American Oriental Bioengineering, Inc.

American Oriental Bioengineering

American Oriental Bioengineering, Inc. (AOB) engages in the development, production, and sale of bioengineered products and traditional Chinese medicinal products, primarily in China. The company has three product segments; Health Food, Chinese Medical, and Soybean Protein Peptide products. The company is organized into three divisions; Harbin Bioengineering, HSPL, and AOBO. AOB offers its products through distributors, sales outlets, and hospital and clinics. The company is headquartered in Harbin, China and its stock is traded on the American Stock Exchange.

AOB has acquired two companies, both as subsidiaries, since its conception in 1999. The first was Harbin Three Happiness Bioengineering Company in 2001. During the 4th quarter of 2004, AOB formed a second subsidiary by acquiring HSPL, a traditional Chinese pharmaceutical company to obtain a distribution network in mainland China. In their most recent filing, Form 10QSB, dated November 14, 2005, covering their 3rd quarter, ending September 30, 2005, for the first time in their history, management has deemed it necessary to provide provisions for impairments to inventory and accounts receivable mainly due to their most recent acquisition.

Under the section titled "Critical Accounting Policies and Estimates", AOB states that management makes certain estimates and assumptions for the required financial statements and these estimates and assertions can differ from the actual results. In previous filings, management has made a point of stating there were no reserves for accounts receivable or inventory. In their latest filing, they have set aside reserve amounts for these items, $307,106 against accounts receivables and a total of $606,927 against inventories.

Management states the provisions for inventories are based on the age of the inventories and their possible obsolescence. Management states the provision against accounts receivables was due to an identifiable segment of the receivables showing significant aging. When examined, one primary customer was identified as being responsible for the majority of the outstanding monies.

Management concluded that the amount owed to AOB is at significant risk due to the financial condition of their customer.

This company is classified as a small cap and has no analyst coverage. When earnings were announced, the price of the stock dropped approximately 20%, even though they reported over a 100% increase in net income, both on a quarter-to-quarter and year-to-year basis. Net earnings per share increased 14%, due to the increase in outstanding shares. These shares, raising $6 million, were issued to finance the acquisition of the HSPL division last year during the 4th quarter. This paper will address the impact of the impairments due to their latest acquisition as they flow through the Balance Sheet, Income Statement, and Statement of Cash Flows.

The anticipated ledger entries for these impairments might appear as follows:

Provision for Obsolete Inventory $ 606,927

Inventory $606,927

Provision for Uncollectible Accounts Receivable $307,106

Accounts Receivable $307,106

Examining the Asset portion of their reported balance sheet, see Attachment 1, both these impairments are shown as a reduction, as anticipated by the above example journal entries. However, the Inventory and Accounts Receivable accounts are shown as a net value, inclusive of the provisions. There are no corresponding asset listings for a contra-asset account. Although the contra-asset account may be hidden, it might also be reasonable to assume that AOB wrote off these impairments. If the inventory was written off, a second set of journal entries must have been performed to balance. The additional ledger entries for the inventory provision might be:

Cost of Goods Sold $ 606,927

Provision for Obsolete Inventory $606,927

Using the above entry, regardless of the method for calculating the value of the consumed inventory, the entry for balancing the provision becomes an adder after the calculations are performed. Using a very a simplified example, AOB would have started with a known inventory value, calculated the

ending inventory value, including the aged/obsolete goods, and then calculated a cost of goods sold taking into consideration all transactions that occurred during the quarter. AOB would then scrap the obsolete portion of the inventory and the value of that obsolete inventory would be added to the previous total for the quarterly cost of goods sold.

A second set of journal entries is also required for the provision against Accounts Receivables. Again, there is not a contra-asset listing for the provision in the balance sheet as the value is listed as a net value after the provision. The following is a possible set of entries might be used to account for the impairment and resulting provision:

Bad Debt Expense $ 307,106

Provision for Uncollectible Accounts Receivable $ 307,106

Examining the Income Statement for these provisions and related the expenses, neither can be found. Each method of accounting for the inventory provision and uncollectible accounts receivable, as outlined above, yield the same overall affect; retained earnings are reduced.

The assumed entries for the provision for obsolete inventory correctly match as inventory is reduced, cost of goods sold is increased, and have the net affect of reducing net income.

Provision for Obsolete Inventory $ 606,927

Inventory $606,927

Cost of Goods Sold $ 606,927

Provision for Obsolete Inventory $606,927

The above outlined method of accounting for the provision for uncollectible accounts receivable is a reasonable guess as to what they used, however my named account, Bad Debt Expense, is not listed on the income statement. I suspect this amount, whatever the name of their expense account is probably included in the total listed under either "Sales and Marketing" or "General and Administrative" expenses.

Provision