UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549







FORM 10-Q





(Mark One)


x
Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934





For the quarterly period ended September 30, 2011





 ̈
Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934





For the transition period from  to





COMMISSION FILE NO: 001-32569





AMERICAN ORIENTAL BIOENGINEERING, INC.


American Oriental Bioengineering, Inc.


(Exact name of registrant as specified in its charter)








NEVADA
84-0605867(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)





1 Liangshuihe First Ave, Beijing E-Town Economic and Technology Development Area, E-Town,


Beijing, 100176, People’s Republic of China


(Address of principal executive offices) (Zip Code)





86-10-5982-2039


(Registrant’s telephone number, including area code)






(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 x    No  ̈





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 o   No x





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
 ̈
Accelerated filer
xNon-accelerated filer
 ̈  (Do not check if a smaller reporting company)
Smaller reporting company
 ̈





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ̈    No x





The number of shares outstanding of each class the issuer’s common stock as of the latest practicable date is stated below


Title of each class of common stock

Outstanding as of November 11, 2011Common Stock, $0.001 par value

78,503,381














TABLE OF CONTENTS





PART I – FINANCIAL INFORMATION
3ITEM 1 – Financial Statements
3Unaudited condensed consolidated balance sheet as of September 30, 2011 and condensed consolidated balance sheet as of December 31, 2010 (restated)
3Unaudited condensed consolidated statements of income and comprehensive income for the three and nine months ended September 30, 2011 and 2010 (restated)
5Unaudited condensed statements of cash flow for the nine months ended September 30, 2011 and 2010 (restated)
6Notes to unaudited condensed consolidated financial statements - September 30, 2011
7ITEM 2 – Management's Discussion and Analysis of Financial Condition and Results of Operations
28ITEM 3 – Quantitative and Qualitative Disclosures About Market Risk
40ITEM 4 – Controls and Procedures
40PART II – OTHER INFORMATION
42ITEM 1 – Legal Proceedings
42ITEM 1A – Risk Factors
42ITEM 2 – Unregistered Sales of Equity Securities and Use of Proceeds
42ITEM 3 – Defaults upon Senior Securities
42ITEM 4 – (Removed and Reserved)
42ITEM 5 – Other Information
42ITEM 6 – Exhibits
42Signatures
43








2





PART I – FINANCIAL INFORMATION





ITEM 1 – FINANCIAL STATEMENTS





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)








SEPTEMBER 30,

2011


DECEMBER 31,

2010(RESTATED)CURRENT ASSETSCash and cash equivalents

$
83,018,431


$
94,568,520Restricted cash


654,977



537,297Accounts and notes receivable, net


64,117,238



80,598,919Inventories, net


24,201,066



12,665,586Advances to suppliers and prepaid expenses


19,547,924



14,246,144Deferred tax assets


221,222



649,503Receivable for disposal of investment


39,832,547



38,567,410Other current assets


1,839,855



2,986,005Total Current Assets


233,433,260



244,819,384LONG-TERM ASSETSProperty, plant and equipment, net


136,405,433



109,547,616Land use rights, net


157,892,698



155,433,311Other long term assets


12,281,370



8,167,880Construction in progress


32,378,396



22,516,044Other intangible assets, net


12,858,509



14,889,127Investments in and advances to equity investments


18,922,088



19,179,235Goodwill


33,164,121



33,164,121Deferred tax assets


84,176



147,024Unamortized financing cost


1,580,721



2,359,404Total Long-Term Assets


405,567,512



365,403,762TOTAL ASSETS

$
639,000,772


$
610,223,146


See accompanying notes to the condensed consolidated financial statements





3





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)





LIABILITIES AND EQUITY





SEPTEMBER 30,

2011


DECEMBER 31,

2010(RESTATED)CURRENT LIABILITIESAccounts payable

$
14,304,039


$
10,716,686Notes payable


654,977



537,297Other payables and accrued expenses


14,987,564



18,039,557Taxes payable


845,753



1,237,169Short-term loans


12,766,861



6,957,258Current portion of long-term bank loans


62,472



61,405Other liabilities


5,160,521



6,284,107Deferred tax liabilities


87,382



243,304Total Current Liabilities


48,869,569



44,076,783LONG-TERM LIABILITIESLong-term bank loans, net of current portion


631,990



679,866Deferred tax liabilities


14,263,066



15,837,479Unrecognized tax benefits


7,874,802



6,055,656Convertible notes


109,500,000



115,000,000Total Long-Term Liabilities


132,269,858



137,573,001TOTAL LIABILITIES


181,139,427



181,649,784COMMITMENTS AND CONTINGENCIESEQUITYSHAREHOLDERS’ EQUITYPreferred stock, $0.001 par value; 2,000,000 shares authorized; 1,000,000 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively


1,000



1,000Common stock, $0.001 par value; 150,000,000 shares authorized; 78,952,544 shares and 78,598,604 shares issued as of September 30, 2011 and December 31, 2010, respectively; 78,503,381 shares and 78,598,604 shares outstanding as of September 30, 2011 and December 31, 2010, respectively


78,952



78,598Common stock to be issued


224,333



350,500Additional paid-in capital


205,971,757



203,322,671Retained earnings (the restricted portion of retained earnings is $26,293,785 at both September 30, 2011 and December 31, 2010)


216,442,093



205,260,681Less: Treasury stock, at cost (449,163 shares and nil as of September 30, 2011 and December 31, 2010, respectively)


(799,999
)


-Less: Prepaid forward repurchase contract


(29,998,616
)


(29,998,616
)Accumulated other comprehensive income


65,421,859



49,053,329Total Shareholders’ Equity


457,341,379



428,068,163Non-controlling Interest


519,966



505,199TOTAL EQUITY


457,861,345



428,573,362TOTAL LIABILITIES AND EQUITY

$
639,000,772


$
610,223,146





See accompanying notes to the condensed consolidated financial statements





4





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME


(UNAUDITED)




THREE MONTHS ENDED

SEPTEMBER 30,


NINE MONTHS ENDED

SEPTEMBER 30,2011


2010


2011


2010(RESTATED)





(RESTATED)Revenues

$
53,934,602


$
91,533,044


$
159,988,508


$
222,579,024Cost of sales


28,730,424



44,250,846



83,863,569



107,219,753GROSS PROFIT


25,204,178



47,282,198



76,124,939



115,359,271Selling, general and administrative expenses


12,080,424



20,920,522



34,577,769



48,326,800Advertising costs


2,964,877



10,983,946



10,185,380



26,949,663Research and development costs


2,825,967



4,724,703



8,652,455



10,754,394Depreciation and amortization expenses


1,804,888



1,682,058



5,359,979



4,902,005Debt extinguishment (gain)


(2,666,829
)


-



(2,666,829
)


-Total operating expenses


17,009,327



38,311,229



56,108,754



90,932,862INCOME FROM OPERATIONS


8,194,851



8,970,969



20,016,185



24,426,409Equity in (losses) earnings from unconsolidated entities


(796,727
)


242,183



(857,811
)


201,097Impairment loss on equity investment


-



(1,083,637
)


-



(1,083,637
)Gain (loss) on changes in ownership of unconsolidated entities


-



-



658,540



(12,240
)Interest expense, net


(1,802,954
)


(1,456,062
)


(4,850,651
)


(4,393,093
)Other (expenses) income, net


(116,196
)


(67,548
)


321,571



(85,340
)INCOME BEFORE INCOME TAXES


5,478,974



6,605,905



15,287,834



19,053,196Provision for income taxes


(2,203,013
)


2,366,398



4,091,655



6,578,178NET INCOME


7,681,987



4,239,507



11,196,179



12,475,018Net (income) loss attributable to non-controlling interest


(28,446
)


7,679



(14,767
)


19,555NET INCOME ATTRIBUTABLE TO CONTROLLING  INTEREST


7,653,541



4,247,186



11,181,412



12,494,573OTHER COMPREHENSIVE INCOMEForeign currency translation gain


5,020,779



7,780,438



16,368,530



9,716,941OTHER COMPREHENSIVE INCOME


5,020,779



7,780,438



16,368,530



9,716,941COMPREHENSIVE INCOME

$
12,674,320


$
12,027,624


$
27,549,942


$
22,211,514EARNINGS PER COMMON SHAREBasic

$
0.10


$
0.06


$
0.15


$
0.17Diluted

$
0.10


$
0.06


$
0.15


$
0.17WEIGHTED AVERAGE COMMON SHARES OUTSTANDINGBasic


74,845,855



74,934,428



74,801,120



74,765,028Diluted


76,524,003



75,965,266



76,307,044



75,647,024





See accompanying notes to the condensed consolidated financial statements





5





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)





NINE MONTHS ENDED

SEPTEMBER 30,2011


2010(RESTATED)CASH FLOWS FROM OPERATING ACTIVITIES:Net income

$
11,196,179


$
12,475,018Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


9,288,606



9,595,579Amortization of deferred issuance cost


695,510



696,216Loss on disposal of property, plant and equipment


9,712



370Impairment loss on equity investment


-



1,083,637Stock-based consulting expenses


64,813



93,917(Reversal) /Provision of doubtful accounts and slow moving inventories


(79,935
)


12,722Deferred taxes


(1,712,491
)


(508,000
)Stock-based compensation expenses


2,258,850



1,983,421Equity in (earnings) /losses from unconsolidated entities


857,811



(201,097
)(Gain) /loss on changes in ownership of unconsolidated entities


(658,540
)


12,240Independent director stock compensation


224,333



266,000Debt extinguishment (gain)


(2,666,829
)


-Changes in operating assets and liabilities:(Increase) decrease in:Accounts and notes receivable


16,554,608



(22,638,890
)Inventories


(11,521,442
)


(8,007,819
)Advances to suppliers and prepaid expenses


(5,326,505
)


5,732,837Other current assets


1,562,285



89,782Increase (decrease) in:Accounts payable


3,622,793



4,077,922Other payables and accrued expenses


(3,853,121
)


(2,206,738
)Taxes payable


(391,416
)


609,868Other liabilities


(1,123,586
)


2,454,682Unrecognized tax benefits


1,785,656



1,712,866Net cash provided by operating activities


20,787,291



7,334,533CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant and equipment


(378,478
)


(609,818
)Purchases of construction in progress


(8,950,290
)


(4,747,741
)Deposit for long-term assets


(30,353,949
)


(29,022
)Advances to equity investments


65,949



(21,368
)Proceeds from disposal of property, plant and equipment


228



-Net cash used in investing activities


(39,616,540
)


(5,407,949
)CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from loans


12,663,526



6,764,562Repayment of loans


(7,157,474
)


(10,612,644
)Repurchase of convertible notes


(2,750,000
)


-Repurchase of common stock


(799,999
)


-Net cash provided by (used in) financing activities


1,956,053



(3,848,082
)Effect of exchange rate changes on cash and cash equivalents


5,323,107



3,251,787NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS


(11,550,089
)


1,330,289Cash and cash equivalents, beginning of period


94,568,520



91,126,486CASH AND CASH EQUIVALENTS, END OF PERIOD

$
83,018,431


$
92,456,775





See accompanying notes to the condensed consolidated financial statements





6
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)


NOTE 1 - BASIS OF PRESENTATION





The unaudited condensed consolidated financial statements of American Oriental Bioengineering, Inc. and subsidiaries (the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. However, the information included in these interim financial statements reflects all adjustments
(consisting solely of normal recurring adjustments) which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full year. The condensed consolidated balance sheet as of December 31, 2010 has been derived from the amended audited consolidated financial statements included in the Company’s Annual Report on Form 10-K/A. These interim financial statements should be read in conjunction with that report.





Basis of Consolidation





The unaudited condensed consolidated financial statements include the financial statements of American Oriental Bioengineering, Inc. and its subsidiaries. All significant inter-company balances and transactions between the Company and its subsidiaries are eliminated upon consolidation. Results of acquired subsidiaries are consolidated from the date on which control is transferred to the Company and are no longer consolidated from the date that control ceases.





Use of Estimates





The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates reflected in the consolidated financial statements include, but are not limited to, the recoverability of the carrying amount and estimated useful lives of long-lived assets, allowance for accounts receivable, realizable values for inventories, valuation
allowance of deferred tax assets, purchase price allocation of its acquisitions, valuation of derivative financial instruments, and share-based compensation expenses. Changes in facts and circumstances may result in revised estimates. Actual results could differ from these estimates.





Foreign Currency





The accompanying consolidated financial statements are presented in United States dollars (“US$”). The functional currency of the Company is US$, while that of the Company’ subsidiaries operating in the PRC is Renminbi (“RMB”), as determined based on the criteria of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ ASC”) 830 “Foreign Currency Matters”.





Assets and liabilities of non-U.S. subsidiaries are translated into U.S. dollars at the noon buying rate certified by the Federal Reserve Bank of New York on September 30, 2011. Income and expense items are translated at average exchange rates prevailing during the period. The resulting translation adjustments are recorded as a component of shareholders’ equity. Gains and losses from foreign currency transactions are included in net income.





SEPTEMBER 30,2011


2010Quarter end RMB : US$ exchange rate


6.4018



6.6981Average quarterly RMB : US$ exchange rate


6.4329



6.7534





The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that the RMB amounts could have been, or could be, converted into US$ at the rates used in translation.





7
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Revenue Recognition





Revenues represent the invoiced value of goods sold and are recognized upon the shipment of goods to customers. The product sales price stated in the sales contract or purchase order is final and not subject to adjustment. Revenues are recognized pursuant to FASB ASC 605 “Revenue Recognition”, when all of the following criteria are met:





●
Persuasive evidence of an arrangement exists,





●
Delivery has occurred or services have been rendered,





●
The seller’s price to the buyer is fixed or determinable, and





●
Collectability is reasonably assured.





Revenue is recognized net of all value-added taxes imposed by governmental authorities and collected from customers concurrent with revenue-producing transactions.





Cost of Sales





Cost of sales includes direct and indirect production costs, as well as freight in and handling costs for products sold.





Selling, General and Administrative Expenses





Selling, general and administrative (SG&A) expenses include salaries, benefits and other staff-related costs associated with sales and marketing, finance and other administrative personnel; facilities and overhead costs; legal expenses and other general and administrative costs. SG&A expenses also include the costs of selling merchandise, including preparing the merchandise for sale, such as picking, packing, warehousing and order charges. All shipping and handling are expensed as incurred and outbound freight is not billed to customers.





Advertising Costs





The Company expenses advertising costs as incurred. Point of sale materials are accounted for as inventories and are charged to expense as utilized.





Research and Development Costs





Research and development costs are expensed as incurred.





FASB ASC 805 “Business combinations” requires the recognition of tangible and intangible assets that result from or are to be used in research and development activities as assets, irrespective of whether the acquired assets have an alternative future use. Acquired In-Progress Research & Development (IPR&D) assets are required to be measured at their acquisition-date fair value. Uncertainty about the outcome of an individual project does not affect the recognition of an IPR&D asset, but is reflected in its fair value.





Comprehensive Income





Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, items that are required to be recognized under current accounting standards as components of comprehensive income are required to be reported in a financial statement that is presented with the same prominence as other financial statements. The Company’s comprehensive income includes net income and foreign currency translation adjustments.





Stock-Based Compensation





Stock-based compensation includes 1) stock options and common stock awards granted to employees and directors for services, and are accounted for under FASB ASC 718 “Compensation - Stock Compensation”, and 2) common stock awards granted to consultants which are accounted for under FASB ASC 505-50 “Equity – Equity-Based Payments to Non-Employees”.





8
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)


All grants of common stock awards and stock options to employees and directors are recognized in the financial statements based on their grant date fair values. The Company has elected to recognize compensation expense using the straight-line method for all common stock awards and stock options granted with service conditions that have a graded vesting schedule, with a corresponding charge to additional paid-in capital.





Common stock awards are granted to directors for services provided. The vested portions of common stock awards granted but not yet issued are recorded in “Common stock to be issued” until issuance.





Common stock awards issued to consultants represent common stock granted to non-employees in exchange for services at fair value. The measurement dates for such awards are set at dates that the contracts are entered into as the awards are non-forfeitable and vest immediately. The measurement date fair value is then recognized over the service period as if the Company has paid cash for such service. The Company does not have significant grants to consultants for any of the period presented.





The Company estimates fair value of common stock awards based on the number of shares granted and the quoted price of the Company’s common stock on the date of grant.





The fair value of stock options is estimated using the Black-Scholes model. The Company’s expected volatility assumption is based on the historical volatility of the Company’s stock. The expected life assumption is presumed to be the mid-point between the vesting date and the end of the contractual term, as is permitted for “plain vanilla” employee stock options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.





FASB ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in the subsequent period if actual forfeitures differ from initial estimates. Forfeiture rate is estimated based on historical and future expectation of employee turnover rate and are adjusted to reflect future change in circumstances and facts, if any. Share-based compensation expense is recorded net of estimated forfeitures such that expense was recorded only for those stock options and common stock awards that are expected to vest.





Income Taxes





The Company accounts for income taxes following the liability method pursuant to FASB ASC 740 “Income Taxes”.  Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if, based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized.  The effect on deferred taxes of a change in tax rate is
recognized in income in the period that includes the enactment date.





The Company accounts for uncertainty in income taxes in accordance with FASB ASC 740-10 “Income Taxes-Overall”. The Company has elected to classify interest and penalties related to an uncertain position, if and when required, as part of interest expenses and other expenses, respectively, in the consolidated statements of income and comprehensive income.





Value-Added Tax (“VAT”)





Enterprises or individuals, who sell commodities, engage in repair and maintenance or import or export goods in the PRC are subject to a value-added tax in accordance with the PRC laws. The value-added tax’s standard rate is 17% of the gross sales price and the Company records its revenue net of VAT. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the production of the Company’s finished products can be used to offset the VAT due on the sales of the finished products.





Segment Reporting





The Company has two operating segments based on its major lines of businesses: manufacturing and distribution. Each operating segment derives its revenues from the sale of products or services, respectively and each is the responsibility of a group of senior management of the Company who has knowledge of product and service specific operational risks and opportunities. The Company’s chief operating decision maker reviews and evaluates separate sets of financial information for decisions regarding resources allocation and performance assessments.





9
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)


Cash and Cash Equivalents





Cash and cash equivalents consist of cash on hand and bank deposits with original maturities of three months or less, which are unrestricted as to withdrawal and use.





Restricted Cash





Restricted cash represents amounts held by a bank as security for bank acceptance notes and therefore is not available for the Company’s use. The restriction on cash is expected to be released within the next twelve months.





Accounts and Notes Receivable





Accounts and notes receivable are carried at net realizable value. An allowance for doubtful accounts is recorded in the period when loss is probable based on an assessment of specific evidence indicating troubled collection, historical experience, accounts aging and other factors. A receivable is written off after all collection effort has ceased.





Financing Costs





Financing costs represent the incurred costs directly attributable to the issuance of the convertible notes. These costs, presented as non-current assets, are deferred and amortized ratably using the effective interest method from the debt issuance date over the earliest redemption date of the convertible notes. If the notes are converted prior to the debt maturity date, the unamortized financing costs will be transferred to equity immediately upon occurrence of such an event.





Inventories





Inventories are stated at the lower of cost or market value. Cost is determined by the weighted average method. Costs of raw materials and consumables and packaging materials are based on purchase costs while costs of work-in-progress and finished goods comprise direct materials, direct labor and an allocation of manufacturing overhead costs.





Recurring agricultural costs include costs relating to irrigation, fertilizing, seedling, utility, farming wages and other ongoing crop and land maintenance activities. Recurring agricultural costs are capitalized as inventory and cease to be accumulated when the crops have reached maturity and ready to be harvested.  Any recurring agricultural costs incurred subsequent to the crops reaching maturity are expensed as incurred. Non-recurring agricultural costs, primarily comprising soil improvements and other long-term crop growing costs that benefit multiple harvests, are deferred and amortized over the estimated production
period.





Fair Value of Financial Instruments





FASB ASC 820 “Fair Value Measurements and Disclosures” establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market.





These tiers include:





●
Level 1 - defined as observable inputs such as quoted prices in active markets;





●
Level 2 - defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and





●
Level 3 - defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.





The carrying amounts of financial assets and liabilities, such as cash and cash equivalents, accounts and notes receivable, short-term bank loans, accounts payable, notes payable and other payables, approximate their fair values because of the short maturity of these instruments. The carrying values of long-term loans approximate their fair values due to the fact that the interest rates on these loans are reset each year based on prevailing market interest rates. The convertible notes are initially recognized based on residual proceeds after allocation to the derivative financial liabilities, if any, at fair value and subsequently carried at amortized cost using the effective interest rate
method, with any accrued and unpaid interest included under other payables and accrued expenses.





10
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)


Construction in Progress





Construction in progress represents direct costs of construction or acquisition, interest and design fees incurred. Capitalization of these costs ceases and the construction in progress is transferred to property, plant and equipment when substantially all the activities necessary to prepare the assets for their intended use are completed. No depreciation is provided until it is completed and ready for intended use.





The Company accounts for interest capitalization in accordance with FASB ASC 835 "Interest".  Interest costs are capitalized if they are incurred during the acquisition, construction or production of a qualifying asset and such costs could have been avoided if expenditures for the assets have not been made.  Capitalization of interest costs commences when the activities to prepare the asset are in progress and expenditures and borrowing costs are being incurred. Interest costs are capitalized until the assets are ready for their intended use.





Land Use Rights





According to the PRC laws, the government owns all the land in the PRC. Companies or individuals are authorized to possess and use the land only through land use rights granted by the PRC government. Land use rights are being amortized using the straight-line method over the lease term ranging from 40 to 50 years.





Property, Plant and Equipment





Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation is provided over their estimated useful lives, using the straight-line method. Estimated useful lives of the property, plant and equipment are as follows:





Buildings
40 yearsMachinery and equipment
10 yearsMotor vehicles
5 yearsOffice equipment
5 yearsOther equipment
5 yearsLeasehold improvements
Shorter of 10 years or the lease term





The cost and related accumulated depreciation of assets sold or otherwise retired are eliminated from the accounts and any gain or loss is included in the consolidated statements of income and comprehensive income. The cost of maintenance and repairs is charged to the statement of income as incurred, whereas significant renewals and betterments are capitalized.





Other Intangible Assets





Other intangible assets include product licenses, trademarks, patents and proprietary technologies, which are stated at acquisition cost less accumulated amortization. Amortization expense is recognized using the straight-line method over the estimated useful life. Proprietary technologies are recorded as an intangible asset only if regulatory approval from the Chinese State Food and Drug Administration, or SFDA, has been obtained and for which the re-registration of the proprietary technologies with the SFDA by the Company in its name is determined to be reasonably assured or perfunctory. The amortization of such intangible assets will not commence until the technology has been re-registered
with the SFDA and hence ready for its intended use.  The cost of the product licenses are amortized over their licensed period of 2 to 12 years; the cost of trademarks are amortized over their registered period of 2 to 10 years; the cost of patents are amortized over their protection period of 7 to 20 years and the cost of proprietary technologies is amortized over its protection period of 10 years. The weighted-average amortization period of product licenses, trademarks, patents and proprietary technologies are 7.56 years, 6.40 years, 12.85 years and 9.42 years, respectively.





Goodwill





Goodwill and other intangible assets are accounted for in accordance with the provisions of FASB ASC 805 and FASB ASC 350 “Intangibles - Goodwill and Other”. Under FASB ASC 805, goodwill is measured as the excess of “a” over “b” below:





a.             The aggregate of the following:





1.
The consideration transferred measured in accordance ASC 805, which generally requires acquisition-date fair value.


2.
The fair value of any non-controlling interest in the acquiree.





11
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





3.
In a business combination achieved in stages, the acquisition-date fair value of the acquirer’s previously held equity interest in the acquiree.





b.
The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with FASB ASC 805.





Other intangible assets are separately recognized from goodwill if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of an intent to do so.





Under FASB ASC 350, goodwill, including any goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have indefinite useful lives are not amortized.





Impairment





The annual evaluation of impairment of goodwill involves comparing the current fair value of each of the Company’s reporting units to their recorded value, including goodwill. The Company utilizes a two-step method to perform a goodwill impairment review in the fourth quarter of each fiscal year or when facts and circumstances indicate goodwill may be impaired. In the first step, the Company determines the fair value of the reporting unit using expected future discounted cash flows and estimated terminal values. If the net book value of the reporting unit exceeds the fair value, the Company would then perform the second step of the impairment test which requires allocation of the
reporting unit’s fair value of all of its assets and liabilities in a manner similar to a purchase price allocation, with any residual fair value being allocated to goodwill. The implied fair value of the goodwill is then compared to the carrying value to determine impairment, if any.





During the nine months ended September 30, 2011, the Company considered the on-going decline in its stock price an impairment indication and conducted an interim goodwill impairment assessment. Based on the first step of the goodwill impairment test, the fair value of the reporting units exceeded the net book value. Therefore, the Company did not perform step two of the goodwill impairment test and no goodwill impairment loss was recognized as of September 30, 2011.





Finite-lived intangible assets are amortized over their respective useful lives and, along with other long-lived assets, are evaluated for impairment periodically whenever events or changes in circumstances indicate that their related carrying amounts may not be recoverable in accordance with FASB ASC 360, “Property, Plant and Equipment”.





In evaluating long-lived assets for recoverability, including finite-lived intangibles and property and equipment, the Company uses its best estimate of future cash flows expected to result from the use of the asset and eventual disposition in accordance with FASB ASC 360-10-15. To the extent that estimated future, undiscounted cash inflows attributable to the asset, less estimated future, undiscounted cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value. Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment,
are reported at the lower of carrying value or fair value less costs to sell.





No impairment loss is subsequently reversed even if facts and circumstances indicate recovery. There was no impairment loss recognized for the periods presented.





Investments





The Company applies FASB ASC 323, “Investments—Equity Method and Joint Ventures”, in accounting for its equity investments. Under FASB ASC 323, the equity method of accounting is used for investments in entities in which the Company has the ability to exercise significant influence but does not own a majority equity interest or otherwise control. Under the equity method, the Company initially records its investment at cost and adjusts the carrying amount of the investment to recognize the Company’s proportionate share of each equity investee’s net income or loss into consolidated statements of income after
the date of acquisition.





The difference between the cost of the equity investee and the amount of the underlying equity in the net assets of the equity investee is recognized as equity method goodwill included in equity method investment on the consolidated balance sheets. The Company monitors its investments for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions, the operating performance of the investee companies including current earnings trends and other company-specific information. Any balance of equity method goodwill is not tested for impairment under the provisions of FASB ASC 350. Instead, equity method goodwill is tested for impairment
together with the related investment as they are not separable.


12
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)











An impairment loss on the equity method investments is recognized in the consolidated statements of income when the decline in value is determined to be other-than-temporary.





Economic and Political Risks





The Company’s operations are conducted in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy.





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





The Company’s products are subject to price control by the PRC government. The maximum prices of the products are published by the PRC price administration authorities from time to time. Any changes in product pricing announced by the PRC price administration authorities affect future sales transactions.





Newly Adopted Accounting Pronouncements





In September 2011, the FASB issued Accounting Standards Update 2011-08 (ASU 2011-08), “Testing Goodwill for Impairment.” ASU 2011-08 is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a “qualitative” assessment to determine whether further impairment testing is necessary. Specifically, an entity has the option to first assess qualitative factors to determine whether it is necessary to perform the current two-step test. If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is
less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. This standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The provisions of ASU 2011-08 are not expected to have a material impact on the financial position, results of operations or cash flows of the Company.





In June 2011, the FASB issued Accounting Standards Update 2011-05 (ASU 2011-05), "Presentation of Comprehensive Income."  ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in shareholders' equity and requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement or in two separate but consecutive statements. This pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The provisions of ASU 2011-05 are not expected to have a material
impact on the financial position, results of operations or cash flows of the Company.





In May 2011, the FASB issued Accounting Standards Update 2011-04 (ASU 2011-04), “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes certain fair value measurement principles and requires additional disclosures about fair value measurements. The updated guidance is effective on a prospective basis for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. The provisions of ASU 2011-04 are not expected to have a material impact
on the financial position, results of operations or cash flows of the Company.








13
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





NOTE 3 – RESTATEMENT OF PRIOR PERIOD CONSOLIDATED FINANCIAL STATEMENTS




Subsequent to the issuance of the consolidated financial statements as of and for the fiscal year ended December 31, 2010, the Company’s Independent Registered Public Accounting Firm identified accounting errors related to the Company’s equity investment in Nuo Hua Affiliate.
  The Company and the Audit Committee undertook a review to determine the total amount of the errors and the accounting periods in which the error occurred and concluded that the Company’s previously issued audited consolidated financial statements as of and for the year ended December 31, 2010, and unaudited interim condensed consolidated financial statements as of September 30, 2010, March 31, 2011 and June 30, 2011, should be and, accordingly, have been restated because of these accounting errors.
  On September 27, 2010, the Company entered into an equity transfer agreement with an unrelated third party pursuant to which the Company agreed to sell its equity interest in Nuo Hua Affiliate, for a consideration of RMB255,000,000 ($38,567,410), with RMB148,543,200 ($22,466,378) to be paid in cash and RMB106,456,800 ($16,101,032) to be paid in equity interests of another company owned by the third party buyer.  In October 2010, the Company’s equity interest in Nuo Hua Affiliate was legally transferred to the third party buyer. As of December 31, 2010 and up to November 14, 2011, the Company has not received the consideration from the third party buyer.
  The Company did not appropriately account for this transaction in its financial statements as filed with the Securities and Exchange Commission for year ended December 31, 2010 or the quarters ended September 30, 2010, March 31, 2011 or June 30, 2011.
  The errors made in accounting for this transaction resulted in:
  ·
For the quarter ended September 30, 2010, the recognition of an impairment loss and a corresponding reduction in the carrying amount of the equity investment.
  ·
For the year ended December 31, 2010, a reclassification from “Investments in and advances to equity investments” to “Receivables for disposal of equity investment”; the recognition of a loss on disposal of equity investment; the reversal of income in equity earnings in unconsolidated entities, and the recording of income tax expense and a corresponding unrecognized tax benefits liability due to the tax effect of the capital gain resulting from the transaction, as the equity interest in Nuo Hua Affiliate was initially purchased at a price that was lower than the disposition consideration.
  ·
For the quarter ended March 31, 2011, a reclassification from “Investments in and advances to equity investments” to “Receivables for disposal of equity investment”, and the reversal of income in equity earnings in unconsolidated entities.
  ·
For the quarter ended June 30, 2011, a reclassification from “Other long-term investment” to “Receivables for disposal of equity investment”; the reversal of income in equity earnings in unconsolidated entities, and the reversal of a gain on change in ownership of unconsolidated entities.
  In the unaudited interim consolidated financial statements as of June 30, 2011, the Company disclosed that it had lost the ability to exercise significant influence over the operating and financial policies of Nuo Hua Affiliate due to a change in ownership. As a result, it discontinued the equity method by reclassifying the investment in Nuo Hua Affiliate to “other long-term investment” in the consolidated balance sheet and recognized a gain of $759,338 which was recorded in “Gain on changes in ownership of unconsolidated entities” in the consolidated statements of income and comprehensive income.  As the investment in Nuo Hua Affiliate had been disposed as of
December 31, 2010, the gain of $759,338 recognized as of June 30, 2011 was also an error as discussed above.
 
 14
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)
 Restatement Adjustments
  The following tables present the impact of the restatement adjustments on the Company’s previously reported quarterly reports on Form 10-Q for the periods ended March 31, 2011 and June 30, 2011. The increase (decrease) in each line item on the Company’s consolidated financial statements is displayed for each line requiring restatement.


CONDENSED CONSOLIDATED BALANCE SHEETS





As of March 31, 2011


As of June 30, 2011Previously


Adjustments


As Restated


Previously


Adjustments


As RestatedReported


ReportedReceivable for disposal of investment

$
-


$
38,812,195


$
38,812,195


$
-


$
39,449,257


$
39,449,257Total Current Assets


204,861,056



38,812,195



243,673,251



183,707,294



39,449,257



223,156,551Other long-term investment


-



-



-



41,772,510



(41,772,510)



-Investments in and advances to equity investments


58,933,172



(40,254,885)



18,678,287



19,759,725



-



19,759,725Total Long-Term Assets


409,752,650



(40,254,885)



369,497,765



447,118,915



(41,772,510)



405,346,405Unrecognized tax benefits


5,551,703



1,011,881



6,563,584



6,666,147



1,043,917



7,710,064Total Long-Term Liabilities


136,871,572



1,011,881



137,883,453



137,986,635



1,043,917



139,030,552TOTAL LIABILITIES


178,834,295



1,011,881



179,846,176



183,189,757



1,043,917



184,233,674TOTAL ASSETS


614,613,706



(1,442,690)



613,171,016



630,826,209



(2,323,253)



628,502,956Retained earnings


208,439,256



(2,366,521)



206,072,735



212,020,274



(3,231,722)



208,788,552Accumulated other comprehensive income


52,258,717



(88,050)



52,170,667



60,536,528



(135,448)



60,401,080Total Shareholders’ Equity


435,277,218



(2,454,571)



432,822,647



447,144,932



(3,367,170)



443,777,762TOTAL EQUITY


435,779,411



(2,454,571)



433,324,840



447,636,452



(3,367,170)



444,269,282TOTAL LIABILITIES AND EQUITY

$
614,613,706


$
(1,442,690)


$
613,171,016


$
630,826,209


$
(2,323,253)


$
444,269,282








CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME





Three months ended March 31, 2011


Three months ended June 30, 2011Previously


Adjustments


As Restated


Previously


Adjustments


As RestatedReported


ReportedEquity in earnings (losses) from unconsolidated entities

$
(409,886
)

$
(112,098
)

$
(521,984
)

$
551,461


$
(90,561
)

$
460,900Interest Income (Expense), Net


-



-



-



(1,518,810
)


(15,302
)


(1,534,112
)Gain (loss) on changes in ownership of unconsolidated entities


-



-



-



1,417,878



(759,338
)


658,540INCOME BEFORE INCOME TAXES


4,046,001



(112,098
)


3,933,903



6,740,158



(865,201
)


5,874,957NET INCOME


921,146



(112,098
)


809,048



3,570,345



(865,201
)


2,705,144NET INCOME ATTRIBUTE TO CONTROLLING INTEREST


924,152



(112,098
)


812,054



3,581,018



(865,201
)


2,715,817Foreign currency translation gain


3,132,466



(15,128
)


3,117,338



8,277,811



(47,398
)


8,230,413OTHER COMPREHENSIVE INCOME, NET OF TAX


3,132,466



(15,128
)


3,117,338



8,277,811



(47,398
)


8,230,413COMPREHENSIVE INCOME


4,056,618



(127,226
)


3,929,392



11,858,829



(912,599
)


10,946,230Basic EPS


0.01



-



0.01



0.05



(0.01
)


0.04Diluted EPS

$
0.01


$
-


$
0.01


$
0.05


$
(0.01
)

$
0.04








15
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS





Three months ended March 31, 2011


Six months ended June 30, 2011Previously

Reported


Adjustments


As Restated


Previously


Adjustments


As RestatedNet income

$
921,146


$
(112,098
)

$
809,048


$
4,491,491


$
(977,299
)

$
3,514,192Equity in (earnings) /losses from unconsolidated entities


409,886



112,098



521,984



(141,575
)


202,659



61,084(Gain)/loss on changes in ownership of unconsolidated entities


-



-



-



(1,417,878
)


759,338



(658,540
)Unrecognized tax benefits

$
-


$
-


$
-


$
1,615,990


$
15,302


$
1,631,292








NOTE 4 - ACCOUNTS AND NOTES RECEIVABLE





Accounts and notes receivable is net of provision for doubtful debts. Provision for doubtful debt activity is as follows:





SEPTEMBER 30,

2011


DECEMBER 31,

2010Beginning balance

$
687,879


$
522,897Provision for doubtful debts


-



164,982Reversal


(57,471
)


-Written off


-



-Ending balance

$
630,408


$
687,879





NOTE 5 - INVENTORIES





Inventories are summarized as follows:





SEPTEMBER 30,

2011


DECEMBER 31,

2010Raw materials

$
14,496,602


$
6,902,658Work in process


1,538,939



2,274,499Finished goods


8,186,117



3,511,163Total inventories


24,221,658



12,688,320Less: provision against slow-moving inventories


(20,592)



(22,734)Inventories, net

$
24,201,066


$
12,665,586





In 2009 and 2010, the Company entered into long-term supply contracts with various third parties to grow Millettia, a major raw material of the Company, on behalf of the Company through leasing land use rights and production arrangements. Under these contracts, the Company bear the costs in relation to Millettia cultivation and in return entitled to a supply price at fair value discounted at a pre-determined rate when delivered. All pre-harvest agricultural costs, including irrigation, fertilization, seeding, laboring, land leasing costs, and other ongoing crop and land maintenance activities, are capitalized as inventory and cease to be accumulated when Millettia has reached
maturity and is ready to be harvested. Land leasing costs incur prior harvest are capitalized as they are an essential pre-condition to the cultivation and an inevitable cost component of the total growing cost during the cultivation period. All costs incurred subsequent to the Millettia reaching maturity will be expensed as incurred.  The Company expects the initial supply of Millettia to occur between year nine and year eleven of the contract period as Millettia is a stem from a certain plant which requires an eight to ten-year period to mature. These contracts expire after 30 years but entitle the Company to renew with terms to be negotiated.





As of September 30, 2011 and December 31, 2010, the Company capitalized agricultural costs in relation to Millettia cultivation of $983,458 and $190,697, respectively. As of September 30, 2011, the Company also made a prepayment of $4,526,852 in relation to Millettia cultivation that is expected to be commenced in June 2012. Such prepayment is capitalized as Advances to suppliers and prepaid expenses in the consolidated balance sheets and will be reclassified to inventory upon the commencement of cultivation (Note 6).





16
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





NOTE 6 - ADVANCES TO SUPPLIERS AND PREPAID EXPENSES





SEPTEMBER 30,

2011


DECEMBER 31,

2010Advance to suppliers

$
14,531,367


$
12,292,689Prepaid expenses


489,705



1,953,455Prepayment for long-term supply contracts (See Note 5)


4,526,852



-Advances to suppliers and prepaid expenses

$
19,547,924


$
14,246,144





Advances to suppliers mainly represent interest-free cash deposits paid to suppliers for future purchases of raw materials. Prepaid expenses mainly relate to the prepaid research and development expenses to external contractors for research on new knowledge and product development.





NOTE 7 - LAND USE RIGHTS





Land use rights consist of the following:





SEPTEMBER 30,

2011


DECEMBER 31,

2010Cost of land use rights

$
171,058,744


$
165,625,682Less: Accumulated amortization


(13,166,046
)


(10,192,371
)Land use rights, net

$
157,892,698


$
155,433,311





As of September 30, 2011 and December 31, 2010, the net book value of land use rights pledged as collateral was $21,026,243 and $20,729,293, respectively. See Note 16.





Amortization expense for the quarter ended September 30, 2011 and 2010 was $875,525 and $833,974, respectively. Amortization expense for the nine months ended September 30, 2011 and 2010 was $2,594,261 and $2,483,327, respectively.





NOTE 8 - CONSTRUCTION IN PROGRESS





Construction in progress as of September 30, 2011 and December 31, 2010 was $32,378,396 and $22,516,044, respectively. Construction in progress represents the construction for production lines and buildings. The Company capitalizes interest as a component of construction in progress in accordance with ASC 835. Total interest costs incurred for the three months ended September 30, 2011 and 2010 amounted to $2,174,163 and $1,884,477, respectively; total interest costs incurred for the nine months ended September 30, 2011 and 2010 amounted to $5,982,908 and $5,707,743, respectively.





Total interest costs capitalized as part of construction in progress for the three months ended September 30, 2011 and 2010 amounted to $274,755 and $338,534, respectively, and for the nine months ended September 30, 2011 and 2010 amounted to $801,129 and $1,051,684, respectively. Capitalized interest included in construction in progress was $2,441,761 and $1,640,632 as of September 30, 2011 and December 31, 2010, respectively.





17
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





NOTE 9 - PROPERTY, PLANT AND EQUIPMENT





Property, plant and equipment consist of the following:





SEPTEMBER 30,

2011


DECEMBER 31,

2010At cost:Buildings

$
135,387,799


$
104,865,498Machinery and equipment


24,254,844



23,512,674Motor vehicles


1,584,441



1,568,813Office equipment


2,643,608



2,529,352Other equipment


4,386,861



3,996,164168,257,553



136,472,501Less: Accumulated depreciationBuildings


(11,878,352)



(9,278,438)Machinery and equipment


(16,214,453)



(14,438,180)Motor vehicles


(1,430,786)



(1,331,806)Office equipment


(1,789,483)



(1,458,772)Other equipment


(539,046)



(417,689)(31,852,120)



(26,924,885)Property, plant and equipment, net

$
136,405,433


$
109,547,616





As of September 30, 2011 and December 31, 2010, the net book value of property, plant and equipment pledged as collateral for bank loans were $6,263,303 and $6,243,893, respectively. See Note 16.





Depreciation expense for the three months ended September 30, 2011 and 2010 was $1,416,939 and $1,265,671, respectively. Depreciation expense for the nine months ended September 30, 2011 and 2010 was $4,214,570 and $3,652,541, respectively.





NOTE 10 - OTHER INTANGIBLE ASSETS, NET





Other intangible assets are summarized as follows:





SEPTEMBER 30,

2011


DECEMBER 31,

2010At cost:Product licenses

$
16,580,293


$
16,053,679Trademarks


11,304,816



10,945,759Patents


5,135,114



4,972,016Proprietary technology


301,568



291,990Software


97,590



94,48833,419,381



32,357,932Less: Accumulated amortizationProduct licenses

$
(10,100,977)


$
(8,891,025)Trademarks


(7,517,448)



(6,009,283)Patents


(2,786,773)



(2,448,111)Proprietary technology


(128,100)



(100,775)Software


(27,574)



(19,611)(20,560,872)



(17,468,805)Other intangible assets, net

$
12,858,509


$
14,889,127





Amortization expense for the three months ended September 30, 2011 and 2010 was $808,808 and $1,011,184, respectively. Amortization expense for the nine months ended September 30, 2011 and 2010 was $2,475,425 and $3,448,668, respectively.





18
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





NOTE 11 – RECEIVABLE FOR DISPOSAL OF INVESTMENT





On September 27, 2010, the Company entered into a share transfer agreement with an unrelated third party to transfer its equity interest in Nuo Hua Affiliate for a consideration of RMB255,000,000 (equivalent to $39.83 million), including cash and equity interest of another company owned by the unrelated third party. The legal procedure of the transfer had been completed in October 2010 and the consideration is expected to be received by the fourth quarter of fiscal 2011.





NOTE 12 - INVESTMENTS IN AND ADVANCES TO EQUITY INVESTMENTS





Investments in and advances to equity investments include our equity investments in Aoxing Pharmaceutical Company, Inc. (“AXN”) and Hezhou Jinji Color Printing Co., Ltd. (“Jinji”). AXN is a PRC-based pharmaceutical company, listed on the NYSE AMEX, specializing in the research, development, manufacture and distribution of narcotic and pain-management products in the PRC. Jinji is a color printing company focusing on the printing of external packaging materials. These investments are accounted for using the equity method.





As of September 30, 2011 and December 31, 2010, the value based on quoted market price and the carrying amount of the investment in AXN is as follows:





SEPTEMBER 30,

2011


DECEMBER 31,

2010Investment in AXN based on quoted market price

$
6,044,113


$
46,841,875Carrying amount of investment in AXN

$
18,701,611


$
18,903,366




The Company performed an interim impairment assessment by comparing fair value of the investment based on a discounted cash flows model to the carrying value. As of September 30, 2011, the derived fair value of the assessment exceeded the carrying value and no impairment loss was recognized. The discounted cash flows model is based on publicly available information issued by AXN, such as annual and quarterly reports, management and investor relations announcements, as well as analyses reports on AXN. This information is further substantiated by internal analysis. The Company will continue to monitor the market price movement closely for impairment assessment.




NOTE 13 - OTHER LONG-TERM ASSETS





SEPTEMBER 30,

2011


DECEMBER 31,

2010Payment for long-term supply contract

$
7,977,444


$
7,724,069Prepaid land leasing costs for long-term supply contracts


4,303,926



443,811Total other long-term assets

$
12,281,370


$
8,167,880





On October 17, 2009, the Company entered into a long-term supply contract with a third party to secure the supply of Xanthoceras Sorbifolia Bge (“XSB”), which is a major raw material of the Company. The Company expects such supply to start from year four of the contract as XSB is a fruit from a certain plant which requires a three-year period to mature. The contract expires after 10 years while the Company is entitled to renewal with terms to be negotiated. Under the contract, the Company is entitled to a supply price at fair value when delivered. The payment will be amortized to inventory upon delivery of the raw material.





Prepaid land leasing costs are prepayment for the Millettia long-term supply contracts the Company entered into in 2009 and 2010, which are amortized over the lease term and the amortized expenses are capitalized as inventory until Millettia has reached maturity and is ready to be harvested (Note 5).





The Company assesses the impairment of the prepayment as of each balance sheet date. As of September 30, 2011 and December 31, 2010, no impairment was recognized.





19
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





NOTE 14 - OTHER PAYABLES AND ACCRUED EXPENSES





The components of other payables and accrued expenses are as follows:





SEPTEMBER 30,

2011


DECEMBER 31,

2010Other taxes payable

$
211,216


$
295,702Other payables


7,650,575



9,378,014Accrued expenses


7,125,773



8,365,841Other payables and accrued expenses

$
14,987,564


$
18,039,557





Other payables balance mainly represent VAT-output for manufacturing subsidiaries.





Accrued expenses mainly represent promotional fee, interest expenses accrued on convertible notes and other banks loans and accrued advertisement expenses.





NOTE 15 - OTHER LIABILITIES





SEPTEMBER 30,

2011


DECEMBER 31,

2010Due to employees

$
596,340


$
2,803,189Advances from customers


3,107,713



2,194,450Other current liabilities


1,456,468



1,286,468Other liabilities

$
5,160,521


$
6,284,107





Due to employees mainly represent deposits collected from the Company’s salesmen to encourage receivables collection.





Advances from customers mainly represent cash received for goods not yet delivered to customers.





NOTE 16 - DEBT





Short-term loans are obtained from local banks and a third party. All of the short-term loans are repayable within one year and the short-term loans from local banks are secured by property, plant and equipment and land use rights owned by the Company. See Notes 6 and 8.





Long-term loans include a mortgage loan that bears interest on daily balances at 2.50% per annum below HSBC HKD best lending rate and is repayable over 15 years. The principal amount of long-term loans is not payable until the end of the term.





Interest expense for all outstanding debt excluding the convertible notes was $ 226,216 and $110,706 for the three months ended September 30, 2011 and 2010, respectively.


Interest expense for all outstanding debt excluding the convertible notes was $442,895 and $405,178 for the nine months ended September 30, 2011 and 2010, respectively.





NOTE 17 - CONVERTIBLE NOTES





On July 15, 2008, the Company closed a private offering and issued $115 million aggregate principal amount of 5.00% Convertible Senior Notes due 2015 (the “Notes”). The Notes were sold to qualified institutional buyers in a private placement exempt from the registration requirements of the Securities Act of 1933, as amended. The net proceeds from the sale of the Notes were $110,474,993, after deducting the placement agents’ commission and offering expenses payable by the Company.





The following is a brief summary of certain terms of this offering:





●
Total offering was $115,000,000 aggregate principal amount of 5.00% Convertible Senior Notes due on July 15, 2015.





●
Interest at 5.00% per year, payable semiannually in arrears in cash.





●
The Notes are convertible, at the option of the holder, at any time prior to the close of business on the second business day preceding the maturity date based on an initial conversion rate of 107.6195 shares per $1,000 principal amount of Notes, which represents an initial conversion price of $9.29 per share.


20
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)











●
The conversion rate is subject to certain adjustments. In particular, holders who convert their Notes in connection with certain events of fundamental changes, as defined pursuant to the convertible notes agreement, may be entitled to a make whole premium in the form of additional shares of our common stock.





●
The initial conversion rate may also be adjusted on January 15, 2009 if the volume weighted average price (“VWAP”) of common stock for each of the 30 consecutive trading days ended on January 15, 2009 is less than $8.08 per share. In such an event, the conversion rate will be increased as a one-time conversion price adjustment such that the conversion price as adjusted would represent the greater of (1) 115.0% of such arithmetic average of the daily VWAP and (2) $8.08.





●
Holders may require the Company to repurchase all or a portion of their Notes on July 15, 2013 for cash at a price equal to 100% of the principal amount of the Notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date.





●
If a fundamental change event occurs, holders will have the right to require the Company to repurchase for cash all or any portion of their Notes. The fundamental change purchase price will be 100% of the principal amount of the Notes to be purchased plus accrued and unpaid interest, if any, up to, but excluding, the fundamental change repurchase date.





●
The Notes are unsecured, unsubordinated obligations and rank equal in right of payment to all of the Company’s existing and future unsecured and unsubordinated indebtedness. The Notes will be effectively subordinated to all of the Company’s existing and future secured indebtedness.





Notes issuance costs incurred by the Company that were directly attributable to the issuance of the Notes were deferred and are charged to the consolidated statements of income and comprehensive income using the effective interest rate method over the term of the Notes.





The Company has determined that the conversion feature embedded in the Notes is not required to be bifurcated and accounted for as a derivative pursuant to FASB ASC 815 “Derivatives and Hedging”, since the embedded conversion feature is indexed to the Company’s own stock and would be classified in shareholders’ equity if it was a free-standing instrument. The holder’s put rights qualify as an embedded derivative, but bifurcation of such is not required since it is considered to have economic characteristic and risks that are clearly and closely related to those of the debt host.





On the date of issuance of the Notes, no portion of the proceeds was attributable to the beneficial conversion feature (“BCF”) since the conversion price of the Notes exceeded the market price of the Company’s common stock. Furthermore, no contingent BCF exists from the one time conversion rate adjustment based on VWAP, as the adjustment is subject to a floor of $8.08, which equals the market price of the Company’s common stock on the issuance date of the Notes.





The VWAP of the Company’s common stock for each of the 30 consecutive trading days ending on January 15, 2009 was $6.02 per share and as such, the initial conversion price of $9.29 per share was adjusted to $8.08 on January 15, 2009.





During the three months ended September 30, 2011, the Company repurchased a total $5,500,000 in principal amount of the Notes for $2,750,000 cash consideration and expensed $83,171 of related unamortized Notes issue cost resulting in a net gain of $2,666,829 and leaving an aggregate of $109,500,000 in principal amount outstanding as of September 30, 2011.





The Notes repurchasedPrincipal

$
5,500,000+unamortized premium


--unamortized bond issue cost


(83,171
)Net Carrying Value


5,416,829Repurchase Price


2,750,000Gain on debt extinguishment

$
2,666,829





The effective interest rate on the Notes for the three months ended September 30, 2011 and 2010 was 5.945%.





The amount of interest cost recognized for the three months ended September 30, 2011 and 2010 was $1,413,819 and $1,437,500, respectively. Interest cost recognized for the nine months ended September 30, 2011 and 2010 was $4,288,819 and $4,312,500, respectively.


21
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)











NOTE 18 - PREPAID FORWARD SHARES REPURCHASE TRANSACTION





In connection with the offering of the Notes, the Company entered into a prepaid forward repurchase contract with an affiliate of the lead placement agent (“Merrill affiliate”). Pursuant to the prepaid forward repurchase contract, the Company paid approximately $30 million to the Merrill affiliate to fund the purchase of 3.7 million shares of common stock for settlement at or about maturity of the Notes, which will occur on July 15, 2015. The forward shares purchase transaction was also intended to reduce the potential dilution of common stock that would result from the conversion of the Notes into shares of common stock.





The $30 million cost of the forward stock repurchase transaction qualifies as an equity transaction and was separately presented under shareholders’ equity in the balance sheet without subsequent recognition of changes in fair value.


The prepaid forward repurchase contract contains an embedded equity forward derivative that is contingently cash settleable based on certain events.  The contingent cash settlement feature was bifurcated from the prepaid forward repurchase contract but its value was insignificant for any of the years presented.





The Company is potentially subject to significant concentration of credit risk with respect to the prepaid forward repurchase contract. The fact that the Merrill affiliate has merged with Bank of America reduced the bankruptcy and default risk. The Company will closely monitor the third depositary and may request early settlement of the contract prior to the maturity of the Notes.





NOTE 19 - SHAREHOLDERS’ EQUITY





Preferred Stock





The Company has 1,000,000 shares of Series A preferred stock (“Series A”) issued and outstanding. Pursuant to the terms of the Series A, the holder holds aggregate voting power equal to 25% of the combined voting power of common stock and preferred stock. The percentage of voting power represented by the Series A cannot be diluted by the issuance of additional shares of common stock. The Series A has a liquidation preference equal to its initial issue price that will be paid to the holders of the Series A upon liquidation, dissolution or winding up and prior to any distributions being made to holders of common stock. The Series A does not participate in profits and dividends with
common stock.





Common Stock





Stock-Based Compensation


At the Annual Shareholders’ Meeting held on October 21, 2006, the shareholders of the Company approved the stock incentive plan (the “2006 Plan”), which allows the Company’s Board of Directors, at its discretion, to offer stock options and common stock awards to employees, directors and consultants of the Company.





The Company has reserved 5,000,000 shares of common stock for issuance upon the exercise of stock options and common stock awards granted under the 2006 Plan. The term of the options granted under the 2006 Plan should be no more than 10 years from the grant date. Options will be granted with an exercise price not less than the fair market value of a share of common stock on the date of the grant.





Common Stock Awards issued to consultants and non-employee directors





Common stock awards are issued to consultants as partial payment in connection with the consulting services rendered or to be rendered, or to directors as compensation for participating in the Company’s board meetings. Number of shares granted and expenses recognized were insignificant during the periods presented.





In connection with common stock awards described above, the Company recorded “Common stock to be issued” for vested but yet to be issued shares. Number of shares to be issued was insignificant during the periods presented.





Stock Options and Common Stock Awards issued to Employees





Stock options and common stock awards granted to employees vest over a five year service period using a graded vesting schedule of 20% per fully completed year (based on each subsequent one-year anniversary of the date of grant). Compensation expense for all stock options and common stock awards granted is recognized over the grantee’s respective requisite service period.





22
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





Stock options





The Company calculated the estimated fair value of the options of the grant date using the Black-Scholes Option Pricing Model with the following assumptions:


Grant Date

April 10,

2009


November 25,

2008


April 9,

2008


August 20,

2007


April 20,

2007Risk-free interest rates


2.33
%



2.41
%



2.93
%



4.45
%



4.59
%Expected term


6.5




6.5




6.5




6.5




6.5Expected volatility


65.70
%



64.81
%



56.89
%



71.71
%



74.69
%Expected dividend yield


0.00
%



0.00
%



0.00
%



0.00
%



0.00
%Fair value of share option


2.64




3.34




4.81




5.87




7.44





The model requires the input of subjective assumptions including the expected stock price volatility and the expected dividend yield. The Company uses historical experience of employee turnover and future expectation to estimate forfeiture rate. For expected volatilities, the Company has made reference to historical volatilities of the Company’s stock. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury Bills yield in effect at the time of grant.





The Company recorded $474,638 compensation cost for both of the three month ended September 30, 2011 and 2010,and $1,423,914 for both of the nine months ended September 30, 2011 and 2010, with corresponding credits to additional paid-in capital. Compensation cost of all stock option awards are recorded in selling, general and administrative expenses. The total fair value of the options granted to employees at the respective grant dates was $9,492,751, of which the unrecognized portion of $2,212,263 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 1.4 years as of September 30, 2011.





The expected forfeiture rate of the stock options granted as of September 30, 2011 is 0%.





Common Stock Awards





On April 10, 2009, April 8, 2010, April 10, 2011, the Compensation Committee of the Board of Directors of the Company approved the grant of common stock awards to the Company’s executive officer and certain senior management members. Common stock awards granted vest over a five-year service period. Compensation expense is recognized for the fair value of common stock on the grant date on a straight-line basis over five years, the requisite service period of the awards.  The number of shares granted and the grant date market price of the Company’s common stock determines the fair value of the common stock awards under the 2006 Plan.





The expected forfeiture rate of the common stock awards granted as of September 30, 2011 is 0%.





The Company recorded selling, general and administrative expenses of $303,491 and $227,954 in connection with such awards for the three months ended September 30, 2011 and 2010, respectively and $834,936 and $559,507 for the nine months ended September 30, 2011 and 2010, respectively.





The total fair value of the common stock awards granted as of the respective grant date was $6,069,829, of which the unrecognized portion of $4,136,682 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 3.7 years as of September 30, 2011.





Statutory Reserves





In accordance with the PRC Regulations on Enterprises with Foreign Investment, an enterprise established in the PRC with foreign investment is required to provide for certain statutory reserves, namely (i) General Reserve Fund, (ii) Enterprise Expansion Fund and (iii) Staff Welfare and Bonus Fund, which are appropriated from net profit as reported in the enterprise’s PRC statutory accounts. A wholly-owned foreign enterprise (“WOFE”) is required to allocate at least 10% of its annual after-tax profit to the General Reserve Fund until the balance of such fund has reached 50% of its respective registered capital.  A non- wholly-owned foreign invested enterprise is
permitted to provide for the above allocation at the discretion of its Board of Directors. Appropriations to the Enterprise Expansion Fund and Staff Welfare and Bonus Fund are at the discretion of the Board of Directors for all foreign invested enterprises. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends.





23
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





As a result, $26,293,785 has been appropriated to the accumulated statutory reserves, which were included in retained earnings, by the Company’s PRC subsidiaries as of September 30, 2011 and December 31, 2010.





Treasury Stock





On March 20, 2011, the Board of Directors authorized the Company to repurchase up to $20 million of the Company’s outstanding common stock over the next two years in the open market, in privately negotiated transactions, block trades and accelerated stock repurchase transactions or otherwise, as determined by the Company and will be funded from available working capital. The timing and extent of any purchases depend upon the trading price of the Company’s common stock, general business and market conditions and other investment opportunities. The Company entered into a share buyback program and engaged a financial institution to act as a broker on behalf of the Company to
repurchase common stock based on a predetermined quantity and price range (“Share Buyback Program”).





Any common stock repurchased by the Company became part of its treasury stock which will be shown as a separate item in the consolidated statements of changes in shareholders’ equity. The treasury stock may be retired or used by the Company to finance or execute acquisitions or other arrangements. As of September 30, 2011, the Company had repurchased 449,163 shares of its common stock at a total cost of $799,999 pursuant to this Share Buyback Program.





NOTE 20 - COMMITMENTS AND CONTINGENCIES





As of September 30, 2011, the Company had entered into capital commitments for the manufacturing facilities under construction in the People’s Republic of China and purchase commitments for the purchase of raw materials. The capital commitments and purchase commitments were $2,954,378 and $4,288,159 within one year and $9,681,839 and $10,038,729 after one year but within five years. In addition, the Company had advertisement contract commitments of $9,637,881 for the next 12 months as well as R&D commitments of $2,570,982 within one year and $676,087 after one year but within five years.





Effective from January 1, 2007, the Company adopted the guidance for accounting for uncertainty in income taxes as provided under FASB ASC 740-10, which prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken in the tax return. As of September 30, 2011, the Company has recorded an unrecognized tax benefit of $6,772,972.





As of September 30, 2011, the Company has no significant litigation claims. Also, the Company does not have significant operating-lease commitments as of September 30, 2011.





24
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





NOTE 21 - SEGMENT REPORTING





For the three months ended September 30, 2011 and 2010 the Company’s segments were as follows:





Three Months Ended

September 30,2011


2010(RESTATED)Manufacturing SegmentRevenue from pharmaceutical products

$
40,276,279


$
77,171,414Revenue from nutraceutical products


8,774,711



10,294,564Total manufacturing revenue


49,050,990



87,465,978Total manufacturing costs


24,181,804



40,307,771Depreciation and amortization expense


1,331,032



1,244,031Selling, general and administrative expenses, research and development costs and advertising costs


15,188,293



33,834,283Operating income of manufacturing segment


10,569,294



9,583,131Distribution SegmentDistribution revenue

$
4,883,612


$
4,067,066Equity in earnings from unconsolidated entities


-



773,038Operating income of distribution segment


12,376



(402,707
)Reconciliation to Consolidated Net Income Attributable to Controlling Interest:Total net operating income, as defined, for reportable segments


10,581,670



9,180,424Unallocated


(2,928,129
)


(4,933,238
)Consolidated Net Income Attributable to Controlling Interest

$
7,653,541


$
4,247,186





For the nine months ended September 30, 2011 and 2010, the Company’s segments were as follows:





Nine months Ended

September 30,2011


2010(RESTATED)Manufacturing SegmentRevenue from pharmaceutical products

$
119,969,639


$
181,813,000Revenue from nutraceutical products


28,110,229



29,894,355Total manufacturing revenue


148,079,868



211,707,355Total manufacturing costs


72,568,527



96,675,330Depreciation and amortization expense


3,956,892



3,659,475Selling, general and administrative expenses, research and development costs and advertising costs


45,220,153



78,668,115Operating income of manufacturing segment


25,466,535



26,208,683Distribution SegmentDistribution revenue

$
11,908,640


$
10,871,669Equity in earnings from unconsolidated entities


-



2,117,833Operating income of distribution segment


(129,635
)


536,230Reconciliation to Consolidated Net Income Attributable to Controlling Interest:Total net operating income, as defined, for reportable segments


25, 336,900



26,744,913Unallocated


(14,155,488
)


(14,250,340
)Consolidated Net Income Attributable to Controlling Interest

$
11,181,412


$
12,494,573





All operating revenues comprise amounts received from external third party customers. All of the Company’s operations are located in the PRC.





25
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)








NOTE 22 - EARNINGS PER SHARE





Basic earnings per share is computed by dividing net income attributable to controlling interest by the weighted average number of common shares outstanding, excluding common shares to be delivered under a prepaid forward repurchase contract (3,712,700 shares). Diluted earnings per share is computed by dividing net income attributable to controlling interest as adjusted for the effect of dilutive potential common shares, if any, by the weighted average number of common shares and dilutive potential common shares outstanding during the period. The potential common stocks are stock options, common stock awards and convertible notes.





The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per share available to common shareholders.





Three Months Ended

September 30,


Nine months Ended

September 30,2011


2010


2011


2010(RESTATED)





(RESTATED)EPS Numerator:Net income attributable to controlling interest

$
7,653,541


$
4,247,186


$
11,181,412


$
12,494,573EPS Denominator:Weighted average shares outstanding – Basic


74,845,855



74,934,428



74,801,120



74,765,028Effect of dilutive instruments:Convertible notes


-



-



-



-Common stock awards to be issued


1,678,148



1,030,838



1,505,924



881,996Weighted average shares outstanding – Diluted


76,524,003



75,965,266



76,307,044



75,647,024





EPS - Basic

$
0.10


$
0.06


$
0.15


$
0.17EPS - Diluted

$
0.10


$
0.06


$
0.15


$
0.17





The calculation of weighted average common shares outstanding for the diluted earnings per share calculation excludes consideration of stock options for the three and nine months ended September 30, 2011 and 2010, because the exercise of these options would not have been dilutive for those periods due to the fact that the exercise prices were greater than the weighted average market price of the Company’s common stock for each period.





As more fully discussed in Note 17, the Company had certain convertible notes outstanding during the periods presented. The aggregate number of shares of common stock that could be issued in the future to settle these notes is deemed outstanding for the purposes of the calculation of diluted earnings per share. This approach, referred to as the if-converted method, requires that such shares be deemed outstanding regardless of whether the notes are then contractually convertible into the Company’s common stock. For this if-converted calculation, the interest expense and issuance costs (net of tax) attributable to these notes are added back to net income attributable to controlling
interest, reflecting the assumption that the notes have been converted.  The calculation of diluted earnings per share excludes the convertible notes for the three and nine months ended September 30, 2011 and 2010 because conversion of the convertible notes under the if-converted method would have been anti-dilutive..





NOTE 23 – TAXES





The Company had total income tax credit of $2,203,013 and income tax expenses of $4,091,655 for the three and nine months ended September 30, 2011, respectively. The Company continues to conduct most of its business through its major PRC subsidiaries whose applicable income tax rates are 15% for the three and nine months ended September 30, 2011 and 2010. A full valuation allowance was recorded for deferred tax assets of those entities within the Company that continue to be in a cumulative loss position. The Company recorded a current tax expense of $5,804,146 for the nine months ended September 30, 2011 of which $1,335,226 was related to an increase in unrecognized tax benefits. The
unrecognized tax benefits were primarily related to the tax impact of deemed interest at PRC subsidiaries. The Company recorded cumulative interests of $919,771 as of September 30, 2011.





The Company's effective tax rates were (40)% and 36% for the three months ended September 30, 2011 and 2010, respectively and were 27% and 35% for the nine months ended September 30, 2011 and 2010, respectively.


26
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF SEPTEMBER 30, 2011
 (UNAUDITED)





The decrease in effective tax rate for the three months ended September 30, 2011 was mainly due to the reverse of the provision for income taxes for the applicable tax rate change of its PRC subsidiaries, GLP, BOKE, Three Happiness, HSPL and CCXA. During the six months ended June 30, 2011, the Company increased its applicable tax rate for these PRC subsidiaries as the High & New Technology status (“HNTE status”) will expire near the year end of 2011. At that stage, the management did not believe it was more-likely-than-not that these entities will qualify for the HNTE status upon renewal; as a result, the Company applied 25% corporate income tax rate for these subsidiaries during
the three and six months ended June 30, 2011. At current stage, the management believed it is probable that these entities will qualify for the HNTE status upon renewal since these entities passed the government assessment; as a result, the Company applied 15% corporate income tax rate for these subsidiaries for the three and nine months ended September 30, 2011.





NOTE 24 - EMPLOYEE DEFINED CONTRIBUTION PLAN





Full time employees of the Company’s subsidiaries in the PRC participate in a government-mandated defined contribution plan pursuant to which certain pension benefits, medical care, unemployment insurance, employee housing fund and other welfare benefits are provided to employees. Chinese labor regulations require that the PRC subsidiaries of the Company make contributions to the government for these benefits based on 41% of the employees’ salaries. The Company’s PRC subsidiaries have no legal obligation for the benefits beyond the contributions made. The total amounts for such employee benefits, which were expensed as incurred, were $1,407,086 and $1,392,671 for the three
months ended September 30, 2011 and 2010, respectively, and $4,252,448 and $2,023,756 for the nine months ended September 30, 2011 and 2010, respectively, and are included in cost, inventory, selling, general and administrative expenses.





NOTE 25 - SUBSEQUENT EVENTS





On October 5, 2011, the Company repurchased a total $1,000,000 in principal amount of the Notes for $405,000 cash consideration, leaving an aggregate of $108,500,000 in principal amount outstanding.





There were no other significant subsequent events that occurred after September 30, 2011.


27


ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS





All of the financial information presented in this Item 2 has been adjusted to reflect the restatement of our condensed consolidated financial statements for the three months ended September 30, 2010. Specifically, we have restated our condensed consolidated balance sheets as of September 30, 2010 and our condensed consolidated statements of operations and cash flows for the nine months ended September 30,2010 as reported in the amended annual report on Form 10K/A for the fiscal year ended December 31, 2010. The restatement is fully described in the “Explanatory
Note” immediately preceding Part I, Item 1of the amended annual report on Form 10K/A for December 31, 2010 filed concurrently with this report and in Note 3 to the condensed consolidated financial statements in this report.





The following discussion should be read in conjunction with the information contained in the condensed consolidated financial statements of the Company and the notes thereto appearing elsewhere herein and in conjunction with the Management’s Discussion and Analysis set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Readers should carefully review the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2010 filed by the Company with the Securities and Exchange Commission (“SEC”).





As used in this report, the terms “Company,” “we,” “our,” “us,” and “AOB” refer to American Oriental Bioengineering, Inc., a Nevada corporation.





PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS





This quarterly report contains forward-looking statements within the meaning of the federal securities laws. These include statements about our expectations, beliefs, intentions or strategies for the future, which we indicate by words or phrases such as “anticipate,” “expect,” “intend,” “plan,” “will,” “we believe,” “AOB believes,” “management believes” and similar language. The forward-looking statements are based on the current expectations of AOB and are subject to certain risks, uncertainties and assumptions, including those set forth in the discussion under “Management’s Discussion
and Analysis of Financial Condition and Results of Operations” in this report. Actual results may differ materially from results anticipated in these forward-looking statements. We base the forward-looking statements on information currently available to us, and we assume no obligation to update them.





Investors are also advised to refer to the information in our previous filings with the SEC, especially on Forms 10-K, 10-Q, and 8-K, in which we discuss in more detail various important factors that could cause actual results to differ from expected or historic results. It is not possible to foresee or identify all such factors. As such, investors should not consider any list of such factors to be an exhaustive statement of all risks and uncertainties or potentially inaccurate assumptions.





CRITICAL ACCOUNTING POLICIES AND ESTIMATES





This section should be read together with the Summary of Significant Accounting Policies included as Note 3 to the consolidated financial statements included in our amended Annual Report on Form 10-K/A for the year ended December 31, 2010.





Estimates affecting accounts and notes receivable and inventories





The preparation of our consolidated financial statements requires management to make estimates and assumptions that affect our reporting of assets and liabilities (and contingent assets and liabilities). These estimates are particularly significant where they affect the reported net realizable value of the Company’s accounts and notes receivable and inventories.





At September 30, 2011, the Company provided a $630,408 reserve against accounts and notes receivable. Management’s estimate of the appropriate reserve on accounts and notes receivable at September 30, 2011 was based on the aged nature of these accounts and notes receivable. In making its judgment, management assessed its customers’ ability to continue to pay their outstanding invoices on a timely basis, and whether their financial position might deteriorate significantly in the future, which would result in their inability to pay their debts to the Company.





At September 30, 2011, the Company provided an allowance against its inventories amounting to $20,592. Management’s determination of this allowance was based on potential impairments to the current carrying value of the inventories due to potential obsolescence of aged inventories. In making its estimate, management considered the probable demand for our products in the future and historical trends in the turnover of our inventories.





While the Company currently believes that there is little likelihood that actual results will differ materially from these current estimates, if customer demand for our products decreases significantly in the near future, or if the financial condition of our customers deteriorates in the near future, the Company could realize significant write downs for slow-moving inventories or uncollectible accounts and notes receivable.





28





Policy affecting recognition of revenue





Among the most important accounting policies affecting our consolidated financial statements is our policy of recognizing revenue in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605 “Revenue Recognition”. Under this policy, all of the following criteria must be met in order for us to recognize revenue:





1.
Persuasive evidence of an arrangement exists;


2.
Delivery has occurred or services have been rendered;


3.
The seller’s price to the buyer is fixed or determinable; and


4.
Collectability is reasonably assured.





The majority of the Company’s revenue results from sales contracts with distributors and revenue is recorded upon the shipment of goods. Management conducts credit background checks for new customers as a means to reduce the subjectivity of assuring collectability. Based on these factors, the Company believes that it can apply the provisions of FASB ASC 605 with minimal subjectivity.





Goodwill





We account for goodwill in accordance with the provisions of FASB ASC 350 “Intangible – Goodwill and Other”. We conduct an impairment test on an annual basis and, in addition, if we notice any indication of impairment, we conduct such test immediately.





The application of the impairment test requires judgment, including the identification of reporting units, assignments of assets and liabilities to reporting units and the determination of the fair value of each reporting unit. Fair value is primarily determined by computing the future discounted cash flows expected to be generated by the reporting unit that are believed to be reasonable under current and forecasted circumstances, the results of which form the basis for making judgments about carrying values of the reported net assets of our reporting units.





We conducted an impairment test as of September 30, 2011 and no impairment loss was identified. We will continue to closely monitor the projections for our reporting units and the economic conditions of the product end-markets. Any significant change in market conditions and estimates or judgments could give rise to impairment in the period that the change becomes known.





Share-based Compensation





We account for the stock options and common stock awards granted under our 2006 stock incentive plan (the “2006 Plan”) in accordance with FASB ASC 718 “Compensation – Stock Compensation”. In accordance with FASB ASC 718, all grants of share options and common stock awards are recognized in the financial statements based on their grant date fair values. We have elected to recognize compensation expense using the straight-line method for all share options and common stock awards granted with services conditions that have a graded vesting schedule.





We have applied the Black-Scholes Option Pricing Model in determining the fair value of the options granted. We estimate expected volatility at the date of grant based on a combination of historical and implied volatilities from comparable publicly listed companies. Forfeiture rate is estimated based on historical forfeiture patterns and adjusted to reflect future changes in circumstances and facts, if any.





Accounting for Income Taxes and Uncertain Income Tax Positions





We account for income taxes in accordance with FASB ASC 740, “Accounting for Income Taxes”. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.





We account for uncertainty in income taxes in accordance with FASB ASC 740-10. FASB ASC 740-10 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of the benefit that is more likely than not to be realized upon ultimate settlement. As of September 30, 2011, the Company recorded an unrecognized tax benefit of approximately $7,874,802, which is mainly related to non-trade
intercompany transactions, fixed assets and intangible assets.


29








Our accounting policy for interest and penalties related to an uncertain position, if any when required, is classified as part of interest expenses and other expenses, respectively.  The Company recorded $919,771 interest and a penalty of nil as of September 30, 2011.





Newly Adopted Accounting Pronouncements





In September 2011, the FASB issued Accounting Standards Update 2011-08 (ASU 2011-08), “Testing Goodwill for Impairment.” ASU 2011-08 is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a “qualitative” assessment to determine whether further impairment testing is necessary. Specifically, an entity has the option to first assess qualitative factors to determine whether it is necessary to perform the current two-step test. If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is
less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. This standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The provisions of ASU 2011-08 are not expected to have a material impact on the financial position, results of operations or cash flows of the Company.





In June 2011, the FASB issued Accounting Standards Update 2011-05 (ASU 2011-05), "Presentation of Comprehensive Income."  ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in shareholders' equity and requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement or in two separate but consecutive statements. This pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The provisions of ASU 2011-05 are not expected to have a material
impact on the financial position, results of operations or cash flows of the Company.




In May 2011, the FASB issued Accounting Standards Update 2011-04 (ASU 2011-04), “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements, changes changes certain fair value measurement principles and requires additional disclosures about fair value measurements. The updated guidance is effective on a prospective basis for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. The provisions of ASU 2011-04 are not expected to have a material
impact on the financial position, results of operations or cash flows of the Company.





30





RESULTS OF OPERATIONS – THREE MONTHS ENDED SEPTEMBER 30, 2011 AS COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2010





The following table sets forth the amounts and the percentage relationship to revenues of certain items in our condensed consolidated statements of income for the quarters ended September 30, 2011 and 2010:





Three Months Ended

September 30,


Three Months Ended

September 30,2011


2010


2011


2010(RESTATED)





(RESTATED)Revenues

$
53,934,602


$
91,533,044



100%



100%Cost of sales


28,730,424



44,250,846



53



48GROSS PROFIT


25,204,178



47,282,198



47



52Selling, general and administrative expenses


12,080,424



20,920,522



22



23Advertising costs


2,964,877



10,983,946



6



12Research and development costs


2,825,967



4,724,703



5



5Depreciation and amortization expenses


1,804,888



1,682,058



3



2Debt extinguishment (gain)


(2,666,829)



-



(5)



-Total operating expenses


17,009,327



38,311,229



31



42INCOME FROM OPERATIONS


8,194,851



8,970,969



16



10Equity in (losses) earnings from unconsolidated entities


(796,727)



242,183



(2)



(1)Impairment loss on equity investment


-



(1,083,637)



-



-Interest expense, net


(1,802,954)



(1,456,062)



(3)



(2)Other expenses, net


(116,196)



(67,548)



-



-INCOME BEFORE INCOME TAX


5,478,974



6,605,905



11



7Provision for income taxes


(2,203,013)



2,366,398



(4)



2NET INCOME


7,681,987



4,239,507



15



5Net (income) loss attributable to non-controlling interest


(28,446)



7,679



-



-NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST EARNINGS PER COMMON SHARE

$
7,653,541


$
4,247,186



15%



5%Basic

$
0.10


$
0.06Diluted

$
0.10


$
0.06





Revenues





Revenues for the third quarter of 2011 were $53,934,602, a decrease of $37,598,442, or 41% compared to revenues for the same period of 2010.





We classify our revenues into two segments: manufacturing revenue and distribution revenue. The manufacturing revenue comprises revenue from pharmaceutical and nutraceutical products. Revenues by segments and product categories were as follows:




Three Months Ended

September 30,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Revenue from pharmaceutical products

$
40,276,279


$
77,171,414


$
(36,895,135)



(48)%Revenue from nutraceutical products


8,774,711



10,294,564



(1,519,853)



(15)%Total manufacturing revenue


49,050,990



87,465,978



(38,414,988)



(44)%Distribution revenue


4,883,612



4,067,066



816,546



20%Total revenues

$
53,934,602


$
91,533,044


$
(37,598,442)



(41)%





Revenue in connection with our pharmaceutical products decreased by $36,895,135, or 48%, as compared to the same period of 2010 primarily due to the following factors:





●
sales from our prescription pharmaceutical products decreased from $37,324,901 for the third quarter of 2010 to $22,262,905 for the same period of 2011, or a 40% decrease. The decrease was primarily due to the decrease in sales from SHL powder and CCXA’s generic pharmaceutical products and partially offset by the increase in sales from our prescription formulated Jinji capsule; and




●
sales from our OTC pharmaceutical products decreased from $39,846,513 for the third quarter of 2010 to $18,013,374 for the same period of 2011, or a 55% decrease. This was mainly due to the decreased sales volume of GLP’s generic OTC drugs.






31





We decreased the manufacturing of certain generic drugs since the TCM raw material price for these drugs has continued to increase during the last quarter. Accordingly, we shifted the products mix toward higher-margin products from lower margin products to minimize the impact from the increased cost of certain raw materials and the continuing government price cut on certain products.





Revenue in connection with our nutraceutical products decreased by 15%, compared to the same period of 2010. The decrease was primarily due to the decrease in sales from our Soy Peptide tablets and partially offset by the increase in sales from our Soy Peptide drinks which we launched commercially in late 2009. We decreased the advertising for certain old nutraceutical products and focused on new products to achieve optimum efficiency while maintaining strict advertising cost control.





The distribution revenue from Nuo Hua's majority owned subsidiary increased by 20%, to $4,883,612. This increase was mainly attributed to Nuo Hua's expanding market coverage.





Cost of Sales and Gross Profit





Cost of sales was $28,730,424 for the third quarter of 2011, compared to $44,250,846 in the same period of 2010. Cost of sales in the third quarter of 2011 and 2010 by segments and product categories were as follows:





Three Months Ended

September 30,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Pharmaceutical products

$
19,201,942


$
35,068,249


$
(15,866,307)



(45)%Nutraceutical products


4,979,862



5,239,522



(259,660)



(5)%Total manufacturing cost


24,181,804



40,307,771



(16,125,967)



(40)%Distribution cost


4,548,620



3,943,075



605,545



15%Total cost

$
28,730,424


$
44,250,846


$
(15,520,422)



(35)%





Gross profit decreased by $22,078,020, or 47%, for the third quarter of 2011 compared to the same period of 2010. Gross profit as a percentage of revenues decreased from 52% in the third quarter of 2010 to 47% in the same period of 2011 mainly due to the new levied urban construction and maintenance tax and educational surcharge.





From December 2010, the urban construction and maintenance tax and educational surcharge were levied on foreign investment enterprises and foreign enterprises who previously enjoyed the exemption. We recognized the urban construction and maintenance tax and educational surcharge in cost of sales. As a result of the regulation change, our gross margin for the third quarter of 2011 was affected by approximately 2%.





We continued our efforts to manage the margin pressure although the increased purchase prices of certain raw materials increased the cost of sales.





Selling, General and Administrative Expenses





Selling, general and administrative expenses decreased by $8,840,098, or 42%, in the third quarter of 2011 compared to the same period of 2010. The details of our sales and marketing expenses were as follows:





Three Months Ended

September 30,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Payroll

$
3,238,886


$
3,707,591


$
(468,705)



(13)%Staff welfare and insurance


873,021



1,162,842



(289,821)



(25)%Promotional materials and fees


2,339,837



8,473,031



(6,133,194)



(72)%Trips and traveling


1,107,824



997,740



110,084



11%Shipping


878,162



1,604,280



(726,118)



(45)%Stock based compensation


850,979



806,417



44,562



6%Professional fees


534,319



1,124,727



(590,408)



(52)%Miscellaneous


2,257,396



3,043,894



(786,498)



(26)%TOTAL

$
12,080,424


$
20,920,522


$
(8,840,098)



(42)%





32





The decrease in selling, general and administrative expenses in the third quarter of 2011 compared to the same period of 2010 was primarily due to the following factors:





●
the decrease of promotional materials and fees by $6,133,194, or 72%, in the third quarter of 2011 as compared to the same period of 2010. This was primarily due to the reduction of our promotional activities in relation to SHL powder and generic prescription and OTC drugs;





●
the decrease of shipping costs by $726,118, or 45%, in the third quarter of 2011 as compared to the same period of 2010. This was mainly due to the reduction of sales volume of our products; and





●
the decrease of payroll expenses and staff welfare and insurance expenses by $468,705 and $289,821, respectively, in the third quarter of 2011, as compared to the same period of 2010. The Company optimized human resource and cutcertain jobs in order to maintain strict expense control.





Advertising Costs





Advertising costs decreased by $8,019,069, or 73%, from $10,983,946 in the third quarter of 2010 to $2,964,877 in the same period of 2011. Advertising costs as a percentage of revenue decreased from 12% in the third quarter of 2010 to 6% in the same period of 2011.





We decreased the advertising costs related to some of our OTC generic drugs during this quarter. We continued to invest in advertising to create a unified megabrand for AOBO so that we can leverage on the establishment of all our individual brands to increase brand awareness and market shares.





Research and Development Costs





Research and development costs decreased by $1,898,736, or 40%, from $4,724,703 in the third quarter of 2010 to $2,825,967 in the same period of 2011. Expressed as a percentage of revenue, research and development costs were 5% for both the third quarter of 2011 and 2010.





Our research and development activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies. Our key research and development programs include the improvement of our existing products and development of new products such as SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel and Jinji series products. The majority of our research and development expenditures are on pharmaceutical products.





Depreciation and Amortization





Depreciation and amortization expenses increased by $122,830, or 7%, in the third quarter of 2011 as compared to the same period of 2010. This was mainly due to the increase of the property, plant and equipment and land use rights during the second half of 2010.





Debt Extinguishment Gain





During the third quarter of 2011, the Company repurchased a total $5,500,000 in principal amount of our convertible Notes for $2,750,000. A gain of debt extinguishment of $2,666,829 was recognized representing the difference between the net carrying value of the notes repurchased and the repurchase price. For additional information, see “Item 1. Financial Statements — Note 16. Convertible Notes”.





Equity in (Losses) Earnings from Unconsolidated Entities





Equity in (loss) earnings from unconsolidated entities decreased from a gain of $242,183 in the third quarter of 2010 to a loss of $796,727 in the same period of 2011. The increased loss was mainly due to the recognition of the share of equity loss from investment in AXN. On October 18, 2010, the Nuo Hua Affiliate was disposed to an unrelated third party. As a result, the Company was no longer entitled to recognize its equity earnings from the Nua Hua Affiliate.





Interest Expense, Net





Net interest expense was $1,802,954 for the third quarter of 2011 compared to net interest expense of $1,456,062 for the same period of 2010. The increase was mainly due to the increase proceeds from short-term loans in the third quarter of 2011 as compared to the same period of 2010.





Income Tax





The Company’s effective tax rate for the third quarter of 2011 was (40)%, which is an decrease of 76% from 36% in the same period of 2010. The decrease in effective tax rate for the third quarter of 2011was mainly due to the reverse of the provision for income taxes for the applicable tax rate change of its PRC subsidiaries, GLP, BOKE, Three Happiness, HSPL and CCXA. For additional information, see “Item 1. Financial Statements — Note 23. Taxes”.






33





RESULTS OF OPERATIONS – NINE MONTHS ENDED SEPTEMBER 30, 2011 AS COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2010





The following table sets forth the amounts and the percentage relationship to revenues of certain items in our condensed consolidated statements of income for the quarters ended September 30, 2011 and 2010:





Nine months Ended

September 30,


Nine months Ended

September 30,2011


2010


2011


2010(RESTATED)





(RESTATED)Revenues

$
159,988,508


$
222,579,024



100%



100%Cost of sales


83,863,569



107,219,753



52



48GROSS PROFIT


76,124,939



115,359,271



48



52Selling, general and administrative expenses


34,577,769



48,326,800



22



22Advertising costs


10,185,380



26,949,663



6



12Research and development costs


8,652,455



10,754,394



6



5Depreciation and amortization expenses


5,359,979



4,902,005



3



2Debt extinguishment (gain)


(2,666,829)



-



(2)



-Total operating expenses


56,108,754



90,932,862



35



41INCOME FROM OPERATIONS


20,016,185



24,426,409



13



11Equity in earnings (losses) from unconsolidated entities


(857,811)



201,097



-



-Impairment loss on equity investment


-



(1,083,637)



-



-Gain (loss) on changes in ownership of unconsolidated entities


658,540



(12,240)



-



-Interest expense, net


(4,850,651)



(4,393,093)



(3)



(2)Other income (expenses), net


321,571



(85,340)



-



-INCOME BEFORE INCOME TAX


15,287,834



19,053,196



10



9Provision for income taxes


4,091,655



6,578,178



3



3NET INCOME


11,196,179



12,475,018



7



6Net (income) loss attributable to non-controlling interest


(14,767)



19,555



-



-NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST EARNINGS PER COMMON SHARE

$
11,181,412


$
12,494,573



7%



6%Basic

$
0.15


$
0.17Diluted

$
0.15


$
0.17





Revenues





Revenues for the nine months ended September 30, 2011 were $159,988,508, a decrease of $62,590,516, or 28%, compared to revenues for the same period of 2010.





34


We classify our revenues into two segments: manufacturing revenue and distribution revenue. The manufacturing revenue comprises revenue from pharmaceutical and nutraceutical products. Revenues by segments and product categories were as follows:


Nine months Ended

September 30,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Revenue from pharmaceutical products

$
119,969,639


$
181,813,000


$
(61,843,361)



(34)%Revenue from nutraceutical products


28,110,229



29,894,355



(1,784,126)



(6)%Total manufacturing revenue


148,079,868



211,707,355



(63,627,487)



(30)%Distribution revenue


11,908,640



10,871,669



1,036,971



10%Total revenues

$
159,988,508


$
222,579,024


$
(62,590,516)



(28)%





Revenue in connection with our pharmaceutical products decreased by $61,843,361, or 34%, as compared to 2010 primarily due to the following factors:





●
sales from our prescription pharmaceutical products decreased from $88,667,804 for the nine months ended September 30, 2010 to $72,554,541 for the same period of 2011, or a 18% decrease. The decrease was primarily due to the decrease in sales from SHL powder and CCXA’s generic pharmaceutical products and partially offset by the increase in sales from our prescription formulated Jinji capsule; and





●
sales from our OTC pharmaceutical products decreased from $93,145,196 for the nine months ended September 30, 2010 to $47,415,098 for the same period of 2011, or a 49% decrease. This was mainly due to the decreased sales volume of GLP’s generic OTC drugs.





We decreased the manufacturing of certain generic drugs since the TCM raw material price for these drugs has continued to increase during this year. Accordingly, we shifted the products mix toward higher-margin products from lower margin products to minimize the impact from the increased cost of certain raw materials and the continuing government price cut on certain products.





Revenue in connection with our nutraceutical products decreased by 6% compared to the same period of 2010. The decrease was mainly due to the decrease in sales from our Soy Peptide tablets and partially offset by the increase in sales from our Soy Peptide drinks which we launched commercially in late 2009. We decreased the advertising for certain old nutraceutical products and focused on new products to achieve optimum efficiency while maintaining strict advertising cost control.





The distribution revenue from Nuo Hua's majority owned subsidiary increased by 10%, to $11,908,640. This increase was mainly attributed to Nuo Hua's expanding market coverage.





Cost of Sales and Gross Profit





Cost of sales was $83,863,569 for the nine months ended September 30, 2011, compared to $107,219,753 in the same period of 2010. Cost of sales in the nine months ended September 30, 2011 and 2010 by segments and product categories were as follows:





Nine months Ended

September 30,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Pharmaceutical products

$
57,172,135


$
81,646,090


$
(24,473,955)



(30)%Nutraceutical products


15,396,392



15,029,240



367,152



2%Total manufacturing cost


72,568,527



96,675,330



(24,106,803)



(25)%Distribution cost


11,295,042



10,544,423



750,619



7%Total cost

$
83,863,569


$
107,219,753


$
(23,356,184)



(22)%





Gross profit decreased by $39,234,332, or 34%, for the nine months ended September 30, 2011 compared to the same period of 2010. Gross profit as a percentage of revenues decreased from 52% for the nine months ended September 30, 2010 to 48% in the same period of 2011 mainly due to the new levied urban construction and maintenance tax and educational surcharge.





From December of 2010, the urban construction and maintenance tax and educational surcharge were levied on foreign investment enterprises and foreign enterprises who previously enjoyed the exemption. We recognized the urban construction and maintenance tax and educational surcharge in cost of sales. As a result of the regulation change, our gross margin for the nine months ended September 30, 2011 was affected by approximately 2%.





We continued our efforts to manage the margin pressure although the increased purchase prices of certain raw materials increased the cost of sales.


35





Selling, General and Administrative Expenses





Selling, general and administrative expenses decreased from $48,326,800 for the nine months ended September 30, 2010 to $34,577,769 in the same period of 2011, representing a 28% decrease. The details of our sales and marketing expenses were as follows:


Nine months Ended

September 30,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Payroll

$
9,511,771


$
9,194,059


$
317,712



3%Staff welfare and insurance


2,706,948



1,949,786



757,162



39%Promotional materials and fees


5,913,443



17,884,830



(11,971,387)



(67)%Trips and traveling


3,116,518



2,866,185



250,333



9%Shipping


2,714,747



4,045,843



(1,331,096)



(33)%Stock based compensation


2,514,251



2,311,921



202,330



9%Professional fees


1,849,396



2,675,680



(826,284)



(31)%Miscellaneous


6,250,695



7,398,496



(1,147,801)



(16)%TOTAL

$
34,577,769


$
48,326,800


$
(13,749,031)



(28)%




The decrease in selling, general and administrative expenses for the nine months ended September 30, 2011 compared to the same period of 2010 was primarily due to the following factors:





●
the decrease of promotional materials and fees by $11,971,387, or 67%, as compared to the same period of 2010. This was primarily due to the reduction of our promotional activities in relation to SHL powder and generic prescription and OTC drugs;





●
the decrease of shipping costs by $1,331,096, or 33%, as compared to the same period of 2010. This was primarily due to the reduction of sales volume of our products; and





●
The decrease in selling, general and administrative expenses was partially offset by the increase of payroll expenses and staff welfare and insurance expenses by $317,712 and $757,162, respectfully, which was mainly due to the increase of the average salaries for our staff as a result of China’s increased labor costs and the increase of our staff welfare and insurance coverage and level as required by Chinese labor law.





Advertising Costs





Advertising costs decreased by $16,764,283, or 62%, from $26,949,663 in the nine months ended September 30, 2010 to $10,185,380 in the same period of 2011. Advertising costs as a percentage of revenue decreased from 12% for the nine months ended September 30, 2010 to 6% for the same period of 2011.





We decreased the advertising costs related to some of our OTC generic drugs during the nine months ended September 30, 2011. We continued to invest in advertising to create a unified megabrand for AOBO so that we can leverage on the establishment of all our individual brands to increase brand awareness and market shares.





Research and Development Costs





Research and development costs decreased by $2,101,939, or 20%, from $10,754,394 for the nine months ended September 30, 2010 to $8,652,455 in the same period of 2011. Expressed as a percentage of revenue, research and development costs were 6% and 5% for the nine months ended September 30, 2011 and 2010, respectively.





Our research and development activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies. Our key research and development programs include the improvement of our existing products and development of new products such as SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel and Jinji series products. The majority of our research and development expenditures are on pharmaceutical products.





Depreciation and Amortization





Depreciation and amortization expenses increased by $457,974, or 9%, for the nine months ended September 30, 2011 as compared to the same period of 2010. This was mainly due to the increase of the property, plant and equipment and land use rights during the second half of 2010.





36





Debt Extinguishment Gain





During the third quarter of 2011, the Company repurchased a total $5,500,000 in principal amount of our convertible Notes for $2,750,000. A gain of debt extinguishment of $2,666,829 was recognized representing the difference between the net carrying value of the notes repurchased and the repurchase price. For additional information, see “Item 1. Financial Statements — Note 16. Convertible Notes”.





Gain (loss) on Changes in Ownership of Unconsolidated Entities





Gain (loss) on changes in ownership of unconsolidated entities includes gain on changes in ownership of AXN.





On June 26, 2011, AXN and six note holders reached an agreement to settle certain outstanding notes and accrued interest there on totaling 42,449,722.63 RMB (approximately USD$6,567,199) by issuing 2,432,296 shares of AXN's common stock at $2.70 per share. As a result, equity interest of AXN owned by the Company decreased from 36.10% to 34.11% while the Company retained a significant influence. A gain of $0.66 million was recognized in the second quarter of 2011 resulting from a reduction in the Company’s ownership interest.





Equity in (Losses) Earnings from Unconsolidated Entities





Equity in (losses) earnings from unconsolidated entities decreased from a gain of $201,097 in the nine months ended September 30, 2010 to a loss of $857,811 in the same period of 2011. The increased loss was mainly due to the recognition of the share of equity losses from investment in AXN. On October 18, 2010, the Nuo Hua Affiliate was disposed to an unrelated third party; as a result, the Company was no longer entitled to recognize its equity earnings from the Nua Hua Affiliate.





Interest Expense, Net





Net interest expense was $4,850,651 for the nine months ended September 30, 2011 compared to net interest expense of $4,393,093 for the same period of 2010. The increase was mainly due to the increase proceeds from short-term loans in the nine months ended September 30, 2011 as compared to the same period of 2010.





Income Tax





The Company’s effective tax rate for the nine months ended September 30, 2011 was 27%, which is a decrease of 8% from 35% in the same period of 2010. The decrease in effective tax rate for the third quarter of 2011was mainly due to the reverse of the provision for income taxes for the applicable tax rate change of its PRC subsidiaries, GLP, BOKE, Three Happiness, HSPL and CCXA. For additional information, see “Item 1. Financial Statements — Note 23. Taxes”.





FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES





Cash





Our cash position at September 30, 2011 was $83,018,431, representing a decrease of $11,550,089, or 12%, compared with our cash position of $94,568,520 at December 31, 2010. The decrease was mainly attributable to the decrease of investing activities of $39,616,540 and partially offset by the operating and financing activities of $ 20,787,291 and $1,956,053.





We currently generate our cash flow through operations. We expect our existing cash and cash flow generated from operations will be sufficient to sustain our working capital, capital expenditures, and milestone payments for the next twelve months. From time to time, we may identify new expansion opportunities for which there will be a need to use cash.





We manage our cash based on thorough consideration of our corporate strategy as well as macroeconomic considerations. Factors we take into account when managing our cash include interest income, foreign currency fluctuation as well as the flexibility in executing our acquisition strategy.





Working Capital





We maintain a significant level of working capital. Our working capital decreased by $16,178,910  to $184,563,691 at September 30, 2011, as compared to $200,742,601 at December 31, 2010, mainly due to a decrease in cash and cash equivalents by $11,550,089, a decrease in net accounts and notes receivable by $16,481,681 and partially offset by an increase of net inventories of $ 11,535,480.


37


Cash Flow





Operating Activities





Cash flows from operations during the nine months ended September 30, 2011 amounted to $ 20,787,291, representing an increase of $13,452,758 compared with cash flows from operations of $7,334,533 for the same period of 2010. The increase in net cash provided by operating activities was primarily attributable to the increase in changes in operating assets and liabilities which aggregated to a net cash inflow of $1,246,431, an increase by $19,421,921 from a net cash outflow of $18,175,490 during the same period of 2010. As reflected in our cash flows, the changes included:





●
cash inflow from accounts and notes receivable amounted to $16,554,608 mainly affected by the timing of collection of our sales revenue during the fourth quarter of 2010;





●
cash outflows from inventories amounted to $11,521,442 and cash outflows from advances to suppliers amounted to $5,326,505 were mainly due to the increased purchases of raw materials for planned inventory buildup; and





●
cash outflows from other payables and accrued expenses amounted to $3,853,121 mainly attributed to the timing of payments to the promotion fee accrued in 2010.





Investing Activities





Our net cash used in investing activities amounted to $39,616,540 during the nine months ended September 30, 2011, compared to net cash used in investing activities of $5,407,949 for the same period of 2010. As reflected in our cash flows, the changes mainly included:





●   cash outflows for the deposit of a long-lived asset acquired, which allow us to have the right to establish a TCM raw material trading center in Northeast China approved by the China’s SFDA amounted to $26,503,473. The investment is intended to be integrated with our competitive infrastructure and whole supply chain management, providing foundation for the Company to start a TCM raw material trading business, offering a long term steadier supply of qualified raw materials with manageable costs.





●   cash outflows for purchases of construction in progress of $8,950,290 during the nine months ended September 30, 2011 for the expansion and upgrade of our manufacturing facilities to complement capacity improvement and efficiency enhancement.





Financing Activities





Our net cash provided from financing activities was $1,956,053 in the nine months ended September 30, 2011, compared to cash outflow of $3,848,082 in the same period of 2010. During the period, we repaid $7,157,474 bank loans and received $12,663,526 short-term loans.





We repurchased a total $5,500,000 in principal amount of our convertible Notes for $2,750,000; we also repurchased 449,163 shares of our common stock at a total cost of $799,999 pursuant to the Share Buyback Program.





Off -balance Sheet Arrangements





We do not have any off -balance sheet arrangements as of September 30, 2011.





Contractual Obligations





During the three months ended September 30, 2011, there have been no material changes outside the ordinary course of the Company’s business to the contractual obligations previously disclosed in PART II: ITEM 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.





Holders of the convertible notes may require the Company to repurchase all or a portion of their notes on July 15, 2013 for cash at a price equal to 100% of the principal amount of the notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date.





We rely largely on operating cash flow to fund our capital expenditure needs. Due to our significant operating cash flow, we believe we have the ability to meet our capital expenditure needs and foresee no delays to planned capital expenditures.





ISSUANCE OF COMMON STOCK





See Part II Item 2.





38





INFLATION





Inflation has not had a material impact on our business.





CURRENCY EXCHANGE FLUCTUATIONS





The Company's operations are exposed to a variety of global market risks, including the effect of changes in foreign currency exchange rates. These exposures are managed, in part, with the use of a financial derivative. The Company does not use financial derivatives to hedge exposures in the ordinary course of business or for speculative purposes.





We currently conduct substantially all of our operations through our PRC subsidiaries. The functional currency of our PRC subsidiaries is the Chinese RMB. The financial statements of our PRC subsidiaries are translated to U.S. dollars using period-end exchange rates as to assets and liabilities and average exchange rates as to revenues, expenses, and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of shareholders’ equity.





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.





As the majority of our assets and substantially all of our revenue, costs and expenses are denominated in RMB, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues and financial condition. For example, if the RMB depreciates against the U.S. dollar, the value of our RMB revenues, earnings, and assets, as expressed in our U.S. dollar financial statements could decline. In addition, if we decide to convert our RMB into U.S. dollars for the purpose of making payments for business purposes, the U.S. dollar equivalent of the RMB we convert would be reduced. On the other hand, to the extent that we need to convert U.S. dollars we receive from an offering
of our securities into RMB for our operations, appreciation of the RMB against the U.S. dollar could reduce the amount of the U.S. dollars available.





The local currencies in the countries in which we sell our products may fluctuate in value in relation to other currencies. Such fluctuations may affect the costs of our products sold and the value of our local currency profits. While we are not conducting any operations in countries other than China at the present time, we may expand to other countries and may then have an increased risk of exposure of our business to currency fluctuation.





The PRC government imposes control over the conversion of RMB, into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.





Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIEs, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit
such foreign exchange to their foreign exchange bank accounts in China. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.





Enterprises in China, including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited amount may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.





Convertibility of foreign exchange in respect of capital account items, such as direct investment and capital contribution, is still subject to certain restrictions, and prior approval from the SAFE or its relevant branches must be sought.





Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar.





39





Since a significant amount of our future revenues are expected to be denominated in RMB, any existing and future restrictions on currency exchange may limit our ability to utilize revenue generated in China to fund our business activities outside of China, if any, or expenditures denominated in foreign currencies, or our ability to meet our foreign currency obligations, which could have a material adverse effect on our business, financial condition and results of operations. We cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions on the convertibility of RMB with respect to foreign exchange transactions.





We recognized a foreign currency translation adjustment of $16.5 million and $9.7 million for the nine months ended September 30, 2011 and 2010, respectively. The balance sheet amounts with the exception of equity at September 30, 2011 were translated at 6.4018 RMB to $1.00 USD as compared to 6.6118RMB at December 31, 2010. The equity accounts were stated at their historical rate. The average translation rates applied to the income and cash flow statement amounts for the nine months ended September 30, 2011 and 2010 were 6.5068 RMB and 6.7677 RMB to $1.00 USD, respectively. We do not hedge our exposure to foreign exchange risk; as such, we may in the future experience economic loss as a result
of any foreign currency exchange rate fluctuations.





ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





There were no material changes in the Company’s market risk components since December 31, 2010. For a discussion of our market risk, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2010 Annual Report on Form 10-K.





ITEM 4 – CONTROLS AND PROCEDURES





Evaluation of Disclosure Controls and Procedures





As of the end of the period covered by this report (the “Evaluation Date”), we carried out an evaluation in accordance with the requirements of applicable U.S. rules.  The Company’s management, which includes its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with respect to this Quarterly Report on Form 10-Q before its filing with the SEC.  The internal audit group made its evaluation pursuant to Rule 13a-15 under
the Exchange Act.





Based upon our evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our Chief Executive Officer and Chief Financial Officer to allow timely decisions regarding required disclosure.





Background of Restatement
 
 Subsequent to the issuance of the consolidated financial statements as of and for the year ended December 31, 2010, the Company’s Independent Registered Public Accounting Firm identified accounting errors related to the Company’s equity investment in Nuo Hua Affiliate.
 
 The Company and the Audit Committee undertook a review to determine the total amount of the errors and the accounting periods in which the errors occurred and concluded that the Company’s previously-issued 2010 consolidated financial statements and unaudited interim condensed consolidated financial statements as of September 30, 2010, March 31, 2011 and June 30, 2011, should be and, accordingly, have been restated as described in Note 3 to the condensed consolidated financial statements included in Item 1 of the quarterly report on Form 10-Q.
  The Audit Committee and the Company’s management requested outside legal counsel to perform a review of the matter and as a result, it was determined that the above-mentioned accounting errors occurred because the Company’s Chief Accounting Officer did not provide adequate disclosures with respect to the transaction at the outset, received knowingly-falsified documentation from the legal representative for Nuo Hua with respect to the transaction, and subsequently provided that documentation to the Company’s Independent Registered Public Accounting Firm in an attempt to provide evidential matter that would appear to appropriately support the transaction to the Company’s
Independent Registered Public Accounting Firm with respect to the accounting treatment adopted by the Company for the Nuo Hua Affiliate. The incident and these accounting errors resulted from a design deficiency in the Company’s  controls over the implications of and accounting for significant contracts and transactions for which the Chief Accounting Officer had, without oversight, the sole authority.  In addition, a design deficiency existed as transactions over a specified threshold were not required to be reported to those with oversight of the financial reporting process. Due to the resulting restatement, these deficiencies were determined to be material weaknesses.
 
 Management has suspended the Chief Accounting Officer from all accounting and finance responsibilities, pending completion of the investigation, and the Company’s legal representative for Nuo Hua was terminated in October 2011.
 40
  Description of Material Weakness
  A material weakness in internal control over financial reporting is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.
 
 Management identified the following control deficiencies as of December 31, 2010 that constituted material weaknesses:
 
 ·
A design deficiency in the Company’s  controls over the implications of and accounting for significant contracts and transactions for which the Chief Accounting Officer had, without oversight, the sole authority .
 
 ·
The design deficiency resulting from the lack of a threshold for reporting significant transactions to those responsible for oversight of the financial reporting process.
 
 Each of these design deficiencies was determined to be a material weakness.
 
 Our Independent Registered Public Accounting Firm, Ernst & Young Hua Ming, who also audited our consolidated financial statements, has issued an adverse opinion on the Company’s internal control over financial reporting, included in Item 9A of the amended annual report on Form 10-K/A.
 Changes in Internal Control over Financial Reporting
 
 There was no change in our internal control over financial reporting that occurred during the third quarter of the fiscal year that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
 Remediation plans
  
  ·
Management is in the process of revising its policies and procedures relating to the identification of significant transactions that will impact its financial accounting and disclosures.  This includes the establishment of a Disclosure Committee consisting of the Chief Executive Office, Chief Financial Officer, other accounting and operational management as deemed necessary and the Audit Committee financial expert.  The responsibility of the Disclosure Committee is to assist the Company’s financial reporting team in ensuring that the accounting consequences of the Company’s material transaction are captured and reflected in the Company’s financial statements on a timely and accurate
manner.
  ·
Management is in the process of establishing a reporting threshold for significant and material transactions to those who are responsible for oversight the financial reporting, particularly to the Audit Committee.
  ·
Management is in the process of designing controls to obtain internal certifications from operational management to ensure all important transactions, contracts and agreements have been appropriately disclosed to the Disclosure Committee.
  The material weaknesses identified by management are not remediated as of the date of the filing of this quarterly report on Form 10-Q. The Company has performed additional substantive procedures to ensure that the financial information reflected in this report is supported and the financial statements are fairly presented as of the date of this amended report. The Audit Committee has directed management to develop a detailed plan and timetable for the implementation of the above-referenced remediation measures. In addition, with the oversight of the Audit Committee, management will continue to review and make necessary changes to the overall design of the system of internal controls and the control environment, as well as
policies and procedures to improve the overall effectiveness of internal control over financial reporting.


41


PART II – OTHER INFORMATION





ITEM 1 – LEGAL PROCEEDINGS





We are not currently involved in any litigation that we believe could have a material adverse effect on our financial condition or results of operations. There is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of our executive officers or any of our subsidiaries, threatened against or affecting our company, our common stock, or any of our subsidiaries, or against our Company’s or our Company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision could have a material adverse effect.


ITEM 1A – RISK FACTORS





There have been no material changes or new risks since our Annual Report on Form 10-K for the year ended December 31, 2010.





ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS





The following summarizes the issuance of our equity securities during the three month ended September 30, 2011:




·
37,030 shares of common stock to a consultant for advisory services rendered in 2010.





The issuance of the foregoing shares was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.





ITEM 3 – DEFAULTS UPON SENIOR SECURITIES





There have been no material defaults.





ITEM 4 – (REMOVED AND RESERVED)








ITEM 5 – OTHER INFORMATION





Not applicable.





ITEM 6 – EXHIBITS





The following exhibits are filed as part of this Quarterly Report on Form 10-Q:





Exhibit No.
Description31.1
Certification of Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended31.2
Certification of Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended32.1
Certification of Chief Executive Officer (Principal Executive Officer) and Chief Financial Officer (Principal Financial Officer) pursuant to 18 U.S.C. 1350, as adopted.101.INS
XBRL Instance Document*101.SCH
XBRL Taxonomy Extension Schema Document*101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document*101.DEF
XBRL Taxonomy Extension Definition Linkbase Document*101.LAB
XBRL Taxonomy Extension Labels Linkbase Document*101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document*










42





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.





AMERICAN ORIENTAL BIOENGINEERING, INC.





/s/ Tony Liu


TONY LIU


CHAIRMAN AND CHIEF EXECUTIVE OFFICER


DATED: November 14, 2011








/s/ Yanchun Li


YANCHUN LI


CHIEF FINANCIAL OFFICER


DATED: November 14, 2011


43





EXHIBIT INDEX








Exhibit No.
Description31.1
Certification of Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended31.2
Certification of Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended32.1
Certification of Chief Executive Officer (Principal Executive Officer) and Chief Financial Officer (Principal Financial Officer) pursuant to 18 U.S.C. 1350, as adopted.101.INS
XBRL Instance Document*101.SCH
XBRL Taxonomy Extension Schema Document*101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document*101.DEF
XBRL Taxonomy Extension Definition Linkbase Document*101.LAB
XBRL Taxonomy Extension Labels Linkbase Document*101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document*