a Chinese enterprise." If the PRC tax authorities subsequently
determine that the Company should be classified as a resident enterprise, then
the organization's global income will be subject to PRC income tax of 25.0%.
Beijing Liang Fang was subject to 25% income tax rate since January 1,
2009.





Taxes
payable are as follows:


March
      31, 2009
                              
                              
                              December
      31, 2008(Unaudited)Value
      added taxes
                              
                              $
                              1,716,963
                              
                              
                              $
                              5,015,908Income
      taxes
                              
                              
                              74,738
                              
                              
                              
                              -Other
      taxes
                              
                              
                              202,687
                              
                              
                              
                              -Total
                              
                              $
                              1,994,388
                              
                              
                              $
                              5,015,908


20


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 11
-SHAREHOLDERS’
EQUITY





Common
Stock





In
February 2009, the Company issued 842,308 shares of common stock to Mr. Liu
Zhongyi, Chairman and CEO of the Company, for his services rendered through
December 31, 2008 as the Company’s chief executive officer. The stock was valued
at the fair value of $0.26 per share on the grant date.





In
February 2009, the Company issued 67,308 shares of common stock to Adam
Wasserman (former CFO) using a fair value of $0.26 per share on the grant date
for his services rendered through December 31, 2008 as the Company’s chief
financial officer.





In
February 2009, the Company issued 48,077 shares of common stock to Mel Rothberg
using a fair value of $0.26 per share on the grant date for his services as an
independent director from January 1, 2008 to April 15, 2008 and consulting
services rendered through November 30, 2008.





Statutory
Reserves





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




The
statutory surplus reserve fund is non-distributable other than during
liquidation and can be used to fund previous years' losses, if any, and may be
utilized for business expansion or converted into share capital by issuing new
shares to existing shareholders in proportion to their shareholding or by
increasing the par value of shares currently held by them, provided that the
remaining reserve balance after such issue is not less than 25% of the
registered capital.





The
discretionary surplus fund may be used to acquire fixed assets or to increase
the working capital to expend on production and operation of the business. The
Company's Board of Directors decided not to make an appropriation to this
reserve for fiscal year 2009.





Pursuant
to the Company's articles of incorporation, the Company is to appropriate 10% of
its net profits as statutory surplus reserve. For the three months ended March
31, 2009 and 2008, the Company appropriated to the statutory surplus reserve in
the amount of $416,645 and $156,851, respectively.





Stock
warrants issued, terminated/forfeited and outstanding during the three months
ended March 31, 2009 (unaudited) are as follows:


Shares
                  
                  
                  Average
      Exercise price per shareWarrants
      outstanding on December 31, 2008
                  
                  
                  5,166,999
                  
                  
                  $
                  1.13Warrants
      issued
                  
                  
                  -
                  
                  
                  
                  -Warrants
      terminated/forfeited
                  
                  
                  -
                  
                  
                  
                  -Warrants
      exercised
                  
                  
                  -
                  
                  
                  
                  -Warrants
      outstanding on March 31, 2009
                  
                  
                  5,166,999
                  
                  
                  $
                  1.13


21


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 12 -
SEGMENT
INFORMATION





The
following information is presented in accordance with SFAS No. 131, Disclosure
about Segments of an Enterprise and Related Information.  In the three
months ended March 31, 2009 and 2008, the Company operated in two reportable
business segments - (1) the manufacture and distribution of pharmaceutical
products and examination of other companies’ products and (2) the retailing of
traditional and Chinese medicines and supplies through ten drug stores located
in Beijing China and other ancillary revenues generated from retail location
such as advertising income and rental income. The Company's reportable segments
are strategic business units that offer different products. They are managed
separately based on the fundamental differences in their
operations.




Information
with respect to these reportable business segments for the three months ended
March 31, 2009 and 2008 is as follows:





For
      the three months
                    ended
      March 31, 2009
                  
                  Wholesale
      and
                    third-party
                    manufacturing
                    and
      examination
                  
                  
                  Retail
                    operations
                  
                  
                  Rent
      and
                    advertising
                  
                  
                  Unallocated
                  
                  
                  TotalNet
      revenues
                  
                  $
                  9,488,971
                  
                  
                  
                  2,137,188
                  
                  
                  
                  198,128
                  
                  
                  
                  -
                  
                  
                  
                  11,824,287Cost
      of sales
                  
                  
                  3,665,352
                  
                  
                  
                  1,509,909
                  
                  
                  
                  10,897
                  
                  
                  
                  -
                  
                  
                  
                  5,186,158Operating
      expenses
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,449,005
                  
                  
                  
                  2,449,005Other
      expense (income)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  546,295
                  
                  
                  
                  546,295Income
      tax
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  74,727
                  
                  
                  
                  74,727Net
      income
                  
                  $
                  5,823,619
                  
                  
                  
                  627,279
                  
                  
                  
                  187,231
                  
                  
                  
                  (3,070,027
                  )
                  
                  
                  3,568,102




For
      the three months
                    ended
      March 31, 2008
                  
                  Wholesale
      and
                    third-party
                    manufacturing
                    and
      examination
                  
                  
                  Retail
                    operations
                  
                  
                  Rent
      and
                    advertising
                  
                  
                  Unallocated
                  
                  
                  TotalNet
      revenues
                  
                  $
                  9,512,895
                  
                  
                  
                  2,016,547
                  
                  
                  
                  179,735
                  
                  
                  
                  -
                  
                  
                  
                  11,709,177Cost
      of sales
                  
                  
                  6,558,497
                  
                  
                  
                  1,209,928
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  7,768,425Operating
      expenses
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,458,979
                  
                  
                  
                  2,458,979Other
      expense (income)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  485,674
                  
                  
                  
                  485,674Income
      tax
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Net
      income
                  
                  $
                  2,954,398
                  
                  
                  
                  806,619
                  
                  
                  
                  179,735
                  
                  
                  
                  (2,944,653
                  )
                  
                  
                  996,099


22


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 12 -
SEGMENT INFORMATION
(Continued)





The
Company does not allocate selling and general and administrative expenses to its
reportable segments, because these activities are managed at a corporate
level.





Asset
information by reportable segment is not reported to or reviewed by the chief
operating decision maker and, therefore, the Company has not disclosed asset
information for each reportable segment. Substantially all of the Company’s
assets are located in China.





NOTE
13—COMMITMENTS AND CONTINGENCIES





Technology Transfer
Agreement




In April
2008, one of the Company’s affiliates, En Ze Jia Shi, entered into a Technology
Transfer Agreement with Dong Guan Kai Fa Biological Medicine LTD (“Dong Guan”)
pursuant to which Dong Guan agreed to transfer the technology material, new
medicine research and rights to the Chinese patent of the anti-asthma new
medicine R-BM to En Ze Jia Shi on an exclusive basis in exchange for a transfer
technology fee of approximately $7 million (RMB 48 million) to be paid at
various intervals. Under the terms of the agreement, En Ze Jia Shi is obligated
to:




•
              complete
      the filing with the Chinese State Food and Drug Administration (SFDA) of
      the medicine’s clinical research ratification
  document,
 
 •
              complete
      the clinical research,
 
 •
              complete
      the medicine’s trial production,
and
 
 •
              provide
      raw materials and formulation related documentation and apply for the new
      medicine certification and production
approval.




In
addition to the payment of the technology transfer fee, En Ze Jia Shi is
responsible for paying all costs associated with its responsibility under the
agreement which are presently estimated at $2.3 million (RMB 16 million). Lotus
East intends to use its working capital to fund the project costs.




Dong Guan
is responsible for preparing and transferring the clinical research and
application documents as well as assisting En Ze Jia Shi in the completing the
clinical research and applying for the new medicine certification and production
approval documents.




Under the
terms of the agreement, the technology transfer fee is to be paid upon the
following schedule:




•
              Approximately
      $1.46 million (RMB 10 million) is due by the 15th business day following
      the receipt of the processing notice of the receipt of the clinical
      application and all related material from SFDA is
  received,
 
 •
              Approximately
      $1.17 million (RMB 8 million) is due by the 10th business day after the
      receipt of the medicine’s clinical ratification
  document,




23


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)




NOTE
13—COMMITMENTS AND CONTINGENCIES (Continued)




•
              Approximately
      $1.46 million (RMB 10 million) is due by the 15th business day after the
      medicine’s Phase I clinical study is completed and ratification from the
      SFDA is obtained, and
 
 •
              Approximately
      $2.92 million (RMB 20 million) is due by the 10th business day after the
      medicine’s Phase II clinical study is completed and ratification from the
      SFDA is obtained.




En Ze Jia
Shi paid Dong Guan a deposit of approximately $2.92 million (RMB 20 million) in
April 2008 which is to be returned to En Ze Jia Shi within 10 days after the
transfer technology fee is fully paid. In the event Dong Guan should be unable
to timely return the deposit, it will pay En Ze Jia Shi a late fee and En Ze Jia
Shi is entitled to damages for Dong Guan’s failure to timely return the
deposit.




The
intellectual property arising from the agreement will be jointly shared by the
parties. In addition, En Ze Jia Shi has guaranteed that both parties must
jointly apply for related government grants prior to when the new medicine is
marketed. Upon receipt of the government grants En Ze Jia Shi guaranteed that
the grant monies will be shared equally by both parties. As of March 31, 2009,
the Company has not received any government grant. The agreement can be
terminated by Dong Guan if En Ze Jia Shi should fail to make any of the
aforedescribed payments in which event the patent rights would revert to Dong
Guan and it is entitled to transfer the project rights to a third
party.




New Manufacturing
Facility




In June
2008, one of the Company’s affiliates, Liang Fang, entered into an agreement
with Cha You Qian Qi Economy Commission, a governmental agency (“Cha You”)
related to the construction of a pharmaceutical plant in Cha You’s Cha Ha Er
Industrial Garden District in Inner Mongolia. The new facility, which will be
comprised approximately 40,000 square meters situated on 600 MU of land
(approximately 400,200 square meters), will be used to expand Liang Fang’s
current manufacturing capacity. The Company was subsequently granted the right
to expand the land use right area to 1,000 MU (approximately 667,000 square
meters). The new facility, which will manufacture medical injection products,
including 0.9% physiological saline injection, hydroxyethyl starch 130/0.4
injection and hydroxyethyl starch 200/0.5 injection, Qiang Yi Ji starch, a
medical corn starch commonly known as O-2-hydeoxyethyl starch, dextran and
additional pharmaceuticals, will require a total investment of RMB 623.66
million, or approximately $91 million. The construction began on the project in
August 2008 and the Company anticipates that it will take between 12 to 30
months to complete the construction. As of March 31, 2009, the Company has
incurred approximately $3.3 million related to this project and the amount has
been included as construction in progress in the consolidated financial
statements.




Included
in the total cost of the project is land cost of approximately $32.7 million
(RMB 223.66 million) which was paid off to Cha You. Other components of the
project include construction costs of approximately $17.5 million (RMB 120
million) costs associated with the various production lines estimated at
approximately $33.6 million (RMB 230 million) and working capital of
approximately $7.3 million (RMB 50 million).




Liang
Fang intends to use its present working capital together with bank loans and
government grants to fund the project. The funds are required to be invested
over the next 15 months under a specified schedule ending in December 2010. As
of March 31, 2009, Liang Fang has paid approximately $36 million (approximately
RMB 246.5 million) of the total investment. Liang Fang, however, has not secured
either the bank loans or government grants and does not have sufficient working
capital to complete this project without securing substantial funds from those
third party sources.




Under the
terms of the agreement, Cha You agreed to abate fees associated with water
resources, waste and other relative supplies for a period of 30 years and agreed
to ensure that the land use tax to be paid by Liang Fang after it begins normal
production will be at the lowest tax rate imposed for five years. Once the
project is completed, for a period of eight years the local reserved portion of
the imposed corporation income tax will be returned to Liang
Fang.


24


LOTUS
PHARMACEUTICALS, INC. AND SUBSIDIARIES
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009 AND 2008
 (UNAUDITED)


NOTE 14 -
OPERATING
RISK





(a)
Country risk





Currently,
the Company’s revenues are primarily derived from the sale of pharmaceutical
products to customers in the Peoples Republic of China (PRC).  The
Company hopes to expand its operations to countries outside the PRC, however,
such expansion has not been commenced and there are no assurances that the
Company will be able to achieve such an expansion
successfully.  Therefore, a downturn or stagnation in the economic
environment of the PRC could have a material adverse effect on the Company’s
financial condition.





(b)
Products risk





In
addition to competing with other manufacturers of pharmaceutical product
offerings, the Company competes with larger Chinese and International companies
who may have greater funds available for expansion, marketing, research and
development and the ability to attract more qualified
personnel.  These Chinese companies may be able to offer products at a
lower price.  There can be no assurance that the Company will remain
competitive.





(c)
Political risk





Currently,
PRC is in a period of growth and is openly promoting business development in
order to bring more business into PRC.  Additionally PRC allows a
Chinese corporation to be owned by a United States corporation.  If
the laws or regulations are changed by the PRC government, the Company's ability
to operate the PRC subsidiaries and controlled entities could be
affected.


25


Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations.





Overview





We
operate, control and beneficially own the pharmaceutical businesses in China of
Lotus East under the terms of the Contractual Arrangements. Other than the
Contractual Arrangements with Lotus East, we do not have any business or
operations. Pursuant to the Contractual Arrangements we provide business
consulting and other general business operation services to Lotus East. Through
these Contractual Arrangements, we have the ability to control the daily
operations and financial affairs of Lotus East, appoint each of their senior
executives and approve all matters requiring stockholder approval. As a result
of these Contractual Arrangements, which enable us to control Lotus East, we are
considered the primary beneficiary of Lotus East. Accordingly, we consolidate
Lotus East's results, assets and liabilities in our financial statements. The
creditors of Lotus East, however, do not have recourse to any assets we may
have.





PRC law
currently places certain limitations on foreign ownership of Chinese companies.
To comply with these foreign ownership restrictions, we operate our business in
China through the Contractual Arrangements with Lotus East. The contractual
relationship among the above companies as follows:










Based in
Beijing, China, Lotus East is engaged in the production, trade and retailing of
pharmaceuticals, focusing on the development of innovative medicines and
investing in strategic growth to address various medical needs. Lotus East owns
and operates 10 drug stores throughout Beijing, China that sell Western and
traditional Chinese medications, lease medical treatment facilities to licensed
physicians, and generate revenues from the leasing of retail space to third
party vendors and the leasing of advertising locations at its retail
stores.





When used
in this section, and except as may be set forth otherwise, the terms "we," "us,"
"ours," and similar terms includes Lotus and its subsidiary Lotus International
as well as Lotus East.




CRITICAL
ACCOUNTING POLICIES AND ESTIMATES





Our
discussion and analysis of our financial condition and results of operations are
based on our financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States of America. The
preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities and expenses.
On an ongoing basis, we evaluate our estimates and judgments, including those
related to accrued expenses, fair valuation of stock related to stock-based
compensation and income taxes. We based our estimates on historical experience
and on various other assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.




REVENUE
RECOGNITION





Product
sales are generally recognized when title to the product has transferred to
customers in accordance with the terms of the sale. The Company recognizes
revenue in accordance with the Securities and Exchange Commission’s (SEC) Staff
Accounting Bulletin (SAB) No. 101, “Revenue Recognition in Financial
Statements” as amended by SAB No. 104 (together,
“SAB 104”), and Statement of Financial Accounting Standards (SFAS)
No. 48 “Revenue
Recognition When Right of Return Exists.”SAB 104 states that
revenue should not be recognized until it is realized or realizable and earned.
In general, the Company records revenue when persuasive evidence of an
arrangement exists, services have been rendered or product delivery has
occurred, the sales price to the customer is fixed or determinable, and
collectability is reasonably assured.




26




SFAS No. 48 states
that revenue from sales transactions where the buyer has the right to return the
product shall be recognized at the time of sale only if the seller’s price to
the buyer is substantially fixed or determinable at the date of sale, the buyer
has paid the seller, or the buyer is obligated to pay the seller and the
obligation is not contingent on resale of the product, the buyer’s obligation to
the seller would not be changed in the event of theft or physical destruction or
damage of the product, the buyer acquiring the product for resale has economic
substance apart from that provided by the seller, the seller does not have
significant obligations for future performance to directly bring about resale of
the product by the buyer, and the amount of future returns can be
reasonably estimated.




The
Company’s net product revenues represent total product revenues less allowances
for returns.





PRODUCT
RETURNS





The
Company accounts for sales returns in accordance with Statements of Financial
Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of
Return Exists, by establishing an accrual in an amount equal to its
estimate of sales recorded for which the related products are expected to be
returned. The Company determines the estimate of the sales return accrual
primarily based on historical experience regarding sales returns, but also by
considering other factors that could impact sales returns. These factors include
levels of inventory in the distribution channel, estimated shelf life, product
discontinuances, and price changes of competitive products, introductions of
generic products and introductions of competitive new products. In general, for
wholesale sales, the Company provides credit for product returns that are
returned six months prior to and up to six months after the product expiration
date. Upon sale, the Company estimates an allowance for future product returns.
The Company provides additional reserves for contemporaneous events that were
not known and knowable at the time of shipment. In order to reasonably estimate
future returns, the Company analyzed both quantitative and qualitative
information including, but not limited to, actual return rates, the level of
product manufactured by the Company, the level of product in the distribution
channel, expected shelf life of the product, current and projected product
demand, the introduction of new or generic products that may erode current
demand, and general economic and industry wide indicators. The Company also
utilizes the guidance provided in SAB 104 in establishing its return
estimates.





OTHER
REVENUE





Other
revenues consist of (i) rental income received for the lease of retail space to
various retail merchants; (ii) advertising revenues from the lease of counter
space at our retail locations; (iii) rental income from the lease of retail
space to licensed medical practitioners; and (iv) revenues received by us for
research and development projects. We recognize revenues upon performance of
such funded research. We recognize revenues from leasing of space as earned from
contracting third parties. Revenues received in advance are reflected as
deferred revenue on the accompanying balance sheets. Additionally, we receive
income from the sale of developed drug formulas. Income from the sale of drug
formulas are recognized upon performance of all of our obligations under the
respective sales contract and are included in other income on the accompanying
consolidated statement of operations.





ACCOUNTS
RECEIVABLE





Accounts
receivable are carried at original invoice amount less an estimate made for
doubtful receivables based on a review of all outstanding amounts on a monthly
basis. Management judgment and estimates are made in connection with
establishing the allowance for doubtful accounts. Specifically, we analyze the
aging of accounts receivable balances, historical bad debts, customer
concentrations, customer credit-worthiness, current economic trends and changes
in our customer payment terms. Significant changes in customer concentration or
payment terms, deterioration of customer credit-worthiness or weakening in
economic trends could have a significant impact on the collectability of
receivables and our operating results. If the financial condition of our
customers were to deteriorate, resulting in an impairment of their ability to
make payments, additional allowances may be required.





27




INVENTORIES





Inventories
are stated at the lower of cost or market with cost determined under the
weighted-average method. Inventory consists of finished capsules, liquids,
finished oral suspension powder and other western and traditional Chinese
medicines and medical equipment. At least on a quarterly basis, we review our
inventory levels and write down inventory that has become obsolete or has a cost
basis in excess of its expected net realizable value or is in excess of expected
requirements. Inventory levels are evaluated by management relative to product
demand, remaining shelf life, future marketing plans and other factors, and
reserves for obsolete and slow-moving inventories are recorded for amounts which
may not be realizable.





PROPERTY
AND EQUIPMENT





Property
and equipment are carried at cost. The cost of repairs and maintenance is
expensed as incurred; major replacements and improvements are capitalized. When
assets are retired or disposed of, the cost and accumulated depreciation are
removed from the accounts, and any resulting gains or losses are included in
income in the year of disposition. In accordance with Statement of Financial
Accounting Standards (SFAS) No. 144, "Accounting for the Impairment or Disposal
of Long-Lived Assets", we examine the possibility of decreases in the value of
fixed assets when events or changes in circumstances reflect the fact that their
recorded value may not be recoverable.





Depreciation
is calculated on a straight-line basis over the estimated useful lives of the
assets. The useful lives for property and equipment are as follows:





Buildings
      and leasehold improvement
                20
      to 40 yearsManufacturing
      equipment
                10
      to 15 yearsOffice
      equipment and furniture
                5
      to 8 years





INCOME
TAXES





Taxes are
calculated in accordance with taxation principles currently effective in the
United States and PRC. We account for income taxes using the liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized as income in the
period that includes the enactment date. A valuation allowance is provided for
the amount of deferred tax assets that, based on available evidence, are not
expected to be realized.





RECENT
ACCOUNTING PRONOUNCEMENTS





In March
2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments
and Hedging Activities-- an amendment of FASB Statement No. 133" ("FAS 161").
FAS 161 changes the disclosure requirements for derivative instruments and
hedging activities. Entities are required to provide enhanced disclosures about
(a) how and why an entity uses derivative instruments, (b) how derivative
instruments and related hedged items are accounted for under Statement 133 and
its related interpretations, and (c) how derivative instruments and related
hedged items affect an entity's financial position, financial performance, and
cash flows. The guidance in FAS 161 is effective for financial statements issued
for fiscal years and interim periods beginning after November 15, 2008, with
early application encouraged. This Statement encourages, but does not require,
comparative disclosures for earlier periods at initial adoption. We are
currently assessing the impact of FAS 161.





In May
2008, the Financial Accounting Standards Board (FASB”) issued FASB Staff
Position (FSP”) APB 14-1,Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement). FSP APB 14-1 clarifies that
convertible debt instruments that may be settled in cash upon either mandatory
or optional conversion (including partial cash settlement) are not addressed by
paragraph 12 of APB Opinion No. 14,Accounting for
Convertible Debt and Debt issued with Stock Purchase Warrants.Additionally, FSP APB 14-1
specifies that issuers of such instruments should separately account for the
liability and equity components in a manner that will reflect the entity’s
nonconvertible debt borrowing rate when interest cost is recognized in
subsequent periods. FSP APB 14-1 is effective for financial statements issued
for fiscal years beginning after December 15, 2008, and interim periods within
those fiscal years. We will adopt FSP APB 14-1 beginning in the first quarter of
fiscal 2010, and this standard must be applied on a retrospective basis. We are
evaluating the impact the adoption of FSP APB 14-1 will have on our consolidated
financial position and results of operations.





28




In May
2008, the FASB issued Statement of Financial Accounting Standards (SFAS”) No.
162,The Hierarchy
of Generally Accepted Accounting Principles.This standard is intended
to improve financial reporting by identifying a consistent framework, or
hierarchy, for selecting accounting principles to be used in preparing financial
statements that are presented in conformity with generally accepted accounting
principles in the United States for non-governmental entities. SFAS No. 162 is
effective 60 days following approval by the U.S. Securities and Exchange
Commission (SEC”) of the Public Company Accounting Oversight Board’s amendments
to AU Section 411,The Meaning of Present
Fairly in Conformity with Generally Accepted Accounting Principles.We do not expect SFAS No.
162 to have a material impact on the preparation of our consolidated financial
statements.





On June
16, 2008, the FASB issued final Staff Position (FSP) No. EITF 03-6-1,
Determining Whether Instruments Granted in Share-Based Payment Transactions Are
Participating Securities”to address the question
of whether instruments granted in share-based payment transactions are
participating securities prior to vesting. The FSP determines that unvested
share-based payment awards that contain rights to dividend payments should be
included in earnings per share calculations. The guidance will be effective for
fiscal years beginning after December 15, 2008. We are currently evaluating the
requirements of (FSP) No. EITF 03-6-1.





On
October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” which
clarifies the application of SFAS 157 in a market that is not active and
provides an example to illustrate key considerations in determining the fair
value of a financial asset when the market for that financial asset is not
active. FSP 157-3 became effective on October 10, 2008, and its adoption did not
have a material impact on our financial position or results.





In
January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment
Guidance of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment
on Purchased and Retained Beneficial Interests in Securitized Financial Assets”.
FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be
more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1
achieves this by amending the impairment model in EITF 99-20 to remove its
exclusive reliance on “market participant” estimates of future cash flows used
in determining fair value. Changing the cash flows used to analyze
other-than-temporary impairment from the “market participant” view to a holder’s
estimate of whether there has been a “probable” adverse change in estimated cash
flows allows companies to apply reasonable judgment in assessing whether an
other-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1
did not have a material impact on our consolidated financial
statements.





Results
of Operations





For
the Three Months Ended March 31, 2009 versus Three Months Ended March 31,
2008





Total
Net Revenues





Total
revenues for the three months ended March 31, 2009 were $11,824,287 as compared
to total revenues of $11,709,177 for the three months ended March 31, 2008, an
increase of $115,110 or approximately 0.98%. For the three months ended March
31, 2009 and 2008, net revenues consisted of the following:





2009
                        
                        
                        2008(Unaudited)
                        
                        
                        (Unaudited)Wholesale
                        
                        $
                        8,940,405
                        
                        
                        $
                        8,437,298Retail
                        
                        
                        2,137,188
                        
                        
                        
                        2,016,547Other
      revenues
                        
                        $
                        746,694
                        
                        
                        $
                        1,255,332Total
                        
                        
                        11,824,287
                        
                        
                        
                        11,709,177




29




·
              For
      the three months ended March 31, 2009, wholesale revenues increased by
      $503,107 or 5.96%. For the three months ended March 31, 2009, While the
      unit price sold for our wholesale drugs decreased by an average of
      approximately 38% compared to the three months ended March 31, 2008, the
      increase in the total wholesale revenue was primarily attributable to the
      increase by approximately 67% of our wholesale quantities compared to
      three months ended March 31, 2008. For our long term growth perspective
      and the purpose to incentivize our distributors, we lowered our average
      wholesale drugs price in a planned way. The significant increase in
      tangible product revenues is mainly attributed to strong sales in
      Valsartan Capsules, Brimonidine Tartrate Eye Drops and Octreotide Acetate
      Injection. The increase in revenue was offset by the decrease in sales in
      Levofloxacin Lactate for Injection, Recombinant Human Granulocyte Colony
      Stimulating Factor Injection and Deproteinized Calfblood Extractives
      Injection. The significant increased sales in Valsartan Capsules and
      Brimonidine Tartrate Eye Drops were primarily due to our strong sales
      effort on promoting this drug. The substantial increased sales in
      Octreotide Acetate Injection were attributable to our acquirement of the
      drug’s distribution channels, including sales representatives, in phases
      by purchase of the drug’s certificate and intellectual property right. In
      December 2008, we entered into a new drug certificate and intellectual
      property right transfer contract with Beijing Yipuan Bio-Medical
      Technology, Co., Ltd. related to the drug of Octreotide Acetate Injection.
      Octreotide Acetate Injection is a highly effective and stable octreotide
      acetate injection solution and used to treat the symptoms of gastric
      ulcers and hemorrhages of the upper digestive tract. We paid off the
      purchase amount in first quarter of fiscal 2009. So, we own all
      intellectual property rights associated with the drug. In late 2007, we
      obtained exclusive distribution rights from a third party Beijing based
      pharmaceutical company for four drugs: Octreotide Acetate Injection,
      Recombinant Human Erythropoietin Injection, Recombinant Human Granulocyte
      Colony-stimulating Factor Injection, and Recombinant Human Interleukin-2
      for Injection. In 2008, we obtained exclusive distribution rights for
      Cervus and Cucumis Polypeptide Injection. Additionally, we also strengthen
      our relationships with the several large drug manufacturers in 2008. As a
      result, we experienced a significant increase in our third party
      manufactured drug sales during the three months ended March 31, 2009. As
      majority of our wholesale products are prescription drugs that are in
      demand by patients in China, we believe the demand for our wholesale
      products will not be impacted by the overall softening economy. We expect
      the sales will continue to have steady growth in our rest fiscal year of
      2009.
 
 ·
              For
      the three months ended March 31, 2009, retail revenues increased by
      $120,641 or 5.98%. The increase is attributable to our continuous efforts
      to diversify products carried by our retail stores to provide more
      varieties as well as better quality products and the favorable RMB
      currency appreciation which converted our revenue in RMB into higher US
      dollar amounts. As a result, our retail revenue increased. We expect our
      retail revenue will stably increase in our rest fiscal year of
      2009.
 
 ·
              For
      the three months ended March 31, 2009, other revenues decreased by
      $508,638 or 40.52%. The decrease in other revenues is attributed to the
      following:




2009
                            
                            
                            2008(Unaudited)
                            
                            
                            (Unaudited)Leasing
      revenues
                            
                            $
                            198,128
                            
                            
                            $
                            179,523Third-party
      manufacturing
                            
                            
                            513,651
                            
                            
                            
                            908,890Advertising
      revenues
                            
                            
                            -
                            
                            
                            
                            212Research
      and development and lab testing services
                            
                            
                            34,915
                            
                            
                            
                            166,707Total
      other revenues
                            
                            $
                            746,694
                            
                            
                            $
                            1,255,332




·
              We
      sublease certain portion our retail stores and counter spaces to various
      other vendors and generate leasing revenue. The leasing revenue remained
      materially consistent with prior year same period. The slight increase was
      primarily due to the favorable RMB currency appreciation which converted
      our revenue in RMB into higher US dollar amounts. We expect our leasing
      revenue to remain flat in the remaining part of the 2009 fiscal
      year.
  ·
              For
      third-party manufacturing, customers supply the raw materials and we are
      paid a fee for manufacturing their products. We had less large
      manufacturing contracts during the three months ended March 31, 2009 as
      the demand for the third-party manufacturing decreased as compared to the
      same period in 2008. Many of our prior customers built their own
      facilities and can manufacture their products at lower costs in their own
      factories. As a result, our third-party manufacturing revenue decreased.
      We anticipate the third-party manufacturing revenue will continue to
      decrease in the remaining part of fiscal 2009 as we do not expect to have
      new customers with large third party manufacturing
    contracts.
  30
  ·
              We
      receive advertising fee for the lease of counter and other space at our
      retail locations in Beijing. We do not have any advertising revenue during
      the three months ended March 31, 2009. Because the local government
      tightens the advertising rules and regulations in the pharmaceutical
      industry, we do not anticipate signing any advertisement contracts in the
      near future.
  ·
              We
      performed research and development and lab testing projects for various
      third parties and performed drug testing and analysis. We preformed less
      R&D testing services and drug testing and analysis work for third
      parties during the three months ended March 31, 2009 as compared to the
      same period in 2008. Some of our historical customers for these services
      purchased relative machinery and they can do similar R&D and lab
      testing in their own labs at a lower price and decided not to use our
      services in 2009. We expect the revenue from R&D and lab testing will
      maintain at its current level with minimal growth in the remaining part of
      2009 fiscal year.




Cost
of Sales





Cost of
sales includes raw materials, packing materials, direct labor, manufacturing
costs, which includes allocated portion of overhead expenses such as Labor fee,
utilities and depreciation directly related to product production, and related
taxes. For the three months ended March 31, 2009, cost of sales amounted to
$5,186,158 or approximately 44% of total net revenues as compared to cost of
sales of $7,768,425 or approximately 66% of total net revenues for the three
months ended March 31, 2008. The decrease in cost of sales as a percentage of
total net revenue was primarily due to better purchase pricing management and
more efficient production cost controls.





Gross
Profit





Gross
profit for the three months ended March 31, 2009 was $6,638,129 or 56% of total
net revenues, as compared to $3,940,752 or 34% of total net revenues for the
three months ended March 31, 2008. The increase in gross profit was attributable
to the decrease in cost of sales as a percentage of revenue. The decrease in
cost of sales as a percentage of revenue was primarily contributed to better
managed raw material and third party manufactured finished goods purchase prices
and more efficient control in labor fees. Although we recognized higher than
average gross profits during the three months ended March 31, 2009, there could
be no assurance that we will continue to recognize similar gross profit margin
in the future.





Operating
Expenses





Total
operating expenses for the three months ended March 31, 2009 were $2,449,005, a
decrease of $9,974 or 0.41% from total operating expenses in the three
months ended March 31, 2008 of $2,458,979. This decrease included the
following:





For the
three months ended March 31, 2009, selling expenses amounted to $1,701,799 as
compared to $1,122,337 for the three months ended March 31, 2008, an increase of
$579,462 or 51.63% from the comparable period in fiscal 2008. This increase is
primarily attributable to the increase of our sales revenues and the improvement
of our collections on accounts receivables and cash flows. In order to generate
sufficient cash to meet our near term capital commitments such as new
manufacture plant construction project, purchase of new drug certificate and
intellectual property right of Octreotide Acetate Injection and acquiring
Chinese Class I drug patent, management incentivized our sales and collection
personnel’s performance. We expect our selling expenses to increase as our
revenues increase and expect to spend increased funds on advertising and
promotion of our products.





For the
three months ended March 31, 2009, we do not have any research and development
costs. So, as compared to $710,225 for the three months ended March 31, 2008, a
decrease of $710,225 or 100% from the comparable period in 2008. In late
2007, we entered into several research and development agreements with third
parties for the design, research and development of designated pharmaceutical
projects. We fulfilled these research and development agreements on June 30,
2008. We did not enter into any new research and development agreement in the
second half of fiscal 2008 and in the first quarter of fiscal 2009. As a result,
expenses related to research and development project is zero during the three
months ended March 31, 2009.





31




For the
three months ended March 31, 2009, general and administrative expenses were
$747,206 as compared to $626,417 for the three months ended March 31, 2008, an
increase of $120,789 or 19.28% from the comparable period in fiscal
2008.  These changes are summarized below:





Three
      Months Ended March 31,2009
                        
                        
                        2008(Unaudited)
                        
                        
                        (Unaudited)Salaries
      and related benefits
                        
                        $
                        172,100
                        
                        
                        $
                        269,468Amortization
      and depreciation expenses
                        
                        
                        242,692
                        
                        
                        
                        57,826Rent
                        
                        
                        75,355
                        
                        
                        
                        51,168Travel
      and entertainment
                        
                        
                        165,651
                        
                        
                        
                        19,762Professional
      fees
                        
                        
                        41,709
                        
                        
                        
                        39,980Other
                        
                        
                        49,699
                        
                        
                        
                        188,213Total
                        
                        $
                        747,206
                        
                        
                        $
                        626,417




The
changes in these expenses from the three months ended March 31, 2009 as compared
to the three months ended March 31, 2008 included the following:


·
              Salaries
      and related benefits decreased $97,368 or 36.13% primarily due to a
      decrease in bonuses paid to administrative personnel. We continue our
      efforts to control corporate spending. As a result, the salaries and
      related benefits costs decreased
accordingly.
  ·
              Depreciation
      on our fixed assets and amortization of our intangible assets increased by
      $184,866 or approximately 319.69% which is primarily attributable to the
      purchase of new intangible assets in the first quarter of fiscal
      2009.
  ·
              Rent
      increased by $24,187 or approximately 47.27% which is primarily
      attributable to the RMB currency appreciation which converted our rent
      expenses in RMB into higher US dollar
amounts.
 
 ·
              Travel
      and entertainment expenses increased by $145,889 or 738.23% which is
      primarily attributable to the increased spending in our travel in order to
      more efficiently manage our business and increased entertainment
      expenditure to enhance our
visibility.
  ·
              Professional
      fees increased $1,729 or 4.33% due to the RMB currency appreciation which
      converted our professional fees in RMB into higher US dollar
      amounts.
  ·
              Other
      general and administrative expenses, which includes postage, office
      expenses, other management fees, officers’ car insurance and meeting
      expenses, decreased by $138,514 or approximately 73.59% reflecting efforts
      at reducing non-sales related corporate activities as well as stricter
      controls on corporate
spending.




Income
from Operations





We
reported income from operations of $4,189,124 for the three months ended March
31, 2009 as compared to income from operations of $1,481,773 for the three
months ended March 31, 2008, an increase of $2,707,351 or approximately
182.71%.





Other
Expense





For the
three months ended March 31, 2009, total other expense amounted to $546,295 as
compared to other expense of $485,674 for the three months ended March 31, 2008,
an increase of $60,621 or 12.48% from the comparable period in 2008. This change
is primarily attributable to:


32
  ·
              For
      the three months ended March 31, 2009, our debt issuance costs of $99,517
      compared to $62,886 for the three months ended March 31, 2008, an increase
      of $36,631 or approximately 58.25%, due to the debt issuance costs on our
      February 2008 funding for which we began our amortization in March
      2008.
 
 ·
              For
      the three months ended March 31, 2009, we recorded interest income of
      $1,319 as compared to $561 for the three months ended March 31, 2008, an
      increase of $758 or 135.12% which is primarily attributable to the
      favorable RMB currency appreciation which converted our interest income in
      RMB into higher US dollar amounts.
 
 ·
              For
      the three months ended March 31, 2009, interest expense was $448,097 as
      compared to $423,349 for the three months ended March 31, 2008, an
      increase of $24,748 or 5.85% which is primarily attributable to our
      February 2008 financing for which we began our amortization of the debt
      discount and to accrue the dividend on preferred stock in March
      2008.




NET
INCOME, OTHER COMPREHENSIVE INCOME AND COMPREHENSIVE INCOME





As a
result of these factors, we reported net income of $3,568,102 for the three
months ended March 31, 2009 as compared to net income of $996,099 for the three
months ended March 31, 2008. This translates to basic and diluted net income per
common share of $0.08, $0.07 and $0.02, $0.02 for the three months ended March
31, 2009 and 2008, respectively.





During
the three months ended March 31, 2009, our unrealized gain on foreign currency
translation of $62,111, a decrease of $1,392,092, or approximately 95.73%, from
the same period in 2008. We report in U.S. dollars, but the functional currency
of Lotus East is the RMB. Translation adjustments result from the process of
translating the local currency financial statements into U.S. dollars, with the
average translation rates applied to our income statement of 6.84659 RMB to
$1.00 during the three months ended March 31, 2009. As a result of this non-cash
gain, we reported comprehensive income of $3,630,213 for the three months ended
March 31, 2009 as compared to $2,450,302 for the same period in
2008.





Liquidity
and Capital Resources





Liquidity
is the ability of a company to generate funds to support its current and future
operations, satisfy its obligations and otherwise operate on an ongoing
basis.





At March
31, 2009, we had a cash balance of $1,228,769. These funds are located in
financial institutions located as follows:





China
                      
                      $
                      1,228,346USA
                      
                      
                      423Total
                      
                      $
                      1,228,769




Our
working capital position decreased $6,585,900 to $ (2,163,717) at March 31,
2009 from $4,422,183 at December 31, 2008. This decrease in working capital is
primarily attributable to a decrease in accounts receivablenet of allowance of
approximately $4.74 million, a decrease in other receivable- related party of
approximately $2.03 million, a decrease in accounts payable and accrued expenses
of approximately $1.31 million, a decrease in taxes payable of approximately
$3.02 million, an increase in other receivable-employee of approximately $0.73
million, an increase in unearned revenue of approximately $0.23 million and an
increase in due to related parties of approximately $0.13 million.





At March
31, 2009, our accounts receivable, net of allowance for doubtful accounts, was
$1,395,054 as compared to $6,132,912 at December 31, 2008, a decrease of
$4,737,858. The decrease was primarily due to our strong collection effort which
significantly improved our accounts receivable aging days. We expect our
accounts receivable will maintain at the current level.





At March
31, 2009, we have an other receivable-employee of $730,396. This is a loan made
to our employee. In May 2009, the employee paid back the money to the Company.
We did not have any other receivable-employee on December 31, 2008.





33




At March
31, 2009, our other receivable- related party was $0 as compared to $2,027,954
at December 31, 2008, a decrease of $2,027,954. The decrease was attributable to
one loan made to our CEO to register a subsidiary in Inner Mongolia. After a few
days, in January 2009, our CEO paid back the money to the Company.





At March
31, 2009, our inventories of raw materials, work in progress, packaging
materials, finished goods and reserve for obsolete inventories totaled
$3,726,128, a decrease of approximately $61,674 from December 31, 2008. Included
in this change were a decrease of $589,397 in raw materials and a decrease of
$2,097 in packing materials offset by increase in finished goods of $529,820. We
expect to maintain slight higher raw materials, packaging materials and finished
goods inventory levels to accommodate for anticipated future sales growth and
productions.





At
March 31, 2009, we have a prepaid expenses and other assets of $77,380 as
compared to $121,274 at March 31, 2008, a decrease of $43,894. The decrease was
primarily due to the completion of our research and development contracts which
were recorded as a prepayment on March 31, 2008 and we did not have similar
research and development contract prepayments on March 31, 2009.





At
March 31, 2009, we have a deferred debt cost of $364,894 as compared to $464,411
at December 31, 2008, a decrease of $ 99,517. The decrease was primarily
attributed to the issuance of the series A convertible redeemable preferred
stock and warrants to purchase 2,873,553 shares of the company’s common stock in
February 2008 financing. We recorded a total deferred debt cost of $796,133 and
amortized it began March 2008.





At
March 31, 2009, we have a deposit on patent of $2,921,585 as compared to
$2,917,919 at December 31, 2008, an increase of $3,666. We made the deposit on
patent in order to acquire a new Chinese Class I anti-asthma medicine drug
patent in accordance with a technology transfer agreement the Company entered
into in April 2008. The increase is attributable to the favorable RMB currency
appreciation which converted our deposit on patent in RMB into higher US dollar
amounts.





At March
31, 2009, we have an installmentson intangible assets of
$35,301,508 as compared to $38,175,134 at December 31, 2008, a decrease of
$2,873,626. The decrease was primarily attributable to the transfer of our
installments in a new drug certificate and intellectual property right--
Yipubishan (common name: Octreotide Acetate Injection) to intangible
assets.





At March
31, 2009, we have an intangible assets, net of accumulated amortization, of
$8,885,346 as compared to $1,231,730 at December 31, 2008, an increase of
$7,653,616. The increase was primarily attributable to purchase of a new drug
certificate and intellectual property right.





At
March 31, 2009, we have an accounts payable and accrued expenses of $856,345 as
compared to $2,170,165 at December 31, 2008, a decrease of $1,313,820. The
decrease was primarily attributed to the decrease in payables for construction
in progress for our new facility in Inner Mongolia.





At March 31, 2009, we have a
taxes payable of $1,994,388 as compared to $5,015,908 at December 31, 2008, a
decrease of $3,021,520. The decrease in the taxes payable is primarily due to
our payments for accrued unpaid taxes made to taxes authority in
China.





Our
balance sheet at March 31, 2009, also reflects a balance due to related parties
of $2,175,892 which was a working capital advance made to us by our president,
vice-president and an officer of the Company and a Board member as well as an
amount payable of approximately $1 million related to an assignment agreement as
discussed elsewhere in this report. These advances are non-interest bearing and
are due on demand. We are currently repaying these balances as operating cash
become available.





At
March 31, 2009, we have a series A convertible redeemable preferred stock of
$4,341,124 as compared to $3,652,341 at December 31, 2008, an increase of
$688,783. The increase was primarily attributed to the amortization of discount
on convertible redeemable preferred stock of $288,783 and the issued additional
convertible redeemable preferred stock of $400,000 as dividend.





Our
balance sheet at March 31, 2009 also reflects notes payable to related parties
of approximately $5 million due on December 30, 2015 which is a working capital
loan made to us in December 31, 2005 by the Company’s Chief Executive Officer,
two employees of the Company and a Board member. These loans bear a variable
annual interest at 80% of current bank rate and are unsecured. During the three
months ended March 31, 2009, we did not repay any portion of these loan
balances.





34




The
changes in asset and liabilities discussed above is based on a comparison of
amounts on our balance sheets at March 31, 2009 and December 31, 2008 and does
necessarily reflect changes in assets and liabilities reflected on our cash flow
statement, which we use the average foreign exchange rate during the period to
calculate these changes.





Net
cash provided by operating activities for the three months ended March 31, 2009
was $7,008,339 as compared to net cash used in operating activities of
$3,610,250 for the three months ended March 31, 2008. For the three months ended
March 31, 2009, net cash provided by operating activities was attributable
primarily to decrease in accounts receivable of $4,744,877, decrease in
inventories of $66,423, decrease in prepaid expenses and other current assets of
$1,329,083 and increase in unearned revenue of $228,143 and the add back of net
income of $3,568,102, depreciation and amortization of $362,467, amortization of
debt issuance costs of  $99,517, amortization of discount on
convertible redeemable preferred stock of $288,783, amortization of prepaid
expense attributable to warrants of $14,849 offset by decrease in accounts
payable and accrued expenses of $666,522 and decrease in taxes payable of
$3,027,383. For the three months ended March 31, 2008, net cash used in
operating activities was attributable primarily to increase in accounts
receivable of $115,927, increase in inventories of $3,161,360, increase in
prepaid expenses and other current assets of $2,012,656, decrease in accounts
payable and accrued expenses of $98,515 and decrease in advances from customers
of $35,197 and the add back of net income of $996,099,  depreciation
and amortization of $148,884, amortization of debt issuance costs of $62,512 and
amortization of debt discount of $208,355 and amortization of discount on
convertible redeemable preferred stock of $84,709, increase in allowance for
doubtful accounts and sales return of $53,305, offset by increase in taxes
payable of $41,792 and increase in unearned revenue of
$217,749.





Net cash
used in investing activities for the three months ended March 31, 2009 amounted
to $7,119,219. For the three months ended March 31, 2009, net cash used in
investing activities was attributable to the purchase of intangible assets of
$7,887,138 and the purchase of property and equipment of $2,153,243 offset by
the decrease in installments on intangible assets of $2,921,162. Net cash used
in investing activities for the three months ended March 31, 2008 amounted to
$0.





Net cash
provided by financing activities was $59,314 for the three months ended March
31, 2009 and was attributable to the proceeds from related party advances of
$59,314. Net cash provided by financing activities was $2,368,814 for the three
months ended March 31, 2008 and was attributable to the receipt of net proceeds
of $5,000,000 from our private financing and proceeds from related party
advances of $357,382 offset by payments on convertible debt of $2,520,000 and
debt issuance costs of $468,568.





We
reported a net decrease in cash for the three months ended March 31, 2009 of
$50,039 as compared to a net decrease in cash of $968,580 for the three months
ended March 31, 2008.




In 2007,
we made advanced approximately $2 million to Lotus East which it used as working
capital.  We obtained the funds to make the loan out of the net
proceeds received from the sale of $3 million principal amount our convertible
debt in February 2008.  These advances are unsecured and interest
free. During the first quarter of 2008, we used a portion of the proceeds from
the sale of Preferred Shares to satisfy these notes, lent Lotus East an
additional $1.6 million and retained the balance to fund our operating expenses.
We have no operations other than the Contractual Arrangements with Lotus East
and, accordingly, we are dependent upon the quarterly service fees due us to
provide cash to pay our operating expenses. Such payments have not been tendered
to us and those funds are being retained by Lotus East to fund their operations.
At March 31, 2009, Lotus East owned us approximately $21.96 million for such
fees and we do not know when such funds will be paid to us. Our CEO is also the
CEO and principal shareholder of Lotus East. Accordingly, we are solely reliant
upon his judgment to ensure that the funds advanced to Lotus East are repaid to
us. If these funds should not be repaid, or if Lotus East use the funds for
options and not pay the quarterly service fee due us under the Contractual
Arrangement, it is possible that we will not have sufficient funds to pay our
operating expenses in future periods.




35




Other
than our existing cash we presently have no other alternative source of working
capital. We believe that our working capital may not be sufficient to fund our
current operations for the next 12 months and we estimate that we will require
additional working capital of at least $350,000 to fund our current operations
for the next 12 months. Lotus East has historically funded its capital
expenditures from their working capital and has advised us that they believe
this capital is sufficient for their current needs. Lotus East has contractual
commitments for approximately $62.81 million related to a Technology Transfer
Agreement and the construction of the new manufacturing
facility.  While it intends to fund the costs associated with the
Technology Transfer Agreement and a portion of the construction of the new
manufacturing facility with its existing working capital, it is dependent upon
the continued growth of its operations and prompt payment of outstanding
accounts receivables by its customers to ensure that it has sufficient cash for
these commitments. In addition, its ability to fully fund the costs associated
with the new manufacturing facility is materially dependent upon its ability to
secured bank financing and/or government grants. As the banking industry is
tightening the credit/lending policy, we expect the bank financing will become
more challenging and the time to obtain the bank funding might be longer than
expected. Although the Chinese government has recently announced an economic
simulation plan, there is no guarantee that we will successfully be awarded the
government grant. As it has no firm commitments for either, while its management
believes the company will be successful in securing the necessary funding
through its increasing revenue, quicker collections on receivables, current
discussions with various commercial banks there are no assurances the funding
will be available in the amounts or at the time required to meet Liang Fang's
commitment.  In the event Lotus East is not successful in obtaining
the funds it needs for the Technology Transfer Agreement, it is possible that it
could default under the terms of the agreement and forfeit any funds paid to
date.  If Lotus East is not successful in obtaining all of the funding
necessary to complete the construction of the new facility, which is estimated
to be approximately $58 million, it would get back approximately $36,009,000
spent to date, including the $32,672,081 for the deposit on the land use rights
which is refundable if the Chinese local government would not grant it land use
rights certificate.





However,
the ability of Lotus East to raise any significant capital to expand their
operations is very limited. We believe that it is in our best long term
interests to assist Lotus East in their growth plans. Accordingly, it is likely
that we will seek to raise working capital not only for our operating expense
but also to provide capital to Lotus East for these projects as well as
providing working capital necessary for its ongoing operations and obligations.
No assurances can be given that we will be successful in obtaining additional
capital, or that such capital will be available in terms acceptable to our
company, particularly given the current conditions in the capital markets. If we
are unable to raise capital as necessary for our operations, and we were no
longer able to timely file our reports with the Securities and Exchange
Commission, our common stock would no longer be eligible for quotation on the
OTC Bulletin Board. In this event (i) the ability of our stockholders to
liquidate their investment in our company would be adversely impacted and (ii)
would could be deemed to have defaulted on our obligations under various
agreements we are a party to with the purchasers of our Preferred
Shares.




Contractual
Obligations and Off-Balance Sheet Arrangements




Contractual
Obligations




We have
certain fixed contractual obligations and commitments that include future
estimated payments. Changes in our business needs, cancellation provisions,
changing interest rates, and other factors may result in actual payments
differing from the estimates. We cannot provide certainty regarding the timing
and amounts of payments. We have presented below a summary of the most
significant assumptions used in our determination of amounts presented in the
tables, in order to assist in the review of this information within the context
of our consolidated financial position, results of operations, and cash flows.
The total of contractual obligations and commitments does not include any
payments made by us.




The
following tables summarize our contractual obligations as of March 31, 2009, and
the effect these obligations are expected to have on our liquidity and cash
flows in future periods.


Payments
      due by periodContractual
      obligations:
                  
                  Total
                  
                  
                  Less
      than 1
                    year
                  
                  
                  1-3
      Years
                  
                  
                  3-5
                    Years
                  
                  
                  5+
      YearsSeries
      A convertible redeemable preferred stock
                  
                  $
                  5,400,000
                  
                  
                  $
                  5,400,000
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Related
      parties indebtedness
                  
                  $
                  7,238,695
                  
                  
                  $
                  1,715,742
                  
                  
                  $
                  460,150
                  
                  
                  $
                  -
                  
                  
                  $
                  5,062,803Patent
      purchase obligations
                  
                  $
                  4,382,377
                  
                  
                  $
                  1,460,792
                  
                  
                  $
                  2,921,585
                  
                  
                  $
                  -
                  
                  
                  $
                  -Construction
      obligations
                  
                  $
                  58,431,693
                  
                  
                  $
                  17,529,508
                  
                  
                  $
                  40,902,185
                  
                  
                  $
                  -
                  
                  
                  $
                  -Total
      contractual obligations
                  
                  $
                  75,452,765
                  
                  
                  $
                  26,106,042
                  
                  
                  $
                  44,283,920
                  
                  
                  $
                  -
                  
                  
                  $
                  5,062,803




36




Off-balance
Sheet Arrangements





As of the
date of this report, we do not have any off-balance sheet arrangements that have
or are reasonably likely to have a current or future effect on our financial
condition, changes in financial condition, revenues or expenses, results of
operations, liquidity, capital expenditures or capital resources that are
material to investors, however we have agreed to guarantee loans for Lotus East,
if required. As of the date of this report, we have not entered into any
guarantee arrangements with Lotus East. The term "off-balance sheet arrangement"
generally means any transaction, agreement or other contractual arrangement to
which an entity unconsolidated with us is a party, under which we have: (i) any
obligation arising under a guarantee contract, derivative instrument or variable
interest; or (ii) a retained or contingent interest in assets transferred to
such entity or similar arrangement that serves as credit, liquidity or market
risk support for such assets.




Item
3.Quantitative and Qualitative
Disclosures About Market Risk.





Not applicable for a smaller reporting
company.





Item
4T.             
Controls and
Procedures.





Our
management does not expect that our disclosure controls and procedures or our
internal control over financial reporting will prevent all error and fraud. A
control system, no matter how well conceived and operated, can provide only
reasonable, but no absolute, assurance that the objectives of a control system
are met. Further, any control system reflects limitations on resources, and the
benefits of a control system must be considered relative to its costs. These
limitations also include the realities that judgments in decision-making can be
faulty and that breakdowns can occur because of simple error or mistake.
Additionally, controls can be circumvented by the individual acts of some
persons, by collusion of two or more people or by management override of a
control. A design of a control system is also based upon certain assumptions
about potential future conditions; over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the policies
or procedures may deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur and
may not be detected.





Evaluation
of Disclosure Controls and Procedures





Disclosure
controls and procedures refer to controls and other procedures designed to
ensure that information required to be disclosed in the reports we file or
submit under the Securities Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the rules and forms of the SEC and
that such information is accumulated and communicated to our management,
including our Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required
disclosure.





We
maintain “disclosure controls and procedures” as such term is defined in Rule
13a-15(e) under the Securities Exchange Act of 1934. In designing and evaluating
our disclosure controls and procedures, our management recognized that
disclosure controls and procedures, no matter how well conceived and operated,
can provide only reasonable, not absolute, assurance that the objectives of
disclosure controls and procedures are met. Additionally, in designing
disclosure controls and procedures, our management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible
disclosure controls and procedures. The design of any disclosure controls and
procedures also is based in part upon certain assumptions about the likelihood
of future events, and there can be no assurance that any design will succeed in
achieving its stated goals under all potential future
conditions.





As
required by Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, our management has carried out an evaluation, with the participation and
under the supervision of our Chief Executive Officer and our Chief Financial
Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures as of March 31, 2009.  As discussed in more detail
below, our Chief Executive Officer and our Chief Financial Officer concluded
that our disclosure controls and procedures are ineffective as of March 31,
2009, due to material weaknesses that we identified in internal control over
financial reporting in our annual report on Form 10-K for the fiscal year ended
December 31, 2008 (the “Form 10-K).





Remediation
Measures of Material Weaknesses





We have
implemented, or plan to implement, the measures described below under the
supervision and guidance of our management to remediate the control deficiencies
identified in the Form 10-K and to strengthen our internal controls over
financial reporting. Key elements of the remediation effort include, but are not
limited to, the following initiatives, which have been implemented, or are in
the process of implementation, as of the date of filing of this
interim report:




37




1.
              We
      have increased efforts to enforce internal control
      procedures.  We have also reorganized the structure of our China
      financial department and clarified the responsibilities of each key
      personnel in order to increase communications and
      accountability.
 
 2.
              We
      have recruited and will continue to bring in additional qualified
      financial personnel for the accounting department to further strengthen
      our China financial reporting
function.
 
 3.
              We
      continually review and improve our standardization of our monthly and
      quarterly data collection, analysis, and reconciliation procedures. To
      further improve the timeliness of data collection, we are selecting and
      will install new point of sale systems and enterprise resource planning
      systems for our wholesale and retail
operations.
 
 4.
              We
      plan on significantly increasing the level of communication and
      interaction among our China management, independent auditors, our
      directors of the Board, and other external
  advisors.
 
 5.
              We
      are in the process of searching for qualified internal control consultants
      to help us be in compliance with internal control obligations, including
      Section 404. We also plan to dedicate sufficient resources to implement
      required internal control
procedures.




We
believe that the foregoing steps will remediate the material weaknesses
identified above, and we will continue to monitor the effectiveness of these
steps and make any changes that our management deems appropriate. Due to the
nature of these material weaknesses in our internal control over financial
reporting, there is more than a remote likelihood that misstatements which could
be material to our annual or interim financial statements could occur that
would not be prevented or detected.





Changes
in Internal Control over Financial Reporting





Except as
described above, there have been no changes in our internal control over
financial reporting during our first fiscal quarter that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.





PART II -
OTHER INFORMATION




Item 1.
Legal Proceedings.




None.




Item 1A.
Risk Factors.




Not
applicable to smaller reporting company.




Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.





None.





Item 3.
Defaults Upon Senior Securities.




None.




Item 4.
Submissions of Matters to a Vote of Security Holders.





None.




Item 5.
Other Information.




None.




38




Item 6.
Exhibits.





No.
                
                Description31.1
                
                Rule
      13a-14(a)/ 15d-14(a) Certification of Chief Executive
    Officer31.2
                
                Rule
      13a-14(a)/ 15d-14(a) Certification of Chief Financial
    Officer32.1
                
                Section
      1350 Certification of Chief Executive Officer32.2
                
                Section
      1350 Certification of Chief Financial
Officer




39


SIGNATURES




Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





Lotus
      Pharmaceuticals, Inc.Date:  May
      15, 2009
                  By:
                  /s/
      Liu Zhong YiLiu
      Zhong YiChief
      Executive Officer and President, principal executive
    officer




Date:  May
      15, 2009
                  By:
                  /s/
      Yan ZengYan
      ZengChief
      Financial Officer, principal financial and accounting
    officer




40