The accompanying notes are an integral part of these combined financial statements.
CHINA PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011 (UNAUDITED) AND DECEMBER 31, 2010
Note 1 - ORGANIZATION
China Pharmaceuticals, Inc. (“the Company”), formerly named Allstar Restaurants, was incorporated in the United States in Nevada on December 22, 2004. China Qinba Pharmaceuticals, Inc. (“China Qinba”), a wholly-owned subsidiary of the Company, was incorporated in the United States in Delaware on May 29, 2008. China Qinba formed and owned 100% of Xi’an Pharmaceuticals Development Co., Ltd. (“Xi’an Pharmaceuticals” or the “WOFE”) in the People’s Republic of China (“PRC”) on August 18, 2008.
On October 28, 2008, WOFE entered into a series of agreements including a Management Entrustment Agreement, a Shareholders’ Voting Proxy Agreement, an Exclusive Option Agreement and a Share Pledge Agreement (the “Agreements”) with Xi’an Qinba Pharmaceutical Co., Ltd ("Xi’an Qinba") and its shareholders (the “Transaction”). Xi’an Qinba is a corporation formed under the laws of the PRC. According to these Agreements, WOFE acquired management control of Xi’an Qinba whereby WOFE is entitled to all of the net profits of Xi’an Qinba as a management fee, and is obligated to fund Xi’an Qinba’s operations and pay all of the debts. In exchange for entering into the Agreements, on October 28, 2008, WOFE issued 25,000,000 shares of its common stock to Xi’an Qinba owners, representing approximately 80% of the Company’s common stock outstanding after the Transaction. Consequently, the owners of Xi’an Qinba own a majority of WOFE's common stock immediately following the Transaction, therefore, the Transaction is being accounted for as a "reverse acquisition", and Xi’an Qinba is deemed to be the accounting acquirer in the reverse acquisition between Xi’an Qinba and WOFE.
These contractual arrangements completed on October 28, 2008 provide that WOFE has controlling interest in Xi’an Qinba as defined by FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities” (“FIN 46R”), included in the FASB Accounting Standards Codification (“ASC”) 810, Consolidation, an Interpretation of Accounting Research Bulletin No. 51, included in the Codification as ASC 810, Consolidation, which requires WOFE to consolidate the financial statements of Xi’an Qinba and ultimately consolidate with its parent company, China Qinba (see Note 2, “Principles of Consolidation”).
On February 12, 2010, the Company completed its merger with China Qinba in accordance with a Merger Agreement (the “Merger Transaction”). Prior to the reverse merger, the Company was a non-operating public shell corporation. Pursuant to Securities and Exchange Commission rules, the merger or acquisition of a private operating company into a non-operating public shell corporation with nominal net assets is considered a capital transaction in substance, rather than a business combination. Accordingly, for accounting purposes, the transaction has been treated as a reverse acquisition and a recapitalization, and pro-forma information is not presented. Transaction costs incurred in the reverse acquisition have been charged to expense, The Company (the legal acquirer) is considered the accounting acquiree and China Qinba (the legal acquiree) is considered the accounting acquirer for accounting purposes. Pursuant to the Merger Agreement, the Company issued 33,600,000 shares (which were subsequently reduced to 9,333,333 shares by reverse split) of Common Stock to the shareholders China Qinba in exchange for 100% of the outstanding shares of China Qinba. Immediately after the Closing, the Company had a total of 10,680,559 shares (post-reverse split) of common stock outstanding, with all of the shareholders of China Qinba Pharmaceuticals (and their assignees) owning approximately 87.39 % of the Company’s outstanding common stock, and the balance held by those who held the Company’s common stock prior to the Closing. Subsequent to the Merger Transaction, the financial statements of the combined entity will in substance be those of China Qinba. The assets, liabilities and historical operations prior to the Merger Transaction will be those of China Qinba. Subsequent to the date of the Merger Transaction, China Qinba is deemed to be a continuation of the business of the Company. Therefore, post-merger financial statements will include the consolidated balance sheets of the Company and China Qinba, the historical operations of the Company and China Qinba from the closing date of the Merger Transaction forward.
Upon the closure of the Merger Transaction, the Company changed its name from Allstar Restaurants to China Pharmaceutical, Inc.
The Company, through its subsidiary and exclusive contractual arrangement with Xi’an Qinba Pharmaceutical Co., Ltd., is engaged in the business of manufacturing and marketing over-the-counter (“OTC”) and prescription pharmaceutical products which include capsules, granules and powder type medicines.
On June 8, 2010, the Company effected a 5 for 6 reverse split of issued and outstanding shares of common stock of the Company without changing the par value of the stock. The shares outstanding before reverse split were 39,650,000 shares; the shares outstanding after reverse split were 33,041,677. Shares after reverse split were retroactively restated from beginning of the period for all the periods presented.
On August 23, 2010, the Company sold 385,769 (post-reverse split) shares of common stock for approximately $1,600,000. On September 10, 2010 the Company effected a 1 for 3 reverse split of issued and outstanding shares of common stock of the Company without changing the par value of the stock. The shares outstanding after reverse split were 11,399,662. Shares after reverse split were retroactively restated from beginning of the period for all the periods presented.
The shares outstanding are presented as following:
| | | | | | 5 for 6 Reverse Split at | | | | | | 1 for 3 reverse split at | |
| | | | | | June 8, 2010 | | | | | | September 10, 2010 | |
| Prior to reverse merger | | | 4,850,014 | | | | 4,041,678 | | | | | | | 1,347,226 | |
| Issued in connection with Reverse merger February 12, 2010 | | | 33,600,000 | | | | 28,000,000 | | | | | | | 9,333,333 | |
| | | | 38,450,014 | | | | 32,041,678 | | | | | | | 10,680,559 | |
| Warrants exercised | | | 1,200,000 | | | | 1,000,000 | | | | | | | 333,333 | |
| Balance prior to 5 for 6 Reverse Split | | | 39,650,014 | | | | | | | | | | | | |
| Balance after 5 for 6 Reverse Split | | | | | | | 33,041,678 | | | | 33,041,678 | | | | | |
| Stock issued for services on August 23, 2010 | | | | | | | | | | | 1,157,307 | | | | 385,769 | |
| Balance prior to 1 for 3 reverse split | | | | | | | | | | | 34,198,985 | | | | | |
| Balance at March 31, 2011 and December 31, 2010 | | | | | | | | | | | | | | | 11,399,662 | |
The unaudited financial statements included herein have been prepared by the Company, pursuant to the rules and regulations of the SEC. The information furnished herein reflects all adjustments (consisting of normal recurring accruals and adjustments) that are, in the opinion of management, necessary to fairly present the operating results for the respective periods. Certain information and footnote disclosures normally present in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) were omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with the audited financial statements and footnotes included in the Company’s 2010 audited financial statements included in the Company’s Annual Report on Form 10-K. The results for the three months ended March 31, 2011 are not necessarily indicative of the results to be expected for the full year ending December 31, 2011.
Note 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying financial statements have been prepared in conformity with US GAAP. The Company's functional currency is the Chinese Yuan Renminbi; however the accompanying consolidated financial statements have been translated and presented in United States Dollars. The accompanying financial statements present the historical financial condition, results of operations and cash flows of the operating companies.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company, its subsidiary and variable interest entity (“VIE”) for which the Company is the primary beneficiary. All inter-company accounts and transactions have been eliminated in consolidation. The Company has adopted FIN 46R, ASC 810, Consolidation, which requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE’s residual returns.
In determining Xi’an Qinba Pharmaceutical is the VIE of Xi’an Pharmaceuticals Development Co., Ltd., the Company considered the following indicators, among others:
| · | Xi’an Pharmaceuticals has the full right to control and administrate the financial affairs and daily operation of Xi’an Qinba and has the right to manage and control all assets of Xi’an Qinba. The equity holders of Xi’an Qinba as a group have no right to make any decision about Xi’an Qinba’s activities without the consent of Xi’an Pharmaceuticals. |
| · | Xi’an Pharmaceuticals was assigned all voting rights of Xi’an Qinba and has the right to appoint all directors and senior management personnel of Xi’an Qinba. The equity holders of Xi’an Qinba possess no substantive voting rights. |
| · | Xi’an Pharmaceuticals will provide financial support if Xi’an Qinba requires additional funds to maintain its operations and to repay its debts. |
| · | Xi’an Pharmaceuticals should be paid a management fee equal to 25% of Xi’an Qinba’s sales amount. If there are no earnings before taxes and other cash expenses, then no fee shall be paid. If Xi’an Qinba sustains losses, they will be carried over to the next period and deducted from the next management fee. Xi’an Pharmaceuticals should assume all operation risks of Xi’an Qinba and bear all losses of Xi’an Qinba. Therefore, Xi’an Pharmaceuticals is the primary beneficiary of Xi’an Qinba. |
Xi’an Qinba is wholly owned by the majority shareholders of the Company. The capital provided to Xi’an Qinba by the Company was recorded as interest-free loan to Xi’an Qinba. There was no written note to this loan and the loan is not interest bearing and was eliminated during consolidation. Under various contractual agreements, the shareholders of Xi’an Qinba are required to transfer their ownership to the Company’s subsidiary in China when permitted by PRC laws and regulations or to designees of the Company at any time when the Company considers it is necessary to acquire Xi’an Qinba. In addition, the shareholders of Xi’an Qinba have pledged their shares in Xi’an Qinba as collateral to secure these contractual arrangements.
Reclassifications
Certain prior year amounts were reclassified to conform to the manner of presentation in the current period.
Foreign Currency Translation
The Company’s reporting currency is the U.S. dollar. The Company’s operation in China uses Chinese Yuan Renminbi (CNY) as its functional currency. The financial statements of the subsidiary are translated into U.S. Dollars (USD) in accordance with Statement of Financial Accounting Standards (SFAS) No. 52, “Foreign Currency Translation”, included in the Codification as ASC 830, Foreign Currency Matters. According to the Statement, all assets and liabilities were translated at the current exchange rate, stockholders’ equity are translated at the historical rates and income statement items are translated at the average exchange rate for the period. The resulting translation adjustments are reported under other comprehensive income in accordance with SFAS No. 130, “Reporting Comprehensive Income,” as a component of shareholders’ equity, included in the Codification as ASC 220, Comprehensive Income. Foreign exchange transaction gains and losses are reflected in the income statement. For the three months ended March 31, 2011 and 2010, the foreign currency translation adjustment to the Company’s comprehensive income (loss) was $221,199 and $(18,284) respectively.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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 financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Risks and Uncertainties
The Company is subject to substantial risks from, among other things, intense competition associated with the industry in general, other risks associated with financing, liquidity requirements, rapidly changing customer requirements, limited operating history, foreign currency exchange rates and the volatility of public markets.
Contingencies
Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought.
If the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed.
Loss contingencies considered to be remote by management are generally not disclosed unless they involve guarantee, in which case the guarantee would be disclosed.
There were no loss contingencies at March 31, 2011.
Cash and Cash Equivalents
Cash and cash equivalents include cash in hand and cash in time deposits, certificates of deposit and all highly liquid debt instruments with original maturities of three months or less.
Accounts Receivable
The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves.
The standard credit period of the Company’s most of client is three months. Within the medical industry in China, the collection period is generally longer than for other industries. Management evaluates the collectability of the receivables at least quarterly. The estimated average collection period was 90 days as of December 31, 2010. The allowance for doubtful account as of March 31, 2011 and December 31, 2010 was $844,948 and $1,115,319, respectively.
Inventories
Inventories are valued at the lower of cost (determined on a weighted average basis) or market. Costs that are capitalized to inventory primarily include direct manufacturing overhead such as labor costs and packing materials. As of March 31, 2011 and December 31, 2010, inventories consisted of the following:
| | | 2011 | | | 2010 | |
| | | | | | | |
| Raw materials | | $ | 300,223 | | | $ | 909,240 | |
| Finished goods | | | 45,786 | | | | 110,153 | |
| | | $ | 346,009 | | | $ | 1,019,393 | |
Property, Plant & Equipment
Property and equipment are stated at cost. Expenditures for maintenance and repairs are charged to earnings as incurred; additions, renewals and betterments are capitalized. When property and equipment are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts, and any gain or loss is included in operations. Depreciation of property and equipment is provided using the straight-line method for substantially all assets with estimated lives of:
| Building and improvements | 20-42 years |
| Machinery | 8-30 years |
| Fixture, furniture and equipment | 5-15 years |
| Motor vehicles | 5-7 years |
Property, Plant & Equipment consisted of the following as of March 31, 2011 and December 31, 2010:
| | | 2011 | | | 2010 | |
| Building and improvements | | $ | 8,866,674 | | | $ | 8,866,674 | |
| Machinery | | | 6,812,297 | | | | 6,812,716 | |
| Fixture, furniture and equipment | | | 831,119 | | | | 867,416 | |
| Motor vehicles | | | 111,834 | | | | 111,834 | |
| | | | 16,621,924 | | | | 16,658,640 | |
| Less: Accumulated depreciation | | | (2,708,770 | ) | | | (2,484,922 | ) |
| | | $ | 13,913,154 | | | $ | 14,173,718 | |
Depreciation expense for the three months ended March 31, 2011 and 2010 was approximately $258,913 and $ 102,946, respectively.
Intangible Assets
Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to fifty years. Management evaluates the recoverability of intangible assets at least annually and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that impairment exists. No impairments of intangible assets have been identified during any of the periods presented. The land use right purchased in 2003 will expire in 2053. All of the Company’s intangible assets are subject to amortization with estimated lives of:
| Land use right | 50 years |
| Proprietary technologies | 20 years |
As of March 31, 2011 and December 31, 2010, the components of intangible assets were as follows:
| | | 2011 | | | 2010 | |
| | | | | | | |
| Land use right | | $ | 1,058,965 | | | $ | 1,058,965 | |
| Proprietary technologies | | | 8,965,538 | | | | 8,965,538 | |
| | | | 10,024,503 | | | | 10,024,503 | |
| Less: Accumulated amortization | | | (1,618,199 | ) | | | (1,484,842 | ) |
| | | | 8,406,304 | | | | 8,539,661 | |
| Less: Impairment | | | (737,315) | | | | (737,315) | |
| | | $ | 7,668,989 | | | $ | 7,802,346 | |
Amortization expense for the three months ended March 31, 2011 and 2010 was $133,358 and $127,126, respectively. The estimated future yearly amortization expenses related to intangible asset as of March 31, 2011 are as follows:
| | | | |
| 2011 | | $ | 540,000 | |
| 2012 | | | 540,000 | |
| 2013 | | | 540,000 | |
| 2014 | | | 540,000 | |
| 2015 | | | 540,000 | |
| Thereafter | | $ | 4,968,989 | |
Long-Lived Assets
The Company accounts for long-lived assets in accordance with Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS No. 144), included in the Codification as ASC 360, Property, Plant, and Equipment, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of APB Opinion No. 30, “Reporting the Results of Operations for a Disposal of a Segment of a Business”, included in the Codification as ASC 225, Income Statement. The Company periodically evaluates the carrying value of long-lived assets to be held and used in accordance with ASC 360. ASC 360 requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets carrying amounts. In that event, a loss is recognized based on the amount by which the carrying amount exceeds the fair market value of the long-lived assets. Loss on long-lived assets to be disposed of is determined in a similar manner, except that fair market values are reduced for the cost of disposal. Based on its review, the Company believes that, as of March 31, 2011 and December 31, 2010, there were no significant impairments of its long-lived assets.
Fair Value of Financial Instruments
Statement of Financial Accounting Standard No. 107, “Disclosures about Fair Value of Financial Instruments”, included in the Codification as ASC 820, Fair Value Measurements and Disclosures, requires that the Company discloses estimated fair values of financial instruments. The carrying amounts reported in the statements of financial position for current assets and current liabilities qualifying as financial instruments are a reasonable estimate of fair value.
Fair Value Measurements and Disclosures
ASC Topic 820, “Fair Value Measurements and Disclosures,” defines fair value, and establishes a three-level valuation hierarchy for disclosures of fair value measurement that enhances disclosure requirements for fair value measures. The three levels are defined as follow:
| | · | Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. |
| | · | Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. |
| | · | Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement. |
As of March 31, 2011 and December 31, 2010, the Company did not identify any assets and liabilities that are required to be presented on the balance sheet at fair value.
Value Added Tax Payable
The Company is subject to a value added tax rate of 17% on product sales by the People’s Republic of China. Value added tax payable is computed net of value added tax paid on purchases for all sales in the People’s Republic of China.
Revenue Recognition
The Company’s revenue recognition policies are in compliance with Staff Accounting Bulletin (SAB) 104, “Revenue Recognition”, included in the Codification as ASC 605, Revenue Recognition. Sales revenue is recognized when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition are satisfied are recorded as unearned revenue.
The Company has one revenue source from manufacturing and selling the pharmaceutical products, and does not allow its customers to return products. The Company’s customers can exchange products only if they are damaged in transportation.
Advertising
Advertising expenses consist primarily of costs of promotion for corporate image and product marketing and costs of direct advertising. The Company expenses all advertising costs as incurred. There was no advertising expense incurred for the three months ended March 31, 2011 and 2010.
Income Taxes
The Company utilizes SFAS No. 109, “Accounting for Income Taxes”, included in the Codification as ASC 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years for differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. There were no deferred tax provision in 2010 and 2009.
The Company adopted the provisions of the FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (codified in FASB ASC Topic 740). When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination.
Interest associated with unrecognized tax benefits is classified as interest expense and penalties are classified as selling, general and administrative expense in the statements of income. The adoption of FIN 48 did not have a material impact on the Company’s financial statements. At March 31, 2011 and December 31, 2010, the Company had not taken any significant uncertain tax position on its tax return for 2010 and prior years or in computing its tax provision for 2010.
Comprehensive Income
Comprehensive income is defined as the change in equity of a company during a period from transactions and other events and circumstances excluding transactions resulting from investments from owners and distributions to owners. For the Company, comprehensive income for the periods presented includes net income, and foreign currency translation adjustments.
Statement of Cash Flows
In accordance with SFAS No. 95, “Statement of Cash Flows”, included in the Codification as ASC 230, Statement of Cash Flows, cash flows from the Company’s operations are based upon the local currencies. As a result, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheet.
Basic and Diluted Earnings (Loss) per Share (EPS)
Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS is similarly computed, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. Diluted net earnings per share are based on the assumption that all dilutive convertible shares and stock options were converted or exercised. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to have been exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.
The following table presents a reconciliation of basic and diluted earnings per share for the three months ended March 31, 2011 and 2010:
| | | | |
| | | 2011 | | | 2010 | |
| Net income | | $ | 2,888,013 | | | $ | 1,547,876 | |
| Weighted average shares outstanding - basic | | | 11,399,662 | | | | 9,333,333 | |
| Effect of dilutive securities: | | | | | | | | |
| Warrants issued | | | 378,378 | | | | - | |
| Weighted average shares outstanding – diluted | | | 11,778,040 | | | | 9,333,333 | |
| Earnings per share – basic | | $ | 0.25 | | | $ | 0.17 | |
| Earnings per share – diluted | | $ | 0.25 | | | $ | 0.17 | |
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk are cash, accounts receivable and other receivables arising from its normal business activities. The Company places its cash in what it believes to be credit-worthy financial institutions. The Company has a diversified customer base, most of which are in China. The Company controls credit risk related to accounts receivable through credit approvals, credit limits and monitoring procedures. The Company routinely assesses the financial strength of its customers and, based upon factors surrounding the credit risk, establishes an allowance, if required, for uncollectible accounts and, as a consequence, believes that its accounts receivable credit risk exposure beyond such allowance is limited.
Research and Development
Research and development costs are related primarily to the development of new drugs by the Company. Research and development costs are expensed as incurred.
The Company also develops new products through arrangements and corporation with several research institutes to develop new pharmaceutical products. The Company only pays these institutes for their research expenses if the research goals are accomplished, including certification of the product and approval for production, and these achievements are then transferred to the Company and recorded as intangible assets. There was no Research and Development expense in the three months ended March 31, 2011 and 2010.
Segment Reporting
Statement of Financial Accounting Standards No. 131, “Disclosure about Segments of an Enterprise and Related Information”, included in Codification ASC 280, Segment Reporting, requires use of the “management approach” model for segment reporting. The management approach model is based on the way a company's management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregates a company.
SFAS 131 has no effect on the Company's financial statements as substantially all of the Company's operations are conducted in one industry segment of manufacturing and marketing over-the-counter and prescription pharmaceutical products. All of the Company's assets are located in the PRC.
New Accounting Pronouncements
In April 2010 the FASB issued Accounting Standards Update (ASU) No. 2010-13, Compensation – Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades. This Update provides amendments to Accounting Standards Codification (ASC) Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The amendments in this Update should be applied by recording a cumulative-effect adjustment to the opening balance of retained earnings. The cumulative-effect adjustment should be calculated for all awards outstanding as of the beginning of the fiscal year in which the amendments are initially applied, as if the amendments had been applied consistently since the inception of the award. The cumulative-effect adjustment should be presented separately. Earlier application is permitted. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In December 2010, FASB issued ASU No. 2010-28, Intangibles – Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. The amendments in this Update affect all entities that have recognized goodwill and have one or more reporting units whose carrying amount for purposes of performing Step 1 of the goodwill impairment test is zero or negative. The amendments in this Update modify Step 1 so that for those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that impairment may exist. The qualitative factors are consistent with existing guidance, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The amendments in this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. Upon adoption of the amendments, any resulting goodwill impairment should be recorded as a cumulative-effect adjustment to beginning retained earnings in the period of an adoption. Any goodwill impairments occurring after the initial adoption of the amendments should be included in earnings. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In December 2010, FASB issued ASU No. 2010-29, Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. The amendments in this Update specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The amendments also expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The amendments in this Update are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company adopted the disclosure requirements for the business combinations in 2011.
On March 5, 2010, the FASB issued ASU No. 2010-11 Derivatives and Hedging Topic 815 “Scope Exception Related to Embedded Credit Derivatives.” This ASU clarifies the guidance within the derivative literature that exempts certain credit related features from analysis as potential embedded derivatives requiring separate accounting. The ASU specifies that an embedded credit derivative feature related to the transfer of credit risk that is only in the form of subordination of one financial instrument to another is not subject to bifurcation from a host contract under ASC 815-15-25, Derivatives and Hedging — Embedded Derivatives — Recognition. All other embedded credit derivative features should be analyzed to determine whether their economic characteristics and risks are “clearly and closely related” to the economic characteristics and risks of the host contract and whether bifurcation is required. The ASU is effective for the Company on July 1, 2010. Early adoption is permitted. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In January 2010, FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This update provides amendments to ASC Topic 820 that will provide more robust disclosures about (1) the different classes of assets and liabilities measured at fair value, (2) the valuation techniques and inputs used, (3) the activity in Level 3 fair value measurements, and (4) the transfers between Levels 1, 2, and 3. This standard is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
Note 3– DEPOSITS AND OTHER RECEIVABLES
At March 31, 2011 and December 31, 2010, the Company had deposits and other receivables of $4,192,711 and $4,374,525, respectively, mainly including $3,817,186 (RMB 25,027,000) prepayment for purchasing two patents of medicine formulation from Xi’an Keli, a local pharmaceutical company (see Note 6).
Note 4 – ACCRUED LIABILITIES AND OTHER PAYABLES
Accrued liabilities and other payables consisted of the following at March 31, 2011 and December 31, 2010:
| | | 2011 | | | 2010 | |
| Accrued salaries | | $ | 7,483 | | | $ | 5,122 | |
| Accrued welfare | | | 33,782 | | | | 33,799 | |
| Other payables | | | 24,461 | | | | 20,463 | |
| Accrued expense | | | 882,068 | | | | 877,733 | |
| Other levies | | | 18,786 | | | | 15,534 | |
| Total | | $ | 966,580 | | | $ | 952,651 | |
Note 5 – COMPENSATED ABSENCES
Regulation 45 of local labor law entitles employees to annual vacation leave after 1 year of service. In general all leave must be utilized annually, with proper notification. Any unutilized leave is cancelled.
Note 6 – COMMITMENTS
Purchasing Agreement
The Company signed a contact with Xi’an Keli, a local pharmaceutical company to purchase two patents of medicine formulation from them; the total contracted amount was approximately $4,530,000 (RMB 30 million). As of March 31, 2011, the Company paid $3,817,186 (RMB 25,027,000), and the remaining $763,000 (RMB 5 million) will be paid upon the Company obtaining the registration certificate of the medicine.
Lease Agreement
As of March 31, 2011, the Company had rental commitment of approximately $900, which will be paid in 2011.
Employment Agreements
Through our wholly-owned subsidiary, China Qinba Pharmaceuticals, Inc, the Company has executed employment agreements with each of our executive officers, specifically, Guozhu Wang, Chief Executive Officer; Guiping Zhang, President and Teo Lei, Chief Financial Officer. Each employment agreement has a term of two years.
On January 1, 2010, the Company entered into a two year Employment Agreement with Guozhu Wang to serve as the Company’s Chief Executive Officer. The Agreement provides for an annual salary of USD$5,095 and an annual bonus of up to 50% of the executive’s annual salary.
On January 1, 2010, the Company entered into a two year Employment Agreement with Guiping Zhang to serve as the Company’s President. The Agreement provides for an annual salary of USD$5,622 and an annual bonus of up to 50% of the executive’s annual salary.
On January 1, 2010, the Company entered into a two year Employment Agreement with Tao Lei to serve as the Company’s Chief Financial Officer. The Agreement provides for an annual salary of USD$4,392 and an annual bonus of up to 50% of the executive’s annual salary.
Note 7 – INCOME TAX
The Company’s Chinese subsidiary (WOFE) and VIE were incorporated in the PRC which is governed by the Income Tax Laws of the PRC and various local tax laws. Effective January 1, 2008, China adopted a uniform tax rate of 25% for all enterprises (including foreign-invested enterprises).
The Company’s VIE is a high-tech enterprise and under PRC Income Tax Laws, it is entitled to a two-year tax exemption for 2006 through 2007. Starting from 2008, the Enterprise Income Tax (EIT) was at a statutory rate of 15%. The Company expensed $464,204 and $ 541,526 for income tax for the three months ended March 31, 2011 and 2010.
The following table reconciles the U.S. statutory rates to the Company’s consolidated effective tax rate for the three months ended March 31, 2011 and 2010:
| | | 2011 | | | 2010 | |
| US statutory rates | | | 34.0 | % | | | 34.0 | % |
| Tax rate difference | | | (9.0 | )% | | | (9.0 | )% |
| Effect of tax holiday | | | (10.3 | )% | | | (10.0 | )% |
| Others | | | (1.5 | )% | | | 10.9 | % |
| Valuation allowance | | | 0.7 | % | | | 0 | % |
| Tax per financial statements | | | 13.9 | % | | | 25.9 | % |
Note 8 – MAJOR CUSTOMERS AND CREDIT RISK
For the three months ended March 31, 2011, no customer accounted for 10% or more of the Company’s sales. For the three months ended March 31, 2010, three customers accounted for 16%, 13% and 12% of the Company’s sales.
Three vendors provided 25%, 15% and 13% of the Company’s purchases of raw materials for the three months ended March 31, 2011; three vendors provided 12%, 10% and 10% of the Company’s purchase of raw materials for the three months ended March 31, 2010. At March 31, 2011 and December 31, 2010, the total payable due to these vendors was approximately $69,300, and $79,500, respectively.
Note 9 – STATUTORY RESERVES
In accordance with the laws and regulations of the PRC, a wholly-owned Foreign Invested Enterprises income, after the payment of the PRC income taxes, shall be allocated to the statutory surplus reserves and statutory public affair fund. Prior to January 1, 2006 the proportion of allocation for reserve was 10 percent of the profit after tax to the surplus reserve fund and additional 5-10 percent to the public affair fund. The public affair fund reserve was limited to 50 percent of the registered capital. Effective January 1, 2006 there is now only one fund requirement. The reserve is 10 percent of income after tax, not to exceed 50 percent of registered capital.
Statutory Reserve funds are restricted for set off against losses, expansion of production and operation or increase in register capital of the respective company. Statutory public welfare fund is restricted to the capital expenditures for the collective welfare of employees. These reserves are not transferable to the Company in the form of cash dividends, loans or advances. These reserves are therefore not available for distribution except in liquidation. As of March 31, 2011 and December 31, 2010, the Company had allocated $ 3,585,087 and $3,274,593 to these non-distributable reserve funds.
Note 10 – STOCK-BASED COMPENSATION PLAN
On December 17, 2009, China Qinba entered into a Shell Referral agreement with Dragon Link Investments, Ltd (Dragon Link) for Dragon Link to identify and refer a public shell company to the Company to consummate a reverse merger in the US. As consideration for the services provided by Dragon Link (and in accordance with a warrant placement agreement dated February 12, 2010 between the Company and Dragon Link), China Qinba agreed to issue to Dragon Link warrants to acquire 1,200,000 shares of the Company’s common stock, subject to adjustment for any forward or reverse splits (and subsequently reduced to 333,333 shares post reverse split), with registration rights, and exercisable at a price of $3.00 per post-split share within three years after the control acquisition or merger by China Qinba with a public company identified by Dragon Link . The warrants will expire on February 11, 2013. The fair value of the warrants at issuing date was $701,058. The warrants were fully exercised in May of 2010. The Company received $1 million proceeds from exercise of the warrants.
On January 5, 2010, China Qinba entered into an agreement with IFG Investments Services, Inc (IFG) to obtain certain consulting services including advising on a merger/acquisition transaction and regulatory filings, and other services and support as requested. In consideration for the consulting services to be performed by IFG (and in accordance with a warrant placement agreement dated February 12, 2010 between the Company and IFG), China Qinba agreed to issue to IFG warrants to acquire 1,800,000 shares of the Company’s common stock, subject to adjustment for any forward or reverse splits (and subsequently reduced to 500,000 shares post reverse split), with registration rights, exercisable at $3.00 per post-split share within three years after the closing of the control acquisition or merger by China Qinba with public company. The warrants will expire on February 11, 2013. The warrants were vested immediately. The fair value of the warrants at issuing date was $1,051,588.
On January 27, 2010, China Qinba entered into an investor relations agreement with HACG Investor Relations Services, Inc (HACG), to obtain certain public company sector services, including advising on and with respect to investor relations. The term of the contract expires January 31, 2011. As consideration for the services to be performed by HACG (and in accordance with a warrant placement agreement dated February 12, 2010 between the Company and HACG), China Qinba agreed to issue to HACG warrants to acquire 1,200,000 shares of the Company’s common stock, subject to adjustment for any forward or reverse splits (and subsequently reduced to 333,333 shares post reverse split), with registration rights, exercisable at $3.00 per post-split share until January 31, 2013. The warrants were vested immediately. The fair value of the warrants at issuing date was $469,976.
Based on the fair value method under ASC Topic 505, the fair value of each warrant granted is estimated on the date of the grant using the Black-Scholes option pricing model and is recognized as compensation expense over the service period of each warrants issued. The Black-Scholes option pricing model has assumptions for risk free interest rates, dividends, stock volatility and expected life of an option grant. The risk free interest rate is based upon market yields for US Treasury debt securities at a maturity near the term remaining on the warrant. Dividend rates are based on the Company’s dividend history. The stock volatility factor is based on the historical volatility of the Company’s stock price. The fair value was estimated at the date of grant using the following range of assumptions: average risk-free interest rate – 1.89%; expected life – 3 years; expected volatility – 219%; and expected dividends – nil. No estimate of forfeitures was made as the Company has a short history of granting warrants.
The following table summarizes activities of these warrants (post-reverse split) for the three months ended March 31, 2011:
| | | Number of Shares | | | Average Exercise Price per Share | | | Weighted Average Remaining Contractual Term in Years | |
| Outstanding at January 1, 2010 | | | - | | | $ | - | | | | - | |
| Exercisable at January 1, 2010 | | | - | | | | | | | | | |
| Cancelled | | | - | | | | - | | | | - | |
| Granted | | | 1,166,666 | | | | 3 | | | | 3.00 | |
| Exercised | | | 333,333 | | | | 3 | | | | - | |
| Outstanding at December 31, 2010 | | | 833,333 | | | $ | 3 | | | | 2.11 | |
| Exercisable at December 31, 2010 | | | 833,333 | | | $ | 3 | | | | 2.11 | |
| Granted | | | | | | | | | | | | |
| Exercised | | | | | | | | | | | - | |
| Outstanding at March 31, 2011 | | | 833,333 | | | $ | 3 | | | | 1.86 | |
| Exercisable at March 31, 2011 | | | 833,333 | | | $ | 3 | | | | 1.86 | |
Note 11 - CONTINGENCY
May 17, 2010, ValueRich, Inc. commenced litigation to compel arbitration against the Company, alleging ownership of 20% of the outstanding shares of the Company’s common stock pursuant to a May 2008 consulting agreement between ValueRich and Xi'an Pharmaceuticals. The Company is currently evaluating the possible outcome of this litigation and does not believe it will have any material effect on the company’s financial position.
Note 12 - CURRENT VULNERABILITY DUE TO CERTAIN RISK FACTORS
The Company’s major operations are carried out in the PRC; therefore the Company is subject to the risks not typically associated with entities operating in the United States of America. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environments in the PRC, by the general state of the PRC's economy. All of the following risks may impair the Company’s business operations. If any of the following risks actually occurs, the Company’s business, financial condition or results of operations could be materially adversely affected. In such case, investor may lose all or part of the investment. Additional risks include:
| § | The Company may not be able to adequately protect and maintain its intellectual property. |
| § | The Company may not be able to obtain regulatory approvals for its products. |
| § | The Company may have difficulty competing with larger and better financed companies in the same sector. New legislative or regulatory requirements may adversely affect the Company’s business and operations. The Company is dependent on certain key existing and future personnel. |
| § | The Company’s growth is dependent on its ability to successfully develop, market, or acquire new drugs. The Company may be subject to product liability claims in the future. |
| § | Changes in the laws and regulations in the PRC may adversely affect the Company’s ability to conduct its business. |
| § | The Company may experience barriers to conducting business due to governmental policy. |
| § | Capital outflow policies in the PRC may hamper the Company’s ability to remit income to the United States. |
| § | Fluctuation of the Renminbi could materially affect the Company’s financial condition and results of operations. |
| § | The Company may face obstacles from the communist system in the PRC. |
| § | The Company may have difficulty establishing adequate management, legal and financial controls in the PRC. |
| § | Trade barriers and taxes may have an adverse affect on the Company’s business and operations. |
| § | There may not be sufficient liquidity in the market for the Company’s securities in order for investors to sell their securities. |
Note 13 – SUBSEQUENT EVENTS
For the three months ended March 31, 2011, the Company has evaluated subsequent events for potential recognition and disclosure through the date of the financial statement issuance.
In May 2011, the board of directors approved the China Pharmaceuticals, Inc. 2011 Incentive Stock Plan which authorized 1,140,000 shares of the Company’s common stock to be used for the exercise of options to be granted to directors, officers, employees and/or consultants to the Company.
