AOBI American Oriental Bioengineering Inc (CE)

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

NOTE 1 – DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

American Oriental Bioengineering, Inc. (“AOB” or “the Company”) is a fully integrated pharmaceutical company dedicated to improving health through the development, manufacture, commercialization and distribution of a broad range of pharmaceutical and healthcare products in the People’s Republic of China (the “PRC”).

Basis of presentation

The accompanying unaudited interim condensed consolidated financial statements of the Company and its subsidiaries as of and for the three months ended March 31, 2013 and 2012 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the ”SEC”) that permit reduced disclosure for interim periods and include, in the opinion of management, all adjustments (consisting of normal recurring adjustments and reclassifications) necessary to present fairly the financial position, results of operations and cash flows as of March 31, 2013 and for all periods presented. Information as of December 31, 2012 has been derived from the audited consolidated financial statements of the Company for the year ended December 31, 2012. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the SEC on June 11, 2013. The results of operations for the three months ended March 31, 2013 are not necessarily indicative of the operating results to be expected for the full year ending December 31, 2013.

Basis of Consolidation

The unaudited consolidated financial statements include the financial statements of American Oriental Bioengineering, Inc. and its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated in 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.

Going Concern

The accompanying consolidated financial statements are prepared under a going concern basis in accordance with US generally accepted accounting principles (“GAAP”) which contemplates the realization of assets and discharge of liabilities and commitments in the normal course of business. For the three months ended March 31, 2013, the Company recorded a loss from operations of $19,017,888 and utilized cash in operations of $1,853,209. As of March 31, 2013, the Company had a working capital deficit of $28,641,009. In addition, the Company was in default of $49,161,000 of its convertible notes due July 15, 2015 (see Note 13). On April 8, 2013, four of the holders of the Notes filed this action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion seeking entry of a default. The Company filed its answer on June 5, 2013 (see Note 14). The Company presently does not have the ability to pay these notes. The Company’s ability to continue as a going concern is dependent upon its ability to return to profitability or to develop additional sources of financing or capital. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. As a result, the Company’s independent registered public accounting firm, in their report on the Company’s 2012 consolidated financial statements, raised substantial doubt about the Company’s ability to continue as a going concern. The Company’s financial statements do not include any adjustments that might result from the outcome of these uncertainties.

Historically, the Company’s main source of cash was through the sales of its products, proceeds from the issuance of common stock, and debt financing.  However, due to the decrease in sales, the Company’s ability to meet contractual obligations and payables depends on its ability to implement cost reductions effectively and obtain additional financing. The Company believes that the ongoing economic challenges and uncertainties experienced in 2012 and the first quarter of 2013 will continue to negatively impact its business in the remainder 2013.  Thus, the Company expects that for 2013 it will continue to generate losses from operations, and its operating cash flows will not be sufficient to cover operating expense; therefore, the Company expects to continue to incur net losses.

To meet its capital needs, the Company is considering multiple alternatives, including, but not limited to, additional debt financing and credit lines, delaying capital spending for future periods, and/or operating cost reductions. The Company believes it can utilize its currently unencumbered buildings and land use rights located in Beijing, PRC with an aggregate net book value of approximately $105,000,000 at March 31, 2013 to secure financing. No assurance can be given that the financing will be available or, if available, that it will be on terms that are satisfactory to the Company. Even if the Company is able to obtain additional financing, it may contain undue restrictions on its operations, in the case of debt financing or cause substantial dilution to shareholders, in the case of equity financing

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America 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 of property, plant, and equipment and intangible assets, allowance for accounts receivable, realizable values for inventories and capitalized agriculturual costs, valuation allowance of deferred tax assets, and valuation of share-based compensation expenses. Changes in facts and circumstances may result in revised estimates. Actual results could differ from these estimates

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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:

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.

Earnings per share

Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the year. The diluted earnings per share calculation gives effect to all potentially dilutive common shares outstanding during the year. As of March 31, 2013, common stock equivalents were composed of options convertible into 883,639 shares of the Company’s common stock and notes convertible into 6,084,282 shares of the Company’s common stock. For the three months ended March 31, 2013 and 2012, common stock equivalents have been excluded from the calculation of earnings per share as their effect is anti-dilutive.

Impairment

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. 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.

In evaluating capitalized agriculture costs, the Company uses its best estimate of the future cash flows expected to result from future market values, yields and costs to harvest. To the extent that estimated future cash inflows attributable to the asset, less estimated future, cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the excess of the carrying value over the estimated fair values of the capitalized agricultural costs.

The Company’s annual impairment testing is performed in the fourth quarter of each year. 

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

Newly Adopted Accounting Pronouncements

In July 2012, FASB issued ASU No. 2012-02, “Intangibles – Goodwill and Other”. This update presents an entity with the option to first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, “Intangibles – Goodwill and Other – General Intangibles Other than Goodwill”. The more-likely-than-not threshold is defined as having a likelihood of more than fifty percent. ASU No. 2012-02 will be effective for annual and impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company’s adoption of this update did not have a material effect on its consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The new guidance requires entities to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income unless the amounts are not reclassified in their entirety to net income. For amounts that are not required to be reclassified in their entirety to net income in the same reporting period, entities are required to cross-reference other disclosures that provide additional detail about those amounts. The new guidance is effective prospectively for all interim and annual periods beginning after December 15, 2012, with early adoption permitted. The Company’s adoption of this update did not have a material effect on its consolidated financial statements.

NOTE 3 – CONCENTRATION OF RISKS

Concentration of credit risks

Assets that potentially subject the Company to significant concentration of credit risk primarily consist of cash and cash equivalents, accounts receivable and prepaid forward repurchase contract. As of March 31, 2013, substantially all of the Company’s cash and cash equivalents were deposited in financial institutions located in PRC, which management believes are of high credit quality. Accounts receivable are typically unsecured and mainly derived from revenue earned from customers in the PRC, which are exposed to credit risk. The risk is mitigated by credit evaluations the Company performs on its customers and its ongoing monitoring process of outstanding balances. The Company maintains reserves for estimated credit losses, which have generally been within its expectations.

Current vulnerability due to certain other concentrations

The Company’s operations may be adversely affected by significant political, economic and social uncertainties in the PRC. Although the PRC government has been pursuing economic reform policies for more than 30 years, no assurance can be given that the PRC government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption or unforeseen circumstances affecting the PRC’s political, economic and social conditions. There is also no guarantee that the PRC government’s pursuit of economic reforms will be consistent or effective.

Currency convertibility risk

The Company transacts the majority of its business in the Renminbi (“RMB”), which is not freely convertible into foreign currencies. On January 1, 1994, the PRC government abolished the dual rate system and introduced a single rate of exchange as quoted daily by the People’s Bank of China (the “PBOC”). However, the unification of the exchange rates does not imply that the RMB may be readily convertible into United States dollars or other foreign currencies. All foreign exchange transactions continue to take place either through the PBOC or other banks authorized to buy and sell foreign currencies at the exchange rates quoted by the PBOC. Approval of foreign currency payments by the PBOC or other institutions requires submitting a payment application form together with suppliers’ invoices, shipping documents and signed contracts. Additionally, the value of the RMB is subject to changes in central government policies and international economic and political developments affecting supply and demand in the PRC foreign exchange trading system market.

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

Provision for doubtful accounts activity is as follows:

Accounts receivable arise from sales to our customers and are generally due on terms ranging from 30 to 180 days beginning after the invoice date. The Company assessed distributors’ credit history, operation performance, financial position, reputation among peers, etc. to assign credit terms. The Company’s management reviews credit terms and conditions of the account receivable balance for each distributor on a quarterly basis.

During the three months ended March 31, 2013 and 2012, the Company reviewed its accounts receivable based on the changing climate in the pharmaceutical business in China and estimated that increases to its allowance was required. The Company estimates that the remaining net receivables will be collected.

Capitalized agricultural costs are summarized as follows:

The Company has reflected capitalized agriculture costs for Millettia and Xanthoceras Sorbifolia Bge (“XSB”) as a long term asset as it does not expect to utilize these assets currently. In 2012, the Company recorded an impairment of approximately $8.5 million in the fourth quarter of 2012 representing the excess of the carrying value over the estimated fair values of the capitalized agricultural costs. Subsequent to December 31, 2012, pre-harvest agriculture costs, including cultivation, labor, land leasing costs, and other crop and land maintenance activities, will be capitalized if it is probable that future economic benefits from the use of the assets will be increased. These pre-harvest agriculture costs usually require substantial investment in the early stages, gradually decreasing to maintenance costs during the growing stage. During the three months ended March 31, 2013, pre-harvest agricultural costs incurred during the period of $2,361,383 were expensed. During the three months ended March 31, 2012, pre-harvest agricultural costs incurred during the period of $3,395,407 were capitalized.

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

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.

Depreciation expense for the three months ended March 31, 2013 and 2012 was $1,611,228 and $1,684,604, respectively. As of March 31, 2013 and December 31, 2012, the net book value of property, plant and equipment pledged as collateral for bank loans was $6,124,558 and $6,099,734, respectively (see Note 11). As of March 31, 2013, the Company had entered into capital commitments for $16,944,950 for manufacturing facilities under construction in the PRC, and all due within one year (see Note 14). In the fourth quarter of 2012 an impairment reserve of $12,584,875 was recorded for property, plant, and equipment.

Amortization expense for the three months ended March 31, 2013 and 2012 was $843,122 and $891,151, respectively.  As of March 31, 2013 and December 31, 2012 , the net book value of land use rights pledged as collateral was $20,777,972 and $20,664,778, respectively (see Note 11). In the fourth quarter of 2012 an impairment reserve of $10,255,550 was recorded against land use rights.

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

Amortization expense for the three months ended March 31, 2013 and 2012 was $580,781 and $425,804, respectively.

The Company conducts impairment tests on a regular basis to determine if the carrying values of acquired intangible assets are in excess of the fair value, and that such assets are active, being used in production of products, or are intended to be utilized in future production. No impairment charges were recognized in the three months ended March 31, 2013 or 2012. In the fourth quarter of 2012 an impairment reserve of $6,928,064 was recorded against acquired intangible assets.

NOTE 10 – INVESTMENTS IN AND ADVANCES TO EQUITY METHOD INVESTMENTS

At March 31, 2013, the Company owned a 33.7% equity interest in AXN, a 49% equity interest in Yushuntang, and a 40% equity interest in Jinji. For the three months ended March 31, 2013, the changes in investments in and advances to equity method investments are summarized as follows:

The Company had previously consolidated the financial statements of Yushuntang as a 55% majority owned subsidiary. Effective December 31, 2012, the Company’s ownership decreased below 50% to 49% and this entity no longer qualified for consolidation and is treated as a long term investment using the equity method. For the three months ended March 31, 2012, Yushuntang reported revenues of $4,239,862, gross profit of $324,863, loss from operations of $67,177, and net loss of $66,298, which are included in the accompanying consolidated statement of operations.

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

NOTE 11 – DEBT

At March 31, 2013 and December 31, 2012, short-term notes payable due to various banks in the PRC were $6,066,997 and $11,054,449, respectively and due at various dates from April 2013 to September 2013. The s hort-term notes payable are lines of credit extended by the banks, which in turn issue the Company a bank acceptance note that can be endorsed and assigned to vendors as payments for purchases. The short-term notes payable are generally payable within three to six months, and guaranteed by the bank. The banks do not charge interest on these notes, but usually charge a transaction fee of 0.05% of the total note value. In addition, the banks usually require the Company to deposit a certain amount of cash at the bank as a guarantee deposit which is classified on the balance sheet as restricted cash. At March 31, 2013 and December 31, 2012, restricted cash as a guarantee for the notes payable amounted to $3,150,665 and 6,514,224, respectively.

At March 31, 2013 and December 31, 2012, short-term loans obtained from local banks were $6,845,390 and $6,807,999, respectively. The short-term loans payable are due on various dates through November 15, 2013, with interest ranging from 6.00% to 6.56% per annum, and secured by property, plant and equipment and land use rights owned by the Company. At March 31, 2013 and December 31, 2012, the short-term loans are secured by property, plant and equipment owned by the Company of $6,124,558 and $6,099,734, respectively, and land use rights owned by the Company of $20,777,972 and $20,664,778, respectively.

At March 31, 2013 and December 31, 2012, the Company has an outstanding long-term bank loan of $602,350 and $619,401, respectively. The long-term bank loan bears interest at 2.50% per annum, is due December 31, 2021, and is secured by property, plant, and equipment with a net book value of $1,226,600 at March 31, 2013.

NOTE 12 – CONVERTIBLE NOTES

On July 15, 2008 the Company issued $115,000,000, 5% unsecured senior convertible notes (the “Notes”), due July 15, 2015, for net proceeds of $110,358,550. At March 31, 2013, the Notes are in default, which was caused by the delisting of the Company’s common stock by the New York Stock Exchange (“NYSE”) as described in Form 25NSE filed on April 16, 2012 by NYSE; and by the non-payment of the semiannual interest payment due on July 15, 2012 and January 15, 2013.

On February 19, 2013, the Company received a notice of acceleration under the terms of the Notes. The notice was sent by certain holders of the Senior Notes that together hold more than 25% of the aggregate principal amount of the Notes. As of March 31, 2013, the aggregate principal amount of the Notes, and unpaid, but accrued interest was $52,330,329. The notice of acceleration resulted in the principal amount of the Notes plus accrued and all unpaid interest and accrued and unpaid additional interest on the Notes through February 19, 2013, to become immediately due and payable.

On April 8, 2013, four of the holders of the Notes filed this action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion seeking entry of a default. The Company filed its answer on June 5, 2013.

The Notes are convertible, at the option of the holder, at an initial conversion price of $9.29 per share, adjusted to $8.08 on January 15, 2009. The conversion rate is subject to certain adjustments. 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.

Through December 31, 2012, the Company had repurchased a total of $65,839,000 in principal amount of the Notes for cash consideration of $21,638,892, leaving an aggregate of $49,161,000 in principal amount outstanding. During the three months ended March 31, 2013 and 2012, there were no repurchases of Notes.

The effective interest rate on the convertible notes for the three months ended March 31, 2013 and 2012 was 5.94% and interest cost recognized for the three months ended March 31, 2013 and 2012 was $614,513 and $1,356,250, respectively.

Note issuance costs incurred by the Company were deferred and are recognized using the effective interest rate method over the term of the Notes. As of March 31, 2013 and December 31, 2012, the unamortized portion of the deferred financing fees was $115,045 and $212,724, respectively.

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

NOTE 13 – SHAREHOLDERS’ EQUITY

Common Stock Awards

During the three months ended March 31, 2013 and 2012, the Company recorded selling, general and administrative expenses of $352,097 and $351,697, respectively, of stock based compensation cost based on the vesting of the common stock awards granted to employees in prior periods. The total fair value of the stock awards granted to employees at the respective grant dates was $5,665,538, of which the unrecognized portion of $2,165,306 at March 31, 2013 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 2.4 years. 

During the three months ended March 31, 2013 and 2012, the Company recorded research and development costs of nil and $25,000, respectively, of stock based compensation cost based on the vesting of the common stock awards granted to consultants in prior periods. At March 31, 2013, these common stock awards were fully amortized. 

During the three months ended March 31, 2013 and 2012, the Company recorded selling, general and administrative expenses of $37,500 and $53,250, respectively of earned director share-based compensation. Independent directors earned common stock awards on a monthly basis, with grants generally made in the following year for shares earned. Shares earned but not granted are reflected in “Common Stock to be issued” on the accompanying condensed consolidated financial statements. During the three months ended March 31, 2013 and 2012, the Company did not issue any shares of common stock related to the director awards.

Stock options

The Company calculates the estimated fair value of granted options on the grant date, using the Black-Scholes-Merton Option Pricing Model. During the three months ended March 31, 2013 and 2012, the Company recorded selling, general and administrative expenses of $171,392 and $294,190, respectively, of stock based compensation based on the vesting of options granted to employees in prior periods. The total fair value of the options granted to employees at the respective grant dates was $9,194,987, of which the unrecognized portion of $326,474 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 0.3 years as of March 31, 2013.

The following table summarizes the stock option activities of the Company:

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

The following table summarizes information about stock options outstanding as of March 31, 2013:

Options granted have no intrinsic value at grant date and at the date of these financial statements as the exercise price of all vested and unvested options was higher than the market price of the Company’s Common Stock.

The weighted average value per share of the 883,639 options issued under the Company’s 2006 Plan is $10.41 per share.

Treasury Stock

During the three months ended March 31, 2012, the Company repurchased 1,003,336 shares of its common stock at a total cost of $1,270,603 that were retired in June 2012. During 2011, the Company repurchased 224,582 shares of its common stock at a total cost of $799,999 that were retired in May 2013. 

NOTE 14 – COMMITMENTS AND CONTINGENCIES

Commitments

As of March 31, 2013, the Company had entered into capital commitments for the manufacturing facilities under construction in the People’s Republic of China. The capital commitments were $16,944,950, all of which were within one year. In addition, the Company had R&D commitments of $3,615,639 within one year and $2,750,891 after one year but within three years, and purchase commitments for Millettia of $2,362,962 within one year and $4,472,297 after one year but within three years.

The Company also has an unconditional purchase commitment in connection with the Millettia long-term supply contracts, which is not expected to be harvested until after 2018 (note 5). The purchase amount will be based on fair value discounted at a pre-determined rate pursuant to the long-term supply contracts. At March 31, 2013, the Company had a commitment to pay maintenance fees of approximately $111,000 (RMB 700,000) per year from 2013 to 2019 related to the XSB long-term supply contract.

Legal proceedings

As of March 31, 2013 and December 31, 2012, the Company was subject to various legal proceedings and claims. Management continues to evaluate the lawsuits discussed below and based on the stage of these proceedings, management is unable to reasonably estimate the likelihood of any loss or the amount or range of any potential loss that could result from the litigation.  Therefore, at March 31, 2013 and December 31, 2012, no accrual has been established for any potential loss in connection with these lawsuits. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. 

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

On June 22, 2012, a putative class action complaint was filed by Kevin McGee against American Oriental Bioengineering Inc, Eileen Brody, Binsheng Li, Yangchun Li, Tony Liu, Cosimo Patti, Xianmin Wang, and Lawrence Wizel alleging violations of Section 10b of the Securities Exchange Act of 1934 and liability pursuant to Section 20(a) thereunder. The complaint, as subsequently amended (see below) centers on the accounting treatment of the sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited and the Company’s Restatement filed on November 14, 2011. Several motions were filed for appointment as lead plaintiff, and on October 16, 2012, the Court appointed lead plaintiff, consolidated the cases, and ordered that a consolidated complaint be filed, which occurred on November 19, 2012. The served defendants (AOB, Brody, Wizel and Patti) moved to dismiss the consolidated complaint, and on March 25, 2013 those motions were granted with leave to amend. On April 15, 2013, Plaintiffs filed a Second Amended Complaint, which the served Defendants moved to dismiss on May 15, 2013. In the interim, the Court granted Plaintiffs’ motion for leave to serve most of the remaining Defendants by alternative means, and on May 15, 2013, the parties entered into a stipulation consenting to the filing of a Third Amended Complaint (“TAC,” setting forth no new paragraphs), deeming the TAC served on all defendants, deeming the motion to dismiss the Second Amended Complaint interposed against the TAC, and reserving all rights of the un-served Defendants.

On October 1, 2012, Peter Barbato filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Eileen Brody, Jun Min, and Baiqing Zhang (collectively, “Defendants”), and the Company as a nominal Defendant.  The Complaint asserts causes of action for Breach of Fiduciary Duty and Unjust Enrichment.  These claims similarly arise out of alleged accounting errors that were made the Company’s financial statements for in the periods between the third quarters ending September 30, 2009 and September 30, 2011, which were filed with the SEC.  The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited, and were disclosed in the Company’s Restatement filed on November 14, 2011.  The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young Hua Ming, discovered throughout the course of the Company’s audit for the year ending 2011.  The Parties have agreed that Defendants need not respond to the complaint until motions to dismiss the class action Complaint filed against the Company in the Central District of California are resolved. 

On December 6, 2012, David Bravetti filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Jun Min, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Baiqing Zhang, Eileen Brody (collectively, “Defendants”). Because the complaint sets forth a shareholder derivative claim, the Company is named as a nominal Defendant, although no relief is sought for the Company and any relief obtained from the Defendants would inure to the benefit of the Company.  The Complaint asserts causes of action for breach of fiduciary duty, waste of corporate assets, and unjust enrichment.  Bravetti’s claims arose out of alleged accounting errors that were made in the Company’s financial statements for the periods between the third quarters ending September 30, 2009 and September 30, 2011, which financial statements were included in filings made with the SEC.  The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited and were disclosed in the Company’s Restatement filed on November 14, 2011.  The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young Hua Ming, discovered throughout the course of the Company’s audit for the year ending 2011.  Although the Complaint claims that jurisdiction is proper in federal court in New Jersey because of diversity of citizenship, according to the Complaint, Bravetti is a New Jersey citizen, as is one of the Defendants. The Company did not file a responsive pleading to Bravetti’s Complaint, and subsequent to seeking and obtaining a default against the Company, Bravetti agreed to dismiss his claim and file elsewhere. Subsequently, however, Bravetti “corrected” his complaint now to claim to be a Florida citizen. On March 26, 2013, Bravetti undertook to provide Defendants proof of his citizenship. That proof has been provided, and Defendants have not come to a conclusion whether this was sufficient. 

On April 8, 2013, four of the holders of the Company’s 5% senior convertible notes issued July 15, 2008 (the “Notes”) filed this action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion seeking entry of a default. The Company filed its answer on June 5, 2013.

There are no other known legal proceedings against the Company.

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

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

As of March 31, 2013 and December 31, 2012, total assets of the manufacturing and distribution segments are as follows:

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

The reconciliation of tax computed by applying the statutory income tax rate applicable to the PRC operations to income tax expenses was as follows:

The tax effects of temporary differences that give rise to the Company’s net deferred tax liabilities as of March 31, 2013 and December 31, 2012 were as follows:

The Company has not recorded a provision for U.S. federal income tax for the three months ended March 31, 2013 and 2012 due to the cumulative tax net operating losses in the United States. As of March 31, 2013, the Company had net operating tax losses carried forward of approximately $22,000,000, $71,000,000 and $8,000,000 in the US, PRC, and Hong Kong, respectively. Those losses carried forward in the US expire between years 2025 and 2030, and in the PRC expire between years 2015 and 2018. Losses incurred in Hong Kong are carried forward indefinitely. In the PRC and Hong Kong the subsidiaries with loss carryforwards are taxed on a separate return basis and the Company has determined all amounts should have full valuation allowances. At March 31, 2013, the tax benefit of the loss carryforwards had not been recorded and therefore is not presented in the table above.

The Company’s PRC subsidiaries that are deemed “high technology” enterprises are subject to preferred tax rates (tax holiday). The table below shows the effect of using the higher rates and earnings per share.

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2013 AND 2012

Accrued Taxes

Effective January 1, 2007, the Company adopted guidance for accounting for uncertainty in income taxes 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, 2013, the Company has recorded an accrued tax of $11,015,810 mainly related to tax positions associated with deemed interest on non-trade intercompany transactions. It is possible that the amount accrued will change in the next 12 months; however, an estimate of the range of the possible change cannot be made at this time. The accrued taxes, if ultimately recognized will impact the effective tax rate.

The Company has various open tax years between 2007 and 2012 in its significant operating jurisdictions.

At March 31, 2013, $300,000 is included in taxes payable for the US for what the Company believes to be the potential liabilities for the untimely filing of IRS Forms 5471 and IRS Report of Foreign Bank and Financial Accounts. However, the potential liabilities could be greater if the IRS were to so determine the Company’s failure to file was willful. The Company believes the likelihood of the IRS considering our failure to file as being willful is remote.

All of the Company’s operations are conducted in the PRC. At March 31, 2013 , the Company’s unremitted foreign earnings of its PRC subsidiaries totaled approximately $128 million and the Company held approximately $9.6 million of cash and cash equivalents in the PRC.  These unremitted earnings are planned to be reinvested indefinitely into the operations of the Company in the PRC.  While repatriation of some cash held in the PRC may be restricted by local PRC laws, most of the Company's foreign cash balances could be repatriated to the United States but, under current U.S. income tax laws, could be subject to U.S. federal income taxes less applicable foreign tax credits.  Determination of the amount of unrecognized deferred U.S. income tax liability on the unremitted earnings is not practicable because of the complexities associated with this hypothetical calculation, and as the Company does not plan to repatriate any cash in the PRC to the United States, no deferred tax liability has not been accrued for cash to be repatriated.