UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549



FORM 10-Q



|x | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------



For the quarterly period ended June 30,
2012

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 0-29185



SAVE THE WORLD AIR, INC.

(Exact name of registrant as specified
in its charter)



|Nevada                                                                 | 52-2088326                                  
|---------------------------------------------------------------------- | --------------------------------------------
|(State or other jurisdiction of
        incorporation or organization) | (I.R.S. Employer
        Identification No.)



735 State Street, Suite 500

Santa Barbara, California 93101

(Address, including zip code, of principal
executive offices

(805)-845-3561

(Registrant’s telephone number,
including area code)



Securities registered pursuant to Section 12(b)
of the Exchange Act: None.



Securities registered pursuant to Section 12(g)
of the Exchange Act: Common Stock, $0.001 par value.



Check
whether the Registrant (1) 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. YesxNoo



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). YesxNoo



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 filero                                            | Accelerated filero        
|------------------------------------------------------------------- | --------------------------
|                                                                    |                           
|Non-accelerated filero(Do not check if a smaller reporting company) | Smaller reporting companyx



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



The number of shares of the Registrant’s
Common Stock outstanding as of August 6, 2012 was 128,461,034.






















SAVE THE WORLD AIR, INC.

FORM 10-Q

INDEX



|                                                                                              |  | Page
|--------------------------------------------------------------------------------------------- |  | ----
|PART I                                                                                        |  |     
|                                                                                              |  |     
|ITEM 1. Financial Statements                                                                  |  | 3   
|Condensed consolidated balance sheets (unaudited)                                             |  | 3   
|Condensed consolidated statements of operations (unaudited)                                   |  | 4   
|Condensed consolidated statement of changes in stockholders’ deficiency (unaudited)           |  | 5   
|Condensed consolidated statements of cash flows (unaudited)                                   |  | 6   
|Notes to condensed consolidated financial statements (unaudited)                              |  | 8   
|ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations |  | 18  
|ITEM 3. Quantitative and Qualitative Disclosures About Market Risk                            |  | 22  
|ITEM 4. Controls and Procedures                                                               |  | 22  
|                                                                                              |  |     
|PART II                                                                                       |  | 24  
|                                                                                              |  |     
|ITEM 1. Legal Proceedings                                                                     |  | 24  
|ITEM 1A. Risk Factors                                                                         |  | 24  
|ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 24  
|ITEM 3. Defaults Upon Senior Securities                                                       |  | 24  
|ITEM 4. Mine Safety Disclosures                                                               |  | 24  
|ITEM 5. Other Information                                                                     |  | 24  
|ITEM 6. Exhibits                                                                              |  | 25  
|                                                                                              |  |     
|SIGNATURES                                                                                    |  | 26  
|                                                                                              |  |     
|EXHIBIT INDEX                                                                                 |  | 27  
|                                                                                              |  |     
|EXHIBIT 31.1                                                                                  |  |     
|EXHIBIT 31.2                                                                                  |  |     
|EXHIBIT 32                                                                                    |  |     





2









PART I



Item 1. Financial Statements



SAVE THE WORLD AIR, INC. AND SUBSIDIARY

(A DEVELOPMENT STAGE ENTERPRISE)



CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                              |  | June 30, 2012 (unaudited) |             |   | December 31, 2011 |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ----------- | - | ----------------- | -
|ASSETS                                                                                                                                                                        |  |                           |             |   |                   |  
|                                                                                                                                                                              |  |                           |             |   |                   |  
|Cash                                                                                                                                                                          |  | $                         | 59,892      |   |                   | $
|Other current assets                                                                                                                                                          |  |                           | 37,350      |   |                   |  
|Total current assets                                                                                                                                                          |  |                           | 97,242      |   |                   |  
|Property and Equipment, net of accumulated depreciation of $231,292 and $212,963 at June 30, 2012 and December 31, 2011, respectively                                         |  |                           | 70,053      |   |                   |  
|Other assets                                                                                                                                                                  |  |                           | 10,330      |   |                   |  
|Total assets                                                                                                                                                                  |  | $                         | 177,625     |   |                   | $
|                                                                                                                                                                              |  |                           |             |   |                   |  
|LIABILITIES AND STOCKHOLDERS’ DEFICIENCY                                                                                                                                      |  |                           |             |   |                   |  
|Current liabilities                                                                                                                                                           |  |                           |             |   |                   |  
|Accounts payable-related parties                                                                                                                                              |  | $                         | 49,328      |   |                   | $
|Accounts payable-license agreements                                                                                                                                           |  |                           | 247,100     |   |                   |  
|Accounts payable-other                                                                                                                                                        |  |                           | 384,985     |   |                   |  
|Accrued expenses-related parties                                                                                                                                              |  |                           | 795,450     |   |                   |  
|Accrued expenses-other                                                                                                                                                        |  |                           | 53,319      |   |                   |  
|Accrued professional fees                                                                                                                                                     |  |                           | 114,442     |   |                   |  
|Convertible debentures, net-of-discount                                                                                                                                       |  |                           | 251,000     |   |                   |  
|Fair value of derivative liabilities                                                                                                                                          |  |                           | 1,725,138   |   |                   |  
|Total current liabilities                                                                                                                                                     |  |                           | 3,620,762   |   |                   |  
|                                                                                                                                                                              |  |                           |             |   |                   |  
|Commitments and contingencies                                                                                                                                                 |  |                           |             |   |                   |  
|                                                                                                                                                                              |  |                           |             |   |                   |  
|Stockholders’ deficiency                                                                                                                                                      |  |                           |             |   |                   |  
|Common stock, $.001 par value: 200,000,000 shares authorized, 128,016,534 and 114,273,470, shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively |  |                           | 128,017     |   |                   |  
|Additional paid-in capital                                                                                                                                                    |  |                           | 72,586,261  |   |                   |  
|Deficit accumulated during the development stage                                                                                                                              |  |                           | (76,157,415 | ) |                   |  
|Total stockholders’ deficiency                                                                                                                                                |  |                           | (3,443,137  | ) |                   |  
|Total liabilities and stockholders’ deficiency                                                                                                                                |  | $                         | 177,625     |   |                   | $





See notes to condensed consolidated financial
statements.





3









SAVE THE WORLD AIR, INC.

(A DEVELOPMENT STAGE ENTERPRISE)



CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS (UNAUDITED)



|                                                              |  | Three months ended June 30, |             |   | Six months ended June 30, |   |             | Inception (February 18, 1998) to | 
|------------------------------------------------------------- |  | --------------------------- | ----------- | - | ------------------------- | - | ----------- | -------------------------------- | 
|                                                              |  | 2012                        |             |   | 2011                      |   |             | 2012                             | 
|                                                              |  |                             |             |   |                           |   |             |                                  | 
|Net sales                                                     |  | $                           | –           |   |                           | $ | –           |                                  | 
|Cost of goods sold                                            |  |                             | –           |   |                           |   | –           |                                  | 
|Gross profit                                                  |  |                             | –           |   |                           |   | –           |                                  | 
|Operating expenses                                            |  |                             | 1,921,814   |   |                           |   | 1,428,251   |                                  | 
|Research and development expenses                             |  |                             | 183,424     |   |                           |   | 81,213      |                                  | 
|Non-cash patent settlement costs                              |  |                             | –           |   |                           |   | –           |                                  | 
|Loss before other income (expense)                            |  |                             | (2,105,238  | ) |                           |   | (1,509,464  | )                                | 
|                                                              |  |                             |             |   |                           |   |             |                                  | 
|Other income (expense)                                        |  |                             |             |   |                           |   |             |                                  | 
|Other income (expense)                                        |  |                             | 2,384       |   |                           |   | (26,913     | )                                | 
|Interest income                                               |  |                             | –           |   |                           |   | –           |                                  | 
|Interest and financing expense                                |  |                             | (351,422    | ) |                           |   | (3,205,280  | )                                | 
|Change in fair value of derivative liabilities                |  |                             | 971,902     |   |                           |   | 345,987     |                                  | 
|Gain on extinguishment of derivative liabilities              |  |                             | 85,576      |   |                           |   | –           |                                  | 
|Costs of private placement                                    |  |                             | –           |   |                           |   | –           |                                  | 
|Costs to induce conversion of notes                           |  |                             | –           |   |                           |   | –           |                                  | 
|Loss on disposition of equipment                              |  |                             | –           |   |                           |   | –           |                                  | 
|Settlement of Debt Due Morale/Matthews                        |  |                             | –           |   |                           |   | –           |                                  | 
|Settlement of litigation and debt                             |  |                             | –           |   |                           |   | –           |                                  | 
|                                                              |  |                             |             |   |                           |   |             |                                  | 
|Loss before provision for income taxes                        |  |                             | (1,396,798  | ) |                           |   | (4,395,670  | )                                | 
|Provision for income taxes                                    |  |                             | 800         |   |                           |   | 800         |                                  | 
|Net loss                                                      |  | $                           | (1,397,598  | ) |                           | $ | (4,396,470  | )                                | 
|Net loss per share, basic and diluted                         |  | $                           | (0.01       | ) |                           | $ | (0.04       | )                                | 
|Weighted average common shares outstanding, basic and diluted |  |                             | 127,283,585 |   |                           |   | 100,431,182 |                                  | 





See notes to condensed consolidated
financial statements.





4









SAVE THE WORLD AIR, INC.

(A DEVELOPMENT STAGE ENTERPRISE)



CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’
DEFICIENCY

SIX MONTHS ENDED JUNE 30, 2012 (UNAUDITED)



|                                                                                     |  | Price Per |     |  | Common Stock |  |             | Additional  Paid-in |  |   | Deficit  Accumulated During the  Development |  |  | Total Stockholders’ |           
|------------------------------------------------------------------------------------ |  | --------- | --- |  | ------------ |  | ----------- | ------------------- |  | - | -------------------------------------------- |  |  | ------------------- | ----------
|                                                                                     |  | Share     |     |  | Shares       |  |             | Amount              |  |   | Capital                                      |  |  | Stage               |           
|Balance, December 31, 2011                                                           |  |           |     |  |              |  | 114,273,470 |                     |  | $ | 114,274                                      |  |  | $                   | 66,069,911
|Common stock issued for convertible debt                                             |  | $         | .25 |  |              |  | 10,930,004  |                     |  |   | 10,930                                       |  |  |                     | 2,721,571 
|Common stock issued upon exercise of warrants                                        |  | $         | .35 |  |              |  | 1,294,726   |                     |  |   | 1,295                                        |  |  |                     | 457,205   
|Fair value of options and warrants issued as compensation                            |  |           | –   |  |              |  | –           |                     |  |   | –                                            |  |  |                     | 1,453,662 
|Common stock issued upon exercise of options                                         |  | $         | .27 |  |              |  | 18,334      |                     |  |   | 18                                           |  |  |                     | 4,932     
|Common stock issued for services                                                     |  | $         | .35 |  |              |  | 1,500,000   |                     |  |   | 1,500                                        |  |  |                     | 518,500   
|Fair value of warrants and beneficial conversion feature of issued convertible notes |  |           | –   |  |              |  | –           |                     |  |   | –                                            |  |  |                     | 1,360,480 
|Net loss for the six months  ended June 30, 2012                                     |  |           | –   |  |              |  | –           |                     |  |   | –                                            |  |  |                     | –         
|Balance, June 30, 2012                                                               |  |           |     |  |              |  | 128,016,534 |                     |  | $ | 128,017                                      |  |  | $                   | 72,586,261







See notes to condensed consolidated financial
statements.



5









SAVE THE WORLD AIR, INC. AND SUBSIDIARY

(A DEVELOPMENT STAGE ENTERPRISE)



CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS (UNAUDITED)



|                                                                                                                                  |  |                           |            |   | Inception  (February 18, 1998) |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ---------- | - | ------------------------------ | -
|                                                                                                                                  |  | Six Months Ended June 30, |            |   | to June 30,                    |  
|                                                                                                                                  |  | 2012                      |            |   | 2011                           |  
|Cash flows from operating activities                                                                                              |  |                           |            |   |                                |  
|Net Loss                                                                                                                          |  | $                         | (6,867,948 | ) |                                | $
|Adjustments to reconcile net loss to net cash used in operating activities:                                                       |  |                           |            |   |                                |  
|Write off of intangible assets                                                                                                    |  |                           | –          |   |                                |  
|Settlement of litigation and debt                                                                                                 |  |                           | (223,774   | ) |                                |  
|Settlement of debt due Morale/Matthews                                                                                            |  |                           | –          |   |                                |  
|Stock based compensation expense                                                                                                  |  |                           | 1,245,736  |   |                                |  
|Issuance of common stock for services                                                                                             |  |                           | 520,000    |   |                                |  
|Issuance of options for legal settlement                                                                                          |  |                           | –          |   |                                |  
|Issuance of warrants for legal settlement                                                                                         |  |                           | –          |   |                                |  
|Issuance of warrants for financing fees                                                                                           |  |                           | –          |   |                                |  
|Issuance of warrants for consulting fees                                                                                          |  |                           | 207,926    |   |                                |  
|Increase in convertible notes related to default                                                                                  |  |                           | –          |   |                                |  
|Interest on related party loans                                                                                                   |  |                           | –          |   |                                |  
|Patent acquisition cost                                                                                                           |  |                           | –          |   |                                |  
|Amortization of issuance costs and original issue debt discounts including beneficial conversion feature-part of interest expense |  |                           | 2,813,959  |   |                                |  
|Fair value of common stock and warrants issued to induce conversion of notes                                                      |  |                           | –          |   |                                |  
|Costs of private placement convertible notes                                                                                      |  |                           | –          |   |                                |  
|Change in fair value of derivative liability                                                                                      |  |                           | 167,575    |   |                                |  
|Gain on extinguishment of derivative liabilities                                                                                  |  |                           | (85,576    | ) |                                |  
|Amortization of deferred compensation                                                                                             |  |                           | –          |   |                                |  
|Loss on disposition of assets                                                                                                     |  |                           | –          |   |                                |  
|Depreciation and amortization of leasehold improvements                                                                           |  |                           | 18,329     |   |                                |  
|Bad debt                                                                                                                          |  |                           | –          |   |                                |  
|Changes in operating assets and liabilities:                                                                                      |  |                           |            |   |                                |  
|Accounts receivable                                                                                                               |  |                           | –          |   |                                |  
|Prepaid expenses and other                                                                                                        |  |                           | 40,557     |   |                                |  
|Other assets                                                                                                                      |  |                           | –          |   |                                |  
|Accounts payable and accrued expenses                                                                                             |  |                           | 35,137     |   |                                |  
|Accounts payable – license agreements                                                                                             |  |                           | 68,975     |   |                                |  
|Accounts payable and accrued expenses – related parties                                                                           |  |                           | (276,218   | ) |                                |  
|Net cash used in operating activities                                                                                             |  |                           | (2,335,322 | ) |                                |  
|Cash flows from investing activities                                                                                              |  |                           |            |   |                                |  
|Purchase of equipment                                                                                                             |  |                           | (12,773    | ) |                                |  
|Proceeds from sale of equipment                                                                                                   |  |                           | –          |   |                                |  
|Net cash used in investing activities                                                                                             |  |                           | (12,773    | ) |                                |  
|Cash flows from financing activities                                                                                              |  |                           |            |   |                                |  
|Net proceeds under equity line of credit                                                                                          |  |                           | –          |   |                                |  
|(Decrease) increase in payables to related parties and stockholder                                                                |  |                           | –          |   |                                |  
|Advances from founding executive officer                                                                                          |  |                           | –          |   |                                |  
|Net proceeds from issuance of convertible notes and warrants                                                                      |  |                           | 1,326,740  |   |                                |  
|Repayment of convertible notes                                                                                                    |  |                           | –          |   |                                |  
|Proceeds from sale of stock and exercise of warrants and options                                                                  |  |                           | 463,450    |   |                                |  
|Net cash provided by financing activities                                                                                         |  |                           | 1,790,190  |   |                                |  
|Net (decrease) increase in cash                                                                                                   |  |                           | (557,905   | ) |                                |  
|Cash, beginning of period                                                                                                         |  |                           | 617,797    |   |                                |  
|Cash, end of period                                                                                                               |  | $                         | 59,892     |   |                                | $





(continued)





6









SAVE THE WORLD AIR, INC. AND SUBSIDIARY

(A DEVELOPMENT STAGE ENTERPRISE)



CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS (UNAUDITED)

(continued)



|                                                                                                  |  | Six Months Ended June 30, |           |  | Inception (February 18, 1998) to June 30, |  
|------------------------------------------------------------------------------------------------- |  | ------------------------- | --------- |  | ----------------------------------------- | -
|                                                                                                  |  | 2012                      |           |  | 2011                                      |  
|Supplemental disclosures of cash flow information                                                 |  |                           |           |  |                                           |  
|Cash paid during the year for:                                                                    |  |                           |           |  |                                           |  
|Interest                                                                                          |  | $                         | 331       |  |                                           | $
|Income taxes                                                                                      |  | $                         | 800       |  |                                           | $
|Non-cash investing and financing activities                                                       |  |                           |           |  |                                           |  
|Acquisition of intangible asset through advance from related party and issuance of common stock   |  | $                         | –         |  |                                           | $
|Deferred compensation for stock options issued for services                                       |  |                           | –         |  |                                           |  
|Purchase of property and equipment financed by advance from related party                         |  |                           | –         |  |                                           |  
|Conversion of related party debt to equity                                                        |  |                           | –         |  |                                           |  
|Issuance of common stock in settlement of payable                                                 |  |                           | –         |  |                                           |  
|Cancellation of stock                                                                             |  |                           | –         |  |                                           |  
|Conversion of accounts payable and accrued expenses to common stock                               |  |                           | –         |  |                                           |  
|Conversion of accounts payable and accrued expenses to convertible debentures                     |  |                           | 33,740    |  |                                           |  
|Conversion of related party debt to convertible debentures                                        |  |                           | –         |  |                                           |  
|Conversion of convertible debentures to common stock                                              |  |                           | 2,732,501 |  |                                           |  
|Issuance of shares for settlement of loans and other payable to Morale/Matthews                   |  |                           | –         |  |                                           |  
|Write off of deferred compensation                                                                |  |                           | –         |  |                                           |  
|Fair value of derivative liability recorded as note discount                                      |  |                           | –         |  |                                           |  
|Proceeds of exercise of options applied to accounts payable                                       |  |                           | –         |  |                                           |  
|Fair value of warrants and beneficial conversion feature associated with issued convertible notes |  |                           | 1,360,480 |  |                                           |  





See notes to condensed consolidated financial
statements.





7











SAVE THE WORLD AIR, INC. AND SUBSIDIARY

(A DEVELOPMENT STAGE ENTERPRISE)



NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

SIX MONTHS ENDED JUNE 30, 2012 AND 2011
(UNAUDITED)



1. Organization and basis of presentation



Description of business



Save the World Air,
Inc. (“STWA” or “Company”) designs, licenses and develops products to reduce operational costs for oil
pipelines, and improve fuel economy and reduce emissions from diesel-powered internal combustion engines.  The Company
is a green technology company that leverages a suite of patented, patent-pending and licensed intellectual properties related to
the treatment of fuels. Technologies patented by or licensed to us utilize either magnetic or uniform electrical fields to alter
physical characteristics of fuels and are designed to create cleaner combustion or improve efficiency of crude oil pipeline transportation.
Cleaner combustion has been shown to improve performance, enhance fuel economy and/or reduce harmful emissions in laboratory testing.



The Company was incorporated
on February 18, 1998, as a Nevada corporation, under the name Mandalay Capital Corporation. The Company changed its name to
Save the World Air, Inc. on February 11, 1999, following the acquisition of marketing and manufacturing rights of the ZEFS
technologies. Our executive offices are at 735 State Street, Suite 500, Santa Barbara, California 93101.  The telephone
number is (877) USA-STWA. Our research and development facility is at 235 Tennant Avenue, Morgan Hill, California 95037. The
corporate website is www.stwa.com.  The Company’s common stock is quoted under the symbol “ZERO”
on the Over-the-Counter Bulletin Board



The Company’s
technology has two commercial applications; AOTTM (Applied Oil Technology) and ELEKTRATM and legacy technologies of ZEFS
and MK IV.  AOTTM and ELEKTRATM are nearing the end of the product development cycle, which we believe will
culminate at the U.S. Department of Energy’s Rocky Mountain Oilfield Testing Center (RMOTC). We believe the testing of AOTTM
at the RMOTC will determine the value of savings the product presents at full scale operation on an active pipeline.



The AOTTM and
ELEKTRATM are technologies, which use electric fields to alter some physical properties of petrochemical fluids to reduce
viscosity of the fluids. The Company differentiates AOTTM and ELEKTRATM products based on their differing attributes
and marketing focus. AOTTM products are primarily designed to reduce operation costs for oil pipelines, and ELEKTRATM
products are primarily designed to improve fuel economy and reduce emissions from diesel-powered internal combustion engines. Our
AOTTM products are intended to reduce the viscosity of crude oil, thereby making it less restrictive to pipeline transport.
Our AOTTM products will be marketed primarily to pipeline operators as well as to pilot and government mandated delivery programs.
Our ELEKTRATM products are intended to increase fuel efficiency and reduce emissions.  ELEKTRATM will be marketed
primarily to specialty consumer accessories market for many types of diesel-fueled vehicles, including but not limited to trucks,
trains, maritime, military and aviation.



Basis of presentation



The accompanying unaudited
condensed consolidated financial statements of Save the World Air, Inc. (the "Company") have been prepared in accordance
with accounting principles generally accepted in the United States of America for interim financial information and pursuant to
the requirements for reporting on Form 10-Q and Regulation S-K for scaled disclosures for smaller reporting companies. Accordingly,
they do not include all the information and footnotes required by accounting principles generally accepted in United States of
America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring
adjustments), which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position
and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to
be obtained for a full fiscal year.



The condensed consolidated
balance sheet information as of December 31, 2011 was derived from the audited consolidated financial statements included in the
Company's Annual Report on Form 10-K filed with the SEC. These interim financial statements should be read in conjunction with
that report.



8









Going concern



Since its
inception, the Company has been primarily engaged in organizational and pre-operating activities. The Company has generated
insignificant revenues and has incurred accumulated losses of $76,157,415 from February 18, 1998 (Inception) through
June 30, 2012. As reflected in the accompanying condensed consolidated financial statements, the Company had a net loss of
$6,867,948 and a negative cash flow from operations of $2,335,322 for the six months ended June 30, 2012, and had a working
capital deficiency (excluding derivative liabilities) of $1,798,382 and a stockholders' deficiency of $3,443,137 at June 30,
2012. As a result, the Company’s independent registered public accounting firm, in their report on the Company’s
2011 consolidated financial statements, raised substantial doubt about the Company’s ability to continue as a going
concern. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue
as a going concern.



The ability of
the Company to continue as a going concern is dependent upon the Company’s ability to raise additional funds and
implement its business plan. The Company’s operations from inception, February 18, 1998 to June 30, 2012 have been
funded through issuances of its common stock and convertible notes. As of June 30, 2012, the Company raised an aggregate
of $29,171,312 of which $17,891,788 was from the sale of convertible notes. As of June 30, 2012, the outstanding
balance of convertible notes was $483,813. The Company expects substantially all of the outstanding notes will be
converted into shares of common stock of the Company. See Note 11 for subsequent conversions.



On June 30, 2012,
the Company had cash on hand in the amount of $59,892. In addition to the funds on hand, the Company will require
additional funds to continue to operate our business. This includes expenses we will incur in connection with license
agreements; product development and commercialization of the AOT and ELEKTRA technologies; costs to manufacture and ship our
products; costs to design and implement an effective system of internal controls and disclosure controls and procedures;
costs of maintaining our status as a public company by filing periodic reports with the SEC and costs required to protect our
intellectual property. In addition, the Company has contractual commitments for salaries to its executive officers pursuant
to employment agreements, consulting fees and Licensing Fees commitment to Temple University, during 2012 and beyond. In
light of the Company’s financial commitments over the next several months and its liquidity constraints, we have
implemented cost reduction measures in all areas of operations. The Company intends to review these measures on an
ongoing basis and make additional decisions as may be required. See Note 11 for subsequent offering.



2. Summary of significant accounting policies



Development
stage enterprise



The Company is a development
stage enterprise.  All losses accumulated since the inception of the Company have been considered as part of the Company’s
development stage activities.



The Company’s
focus is on product development and marketing of proprietary devices that are designed to reduce operation costs of petrochemical
pipeline transport and fuel efficiency of diesel engines and has not yet generated meaningful revenues.  The technologies
are called “AOT” and “ELEKTRA”.  The Company is currently in the mid-late stages of developing
its AOTTM and ELEKTRATM technologies for commercial applications.  Expenses have been funded through the sale
of company stock, convertible notes and the exercise of warrants.  The Company has taken actions to secure the intellectual
property rights to the AOTTM and ELEKTRATM technologies and is the worldwide exclusive licensee for patent pending technologies
associated with the development of ELEKTRATM.



Estimates



The preparation of
financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period. Certain significant estimates
were made in connection with preparing the Company’s financial statements. Actual results could differ from those estimates.





9









Loss per share



Basic loss per share
is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during
the period. Diluted loss per share reflects the potential dilution, using the treasury stock method that could occur if securities
or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock
that then shared in the loss of the Company. In computing diluted loss per share, the treasury stock method assumes that outstanding
options and warrants are exercised and the proceeds are used to purchase common stock at the average market price during the period.
Options and warrants may have a dilutive effect under the treasury stock method only when the average market price of the common
stock during the period exceeds the exercise price of the options and warrants. For the six month period ended June 30, 2012 and
2011, the dilutive impact of outstanding stock options of 28,899,558 and 22,177,892 respectively, and outstanding warrants of 51,690,896
and 37,701,079 have been excluded because their impact on the loss per share is anti-dilutive.



Stock-Based Compensation



The Company periodically
issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing
costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance
provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized
over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance
with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based
upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at
which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally
are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance
requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded
in the period of the measurement date.



The fair value of the
Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions
related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation
expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The
assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.



Accounting for
Warrants and Derivatives



The Company evaluates
all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded
derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially
recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated
statements of operations.  For stock-based derivative financial instruments, the Company uses a probability weighted
average series Black-Scholes-Merton option pricing models to value the derivative instruments at inception and on subsequent
valuation dates.



The classification
of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the
end of each reporting period.  Derivative instrument liabilities are classified in the balance sheet as current or non-current
based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet
date.



Fair value of
financial instruments



Effective January 1,
2008, fair value measurements are determined by the Company's adoption of authoritative guidance issued by the FASB, with the exception
of the application of the statement to non-recurring, non-financial assets and liabilities as permitted. The adoption of the authoritative
guidance did not have a material impact on the Company's fair value measurements.  Fair value is defined in the authoritative
guidance as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous
market for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy
was established, which prioritizes the inputs used in measuring fair value into three broad levels as follows:



Level 1—Quoted
prices in active markets for identical assets or liabilities.



Level 2—Inputs,
other than the quoted prices in active markets, are observable either directly or indirectly.



Level 3—Unobservable
inputs based on the Company's assumptions.





10







The Company is required
to use observable market data if such data is available without undue cost and effort



The following table
presents certain investments and liabilities of the Company’s financial assets measured and recorded at fair value on the
Company’s condensed consolidated balance sheets on a recurring basis and their level within the fair value hierarchy as of June
30, 2012 and 2011.



|                                                     |   | Level 1 |  |  |   | Level 2 |  |  | Level 3 |           |  | Total |  
|---------------------------------------------------- | - | ------- |  |  | - | ------- |  |  | ------- | --------- |  | ----- | -
|Fair value of Derivative Liability-June 30, 2012     | $ | -0-     |  |  | $ | -0-     |  |  | $       | 1,725,138 |  |       | $
|Fair value of Derivative Liability-December 31, 2011 | $ | -0-     |  |  | $ | -0-     |  |  | $       | 1,643,139 |  |       | $



Recent Accounting
Pronouncements



In May 2011, the
Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04,
“Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. ASU No. 2011-4
does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices
outside of financial reporting. The ASU is effective for interim and annual periods beginning after December 15, 2011. The
Company adopted ASU No. 2011-04 effective January 1, 2012 and it did not affect the Company’s results of operations, financial
condition or liquidity.



In June 2011,
the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”. The ASU eliminates the option to present
the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires
consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive
income or in two separate but consecutive statements. ASU No. 2011-5 is effective for interim and annual periods beginning
after December 15, 2011. The Company adopted ASU 2011-05 effective January 1, 2012 and it did not affect the Company’s
results of operations, financial condition or liquidity.



In September 2011,
the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of
goodwill impairment. This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative
factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount
before performing the two step impairment review process. It also amends the examples of events or circumstances that would be
considered in a goodwill impairment evaluation. The amendments are effective for annual and interim goodwill impairment tests performed
for fiscal years beginning after December 15, 2011. The Company adopted ASU 2011-08 effective January 1, 2012. We do not believe
that the adoption of this new accounting guidance will have a significant effect on our goodwill impairment assessments in the
future.



In December 2011, the
Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11, “Balance
Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” This ASU requires an entity to disclose information
about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements
on its financial position. ASU No. 2011-11 will be applied retrospectively and is effective for annual and interim reporting periods
beginning on or after January 1, 2013. The Company does not expect adoption of this standard to have a material impact on its consolidated
results of operations, financial condition, or liquidity.



Other recent accounting
pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission
(the “SEC”) did not or are not believed by management to have a material impact on the Company's present or future consolidated
financial statements.



3. Certain relationships and related transactions



Accounts Payable
to related parties



As of June 30,
2012 and December 31, 2011, the Company had accounts payable to related parties in the amount of $49,328 and $63,003, respectively.
These amounts are unpaid Directors Fees and expenses incurred by officers and directors.



Accrued expense
due to related parties



As of June
30, 2012 and December 31, 2011, the Company accrued the unpaid salaries, unused vacation and the corresponding payroll taxes
of its employees in the amount of $795,450 and
$812,993, respectively. Included in these accruals are the salaries due to the President and to a former officer of the Company.



The President of the
Company has agreed to defer payment of salary for an indefinite period of time. No payment was made during the period ended June
30, 2012 and balance as of June 30, 2012 was $459,143 including payroll taxes of $32,628.





A former officer of the
Company has agreed to a monthly payment schedule $10,000 to $15,000 which will end in October 2013 pursuant to a December 2011
Settlement Agreement upon his resignation. During the period ended June 30, 2012, the Company paid $75,000 leaving a balance of
$245,000.



Cash Bonus Paid
to Chief Executive Officer



General and
administrative expenses for the three and six months ending June 30, 2012, include a cash bonus of $100,000 paid to the
Company’s Chief Executive Officer.





11









4. Convertible Debentures



Convertible debentures
consist of the following:



|                              |  | June 30,  2012 |          |   | December 31,  2011 |  
|----------------------------- |  | -------------- | -------- | - | ------------------ | -
|                              |  |                |          |   |                    |  
|Convertible debentures        |  | $              | 483,813  |   |                    | $
|                              |  |                |          |   |                    |  
|Less, remaining debt discount |  |                | (232,813 | ) |                    |  
|Convertible debentures, net   |  | $              | 251,000  |   |                    |  



From December 13,
2010 through February 3, 2012, the Company conducted private offerings of up to $10,000,000 aggregate face amount of its
convertible notes. A total of $7,722,783 aggregate face amount of the notes were sold for an aggregate purchase price of
$7,020,711. Through December 31, 2011, $6,239,029 of these notes were sold, of which $4,518,425 were converted during
2011, leaving a balance of convertible notes outstanding as of December 31, 2011 of $1,720,460. During 2012, the Company sold
an additional $1,495,854 of these convertible notes, and an additional $2,732,501 of these notes were converted, leaving a
balance of convertible notes outstanding of June 30, 2012 of $483,813. While the stated interest rate on the notes is 0%, the
actual interest rate on the notes is 10% per annum. The notes mature on the first anniversary of their respective date of
issuance. The notes outstanding at June 30, 2012 are convertible, at the option of the note holder, into 1,935,252  shares
of common stock of the Company (the “Conversion Shares”) a conversion price of $0.25 per share.



Each of the
investors in the offerings received, for no additional consideration, a warrant entitling the holder to purchase a number of
shares of the Company’s common stock equal to 100% of the number of shares of common stock into which the notes are
convertible (the “Warrant Shares”).  Each warrant is exercisable on a cash basis only at an initial price of
$0.30 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance.
Warrants to acquire 5,983,416 shares of common stock were granted during
the six  months ended June 30, 2012.



During 2012, the
Company sold $1,495,854 of convertible notes for aggregate consideration of $1,326,740, resulting in a discount of $135,374
and conversion of previously recorded liabilities of $33,740. The aggregate relative value of the warrants issued in the 2012
offerings were valued at $593,208 using the Black-Scholes-Merton option valuation model with the following assumptions;
risk-free interest rate of .27%; dividend yield of 0%; volatility factors of the expected market price of common stock of
121%; and an expected life of two years (statutory term). The Company also determined that the notes contained a beneficial
conversion feature of $766,603.  The aggregate value of $1,495,854 of the 2012 Offering Warrants, the beneficial
conversion feature and the note discount are considered as debt discount and will be amortized over the life of the notes.
 The value of this debt discount was added to the outstanding debt discount of $1,550,918 as of December 31, 2011.
 During the period ended June 30, 2012, the Company amortized $2,813,959 of debt discount, resulting in an unamortized
debt discount balance of 232,813 as of June 30, 2012.



As of June 30, 2012,
the outstanding balance of the notes was $483,813.



5. Capital stock



During the six months
ended June 30, 2012, the Company issued 10,930,004 shares of common stock in exchange for conversion of $2,732,501 of Convertible
Notes.



During the six months
ended June 30, 2012, the Company issued 1,294,726 shares of common stock upon exercise of warrants at an average price of $0.35
per share and valued at $458,500.



During the six months
ended June 30, 2012, the Company issued 1,500,000 shares of common stock for consulting services at an average price of $0.35 per
share and valued at $520,000.



During the six months
ended June 30, 2012, the Company issued 18,334 shares of common stock upon exercise of options at $0.27 per share and valued at
$4,950.





12









6. Stock Options and warrants



The Company periodically
issues stock options and warrants to employees and non-employees in capital raising transactions, for services and for financing
costs.  Stock-based compensation is measured at the grant date, based on the fair value of the award, and is recognized
as expense over the requisite service period.  Options vest and expire according to terms established at the grant date.



Options



The Company currently
issues stock options to employees, directors and consultants under the 2004 Stock Option Plan (the Plan). The Company could issue
options under the Plan to acquire up to 5,000,000 shares of common stock. In February 2006, the board approved an amendment
to the Plan (approved by the Shareholders in May 2006), increasing the authorized shares by 2,000,000 shares to 7,000,000 shares.
At June 30, 2012, 2,750,442 were available to be granted under the Plan. Prior to 2004, the Company granted 3,250,000 options outside
the Plan to officers of the Company.



On February 1,
2012, the Company issued 4,000,000 options to its Chief Financial Officer, valued at $1,207,193 using
Black-Scholes-Merton calculation. The options have an exercise price of $0.25 per share, vest over a four year period, and
expire ten years from date of grant. Twelve and a half percent vested immediately, twelve and a half percent will vest on the
first anniversary date, and twenty-five percent will vest on the following three anniversary dates. During the period ended
June 30, 2012, the Company recognized $213,774 in compensation costs based upon the vesting of these options.



On May 18,
2012, the Company issued 850,000 options to its employees valued at $242,963 using Black-Scholes-Merton calculation. The
options have an exercise price $0.30 per share, vesting immediately, and expire ten- years from date of grant.



Employee options vest
according to the terms of the specific grant and expire from 5 to 10 years from date of grant. Non-employee option grants
to date are vested upon issuance. The weighted-average, remaining contractual life of employee options outstanding at June 30,
2012 was 8.3 years. Stock option activity for the period January 1, 2012 to June 30, 2012, was as follows:



|Options                                 |  | Shares |            |   | Weighted- Average Exercise Price |   |      | Weighted- Average Remaining Contractual Term |  |  | Aggregate Intrinsic Value | 
|--------------------------------------- |  | ------ | ---------- | - | -------------------------------- | - | ---- | -------------------------------------------- |  |  | ------------------------- | 
|Outstanding at January 1, 2012          |  |        | 24,067,892 |   |                                  | $ | 0.30 |                                              |  |  |                           | 
|Granted                                 |  |        | 4,850,000  |   |                                  |   | 0.26 |                                              |  |  |                           | 
|Exercised                               |  |        | (18,334    | ) |                                  |   | 0.27 |                                              |  |  |                           | 
|Forfeited or expired                    |  |        | –          |   |                                  |   | –    |                                              |  |  |                           | 
|Outstanding at June 30, 2012            |  |        | 28,899,558 |   |                                  | $ | 0.30 |                                              |  |  | 8.3                       | 
|Vested and exercisable at June 30, 2012 |  |        | 11,319,558 |   |                                  | $ | 0.37 |                                              |  |  | 7.6                       | 



The weighted average
exercise prices, remaining contractual lives for options granted, exercisable, and expected to vest under the Plan as of June 30,
2012 were as follows:



|                                 |  |  |        | Outstanding Options |            |               | Exercisable Options |    
|-------------------------------- |  |  | ------ | ------------------- | ---------- | ------------- | ------------------- | ---
|Option  Exercise Price Per Share |  |  | Shares |                     |            | Life  (Years) |                     |    
|$ 0.21 - $ 0.99                  |  |  |        | 28,572,012          |            |               |                     | 8.4
|$ 1.00 - $ 1.99                  |  |  |        | 327,546             |            |               |                     | 2.9
|                                 |  |  |        |                     | 28,899,558 |               |                     |    



During the
six months ended June 30, 2012, the Company amortized $683,423 of compensation cost based on the vesting of the options
granted in prior periods. Future unamortized compensation expense on the outstanding options at June 30, 2012 is $5,987,964.



13









Black-Scholes-Merton
value of options



During the six months
ended June 30, 2012 and 2011, the Company valued options at the grant date using the Black-Scholes-Merton
pricing model with the following average assumptions:



|                        |  | June 30, |              
|----------------------- |  | -------- | -------------
|                        |  | 2012     |              
|                        |  |          |              
|Expected life (years)   |  |          | 5.0 – 7.0    
|Risk free interest rate |  |          | .75% - 1.27% 
|Volatility              |  |          | 125% -132.00%
|Expected dividend yield |  |          | 0.00%        



Warrants



During the period
ended June 30, 2012, the Company granted warrants to consultants to purchase 600,000 shares of its common
stock.  The warrants have an average exercise price of $0.26/share, vesting immediately and will expire in two to
three years from grant date. Total fair value of the warrant amounted to $123,734 using the Black-Scholes Merton
valuation model with the following average assumptions: risk-free interest rate of 0.23% to 0.37%; dividend yield of 0%;
volatility of 112%; and an expected life of two to three years. During the period ended June 30, 2012, the Company
recognized compensation expense of $123,734 based upon vesting of warrants..



During the period ended
June 30, 2012, the Company granted issued 5,983,416 warrants to acquire shares of its common stock in connection of its issuance
of convertible notes.  The warrant is exercisable at $0.30/share, fully vested, and will expire in two years for date
of grant (See note 4).



The following table
summarizes certain information about the Company’s stock purchase warrants from January 1, 2012 to June 30, 2012:



|Warrants                                |  | Shares |            |   | Weighted-  Average  Exercise  Price |   |      | Weighted-  Average  Remaining  Contractual  Term |  |  | Aggregate  Intrinsic  Value | 
|--------------------------------------- |  | ------ | ---------- | - | ----------------------------------- | - | ---- | ------------------------------------------------ |  |  | --------------------------- | 
|Outstanding at January 1, 2012          |  |        | 49,106,280 |   |                                     | $ | 0.28 |                                                  |  |  |                             | 
|Granted                                 |  |        | 6,583,416  |   |                                     |   | 0.30 |                                                  |  |  |                             | 
|Exercised                               |  |        | (1,354,250 | ) |                                     |   | 0.35 |                                                  |  |  |                             | 
|Forfeited or expired                    |  |        | (2,644,550 | ) |                                     |   | 0.56 |                                                  |  |  |                             | 
|Outstanding at June 30, 2012            |  |        | 51,690,896 |   |                                     | $ | 0.30 |                                                  |  |  | 1.5                         | 
|Vested and exercisable at June 30, 2012 |  |        | 49,978,396 |   |                                     | $ | 0.30 |                                                  |  |  | 1.3                         | 



|                                 |  |  |        | Outstanding Warrants |            |               | Exercisable Warrants |    
|-------------------------------- |  |  | ------ | -------------------- | ---------- | ------------- | -------------------- | ---
|Warrant Exercise Price Per Share |  |  | Shares |                      |            | Life  (Years) |                      |    
|$ 0.25 - $ 0.99                  |  |  |        | 51,190,896           |            |               |                      | 1.5
|$ 1.00 - $ 1.99                  |  |  |        | 500,000              |            |               |                      | 2.0
|                                 |  |  |        |                      | 51,690,896 |               |                      |    



During the
six months ended June 30, 2012, the Company amortized $189,768 of the compensation based on the vesting of these warrants
granted in prior periods. Future unamortized compensation expense on the outstanding warrants at June 30, 2012 is $311,168.









14









7.
Research and development



The Company has research
and development facilities in Morgan Hill, California. The Company has tested ELEKTRA technologies and legacy products incorporating
its “legacy” ZEFS, MK IV, ELEKTRA for multiple makes and models diesel engines, motorbikes, boats, generators, lawn
mowers and other small engines. The Company has purchased test vehicles, test engines and testing equipment.



The Company incurred
costs of $183,424 and $81,213 and $350,890 and $552,568 for the three and six months ended June 30, 2012 and 2011, respectively,
on its research and development activities and $7,795,887 from February 18, 1998 (inception) to June 30, 2012.



Temple University
Research & Development Agreement



On February
2, 2007, the  Company entered into a research and development agreement (R&D Agreement) with
Temple University to conduct further research on the ELEKTRA technology. Under the R&D Agreement Temple University
will conduct a 24-month research project towards expanding the scope of, and developing products utilizing, the technologies
covered under the License Agreements, including design and manufacture of prototypes utilizing electric fields to improve
diesel, gasoline and kerosene fuel injection in engines using such fuels and a device utilizing a magnetic field to reduce
crude oil viscosity for crude oil (paraffin and mixed base) and edible oil flow in pipelines. If the research project yields
results within the scope of the technologies licensed pursuant to the License Agreements, those results will be deemed
included as rights licensed to the Company pursuant to the License Agreements. If the research project yields results outside
of the scope of the technologies covered by the License Agreements, the Company has a six-month right of first negotiation to
enter into a new worldwide, exclusive license agreement with Temple University for the intellectual property covered by
those results. Pursuant to the R & D Agreement, the Company will make payments to Temple University in the aggregate
amount of $500,000. At June 30, 2012 the Company has completed payment in full of $500,000 under the R & D Agreement.



On August 1, 2011,
the Company and Temple University (“Temple”) entered into two (2) Exclusive License Agreements (collectively, the “License
Agreements”) relating to Temple’s patent applications, patents and technical information pertaining to technology associated
with an electric and/or magnetic field assisted fuel injector system (the “First Temple License”), and to technology
to reduce crude oil viscosity (the “Second Temple License”).  The License Agreements are exclusive and the
territory licensed to the Company is worldwide and replace previously issued License Agreements.



Pursuant to
the two licensing agreements, the Company agreed to pay Temple the following: (i) non-refundable license maintenance fee
of $300,000; (ii) annual maintenance fees of $187,500; (iii) royalty fee ranging from 4% up to 7% from revenues generated
from the licensing agreements; and (iv) 25% of all revenues generated from sub-licensees to secure or maintain the
sub-license or option thereon. Temple also agreed to defer payment of the  $37,500 of the amount due if the Company agrees to
fund at least $250,000 in research or development of Temple’s patent rights licensed to the Company. The term of the
licenses commences in August 2011 through the expiration of the patents contemplated thereunder, or unless sooner terminated
under terms of the licensing agreements. The Company recorded the entire $300,000 non-refundable license maintenance fee as
part of its research and development costs at the date of the agreement, of which, $200,000 was paid in November 2011 and
$100,000 was paid in February 2012.



Research
and development costs on the accompanying statement of operations for the six month period ending June 30, 2012, include
$93,750 relating to these agreements.



As of June 30, 2012,
there were no revenues generated from these two licenses.





15











Sponsored Research Agreement



Effective April 1,
2012 the Company entered into an agreement with Temple University in the amount of $500,000 to be paid over a two year period to
engage the University as well as Physics Department Chairman Dr. Rongia Tao. This agreement specifies that the Company and Temple
University will work collaboratively regarding further research and development of the AOT device. This agreement allows the Company
to have access to Temple University proprietary research and intellectual property.



Research
and development costs on the accompanying statement of operations for the six month period ending June 30, 2012, include
$62,500 relating to this agreement.



AOT Testing



On July 16, 2010,
the Company entered into a Letter of Intent with the U.S. Department of Energy-Naval Petroleum Reserve/Rocky Mountain Oilfield
Testing Center (RMOTC) in Wyoming. On December 22, 2010, a formal Agreement was entered into with RMOTC for testing of our Applied
Oil Technology (AOT). Third-party vendors were used to build the AOT 1.X prototype(s) to be used at for full scale testing purposes.
Third-party vendors were also used to furnish hardware, electrical supplies, oil tanks and engineering testing devices, and other
testing-related equipment. Costs incurred for the testing during the six months ended June 30, 2012 was $182,692. Testing began
in July 2011 and the Company has the exclusive right to use the facility for testing until December 31, 2016.



8. Derivative liability



In June 2008, the FASB
issued authoritative guidance on determining whether an instrument (or embedded feature) is indexed to an entity’s own stock.  Under
the authoritative guidance, effective January 1, 2009, instruments which do not have fixed settlement provisions are deemed to
be derivative instruments.  The strike price of the warrants issued by the Company in connection with certain convertible
note offerings made during 2009 and 2010 in the aggregate of 8,322,500 warrants, exercisable at $.25 per share, contain exercise
prices that may fluctuate based on the occurrence of future offerings or events.  As a result, these warrants are not
considered indexed to the Company’s own stock.  The Company characterized the fair value of these warrants as derivative
liabilities upon issuance.  The FASB’s guidance requires the fair value of these liabilities be re-measured at
the end of every reporting period with the change in value reported in the statement of operations.



The derivative liabilities
were valued using a probability weighted average series of Black-Scholes-Merton models as a valuation technique with the following
assumptions:





|                         |  | Fair Value of Warrants |            
|------------------------ |  | ---------------------- | -----------
|                         |  | June 30, 2012          |            
|Risk-free interest rate  |  |                        | 0.16%      
|Expected volatility      |  |                        | 117%       
|Expected life (in years) |  |                        | 0.25 – 0.50
|Expected dividend yield  |  |                        | 0%         
|Fair Value:              |  |                        |            
|2009 Summer Warrants     |  |                        | 367,896    
|2009 Wellfleet Warrants  |  |                        | –          
|2009 Fall Warrants       |  |                        | 1,357,242  
|Total Fair Value         |  | $                      | 1,725,138  





The risk-free interest
rate is based on the yield available on U.S. Treasury securities.  The Company estimates volatility based on the historical
volatility of its common stock.  The expected life warrants are based on the expiration date of the related warrants.  The
expected dividend yield was based on the fact that the Company has not paid dividends to common shareholders in the past and does
not expect to pay dividends to common shareholders in the future.



As of June 30,
2012, the Company re-measured the derivative liabilities and determined the fair value to be $1,725,138. For the six months
ended June 30, 2012, the Company recorded a loss on the change in fair value of derivatives of $167,575 and a gain on
extinguishment of derivative liability of $85,576 due to exercise of warrants to shares of common stock.



9. Commitments and contingencies



Legal matters



There is no other litigation
of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.





16









Lease agreement



The Company entered into a lease agreement
with Balboa building on February 1, 2012. This agreement calls for the company to lease suites 215, 216, 217, 218, 219, 220, 221,
229, 230 on the second floor of the Balboa building located at 735 State St. Santa Barbara, CA. This lease was executed in anticipation
of the Company's growth and the need to increase square footage while space is available. The lease agreement calls for a monthly
rental of $5,845 and will expire on December 31, 2013.



10. Other income



One of the Company’s legal
counsel agreed to cancel $223,774 of unpaid legal fees for services rendered as of June 30, 2012.  As a result, the
Company recognized a gain of $223,774 during the period ended due to the cancellation of debt.



11. Subsequent events



2012 Summer  Offering



From
June 29, 2012 through July 23, 2012, the Company conducted a private offering (the "Summer 2012 Offering") of up to $2,000,000
aggregate face amount of its convertible notes (the "Summer 2012 Notes"). A total of $568,920 aggregate face amount of
the Summer 2012 Notes were sold for an aggregate purchase price of $517,200. While the stated interest rate on the Summer 2012
Notes is 0%. the actual interest rate on the Summer 2012 Notes is 10% per annum. The Summer 2012 Notes mature on the first anniversary
of their date of issuance. The Summer 2012 Notes are convertible, at the option of the noteholders into 1,422,300 shares of common
stock of the Company (the "Conversion Shares") at an initial conversion price of $0.40 per share (the "Conversion
Price").



Each of the investors
in the Summer 2012 Offering received, for no additional consideration, a warrant (the "Summer 2012 Warrants"),
entitling the holder to purchase a number of shares of the Company's common stock equal to 100% of the number of shares of common
stock into which the Summer 2012 Notes are convertible (the "Warrant Shares"). Each Summer 2012 Warrant is exercisable
on a cash basis only at an initial price of $0.40 per share, and is exercisable immediately upon issuance and for a period of
three (3)years from the date of issuance. Up to 1,422,300 Warrant
Shares are initially issuable to date on exercise of the Summer 2012 Warrants.





Increase in Outstanding Shares



During the period from
July 1, 2012 through August 6, 2012, the Company issued 444,500 shares of its common stock.  This was comprised of the
following:



The Company issued
198,000 shares of its common stock upon conversion of $49,500 of debt to its existing convertible note holders.



The Company issued
246,500 shares of its common stock upon exercise of warrants for aggregate proceeds of $73,950.



Investor Relations Agreements



The Company entered
into two separate Independent Contractor Agreements whereby, contractor will provide investor relations and communication services
for the Company. The term of the agreement shall be for one year commencing on July 1, 2012 and shall continue from month-to-month
thereafter. The Company issued warrants to purchase 1,000,000 shares of restricted common stock at an exercise price of $0.30 per
share, vested immediately and shall expire in three years. The warrants were valued at $301,600 based on Black-Scholes-Merton valuation
method.



17









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



This Quarterly Report
on Form 10-Q contains forward-looking statements. These forward-looking statements include predictions regarding our future:



|● | revenues and profits;                                                                              
|- | ---------------------------------------------------------------------------------------------------
| 
|● | customers;                                                                                         
| 
|● | research and development expenses and efforts;                                                     
| 
|● | scientific and other third-party test results;                                                     
| 
|● | sales and marketing expenses and efforts;                                                          
| 
|● | liquidity and sufficiency of existing cash;                                                        
| 
|● | technology and products;                                                                           
| 
|● | the outcome of pending or threatened litigation; and                                               
| 
|● | the effect of recent accounting pronouncements on our financial condition and results of operations



You can identify these
and other forward-looking statements by the use of words such as “may,” “will,” “expects”,
“anticipates,” “believes,” “estimates,” “continues,” or the negative of such terms,
or other comparable terminology.



Forward-looking statements
also include the assumptions underlying or relating to any of the foregoing statements.



Our actual results
could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those
set forth under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011.
All forward-looking statements included in this document are based on information available to us on the date hereof. We assume
no obligation to update any forward-looking statements.



Overview



Save the World Air,
Inc. (“STWA” or “Company” or “we”) designs, licenses and develops products to improve energy
efficiency of large-scale energy production and improve diesel engine performance reducing emissions and improving fuel economy.
We are a green technology company that leverages a suite of patented, patent-pending and licensed intellectual properties related
to the treatment of fuels. Technologies patented by or licensed to us utilize either magnetic or uniform electrical fields to alter
physical characteristics of fuels and are designed to create cleaner combustion. Cleaner combustion has been shown to improve performance,
enhance fuel economy and/or reduce harmful emissions in laboratory testing.



On August 1, 2011,
Save The World Air, Inc. and Temple University entered into two Exclusive License Agreements. One Agreement relates to Temple’s
international patent applications, patents and technical information pertaining to technology associated with an electric and/or
magnetic field assisted fuel injection system. The second agreement relates Temple’s international patent applications and
patents and technical information pertaining to technology to reduce crude oil viscosity. The License Agreements are exclusive
to the Company and the territory licensed to the Company is worldwide.



We have two product
lines;  Applied Oil Technology (“AOT”) and ELEKTRATM.



AOT



On July 16, 2010, the
Company entered into a Letter of Intent with the U.S. Department of Energy-Naval Petroleum Reserve/Rocky Mountain Oilfield Testing
Center (RMOTC) in Wyoming. On December 22, 2010, a formal Agreement was entered into with RMOTC for testing of our Applied Oil
Technology (AOT). Third-party vendors and suppliers were used by the Company to provide the facility construction materials and
the prototype’s design and fabrication To conduct the testing, the Company was responsible for upgrading the testing facility’s
existing infrastructure, located on the Naval Petroleum Reserve #3. Design and engineering began in January 2011 and construction
was completed in June 2011.



The AOT Phase II testing
program began in July 2011. It is the Company’s belief that the Phase II testing of the prototype will yield important information
and data to the Company’s product development team. Costs incurred for the testing during the six months ended June 30, 2012
was $182,692. (See “Item 5 Other information”)





18









Elektra



The Company’s
ELEKTRA technology improves diesel fuel economy in both land and marine diesel engines. The Company’s preliminary experimental
prototypes have shown repeatable improvements in fuel economy. Research is being conducted under controlled conditions at the Company’s
research facility in Morgan Hill California.



We operate in a highly
competitive industry.  Many of our activities are subject to governmental regulation.  We have taken aggressive
steps to protect our intellectual property.



There are significant
risks associated with our business, our Company and our stock.



We are a development
stage Company that generated minimal revenues in 2006 and 2007. We did not generate any sales or revenues from 2008 up to June
30, 2012. Our expenses to date have been funded primarily through the sale of stock and convertible debt, as well as proceeds from
the exercise of stock purchase warrants. We raised capital in 2011 and will need to raise substantial additional capital in 2012,
and beyond, to fund our sales and marketing efforts, continuing research and development, and certain other expenses, until our
revenue base grows sufficiently to cover such expenditures.  See “Management’s Discussion and Analysis”
below.



Our company was incorporated
on February 18, 1998, as a Nevada corporation, under the name Mandalay Capital Corporation. We changed our name to Save the
World Air, Inc. on February 11, 1999, following the acquisition of marketing and manufacturing rights of the ZEFS (legacy)
technologies. Our mailing address is 735 State Street, Suite 500, Santa Barbara, California 93101. Our telephone number is (805)
845-3581. Our corporate website is www.stwa.com.



Our common stock is quoted under the symbol “ZERO”
on the Over-the-Counter Bulletin Board



Results of Operations



We did not generate
any revenue for the three-month and six-month periods ended June 30, 2012 and 2011.



Operating
expenses were $1,921,814 for the three-month period ended June 30, 2012, compared to $1,428,251 for the three-month period
ended June 30, 2011, an increase of $493,563. This increase is attributable to an increase in non-cash expenses of $515,081,
offset by a decrease in cash expenses of $21,518. Specifically, the increase in non-cash expense is attributable to increases
in stocks, options and warrants given to consultants and employees of $463,081 and bad debt expense of $52,000. Specifically,
the decrease in cash expense is attributable to decreases consulting and professional fees of $211,984, corporate expenses of
$52,853, office and other expenses of $10,320, offset by an increase in salaries and benefits of $253,639.



Operating
expenses were $3,859,719 for the six-month period ended June 30, 2012, compared to $2,511,235 for the six-month period ended
June 30, 2011, an increase of $1,348,484. This increase is attributable to increases in non-cash expenses of $1,215,028 and
cash expenses of $133,456. Specifically, the increase in non-cash expense is attributable to increases in stocks, options and
warrants given to consultants and employees of $1,163,028 and bad debt expense of $52,000. Specifically, the increase in cash
expense is attributable to increases in salaries and benefits of $349,561, office and other expenses of $34,361, offset by
decreases in consulting and professional fees of $186,070 and corporate expenses of $64,396.



Research and development
expenses were $183,424 for the three-month period ended June 30, 2012, compared to $81,213 for the three-month period ended June
30, 2011, an increase of $102,211. This increase is attributable to an increase in contract fees of $109,375, offset by a
decrease in product testing, research and supplies of $7,164.



Research
and development expenses were $350,890 for the six-month period ended June 30, 2012, compared to $552,568 for the six-month period
ended June 30, 2011, a decrease of $201,678. This decrease is attributable to a decrease in product testing, research and
supplies of $357,928, offset by an increase in contract fees of $156,250.



Other income and expense
were $708,440 income for the three-month period ended June 30, 2012, compared to $2,886,206 expense for the three-month period
ended March 31, 2011, a decrease in expense of $3,594,646. This decrease is attributable to decreases in interest and financing
expense of $2,853,858, fair value of derivative liabilities of $711,491 and other expense of $29,297.



Other income and expense
were $2,656,539 expense for the six-month period ended June 30, 2012, compared to $2,194,658 expense for the six-month period ended
June 30, 2011, an increase in expense of $461,881. This increase is attributable to increases in the fair value of derivative liabilities
of $1,645,583, other expense of $22,475, offset by a decrease in interest and financing expense of $982,403 and an increase in
other income of $223,774 due to settlement of debt.





19









We had a net loss of
$1,397,598, or $0.01 per share, for the three-month period ended June 30, 2012, compared to a net loss of $4,396,470, or $0.04
per share, for the three-month period ended June 30, 2011.



We had a net loss of
$6,867,948, or $0.06 per share, for the six-month period ended June 30, 2012, compared to a net loss of $5,259,261, or $0.06 per
share, for the six-month period ended June 30, 2011.



We expect to incur
additional net loss in the fiscal year ending December 31, 2012 primarily attributable to continued operating and marketing-related
expenditures without the benefit of any significant revenue for the remainder of the year.



Liquidity and Capital Resources



Since its inception,
we have been primarily engaged in organizational and pre-operating activities. We have generated insignificant revenues and have
incurred accumulated losses of $76,157,415 from February 18, 1998 (Inception) through June 30, 2012. As reflected in the accompanying
condensed consolidated financial statements, we had a net loss of $6,867,948 and a negative cash flow from operations of $2,335,322
for the six months ended June 30, 2012, and had a working capital deficiency (excluding derivative liabilities) of $1,798,382 and
a stockholders' deficiency of $3,443,137 at June 30, 2012. As a result, our independent registered public accounting firm, in their
report on our 2011 consolidated financial statements, raised substantial doubt about our ability to continue as a going concern.
 The financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.



Our ability to continue
as a going concern is dependent upon our ability to raise additional funds and implement our business plan. Our operations from
inception, February 18, 1998 to June 30, 2012 have been funded through issuances of our common stock and convertible notes.
As of June 30, 2012, we raised an aggregate of $29,171,312 of which $17,891,788 was from the sale of convertible notes. As
of June 30, 2012, the outstanding balance of convertible notes was $483,813, of which $148,753 represented convertible note offering,
which closed on February 3, 2012. We expect substantially all of the outstanding notes will be converted into shares of common
stock of the Company (see “Item 5 Other Information”).



On June 30, 2012, we
had cash on hand in the amount of $59,892. In addition to the funds on hand, we will require additional funds to continue to operate
our business. This includes expenses we will incur in connection with license agreements; product development and commercialization
of the AOT and ELEKTRA technologies; costs to manufacture and ship our products; costs to design and implement an effective system
of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company by filing periodic
reports with the SEC and costs required to protect our intellectual property. In addition, we have contractual commitments for
salaries to one of our executive officers pursuant to an employment agreement, severance payments to a former officer and consulting
fees, during 2011 and beyond. In light of our financial commitments over the next several months and its liquidity constraints,
we have implemented cost reduction measures in all areas of operations. We intend to review these measures on an ongoing basis
and make additional decisions as may be required.



Details of Recent
Financing Transactions





From December
13, 2010 through February 3, 2012, we conducted private offerings of up to $10,000,000 aggregate face amount of
its convertible notes. A total of $7,722,783 aggregate face amount of the notes were sold for an aggregate purchase price
of $7,020,711. Through December 31, 2011, $6,239,029 of these notes were sold, of which $4,518,425 were converted
during 2011, leaving a balance of convertible notes outstanding as of December 31, 2011 of $1,720,460. During 2012, we sold an additional $1,495,854 of these convertible notes, and an additional $2,732,501 of these notes were converted,
leaving a balance of convertible notes outstanding of June 30, 2012 of $483,813. While the stated interest rate on the notes
is 0%, the actual interest rate on the notes is 10% per annum. The notes mature on the first anniversary of their respective
date of issuance. The notes outstanding at June 30, 2012 are convertible, at the option of the note holder, into 1,935,252
shares of our common stock (the “Conversion Shares”) a conversion price of $0.25 per share.



Each of the investors
in the offerings received, for no additional consideration, a warrant entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the notes are convertible (the “Warrant
Shares”).  Each warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable
immediately upon issuance and for a period of two (2) years from the date of issuance. Warrants to acquire 5,983,416 shares of
common stock were granted during the six months ended June 30, 2012.









20











During 2012, we sold $1,495,854 of convertible notes for aggregate consideration of $1,326,740, resulting in a discount of
$135,374 and conversion of previously recorded liabilities of $33,740. The aggregate relative value of the warrants issued in
the 2012 offerings were valued at $593,208 using the Black-Scholes-Merton option valuation model with the following
assumptions; risk-free interest rate of .27%; dividend yield of 0%; volatility factors of the expected market price of common
stock of 121%; and an expected life of two years (statutory term). We determined that the notes contained a
beneficial conversion feature of $766,603.  The aggregate value of $1,495,854 of the 2012 Offering Warrants, the
beneficial conversion feature and the note discount are considered as debt discount and will be amortized over the life of
the notes.  The value of this debt discount was added to the outstanding debt discount of $1,550,918 as of December 31,
2011.  During the period ended June 30, 2012, we amortized $2,813,959 of debt discount, resulting in an
unamortized debt discount balance of 232,813 as of June 30, 2012.



As of June 30, 2012,
the outstanding balance of the notes was $483,813.









Critical Accounting Policies and
Estimates



Our discussion and
analysis of our condensed consolidated financial condition and results of operations is based upon our financial statements, which
have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation
of these condensed consolidated financial statements and related disclosures requires us to make estimates and judgments that affect
the reported amounts of assets, liabilities, expenses, and related disclosure of contingent assets and liabilities. We evaluate,
on an on-going basis, our estimates and judgments, including those related to the useful life of the assets. We base our estimates
on historical experience and 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.



The methods, estimates
and judgments we use in applying our most critical accounting policies have a significant impact on the condensed consolidated
results that we report in our financial statements. The SEC considers an entity’s most critical accounting policies to be
those policies that are both most important to the portrayal of a company’s financial condition and results of operations
and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make
estimates about matters that are inherently uncertain at the time of estimation.. For a more detailed discussion of the accounting
policies of the Company, see Note 2 of Notes to the condensed consolidated financial statements.



We believe the following critical accounting
policies, among others, require significant judgments and estimates used in the preparation of our condensed consolidated financial
statements:



The preparation of
financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period. Certain significant estimates
were made in connection with preparing our condensed consolidated financial statements as described in Note 1 to Notes to condensed
consolidated financial statements. Actual results could differ from those estimates.



Stock-Based Compensation



The Company periodically
issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing
costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance
provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized
over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance
with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based
upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at
which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally
are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance
requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded
in the period of the measurement date.



The fair value of the
Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions
related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation
expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The
assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.



Accounting for Warrants and Derivatives



The Company evaluates
all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded
derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially
recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated
statements of operations. For stock-based derivative financial instruments, the Company uses a probability weighted average series
Black-Scholes-Merton option pricing models to value the derivative instruments at inception and on subsequent valuation dates.





21









The classification
of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the
end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based
on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.



Recent Accounting Pronouncements



In May 2011, the
Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04,
“Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. ASU No. 2011-4
does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices
outside of financial reporting. The ASU is effective for interim and annual periods beginning after December 15, 2011. The
Company adopted ASU No. 2011-04 effective January 1, 2012 and it did not affect the Company’s results of operations, financial
condition or liquidity.



In June 2011,
the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”. The ASU eliminates the option to present
the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires
consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive
income or in two separate but consecutive statements. ASU No. 2011-5 is effective for interim and annual periods beginning
after December 15, 2011. The Company adopted ASU 2011-05 effective January 1, 2012 and it did not affect the Company’s
results of operations, financial condition or liquidity.



In September 2011,
the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of
goodwill impairment. This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative
factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount
before performing the two step impairment review process. It also amends the examples of events or circumstances that would be
considered in a goodwill impairment evaluation. The amendments are effective for annual and interim goodwill impairment tests performed
for fiscal years beginning after December 15, 2011. The Company adopted ASU 2011-08 effective January 1, 2012. We do not believe
that the adoption of this new accounting guidance will have a significant effect on our goodwill impairment assessments in the
future.



In December 2011, the Financial Accounting
Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11, “Balance Sheet (Topic
210): Disclosures about Offsetting Assets and Liabilities.” This ASU requires an entity to disclose information about offsetting
and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial
position. ASU No. 2011-11 will be applied retrospectively and is effective for annual and interim reporting periods beginning on
or after January 1, 2013. The Company does not expect adoption of this standard to have a material impact on its consolidated results
of operations, financial condition, or liquidity.



Other recent accounting
pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission
(the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated
financial statements.





Item 3. Quantitative and Qualitative Disclosures about Market Risk



Not applicable.



Item 4. Controls and Procedures



Evaluation of
Disclosure Controls and Procedures





Our management evaluated,
with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls
and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive
Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e)
under the Securities Exchange Act of 1934 (the “Exchange Act”)  is not effective as of June 30, 2012.



Disclosure controls
are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed
under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods
specified in the SEC’s rules and forms.  Disclosure controls are also designed with the objective of ensuring 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.  Internal control consists of procedures which
are designed with the objective of providing reasonable assurance that our transactions are properly authorized, recorded and reported
and our assets are safeguarded against unauthorized or improper use, to permit the preparation of our financial statements in conformity
with generally accepted accounting principles.



We identified
certain matters that constitute material weakness (as defined under the Public Company Accounting Oversight Board Auditing Standard
No. 2) in our internal control over financial reporting as discussed on Management’s Annual Report on Internal Control Over
Financial Reporting below.



In light of the material
weaknesses in internal control over financial reporting described below, we performed additional analysis and other post-closing
procedures to ensure that our financial statements were prepared in accordance with generally accepted accounting principles.
Despite material weaknesses in our internal control over financial reporting, we believe that the financial statements included
in our Form 10-Q for the period ended June 30, 2012 fairly present, in all material respects, our financial condition, results
of operations, changes in shareholder’s equity and cash flows for the periods presented.









22







We have created
policies and procedures to allow for segregation of duties, check of disbursements, level of authorities and operating
budget. These are currently being implemented. The reviewing, recording, and depositing of money received are completed by
separate employees. Bank reconciliations will be performed by two accounting personnel on a monthly basis. We require all
disbursements to be reviewed by the appropriate personnel and be signed by two other personnel. We have set a limit to each
signer’s authority to sign and have required all disbursements be supported with appropriate documents, invoices,
receipts, etc. We have also required Board approval for contracts and agreements exceeding $200,000USD. The Company also
implemented a monthly operating budget which must be analyzed with explanation of variances. We expect these procedures to be
fully implemented by December 31, 2012.





Management’s Annual Report
on Internal Control over Financial Reporting.





Internal control over financial reporting is a process designed 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 and includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable
detail accurately and fairly reflect the transaction and dispositions of our assets; (ii) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted
accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our
management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of our assets that could have a material effect on the financial statements.



Because of its inherent limitation, internal control over financial reporting cannot provide absolute assurance of achieving
financial reporting objectives.



Our Chief Executive Officer, Chief Financial Officer and Controller conducted an assessment of the effectiveness of our
internal control over financial reporting as of June 30, 2012 based on the framework in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). A material
weakness 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 the Company’s annual or interim financial statements will not
be prevented or detected on a timely basis.



Based on that assessment, we have identified the following material weaknesses and have implemented the following remediation
of material weaknesses in internal control over financial reporting:



Lack of segregation of duties

We have limited staff in our corporate offices and, as such, there is a lack of segregation of duties. We recently developed
an internal control procedure manual that allows for segregation of duties from within the accounting department. This will
be submitted for approval with a Board Resolution and will be implemented soon.



Lack of documented and reviewed system of internal control

We have an internal control weakness due to the lack of a documented and reviewed system of internal control. We are currently
reviewing an implementation process so as to be more in line with Sarbanes-Oxley 302. We have started to enhance some of our
key internal control systems surrounding inventory purchasing and control, and to document those changes; however, this process
is on-going and the implementation of policies and procedures may take several quarters.



As a result of the material weaknesses described above, we are currently implementing a process to ensure all invoices
and statements of account are reviewed and approved by at least two individuals within the financial department.



We are conducting an evaluation to design and implement adequate systems of accounting and financial statement disclosure
controls. We expect to complete a review during 2012 to comply with the requirements of the SEC, which as required by SEC
rules, may include an opinion from our auditors regarding management’s report on internal control over financial reporting
for our fiscal year ending 2012. We believe that the ultimate success of our plan to improve our internal control over financial
reporting will require a combination of additional financial resources, outside consulting services, legal advice, additional
personnel, further reallocation of responsibility among various persons, and substantial additional training of those of our
officers, personnel and others, including certain of our directors such as our Chairman of the Board and committee chairs,
who are charged with implementing and/or carrying out our plan. It should also be noted that the design of any system of controls
and procedures is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.



In addition, our management with the participation of our Chief Executive Officer and Chief Financial Officer have determined
that no change in our internal control over financial reporting (as that term is defined in Rules 13(a)-15(f) and 15(d)-15(f)
of the Securities Exchange Act of 1934) occurred during or subsequent to the quarter ended June 30, 2012 that has materially
affected, or is reasonably likely to materially affect, our internal control over financial reporting.







23











PART II



Item 1. Legal Proceedings



There is no other litigation
of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.



Item 1A. Risk Factors



There have been no
material changes in the risk factors previously disclosed in Form 10-K for the period ended December 31, 2011, which we filed with
the SEC on March 30, 2012.



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



2011 and 2012
Offering.From December 13, 2010, through February 3, 2012, we conducted a private offering consisting of an aggregate
of $7,722,783 of Convertible Promissory Notes. The Notes were sold for an aggregate purchase price of $7,020,711 net proceeds. The
Notes are convertible into 30,891,132 shares of our common stock and in addition investors received warrants to purchase up to
30,891,130 shares of our common stock.  (See “Details of Recent Financing Transactions”).



The sales of the securities
described above were made in reliance on the exemptions from registration set forth in Section 4(2) of the Securities Act
of 1933, as amended (the “Act”), or Regulation S promulgated thereunder, and other applicable exemptions.



Other Issuances.



During the six months
ended June 30, 2012, we issued 10,930,004 shares of common stock in exchange for conversion of $2,732,501 of Convertible Notes.



During the six months
ended June 30, 2012, we issued 1,294,726 shares of common stock upon exercise of warrants at an average price of $0.35 per share
and valued at $458,500.



During the six months
ended June 30, 2012, we issued 1,500,000 shares of common stock for consulting services at and average price of $0.35 per share
and valued at $520,000.



During the six months
ended June 30, 2012, we issued 18,334 shares of common stock upon exercise of options at $0.27 per share and valued at $4,950.



Item 3. Defaults Upon Senior Securities



None



Item 4. Mine Safety Disclosures



None



Item 5. Other Information



Increase in Outstanding Shares



During the period from
July 1, 2012 through August 6, 2012, we issued 444,500 shares of our common stock.  This was comprised of the following:



We issued 198,000 shares
of our common stock upon conversion of $49,500 of debt to its existing convertible note holders.



We issued 246,500 shares
of our common stock upon exercise of warrants for aggregate proceeds of $73,950.





24









Investor Relations Agreements





We entered into two
separate Independent Contractor Agreements whereby, contractor will provide investor relations and communication services for
the Company. The term of the agreement shall be for one year commencing on July 1, 2012 and shall continue from month-to-month
thereafter. We issued warrants to purchase 1,000,000 shares of restricted common stock at an exercise price of $0.30 per share,
vested immediately and shall expire in three years. The warrants were valued at $301,600 based on Black-Scholes-Merton valuation
method.



Cash Bonus to Cecil
B. Kyte



On July 19, 2012,
the Company’s Board of Directors elected to ratify and approve a cash bonus for Cecil B. Kyte, the Company’s CEO
and Chairman of the Board, in the amount of $100,000 for his efforts and services during the period December 1, 2011, through
July 19, 2012. On Mr. Kyte’s request, the Company initially paid him the sum of $100,000 under the mistaken
belief that such sum represented payment in lieu of accrued vacation time. The Board determined otherwise; but nonetheless
acknowledged Mr. Kyte’s exceptional services to the Company. The Board also acknowledged that a cash bonus to Mr. Kyte
was already under consideration. The Board thus determined to treat the payments to Mr. Kyte as a cash bonus.



Item 6. Exhibits



|Exhibit No. |         | Description
|----------- | ------- | -----------
|            |         |            
|            | 31.1    |            
|            |         |            
|            | 31.2    |            
|            |         |            
|            | 32      |            
|            |         |            
|            | 101.INS |            
|            |         |            
|            | 101.SCH |            
|            |         |            
|            | 101.CAL |            
|            |         |            
|            | 101.LAB |            
|            |         |            
|            | 101.PRE |            
|            |         |            
|            | 101.DEF |            





25









SIGNATURES



In accordance with
Section 13 or 15(d) of the Exchange Act, the Registrant has caused this Report to be signed on its behalf by the undersigned,
hereunto duly authorized.



|                      | SAVE THE WORLD AIR, INC. |                        
|--------------------- | ------------------------ | -----------------------
|                      |                          |                        
|                      |                          |                        
|Date: August 14, 2012 | By:                      | /s/ GREGG BIGGER       
|                      |                          | Gregg Bigger           
|                      |                          | Chief Financial Officer
|                      |                          |                        









26









EXHIBIT INDEX



|Exhibit No. |      | Description
|----------- | ---- | -----------
|            |      |            
|            | 31.1 |            
|            |      |            
|            | 31.2 |            
|            |      |            
|            | 32   |            



| | 101.INS |  | XBRL Instance Document*             
| | ------- |  | ------------------------------------
| |         |  |                                     
| | 101.SCH |  | XBRL Schema Document*               
| |         |  |                                     
| | 101.CAL |  | XBRL Calculation Linkbase Document* 
| |         |  |                                     
| | 101.LAB |  | XBRL Label Linkbase Document*       
| |         |  |                                     
| | 101.PRE |  | XBRL Presentation Linkbase Document*
| |         |  |                                     
| | 101.DEF |  | XBRL Definition Linkbase Document*  



* Pursuant to Rule 405(a)(2) of Regulation
S-T, the Company will furnish the XBRL Interactive Data Files with detailed footnote tagging as Exhibit 101 in an amendment to
this Form 10-Q within the permitted 30-day grace period for the first quarterly period in which detailed footnote tagging is required
after the filing date of this Form 10-Q.





27