UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2010

or

o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________________ to __________________

Commission file number: 000-32581

LOTUS PHARMACEUTICALS, INC.

(Name of registrant as specified in its charter)

NEVADA	20-0507918
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

16 Cheng Zhuang Road, Feng Tai District, Beijing 100071 People’s Republic of China	N/A
(Address of principal executive offices)	(Zip Code)

86-10-63899868

(Registrant's telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x   No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes o   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer o	Accelerated filer o
Non-accelerated filer o (Do not check if smaller reporting company)	Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

Yes o   No x

Indicated the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date, 52,996,664 shares of common stock are issued and outstanding as of May 13, 2010.

TABLE OF CONTENTS

		Page No.
PART I. - FINANCIAL INFORMATION
Item 1.	Financial Statements.	4
	Condensed Consolidated Balance Sheets as of March 31, 2010 (Unaudited) and December 31, 2009	4
	Condensed Consolidated Statements of Income and Other Comprehensive Income for the Three Months Ended March 31, 2010 and 2009 (Unaudited)	5
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2010 and 2009 (Unaudited)	6
	Notes to Unaudited Condensed Consolidated Financial Statements	7
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations.	30
Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	42
Item 4T	Controls and Procedures.	42
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings.	44
Item 1A.	Risk Factors.	44
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds.	44
Item 3.	Defaults Upon Senior Securities.	44
Item 4.	Submission of Matters to a Vote of Security Holders.	44
Item 5.	Other Information.	44
Item 6.	Exhibits.	44

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

Certain statements in this report contain or may contain forward-looking statements that are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These forward-looking statements were based on various factors and were derived utilizing numerous assumptions and other factors that could cause our actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to, our ability to enforce the Contractual Arrangements, Lotus East's strategic initiatives, economic, political and market conditions and fluctuations, U.S. and Chinese government and industry regulation, interest rate risk, U.S., Chinese and global competition, and other factors. Most of these factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in connection with any forward-looking statements that may be made herein. Readers are cautioned not to place substantial reliance on these forward-looking statements and readers should carefully review this report in its entirety together with our Annual Report on Form 10-K for the year ended December 31, 2009 as filed with the SEC, including the risks described in Item 1A. Risk Factors. Except for our ongoing obligations to disclose material information under the Federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events. These forward-looking statements speak only as of the date of this report, and you should not rely on these statements without also considering the risks and uncertainties associated with these statements and our business.

2

OTHER PERTINENT INFORMATION

We maintain a web site at www.lotuspharma.com. Information on this web site is not a part of this report.

CERTAIN DEFINED TERMS USED IN THIS REPORT

Unless specifically set forth to the contrary, when used in this report the terms:

· "Lotus," "we," "us," "our," the "Company," and similar terms refer to Lotus Pharmaceuticals, Inc., a Nevada corporation formerly known as S.E. Asia Trading Company, Inc., and its subsidiary,

· "Lotus International" refers to Lotus Pharmaceutical International, Inc., a Nevada corporation and a subsidiary of Lotus,

· "Lotus Century" refers to Lotus Century Pharmaceutical (Beijing) Technology Co., Ltd., a wholly foreign-owned enterprise (WFOE) Chinese company which is a subsidiary of Lotus,

· "Liang Fang" refers to Beijing Liang Fang Pharmaceutical Co., Ltd., a Chinese limited liability company formed on June 21, 2000,

· "En Ze Jia Shi" refers to Beijing En Ze Jia Shi Pharmaceutical Co., Ltd., a Chinese limited liability company formed on September 17, 1999 and an affiliate of Liang Fang,

· "Lotus East" collectively refers to Liang Fang and En Ze Jia Shi,

· "Consulting Services Agreements" refers to the Consulting Services Agreements dated September 20, 2006 between Lotus and Lotus East.

· "Operating Agreements" refers to the Operating Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,

· "Equity Pledge Agreements" refers to the Equity Pledge Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,

· "Option Agreements" refers to the Option Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,

· "Proxy Agreements" refers to the Proxy Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,

· "Contractual Arrangements" collectively refers to the Consulting Services Agreements, Operating Agreements, Equity Pledge Agreements, Option Agreements and the Proxy Agreements,

·  “SFDA” refers to The State Food and Drug Administration,

· "China" or the "PRC" refers to the People's Republic of China, and

· "RMB" refers to the renminbi which is the currency of mainland PRC of which the yuan is the principal currency.

3

PART 1. - FINANCIAL INFORMATION

Item 1.     Financial Statements.

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

	As of
	March 31, 2010		December 31, 2009
	(Unaudited)
ASSETS
CURRENT ASSETS:
Cash	$	1,125,181	$	3,945,740
Accounts receivable		1,669,704		1,784,194
Other receivable		16,135		16,132
Inventories		3,301,050		1,039,867
Prepaid expenses and other assets - current		1,091,909		856,691
Deferred debt costs		—		52,226
Total Current Assets		7,203,979		7,694,850
PROPERTY AND EQUIPMENT, net		21,309,774		16,223,775
OTHER ASSETS
Prepaid expenses		1,169,167		1,359,583
Deposits and Installments on intangible assets		9,215,781		9,214,299
Intangible assets, net		49,458,233		49,888,428
Total Assets	$	88,356,934	$	84,380,935
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses	$	301,442	$	427,924
Other payables		1,418,234		2,262,760
Taxes payable		2,481,808		3,131,908
Unearned revenue		795,620		1,163,771
Due to related parties		1,668,007		1,490,649
Series A convertible redeemable preferred stock, $.001 par value; 10,000,000 shares
authorized; 2,847,623 and 4,967,959 shares issued and outstanding at March 31, 2010
and December 31, 2009, respectively, net of discount		2,477,433		4,170,572
Total Current Liabilities		9,142,544		12,647,584
LONG-TERM LIABILITIES:
Due to related parties		859,819		866,102
Notes payable - related parties		5,069,839		5,069,023
Total Liabilities		15,072,202		18,582,709
STOCKHOLDERS' EQUITY:
Common stock ($.001 par value; 200,000,000 shares authorized; 50,863,217 and 47,306,332
shares issued and outstanding at March 31, 2010 and December 31, 2009, respectively)		50,863		47,306
Additional paid-in capital		18,192,431		15,649,328
Statutory reserves		6,240,202		5,674,324
Retained earnings		44,429,076		40,066,036
Accumulated other comprehensive income		4,372,160		4,361,232
Total stockholders' Equity		73,284,732		65,798,226
Total Liabilities and Stockholders' Equity	$	88,356,934	$	84,380,935

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements

4

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)

	For the Three Months Ended March 31,
	2010			2009
NET REVENUES:
Wholesale	$	11,498,086		$	8,940,405
Retail		3,252,392			2,137,188
Other revenues		198,434			746,694
Total Net Revenues		14,948,912			11,824,287
COST OF SALES		6,243,629			5,186,158
GROSS PROFIT		8,705,283			6,638,129
OPERATING EXPENSES:
Selling expenses		2,168,953			1,701,799
General and administrative		1,021,857			747,206
Total Operating Expenses		3,190,810			2,449,005
INCOME FROM OPERATIONS		5,514,473			4,189,124
OTHER INCOME (EXPENSE):
Debt issuance costs		(52,226	)		(99,517	)
Interest income		1,280			1,319
Interest expense		(432,402	)		(448,097	)
Total Other Income (Expense)		(483,348	)		(546,295	)
INCOME BEFORE INCOME TAXES		5,031,125			3,642,829
INCOME TAXES		102,207			74,727
NET INCOME	$	4,928,918		$	3,568,102
COMPREHENSIVE INCOME:
NET INCOME		4,928,918			3,568,102
OTHER COMPREHENSIVE INCOME:
Foreign currency translation gain		10,928			62,111
COMPREHENSIVE INCOME	$	4,939,846		$	3,630,213
NET INCOME PER COMMON SHARE:
Basic	$	0.10		$	0.08
Diluted	$	0.09		$	0.07
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic		49,559,184			43,048,060
Diluted		53,708,923			49,254,950

The accompanying notes are an integral part of these unaudtied condensed consolidated financial statements

5

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

	For the Three Months Ended March 31,
	2010			2009
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	4,928,918		$	3,568,102
Adjustments to reconcile net income from operations to net cash provided by
operating activities:
Depreciation and amortization		444,812			362,467
Amortization of deferred debt issuance costs		52,226			99,517
Amortization of discount on convertible redeemable preferred stock		151,553			288,783
Amortization of prepaid expense attributable to warrants		—			14,849
Interest expense attributable to beneficial conversion feature of preferred shares		184,660			—
Stock-based compensation		23,000			—
Changes in assets and liabilities:
Accounts receivable		114,778			4,744,877
Inventories		(2,261,039	)		66,423
Prepaid expenses and other current assets		208,214			1,329,083
Accounts payable and accrued expenses		194,827			(666,522	)
Other current payables		(844,890	)		—
Taxes payable		(650,611	)		(3,027,383	)
Unearned revenue		(368,342	)		228,143
Due to related parties		90,697			—
NET CASH PROVIDED BY OPERATING ACTIVITIES		2,268,803			7,008,339
CASH FLOWS FROM INVESTING ACTIVITIES:
Payments on intangible assets		—			(4,965,976	)
Purchase of property and equipment		(5,090,025	)		(2,153,243	)
NET CASH USED IN INVESTING ACTIVITIES		(5,090,025	)		(7,119,219	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from related party advances		—			59,314
NET CASH PROVIDED BY  FINANCING ACTIVITIES		—			59,314
EFFECT OF EXCHANGE RATE ON CASH		663			1,527
NET DECREASE IN CASH		(2,820,559	)		(50,039	)
CASH  - beginning of period		3,945,740			1,278,808
CASH - end of period	$	1,125,181		$	1,228,769
SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:
Cash paid for:
Interest	$	—		$	—
Income taxes	$	—		$	—
Non-cash investing and financing activities:
Common stock issued for services	$	253,000		$	249,000
Common stock issued for conversion of convertible redeemable preferred stock	$	2,166,000		$	—
Convertible redeemable preferred stock issued for dividend payable	$	321,308		$	400,000

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements

6

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The interim consolidated financial statements included herein have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in an annual financial statement prepared in accordance with generally accepted accounting principles in the United States (“US GAAP”) have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the interim consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the statement of the results for the interim periods presented. These condensed interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto, as well as the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2009 included in its Annual Report on Form 10-K. Interim financial results are not necessarily indicative of the results that may be expected for a full year.

Use of estimates

The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ from those estimates. Significant estimates in the three months ended March 31, 2010 and 2009 include the allowance for doubtful accounts, the allowance for obsolete inventory, the useful life of property and equipment and intangible assets, fair value of warrants and beneficial conversion features related to the convertible preferred stock and fair value of warrants granted.

Fair value of financial instruments

The Company adopted ASC 820, Fair Value Measurements and Disclosures. ASC 820 clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:

Level 1-Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.

Level 2-Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other then quoted prices that are observable, and inputs derived from or corroborated by observable market data.

Level 3-Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

The carrying amounts reported in the balance sheets for cash, accounts receivable, accounts payable and accrued expenses, convertible debt, customer advances, and amounts due to related parties approximate their fair market value based on the short-term maturity of these instruments. The carrying value of the long-term debt approximates fair value based on market rates and terms currently available to the Company. The Company did not identify any assets or liabilities that are required to be presented on its condensed consolidated balance sheets at fair value in accordance with ASC 820.

Cash and cash equivalents

For purposes of the condensed consolidated statements of cash flows, the Company considers all highly liquid instruments purchased with a maturity of three months or less and money market accounts to be cash equivalents. The Company maintains cash and cash equivalents with various financial institutions mainly in the PRC and the United States. Balances in the United States are insured up to $250,000 at each bank. Balances at financial institutions or state-owned banks within the PRC are not covered by insurance. Non-performance by these institutions could expose the Company to losses for amounts in excess of insured balances.

7

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Accounts receivable

The Company records accounts receivable, net of an allowance for doubtful accounts and sales returns. The Company maintains allowances for doubtful accounts for estimated losses. The Company reviews the accounts receivable on a periodic basis and makes general and specific allowances when there is doubt as to the collectability of individual balances. In evaluating the collectability of individual receivable balances, the Company considers many factors, including the age of the balance, customer’s historical payment history, its current credit-worthiness and current economic trends. The amount of the provision, if any is recognized in the consolidated statement of operations within “General and Administrative Expenses”. Accounts are written off after exhaustive efforts at collection. Because of the Company’s good relationship with its customers and the efforts of the Company’s collection representative to collect outstanding receivables, the majority age of the balance of the Company’s accounts receivable are less than three months. Based on a review of its outstanding balances, the Company did not consider it necessary to record any allowance for doubtful accounts during the three months ended March 31, 2010 and 2009.

Inventories

Inventories, consisting of raw materials, packaging materials, work-in-process and finished goods related to the Company’s products are stated at the lower of cost or market utilizing the average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, the Company will record reserves for the difference between the cost and the market value. These reserves are recorded based on estimates and reflected in cost of sales. The Company did not record any inventory reserve during the three months ended March 31, 2010 and 2009.

Property and equipment

Property and equipment are carried at cost and are depreciated on a straight-line basis over the estimated useful lives of the assets. The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition.

The construction-in-progress which consists of factories and office buildings under construction in China was included in property and equipment. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use.

Impairment of long-lived assets

In accordance with ASC 360, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company periodically reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value. For the three months ended March 31, 2010, no impairment is necessary.

Income taxes

The Company is governed by the Income Tax Law of the People’s Republic of China and the United States. Income taxes are accounted for under ASC 740, “Accounting for Income Taxes,” which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns.

8

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Income taxes (continued)

In 2006, FASB issued ASC 740, "Accounting for Uncertainty in Income Taxes," which clarifies the accounting and disclosure for uncertain tax positions. This interpretation is effective for fiscal years beginning after December 15, 2006, and the Company has implemented this interpretation as of July 1, 2007. ASC 740 prescribes a recognition threshold and measurement attribute for recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

Under ASC 740, evaluation of a tax position is a two-step process. The first step is to determine whether it is more likely than not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met.

Value added tax

The Company is subject to value added tax (“VAT”) for manufacturing and selling products and business tax for services provided. The applicable VAT rate is 17% for products sold in the PRC. The amount of VAT liability is determined by applying the applicable tax rate to the invoiced amount of goods sold (output VAT) less VAT paid on purchases made with the relevant supporting invoices (input VAT). Under the commercial practice of the PRC, the Company paid VAT based on tax invoices issued. The tax invoices may be issued subsequent to the date on which revenue is recognized, and there may be a considerable delay between the date on which the revenue is recognized and the date on which the tax invoice is issued. In the event that the PRC tax authorities dispute the date on which revenue is recognized for tax purposes, the PRC tax office has the right to assess a penalty, which can range from zero to five times the amount of the taxes which are determined to be late or deficient, and will be charged to operations in the period if and when a determination is been made by the taxing authorities that a penalty is due.

Revenue recognition

Product sales

Product sales are generally recognized when title to the product has transferred to customers in accordance with the terms of the sale. The Company recognizes revenue in accordance with ASC 360. ASC 360 states that revenue should not be recognized until it is realized or realizable and earned. In general, the Company records revenue when persuasive evidence of an arrangement exists, services have been rendered or product delivery has occurred, the sales price to the customer is fixed or determinable, and collectability is reasonably assured.

ASC 605 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if the seller’s price to the buyer is substantially fixed or determinable at the date of sale, the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, the buyer acquiring the product for resale has economic substance apart from that provided by the seller, the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and the amount of future returns can be reasonably estimated.

9

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Revenue recognition (continued)

 Allowance for returns

The Company accounts for sales returns in accordance with ASC 605, Revenue Recognition When Right of Return Exists, by establishing an accrual in an amount equal to its estimate of sales recorded for which the related products are expected to be returned. The Company determines the estimate of the sales return accrual primarily based on historical experience regarding sales returns, but also by considering other factors that could impact sales returns. These factors include levels of inventory in the distribution channel, estimated shelf life, product discontinuances, and price changes of competitive products, introductions of generic products and introductions of competitive new products. In general, for wholesale sales, the Company provides credit for product returns that are returned six months prior to and up to six months after the product expiration date. Upon sale, the Company estimates an allowance for future product returns. The Company provides additional reserves for contemporaneous events that were not known and knowable at the time of shipment. In order to reasonably estimate future returns, the Company analyzed both quantitative and qualitative information including, but not limited to, actual return rates, the level of product manufactured by the Company, the level of product in the distribution channel, expected shelf life of the product, current and projected product demand, the introduction of new or generic products that may erode current demand, and general economic and industry wide indicators. The Company also utilizes the guidance provided in ASC 360 in establishing its return estimates. Historically, the Company’s sales returns have been minimal.  Accordingly, based upon the Company’s experience, it historically does not record a reserve at the time of sale and there have been no accounting entries related to its product return policy which have reduced its gross revenues or had any material impact on its financial statements.

Other revenues 

Other revenues consist of (i) rental income received for the lease of retail space to various retail merchants and licensed medical practitioners; (ii) revenues received for research and development projects and lab testing jobs conducted on behalf of third party companies; and (iii) revenues received for performing third party contract manufacturing projects. The Company recognizes revenues from leasing of space as earned from contracting third parties. The Company recognizes revenues upon performance of any research or lab testing jobs. In connection with third-party manufacturing, the customer supplies the raw materials and the Company is paid a fee for manufacturing their product and revenue is recognized at the completion of the manufacturing job. Revenues received in advance are reflected as unearned revenue on the accompanying balance sheets.

Concentrations of credit risk

Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially, all of the Company’s cash is maintained with state-owned banks within the People’s Republic of China of which no deposits are covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any risks on its cash in bank accounts. A significant portion of the Company’s sales are credit sales which are primarily to customers whose ability to pay is dependent upon the industry economics prevailing in these areas; however, concentrations of credit risk with respect to trade accounts receivables is limited due to generally short payment terms. The Company also performs ongoing credit evaluations of its customers to help further reduce credit risk.

Unearned Revenue

Unearned revenue consists of prepayments from customers for merchandise that had not yet been shipped. The Company will recognize the deposits as revenue when customers take delivery of the goods, in accordance with its revenue recognition policy. At March 31, 2010 and December 31, 2009, the Company had unearned revenue of $795,620 and $1,163,771, respectively.

10

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Stock-based compensation  

Stock-based compensation is accounted for under ASC 718, “Share-Based Payment.” ASC 718 requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively the vesting period). ASC 718 also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award. The Company accounts for non-employee share-based awards in accordance with ASC 505, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquisition, or in Conjunction with Selling, Goods or Services.”

Shipping and handling

Shipping and handling costs are expensed as incurred. Shipping and handling costs were included in selling expenses. For the three months ended March 31, 2010 and 2009, all of the shipping and handling expenses were paid by the Company’s customers.

Employee benefits

The Company’s operations and employees are all located in the PRC. The Company makes mandatory contributions to the PRC government’s health, retirement benefit and unemployment funds in accordance with the relevant Chinese social security laws, which is approximately 5% of salaries. The costs of these payments are charged to the same accounts as the related salary costs in the same period as the related salary costs and are not material.

Advertising

Advertising is expensed as incurred. Advertising expenses were included in selling expenses and amounted to $0 and $6,500 for the three months ended March 31, 2010 and 2009, respectively.

Research and development

Research and development costs are expensed as incurred. These costs primarily consist of cost of material used and salaries paid for the development of the Company’s products and depreciation related to facilities used and fees paid to third parties. For the three months ended March 31, 2010 and 2009, the Company did not incur any research and development expense.

Foreign currency translation

The reporting currency of the Company is the U.S. dollar. The functional currency of the Company is U.S. dollars, but the functional currency of the Company’s operating subsidiaries and affiliates is Chinese Reminbi (“RMB”). For the subsidiaries and affiliates whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the unified exchange rate at the end of the period, and equity is translated at historical exchange rates. Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income.  The cumulative translation adjustment and effect of exchange rate changes on cash for the three months ended March 31, 2010 and 2009 was $663 and $1,527, respectively. Transactions denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing on the transaction dates with any transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. All of the Company’s revenue transactions are transacted in the functional currency. The Company does not enter any material transaction in foreign currencies and accordingly, transaction gains or losses have not had, and are not expected to have, a material effect on the results of operations of the Company.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Foreign currency translation (continued)

Asset and liability accounts on March 31, 2010 and December 31, 2009 were translated at 6.8361 RMB to $1.00 USD and at 6.8372 RMB to $1.00 USD, respectively. Equity accounts were stated at their historical rate. The average translation rates applied to income statements for the three months ended March 31, 2010 and 2009 were 6.83603 RMB and 6.84659 RMB to $1.00 USD, respectively. In accordance with Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows,” cash flows from the Company’s operations is calculated based upon the local currencies using the average translation rate. 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 sheets.

Earnings per common share

Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during each period. Potentially dilutive common shares consist of common shares issuable upon the conversion of series A preferred stock (using the if-converted method) and common stock warrants (using the treasury stock method). The following table presents a reconciliation of basic and diluted net income per share:

	For the Three Months Ended March 31,
	2010		2009
Net income for basic and diluted earnings per share	$	4,928,918	$	3,568,102
Weighted average shares outstanding – basic		49,559,184		43,048,060
Effect of dilutive securities:
Unexercised warrants		671,184		—
Convertible debentures		3,478,555		6,206,890
Weighted average shares outstanding– diluted		53,708,923		49,254,950
Earnings per share – basic	$	0.10	$	0.08
Earnings per share – diluted	$	0.09	$	0.07

As of March 31, 2010 and 2009, a total of 400,000 and 5,166,999 warrants, respectively, have not been included in the calculation of diluted earnings per share in order to avoid any anti-dilutive effect.

Accumulated other comprehensive income

The Company follows ASC 220 “Reporting Comprehensive Income” to recognize the elements of comprehensive income. Comprehensive income is comprised of net income and all changes to the statements of stockholders’ equity, except those due to investments by stockholders, changes in paid-in capital and distributions to stockholders. For the Company, accumulated other comprehensive income consisted of unrealized gains on foreign currency translation adjustments from the translation of financial statements from Chinese RMB to US dollars. For the Company, comprehensive income for the three months ended March 31, 2010 and 2009 included net income and unrealized gains from foreign currency translation adjustments.

Segment reporting

ASC 280 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. During the three months ended March 31, 2010 and 2009, the Company operated in two business segments - (1) Wholesales segment and (2) Retail segment.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Subsequent Events

For purposes of determining whether a post-balance sheet event should be evaluated to determine whether it has an effect on the financial statements for the three months ended March 31, 2010, subsequent events were evaluated by the Company as of the date on which the consolidated financial statements at and for the three months ended March 31, 2010, were available to be issued.

Recent Accounting Pronouncements

In August 2009, FASB issued an Accounting Standards Update (“ASU”) regarding measuring liabilities at fair value. This ASU provides additional guidance clarifying the measurement of liabilities at fair value in circumstances in which a quoted price in an active market for the identical liability is not available; under those circumstances, a reporting entity is required to measure fair value using one or more of valuation techniques, as defined. This ASU is effective for the first reporting period, including interim periods, beginning after the issuance of this ASU. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In October 2009, FASB issued an ASU regarding accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing. This ASU requires that at the date of issuance of the shares in a share-lending arrangement entered into in contemplation of a convertible debt offering or other financing, the shares issued shall be measured at fair value and be recognized as an issuance cost, with an offset to additional paid-in capital. Further, loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. This ASU is effective for fiscal years beginning on or after December 15, 2009, and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In December 2009, FASB issued ASU No. 2009-16, “Accounting for Transfers of Financial Assets”. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 166, “Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140”.The amendments in this Accounting Standards Update improve financial reporting by eliminating the exceptions for qualifying special-purpose entities from the consolidation guidance and the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, the amendments require enhanced disclosures about the risks that a transferor continues to be exposed to because of its continuing involvement in transferred financial assets. Comparability and consistency in accounting for transferred financial assets will also be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.

In December, 2009, FASB issued ASU No. 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 167, “Amendments to FASB Interpretation No. 46(R)”. The amendments in this Accounting Standards Update replace the quantitative-based risks and rewards calculation for determining which reporting entity, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which reporting entity has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and: (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. An approach that is expected to be primarily qualitative will be more effective for identifying which reporting entity has a controlling financial interest in a variable interest entity. The amendments in this Update also require additional disclosures about a reporting entity’s involvement in variable interest entities, which will enhance the information provided to users of financial statements. The adoption of this ASU did not have a material impact on its consolidated financial statements.

In January 2010, FASB issued ASU No. 2010-02 regarding accounting and reporting for decreases in ownership of a subsidiary. Under this guidance, an entity is required to deconsolidate a subsidiary when the entity ceases to have a controlling financial interest in the subsidiary. Upon deconsolidation of a subsidiary, an entity recognizes a gain or loss on the transaction and measures any

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recent Accounting Pronouncements (continued)

retained investment in the subsidiary at fair value. In contrast, an entity is required to account for a decrease in its ownership interest of a subsidiary that does not result in a change of control of the subsidiary as an equity transaction. This ASU clarifies the scope of the decrease in ownership provisions, and expands the disclosures about the deconsolidation of a subsidiary or de-recognition of a group of assets. This ASU is effective for beginning in the first interim or annual reporting period ending on or after December 31, 2009. 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. 2010-01, “Accounting for Distributions to Shareholders with Components of Stock and Cash”. The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. 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. 2010-02, “Accounting and Reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification”. The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity. The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. 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 “Improving Disclosures about Fair Value Measurements”. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: (1) Transfers in and out of Levels 1 and 2. A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. (2)  Activity in Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarify existing disclosures as follows: (1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. (2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are 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 does not have a material impact on the Company’s consolidated financial statements.

Reclassifications

Certain prior period amounts have been reclassified to conform to the current year presentation. These reclassifications have no effect on the previously reported financial position, results of operations and cash flows.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 – ACCOUNTS RECEIVABLE

At March 31, 2010 and December 31, 2009, accounts receivable consisted of the following:

		March 31, 2010		December 31, 2009
		(Unaudited)
Accounts receivable	$	1,669,704	$	1,784,194
Less: allowance for sales returns		—		—
Less: allowance for doubtful accounts		—		—
	$	1,669,704	$	1,784,194

NOTE 3 – INVENTORIES

At March 31, 2010 and December 31, 2009, inventories consisted of the following:

		March 31, 2010		December 31, 2009
		(Unaudited)
Raw materials	$	424,670	$	773,211
Packaging materials		125,937		16,023
Finished goods		2,750,443		250,633
Total	$	3,301,050	$	1,039,867

NOTE 4 – PROPERTY AND EQUIPMENT

At March 31, 2010 and December 31, 2009, property and equipment consist of the following:

	Useful Life		March 31, 2010		December 31, 2009
Office equipment and furniture	3 – 8 Years	$	244,529	$	244,490
Manufacturing equipment	10 – 15 Years		5,590,390		5,589,490
Building and building improvements	20 – 40 Years		2,339,988		2,339,612
Construction in progress			17,712,229		12,620,225
			25,887,136		20,793,817
Less: accumulated depreciation			(4,577,362)		(4,570,042)
		$	21,309,774	$	16,223,775

On March 31, 2010, construction in progress amounted to $17,712,229, representing (i) payments for construction of a new manufacturing plant of approximately $7.02 million located in Cha Ha Er Industrial Park in Inner Mongolia, China, and (ii) payment for construction of a new building of approximately $10.69 million in Beijing, China. The amount for the new plant in Inner Mongolia includes costs for road, paving, water well, water reservoir, pump station, switchboard room, distribution room materials, equipment installation engineering (such as transformation boxes, related corollary equipments and various cables etc.,), filter plant, flameproof equipment, fire control pond and pump, civil defense engineering and underground long corridor project, such as electrical, drainage system, heating, water pipes construction and payment for design service. The amount for the new building under construction in Beijing includes payments for design service, water supply and sewerage work, civil air-defense construction fees, heating systems, old building removal, construction materials and related costs the new building will be built on land of 6,700 square meters.

The Company expects to finish the construction of the new building by July, interior decoration by September and GMP certification by December 2010. Currently, the Company’s administration office, sales office, R&D center and production base are widely separated in various districts of Beijing.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 – PROPERTY AND EQUIPMENT (Continued)

After finishing the construction of the new building, the Company will relocate certain operating units into one concentrated area, which would improve operational efficiency. Upon completion of the construction in progress, the assets will be classified to the property and equipment category.

For the three months ended March 31, 2010, depreciation expense amounted to $ 6,585, of which $0 was included in cost of sales since the Company did not perform any production during the first quarter of 2010. For the three months ended March 31, 2009, depreciation expense amounted to $126,291, of which $119,775 was included in cost of sales.

NOTE 5 – DEPOSIT ON PATENT AND INSTALLMENT ON INTANGIBLE ASSETS 

Deposit and Installments on a Chinese Class I drug patent-Laevo-Bambuterol

Pursuant to the technology transfer agreement the Company entered into in April 2008 (See note 12), the Company made a deposit to acquire a Chinese Class I drug patent. Accordingly, the Company recorded $2,925,645 (RMB 20 million) as a deposit on a patent as of March 31, 2010.

Also, the Company has arranged an installment payment plan on the Chinese Class I drug patent to obtain the patent according to the signed contract. Therefore, the Company made $5,412,443 (RMB 37 million) as installment payments on the intangible assets as of March 31, 2010. The Company will need to make additional installment payments of approximately $1.6 million (RMB 11 million) to obtain the patent.

In addition, the Company expects to incur approximately $5.85 million (RMB 40 million) related to the Laevo-Bambuterol drug that has completed the Chinese SFDA special review process in the next 33 months.

Installments on Gliclazide-Controlled Release Tablets

Pursuant to the new drug patent transfer agreement the Company entered into in February 2009 (See note 12 for Gliclazide-Controlled Release Tablets), the Company has made the first installment to the transferor to obtain the patent. Hence, the Company recorded $877,693 (RMB 6 million) as installment payment on intangible assets as of March 31, 2010. In order to acquire the patent, the Company needs to make additional installments of approximately $439,000 (RMB 3 million).

In addition, the Company expects to incur approximately $293,000 million (RMB 2 million) related to our Gliclazide-Controlled Release Tablets that was recently accepted by the Chinese SFDA for medicine registration application in the next 10months.

NOTE 6 – INTANGIBLE ASSETS

On October 9, 2006, the Company entered into a five-year loan agreement (the “Loan Agreement”) and a contract with Wu Lan Cha Bu Emergency Hospital (“Wu Lan”), whereby the Company agreed to lend Wu Lan approximately $4 million (RMB 30 million) for the construction of a hospital ward in Inner Mongolia, China. In exchange for the loan, Wu Lan agreed to grant the Company an exclusive right to supply all medicines and disposable medical treatment apparatus to Wu Lan for a period of twenty (20) years. In October 2006, the Company’s chief executive officer, Mr. Liu Zhongyi (hereafter, “Mr. Liu”), made this loan to Wu Lan on behalf of the Company. On October 21, 2006, the Company entered into an assignment agreement whereby the Company assigned all of its rights, obligations, and receipts under the Loan Agreement to Mr. Liu, except the rights to receive revenues from the sale of medical and disposable medical treatment apparatus. Since Mr. Liu accepted the assignment with all the risks and obligations but no right to revenues from the sale of medical and disposable medical treatment apparatus, the Company agreed to pay Mr. Liu compensation for approximately $1.3 million (RMB 9 million) in five (5) equal annual installments of approximately $263,000 (RMB 1.8 million) commencing October 21, 2006. Accordingly, the Company recorded an intangible asset of approximately $1.3 million (RMB 9 million) related to the exclusive rights to provide all medicines and disposable medical treatment apparatus to Wu Lan for a period of twenty (20) years. The Company will amortize this exclusive right over a term of 20 years.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 – INTANGIBLE ASSETS (Continued)

The Company entered into an intellectual rights transfer contract with Beijing Yipuan Bio-Medical Technology Co., Ltd. in December 2008 to acquire the drug property right of Yipubishan. The intellectual property right is valued at a fixed amount of RMB 54 million (approximately $7.9 million). We have paid the transfer fee in full for the intellectual property right to Yipuan as of June 30, 2009. The intellectual property right has a term of 10 years and will not expire until December 31, 2018. The Company amortizes the intellectual property right over the term of the intellectual property right.

All land in the PRC is owned by the PRC government and cannot be sold to any individual or company. The Company has recorded the amounts paid to the PRC government to acquire long-term interests to utilize land underlying the Company’s facilities as land use rights. This type of arrangement is common for the use of land in the PRC. Land use rights are amortized on the straight-line method over the terms of the land use rights, which range from 40 to 50 years. The Company acquired one parcel of land use right in Beijing and the other parcel of land use right in Inner Mongolia, China. The Company has received land use right certificate on the parcel of land in Beijing. While, as of the quarterly reporting filing date, the Company has not received land use right certificate on the parcel of land in Inner Mongolia. The delay is common in China. The Company acquired the two parcels of land use rights in the amounts of approximately $42.5 million (RMB 290,429,504), which are included in intangible assets.

At March 31, 2010 and December 31, 2009, intangible assets consist of the following: 

		March 31, 2010		December 31, 2009
		(Unaudited)
Revenue rights		1,316,540		1,316,328
Intellectual rights		7,899,241		7,897,970
Land use rights		42,484,677		42,477,842
Software		10,825		10,823
		51,711,283		51,702,963
Less: accumulated amortization		(2,253,050)		(1,814,535)
	$	49,458,233	$	49,888,428

Amortization expense amounted to approximately $438,227 and $236,176 for the three months ended March 31, 2010 and 2009, respectively.

The projected amortization expense attributed to future periods is as follows:

Period ending March 31:		Expense
2011	$	1,752,891
2012		1,751,306
2013		1,750,258
2014		1,750,258
Thereafter		42,453,520
	$	49,458,233

NOTE 7 – RELATED PARTY TRANSACTIONS

Notes payable – related parties

Notes payable - related parties consisted of the following at March 31, 2010 and December 31, 2009:

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7 – RELATED PARTY TRANSACTIONS (Continued)

Notes payable – related parties (continued)

		March 31, 2010		December 31, 2009
		(Unaudited)
Note to Song Guoan, father of Song Zheng Hong, director and spouse of the company’s CEO Liu Zhongyi, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4,69% and 4.75% at March 31, 2010 and December 31, 2009, respectively), and unsecured	$	763,911	$	763,788
Note to Zheng Guixin, employee, due on December 30, 2015 with with variable annual interest at 80% of current bank rate (4,69% and 4.75% at March 31, 2010 and December 31, 2009, respectively), and unsecured		1,653,721		1,653,455
Note to Ma Zhaozhao, employee, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4,69% and 4.75% at March 31, 2010 and December 31, 2009, respectively), and unsecured		662,311		662,204
Note to Liu Zhongyi, CEO and director, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4,69% and 4.75% at March 31, 2010 and December 31, 2009, respectively), and unsecured		1,409,816		1,409,590
Note to Song Zhenghong, director and spouse of the Company Chief Executive Officer, Liu Zhong Yi, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4,69% and 4.75% at March 31, 2010 and December 31, 2009, respectively), and unsecured		580,080		579,986
Total notes payable – related parties, long term	$	5,069,839	$	5,069,023

For the three months ended March 31, 2010 and 2009, the Company recorded a total interest expense of $59,405 and $59,314 related to the above loans, respectively.

Due to related parties

The Chief Executive Officer of the Company Mr. Liu Zhongyi and his spouse and several employees of the Company, from time to time, provided advances to the Company for working capital purposes. During the three months ended March 31, 2010 and 2009, the Company did not repay any of these advances. At March 31, 2010 and December 31, 2009, the Company had a payable to its Chief Executive Officer and his spouse and other employees at an amount of $720,439 and $720,323, respectively. These advances are short-term in nature and non-interest bearing.

As mentioned in Note 6, the Company entered into a five-year loan agreement and a contract with Wu Lan, whereby the Company agreed to lend Wu Lan approximately $4 million (RMB 30 million) for the construction of a hospital ward in Inner Mongolia, China. The Company’s CEO, Mr. Liu, made this loan to Wu Lan on behalf of the Company. In return, the Company entered into an assignment agreement whereby the Company assigned all of its rights, obligations, and receipts under the Loan Agreement to Mr. Liu, except the rights to receive revenues from the sale of medical and disposable medical treatment apparatus. Since Mr. Liu accepted the assignment with all the risks and obligations but had no right to revenues from the sale of medical and disposable medical treatment apparatus, the Company agreed to pay Mr. Liu compensation for an aggregate of approximately $1.3 million (RMB 9 million) in 5 equal annual installments of approximately $263,000 (RMB 1.8 million) started from October 21, 2006.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7 – RELATED PARTY TRANSACTIONS (Continued)

Due to related parties (continued)

For the three months ended March 31, 2010 and 2009, the Company did not pay anything to Mr. Liu for the liability incurred by the assignment in the agreement mentioned above. At March 31, 2010 and December 31, 2009, amounts due under this assignment agreement were $1,033,758 and $1,033,592 respectively, of which $197,481 and $263,266 were included in long-term liabilities and has been included in due to related parties on the accompanying balance sheets, respectively.

At March 31, 2010 and December 31, 2009, the Company has recorded accrued interest relating to notes payable - related parties of $662,338 and $602,836, respectively, which have been included in due to related parties – non-current on the accompanying balance sheets. The accrued and unpaid interest relating to notes payable will be paid in full on the due date of the notes in accordance with the loan agreement. Therefore, the accrued interest is long-term in nature.

During the period from January 1, 2010 to March 31, 2010, the Chief Executive Officer of the Company, Mr. Liu Zhongyi, from time to time, made payments to various unrelated third parties on behalf of the Company. At March 31, 2010, the Company had a payable to its Chief Executive Officer at an amount of $111,291.

For the three months ended March 31, 2010, a summary of activities in due to related parties is as follows:

		Assignment fee payable		Working capital advances		Accrued interest		Payments made on behalf of the Company		Total
Balance- December 31, 2009	$	1,033,592	$	720,323	$	602,836	$	—	$	2,356,751
Additions		—		—		59,405		111,291		170,696
Payments made		—		—		—		—		—
Foreign currency fluctuations		166		116		97		—		379
Balance- March 31, 2010	$	1,033,758	$	720,439	$	662,338	$	111,291	$	2,527,826

NOTE 8 – CONVERTIBLE REDEEMABLE PREFERRED STOCKS

On February 25, 2008 (“Closing Date”), the Company sold, pursuant to a Convertible Redeemable Preferred Share and Warrant Purchase Agreement (the “Purchase Agreement”) by and among the Company, Dr. Liu Zhongyi and Mrs. Song Zhenghong (the “Founders”), and accredited investors (each a “Purchaser” and collectively, the “Purchasers”), 5,747,118 shares of the Company’s Series A Convertible Redeemable Preferred Stock (the “Preferred Stock”) and warrants (the “Warrants”) to purchase 2,873,553 shares of the Company’s common stock, in a private placement (the “February 2008 Private Placement”) pursuant to Regulation D under the Securities Act of 1933, for an aggregate purchase price of $5 million (the “Transaction”). Net proceeds, exclusive of expenses of the transaction were $4.6 million in cash, after the Company paid fees of approximately $469,000 in cash, of which $400,000 was paid to Maxim Group, LLC, the placement agent for the Transaction. The Company recorded $796,133 in fees, of which $327,565 was related to the value of the warrants granted to the placement agent, as a deferred debt cost and amortized approximately $52,226 and $99,517 of the deferred cost during the three months ended March 31, 2010 and 2009, respectively. The convertible redeemable preferred stock is deemed debt due to the mandatory redeemable feature of the Preferred Stock according to ASC 480 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity".

The Company used $2,576,556 of the net proceeds of the Transaction to repay in full all of its outstanding principal obligations including accrued interest under the 14% Secured Convertible Notes due February 2008, and the Company used the remainder of the net proceeds for working capital and general corporate purposes.

Pursuant to the Purchase Agreement, the Company issued to the Purchasers an aggregate of 5,747,118 shares of the Company’s Preferred Stock, par value $0.001 per share, at a price equal to $0.87 per share (the “Preferred Shares”). Each of these Preferred Shares is convertible into one share of the Company’s common stock (as adjusted for stock splits, stock dividends, reclassification and the like), pays an 8% dividend annually, payable in additional Convertible Preferred Shares and also pays any dividend to be paid on

19

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 – CONVERTIBLE REDEEMABLE PREFERRED STOCKS (Continued)

the common shares on an as-converted basis. Until May 25, 2010, the Preferred Shares may be redeemed at the option of the Purchasers at the redemption price of $0.87 per share (as adjusted for stock splits, stock dividends, reclassification and the like), and no other capital stock of the Company may be redeemable prior to the Preferred Shares. Holders of Preferred Shares may not convert Preferred Shares to common shares if the conversion would result in the holder beneficially owning more than 4.99% of the Company’s outstanding common shares. That limitation may be waived by a holder of Preferred Shares on not less than 61 days written notice to the Company. In addition, the Company issued to the Purchasers warrants to purchase up to 2,873,553 shares of the Company’s common stock in the aggregate.

The Warrants have an exercise price of $1.21 (subject to adjustment pursuant to the terms of the warrants). The warrants are exercisable for a period of five (5) years from the closing date. Holders of the warrants may not exercise the warrants if the exercise would result in the holder beneficially owning more than 4.99% of the Company’s outstanding common shares. That limitation may be waived by a holder of the warrants on not less than 61 days written notice to the Company. 

The warrants issued to the investors to purchase 2,873,553 shares of the Company’s common stock were treated as a discount on the convertible redeemable preferred stocks and were valued at $1,188,926 and will be amortized over the term of the Purchase Agreement. Additionally, the convertible redeemable preferred stocks were considered to have an embedded beneficial conversion feature (BCF) because the effective conversion price was less than the fair value of the Company’s common stock. The value of the beneficial conversion feature was $1,121,337 and was recorded as a discount on the convertible redeemable preferred stocks and will be amortized over the term of the Purchase Agreement. Hence, in connection with the issuance of the Preferred Shares and Warrants, the Company recorded a total debt discount of $2,310,263 to be amortized over the term of the convertible preferred stocks. For the three months ended March 31, 2010 and 2009, amortization of debt discount amounted to $151,553 and $288,783, respectively, have been included in interest expense.

The fair value of the warrants granted to the placement agent and issued to the investors with the private placement was computed using the Black-Scholes option-pricing model. Variables used in the option-pricing model include (1) risk-free interest rate at the date of grant (4.64%), (2) expected warrant life of 5 years, (3) expected volatility of 91.85%, (4) expected dividend yield of 0 and (5) grant date share fair value of $0.81.

Other key provisions of the February 2008 Private Placement:

· The Preferred Shares vote with the common stock on an as converted basis, except that the Preferred Shares are not entitled to vote for directors. The Company is prohibited from taking certain corporate actions, including, without limitation, issuing securities senior to the Preferred Shares, selling substantially all assets, repurchasing securities and declaring or paying dividends, without the approval of the holders of a majority of the Preferred Shares then outstanding.

· The Company agreed to undertake to file a resale registration statement within 60 days following the Closing Date registering the maximum number of shares common stock issuable upon conversion of the Preferred Shares and exercise of the warrants allowable under applicable federal securities regulations. If the Company was informed by the SEC that there were no comments to the registration statement, then the registration statement was required to be declared effective within five (5) business days thereafter or on the 60th day after the filing date, whichever is sooner. If the SEC issued comments to the registration statement, then the registration statement was required to be declared effective by the 120th day after it was filed. If the registration statement was not declared effective by the applicable date, the Company would be subject to liquidated damages, equal to 1% of the total conversion price and exercise price for the common stock being registered under the registration statement, for every 30-day period following the date that the registration statement should have been effective, prorated for any period less than 30 days, until either all of common shares registered under the registration statement have been sold or all such common shares may be sold in any three (3) month period pursuant to Rule 144 promulgated under the Securities Act, whichever is earlier. The Company must also pay the liquidated damages if sales cannot be made pursuant to the registration statement for any reason (excepting market conditions). The maximum amount of liquidated damages is $500,000. The Company filed the resale registration statement on May 13, 2008 and received comments from the SEC. The SEC declared the resale registration statement effective on July 25, 2008.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 – CONVERTIBLE REDEEMABLE PREFERRED STOCKS (Continued)

· The Founders delivered in the aggregate 7,500,000 shares of the Company’s common stock owned by them (the “Escrow Shares”) to an escrow account. Portions of the Escrow Shares are being held in escrow subject to the Company meeting certain net income targets in fiscal years 2007, 2008 and 2009. The target for 2007 is $8.5 million in net income. The target for 2008 is 95% of $13.8 million in net income after eliminating the effect of non-cash charges associated with the Transaction and adjusting for differences in the exchange rate between Chinese Renminbi and US dollars used in the Company’s 2008 financial statements and an exchange rate of RMB 7.30 to USD 1.00. The target for 2009 is 95% of $17.5 million in net income after eliminating the effect of non-cash charges associated with the Transaction and adjusting for differences in the exchange rate between Chinese Renminbi and US dollars used in the Company’s 2009 financial statements and an exchange rate of RMB 7.30 to USD 1. A portion of the Escrow Shares will be transferred to the Purchasers if the Company does not meet the earning targets, and released back to the Founders if the Company does; another portion of the Escrow Shares is being held in escrow subject to the Company listing on the NASDAQ Stock Market within 18 months following the Closing Date. These Escrow Shares will be transferred to the Purchasers if the listing is not completed within that time period, and released back to the Founders if it is. These net income targets for 2007, 2008 and 2009 were achieved by the Company. In September 2009, a total of 416,667 Escrow Shares subject to the Company listing on the NASDAQ Stock Market within 18 months following the Closing Date were transferred to the Purchasers since the listing was not completed within that time period. The Company valued these Escrow Shares transferred to the Purchasers at the fair value on the transfer date at $0.81 per share or an aggregate of $337,500. In connection with transfer of the 416,667 shares of the Company’s common stock, the Company recorded interest expense of $337,500 with a corresponding credit to additional paid-in capital of $337,500. In addition, two-thirds of the Escrow Shares are held in escrow to ensure that the Purchasers receive their full redemption payments if they choose to redeem their Preferred Shares. If a Purchaser receives less than the full redemption amount for each Preferred Share being redeemed, the Purchaser will receive a number of Escrow Shares to make up the difference, based on the then-current market price of the common shares. Following the end of the redemption period, these Escrow Shares, less those transferred to any Purchasers that redeemed their Preferred Shares, will be released back to the Founders.

In fiscal year 2008, the Company evaluated whether or not the Preferred Stock contains embedded conversion options, which meet the definition of derivatives under ASC 815 “Accounting for Derivative Financial Instruments and Hedging Activities” and related interpretations. The Company concluded that since the Preferred Stock had a fixed redemption price of $0.87, the convertible redeemable preferred stock was not a derivative instrument.

On February 25, 2009, the Company issued 459,772 additional shares of Preferred Stock to the holders of Series A Preferred Stock for the first mandatory 8% annual dividends.

During the period from May 1, 2009 to December 31, 2009, the Company issued 36,925 shares of Preferred Stock to certain of its Series A preferred stockholders for their mandatory dividends since they fully converted their convertible redeemable preferred stock into common stock.

During the fiscal year 2009, 1,275,856 shares of Preferred Stock were converted into 1,275,856 shares of the Company’s common stock.

On February 25, 2010, the Company issued 369,319 additional shares of Preferred Stock to the holders of Series A convertible redeemable preferred stock for the second mandatory 8% annual dividends of $321,308. The price of the Preferred Stock was $0.87 per share which was less than the market price of the Company's common stock on February 25, 2010 and each of these Preferred Shares was convertible into one share of the Company's common stock (as adjusted for stock splits, stock dividends, reclassification and the like). We recognized the beneficial conversion feature as an interest expense of $184,660, representing the difference between the fair market value of the 369,319 shares of the Preferred Stock, determined on an "as if converted" basis, and the price of the 369,319 shares of the Preferred Stock ($321,308) with a corresponding credit to additional paid-in capital of $184,660

During the period from January 1, 2010 to March 31, 2010, 2,489,655 shares of Preferred Stock were converted into 2,489,655 shares of the Company’s common stock.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 – CONVERTIBLE REDEEMABLE PREFERRED STOCKS (Continued)

The Preferred Stock at March 31, 2010 and December 31, 2009 was as follows:

		March 31, 2010		December 31, 2009
Series A convertible redeemable preferred stock	$	2,477,433	$	4,322,125
Less: unamortized discount		—		(151,553)
Series A convertible redeemable preferred stock, net	$	2,477,433	$	4,170,572

The discount on the Preferred Stock was fully amortized over the term of the convertible redeemable preferred stock. Under the designations of related agreements, rights and preferences of the Preferred Stock, the Company can be required to redeem the Preferred Stock at the option of the holder for a period of 90 days beginning on February 25, 2010. The redemption price which is equal to $0.87 per share plus any accrued but unpaid dividends must be paid in cash, in one lump sum within one month from the end of the 90 day period.

NOTE 9 – TAXES PAYABLE

Income Tax  

The Company is subject to income taxes on an entity basis on income arising in or derived from the tax jurisdiction in which each entity is domiciled.

TheCompany was incorporated in the United States and has incurred a net operating loss for income tax purposes for the three months ended March 31, 2010. The Company had estimated loss carry forwards of approximately $4,240,000 and $3,683,000 as of March 31, 2010 and December 31, 2009, respectively, subject to the Internal Revenue Code Section 382, which places a limitation on the amount of taxable income that can be offset by net operating losses after a change in ownership. The net operating loss carry forwards for United States income taxes, which may be available for offset against future taxable U.S. income expire in 2030 and 2029, respectively.

Management believes that the realization of the benefits from these losses carryforward appears uncertain due to the Company's limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero. Management will review this valuation allowance periodically and make adjustments as needed. The valuation allowance at March 31, 2010 and December 31, 2009 was approximately $1,442,000 and $1,252,000, respectively. The net change in the valuation allowance was an increase of approximately $190,000 during the three months ended March 31, 2010. The consolidated income is earned overseas and will continue to be indefinitely reinvested in oversea operations. Accordingly, no provision has been made for U.S. deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if we concluded that such earnings will be remitted in the future.

Deferred tax assets and liabilities are provided for significant income and expense items recognized in different years for income tax and financial reporting purposes. Temporary differences, which give rise to a net deferred tax asset for the Company as of March 31, 2010 and December 31, 2009 is as follows:

	March 31, 2010			December 31, 2009
Tax benefit of net operating loss carryforward	$	1,442,000		$	1,252,000
Valuation allowance		(1,442,000	)		(1,252,000	)
Net deferred tax asset	$	—		$	—

Lotus Pharmaceutical International, Inc. was incorporated in the United States and it was an affiliated group of Lotus Pharmaceuticals Inc. for United States income tax purpose. So, no income tax provision was made for Lotus Pharmaceutical International, Inc.

Lotus Century Pharmaceutical (Beijing) Technology Co., Ltd. and Lotus East were incorporated in the PRC and are subject to PRC income tax which is computed according to the relevant laws and regulations in the PRC.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9 – TAXES PAYABLE (Continued)

Lotus Century Pharmaceutical (Beijing) Technology Co., Ltd. did not have any business activity for PRC income tax purpose. So, no income tax provision was made for Lotus Century Pharmaceutical (Beijing) Technology Co., Ltd.

Income Tax (continued)

Beijing Liang Fang was subject to 25% income tax rate since January 1, 2009. Located in Inner Mongolia, Liang Fang’s branch received income tax exemption for its fiscal 2010 and 2009 taxable income from the Cha You Qian Qi government situated in Inner Mongolia, P.R.C. on June 3, 2008.

The table below summarizes the differences between the U.S. statutory federal rate and the Company’s effective tax rate for the three months ended March 31, 2010 and 2009:

	2010	2009
US statutory rates	34%	34%
Foreign income not recognized in the US	(34%)	(34%)
China statutory rates	25%	25%
China income tax exemption	(22.97%)	(22.95%)
Effective income tax rates	2.03%	2.05%

Value Added Tax  

Enterprises or individuals who sell commodities, engage in repair and maintenance or import and export goods in the PRC are subject to a value added tax, or VAT, in accordance with Chinese laws. The applicable VAT tax rate is 17% for products sold in the PRC. The amount of VAT liability is determined by applying the applicable tax rate to the invoiced amount of goods sold (output VAT) less VAT paid on purchases made with the relevant supporting invoices (input VAT).

VAT on sales and VAT on purchases amounted to $2,507,555, and $189,519 for the three months ended March 31, 2010 and $1,883,463 and $267,332 for the three months ended March 31, 2009, respectively. Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent because the VAT taxes are not impacted by the income tax holiday. As of March 31, 2010 and December 31, 2009, the VAT payable amounted to $977,967 and $2,411,459, respectively.

At March 31, 2010 and December 31, 2009, taxes payable are as follows:

		March 31, 2010		December 31, 2009
Value added tax payable	$	977,967	$	2,411,459
Corporation income tax payable		471,143		368,878
Other taxes payable		1,032,698		351,571
Total	$	2,481,808	$	3,131,908

NOTE 10 – STOCKHOLDERS’ EQUITY

Common Stock and Additional Paid-in Capital

In January 2010, the Company issued an aggregate of 659,113 shares of common stock to Longview Fund LP for its cashless exercise of 1,315,000 warrants at the exercise price of $0.87 per warrant.

In January 2010, the Company issued McLaughlin & Stern, LLP, warrants to purchase 150,000 shares of common stock at an exercise price of $1.91 per share in connection with legal services rendered.

In March 2010, the Company issued YA Global Master SPV Ltd. (“YA”) an aggregate of 208,117 shares of its common Stock as a commitment fee of $300,000 in connection with a Standby Equity Distribution Agreement entered into with YA. The shares were valued at the fair value on the grant date.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10 – STOCKHOLDERS’ EQUITY (Continued)

Common Stock and Additional Paid-in Capital (continued)

In March 2010, the Company issued Gragnola Limited an aggregate of 200,000 shares of common stock in connection with corporate affairs and development services to be rendered. The shares were valued at the fair value of $1.38 per share on the grant date. In connection with the issuance of these shares, the Company recorded prepaid expenses of $276,000 and will amortize it over the service period. For the three months ended March 31, 2010, the amortization expense related to this issuance was $23,000.

On February 25, 2010, the Company issued 369,319 additional shares of Preferred Stock to the holders of Series A convertible redeemable preferred stock for the second mandatory 8% annual dividends of $321,308. The price of the Preferred Stock was $0.87 per share which was less than the market price of the Company's common stock on February 25, 2010 and each of these Preferred Shares was convertible into one share of the Company's common stock (as adjusted for stock splits, stock dividends, reclassification and the like). We recognized the beneficial conversion feature as an interest expense of $184,660, representing the difference between the fair market value of the 369,319 shares of the Preferred Stock, determined on an "as if converted" basis, and the price of the 369,319 shares of the Preferred Stock ($321,308) with a corresponding credit to additional paid-in capital of $184,660 (see note 8).

During the period from January 1, 2010 to March 31, 2010, the Company issued an aggregate of 2,489,655 shares of common stock to various Series A convertible redeemable preferred stockholders in connection with the conversion of 2,489,655 shares of Series A preferred stock.

In 2010, the Chief Executive Officer of the Company made payments of $80,000 on behalf of the Company as financing costs in connection with a Standby Equity Distribution Agreement entered into with YA. The Company recorded the financing costs as Additional Paid-in Capital.

Statutory Surplus Reserves  

The Company is required to make appropriations to statutory surplus reserve, based on after-tax net income determined in accordance with generally accepted accounting principles of the PRC (“PRC GAAP”). Appropriations to the statutory surplus reserve is required to be at least 10% of the after tax net income determined in accordance with PRC GAAP until the reserve is equal to 50% of the entities’ registered capital.

The statutory surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of shares currently held by them, provided that the remaining statutory surplus reserve balance after such issue is not less than 25% of the registered capital.

Pursuant to the Company’s articles of incorporation, the Company is to appropriate 10% of its net profits as statutory surplus reserve. For the three months ended March 31, 2010, statutory surplus reserve activity was as follows:

		Statutory Surplus Reserve
Balance – December 31, 2009	$	5,674,324
Addition to statutory reserves		565,878
Balance – March 31, 2010	$	6,240,202

Stock Warrants  

Stock warrants issued, terminated/forfeited, exercised and outstanding during the three months ended March 31, 2010 were as follows:

	Shares			Average Exercise Price per share
Warrants outstanding, December 31, 2009		5,166,999		$	1.13
Warrants granted		150,000			1.91
Warrants expired/forfeited		—			—
Warrants exercised		(1,315,000	)		0.87
Warrants outstanding, March 31, 2010		4,001,999		$	1.24

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10 – STOCKHOLDERS’ EQUITY (Continued)

Stock Warrants (continued)

The following table summarizes the shares of the Company’s common stock issuable upon exercise of warrants outstanding at March 31, 2010:

Warrants Outstanding						Warrants Exercisable
	Range of Exercise Price	Number Outstanding at March 31, 2010	Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price	Number Exercisable at March 31, 2010		Weighted Average Exercise Price
$	0.87	125,000	1.87	$	0.87	125,000	$	0.87
	1.20	2,873,553	2.91		1.20	2,873,553		1.20
	1.21	603,446	2.91		1.21	603,446		1.21
	1.50	250,000	1.82		1.50	250,000		1.50
$	1.91	150,000	4.78		1.91	150,000		1.91
		4,001,999	2.88	$	1.24	4,001,999	$	1.24

NOTE 11 – SEGMENT INFORMATION

The following information is presented in accordance with ASC 280, Disclosure about Segments of an Enterprise and Related Information. In the three months ended March 31, 2010 and 2009, the Company operated in two reportable business segments: (1) the manufacture and distribution of pharmaceutical products and examination of other companies’ products and (2) the retailing of traditional and Chinese medicines and supplies through ten drug stores located in Beijing China and other ancillary revenues generated from retail locations such as rental income. The Company’s reportable segments are strategic business units that offer different products. They are managed separately based on the fundamental differences in their operations.

Information with respect to these reportable business segments for the three months ended March 31, 2010 and 2009 was as follows:

For the three  months ended March 31, 2010		Wholesale and third-party manufacturing and examination		Retail operations		Rent		Unallocated		Total
Net revenues	$	11,498,086	$	3,252,392	$	198,434	$	—	$	14,948,912
Cost of sales		3,913,198		2,319,517		10,914		—		6,243,629
Operating expenses		—		—		—		3,190,810		3,190,810
Other expense (income)		—		—		—		483,348		483,348
Income tax		—		—		—		102,207		102,207
Net income	$	7,584,888	$	932,875	$	187,520	$	(3,776,365)	$	4,928,918

For the three months ended March 31, 2009		Wholesale and third-party manufacturing and examination		Retail operations		Rent		Unallocated		Total
Net revenues	$	9,488,971	$	2,137,188	$	198,128	$	—	$	11,824,287
Cost of sales		3,665,352		1,509,909		10,897		—		5,186,158
Operating expenses		—		—		—		2,449,005		2,449,005
Other expense (income)		—		—		—		546,295		546,295
Income tax		—		—		—		74,727		74,727
Net income	$	5,823,619	$	627,279	$	187,231	$	(3,070,027)	$	3,568,102

The Company does not allocate selling expenses, research and development expenses, general and administrative expenses, other expense (income) and income tax to its reportable segments, because these activities are managed at a corporate level.

Asset information by reportable segment is not reported to or reviewed by the chief operating decision maker and, therefore, the Company has not disclosed asset information for each reportable segment. Substantially all of the Company’s assets are located in China.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12 – COMMITMENTS AND CONTINGENCIES

Technology Transfer Agreement

In April 2008, one of the Company’s affiliates, En Ze Jia Shi, entered into a Technology Transfer Agreement with Dong Guan Kai Fa Biological Medicine LTD (“Dong Guan”) pursuant to which Dong Guan agreed to transfer the technology material, new medicine research and rights to the Chinese patent of the anti-asthma new medicine R-BM to En Ze Jia Shi on an exclusive basis in exchange for a transfer technology fee of approximately $7.02 million (RMB 48 million) to be paid at various intervals. Under the terms of the agreement, En Ze Jia Shi is obligated to:

• complete the filing with the SFDA of the medicine’s clinical research ratification document,

• complete the clinical research,

• complete the medicine’s trial production, and

• provide raw materials and formulation related documentation and apply for the new medicine certification and production approval.

In addition to the payment of the technology transfer fee, En Ze Jia Shi is responsible for paying all costs associated with its responsibility under the agreement which are presently estimated at $11.7 million (RMB 80 million). Lotus East intends to use its working capital to fund the project costs.

Dong Guan is responsible for preparing and transferring the clinical research and application documents as well as assisting En Ze Jia Shi in the completing the clinical research and applying for the new medicine certification and production approval documents.

Under the terms of the agreement, the technology transfer fee is to be paid upon the following schedule: 

• Approximately $1.46 million (RMB 10 million) is due by the 15th business day following the receipt of the processing notice of the receipt of the clinical application and all related material from SFDA is received,

• Approximately $1.17 million (RMB 8 million) is due by the 10th business day after the receipt of the medicine’s clinical ratification document,

• Approximately $1.46 million (RMB 10 million) is due by the 15th business day after the medicine’s Phase I clinical study is completed and ratification from the SFDA is obtained, and

• Approximately $2.93 million (RMB 20 million) is due by the 10th business day after the medicine’s Phase II clinical study is completed and ratification from the SFDA is obtained.

En Ze Jia Shi paid Dong Guan a deposit of approximately $2.93 million (RMB 20 million) in April 2008 which is to be returned to En Ze Jia Shi within 10 days after the transfer technology fee is fully paid. In the event Dong Guan should be unable to timely return the deposit, it will pay En Ze Jia Shi a late fee and En Ze Jia Shi is entitled to damages for Dong Guan’s failure to timely return the deposit.

The intellectual property arising from the agreement will be jointly shared by the parties. In addition, En Ze Jia Shi has guaranteed that both parties must jointly apply for related government grants prior to when the new medicine is marketed. Upon receipt of the government grants En Ze Jia Shi guaranteed that the grant monies will be shared equally by both parties. As of March 31, 2010, the Company has not received any government grant. The agreement can be terminated by Dong Guan if En Ze Jia Shi should fail to make any of the aforedescribed payments in which event the patent rights would revert to Dong Guan and it is entitled to transfer the project rights to a third party.

26

LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12 – COMMITMENTS AND CONTINGENCIES (Continued)

New Manufacturing Facility

In June 2008, one of the Company’s affiliates, Liang Fang, entered into an agreement with Cha You Qian Qi Economy Commission, a governmental agency (“Cha You”) related to the construction of a pharmaceutical plant in Cha You’s Cha Ha Er Industrial Garden District in Inner Mongolia. The new facility, which will be comprised of approximately 40,000 square meters situated on 600 MU of land (approximately 400,200 square meters), will be used to expand Liang Fang’s current manufacturing capacity. The Company was subsequently granted the right to expand the land use right area to 1,000 MU (approximately 667,000 square meters). The new facility, which will manufacture medical injection products, including 0.9% physiological saline injection, hydroxyethyl starch 130/0.4 injection and hydroxyethyl starch 200/0.5 injection, Qiang Yi Ji starch, a medical corn starch commonly known as O-2-hydeoxyethyl starch, dextran and additional pharmaceuticals, will require a total investment of RMB 623.66 million, or approximately $91 million. The construction began on the project in August 2008 and the Company anticipates that it will take five years to complete the construction. As of March 31, 2010, the Company has incurred approximately $39.7 million related to this project and the amount has been included as construction in progress of approximately $7 million and intangible assets of approximately $32.7 million in the consolidated financial statements.

Included in the total cost of the project is land cost of approximately $32.7 million (RMB 223.66 million) which was paid in full to Cha You government. Other components of the project include construction costs of approximately $17.6 million (RMB 120 million) costs associated with the various production lines estimated at approximately $33.6 million (RMB 230 million) and working capital of approximately $7.3 million (RMB 50 million).

Liang Fang intends to use its present working capital together with bank loans and government grants and third party finance to fund the project. The funds are required to be invested over the next five years. As of March 31, 2010, Liang Fang has paid approximately $39.4 million (approximately RMB 269.5 million) of the total investment. Liang Fang, however, has not secured either the bank loans or government grants and does not have sufficient working capital to complete this project without securing substantial funds from those third party sources.

Under the terms of the agreement, Cha You agreed to abate fees associated with water resources, waste and other relative supplies for a period of 30 years and agreed to ensure that the land use tax to be paid by Liang Fang after it begins normal production will be at the lowest tax rate imposed for five years. Once the project is completed, for a period of eight years the local reserved portion of the imposed corporation income tax will be returned to Liang Fang.

New Drug Patent Transfer Agreement

In February 2009, one of the Company’s  affiliates, En Ze Jia Shi, entered into a New Drug Patent Transfer Agreement with Beijing Huicheng Ruixiang Pharmaceutical Technology Co. LTD (“Huicheng”) pursuant to which Huicheng agreed to transfer the patent technology and related research materials about the Chinese drug of Gliclazide-Controlled Released Tablets to En Ze Jia Shi on an exclusive basis in exchange for a transfer patent fee of approximately $1.3 million (RMB 9 million) to be paid at various intervals. Under the terms of the agreement, En Ze Jia Shi is obligated to:

• Finishing other needed related technical materials of this new medicine and providing the legal invoice for raw materials and purchase agreement etc.,

• Providing enough raw materials, to enable Huicheng to prepare new medicine of 100,000 dosage units, and standard samples for experiments and research,

• Providing the choice basis and quality standards of the package materials,

• Paying for organization, seal, signature, field-exam, registration and related fees including registration and examination fees, registration evaluation fees etc. for the new medicine registration materials,

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12 – COMMITMENTS AND CONTINGENCIES (Continued)

New Drug Patent Transfer Agreement (continued)

• Completing clinical research and paying related fees if the new medicine is required for clinical research, and

• Making payment to Huicheng according to specific schedule mentioned in the agreement.

In addition to the payment of the patent transfer fee, En Ze Jia Shi is responsible for paying all costs associated with its responsibility under the agreement which are presently estimated at approximately $293,000 million (RMB 2 million). Lotus East intends to use its working capital to fund the project costs.

Huicheng Ruixiang Pharmaceutical Technology Co. Ltd. is obligated to

• Provide the patent of the new medicine,

• Provide the related technical materials and the original records of the experiments which satisfy the requirement of the fifth classified chemical drug registration by Drug Registration Administration Method (2005) issued by Chinese SFDA. The Huicheng has to provide above mentioned materials to En Ze Jia Shi in 30 days after it received first installment payment and qualified documents from En Ze Jia Shi,

• Provide the new medicine registration samples with 100,000 dosage units, and

• Supplement and improve the technical materials according to the requirement of the Evaluation Center of Chinese State Drug Administration.

Under the terms of the agreement, the technology transfer fee is to be paid upon the following schedule: 

• Approximately $0.9 million (RMB 6 million) is due by the 90^th business day following the receipt of the Notice of China Accepted Patent and Notice of Medicine Registration Application,

• Approximately $0.2 million (RMB 1.5 million) is due by the 30^th business day after the receipt of the medicine’s clinical ratification document, and

• Approximately $0.2 million (RMB1.5 million) is due by the 30^th business day after the production ratification from the SFDA is obtained.

En Ze Jia Shi made the first installment of approximately $0.9 million (RMB 6 million) to Huicheng in May 2009 which is to be returned to En Ze Jia Shi if it can not obtain the production ratification from the SFDA due to any fault caused by Huicheng.

Employee Severance Payment

The Company's operations are carried out in the PRC and the Company does not have any employee in USA. The Company does not have any contingent liability for severance payment for employees who work for the Company over two years.

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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 13 – CONCENTRATIONS OF MAJOR CUSTOMERS AND SUPPLIERS

Customers

During the three months ended March 31, 2010 and 2009, no customer accounted for more than 10% of the Company’s total sales.

Suppliers

Two major suppliers provided approximately 31% of the Company’s purchases of raw materials and third party manufactured finished goods for the three months ended March 31, 2010 and the Company did not have any amount of advance to this supplier as of March 31, 2010. During the three months ended March 31, 2009, no supplier accounted for more than 10% of the Company’s total purchases.

NOTE 14 – SUBSEQUENT EVENT

In April 2010, 2,133,447 shares of the Company’s common stock were issued in connection with the conversion of 2,133,447 shares of convertible redeemable preferred stock.

The Company has performed an evaluation of subsequent events through May 13, 2010, the date these consolidated financial statements were issued.

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Item 2.      Management's Discussion and Analysis of Financial Condition and Results of Operations.

Overview

We develop, manufacture, and sell pharmaceuticals in the PRC. We produce medicine and drugs in forms of tablets, capsules, granules, eye-drops, and freeze-dried powder injection. We have established markets for several drugs that are self-branded or self-patented, including (i) Maixin - valsartan capsules for the treatment of hypertension, (ii) Muxin – eye drops for the treatment of glaucoma and (iii) Yipubishan - octreotide Acetate Injection solution for the treatment of gastric ulcers. Our drug development is focused on the treatment of cerebro-cardiovascular disease, asthma, and diabetes. We have a nationwide sales network to directly and indirectly sell to hospitals, clinics and drugs stores in approximately 30 provinces in China. Additionally, through our 10 retail pharmacy locations in Beijing, China, we sell traditional Chinese and American medications and medical treatment equipment.

To be in compliance with China’s regulations on foreign ownership in the pharmaceutical industry and to consolidate the financial statements of our operating entities in Lotus East, we operate our business in China through the Contractual Arrangements with Lotus East. The contractual relationship among the above companies as follows:

The term of Contractual Arrangements was approved and extended by the board of directors in April 2010 from 10 years to 30 years, i.e. 2006-2036.

Based in Beijing, China, Lotus East is engaged in development, manufacture, and selling pharmaceuticals in the PRC. Lotus East produces medicine and drugs in forms of tablets, capsules, granules, eye-drops, and freeze-dried powder injection. Lotus East has established markets for several drugs that are self-branded or self-patented, including: (i) Maixin - Valsartan capsules for the treatment of hypertension, (ii) Muxin – eye drops for the treatment of glaucoma and (iii) Yipubishan - Octreotide Acetate Injection solution for the treatment of gastric ulcers. Lotus East’s drug development is focused on the treatment of cerebro-cardiovascular disease, asthma, and diabetes. Lotus East has a nation-wide sales network to directly and indirectly sell to hospitals, clinics and drug stores in 30 provinces in China. Additionally, through our 10 retail pharmacy locations in Beijing, China, Lotus East sells Western and traditional Chinese medications, leases medical treatment facilities to licensed physicians, and generates revenues from the leasing of retail space to third party vendors at its retail stores.

When used in this section, and except as may be set forth otherwise, the terms "we," "us," "ours," and similar terms includes Lotus and its subsidiary Lotus International as well as Lotus East.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses, fair valuation of stock related to stock-based compensation, etc. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the financial statements.

VARIABLE INTEREST ENTITIES

We have adopted ASC 810 “Consolidation of Variable Interest Entities” (“ASC 810”), an Interpretation of Accounting Research Bulletin No. 51. ASC 810 requires a Variable Interest Entity (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. VIEs are those entities in which we, through contractual arrangements, bear the risks of, and enjoy the rewards normally associated with ownership of the entities, and therefore we are the primary beneficiary of these entities. As a VIE, Lotus East’s revenues are included in our total revenues, Lotus East’s income from operations is consolidated with ours, and our net income includes all of Lotus East’s net income.

REVENUE RECOGNITION

Product sales are generally recognized when title to the product has transferred to customers in accordance with the terms of the sale. The Company recognizes revenue in accordance with the SEC Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition in Financial Statements” as amended by SAB No. 104 (together, “SAB 104”), and ASC 605 “Revenue Recognition When Right of Return Exists.” SAB 104 states that revenue should not be recognized until it is realized or realizable and earned. In general, the Company records revenue when persuasive evidence of an arrangement exists, services have been rendered or product delivery has occurred, the sales price to the customer is fixed or determinable, and collectability is reasonably assured.

ASC 605 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if the seller’s price to the buyer is substantially fixed or determinable at the date of sale, the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, the buyer acquiring the product for resale has economic substance apart from that provided by the seller, the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and the amount of future returns can be reasonably estimated.

PRODUCT RETURNS

The Company accounts for sales returns in accordance with Statements of ASC 605, Revenue Recognition When Right of Return Exists, by establishing an accrual in an amount equal to its estimate of sales recorded for which the related products are expected to be returned. The Company determines the estimate of the sales return accrual primarily based on historical experience regarding sales returns, but also by considering other factors that could impact sales returns. These factors include levels of inventory in the distribution channel, estimated shelf life, product discontinuances, and price changes of competitive products, introductions of generic products and introductions of competitive new products. In general, for wholesale sales, the Company provides credit for product returns that are returned six months prior to and up to six months after the product expiration date. Upon sale, the Company estimates an allowance for future product returns. The Company provides additional reserves for contemporaneous events that were not known and knowable at the time of shipment. In order to reasonably estimate future returns, the Company analyzed both quantitative and qualitative information including, but not limited to, actual return rates, the level of product manufactured by the Company, the level of product in the distribution channel, expected shelf life of the product, current and projected product demand, the introduction of new or generic products that may erode current demand, and general economic and industry wide indicators. The Company also utilizes the guidance provided in SAB 104 in establishing its return estimates.

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OTHER REVENUE

Other revenues consist of (i) rental income received for the lease of retail space to various retail merchants and licensed medical practitioners; (ii) revenues received for research and development projects and lab testing jobs conducted on behalf of third party companies; and (iii) revenues received for performing third party contract manufacturing projects. We recognize revenues from leasing of space as earned from contracting third parties. We recognize revenues upon performance of any research or lab testing jobs. In connection with third-party manufacturing, the customer supplies the raw materials and we are paid a fee for manufacturing their product and revenue is recognized at the completion of the manufacturing job. Revenues received in advance are reflected as unearned revenue on the accompanying balance sheets.

ACCOUNTS RECEIVABLE

Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management judgment and estimates are made in connection with establishing the allowance for doubtful accounts. Specifically, we analyze the aging of accounts receivable balances, historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms. Significant changes in customer concentration or payment terms, deterioration of customer credit-worthiness or weakening in economic trends could have a significant impact on the collectability of receivables and our operating results. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

INVENTORIES

Inventories are stated at the lower of cost or market with cost determined under the average method. Inventory consists of raw material, packaging material, work-in-process, finished capsules, liquids, finished oral suspension powder and other western and traditional Chinese medicines and medical equipment. At least on a quarterly basis, we review our inventory levels and write down inventory that has become obsolete or has a cost basis in excess of its expected net realizable value or is in excess of expected requirements. Inventory levels are evaluated by management relative to product demand, remaining shelf life, future marketing plans and other factors, and reserves for obsolete and slow-moving inventories are recorded for amounts which may not be realizable.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost less accumulated depreciation. The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition.

In accordance with ASC 360, “Accounting for the Impairment or Disposal of Long-Lived Assets”, we examine the possibility of decreases in the value of property and equipment when events or changes in circumstances reflect the fact that their recorded value may not be recoverable. We recognize an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value.

Depreciation is calculated on a straight-line basis over the estimated useful lives of the assets. The useful lives for property and equipment are as follows:

Buildings and leasehold improvement	20 to 40 years
Manufacturing equipment	10 to 15 years
Office equipment and furniture	5 to 8 years

INTANGIBLE ASSETS

Intangible assets consist of revenue right, intellectual right, software and land use rights. Revenue right is amortized over 20 years, which is the term the Company would benefit from it. Intellectual right is being amortized over 10 years as based on the transfer agreement. Land use rights are carried at cost and charged to expense on a straight-line basis over the period the rights are granted, 40 -50 years. Software is amortized over 3 years, its estimated useful life.

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RESEARCH AND DEVELOPMENT

Research and development costs are expensed as incurred. These costs primarily consist of cost of material used and depreciation for facilities related to research and development activities and salaries paid for the development of our products and fees paid to third parties. We had no research and development expenses during the three months ended March 31, 2010.

INCOME TAXES

We are governed by the Income Tax Law of the PRC and the United States. Income taxes are accounted for pursuant to accounting standards, which is an asset and liability approach. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. A valuation allowance is provided for the amount of deferred tax assets that, based on available evidence, are not expected to be realized.

STOCK-BASED COMPENSATION

Stock based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively, the vesting period). The Accounting Standards Codification also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.

Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the vesting period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. The Company records compensation expense based on the fair value of the award at the reporting date. The awards to consultants and other third-parties are then revalued, or the total compensation is recalculated based on the then current fair value, at each subsequent reporting date.

RECENT ACCOUNTING PRONOUNCEMENTS

In August 2009, FASB issued an Accounting Standards Update (“ASU”) regarding measuring liabilities at fair value. This ASU provides additional guidance clarifying the measurement of liabilities at fair value in circumstances in which a quoted price in an active market for the identical liability is not available; under those circumstances, a reporting entity is required to measure fair value using one or more of valuation techniques, as defined. This ASU is effective for the first reporting period, including interim periods, beginning after the issuance of this ASU. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In October 2009, FASB issued an ASU regarding accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing. This ASU requires that at the date of issuance of the shares in a share-lending arrangement entered into in contemplation of a convertible debt offering or other financing, the shares issued shall be measured at fair value and be recognized as an issuance cost, with an offset to additional paid-in capital. Further, loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. This ASU is effective for fiscal years beginning on or after December 15, 2009, and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In December 2009, FASB issued ASU No. 2009-16, “Accounting for Transfers of Financial Assets”. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 166, “Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140”. The amendments in this Accounting Standards Update improve financial reporting by eliminating the exceptions for qualifying special-purpose entities from the consolidation guidance and the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, the amendments require enhanced disclosures about the risks that a transferor continues to be exposed to because of its continuing involvement in transferred financial assets. Comparability and consistency in accounting for transferred financial assets will also be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. The adoption of this ASU did not have a material impact on the Company's consolidated financial statements.

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In December, 2009, FASB issued ASU No. 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 167, “Amendments to FASB Interpretation No. 46(R)”. The amendments in this Accounting Standards Update replace the quantitative-based risks and rewards calculation for determining which reporting entity, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which reporting entity has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and: (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. An approach that is expected to be primarily qualitative will be more effective for identifying which reporting entity has a controlling financial interest in a variable interest entity. The amendments in this Update also require additional disclosures about a reporting entity’s involvement in variable interest entities, which will enhance the information provided to users of financial statements. 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. 2010-02 regarding accounting and reporting for decreases in ownership of a subsidiary. Under this guidance, an entity is required to deconsolidate a subsidiary when the entity ceases to have a controlling financial interest in the subsidiary. Upon deconsolidation of a subsidiary, an entity recognizes a gain or loss on the transaction and measures any retained investment in the subsidiary at fair value. In contrast, an entity is required to account for a decrease in its ownership interest of a subsidiary that does not result in a change of control of the subsidiary as an equity transaction. This ASU clarifies the scope of the decrease in ownership provisions, and expands the disclosures about the deconsolidation of a subsidiary or de-recognition of a group of assets. This ASU is effective for beginning in the first interim or annual reporting period ending on or after December 31, 2009. 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. 2010-01, “Accounting for Distributions to Shareholders with Components of Stock and Cash”. The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. 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. 2010-02, “Accounting and Reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification”. The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity. The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. 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 “Improving Disclosures about Fair Value Measurements”. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: (1) Transfers in and out of Levels 1 and 2. A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. (2)  Activity in Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarify existing disclosures as follows: (1) Level of disaggregating. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. (2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are 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 does not have a material impact on the Company's consolidated financial statements.

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FOREIGN CURRENCY TRANSLATION

Our financial statements are expressed in U.S. dollars and the functional currency of Lotus Pharmaceuticals, Inc., our parent company, is U.S. dollars, but the functional currency of our operating subsidiaries and affiliates is Chinese Reminbi (“RMB”). For the subsidiaries and affiliates whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the unified exchange rate at the end of the period, and equity is translated at historical exchange rates. Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income. Transactions denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing on the transaction dates with any transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. All of the Company’s revenue transactions are transacted in the functional currency. The Company does not enter any material transaction in foreign currencies and accordingly, transaction gains or losses have not had, and are not expected to have, a material effect on the results of operations of the Company.

Results of Operations

Three Months Ended March 31, 2010 Compared to Three Months Ended March 31, 2009

Total Net Revenues

Total net revenues for the three months ended March 31, 2010 were $14,948,912 as compared to total net revenues of $11,824,287 for the three months ended March 31, 2009, an increase of $3,124,625 or approximately 26.4%. For the three months ended March 31, 2010 and 2009, net revenues consisted of the following:

	Three Months Ended March 31,
	2010		2009
	(Unaudited)		(Unaudited)
Wholesale	$	11,498,086	$	8,940,405
Retail		3,252,392		2,137,188
Other revenues		198,434		746,694
Total net revenues	$	14,948,912	$	11,824,287

· For the three months ended March 31, 2010, wholesale revenues increased $2,557,681 or approximately 28.6%. In the first quarter of fiscal 2010, we added five new prescription drugs to our products delivered through our national wholesale channels. The five new prescription drugs covered by the National Health Insurance Program have proven their market acceptance. One of the five new prescription drugs is Omeprazole Enteric-coated Capsule which is for the treatment of duodenal ulcer. The other four drugs are traditional Chinese medicine in capsules, tablets and ointment for the treatment of chronic prostate infection, psoriasis, influenza and meridian pain, respectively. As a result, our wholesale revenues for the three months ended March 31, 2010 increased.  We anticipate that our wholesale revenues will continue to increase in the rest of 2010 since the newly added five prescription drugs are expected to increase our market share.

· For the three months ended March 31, 2010, retail revenues increased by $1,115,204 or 52.2%. At the end of fiscal 2009, we appointed a general manager for our Over-the-Counter Drug Division that manages our own ten drug stores' sales, and the newly created direct sales to other Over-the-Counter drug stores in Beijing. The general manager has strong management skills in medical sales and marketing and logistics and is an expert in delivery of services to drug stores in Beijing. As of the end of last fiscal year, our Over-the-Counter Drug Division successfully entered into supply contracts with more than five hundred drug stores in Beijing. All contracts have a term from one to two years and are renewable upon mutual agreement. In the first quarter of fiscal 2010, we served more than 700 other Over-the-Counter drug stores in Beijing. Due to the growth and success of our OTC Drug Division's sales force, our retail revenues for the first quarter of fiscal 2010 substantially increased. We expect our retail revenue from our own ten drug stores will remain in its current level with small growth and our retail revenue from our direct sales to other drug stores in Beijing will continue to increase in the rest of 2010.

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· For the three months ended March 31, 2010, other revenues decreased by $548,260 or approximately 73.4%. The decrease in other revenues is attributable to the following:

	Three Months Ended March 31,
	2010		2009
	(Unaudited)		(Unaudited)
Leasing revenues	$	198,434	$	198,128
Third-party manufacturing		—		513,651
Research and development and lab testing services		—		34,915
Total other revenues	$	198,434	$	746,694

· We sublease certain portions of our retail stores and counter spaces to various other vendors which generate leasing revenues. The slight increase was primarily due to the favorable RMB currency appreciation which converted our leasing revenue in RMB into higher US dollar amounts. We expect these lease revenues will maintain at its current level with minimal growth in the rest of 2010.

· For third-party manufacturing, customers supply the raw materials and we are paid a fee for manufacturing their products. For the three months ended March 31, 2010, we did not have any third-party manufacturing revenue as compared to $513,651 for the three months ended March 31, 2009, a decrease of $513,651 or 100%. Our prior customers built their own facilities and can manufacture their products at lower costs in their own factories. As a result, we did not generate any third-party manufacturing revenue in the first quarter of 2010. We do not anticipate that we will generate any third-party manufacturing revenue in the rest of 2010 since we do not expect to find any customer with third party manufacturing contracts.

· We performed research and development (“R&D”) and lab testing projects for various third parties and performed drug testing and analysis. For the three months ended March 31, 2010, we did not have any research and development and lab testing revenue as compared to $34,915 for the three months ended March 31, 2009, a decrease of $34,915 or 100%. Our historical customers for these services purchased related machinery and they can do similar R&D and lab testing in their own labs at a lower price and decided not to use our services. We do not expect that we will generate any revenue from R&D and lab testing in the rest of 2010 since we do not anticipate finding new customers with research and development and lab testing projects.

Cost of Sales

Cost of sales for our retail revenues includes packing materials, purchased third-party manufactured finished goods and related taxes. Cost of sales for our wholesale and other revenues includes direct materials, direct labor fees, manufacturing overhead such as indirect materials, indirect labor fees, utilities and depreciation indirectly related to production, and related taxes. For the three months ended March 31, 2010, our total cost of sales amounted to $6,243,629 or approximately 41.8% of total revenues as compared to cost of sales of $5,186,158 or approximately 43.9% of total revenues for the three months ended March 31, 2009. The slight decrease in cost of sales as a percentage of total revenue was primarily due to better purchase pricing management for raw material and third party manufactured finished goods as well as more efficient controls in labor fees.

Gross Profit

Gross profit for the three months ended March 31, 2010 was $8,705,283 or 58.2% of total revenues, as compared to $6,638,129 or 56.1% of total revenues for the three months ended March 31, 2009. The slight increase in gross profit margin was attributable to the decrease in cost of sales as a percentage of revenue. The decrease in cost of sales as a percentage of revenue was primarily contributed to better managed raw materials and third party manufactured finished goods purchase as well as more efficient control in labor fees. We expect that our gross profit margin will remain in its current level with slight growth in the future.

Operating Expenses

Total operating expenses for the three months ended March 31, 2010 were $3,190,810, as compared to the total operating expenses of $2,449,005 for the three months ended March 31, 2009, an increase of $741,805 or approximately 30.3%. This increase included the following:

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For the three months ended March 31, 2010, selling expenses amounted to $2,168,953 as compared to $1,701,799 for the three months ended March 31, 2009, an increase of $467,154 or approximately 27.5%. This increase is primarily attributable to the increase of our sales revenues. We expect our selling expenses will increase in the near future since we anticipate that our revenues will increase in the rest of 2010.

For the three months ended March 31, 2010, general and administrative expenses were $1,021,857, as compared to the general and administrative expenses of $747,206 for the three months ended March 31, 2009, an increase of $274,651 or approximately 36.8%. These changes were summarized below:

	Three Months Ended March 31,
		2010		2009
		(Unaudited)		(Unaudited)
Salaries and related benefits	$	156,455	$	172,100
Amortization and depreciation expenses		444,812		242,692
Rent		75,579		75,355
Travel and entertainment		—		165,651
Professional fees		310,542		41,709
Other		34,469		49,699
Total	$	1,021,857	$	747,206

The changes in these expenses from the three months ended March 31, 2010 as compared to the three months ended March 31, 2009 included the following:

· Salaries and related benefits decreased $15,645 or approximately 9.1%. The slight decrease was mainly attributable to our continuous efforts to control corporate spending. We anticipate that our salaries and related benefits will remain in its current level with minimal increase in the rest of 2010.

· Amortization of our intangible assets and depreciation on our fixed assets increased by $202,120 or approximately 83.3%, which was primarily attributable to an increase in amortization on land use rights of approximately $224,000 offset by a decrease in amortization on manufacturing right of approximately $22,000 because the manufacturing right was fully amortized in fiscal 2009.

· Rent increased $224 or approximately 0.3% which is primarily attributable to the RMB currency appreciation which converted our rent expenses in RMB into higher US dollar amounts.

· For the first quarter of fiscal 2010, we did not incur any travel and entertainment expenses as compared to $165,651 for the comparable period of fiscal 2009, a decrease of $165,651 or 100%.  During the three months ended March 31, 2010, we did not have any travel and entertainment activities, therefore, the travel and entertainment expenses for the period was zero.

· Professional fees increased $268,833 or approximately 644.5%, which was primarily attributable to an increase in fees related to our consultants’ service of approximately $223,000, an increase in fees related to our attorney’s service of approximately $12,000, an increase in fees paid for our audit service of approximately $15,000, an additional payment for internal control service of approximately $15,000 for which we did not have any corresponding expense in the comparable period of fiscal 2009 and the RMB currency appreciation which converted our professional fees in RMB into higher US dollar amounts.

· Other general and administrative expenses, which included office supplies, general management fees, car insurance, meeting expenses and other office expenses, decreased by $15,230 or approximately 30.6%  reflecting efforts at reducing non-sales related corporate activities as well as stricter controls on corporate spending.  

Income from Operations

As a result of foregoing, we reported income from operations of $5,514,473 for the three months ended March 31, 2010 as compared to income from operations of $4,189,124 for the three months ended March 31, 2009, an increase of $1,325,349 or approximately 31.6%.

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Other Expenses

For the three months ended March 31, 2010, total other expenses amounted to $483,348 as compared to other expense of $546,295 for the three months ended March 31, 2009, a decrease of $62,947 or approximately 11.5%. This change was primarily attributable to:

· For the three months ended March 31, 2010, our debt issuance costs amounted to $52,226 as compared to $99,517 for the three months ended March 31, 2009, a decrease of $47,291 or approximately 47.5%. The decrease was attributable to the decrease in amortization amount on debt issuance costs on our February 2008 financing for which we amortize on a 24-month period and began our amortization on the February 2008 debt issuance costs in March 2008. As a result, the debt issuance costs were fully amortized in February 2010. Therefore, the amortization amount on the February 2008 debt issuance costs in the first quarter of fiscal 2010 was smaller than the amortization amount on the February 2008 debt issuance costs in the first quarter of fiscal 2009.

· For the three months ended March 31, 2010, interest expense was $432,402 as compared to $448,097 for the three months ended March 31, 2009, a decrease of $15,695 or approximately 3.5%. The decrease in interest expense was primarily attributable the decrease in accrued interest for outstanding February 2008 debt.

Income Taxes

For the three months ended March 31, 2010, our income tax expense was $102,207, as compared to $74,727 for the three months ended March 31, 2009, an increase of $27,480 or approximately 36.8%.  The increase in income tax expense was mainly attributable to the increase in taxable income generated by our operating entities.

Net Income

As a result of these factors, we reported net income of $4,928,918 for the three months ended March 31, 2010 as compared to net income of $3,568,102 for the three months ended March 31, 2009. This translated to basic earnings per common share of $0.10 and $0.08, and diluted earnings per common share of $0.09 and $0.07, for the three months ended March 31, 2010 and 2009, respectively.

Other Comprehensive Income

The functional currency of our subsidiaries and affiliates operating in the PRC is the Chinese Yuan or Renminbi (“RMB”). The financial statements of our subsidiaries and affiliates are translated to U.S. dollars using period end rates of exchange for assets and liabilities, and average rates of exchange (for the period) for revenues, costs, and expenses. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations. As a result of these translations, which are a non-cash adjustment, we reported a foreign currency translation gain of $10,928 for the three months ended March 31, 2010 as compared to $62,111 for the three months ended March 31, 2009. This non-cash gain had the effect of increasing our reported comprehensive income.

Comprehensive Income

As a result of our foreign currency translation gains, we had comprehensive income for the three months ended March 31, 2010 of $4,939,846, compared with $3,630,213 for the three months ended March 31, 2009.

Liquidity and Capital Resources

Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations and otherwise operate on an ongoing basis.

At March 31, 2010 and December 31, 2009, we had a cash balance of $1,125,181 and $3,945,740, respectively. These funds are distributed in financial institutions located in China.

Our working capital position increased $3,014,169 from $(4,952,734) at December 31, 2009 to $(1,938,565) at March 31, 2010. This increase in working capital is primarily attributed to an increase in inventories of approximately $2.26 million, an increase in prepaid expenses and other assets (current portion) of approximately $0.24 million, a decrease in accounts payable and accrued expenses of approximately $0.13 million, a decrease in other payables of approximately $0.84 million, a decrease in taxes payable of approximately $0.65 million, a decrease in unearned revenue of approximately $0.37 million, a decrease in Series A convertible redeemable preferred stock of approximately $1.69 million offset by a decrease in cash of approximately $2.82 million, a decrease in accounts receivable of approximately $0.11 million and an increase in due to related parties (current portion) of approximately $0.18 million.

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As of March 31, 2010, our accounts receivable, was $1,669,704 as compared to $1,784,194 as of December 31, 2009, a decrease of $114,490. The decrease was primarily due to our strong collection effort which improved our accounts receivable age days. We expect that our accounts receivable will maintain at the current level.

As of March 31, 2010, our inventories of raw materials, packaging materials, and finished goods totaled $3,301,050, as compared to $1,039,867 as of December 31, 2009, an increase of $2,261,183. This change included a decrease of $348,541 in raw materials and an increase of $109,914 in packing materials and an increase in finished goods of $2,499,810. We expect our inventory will maintain at its current level in the near future.

As of March 31, 2010, our prepaid expenses and other assets was $2,261,076 as compared to $2,216,274 as of December 31, 2009, an increase of $44,802. The increase was primarily attributable to the increase in prepaid consulting fees of approximately $253,000 offset by the decrease in other assets of approximately $208,000.

As of March 31, 2010, we had deferred debt costs of $0 as compared to $52,226 as of December 31, 2009, a decrease of $52,226. In the February 2008 financing, the Company paid fees of $468,568 in cash and granted warrants to placement agent for the transaction. The value of the warrants granted to the placement agent was $327,565. Accordingly, we recorded a total deferred debt cost of $796,133 and started to amortize it in March 2008. The deferred debt costs were fully amortized in the first quarter of fiscal 2010. As a result, our deferred debt costs as of March 31, 2010 were zero.

As of March 31, 2010, we had a property and equipment, net of accumulated depreciation, of $21,309,774 as compared to $16,223,775 as of December 31, 2009, an increase of $5,085,999.The increase was primarily attributable to the increased purchases of approximately $5,092,000 for our construction-in-progress of Beijing office building (See note 4) and the favorable RMB currency appreciation which converted our property and equipment, net of accumulated depreciation, in RMB into higher US dollar amounts offset by the depreciation on our fixed assets of approximately $7,000 for the first quarter of fiscal 2010.

As of March 31, 2010, we had intangible assets, net of accumulated amortization, of $49,458,233 as compared to $49,888,428 as of December 31, 2009, a decrease of $430,195. The decrease was primarily attributed to the amortization on intangible assets of approximately $438,000 for the first quarter of fiscal 2010 offset by the RMB currency appreciation which converted our intangible assets, net of accumulated amortization, in RMB into higher US dollar amounts.

As of March 31, 2010, we had accounts payable and accrued expenses of $301,442 as compared to $427,924 as of December 31, 2009, a decrease of $126,482. The decrease was primarily attributable to the decrease in accrued dividend payable of approximately $285,000 offset by the increase in trade accounts payable of approximately $85,000 and the increase in accrued compensation of approximately $73,000.

As of March 31, 2010, we had other payables of $1,418,234 as compared to $2,262,760 as of December 31, 2009, a decrease of $844,526. The decrease in other payables was primarily due to the decrease in payables for sales representatives’ commission of approximately $878,000 offset by the increase in payables forother parties of approximately $33,000 in the first quarter of fiscal 2010.

As of March 31, 2010, we had a taxes payable of $2,481,808 as compared to $3,131,908 as of December 31, 2009, a decrease of $650,100. The decrease in the taxes payable was mainly due to the payments that we made to the China tax authority.

As of March 31, 2010, we had unearned revenue of $795,620 as compared to $1,163,771 as of December 31, 2009, a decrease of $368,151. The decrease was primarily attributable to the recognition of revenue on our deferred revenue in the first quarter of fiscal 2010.

At March 31, 2010, we had a $2,527,826 due to related parties as compared to $2,356,751 at December 31, 2009, an increase of $171,075. The increase was primarily attributable to the accrued and unpaid interest for the first quarter of fiscal 2010 of approximately $59,000 related to a working capital advance made to us by our CEO and his wife and a Board member and two employees and the payments made by our Chief Executive Officer on behalf of us in the first quarter of fiscal 2010 of approximately $111,000 and the RMB currency appreciation which converted our due to related parties in RMB into higher US dollar amounts.

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At March 31, 2010, we had Series A Convertible Redeemable Preferred Stock of $2,477,433 as compared to $4,170,572 at December 31, 2009, a decrease of $1,693,139. The decrease was primarily attributable to the conversion of the Series A Convertible Redeemable Preferred Stock of $2,166,000 offset by the amortization of discount on convertible redeemable preferred stock of $151,553 and the issued additional convertible redeemable preferred stock of $321,308 as dividends in the first quarter of fiscal 2010.

Our balance sheet as of March 31, 2010 also reflects notes payable to related parties of $5,069,839 due on December 30, 2015 which was a series of working capital loans made to us since December 31, 2005 by the Company’s Chief Executive Officer, his wife, two employees of the Company and a Board member. These loans bear interest based on a floating annual interest rate, which is 80% of China bank interest rate and are unsecured. During the three months ended March 31, 2010, we did not repay any portion of the principal of these loan balances.

The changes in asset and liabilities discussed above is based on a comparison of amounts on our balance sheets as of March 31, 2010 and December 31, 2009 and does not necessarily reflect changes in assets and liabilities reflected on our cash flow statement, for which we use the average foreign exchange rate during the period to calculate these changes.

Net cash provided by operating activities for the three months ended March 31, 2010 was $2,268,803 as compared to net cash provided by operating activities of $7,008,339 for the three months ended March 31, 2009. For the three months ended March 31, 2010, net cash provided by operating activities was primarily attributable to a decrease in accounts receivable of approximately $115,000, a decrease in prepaid expenses and other current assets of approximately $208,000, an increase in accounts payable and accrued expenses of approximately $195,000 and an increase in due to related parties of approximately $91,000, and the add back of net income of approximately $4,929,000, depreciation and amortization of approximately $445,000, amortization of deferred debt issuance costs of approximately $52,000, amortization of discount on convertible redeemable preferred stock of approximately $152,000, interest expense attributable to beneficial conversion feature of preferred shares of approximately $185,000 and stock-based compensation of approximately $23,000 offset by an increase in inventories of approximately $2,261,000, a decrease in other current payables of approximately $845,000, a decrease in taxes payable of approximately $651,000 and a decrease in unearned revenue of approximately $368,000. For the three months ended March 31, 2009, net cash provided by operating activities was attributable primarily to a decrease in accounts receivable of approximately $4,745,000, a decrease in inventories of approximately $66,000, a decrease in prepaid expenses and other current assets of approximately $1,329,000 and an increase in unearned revenue of approximately $228,000 and the add back of net income of approximately $3,568,000, depreciation and amortization of approximately $362,000, amortization of debt issuance costs of approximately $100,000, amortization of discount on convertible redeemable preferred stock of approximately $289,000, amortization of prepaid expense attributable to warrants of approximately $15,000 offset by a decrease in accounts payable and accrued expenses of approximately $667,000 and a decrease in taxes payable of approximately $3,027,000.

Net cash used in investing activities for the three months ended March 31, 2010 amounted to $5,090,025. For the three months ended March 31, 2010, net cash used in investing activities was attributable to the purchase of property and equipment of approximately $5,090,025. For the three months ended March 31, 2009, net cash used in investing activities was attributable to the payments on intangible assets of approximately $4,966,000 and the purchase of property and equipment of approximately $2,153,000.

Net cash provided by financing activities was $0 for the three months ended March 31, 2010.Net cash provided by financing activities was $59,314 for the three months ended March 31, 2009 and was attributable to the proceeds from related party advances of $59,314.

We reported a net decrease in cash for the three months ended March 31, 2010 of $2,820,559 as compared to a net decrease in cash of $50,039 for the three months ended March 31, 2009.

We believe that our working capital is sufficient to fund our current operations for the next 12 months. Lotus East has historically funded its capital expenditures from its working capital. Lotus East has contractual commitments for approximately $53.9 million related to a Technology Transfer Agreement and the construction of the new manufacturing facility in Inner Mongolia and a New Drug Patent Transfer Agreement. While it intends to fund the costs with its existing working capital associated with the Technology Transfer Agreement and the New Drug Patent Transfer Agreement and a portion of the construction of the new manufacturing facility, it is dependent upon the continued growth of its operations and prompt payment of outstanding accounts receivables by its customers to ensure that it has sufficient cash for these commitments. In addition, its ability to fully fund the costs associated with the new manufacturing facility is materially dependent upon its ability to obtain secured bank financing and/or government grants and/or third party finance.

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There is no guarantee that Lotus East can obtain these financings on favorable terms at the right time. Although the Chinese government has recently announced an economic stimulation plan, there is no guarantee that we will be awarded the government grants successfully. While Lotus East’s management believes the Company will be successful in securing the necessary funding through its increasing revenue, faster collections on receivables, and continuance discussions with various commercial banks, there are no assurances that the funding will be available in the amounts or at the time required to meet Liang Fang’s commitments. In the event that Lotus East is not successful in obtaining the funds it needs for the Technology Transfer Agreement and the New Drug Patent Transfer Agreement, it is possible that it could default under the terms of the two agreements and forfeit any funds paid to date. If Lotus East fails to obtain all of the funding necessary to complete the construction of the new facility in Inner Mongolia, which is estimated to be approximately $51.8 million in the next five years, it could get back approximately $39.7 million spent to date, including the approximately $32.7 million for the installments on the land use rights, which is refundable if the Chinese local government would not grant it land use rights certificate.

In addition, under the designations, rights and preferences of the Series A Convertible Redeemable Preferred Stock, the Company can be required to redeem the Series A Preferred Stock at the option of the holder for a period of 90 days beginning on February 25, 2010. The redemption price which is equal to $0.87 per share plus any accrued but unpaid dividends, must be paid in cash, in one lump sum within one month from the end of the 90 day period. Assuming that sufficient funds are available to us to pay these redemption amounts, if one or more of the holders of the Series A Convertible Redeemable Preferred Stock should elect redemption of those shares, the payment of the redemption price will materially and adversely impact our liquidity. As of the date on which this quarterly reporting is available to be filed, we anticipate that sufficient funds should be available as the aggregate redemption amount for the 714,176 shares of outstanding Series A Convertible Redeemable Preferred Stock is $621,333.

Recent Capital Raising Transaction

In order to improve our access to capital, on March 3, 2010, we entered into a Standby Equity Distribution Agreement (the “SEDA”) with YA Global Master SPV Ltd. (“YA Global”) pursuant to which we may, at our sole and exclusive option, periodically sell to YA Global shares of our common stock, $0.001 par value per share for a total purchase price of up to ten million dollars ($10,000,000). Each advance under the SEDA shall not be more than $200,000. For each share of Common Stock purchased pursuant to an advance under the SEDA, YA Global will pay to us the higher of (i) ninety-three (93%) of the lowest daily volume weighted average price of the Common Stock during the five (5) consecutive trading days following delivery by us of an advance notice or (ii) $0.87, the minimum acceptable price. Under the SEDA, we cannot begin to take advances until such time as we file with the Securities and Exchange Commission (“SEC”) a registration statement which registers the resale of the shares of our Common Stock to be issued to YA Global, and such registration statement is declared effective by the SEC. Additionally, any advance under the SEDA which causes YA Global to own more than 4.99% of our Common Stock will be automatically withdrawn. We are not obligated to utilize any of the $10 million available under the SEDA and there are no minimum commitments or minimum use penalties. The SEDA, unless terminated by us, shall terminate on the earlier of (i) the two-year anniversary of the date that the registration statement shall be declared effective by the SEC or (ii) the date on which the Company has drawn down the maximum amount permitted under the SEDA.

Contractual Obligations and Off-Balance Sheet Arrangements

Contractual Obligations

We have certain fixed contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our determination of amounts presented in the tables, in order to assist in the review of this information within the context of our consolidated financial position, results of operations, and cash flows. The total of contractual obligations and commitments does not include any payments made by us.

The following tables summarize our contractual obligations as of March 31, 2010, and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

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	Payments due by period
	Total		Less than 1 year		1-3 Years		3-5 Years		5+ Years
Series A convertible redeemable preferred stock	$	2,477,433	$	2,477,433	$	—	$	—	$	—
Related parties indebtedness	$	7,597,665	$	1,668,007	$	197,481	$	—	$	5,732,177
Technology purchase obligations	$	1,609,104	$	804,552	$	804,552	$	—	$	—
New drug patent purchase obligations	$	438,846	$	438,846	$	—	$	—	$	—
Construction obligations in Inner Mongolia	$	51,846,000	$	846,000	$	10,000,000	$	41,000,000	$	—
Total contractual obligations	$	63,969,048	$	6,234,838	$	11,002,033	$	41,000,000	$	5,732,177

Off-balance Sheet Arrangements

As of the date of this report, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors, however we have agreed to guarantee loans for Lotus East, if required. As of the date of this report, we have not entered into any guarantee arrangements with Lotus East. The term “off-balance sheet arrangement” generally means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with us is a party, under which we have: (i) any obligation arising under a guarantee contract, derivative instrument or variable interest; or (ii) a retained or contingent interest in assets transferred to such entity or similar arrangement that serves as credit, liquidity or market risk support for such assets.

Item 3.     Quantitative and Qualitative Disclosures About Market Risk.

Not applicable for a smaller reporting company.

Item 4T.  Controls and Procedures.

Our internal control over financial reporting is a process designed by or under the supervision of our principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on our financial statements.

Our management does not expect that our disclosure controls or our internal controls over financial reporting will prevent all errors and frauds. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control systems are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected. Such limitations include the fact that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures, such as simple errors or mistakes or intentional circumvention of the established process.

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating and implementing possible controls and procedures.

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As required by Rule 13a-15 under the Exchange Act, our management has carried out an evaluation, with the participation and under the supervision of our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2010. As discussed in more detail below, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of March 31, 2010, due to the significant deficiencies that we identified in internal control over financial reporting in our annual report on Form 10-K for the fiscal year ended December 31, 2009 (the “Form 10-K).

Remediation Measures of Material Weaknesses

We have implemented, or plan to implement, the measures described below under the supervision and guidance of our management to remediate the control deficiencies identified in the Form 10-K and to strengthen our internal controls over financial reporting. Key elements of the remediation effort include, but are not limited to, the following initiatives, which have been implemented, or are in the process of implementation, as of the date of filing of this interim report:

• We have recruited and will continue to bring in additional qualified financial personnel for the accounting department to further strengthen our financial reporting function. We have started training our internal accounting staff on US GAAP and financial reporting requirements.

• We engaged a qualified internal control consultant, Union Strength Business Consulting Co. Ltd, to help us comply with internal control obligations, including Section 404. We had adopted a timetable to commence the design phase of our Sarbanes-Oxley Compliance Project in March 2010 and enter implementation stage in June, to ensure full and timely Sarbanes-Oxley Act compliance in 2010. We have put together multileveled teams to execute the compliance under the assistance of the independent consultant.

• We have commenced to establish the effective internal audit functions, however, due to the scarcity of qualified candidates with extensive experience in U.S. GAAP reporting and accounting in the region, we were not able to hire sufficient internal audit persons before the end of 2009. However, we will increase our search for qualified candidates with assistance from recruiters and through referrals.

• Due to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible. However, to the extent possible, we will implement procedures to assure that the initiation of transactions, the custody of assets and the recording of transactions will be performed by separate individuals.

We believe that the foregoing steps will remediate the significant deficiencies identified above, and we will continue to monitor the effectiveness of these steps and make any changes that our management deems appropriate.

A material weakness (within the meaning of PCAOB Auditing Standard No. 5) is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness; yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.

Our management is not aware of any material weaknesses in our internal control over financial reporting, and nothing has come to the attention of management that causes them to believe that any material inaccuracies or errors exist in our financial statements as of March 31, 2010. The reportable conditions and other areas of our internal control over financial reporting identified by us as needing improvement have not resulted in a material restatement of our financial statements. Nor are we aware of any instance where such reportable conditions or other identified areas of weakness have resulted in a material misstatement in any report we have filed with or submitted to the Commission.

Changes in Internal Control over Financial Reporting

Except as described above, there have been no changes in our internal control over financial reporting during our first fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

None.

Item 1A. Risk Factors.

Not applicable to smaller reporting company.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None. 

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Submissions of Matters to a Vote of Security Holders.

Removed and Reserved. 

Item 5. Other Information.

None.

Item 6. Exhibits.

No.	Description
31.1	Rule 13a-14(a)/ 15d-14(a) Certification of Chief Executive Officer
31.2	Rule 13a-14(a)/ 15d-14(a) Certification of Chief Financial Officer
32.1	Section 1350 Certification of Chief Executive Officer
32.2	Section 1350 Certification of Chief Financial Officer

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Lotus Pharmaceuticals, Inc.
Date:  May 13, 2010	By:	/s/ Liu Zhong Yi
		Liu Zhong Yi
		Chief Executive Officer and President, principal executive officer
Date:  May 13, 2010	By:	/s/ Yan Zeng
		Yan Zeng
		Chief Financial Officer, principal financial and accounting officer

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