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 March 31, 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  ̈   No  ̈





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 May 6, 2011Common Stock, $0.001 par value

78,178,386








TABLE OF CONTENTS





PART I – FINANCIAL INFORMATION
3ITEM 1 – Financial Statements
3Unaudited condensed consolidated balance sheet as of March 31, 2011 and condensed consolidated balance sheet as of December 31, 2010
3Unaudited condensed consolidated statements of income and comprehensive income for the three months ended March 31, 2011 and 2010
5Unaudited condensed statements of cash flow for the three months ended March 31, 2011 and 2010
6Notes to unaudited condensed consolidated financial statements - March 31, 2011
7ITEM 2 – Management's Discussion and Analysis of Financial Condition and Results of Operations
23ITEM 3 – Quantitative and Qualitative Disclosures About Market Risk
30ITEM 4 – Controls and Procedures
30PART II – OTHER INFORMATION
31ITEM 1 – Legal Proceedings
31ITEM 1A – Risk Factors
31ITEM 2 – Unregistered Sales of Equity Securities and Use of Proceeds
31ITEM 3 – Defaults upon Senior Securities
31ITEM 4 – (Removed and Reserved)
31ITEM 5 – Other Information
31ITEM 6 – Exhibits
31Signatures
32





2





PART I – FINANCIAL INFORMATION





ITEM 1 – FINANCIAL STATEMENTS





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)





ASSETS





MARCH 31,

2011


DECEMBER 31,

2010CURRENT ASSETSCash and cash equivalents

$
111,432,776


$
94,568,520Restricted cash


875,318



537,297Accounts and notes receivable, net


46,865,375



80,598,919Inventories, net


25,138,004



12,665,586Advances to suppliers and prepaid expenses


16,715,346



14,246,144Deferred tax assets


440,174



649,503Other current assets


3,394,063



2,986,005Total Current Assets


204,861,056



206,251,974LONG-TERM ASSETSProperty, plant and equipment, net


108,907,254



109,547,616Land use rights, net


155,562,594



155,433,311Other long term assets


8,212,645



8,167,880Construction in progress


28,556,117



22,516,044Other intangible assets, net


14,144,113



14,889,127Goodwill


33,164,121



33,164,121Investments in and advances to equity investments


58,933,172



59,068,491Deferred tax assets


145,302



147,024Unamortized financing cost


2,127,332



2,359,404Total Long-Term Assets


409,752,650



405,293,018TOTAL ASSETS

$
614,613,706


$
611,544,992





See accompanying notes to the condensed consolidated financial statements




3





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)





LIABILITIES AND EQUITY





MARCH 31,

2011


DECEMBER 31,

2010CURRENT LIABILITIESAccounts payable

$
11,436,580


$
10,716,686Notes payable


875,318



537,297Other payables and accrued expenses


13,922,647



18,039,557Taxes payable


2,590,172



1,237,169Short-term bank loans


7,001,416



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


61,706



61,405Other liabilities


5,881,213



6,284,107Deferred tax liabilities


193,671



243,304Total Current Liabilities


41,962,723



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


663,783



679,866Deferred tax liabilities


15,656,086



15,837,479Unrecognized tax benefits


5,551,703



5,050,157Convertible notes


115,000,000



115,000,000Total Long-Term Liabilities


136,871,572



136,567,502TOTAL LIABILITIES


178,834,295



180,644,285COMMITMENTS AND CONTINGENCIESEQUITYSHAREHOLDERS’ EQUITYPreferred stock, $0.001 par value; 2,000,000 shares authorized; 1,000,000 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively


1,000



1,000Common stock, $0.001 par value; 150,000,000 shares authorized; 78,598,604 shares issued and outstanding at both March 31, 2011 and December 31, 2010


78,598



78,598Common stock to be issued


435,000



350,500Prepaid forward repurchase contract


(29,998,616)



(29,998,616)Additional paid-in capital


204,063,263



203,322,671Retained earnings (the restricted portion of retained earnings is $26,471,124 at both March 31, 2011 and December 31, 2010)


208,439,256



207,515,104Accumulated other comprehensive income


52,258,717



49,126,251Total Shareholders’ Equity


435,277,218



430,395,508Non-controlling Interest


502,193



505,199TOTAL EQUITY


435,779,411



430,900,707TOTAL LIABILITIES AND EQUITY

$
614,613,706


$
611,544,992





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 MARCH 312011


2010Revenues

$
52,002,110


$
53,749,768Cost of sales


26,926,200



25,513,047GROSS PROFIT


25,075,910



28,236,721Selling, general and administrative expenses


11,239,247



10,742,712Advertising costs


3,821,148



6,748,470Research and development costs


2,701,212



2,778,809Depreciation and amortization expenses


1,770,711



1,596,958Total operating expenses


19,532,318



21,866,949INCOME FROM OPERATIONS


5,543,592



6,369,772Equity in (losses) earnings from unconsolidated entities


(409,886)



117,473Interest expense, net


(1,513,585)



(1,565,785)Other income, net


425,880



12,247INCOME BEFORE INCOME TAX


4,046,001



4,933,707Income tax


3,124,855



1,815,930NET INCOME


921,146



3,117,777Net loss attributable to non-controlling interest


3,006



5,400NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST


924,152



3,123,177OTHER COMPREHENSIVE INCOMEForeign currency translation gain


3,132,466



92,849OTHER COMPREHENSIVE INCOME


3,132,466



92,849COMPREHENSIVE INCOME

$
4,056,618


$
3,216,026EARNINGS PER COMMON SHAREBasic

$
0.01


$
0.04Diluted

$
0.01


$
0.04WEIGHTED AVERAGE COMMON SHARES OUTSTANDINGBasic


74,987,374



74,697,044Diluted


76,018,561



89,460,953





See accompanying notes to the condensed consolidated financial statements




5





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)





THREE MONTHS ENDED

MARCH 312011



2010CASH FLOWS FROM OPERATING ACTIVITIES:Net income

$
921,146


$
3,117,777Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


3,089,788



3,219,284Amortization of deferred issuance cost


232,072



232,072Loss on disposal of property, plant and equipment


1,754



370Stock-based consulting expenses


54,175



20,200Reversal of doubtful accounts and slow moving inventories


(51,172)



(11,792)Deferred taxes


(116,775)



5,477Stock-based compensation expenses


702,592



578,237Equity in losses (earnings) from unconsolidated entities


409,886



(117,473)Independent director stock compensation


84,500



97,000Changes in operating assets and liabilities:(Increase) decrease in:Accounts and notes receivable


33,782,909



3,994,962Inventories


(12,471,128)



(9,805,226)Advances to suppliers and prepaid expenses


(2,485,377)



8,375,368Other current assets


(408,058)



(268,484)Increase (decrease) in:Accounts payable


781,026



3,163,172Other payables and accrued expenses


(4,375,610)



(7,738,112)Taxes payable


1,353,003



(594,899)Other liabilities


(402,894)



940,896Unrecognized tax benefits


501,546



554,064Net cash provided by operating activities


21,603,383



5,762,893CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant and equipment


(153,392)



(161,759)Purchases of construction in progress


(5,630,967)



(928,436)Deposit for long-term assets


-



(19,751)Advances to equity investments


(19,263)



(12,101)Proceeds from disposal of property, plant and equipment


228



-Net cash used in investing activities


(5,803,394)



(1,122,047)CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from bank loans


758,610



820,716Repayment of bank loans


(778,345)



(842,206)Net cash used in financing activities


(19,735)



(21,490)Effect of exchange rate changes on cash and cash equivalents


1,084,002



41,459NET INCREASE IN CASH AND CASH EQUIVALENTS


16,864,256



4,660,815Cash and cash equivalents, beginning of period


94,568,520



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

$
111,432,776



95,787,301





See accompanying notes to the condensed consolidated financial statements




6





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 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 audited consolidated financial statements included in the Company’s Annual Report on Form 10-K. 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 March 31, 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.





MARCH 31,2011


2010Quarter end RMB : US$ exchange rate


6.5701



6.8361Average quarterly RMB : US$ exchange rate


6.5910



6.8367





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 MARCH 31, 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 MARCH 31, 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 MARCH 31, 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 MARCH 31, 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:





11





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


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.


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.





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. The cost method is used for investments over which the Company does not have the ability to exercise significant influence or control.





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 MARCH 31, 2011
 (UNAUDITED)




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.





NOTE 3 - ACCOUNTS AND NOTES RECEIVABLE





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





MARCH 31,

2011


DECEMBER 31,

2010Beginning balance

$
687,879


$
522,897Provision for doubtful debts


-



164,982Reversal


(49,365)



-Written off


-



-Ending balance

$
638,514


$
687,879





NOTE 4 - INVENTORIES





Inventories are summarized as follows:





MARCH 31,

2011


DECEMBER 31,

2010Raw materials

$
15,195,634


$
6,902,658Work in process


2,143,306



2,274,499Finished goods


7,824,309



3,511,163Total inventories


25,163,249



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


(25,245)



(22,734)Inventories, net

$
25,138,004


$
12,665,586





As of March 31, 2011 and December 31, 2010, raw materials included capitalized agricultural costs of $195,720 and 190,697, respectively.





NOTE 5 - ADVANCES TO SUPPLIERS AND PREPAID EXPENSES





MARCH 31,

2011


DECEMBER 31,

2010Advance to suppliers

$
15,573,381


$
12,292,689Prepaid expenses


1,141,965



1,953,455Advances to suppliers and prepaid expenses

$
16,715,346


$
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.




13


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


NOTE 6 - LAND USE RIGHTS





Land use rights consist of the following:





MARCH 31,

2011


DECEMBER 31,

2010Cost of land use rights

$
166,676,896


$
165,625,682Less: Accumulated amortization


(11,114,302)



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

$
155,562,594


$
155,433,311





As of March 31, 2011 and December 31, 2010, the net book value of land use rights pledged as collateral was $20,736,451 and $20,729,293, respectively. See Note 14.





Amortization expense for the quarter ended March 31, 2011 and 2010 was $854,523 and $823,813, respectively.





NOTE 7 - CONSTRUCTION IN PROGRESS





Construction in progress as of March 31, 2011 and December 31, 2010 was $28,556,117 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 March 31, 2011 and 2010 amounted to $1,876,151 and $1,996,625, respectively.





Total interest costs capitalized as part of construction in progress for the three months ended March 31, 2011 and 2010 amounted to $258,700 and $352,840, respectively. Capitalized interest included in construction in progress was $1,899,332 and $1,640,632 as of March 31, 2011 and December 31, 2010, respectively.





NOTE 8 - PROPERTY, PLANT AND EQUIPMENT





Property, plant and equipment consist of the following:





MARCH 31,

2011


DECEMBER 31,

2010At cost:Buildings

$
105,517,606


$
104,865,498Machinery and equipment


23,679,910



23,512,674Motor vehicles


1,543,853



1,568,813Office equipment


2,567,553



2,529,352Other equipment


4,037,156



3,996,164137,346,078



136,472,501Less: Accumulated depreciationBuildings


(10,004,749)



(9,278,438)Machinery and equipment


(15,006,526)



(14,438,180)Motor vehicles


(1,335,996)



(1,331,806)Office equipment


(1,559,085)



(1,458,772)Other equipment


(532,468)



(417,689)(28,438,824)



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

$
108,907,254


$
109,547,616





As of March 31, 2011 and December 31, 2010, the net book value of property, plant and equipment pledged as collateral for bank loans were $6,228,284 and $6,243,893, respectively. See Note 14.





Depreciation expense for the three months ended March 31, 2011 and 2010 was $1,395,159 and $1,178,005, respectively.




14


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


NOTE 9 - OTHER INTANGIBLE ASSETS, NET





Other intangible assets are summarized as follows:





MARCH 31,

2011


DECEMBER 31,

2010At cost:Product licenses

$
16,155,571


$
16,053,679Trademarks


11,015,231



10,945,759Patents


5,003,572



4,972,016Proprietary technology


293,843



291,990Software


95,089



94,48832,563,306



32,357,932Less: Accumulated amortizationProduct licenses

$
(9,265,418)


$
(8,891,025)Trademarks


(6,474,885)



(6,009,283)Patents


(2,547,561)



(2,448,111)Proprietary technology


(109,216)



(100,775)Software


(22,113)



(19,611)(18,419,193)



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

$
14,144,113


$
14,889,127





Amortization expense for the three months ended March 31, 2011 and 2010 was $836,853 and $1,217,466, respectively.





NOTE 10 - INVESTMENTS IN AND ADVANCES TO UNCONSOLIDATED ENTITIES





Long-term investments and advances include our equity investment in Aoxing Pharmaceutical Company, Inc. (“AXN”), Nuo Hua Affiliate 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. Nuo Hua Affiliate maintains a presence in pharmaceutical wholesale and retail distribution in the PRC. Jinji is a color printing company focusing on the printing of external packaging materials. Long-term investments are accounted for using the equity accounting method.





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




MARCH 31,

2011


DECEMBER 31,

2010Investment in AXN based on quoted market price

$
36,264,677


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

$
18,380,562


$
18,903,366





NOTE 11 - OTHER LONG-TERM ASSETS





MARCH 31,

2011


DECEMBER 31,

2010Payment for long-term supply contract

$
7,773,093


$
7,724,069Deposits for long-term assets


439,552



443,811Total other long-term assets

$
8,212,645


$
8,167,880





Payment for long-term supply contract represents a payment for a long-term supply contract entered into with a third party on October 17, 2009 to secure the supply of Xanthoceras Sorbifolia Bge (“XSB”), a major raw material of a subsidiary 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. The Company assesses the impairment of the payment as of each balance date. As of March 31, 2011 and December 31, 2010, no impairment was recognized.





15





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


Deposits for long term assets are refundable deposits to acquire land use rights located in the PRC. The long-lived assets to be acquired will be for use in the expansion of some of the Company's current manufacturing facilities and are not intended for resale by the Company. The deposits will be reclassified to the respective accounts under long-lived assets upon the transfers of legal title.





NOTE 12 - OTHER PAYABLES AND ACCRUED EXPENSES





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





MARCH 31,

2011


DECEMBER 31,

2010Other taxes payable

$
395,548


$
295,702Other payables


7,551,002



9,378,014Accrued expenses


5,976,097



8,365,841Other payables and accrued expenses

$
13,922,647


$
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 13 - OTHER LIABILITIES





MARCH 31,

2011


DECEMBER 31,

2010Due to employees

$
509,494


$
2,803,189Advances from customers


3,755,826



2,194,450Other current liabilities


1,615,893



1,286,468Other liabilities

$
5,881,213


$
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 14 - DEBT





Short-term bank loans are obtained from local banks. All of the short-term bank loans are repayable within one year and 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 $104,360 and $149,126 for the three months ended March 31, 2011 and 2010, respectively.





NOTE 15 - 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.





16





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


●
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.





●
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.





The effective interest rate on the Notes for the three months ended March 31, 2011 and 2010 was 5.945%.





The amount of interest cost recognized for the three months ended March 31, 2011 and 2010 was $1,437,500.





NOTE 16 - 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.





17





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


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 17 - 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 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.





18





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 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 periods ended March 31, 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 $3,161,538 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 1.9 years as of March 31, 2011.





The expected forfeiture rate of the stock options granted as of March 31, 2011 is 0%.





Common Stock Awards





On April 10, 2009 and April 8, 2010, 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 March 31, 2011 is 0%.





The Company recorded selling, general and administrative expenses of $227,954 and $103,599 in connection with such awards for the three months ended March 31, 2011 and 2010, respectively.





The total fair value of the common stock awards granted as of the respective grant date was $4,559,083, of which the unrecognized portion of $3,232,919 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 3.5 years as of March 31, 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.





As a result, $26,471,124 has been appropriated to the accumulated statutory reserves, which were included in retained earnings, by the Company’s PRC subsidiaries as of March 31, 2011 and December 31, 2010.





19




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


NOTE 18 - COMMITMENTS AND CONTINGENCIES





As of March 31, 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 $3,997,278 and $28,919 within one year and $9,465,609 and nil after one year but within five years. In addition, the Company had advertisement contract commitments of $16,996,790 for the next 12 months as well as R&D commitments of $3,005,798 within one year and $420,330 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 March 31, 2011, the Company has recorded an unrecognized tax benefit of $5,551,703.





As of March 31, 2011, the Company has no significant litigation claims. Also, the Company does not have significant operating-lease commitments as of March 31, 2011.





NOTE 19 - SEGMENT REPORTING





For the three months ended March 31, 2011 and 2010 the Company’s segments were as follows:


Three Months Ended March 31,2011


2010Manufacturing SegmentRevenue from pharmaceutical products

$
38,961,981


$
40,865,081Revenue from nutraceutical products


9,785,800



9,665,703Total manufacturing revenue


48,747,781



50,530,784Total manufacturing costs


23,835,153



22,391,568Depreciation and amortization expense


1,309,671



1,195,356Selling, general and administrative expenses, research and development costs and advertising costs


15,012,588



17,966,221Operating income of manufacturing segment


7,004,715



7,453,894Distribution SegmentDistribution revenue

$
3,254,329


$
3,218,984Equity in earnings (loss) from unconsolidated entities


112,098



604,450Operating income of distribution segment


65,916



432,072Reconciliation to Consolidated Net Income Attributable to Controlling Interest:Total net operating income, as defined, for reportable segments


7,070,631



7,885,966Unallocated


(6,146,479)



(4,762,789)Consolidated Net Income Attributable to Controlling Interest

$
924,152


$
3,123,177





All operating revenues comprise amounts received from external third party customers.





All of the Company’s operations are located in the PRC.





NOTE 20 - 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.




20


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


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 March 31,2011


2010EPS Numerator:Net income attributable to controlling interest

$
924,152


$
3,123,177Interest expense on convertible securities, net of taxes


-



1,437,500Amortization of financing costs, net of taxes


-



232,072Less: capitalization of interest on convertible securities


-



(352,840)Net income, as adjusted

$
924,152


$
4,439,909EPS Denominator:Weighted average common shares outstanding – Basic


74,987,374



74,697,044Effect of dilutive instruments:Convertible notes


-



14,232,673Common stock awards to be issued


1,031,187



531,236Weighted average common shares outstanding – Diluted


76,018,561



89,460,953





EPS - Basic

$
0.01


$
0.04EPS - Diluted

$
0.01


$
0.04





The calculation of weighted average common shares outstanding for the diluted earnings per share calculation excludes consideration of stock options for the three months ended March 31, 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 15, 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 months ended March 31, 2011 because conversion of the convertible notes under the if-converted method would have been anti-dilutive.





NOTE 21 – TAXES





The Company's effective tax rates were 77% and 37% for the three months ended March 31, 2011 and 2010, respectively. The increase in effective tax rate was mainly due to an increase of applicable tax rate for the PRC subsidiaries as the High & New Technology status will expire near the year end of 2011. At the current stage, management did not believe it is 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 GLP, BOKE, Three Happiness, HSPL and CCXA for the three months ended March 31, 2011. The assessment of qualification for the HNTE status is performed on an on-going basis by management. Additionally, in 2011, there was an increase in valuation allowance change because some of the entities within the group made a relatively larger accounting loss for the three months ended comparing to 2010 for which valuation allowance was fully provided. The Company had total income tax expense of $3,124,855 for the three months ended March 31, 2011. The Company continues to conduct most of its business through its major PRC subsidiaries whose applicable income tax rates are 25% and 15% for March 31, 2011 and 2010, respectively. 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 $3,241,467 for the three months ended March 31, 2011 of which $696,022 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 $500,613 as of March 31, 2011.





21





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2011
 (UNAUDITED)


NOTE 22 - 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 $1,433,498 and $216,738 for the three months ended March 31, 2011 and 2010, respectively and are included in cost, inventory, selling, general and administrative expenses.





NOTE 23 - SUBSEQUENT EVENTS





Share Buyback Program





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”).





In April 2011, the Company repurchased 420,218 shares of its common stock under the Share Buyback Program for an aggregate purchase consideration of $763,013, including transaction costs of $10,505, at an average price of $1.79 per share.  In accordance with ASC Subtopic 505-30 (“ASC 505-30”) “Treasury Stock”, the Company accounted for the repurchased common stock as treasury stock , which will be shown as a separate item in the consolidated statements of changes in shareholders’ equity, as the Company has not yet decided on the ultimate disposition of the repurchased common stock.





22




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





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 Annual Report on Form 10-K 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 March 31, 2011, the Company provided a $638,514 reserve against accounts and notes receivable. Management’s estimate of the appropriate reserve on accounts and notes receivable at March 31, 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 March 31, 2011, the Company provided an allowance against its inventories amounting to $25,245. 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.





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.





23




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 December 31, 2010 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 the three months ended March 31, 2011, the Company recorded an unrecognized tax benefit of approximately $5,551,703, which is mainly related to non-trade intercompany transactions, fixed assets and intangible assets.





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 $500,613 interest and a penalty of nil as of March 31, 2011.





24




RESULTS OF OPERATIONS – THREE MONTHS ENDED MARCH 31, 2011 AS COMPARED TO THREE MONTHS ENDED MARCH 31, 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 March 31, 2011 and 2010:





Three Months Ended

March 31,


Three Months Ended

March 31,2011


2010


2011


2010Revenues

$
52,002,110


$
53,749,768



100%



100%Cost of sales


26,926,200



25,513,047



52



4725,075,910



28,236,721



48



53GROSS PROFITSelling, general and administrative expenses


11,239,247



10,742,712



22



20Advertising costs


3,821,148



6,748,470



7



13Research and development costs


2,701,212



2,778,809



5



5Depreciation and amortization


1,770,711



1,596,958



3



3Total operating expenses


19,532,318



21,866,949



38



41INCOME FROM OPERATIONS


5,543,592



6,369,772



11



12Equity in (losses) earnings from unconsolidated entities


(409,886)



117,473



(1)



-Interest expense, net


(1,513,585)



(1,565,785)



(3)



(3)Other income, net


425,880



12,247



1



-INCOME BEFORE INCOME TAX


4,046,001



4,933,707



8



9Income tax


3,124,855



1,815,930



6



3NET INCOME


921,146



3,117,777



2



6Net loss attributable to non-controlling interest


3,006



5,400



-



-NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST EARNINGS PER COMMON SHARE

$
924,152


$
3,123,177



2%



6%Basic

$
0.01


$
0.04Diluted

$
0.01


$
0.04




Revenues





Revenues for the first quarter of 2011 were $52,002,110, a decrease of $1,747,658, or 3% 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

March 31,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Revenue from pharmaceutical products

$
38,961,981


$
40,865,081


$
(1,903,100)



(5)%Revenue from nutraceutical products


9,785,800



9,665,703



120,097



1%Total manufacturing revenue


48,747,781



50,530,784



(1,783,003)



(4)%Distribution revenue


3,254,329



3,218,984



35,345



1%Total revenues

$
52,002,110


$
53,749,768


$
(1,747,658)



(3)%





Revenue in connection with our pharmaceutical products decreased by $1,903,100, or 5%, as compared to 2010 primarily due to the following factors:





●
sales from our prescription pharmaceutical products increased from $20,946,430 for the first quarter of 2010 to $24,069,249 for the same period of 2011, or a 15% increase. The increase was primarily due to the increase in sales from our prescription formulated Jinji capsule, SHL powder and the expansion of CCXA generic pharmaceutical products in the rural market. The increase in sales was supported by our continuous marketing efforts, increase in new products offerings, as well as expanding coverage in the rural market;





25





●
the increase was offset by a decrease of sales revenue from our OTC pharmaceutical products from $19,918,651 for the first quarter of 2010 to $14,892,732 for the same period of 2011, or a 25% decrease. This was mainly due to the decreased sales volume of GLP’s generic OTC drugs. We decreased the manufacturing of certain generic OTC drugs since the TCM raw material price for these drugs has continued to increase this 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 was in line with the same period of 2010, increased by 1%, to $9,785,800.





The distribution revenue from Nuo Hua's majority owned subsidiary was in line with the same period of 2010, increased by 1%, to $3,254,329.





Cost of Sales and Gross Profit





Cost of sales was $26,926,200 for the first quarter of 2011, compared to $25,513,047 in the same period of 2010. Cost of sales in the first quarter of 2011 and 2010 by segments and product categories were as follows:





Three Months Ended

March 31,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Pharmaceutical products

$
18,602,757


$
17,624,204


$
978,553



6%Nutraceutical products


5,232,396



4,767,364



465,032



10%Total manufacturing cost


23,835,153



22,391,568



1,443,585



6%Distribution cost


3,091,047



3,121,479



(30,432)



(1)%Total cost

$
26,926,200


$
25,513,047


$
1,413,153



6%





The cost of sales of pharmaceutical and nutraceutical products increased by 6% and 10%, respectively, in the first quarter of 2011 compared to the same period of 2010.





Gross profit decreased by $3,160,811, or 11%, for the first quarter of 2011 compared to the same period of 2010. Gross profit as a percentage of revenues decreased from 53% in the first quarter of 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 enjoyed exemption before. 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 first 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, and a greater proportion of generic product sales in the rural market also contributed to lower gross margin.





Selling, General and Administrative Expenses





Selling, general and administrative expenses increased from $10,742,712 in the first quarter of 2010 to $11,239,247 in the same period of 2011, representing a 5% increase. The details of our sales and marketing expenses were as follows:




Three Months Ended

March 31,


Increase/


Increase/2011


2010


(Decrease)


(Decrease)Payroll

$
3,255,781


$
2,425,895


$
829,886



34%Staff welfare and insurance


1,123,107



416,255



706,852



170%Promotional materials and fees


1,549,052



2,431,711



(882,659)



(36)%Trips and traveling


984,402



947,017



37,385



4%Shipping


915,329



973,629



(58,300)



(6)%Stock based compensation


812,267



695,437



116,830



16%Professional fees


650,772



779,129



(128,357)



(17)%Miscellaneous


1,948,537



2,073,639



(125,102)



(6)%TOTAL

$
11,239,247


$
10,742,712


$
496,535



5%





26





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





●
the increase of payroll expenses was primarily due to the increase of the average salaries and bonuses for our staff as a result of the increased market need for sales people and China’s increased labor costs;





●
the increase of staff welfare and insurance expenses was primarily due to the increase of our staff welfare and insurance coverage and level as required by Chinese labor law;





●
stock compensation expense increased due to our amortization cost of additional restricted common stock issued to the executives and the senior management in 2010; and





●
the increase was partially offset by a decrease of promotional materials and fees by $882,659, or 36% in the first 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 our generic OTC drugs.





Advertising Costs





Advertising costs decreased by $2,927,322, from $6,748,470 in the first quarter of 2010 to $3,821,148 in the same period of 2011. Advertising costs as a percentage of revenue decreased from 13% in the first quarter of 2010 to 7% 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 mega brand for AOBO so that we can leverage on the establishment of all our individual brands to increase the brand awareness and market shares.





Research and Development Costs





Research and development costs maintained the same level in the first quarter of 2011 as the same period of 2010. Expressed as a percentage of revenue, research and development costs was 5% for the first quarter of both 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 $173,753, or 11%, in the first 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.





Equity in (Losses) Earnings from Unconsolidated Entities





Equity in (loss) earnings from unconsolidated entities decreased from a gain of $117,473 in the first quarter of 2010 to a loss of $409,886 in the same period of 2011. For additional information, see “Item 1. Financial Statements — Note 10. Investments in and advances to unconsolidated entities.”





Interest Expense, Net





Net interest expense was $1,513,585 for the first quarter of 2011 compared to net interest expense of $1,565,785 for the same period of 2010.





Income Tax





The Company’s effective tax rate for the first quarter of 2011 was 77%, which is an increase of 40% from the same period of 2010. The increase in the effective tax rate is mainly due to the change of our applicable income tax rate of our major PRC subsidiaries from 15% in the first quarter of 2010 to 25% in the same period of 2011. For additional information, see “Item 1. Financial Statements — Note 21. Taxes”.





27




FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES





Cash





Our cash position at March 31, 2011 was $111,432,776, representing an increase of $16,864,256, or 18%, compared with our cash position of $94,568,520 at December 31, 2010. The increase was mainly attributable to the increase of operating activities of $21,603,383 and partially offset by the investing and financing activities of $5,803,394 and $19,735.





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 macro economic 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 increased by $723,142 to $162,898,333 at March 31, 2011, as compared to $162,175,191 at December 31, 2010, primarily due to an increase in cash and cash equivalents by $16,864,256, an increase in net inventories by $12,472,418, and a decrease in current liabilities by $2,114,060.





Cash Flow





Operating Activities





Cash flows from operations during the first quarter of 2011 amounted to $21,603,383, representing an increase of $15,840,490 compared with cash flows from operations of $5,762,893 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 $16,275,416, an increase by $17,653,675 from a net cash outflow of $1,378,259 during the same period of 2010. As reflected in our cash flows, the changes included:





●
cash inflow from accounts and notes receivable amounted to $33,782,909 primarily affected by the timing of collection of our sales revenue during the second half year of 2010;





●
cash outflow from advances to suppliers and prepaid expenses amounted to $2,485,377 primarily attributed to the advanced payment in purchasing certain raw materials. These advanced payments were for a potential increase of raw materials’ future purchase prices and some of them were settled with inventories by our suppliers during the first quarter of 2011;





●
cash outflows from inventories amounted to $12,471,128 mainly due to the increased purchases of raw materials for planned inventory buildup; and





●
cash outflows from other payables and accrued expenses amounted to $4,375,610 primarily attributed to the timing of payments to the promotion fee accrued in 2010.





Investing Activities





Our net cash used in investing activities amounted to $5,803,394 during the first quarter of 2011, compared to net cash used in investing activities of $1,122,047 for the same period of 2010. The changes in net cash used in investing activities were primarily attributable to the purchases of construction in progress of $5,630,967 during the first quarter of 2011 for the expansion and upgrade of our manufacturing facilities to complement capacity improvement and efficiency enhancement.





Financing Activities





Our net cash used in financing activities was $19,735 in the first quarter of 2011,compared to cash outflow of $21,490 in the same period of 2010.





Off -balance Sheet Arrangements





We do not have any off -balance sheet arrangements as of March 31, 2011.





28




Contractual Obligations





During the three months to March 31, 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





None.





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.





29




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.





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 $3.1 million and $0.1 million for the first quarter of 2011 and 2010, respectively. The balance sheet amounts with the exception of equity at March 31, 2011 were translated at 6.5701 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 first quarter of 2011 and 2010 were 6.5910 RMB and 6.8367 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 auditing standards and applicable U.S. rules.  The Company’s internal audit group, 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 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.





Changes in Internal Control over Financial Reporting




There was no change in our internal control over financial reporting that occurred during the first quarter of 2011 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





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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





None.





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.





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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: May 9, 2011








/s/ Yanchun Li


YANCHUN LI


CHIEF FINANCIAL OFFICER


DATED: May 9, 2011





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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.


























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