UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q/A


(Amendment
Number 1)





x
            QUARTERLY
      REPORT UNDER SECTION 13 0R 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
quarterly period ended  March 31, 2009





 ̈
            TRANSITION
      REPORT UNDER SECTION 13 0R 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
transition period from:




Commission
file number: 002-95626-D





SIONIX
CORPORATION


(Exact name of registrant as
specified in its charter)





Nevada
            
            87-0428526(State
      or other jurisdiction of incorporation or organization)
            
            (I.R.S. Employer Identification
      No.)2801
      Ocean Park Blvd, Suite 339, Santa Monica, California
            
            90405(Address
      of principal executive offices)
            
            (Zip
      Code)





Issuer’s
telephone number (847)
235-4566






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





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x No  ̈





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


 ̈ Yes    ̈ No





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 filed,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.





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





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).  ̈ Yes x No





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date.  As of May 11, 2009 the
number of shares of the registrant’s classes of common stock outstanding was
142,303,907.













EXPLANATORY
NOTE







Between
October 17, 2006 and February 27, 2007 the Sionix Corporation issued 25 secured
convertible promissory notes for total proceeds to the Company of $750,000
(“Convertible Notes 1”). Convertible Notes 1 could be converted into shares of
the Company’s common stock at a conversion price of $0.05 per share Convertible
Notes 1 contained a provision that would automatically adjust the conversion
price if equity securities or instruments convertible into equity securities
were issued at a conversion price less than $0.05.




On June
6, 2007, the Company issued 5 convertible promissory notes for a total of
$86,000 (“Convertible Notes 2”).  No warrants were issued in
connection with Convertible Notes 2. Convertible Notes 2 mature on December 31,
2008 and are convertible into common stock at $0.01 per share.




As a
result of the issuance of Convertible Notes 2, the conversion price for
Convertible Notes 1 was adjusted down from $0.05 to $0.01.  The
decrease in the conversion price increased the potential dilutive shares from
15,000,000 to 75,000,000, and this subsequently increased the total outstanding
and potential dilutive shares over the authorized common share limit of
150,000,000.  Because there were insufficient authorized shares to
fulfill all potential conversions, the Company should have classified all
potentially dilutive securities as derivative liabilities as of June 6,
2007.  The Company researched its debt and equity instruments and
determined that the potentially dilutive securities are as follows:




·
            2001
      Executive Officers Stock Option
Plan


·
            Advisory
      Board Compensation


·
            Warrants
      Related to 2004 Stock Purchase
Agreement


·
            Convertible
      Notes 1


·
            Convertible
      Notes 2


·
            Subordinated
      Convertible Notes 3


·
            Warrants
      related to Subordinated Convertible Notes
3





As a
result of these transactions, we are filing amendment number 1 (“Amendment 1”)
to our Form 10-Q (the “Original Report”) that was originally filed with the
Securities and Exchange Commission (the “SEC”) on May 20, 2009 for the period
ended March 31, 2009.





The
primary purpose of this Amendment 1 is to disclose the restatement of our
financial statements for the three and six months ended March 31, 2009 and
cumulative inception to date operations for March 31, 2009.  A
complete discussion of the restatement is included in the section of this
Amendment 1 titled “Management’s Discussion and Analysis or Plan of Operation”
and in Note 17 to our financial statements for the period ended March 31,
2009.





This
Amendment 1 includes all of the information contained in the Original Report,
and we have made no attempt in this Amendment 1 to modify or update the
disclosures presented in the Original Report, except as identified.





The
disclosures in this Amendment continue to speak as of the date of the Original
Report, and do not reflect events occurring after the filing of the Original
Report.  Accordingly, this Amendment should be read in conjunction
with our other filings made with the SEC subsequent to the filing of the
Original Report, including any amendments to those filings.  The
filing of this Amendment 1 shall not be deemed to be an admission that the
Original Report, when made, included any untrue statement of a material fact or
omitted to state a material fact necessary to make a statement not
misleading.





During
the period ended March 31, 2009, certain investors converted $11,797 of
convertible notes into 294,930 common shares at $0.04 per share; however, the
conversion rate should have been $0.01.  At March 31, 2009, the
Company owes an additional 12,248,173 shares to the investors related to the
$11,797 converted during the period ended March 31, 2009 and the $151,512
converted during the period ended September 30, 2008.  The Company
recorded a liability of $979,854 which is recorded in accrued expenses in the
accompanying financial statements.  The change in the fair value of
the shares will be recorded as a change in fair value of beneficial conversion
liability.





The
following adjustments were made to our financial statements for the periods
ended March 31, 2009:


2


As
      Previously Stated
              
              
              Beneficial
      Conversion
              
              
              Warrants
      and
              
              
              
              
              
              As
      RestatedMarch
      31, 2009
              
              
              Options
              
              
              Options
              
              
              Reclassifications
              
              
              March
      31, 2009Balance
      SheetOther
      assets
              
              $
              34,165
              
              
              $
              -
              
              
              $
              -
              
              
              $
              155,000
              
              
              $
              189,165Accrued
      expenses
              
              
              2,734,069
              
              
              
              979,854
              
              
              
              -
              
              
              
              155,000
              
              
              
              3,868,923Warrant
      and option liability
              
              
              2,180,429
              
              
              
              -
              
              
              
              1,790,486
              
              
              
              -
              
              
              
              3,970,915Beneficial
      conversion liability
              
              
              -
              
              
              
              4,740,412
              
              
              
              -
              
              
              
              -
              
              
              
              4,740,412Additional
      paid-in capital
              
              
              13,383,049
              
              
              
              -
              
              
              
              (1,847,488
              )
              
              
              -
              
              
              
              11,535,561Deficit
      accumulated during developmental stage
              
              
              (21,869,332
              )
              
              
              (5,720,266
              )
              
              
              57,002
              
              
              
              -
              
              
              
              (27,532,596
              )Statement
      of Operations (for the three months ended March 31, 2009)Gain
      (loss) on change in fair value of warrant and option
    liability
              
              $
              (219,981
              )
              
              $
              -
              
              
              $
              837,506
              
              
              $
              -
              
              
              $
              617,525Gain
      on change in fair value of beneficial conversion liability
              
              
              -
              
              
              
              907,549
              
              
              
              -
              
              
              
              -
              
              
              
              907,549Statement
      of Operations (for the six months ended March 31, 2009)Gain
      on change in fair value of warrant and option liability
              
              $
              1,631,387
              
              
              $
              -
              
              
              $
              1,490,193
              
              
              $
              -
              
              
              $
              3,121,580Gain
      on change in fair value of beneficial conversion liability
              
              
              26,000
              
              
              
              4,742,622
              
              
              
              -
              
              
              
              -
              
              
              
              4,768,622Statement
      of Operations (since inception)Gain
      on change in fair value of warrant and option liability
              
              $
              6,849,627
              
              
              $
              -
              
              
              $
              516,466
              
              
              $
              -
              
              
              $
              7,366,093Gain
      on change in fair value of beneficial conversion liability
              
              
              1,426,767
              
              
              
              29,000,652
              
              
              
              -
              
              
              
              -
              
              
              
              30,427,419General
      and administrative expense
              
              
              21,740,171
              
              
              
              3,787,032
              
              
              
              83,855
              
              
              
              -
              
              
              
              25,611,058Interest
      expense and financing costs
              
              
              (2,457,641
              )
              
              
              (30,536,702
              )
              
              
              (897,793
              )
              
              
              -
              
              
              
              (33,892,136
              )Statement
      of Cash Flows (for the six months ended March 31, 2009)Net
      income
              
              $
              149,324
              
              
              $
              4,742,622
              
              
              $
              1,490,193
              
              
              $
              -
              
              
              $
              6,382,139Gain
      on change in fair value of warrant and option liability
              
              
              (1,631,387
              )
              
              
              -
              
              
              
              (1,490,193
              )
              
              
              -
              
              
              
              (3,121,580
              )Gain
      on change in fair value of beneficial conversion liability
              
              
              (26,000
              )
              
              
              (4,742,622
              )
              
              
              -
              
              
              
              -
              
              
              
              (4,768,622
              )Statement
      of Cash Flows (since inception)Net
      loss
              
              $
              (21,744,332
              )
              
              $
              (5,323,082
              )
              
              $
              (465,182
              )
              
              $
              -
              
              
              $
              (27,532,596
              )Gain
      on change in fair value of warrant and option liability
              
              
              (6,849,627
              )
              
              
              -
              
              
              
              (516,466
              )
              
              
              -
              
              
              
              (7,366,093
              )Gain
      on change in fair value of beneficial conversion liability
              
              
              (1,426,768
              )
              
              
              (29,000,652
              )
              
              
              -
              
              
              
              -
              
              
              
              (30,427,420
              )Non-cash
      compensation expense
              
              
              -
              
              
              
              3,787,032
              
              
              
              83,855
              
              
              
              -
              
              
              
              3,870,887Non-cash
      financing costs
              
              
              -
              
              
              
              30,536,702
              
              
              
              897,793
              
              
              
              -
              
              
              
              31,434,495


3








Table
of Contents




Part
      I - Financial InformationItem
      1. Financial Statements
            5Balance
      Sheets as of March 31, 2009 (Unaudited) and September 30, 2008
      (Restated)
            5Statements
      of Income (Operations) (Unaudited) for the three and six months ended
      March 31, 2009 and March 31, 2008 (Restated) and from inception (October
      3, 1994) to March 31, 2009 (Restated)
            6Statement
      of Stockholders Equity (Deficit) (Unaudited) for the period from inception
      (October 3, 1994) to March 31, 2009 (Restated)
            7Statements
      of Cash Flows (Unaudited) for the three and six months ended March 31,
      2009 and March 31, 2008 (Restated) and from inception (October 3, 1994) to
      March 31, 2009 (Restated)
            8Notes
      to unaudited condensed financial statements
            9Forward-Looking
      StatementsItem 2. Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            47Item 3. Quantitative and Qualitative Disclosures
      About Market Risk
            65Item 4T. Controls and
      Procedures
            65Part II – Other InformationItem 1. Legal Proceedings
            66Item 1A. Risk Factors
            66Item 2. Unregistered Sales of Equity
      Securities and Use of Proceeds
            66Item 3. Defaults Upon Senior
      Securities
            67Item 4. Submission of Matters to a Vote of
      Security Holders
            68Item 5. Other Information
            68Item 6. Exhibits
            68Signatures
            69








4








Part
I, Item 1.  Financial Statements.





SIONIX
      CORPORATIONA
      DEVELOPMENT STAGE COMPANYBALANCE
      SHEETSMarch
      31,
            
            
            September
      30,2009
            
            
            2008(Unaudited)(As
      Restated)
            
            
            (As
      Restated)ASSETSCURRENT
      ASSETSCash
      and cash equivalents
            
            $
            25,613
            
            
            $
            1,220,588Inventory
            
            
            608,565
            
            
            
            -Other
      current assets
            
            
            189,165
            
            
            
            138,895TOTAL
      CURRENT ASSETS
            
            
            823,343
            
            
            
            1,359,483PROPERTY
      AND EQUIPMENT, net
            
            
            77,543
            
            
            
            87,101DEPOSITS
            
            
            28,495
            
            
            
            33,095TOTAL
      ASSETS
            
            $
            929,381
            
            
            $
            1,479,679LIABILITIES
      AND STOCKHOLDERS' DEFICITCURRENT
      LIABILITIESAccounts
      payable
            
            $
            351,862
            
            
            $
            259,355Accrued
      expenses
            
            
            3,868,923
            
            
            
            4,312,844Customer
      deposits
            
            
            1,460,000
            
            
            
            1,260,000Liquidated
      damages liability
            
            
            78,750
            
            
            
            153,750Notes
      payable – related parties
            
            
            107,000
            
            
            
            114,000Convertible
      notes, net of debt discounts of $781,333
            
            
            1,781,333
            
            
            
            2,041,44310%
      subordinated convertible notes, net of debt discounts of
$0
            
            
            425,000
            
            
            
            400,796Warrant
      and option liability
            
            
            3,970,915
            
            
            
            6,869,244Beneficial
      conversion liability
            
            
            4,740,412
            
            
            
            8,881,272TOTAL
      CURRENT LIABILITIES
            
            
            16,784,195
            
            
            
            24,292,704STOCKHOLDERS'
      DEFICITCommon
      stock (150,000,000 shares authorized; 141,303,906 and
      141,822,006 shares issued and outstanding at March 31, 2009,
      respectively and 134,756,213 and 134,274,313 shares issuedand
      outstanding at September 30, 2008, respectively)
            
            
            141,821
            
            
            
            134,274Additional
      paid-in capital
            
            
            11,535,561
            
            
            
            10,841,007Shares
      to be issued
            
            
            400
            
            
            
            126,429Deficit
      accumulated during development stage
            
            
            (27,532,596
            )
            
            
            (33,914,735
            )TOTAL
      STOCKHOLDERS' DEFICIT
            
            
            (15,854,814
            )
            
            
            (22,813,025
            )TOTAL
      LIABILITIES AND STOCKHOLDERS' DEFICIT
            
            $
            929,381
            
            
            $
            1,479,679





The
accompanying notes form an integral part of these unaudited condensed financial
statements.


5





SIONIX
      CORPORATIONA
      DEVELOPMENT STAGE COMPANYSTATEMENT
      OF OPERATIONS(UNAUDITED)Cumulative
      fromFor
      the three months
            
            
            For
      the six months
            
            
            Inceptionended
      March 31,
            
            
            ended
      March 31,
            
            
            (October
      3, 1994) to2009
            
            
            2008
            
            
            2009
            
            
            2008
            
            
            March
      31, 2009(As
      Restated)
            
            
            (As
      Restated)
            
            
            (As
      Restated)
            
            
            (As
      Restated)
            
            
            (As
      Restated)Revenues
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Operating
      expensesGeneral
      and administrative
            
            
            314,055
            
            
            
            627,224
            
            
            
            964,891
            
            
            
            5,691,794
            
            
            
            25,611,058Research
      and development
            
            
            178,265
            
            
            
            329,028
            
            
            
            357,229
            
            
            
            565,932
            
            
            
            3,394,102Depreciation
      and amortization
            
            
            7,615
            
            
            
            8,157
            
            
            
            15,104
            
            
            
            16,314
            
            
            
            572,479Total
      operating expenses
            
            
            499,935
            
            
            
            964,409
            
            
            
            1,337,224
            
            
            
            6,274,040
            
            
            
            29,577,639Loss
      from operations
            
            
            (499,935
            )
            
            
            (964,409
            )
            
            
            (1,337,224
            )
            
            
            (6,274,040
            )
            
            
            (29,577,639
            )Other
      income (expense)Interest
      income
            
            
            277
            
            
            
            366
            
            
            
            3,868
            
            
            
            1,279
            
            
            
            70,242Interest
      expense and financing costs
            
            
            (63,758
            )
            
            
            (554,065
            )
            
            
            (158,523
            )
            
            
            (680,350
            )
            
            
            (33,892,136
            )Gain
      on change in fair value of warrant and option liability
            
            
            617,525
            
            
            
            1,765,338
            
            
            
            3,121,580
            
            
            
            3,943,843
            
            
            
            7,366,093Gain
      on change in fair value of beneficial conversion liability
            
            
            907,549
            
            
            
            11,088,577
            
            
            
            4,768,622
            
            
            
            18,922,878
            
            
            
            30,427,419Impairment
      of intangibles
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,267,278
            )Inventory
      obsolescence
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (365,078
            )Legal
      settlement
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            344,949Loss
      on settlement of debt
            
            
            (16,184
            )
            
            
            -
            
            
            
            (16,184
            )
            
            
            -
            
            
            
            (371,595
            )Loss
      on lease termination
            
            
            -
            
            
            
            (129,166
            )
            
            
            -
            
            
            
            (129,166
            )
            
            
            (129,166
            )Write-off
      of property and equipment
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (125,015
            )Total
      other income
            
            
            1,445,409
            
            
            
            12,171,050
            
            
            
            7,719,363
            
            
            
            22,058,484
            
            
            
            2,058,435Income
      (loss) before income taxes
            
            
            945,474
            
            
            
            11,206,641
            
            
            
            6,382,139
            
            
            
            15,784,444
            
            
            
            (27,519,204
            )Income
      taxes
            
            
            -
            
            
            
            
            
            
            
            -
            
            
            
            900
            
            
            
            13,392Net
      income (loss)
            
            $
            945,474
            
            
            $
            11,206,641
            
            
            $
            6,382,139
            
            
            $
            15,783,544
            
            
            $
            (27,532,596
            )Basic
      income per share
            
            $
            0.01
            
            
            $
            0.10
            
            
            $
            0.05
            
            
            $
            0.15Dilutive
      income per share
            
            $
            0.01
            
            
            $
            0.10
            
            
            
            0.05
            
            
            $
            0.15Basic
      weighted average number ofshares
      of common stock outstanding
            
            
            136,973,884
            
            
            
            107,494,374
            
            
            
            136,277,277
            
            
            
            107,494,374Dilutive
      weighted average number ofshares
      of common stock outstanding
            
            
            136,973,884
            
            
            
            107,494,374
            
            
            
            136,277,277
            
            
            
            107,494,374





The
accompanying notes form an integral part of these unaudited condensed financial
statements.


6





SIONIX CORPORATIONA
      DEVELOPMENT STAGE COMPANYSTATEMENTS
      OF STOCKHOLDERS' EQUITY (DEFICIT)FOR
      THE PERIOD FROM OCTOBER 3, 1994 (INCEPTION) TO MARCH 31,
    2009(UNAUDITED)Deficit
            
            
            TotalCommon
      Stock
            
            
            Additional
            
            
            Shares
            
            
            Stock
            
            
            Shares
            
            
            Unamortized
            
            
            Accumulated
            
            
            Stockholders'Number
            
            
            
            
            
            Paid-in
            
            
            to
      be
            
            
            Subscription
            
            
            to
      be
            
            
            Consulting
            
            
            from
            
            
            Equityof
      Shares
            
            
            Amount
            
            
            Capital
            
            
            Issued
            
            
            Receivable
            
            
            Cancelled
            
            
            Fees
            
            
            Inception
            
            
            (Deficit)Stock
      issued for cash, October 3, 1994
            
            
            10,000
            
            
            $
            10
            
            
            $
            90
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            100Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,521
            )
            
            
            (1,521
            )Balance
      at December 31, 1994
            
            
            10,000
            
            
            
            10
            
            
            
            90
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,521
            )
            
            
            (1,421
            )Shares
      issued for assignment rights
            
            
            1,990,000
            
            
            
            1,990
            
            
            
            (1,990
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Shares
      issued for services
            
            
            572,473
            
            
            
            572
            
            
            
            135,046
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            135,618Shares
      issued for debt
            
            
            1,038,640
            
            
            
            1,038
            
            
            
            1,164,915
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,165,953Shares
      issued for cash
            
            
            232,557
            
            
            
            233
            
            
            
            1,119,027
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,119,260Shares
      issued for subscription receivable
            
            
            414,200
            
            
            
            414
            
            
            
            1,652,658
            
            
            
            -
            
            
            
            (1,656,800
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (3,728
            )Shares
      issued for productions costs
            
            
            112,500
            
            
            
            113
            
            
            
            674,887
            
            
            
            -
            
            
            
            (675,000
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (914,279
            )
            
            
            (914,279
            )Balance
      at December 31, 1995
            
            
            4,370,370
            
            
            
            4,370
            
            
            
            4,744,633
            
            
            
            -
            
            
            
            (2,331,800
            )
            
            
            -
            
            
            
            -
            
            
            
            (915,800
            )
            
            
            1,501,403Shares
      issued for reorganization
            
            
            18,632,612
            
            
            
            18,633
            
            
            
            (58,033
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (39,400
            )Shares
      issued for cash
            
            
            572,407
            
            
            
            573
            
            
            
            571,834
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            572,407Shares
      issued for services
            
            
            24,307
            
            
            
            24
            
            
            
            24,283
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            24,307Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (922,717
            )
            
            
            (922,717
            )Balance
      at September 30, 1996
            
            
            23,599,696
            
            
            
            23,600
            
            
            
            5,282,717
            
            
            
            -
            
            
            
            (2,331,800
            )
            
            
            -
            
            
            
            -
            
            
            
            (1,838,517
            )
            
            
            1,136,000Shares
      issued for cash
            
            
            722,733
            
            
            
            723
            
            
            
            365,857
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            366,580Shares
      issued for services
            
            
            274,299
            
            
            
            274
            
            
            
            54,586
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            54,860Cancellation
      of shares
            
            
            (542,138
            )
            
            
            (542
            )
            
            
            (674,458
            )
            
            
            -
            
            
            
            675,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (858,915
            )
            
            
            (858,915
            )Balance
      at September 30, 1997
            
            
            24,054,590
            
            
            
            24,055
            
            
            
            5,028,702
            
            
            
            -
            
            
            
            (1,656,800
            )
            
            
            -
            
            
            
            -
            
            
            
            (2,697,432
            )
            
            
            698,525Shares
      issued for cash
            
            
            2,810,000
            
            
            
            2,810
            
            
            
            278,190
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            281,000Shares
      issued for services
            
            
            895,455
            
            
            
            895
            
            
            
            88,651
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            89,546Shares
      issued for compensation
            
            
            2,200,000
            
            
            
            2,200
            
            
            
            217,800
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            220,000Cancellation
      of shares
            
            
            (2,538,170
            )
            
            
            (2,538
            )
            
            
            (1,534,262
            )
            
            
            -
            
            
            
            1,656,800
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            120,000Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,898,376
            )
            
            
            (1,898,376
            )Balance
      at September 30, 1998
            
            
            27,421,875
            
            
            
            27,422
            
            
            
            4,079,081
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (4,595,808
            )
            
            
            (489,305
            )Shares
      issued for compensation
            
            
            3,847,742
            
            
            
            3,847
            
            
            
            389,078
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            392,925Shares
      issued for services
            
            
            705,746
            
            
            
            706
            
            
            
            215,329
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            216,035Shares
      issued for cash
            
            
            9,383,000
            
            
            
            9,383
            
            
            
            928,917
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            938,300Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,158,755
            )
            
            
            (1,158,755
            )Balance
      at September 30, 1999
            
            
            41,358,363
            
            
            
            41,358
            
            
            
            5,612,405
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (5,754,563
            )
            
            
            (100,800
            )Shares
      issued for cash
            
            
            10,303,500
            
            
            
            10,304
            
            
            
            1,020,046
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,030,350Shares
      issued for compensation
            
            
            1,517,615
            
            
            
            1,518
            
            
            
            1,218,598
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,220,116Shares
      issued for services
            
            
            986,844
            
            
            
            986
            
            
            
            253,301
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            254,287Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (2,414,188
            )
            
            
            (2,414,188
            )Balance
      at September 30, 2000
            
            
            54,166,322
            
            
            
            54,166
            
            
            
            8,104,350
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (8,168,751
            )
            
            
            (10,235
            )Shares
      issued for services
            
            
            2,517,376
            
            
            
            2,517
            
            
            
            530,368
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (141,318
            )
            
            
            -
            
            
            
            391,567Shares
      issued for cash
            
            
            6,005,000
            
            
            
            6,005
            
            
            
            594,495
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            600,500Shares
      to be issued for cash (100,000 shares)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            10,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            10,000Shares
      to be issued for debt (639,509 shares)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            103,295
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            103,295Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,353,429
            )
            
            
            (1,353,429
            )Balance
      at September 30, 2001
            
            
            62,688,698
            
            
            
            62,688
            
            
            
            9,229,213
            
            
            
            113,295
            
            
            
            -
            
            
            
            -
            
            
            
            (141,318
            )
            
            
            (9,522,180
            )
            
            
            (258,302
            )Shares
      issued for services
            
            
            1,111,710
            
            
            
            1,112
            
            
            
            361,603
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            54,400
            
            
            
            -
            
            
            
            417,115Shares
      issued as a contribution
            
            
            100,000
            
            
            
            100
            
            
            
            11,200
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            11,300Shares
      issued for compensation
            
            
            18,838
            
            
            
            19
            
            
            
            2,897
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            2,916Shares
      issued for cash
            
            
            16,815,357
            
            
            
            16,815
            
            
            
            1,560,782
            
            
            
            (10,000
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,567,597Shares
      issued for debt
            
            
            1,339,509
            
            
            
            1,340
            
            
            
            208,639
            
            
            
            (103,295
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            106,684Shares
      to be issued related to equityfinancing
      (967,742 shares)
            
            
            -
            
            
            
            -
            
            
            
            (300,000
            )
            
            
            300,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Cancellation
      of shares
            
            
            (7,533,701
            )
            
            
            (7,534
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (7,534
            )Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,243,309
            )
            
            
            (1,243,309
            )Balance
      at September 30, 2002
            
            
            74,540,411
            
            
            
            74,540
            
            
            
            11,074,334
            
            
            
            300,000
            
            
            
            -
            
            
            
            -
            
            
            
            (86,918
            )
            
            
            (10,765,489
            )
            
            
            596,467Shares
      issued for services
            
            
            2,467,742
            
            
            
            2,468
            
            
            
            651,757
            
            
            
            (300,000
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            354,225Shares
      issued for capital equity line
            
            
            8,154,317
            
            
            
            8,154
            
            
            
            891,846
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            900,000Amortization
      of consulting fees
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            86,918
            
            
            
            -
            
            
            
            86,918Cancellation
      of shares
            
            
            (50,000
            )
            
            
            (50
            )
            
            
            50
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Shares
      to be cancelled (7,349,204 shares)
            
            
            -
            
            
            
            -
            
            
            
            7,349
            
            
            
            -
            
            
            
            -
            
            
            
            (7,349
            )
            
            
            -
            
            
            
            -
            
            
            
            -Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,721,991
            )
            
            
            (1,721,991
            )Balance
      at September 30, 2003
            
            
            85,112,470
            
            
            
            85,112
            
            
            
            12,625,336
            
            
            
            -
            
            
            
            -
            
            
            
            (7,349
            )
            
            
            -
            
            
            
            (12,487,480
            )
            
            
            215,619Shares
      issued for capital equity line
            
            
            19,179,016
            
            
            
            19,179
            
            
            
            447,706
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            466,885Shares
      issued for services
            
            
            5,100,004
            
            
            
            5,100
            
            
            
            196,997
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (13,075
            )
            
            
            -
            
            
            
            189,022Share
      to be issued for cash (963,336 shares)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            28,900
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            28,900Shares
      to be issued for debt (500,000 shares)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            15,000
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            15,000Cancellation
      of shares
            
            
            (7,349,204
            )
            
            
            (7,349
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            7,349
            
            
            
            -
            
            
            
            -
            
            
            
            -Issuance
      of warrants related to 2004 stock purchase
            
            
            -
            
            
            
            -
            
            
            
            24,366
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            24,366Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,593,135
            )
            
            
            (1,593,135
            )Balance
      at September 30, 2004
            
            
            102,042,286
            
            
            
            102,042
            
            
            
            13,294,405
            
            
            
            43,900
            
            
            
            -
            
            
            
            -
            
            
            
            (13,075
            )
            
            
            (14,080,615
            )
            
            
            (653,343
            )Amortization
      of consulting fees
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            13,075
            
            
            
            -
            
            
            
            13,075Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (722,676
            )
            
            
            (722,676
            )Balance
      at September 30, 2005
            
            
            102,042,286
            
            
            
            102,042
            
            
            
            13,294,405
            
            
            
            43,900
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (14,803,291
            )
            
            
            (1,362,944
            )Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (1,049,319
            )
            
            
            (1,049,319
            )Balance
      at September 30, 2006
            
            
            102,042,286
            
            
            
            102,042
            
            
            
            13,294,405
            
            
            
            43,900
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (15,852,610
            )
            
            
            (2,412,263
            )Stock
      issued for consulting
            
            
            4,592,915
            
            
            
            4,593
            
            
            
            80,336
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            84,929Reclassification
      to warrant and option liability
            
            
            -
            
            
            
            -
            
            
            
            (2,277,013
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (2,277,013
            )Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (33,612,516
            )
            
            
            (33,612,516
            )Balance
      at September 30, 2007, restated
            
            
            106,635,201
            
            
            
            106,635
            
            
            
            11,097,728
            
            
            
            43,900
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (49,465,126
            )
            
            
            (38,216,863
            )Conversion
      of note payable into common stock
            
            
            17,149,359
            
            
            
            17,149
            
            
            
            886,633
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            903,782Common
      stock issued for services
            
            
            1,539,750
            
            
            
            1,540
            
            
            
            254,330
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            255,870Common
      stock issued for cash
            
            
            8,950,003
            
            
            
            8,950
            
            
            
            784,550
            
            
            
            (43,500
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            750,000Common
      stock to be issued for cash
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            126,029
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            126,029Issuance
      of warrants with stock
            
            
            -
            
            
            
            -
            
            
            
            (2,182,234
            )
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (2,182,234
            )Net
      income
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            15,550,391
            
            
            
            15,550,391Balance
      at September 30, 2008, restated
            
            
            134,274,313
            
            
            
            134,274
            
            
            
            10,841,007
            
            
            
            126,429
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (33,914,735
            )
            
            
            (22,813,025
            )Conversion
      of note payable into common stock
            
            
            6,114,221
            
            
            
            6,114
            
            
            
            444,958
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            451,072Common
      stock issued for services
            
            
            600,139
            
            
            
            600
            
            
            
            125,429
            
            
            
            (126,029
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Common
      stock issued for property and equipment
            
            
            833,333
            
            
            
            833
            
            
            
            124,167
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            125,000Net
      income
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            6,382,139
            
            
            
            6,382,139Balance
      at March 31, 2009, restated
            
            
            141,822,006
            
            
            $
            141,821
            
            
            $
            11,535,561
            
            
            $
            400
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            (27,532,596
            )
            
            $
            (15,854,814
            )








The
accompanying notes form an integral part of these unaudited condensed financial
statements.


7




SIONIX
      CORPORATIONA
      DEVELOPMENT STAGE COMPANYSTATEMENT
      OF CASH FLOWS(UNAUDITED)CumulativefromFor
      the Six Months
            
            
            InceptionEnded
      March 31,
            
            
            (October
      3, 1994) to2009
            
            
            2008
            
            
            March
      31, 2009(As
      Restated)
            
            
            (As
      Restated)
            
            
            (As
      Restated)OPERATING
      ACTIVITIES:Net
      income (loss)
            
            $
            6,382,139
            
            
            $
            15,783,544
            
            
            $
            (27,532,596
            )Adjustments
      to reconcile net loss to net cash used inoperating
      activities:Depreciation
            
            
            15,104
            
            
            
            16,314
            
            
            
            659,396Amortization
      of beneficial conversion features discount andwarrant
      discount
            
            
            27,094
            
            
            
            833,775
            
            
            
            2,074,433Stock
      based compensation expense - employee
            
            
            116,241
            
            
            
            1,791,360
            
            
            
            3,795,143Stock
      based compensation expense - consultant
            
            
            248,752
            
            
            
            3,171,049
            
            
            
            6,899,343Gain
      on change in fair value of warrant and option liability
            
            
            (3,121,580
            )
            
            
            (3,943,843
            )
            
            
            (7,366,093
            )Gain
      on change in fair value of beneficial conversion liability
            
            
            (4,768,622
            )
            
            
            (18,922,878
            )
            
            
            (30,427,420
            )Non-cash
      compensation costs
            
            
            -
            
            
            
            -
            
            
            
            3,870,887Non-cash
      financing costs
            
            
            -
            
            
            
            -
            
            
            
            31,434,495Impairment
      of assets
            
            
            -
            
            
            
            -
            
            
            
            514,755Write-down
      of obsolete assets
            
            
            -
            
            
            
            -
            
            
            
            38,862Impairment
      of intangible assets
            
            
            -
            
            
            
            -
            
            
            
            1,117,601Loss
      on settlement of debt
            
            
            16,184
            
            
            
            -
            
            
            
            400,761Loss
      on termination of lease
            
            
            -
            
            
            
            129,166
            
            
            
            129,166Write-off
      of beneficial conversion features
            
            
            -
            
            
            
            (380,440
            )
            
            
            (576,000
            )Stock
      issued for services and rent
            
            
            -
            
            
            
            -
            
            
            
            114,850Accrual
      of liquidated damages
            
            
            -
            
            
            
            138,375
            
            
            
            153,750Other
            
            
            -
            
            
            
            -
            
            
            
            (799,044
            )(Increase)
      decrease in assets:Inventory
            
            
            (608,565
            )
            
            
            -
            
            
            
            (608,565
            )Other
      current assets
            
            
            12,230
            
            
            
            (33,650
            )
            
            
            (34,165
            )Other
      assets
            
            
            (150,400
            )
            
            
            -
            
            
            
            (128,495
            )Increase
      (decrease) in liabilities:Accounts
      payable
            
            
            92,508
            
            
            
            345,724
            
            
            
            508,027Accrued
      expenses
            
            
            189,486
            
            
            
            174,508
            
            
            
            2,834,698Customer
      deposits
            
            
            344,486
            
            
            
            -
            
            
            
            1,460,000Net
      cash used in operating activities
            
            
            (1,194,429
            )
            
            
            (896,996
            )
            
            
            (11,466,211
            )INVESTING
      ACTIVITIES:Acquisition
      of property and equipment
            
            
            (5,546
            )
            
            
            (29,164
            )
            
            
            (473,553
            )Acquisition
      of patents
            
            
            -
            
            
            
            -
            
            
            
            (158,212
            )Net
      cash used in investing activities
            
            
            (5,546
            )
            
            
            (29,164
            )
            
            
            (631,765
            )FINANCING
      ACTIVITIES:Payment
      on notes payable to officer
            
            
            -
            
            
            
            (19,260
            )
            
            
            (218,502
            )Proceeds
      from notes payable, related party
            
            
            -
            
            
            
            -
            
            
            
            457,433Payments
      on notes payable to related party
            
            
            -
            
            
            
            (5,000
            )
            
            
            (15,000
            )Receipt
      from (payments to) equity line of credit
            
            
            -
            
            
            
            (27,336
            )
            
            
            428,664Proceeds
      from convertible notes payable
            
            
            -
            
            
            
            -
            
            
            
            2,861,000Proceeds
      from 10% subordinated notes payable
            
            
            -
            
            
            
            425,000
            
            
            
            425,000Issuance
      of common stock
            
            
            5,000
            
            
            
            -
            
            
            
            8,184,594Receipt
      of cash for stock to be issued
            
            
            -
            
            
            
            283,000
            
            
            
            400Net
      cash provided by financing activities
            
            
            5,000
            
            
            
            656,404
            
            
            
            12,123,589NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
            
            
            (1,194,975
            )
            
            
            (269,756
            )
            
            
            25,613CASH
      AND CASH EQUIVALENTS, BEGINNING
            
            
            1,220,588
            
            
            
            372,511
            
            
            
            -CASH
      AND CASH EQUIVALENTS, ENDING
            
            $
            25,613
            
            
            $
            102,755
            
            
            $
            25,613SUPPLEMENTAL
      INFORMATION:Cash
      and cash equivalents paid for interest
            
            $
            -
            
            
            $
            -
            
            
            $
            -Cash
      and cash equivalents paid for taxes
            
            $
            -
            
            
            $
            -
            
            
            $
            -


The accompanying notes form an
integral part of these unaudited condensed financial
statements.


8


Sionix
Corporation


A
Development Stage Company


March
31, 2009





Notes
to Financial Statements (Unaudited)





NOTE1 ORGANIZATION AND DESCRIPTION OF
BUSINESS





Sionix
Corporation (the "Company") was incorporated in Utah in 1985.  The
Company was formed to design, develop, and market automatic water filtration
systems primarily for small water districts.





The
Company completed its reincorporation as a Nevada corporation effective July 1,
2003. The reincorporation was completed pursuant to an Agreement and Plan of
Merger between Sionix Corporation, a Utah corporation ("Sionix Utah") and its
wholly-owned Nevada subsidiary, Sionix Corporation ("Sionix Nevada"). Under the
merger agreement, Sionix Utah merged with and into Sionix Nevada, and each share
of Sionix Utah’s Common Stock was automatically converted into one share of
Common Stock, par value $0.001 per share, of Sionix Nevada. The merger was
effected by the filing of Articles of Merger, along with the Agreement and Plan
of Merger, with the Secretary of State of Nevada.





The
Company is a development stage company as defined in Statement of Financial
Accounting Standards (“SFAS”) No. 7, “Accounting and Reporting by Development
Stage Enterprises.” The Company is in the development stage and its efforts have
been principally devoted to research and development, organizational activities,
and raising capital. All losses accumulated since inception have been considered
as part of the Company’s development stage activities.





NOTE 2 SUMMARYOF SIGNIFICANT ACCOUNTING
POLICIES




USE
OF ESTIMATES




The
preparation of financial statements in conformity with generally accepted
accounting principles in the United States (“GAAP”) requires management to make
certain estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results could differ from those
estimates.  Significant estimates include collectability of accounts
receivable, accounts payable, sales returns and recoverability of long-term
assets.





CASH
AND CASH EQUIVALENTS




Cash and
cash equivalents represent cash and short-term highly liquid investments with
original maturities of three months or less.





INVENTORY




Inventory
is stated at the lower of cost, using the first in, first out method, or market.
Management compares the cost of inventories with the market value, and an
allowance is made for writing down the inventories to their market value, if
lower.  As of March 31, 2009, the Company believes that no reserve is
required. Inventory at March 31, 2009 was $608,585 and consisted of work in
process.





PROPERTY
AND EQUIPMENT




Property
and equipment is stated at cost. The cost of additions and improvements are
capitalized while maintenance and repairs are expensed as incurred. Depreciation
of property and equipment is provided on a straight-line basis over the
estimated useful lives of the assets.





9


Property
and equipment are being depreciated and amortized on the straight-line basis
over the following estimated useful lives:





YearsMachinery
      and equipment
            
            
            5Furniture
      and fixtures
            
            
            3-5Leasehold
      improvements
            
            
            3


ADVERTISING




The cost
of advertising is expensed as incurred. There were no advertising costs for the
three and six months ended March 31, 2009, respectively. Total advertising costs
were $2,474 for the three and six months ended March 31, 2008,
respectively.





ACCRUED
DERIVATIVE LIABILITIES




The
Company applies a two-step model to determine whether a financial instrument or
an embedded feature is indexed to an issuer’s own stock and thus able to qualify
for equity treatment. However, liability accounting is triggered as there were
insufficient shares to fulfill all potential conversions. The Company determines
which instruments or embedded features require liability accounting and records
the fair values as an accrued derivative liability. The changes in the values of
the accrued derivative liabilities are shown in the accompanying statements of
operations as “gain on change in fair value of warrant and option liability” and
“gain on change in fair value of beneficial conversion liability.”




STOCK
BASED COMPENSATION




Effective
October 1, 2006, the Company adopted Statement of Financial Accounting Standards
(SFAS) No. 123-R, “Share-Based Payment” (“SFAS 123-R”), which requires the
measurement and recognition of compensation expense for all share-based payment
awards made to employees and directors, including stock options, to be based on
their fair values. SFAS 123-R supersedes Accounting Principles Board Opinion No.
25, “Accounting for Stock Issued to Employees” (“APB 25”), which the Company
previously followed in accounting for stock-based awards. In March 2005, the SEC
issued Staff Accounting Bulletin No. 107 (SAB 107) to provide guidance on SFAS
123-R. The Company has applied SAB 107 in its adoption of SFAS
123-R.





EARNINGS
PER SHARE




Statement
of Financial Accounting Standards No. 128, “Earnings per share” requires the
presentation of basic earnings per share and diluted earnings per
share.  Basic and diluted earnings per share computations presented by
the Company conform to the standard and are based on the weighted average number
of shares of Common Stock outstanding during the year.





Basic
earnings per share is computed by dividing net income or loss by the weighted
average number of shares outstanding for the year.  “Diluted” earnings
per share is computed by dividing net income or loss by the total of the
weighted average number of shares outstanding, and the dilutive effect of
outstanding stock options (applying the treasury stock method).





During
the three and six months ended March 31, 2009 and 2008, the Company had net
income; however, the net income was due to the change in the fair value of the
warrant and option liability and in the change in the fair value of the
beneficial conversion liability. If these securities had been converted at the
beginning of the period, then the Company would have realized a loss for the
nine month period ended June 30, 2008.  As such, these securities are
determined to be anti-dilutive and the number of shares used to determine the
basic and dilutive earnings per share is the same.


The
following is a reconciliation of the numerators and denominators of the basic
and diluted earnings per share computations:





For the Three Months Ended March 31,2009
            
            
            2008Net
            
            
            
            
            
            Per
            
            
            Net
            
            
            
            
            
            PerIncome
            
            
            Shares
            
            
            Share
            
            
            Income
            
            
            Shares
            
            
            ShareBasic
      Earnings Per ShareNet
      (Loss) Income Available to Stockholders
            
            $
            945,474
            
            
            
            136,973,884
            
            
            $
            0.01
            
            
            $
            11,206,641
            
            
            
            107,494,374
            
            
            $
            0.10Effect
      of Dilutive Securities
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Diluted
      Earnings Per Share
            
            
            945,474
            
            
            
            136,973,884
            
            
            $
            0.01
            
            
            $
            11,206,641
            
            
            
            107,494,374
            
            
            $
            0.10







10




FortheSixMonthsEndedMarch31,2009
            
            
            2008Net
            
            
            
            
            
            Per
            
            
            Net
            
            
            
            
            
            PerIncome
            
            
            Shares
            
            
            Share
            
            
            Income
            
            
            Shares
            
            
            ShareBasic
      Earnings Per ShareNet
      Loss Available to Stockholders
            
            $
            6,382,139
            
            
            
            136,277,277
            
            
            $
            0.00
            
            
            $
            15,783,544
            
            
            
            107,494,374
            
            
            $
            0.15Effect
      of Dilutive Securities
            
            
            
            
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Diluted
      Earnings Per Share
            
            $
            6,382,139
            
            
            
            136,277,277
            
            
            $
            0.00
            
            
            $
            15,783,544
            
            
            
            107,494,374
            
            
            $
            0.14
            )





FAIR
VALUE OF FINANCIAL INSTRUMENTS




Statement
of Financial Accounting Standard No. 107, Disclosures about Fair Value of
Financial Instruments, requires that the Company disclose estimated fair
values of financial instruments. The carrying amounts reported in the statements
of financial position for assets and liabilities qualifying as financial
instruments are a reasonable estimate of fair value.




CONCENTRATION
OF CREDIT RISK




During
the six months ended March 31, 2008 the Company had deposits in financial
institutions over the federally insured limits of $100,000. The Company does not
believe there is any credit risk related to these deposits due to the financial
condition of the financial institution.





RELATED
PARTY TRANSACTION




On
October 14, 2008, the Company entered into an agreement to purchase machinery
and equipment with a fair value of $125,000 from RJ Metal, Co. The Company
issued 833,333 shares of Common Stock as payment.  The purchase
qualified as a related party transaction because the Company’s interim Chief
Executive Officer, who is also a director, is also a director, officer and
significant stockholder of RJ Metal, Co.





RECLASSIFICATIONS





Certain
items in the prior year financial statements have been reclassified to conform
to the current period’s presentation. These reclassifications have no effect on
the previously reported net loss.


NOTE
3 PROPERTY AND EQUIPMENT




Property
and equipment consisted of the following at:




March 31,
            
            
            September 30,2009
            
            
            2008(Unaudited)Machinery
      and equipment
            
            $
            271,972
            
            
            $
            266,426Furniture
      and fixtures
            
            
            41,176
            
            
            
            41,176Leasehold
      improvement
            
            
            1,695
            
            
            
            1,695TOTAL
      PROPERTY AND EQUIPMENT
            
            
            314,843
            
            
            
            309,296Less
      accumulated depreciation
            
            
            (237,300
            )
            
            
            (222,195
            )NET
      PROPERTY AND EQUIPMENT
            
            $
            77,543
            
            
            $
            87,101





Depreciation
expenses for the three and six months ended March 31, 2009 were $7,615 and
$15,104, respectively. Depreciation expenses for the three and six months ended
March 31, 2008 were $8,157 and $16,314, respectively


11


NOTE
4 ACCRUED EXPENSES (RESTATED)




Accrued
expenses consisted of the following at:





March 31,
            
            
            September 30,2009
            
            
            2008(Unaudited)Accrued
      salaries
            
            $
            1,474,785
            
            
            $
            1,493,444Advisory
      board compensation
            
            
            576,000
            
            
            
            576,000Auto
      allowance accruals
            
            
            104,785
            
            
            
            94,408Interest
      payable
            
            
            346,957
            
            
            
            272,016Other
      accruals
            
            
            1,366,396
            
            
            
            1,876,976TOTAL
      ACCRUED EXPENSES
            
            $
            3,868,923
            
            
            $
            4,312,844





NOTE
5 CUSTOMER DEPOSITS





In May
2008, the Company received an order for two water filtration systems, which
required a deposit. The Company is in the design phase of the manufacturing
process, and has not recognized any revenue related to these water filtration
systems. As of March 31, 2009 and September 30, 2008 customer deposits were
$1,420,000 and $1,260,000.





NOTE
6 NOTES PAYABLE – RELATED PARTIES




The
Company has received advances in the form of unsecured promissory notes from
stockholders in order to pay ongoing operating expenses. These notes bear
interest at rates up to 13% and are due on demand. As of March 31, 2009 and
September 30, 2008, notes payable amounted to $107,000 and $114,000. Accrued
interest on the notes amounted to $78,539 and $74,482 at March 31, 2009 and
September 30, 2008, respectively, and is included in accrued expenses. Interest
expenses on these notes for the three and six months ended March 31, 2009 were
$2,886 and $5,872, respectively. Interest expenses on these notes for the three
and six months ended March 31, 2008 were $3,204 and $6,443,
respectively





NOTE
7 CONVERTIBLE NOTES





Convertible
Notes 1





Between
October 2006 and February 2007, the Company completed an offering of $750,000 in
principal amount of convertible notes, which bear interest at 10% per annum and
mature at the earlier of (i) 18 months from the date of issuance (ii) an event
of default or (iii) the closing of any equity related financing by the Company
in which the gross proceeds are a minimum of $2,500,000. These notes are
convertible into shares of the Company’s Common Stock at $0.05 per share or
shares of any equity security issued by the Company at a conversion price equal
to the price at which such security is sold to any other party. In the event
that a registration statement covering the underlying shares was not declared
effective within 180 days after the closing, the conversion price was to be
reduced by $0.0025 per share for each 30 day period that the effectiveness of
the registration statement was delayed but in no case could the conversion price
to be reduced below $0.04 per share. As of March 31, 2009 the conversion price
was $0.04 per share.


12


SFAS 133,
paragraph 12 was applied to determine if the embedded beneficial conversion
features should be bifurcated from the convertible notes. The Company determined
that the economic characteristics of the embedded beneficial conversion features
are not clearly and closely related to the convertible notes, the embedded
beneficial conversion feature and convertible notes are not remeasured at fair
value at each balance sheet date, and a separate contract with the same terms
would be a derivative pursuant to SFAS 133, paragraphs 6-11. Therefore, the
embedded beneficial conversion features were bifurcated from the convertible
notes. SFAS 133, paragraph 6 was applied to determine if the embedded beneficial
conversion features were within the scope and definition of a derivative. The
embedded beneficial conversion features had one or more underlings and one or
more notional amounts, required no initial investment and required or permitted
net settlement. Therefore, the embedded beneficial conversion features were
determined to be derivatives. The terms of the conversion feature only allow the
counterparty to convert the notes into shares of Common Stock. Therefore, EITF
00-19, paragraphs 12-33 were included in the analysis to determine the
classification of the conversion feature. The Company included SFAS 150 in the
analysis of the convertible notes.  SFAS 150 requires
three classes of freestanding financial instruments, as defined in paragraphs 8
through 17, to be classified as liabilities. The first class, as defined in
paragraph 9, is financial instruments that are mandatorily redeemable financial
instruments. There are no terms or conditions that require the Company to
unconditionally redeem the convertible notes by transferring assets at a
specified or determinable date. The second class, as defined in paragraph 11, is
financial instruments that require the repurchase of shares of Common Stock by
transferring assets. There are no terms or conditions that require the Company
to repurchase shares of Common Stock. The third class, as defined in paragraph
12, is financial instruments that require the issuance of a variable number of
shares of Common Stock. There are no terms or conditions that require the
Company to issue a variable number of shares of Common Stock. Therefore, the
Company concluded that the convertible notes were not within the scope of SFAS
150.





The fair
value of the embedded beneficial conversion features was $750,000 at the date of
issuance using the Black-Scholes valuation model  with the following
assumptions: risk free rate of return ranging from 2.02% to 5.09%; volatility
ranging from 268% to 275%; dividend yield of 0%; and expected term of 1.5
years.
  Based on
the calculation of the fair value of the embedded beneficial conversion feature,
the Company allocated $750,000 to the beneficial conversion feature and the
beneficial conversion feature discount, and none to the convertible note at the
date of issuance. The embedded beneficial conversion feature discount is
amortized to interest expense over the term of the note, which is $41,667 per
month.





As of
March 31, 2009, the outstanding principal amount of the convertible notes was
$523,333 and there was no unamortized embedded beneficial conversion feature
discount. As of August 27, 2008, the convertible notes had matured and the
outstanding principal amount of $533,333 and accrued interest of $86,981 were
due. Since the convertible notes matured, $10,000 of principal has been
converted into 250,000 shares of Common Stock and the Company has not repaid the
remaining outstanding amount of the convertible notes.





As of
September 30, 2008, the outstanding principal amount of the convertible notes
was $533,333 and there was no unamortized embedded beneficial conversion feature
discount.





For the
three and six months ended March 31, 2009, interest expense was $13,083 and
$26,638, respectively, which was included in the other income (expense) section
of the statement of operations.





For the
three and six months ended March 31, 2008, interest expense was $18,958 and
$38,334, respectively, and amortization expense for the embedded beneficial
conversion feature discount was $125,000 and $250,000, respectively, which was
included in interest expense in the other income (expense) section of the
statement of operations.





Calico
Capital Management, LLC acted as a financial advisor for Convertible Notes 1 and
2 for the Company and received a fee of $75,000. Southridge Investment Group
LLC, Ridgefield, Connecticut (“Southridge) acted as an agent for the Company in
arranging the transaction for Convertible Notes 1 and 2. The Company recorded
these fees as an expense during the period.





Convertible
Notes 2





On June
6, 2007, the Company completed an offering of $86,000 in principal amount of
convertible notes, which bear interest at 10% per annum and are due and payable
upon the earlier of (i) the occurrence of an Event of Default or (ii) the
Maturity Date, which is defined as any business day that is not sooner than
December 31, 2008, as the holder of the notes may specify in written notice
delivered to the Company not less than 30 days prior to such specified date.
These notes are convertible into shares of the Company’s Common Stock at $0.01
per share or shares of any equity security issued by the Company at a conversion
price equal to the price at which such security is sold to any other party.
There are no registration rights associated with these notes.




13


SFAS 133,
paragraph 12 was applied to determine if the embedded beneficial conversion
features should be bifurcated from the convertible notes. The Company determined
that the economic characteristics of the embedded beneficial conversion features
are not clearly and closely related to the convertible notes, the embedded
beneficial conversion feature and convertible notes are not remeasured at fair
value at each balance sheet date, and a separate contract with the same terms
would be a derivative pursuant to SFAS 133, paragraphs 6-11. Therefore, the
embedded beneficial conversion features were bifurcated from the convertible
notes. SFAS 133, paragraph 6 was applied to determine if the embedded beneficial
conversion features were within the scope and definition of a derivative. The
embedded beneficial conversion features had one or more underlings and one or
more notional amounts, required no initial investment and required or permitted
net settlement. Therefore, the embedded beneficial conversion features were
determined to be derivatives.  The terms of the
conversion feature only allow the counterparty to convert the notes into shares
of common stock. Therefore, EITF 00-19, paragraphs 12-33 were included in the
analysis to determine the classification of the conversion feature. The Company
included SFAS 150 in the analysis of the convertible notes. SFAS 150 requires
three classes of freestanding financial instruments, as defined in paragraphs 8
through 17, to be classified as liabilities. The first class, as defined in
paragraph 9, is financial instruments that are mandatorily redeemable financial
instruments. There are no terms or conditions that require the Company to
unconditionally redeem the convertible notes by transferring assets at a
specified or determinable date. The second class, as defined in paragraph 11, is
financial instruments that require the repurchase of shares of Common Stock by
transferring assets. There are no terms or conditions that require the Company
to repurchase shares of Common Stock. The third class, as defined in paragraph
12, is financial instruments that require the issuance of a variable number of
shares of Common Stock. There are no terms or conditions that require the
Company to issue a variable number of shares of Common Stock. Therefore, the
Company concluded that the convertible notes were not within the scope of SFAS
150.





The fair
value of the embedded beneficial conversion features was $86,000 at the date of
issuance using the Black-Scholes valuation model with the following assumptions:
risk free rate of return of 4.96%; volatility of 259.58%; dividend yield of 0%
and expected term of 1.5 years.





Based on
the calculation of the fair value of the embedded beneficial conversion feature,
the Company allocated $86,000 to the beneficial conversion feature and the
beneficial conversion feature discount, and none to the convertible note. The
embedded beneficial conversion feature discount is amortized to interest expense
over the term of the note, which is $4,778 per month.





As of
March 31, 2009, the outstanding principal amount of the convertible notes was
$8,000 and there was no unamortized embedded beneficial conversion feature
discount. As of December 31, 2008, the convertible notes had matured and the
outstanding principal amount of $26,000 and accrued interest of $4,153 were due.
Since the convertible notes matured, $18,000 of principal has been converted
into 1,800,000 shares of Common Stock and the Company has not repaid the
remaining outstanding amount of the convertible notes.





As of
September 30, 2008, the outstanding principal amount of the convertible notes
was $26,000 and unamortized embedded beneficial conversion feature discount was
$2,890.





For the
three and six months ended March 31, 2009, interest expense was $626 and $1,290,
and amortization expense for the embedded beneficial conversion feature discount
was $2,890, which was included in interest expense in the other income (expense)
section of the statement of operations.





For the
three and six months ended March 31, 2008, interest expense was $2,144 and
$4,335, respectively, and amortization expense for the embedded beneficial
conversion feature discount was $14,333 and $28,666, which was included in
interest expense in the other income (expense) section of the statement of
operations.


Calico
Capital Management, LLC acted as a financial advisor for Convertible Notes 1 and
2 for the Company and received a fee of $75,000. Southridge acted as an agent
for the Company in arranging the transaction for Convertible Notes 1 and 2. The
Company recorded these fees as an expense during the period.





Convertible
Notes 3




On July
17, 2007, the Company completed an offering of $1,025,000 in principal amount of
Subordinated Convertible Debentures to a group of institutional and accredited
investors, which bear interest at the rate of 8% per annum, and mature 12 months
from the date of issuance. Convertible Notes 3 are convertible into shares of
the Company’s Common Stock at an initial conversion rate of $0.22 per share,
subject to anti-dilution adjustments. As part of the above offering the Company
issued warrants to purchase 2,329,546 shares of Common Stock at an initial
exercise price of $0.50 per share. An amendment dated March 13, 2008 reduces the
conversion rate of the notes to $0.15 per share and the exercise price of the
warrants to $0.30 per share.





Under the
terms of a Registration Rights Agreement signed in conjunction with this
offering, the Company is required to file a registration statement under the
Securities Act of 1933 in order to register the resale of the shares of Common
Stock issuable upon conversion of the  Convertible Notes 3 and the
warrant shares (collectively, the "Registrable Securities"). If the Company did
not file a registration statement with respect to the Registrable Securities
within 45 days following the closing of the offering, or if the registration
statement was not declared effective by the Securities and Exchange Commission
within 90 days, then the Company was required to pay to each purchaser damages
equal to 1.5% of the purchase price paid by the purchaser for Convertible Notes
3 for each 30 day period that followed these deadlines. The aggregate amount of
damages payable by the Company is limited to 15% of the purchase price. The
Company had until August 31, 2007 to file the registration statement and has
accrued $153,750 of expenses as liquidated damages. For the three and six months
ended March 31, 2009, $75,000 of the liquidating damages were converted into
937,500 shares of Common Stock For the three and six months ended March 31,
2008, the Company recorded $92,250 and $138,375 as liquidated damages,
respectively. No derivative liability is recorded as the amount of liquidated
damage is fixed with a maximum ceiling.





14


The
Company applied APB 14, paragraph 15 to determine the allocation of the proceeds
of the convertible debt, which states that proceeds from the sale of debt with
stock purchase warrants should be allocated between the debt and warrants, and
paragraph 16 states that the proceeds should be allocated based on the relative
fair values of the two securities at the time of issuance.





The fair
value of the warrants was $741,341 at the date of issuance calculated using the
Black-Scholes valuation model with the following assumptions: risk free rate of
return ranging from  4.96% to 5.02%; volatility ranging from 219.89%
to 226.04%; dividend yield of 0%; and expected term of 5 years.  As a result, the
relative fair value of the warrants was $430,189.
  SFAS 133,
paragraph 12 was applied to determine if the embedded beneficial conversion
features should be bifurcated from the convertible notes. The Company determined
that the economic characteristics of the embedded beneficial conversion features
are not clearly and closely related to the convertible notes, the embedded
beneficial conversion feature and convertible notes are not remeasured at fair
value at each balance sheet date, and a separate contract with the same terms
would be a derivative pursuant to SFAS 133, paragraphs 6-11. Therefore, the
embedded beneficial conversion features were bifurcated from the convertible
notes. SFAS 133, paragraph 6 was applied to determine if the embedded beneficial
conversion features were within the scope and definition of a derivative. The
embedded beneficial conversion features had one or more underlings and one or
more notional amounts, required no initial investment and required or permitted
net settlement. Therefore, the embedded beneficial conversion features were
determined to be derivatives.  The terms of the
conversion feature only allow the counterparty to convert the notes into shares
of Common Stock. Therefore, EITF 00-19, paragraphs 12-33 were included in the
analysis to determine the classification of the conversion
feature.  The Company included SFAS 150 in the analysis of the
convertible notes.  SFAS 150 requires
three classes of freestanding financial instruments, as defined in paragraphs 8
through 17, to be classified as liabilities. The first class, as defined in
paragraph 9, is financial instruments that are mandatorily redeemable financial
instruments. There are no terms or conditions that require the Company to
unconditionally redeem the convertible notes by transferring assets at a
specified or determinable date. The second class, as defined in paragraph 11, is
financial instruments that require the repurchase of shares of Common Stock by
transferring assets. There are no terms or conditions that require the Company
to repurchase shares of Common Stock. The third class, as defined in paragraph
12, is financial instruments that require the issuance of a variable number of
shares of Common Stock. There are no terms or conditions that require the
Company to issue a variable number of shares of Common Stock. Therefore, the
Company concluded that the convertible notes were not within the scope of SFAS
150.


The fair
value of the embedded beneficial conversion features was $594,811 at the date of
issuance using the Black-Scholes valuation model  with the following
assumptions: risk free rate of return ranging from  4.96% to 5.02%;
volatility ranging from 219.89% to 226.04%; dividend yield of 0%; and expected
term of 1 year.


Southridge
acted as the Company’s agent in arranging the transaction and received a
placement fee of $102,500. Southridge also received warrants to purchase 465,909
shares of the Company’s Common Stock on the same terms and conditions as the
warrants issued to the purchasers. The Company recorded the placement fees as an
expense. The grant date fair value of the warrants amounted to $124,060 and was
calculated using the Black-Scholes valuation model, using the following
assumptions: risk free rate of return of 5.01%, volatility of 226.04%, dividend
yield of 0% and expected term of 5 years.





As of
March 31, 2009, the outstanding principal amount of the convertible notes was
$250,000, there was no unamortized warrant discount or embedded beneficial
conversion feature discount, and the number of outstanding warrants was
2,329,546. As of July 16, 2008, the convertible notes had matured and the
outstanding principal amount of $485,000 and accrued interest of $67,417 were
due. Since the convertible notes matured, $235,000 of principal has been
converted into 1,566,667 shares of Common Stock and the Company has not repaid
the remaining outstanding principal amount or accrued interest of the
convertible notes.





As of
September 30, 2008, the outstanding principal amount of the convertible notes
was $485,000, there was no unamortized warrant discount or embedded beneficial
conversion feature discount, and the number of outstanding warrants was
2,329,546.





For the
three and six months ended March 31, 2009, interest expense was $7,105 and
$16,595, respectively, which was included in the other income (expense) section
of the statement of income (operations).





For the
three and six months ended March 31, 2008, interest expense was $20,444 and
$40,663, amortization expense for the warrant discount was $111,031 and
$218,578, which was included in interest expense in the other income (expense)
section of the statement of operations, and amortization expense for the
beneficial conversion feature discount was $153,553 and $302,255, which was also
included in interest expense in the other income (expense) section of the
statement of income (operations).







15


12%
SUBORDINATED CONVERTIBLE NOTES




On July
29, 2008, the Company completed an offering of $1,000,000 in principal amount of
Subordinated Debentures to a group of institutional and accredited
investors.  The 12% Subordinated Convertible Notes mature on July 29,
2009 or   sooner if declared due and payable by the holder upon the
occurrence of an event of default, and bear interest at the rate of 12% per
annum. The Debentures will be convertible into Common Stock at a conversion
price of $0.25 per share (the “Conversion Price”) from and after such time as
the authorized Common Stock is increased in accordance with applicable federal
and state laws. In the event of an offering of Common Stock, or securities
convertible into Common Stock, at a price, conversion price or exercise price
less than the conversion price (a “dilutive issuance”), then the conversion
price of any then outstanding subordinated convertible notes will be reduced to
equal such lower price, except in connection with certain exempt
issuances.  In an event of default, the conversion price will be
reduced to $0.15 per share. As part of the above offering, the Company issued
warrants to purchase 3,333,333 shares of Common Stock, which expire five years
from the date of grant, are exercisable at an exercise price of $0.30 per share
from and after such time as the authorized Common Stock is increased in
accordance with applicable federal and state laws, and may be exercised on a
cashless basis at the election of the holder.  In the event of a
dilutive issuance, the exercise price of the warrants will be reduced to equal
the price of the securities issued in the dilutive issuance, except in
connection with certain exempt issuances.


The
requirement to increase the number of authorized shares of Common Stock is a
condition that has not occurred, is not certain to occur, and is outside the
control of the Company. Therefore, the Company has not recognized the related
beneficial conversion feature or the warrants related to these notes. If and
when this condition does occur, the Company will recognize the beneficial
conversion feature and warrants at fair value on the date the number of
authorized shares is increased. The note will be converted into 4,000,000 shares
of Common Stock at a conversion price of $0.25 per share. These shares were
excluded from the earnings per share calculation as the effect of dilutive
securities is anti-dilutive.





Calico
Capital Management, LLC acted as a financial advisor for the Company and
received a fee of $40,000. LBS Financial Services, LLC acted as an agent for the
Company in arranging the transaction and received a fee of $120,000. The Company
recorded these fees as an expense during the period.





As of
March 31, 2009 and September 30, 2008, the principal outstanding totaled
$1,000,000.





For the
three and six months ended March 31, 2009, interest expense was $29,589 and
$59,836, respectively.





NOTE
8 10% SUBORDINATED NOTES PAYABLE




In
January 2008, the Company completed an offering of $425,000 in principal amount
of Subordinated Debentures to a group of institutional and accredited
investors.  The Subordinated Debentures mature on December 31, 2008,
and bear interest at the rate of 10% per annum. As part of the above offering,
the Company issued warrants to purchase 850,000 shares of Common Stock, which
expire six years from the date of grant.





The
Company applied APB 14, paragraphs 15 and 16, to determine the allocation of the
proceeds of the convertible debt. Paragraph 15 states that proceeds from the
sale of debt with stock purchase warrants should be allocated between the debt
and warrants, and paragraph 16 states that the proceeds should be allocated
based on the relative fair values of the two securities at the time of
issuance.





The grant
date fair value of the warrants was determined to be $125,462 which was
calculated using the Black-Scholes valuation model, using the following
assumptions: risk free rate of return ranging from 2.64% to 3.26%, volatility
ranging from 97.08% to 98.27%, dividend yield of 0%; and expected life of 6
years. As a result, the relative fair value of the warrants was determined to be
$96,814.


As of
March 31, 2009, the principal outstanding totaled $425,000, and there was no
unamortized warrant discount. As of December 31, 2008, the notes had matured and
the outstanding principal amount of $425,000 and accrued interest of $41,081
were due.





As of
September 30, 2008, the principal outstanding totaled $425,000, and unamortized
warrant discount was $24,204.





For the
three and six months ended March 31, 2009, interest expense was $10,479 and
$21,192, respectively.





For the
three and six months ended March 31, 2008, interest expense was $8,938, and
amortization expense for the warrant discount was $24,204, which was included in
interest expense in the other income (expense) section of the statement of
operations.





16


NOTE
9 WARRANT LIABILITY





2001
Executive Officers Stock Option Plan





In
October 2000, the Company amended its employment agreements with its executive
officers. In conjunction with the amendments the Company adopted the 2001
Executive Officers Stock Option Plan. The plan has reserved 7,576,680 shares of
Common Stock and has issued options for the purchase of 7,034,140 shares of
Common Stock.  The options expire 5 years from the date of
issuance.





On the
grant date, the Company applied SFAS 133, paragraph 6 to determine if the
options were within the scope and definition of a derivative. The options had
one or more underlings, one or more notional amounts, required no initial
investment, and required or permitted net settlement. Therefore, the options
were determined to be derivatives. In order to determine how to classify the
options, the Company followed the guidance of paragraphs 7 and 8 of EITF 00-19,
which states that contracts  that require
settlement in shares are equity instruments. In order to determine the value of
the options, the Company applied EITF 00-19, paragraph 9, which states that
contracts that require the company to deliver shares as part of a physical
settlement or net-share settlement should be initially measured at fair value.
In accordance with EITF 00-19, the options were recorded in additional paid-in
capital at fair value on the date of issuance.





In
accordance with EITF 00-19, the options were reclassified as of July 17, 2007
from additional paid-in capital to warrant liability on the balance sheet, at
the fair value of $2,271,879 using the Black-Scholes valuation model with the
following assumptions: risk free rate of return of 5.02%; volatility of 219.89%;
dividend yield of 0%; and expected term of 3.67 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the options as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the options issued remained derivatives
as of March 31, 2009. All of the criteria in the original analysis were met, and
the options issued were determined to be within the scope and definition of a
derivative. The Company next followed the guidance of EITF 00-19, paragraph 19,
which states that if a company is required to obtain shareholder approval to
increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability. The Company next applied
EITF 00-19, paragraph 10, which states that if classification changes as the
result of an event, the contract should be reclassified as of the date of the
event at fair value. The event responsible for the change in classification was
the issuance of the Convertible Note 3 on July 17, 2007.





The fair
value of the options was $251,036 as of March 31, 2009, calculated using the
Black-Scholes valuation model with the following assumptions: risk free rate of
return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected term
of 2.00 years.





The fair
value of the options was $484,440 as of September 30, 2008, calculated using the
Black-Scholes model with the following assumptions: risk free rate of return of
1.78%; volatility of 84.94%; dividend yield of 0%; and expected term of 2.5
years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the options was recorded by increasing (decreasing) warrant liability
on the balance sheet by $18,522 and $(233,404), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
options was recorded by decreasing warrant liability on the balance sheet by
$766,474 and $1,469,800, respectively.





Warrants
Related to Convertible Notes 3





On July
17, 2007 the Company completed an offering of $1,025,000 of Convertible Notes 3
to a group of institutional and accredited investors which included warrants to
purchase 2,795,454 shares of Common Stock (2,329,546 shares of Common Stock to
holders of the Convertible Notes 3 and 465,908 shares of Common Stock as a
placement fee) at an exercise price of $0.50 per share. An amendment dated March
13, 2008 reduces the exercise price of the warrants to $0.30 per
share.





On the
date of grant, the Company followed the guidance of SFAS 133, paragraph 6, to
determine if the warrants were within the scope and definition of a derivative.
The warrants had one or more underlings and one or more notional amounts,
required no initial investment and required or permitted net settlement.
Therefore, the warrants were determined to be derivatives at the date of
issuance. In order to determine how to classify the warrants, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts that require net-cash settlement (including a requirement to net cash
settle the contract if an event occurs and if that event is outside the control
of the company) are liability instruments.  In order to determine
the value of the options, the Company followed the guidance of EITF 00-19,
paragraph 9, which states that contracts which require the company to deliver
shares as part of a physical settlement or net-share settlement should be
initially measured at fair value.


17





The fair
value of the warrants was $554,249 ($430,189 attributable to the holders of the
Convertible Notes 3 and $124,060 attributable to the placement fee) at the date
of issuance calculated using the Black-Scholes valuation model  with the following
assumptions: risk free rate of return ranging from 4.96% to 5.02%; volatility
ranging from 219.89% to 226.04%; dividend yield of 0%; and expected term of 5
years.


The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the options as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the options issued remained derivatives
as of March 31, 2009. All of the criteria in the original analysis were met, and
the options issued were determined to be within the scope and definition of a
derivative. The Company next followed the guidance of EITF 00-19, paragraph 19,
which states that if a company is required to obtain shareholder approval to
increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability.





The fair
value of the warrants was determined to be $96,411 ($79,391 attributable to the
holders of the Convertible Notes 3 and $17,020 attributable to the placement
fee) as of March 31, 2009, which was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
0.57%; volatility of 109.22%; dividend yield of 0%; and expected term of 3.17 to
3.25 years.





The fair
value of the warrants was determined to be $153,789 ($125,440 attributable to
the holders of the Convertible Notes 3 and $28,349 attributable to the placement
fee)  as of
September 30, 2008, which was calculated using the Black-Scholes model with the
following assumptions: risk free rate of return of 1.78%; volatility of 84.94%;
dividend yield of 0%; and expected term of 3.67 to 3.75 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrants was recorded by increasing (decreasing) warrant liability
on the balance sheet by $15,720 ($12,778 attributable to the holders of the
Convertible Notes 3 and $2,942 attributable to the placement fee) and $(57,378)
($(46,048) attributable to the holders of the Convertible Notes 3 and $(11,329)
attributable to the placement fee), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
warrants was recorded by decreasing warrant liability on the balance sheet by
$185,827 ($143,242 and attributable to the holders of the Convertible Notes 3
and $42,585 attributable to the placement fee) and $363,982 ($268,469 and
attributable to the holders of the Convertible Notes 3 and $95,513 attributable
to the placement fee), respectively.





Warrant
Issued to Legal Counsel





The
Company entered into an agreement with its legal counsel to issue 150,000 shares
of Common Stock and a five year warrant to purchase up to 150,000 shares of
Common Stock at an exercise price of $0.25 per share for services.





On the
grant date, the Company followed the guidance of FASB 133, paragraph 6, to
determine if the warrant was within the scope and definition of a derivative.
The warrant had one or more underlings and one or more notional amounts,
required no initial investment and required or permitted net settlement.
Therefore, the warrant was determined to be a derivative at the date of
issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts that require net-cash settlement (including a requirement to net cash
settle the contract if an event occurs and if that event is outside the control
of the company) are liability instruments. In order to determine the value of
the warrant, the Company followed the guidance of EITF 00-19, paragraph 9, which
states that contracts which require a company to deliver shares as part of a
physical settlement or net-share settlement should be initially measured at fair
value.


18








The fair
value of the warrant was $32,394 at the date of issuance and was calculated
using the Black-Scholes valuation model with the following assumptions: risk
free interest rate of 3.93%, volatility of 116.99%, dividend yield of 0% and
expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the options as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the options issued remained derivatives
as of March 31, 2009. All of the criteria in the original analysis were met, and
the options issued were determined to be within the scope and definition of a
derivative. The Company next followed the guidance of EITF 00-19, paragraph 19,
which states that if a company is required to obtain shareholder approval to
increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability.





The fair
value of the warrant was determined to be $6,353 as of March 31, 2009, using the
Black-Scholes valuation model with the following assumptions: risk free rate of
return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected term
of 3.50 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrant was recorded by increasing (decreasing) warrant liability
on the balance sheet by $906 and $(4,155), respectively.





Warrants
Issued to Advisory Board Members





On
December 13, 2007, the Company’s Board of Directors approved the issuance of
five year warrants to the Company’s three advisory board members to purchase a
total of 8,640,000 shares of the Company’s Common Stock at an exercise price of
$0.25 per share.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrants were within the scope and definition of a derivative at the date of
issuance. The warrants had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrants were determined to be derivatives at the
date of issuance. In order to determine how to classify the warrants, the
Company followed the guidance of EITF 00-19, paragraphs 7 and 8, which state
that contracts that require net-cash settlement (including a requirement to net
cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrants, the Company followed the guidance of EITF 00-19,
paragraph 9, which states that contracts which require a company to deliver
shares as part of a physical settlement or net-share settlement should be
initially measured at fair value.





The fair
value of the warrants was $1,557,705 at the date of issuance and was calculated
using the Black-Scholes option valuation model with the following assumptions:
risk free interest rate of 3.22%, expected volatility of 99.86%, dividend yields
of 0% and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the options as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the options issued remained derivatives
as of March 31, 2009. All of the criteria in the original analysis were met, and
the options issued were determined to be within the scope and definition of a
derivative. The Company next followed the guidance of EITF 00-19, paragraph 19,
which states that if a company is required to obtain shareholder approval to
increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability.


19








The fair
value of the warrants was determined to be $378,136 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free rate
of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected
term of 3.67 years.





The fair
value of the warrants was determined to be $620,453 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free rate of
return of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term
of 4.17 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrants was recorded by increasing (decreasing) warrant liability
on the balance sheet by $53,039 and $(242,317), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
warrants was recorded by decreasing warrant liability on the balance sheet by
$983,628 and $1,008,033, respectively.





Option
Issued to Director





On
December 13, 2007, the Company’s Board of Directors approved the issuance of a
five year option to a Company director to purchase a total of 1,000,000 shares
of the Company’s common stock at an exercise price of $0.25 per
share.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
option was within the scope and definition of a derivative at the date of
issuance. The option had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the option was determined to be a derivative at the date
of issuance. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts that require net-cash settlement (including a requirement to net cash
settle the contract if an event occurs and if that event is outside the control
of the company) are liability instruments. In order to determine the value of
the option, the Company followed the guidance of EITF 00-19, paragraph 9, which
states that contracts which require the company to deliver shares as part of a
physical settlement or net-share settlement should be initially measured at fair
value.





The fair
value of the option was $171,520 at the date of issuance and was calculated
using the Black-Scholes option valuation model with the following assumptions:
risk free interest rate of 3.22%, expected volatility of 99.86%, dividend yields
of 0% and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. The Company analyzed
the option as of March 31, 2009 by following the guidance of SFAS 133, paragraph
6 to ascertain if the option remained a derivative as of March 31, 2009. All of
the criteria in the original analysis were met, and the option was determined to
be within the scope and definition of a derivative. The Company next followed
the guidance of EITF 00-19, paragraph 19, which states that if a company is
required to obtain shareholder approval to increase the company’s authorized
shares in order to net-share or physically settle a contract, share settlement
is not controlled by the company, and the contract is required to be classified
as a liability.





The fair
value of the option was determined to be $43,766 as of March 31, 2009, using the
Black-Scholes valuation model with the following assumptions: risk free rate of
return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected term
of 3.67 years.





The fair
value of the option was determined to be $71,812 as of September 30, 2008, using
the Black-Scholes model with the following assumptions: risk free rate of return
of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term of 4.17
years.





20








For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the option was recorded by increasing (decreasing) warrant liability on
the balance sheet by $6,139 and $(28,046), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
option was recorded by decreasing warrant liability on the balance sheet by
$113,845 and $107,900, respectively.





Option
Issued to Former Chief Financial Officer





On
December 13, 2007, the Company’s Board of Directors approved the issuance to the
Chief Financial Officer of a five year option to purchase a total of 1,000,000
shares of the Company’s common stock at an exercise price of $0.25 per
share.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
option was within the scope and definition of a derivative at the date of
issuance. The option had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the option was determined to be a derivative at the date
of issuance. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts that require net-cash settlement (including a requirement to net cash
settle the contract if an event occurs and if that event is outside the control
of the company) are liability instruments. In order to determine the value of
the option, the Company followed the guidance of EITF 00-19, paragraph 9, which
states that contracts which require the company to deliver shares as part of a
physical settlement or net-share settlement should be initially measured at fair
value.





The fair
value of the option was $171,520 at the date of issuance and was calculated
using the Black-Scholes option valuation model with the following assumptions:
risk free interest rate of 3.22%, expected volatility of 99.86%, dividend yield
of 0% and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the option as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the option remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
option was determined to be within the scope and definition of a derivative. The
Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the option was determined to be $43,766 as of March 31, 2009, using the
Black-Scholes valuation model with the following assumptions: risk free rate of
return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected term
of 3.67 years.





The fair
value of the option was determined to be $71,812 as of September 30, 2008, using
the Black-Scholes model with the following assumptions: risk free rate of return
of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term of 4.17
years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the options was recorded by increasing (decreasing) warrant liability
on the balance sheet by $6,139 and $(28,046), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
options was recorded by decreasing warrant liability on the balance sheet by
$113,845 and $107,900, respectively.





Option
Issued to Former Chief Executive Officer





On
December 19, 2007, the Company entered into a one year Employment Agreement with
Richard H. Papalian pursuant to which Mr. Papalian had been appointed as the
Company’s Chief Executive Officer. As compensation for his services, the Company
granted Mr. Papalian a five year option to purchase up to 8,539,312 shares of
the Company’s Common Stock at an exercise price of $0.25 per share. As per the
terms of the stock option agreement, the right to purchase 340,000 shares of
Common Stock is not exercisable until the notes dated June 6, 2007 (Convertible
Notes 2 as discussed in Note 7 above) are eligible for conversion into shares of
Common Stock. These options were not issued from the 2001 Executive Officers
Stock Option Plan.   On August 14, 2008, Mr. Papalian resigned as the
Company’s Chief Executive Officer





21








On the
grant date, the Company applied FASB 133, paragraph 6 to determine if the option
was within the scope and definition of a derivative. The option had one or more
underlings and one or more notional amounts, required no initial investment, and
required or permitted net settlement. Therefore, the option was determined to be
a derivative. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts that require net-cash settlement (including a requirement to net cash
settle the contract if an event occurs and if that event is outside the control
of the company) are liability  instruments. In order
to determine the value of the option, the Company applied EITF 00-19, paragraph
9, which states that contracts that require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the option was $1,448,321 at the date of issuance, which was calculated
using the Black-Scholes model with the following assumptions: risk free rate of
return of 3.26%; volatility of 98.01%; dividend yield of 0%; and expected term
of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the option as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the option remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
option was determined to be within the scope and definition of a derivative. The
Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the option was determined to be $128,388 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free rate
of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected
term of 3.67 years.





The fair
value of the option was determined to be $613,223 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free rate of
return of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term
of 4.17 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the option was recorded by increasing (decreasing) warrant liability on
the balance sheet by $18,008 and $(484,835), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
option was recorded by decreasing warrant liability on the balance sheet by
$972,165 and $905,054, respectively.





Warrant
Issued to Consultant





On
December 19, 2007, the Company entered into a one year Consulting Agreement with
Mark Maron pursuant to which Mr. Maron has been appointed as Special Adviser to
the Company. As compensation for his services, the Company granted Mr. Maron a
five year warrant to purchase up to 8,539,312 shares of the Company’s Common
Stock at an exercise price of $0.25 per share. As per the terms of the warrant
agreement, the right to purchase 340,000 shares of Common Stock is not
exercisable until the notes dated June 6, 2007 (Convertible Notes 2 as discussed
in Note 7 above) are eligible for conversion into shares of Common
Stock.  The warrant was not issued from the 2001 Executive Officers
Stock Option Plan.


22








The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts that require net-cash settlement (including a requirement to net cash
settle the contract if an event occurs and if that event is outside the control
of the company) are liability instruments. In order to determine the
value of the warrant, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the warrant was $1,448,321 at the date of issuance and was calculated
using the Black-Scholes option valuation model with the following assumptions:
risk free interest rate of 3.26%, expected volatility of 98.01%, dividend yield
of 0% and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrant as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrant remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
warrant was determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the warrant was determined to be $373,729 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free rate
of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected
term of 3.67 years.





The fair
value of the warrant was determined to be $613,223 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free rate of
return of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term
of 4.17 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrants was recorded by increasing (decreasing) warrant liability
on the balance sheet by $52,421 and $(239,494), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
warrants was recorded by decreasing warrant liability on the balance sheet by
$972,165 and $905,054, respectively.





Warrants
Related to 10% Subordinated Debentures





In
January 2008, the Company completed an offering of $425,000 in principal amount
of Subordinated Debentures to a group of institutional and accredited investors.
As part of the above offering, the Company issued warrants to purchase 850,000
shares of Common Stock.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrants were within the scope and definition of a derivative at the date of
issuance. The warrants had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrants were determined to be derivatives at the
date of issuance. In order to determine how to classify the warrants, the
Company followed the guidance of EITF 00-19, paragraphs 7 and 8, which state
that contracts that require net-cash settlement (including a requirement to net
cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrants, the Company followed the guidance of EITF 00-19,
paragraph 9, which states that contracts which require a company to deliver
shares as part of a physical settlement or net-share settlement should be
initially measured at fair value.





23








The fair
value of the warrants was determined to be $96,814 at the date of issuance,
which was calculated using the Black-Scholes valuation model, using the
following assumptions: risk free rate of return of 2.64% to 3.26%, volatility
ranging from 97.08% to 98.27%, dividend yield of 0% and expected life of six
years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrants as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrants issued remained
derivatives as of March 31, 2009. All of the criteria in the original analysis
were met, and the warrants were determined to be within the scope and definition
of a derivative. The Company next followed the guidance of EITF 00-19, paragraph
19, which states that if a company is required to obtain shareholder approval to
increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability.





The fair
value of the warrants was determined to be $36,060 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free rate
of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and expected
term of 4.83 years.





The fair
value of the warrants was determined to be $52,609 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free rate of
return of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term
of 5.33 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrants was recorded by increasing (decreasing) warrant liability
on the balance sheet by $5,970 and $(16,548), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
warrants was recorded by decreasing warrant liability on the balance sheet by
$51,429.





Warrants
Related to $750,000 Stock Issuance





On May
28, 2008 the Company completed an offering of units consisting of Common Stock
and warrants to purchase shares of its Common Stock to a group of institutional
and accredited investors.  The Company raised a total of $750,000
through this offering.  The Company issued warrants to purchase
15,000,000 shares of Common Stock at an exercise price of $0.10 per share. The
warrants expire three years from the date of issuance.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrants were within the scope and definition of a derivative at the date of
issuance. The warrants had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrants were determined to be derivatives at the
date of issuance. In order to determine how to classify the warrants, the
Company followed the guidance of EITF 00-19, paragraphs 7 and 8, which state
that contracts that require net-cash settlement (including a requirement to net
cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrants, the Company followed the guidance of EITF 00-19,
paragraph 9, which states that contracts which require a company to deliver
shares as part of a physical settlement or net-share settlement should be
initially measured at fair value.





The fair
value of the warrants was determined to be $483,476 at the date of issuance,
which was calculated using the Black-Scholes valuation model, using the
following assumptions: risk free rate of return ranging from 1.32% to 2.17%;
volatility ranging from 72.4% to 77.86%; dividend yield of 0%; and expected term
of 3 years.


The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrants as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrants issued remained
derivatives as of March 31, 2009. All of the criteria in the original analysis
were met, and the warrants issued were determined to be within the scope and
definition of a derivative. The Company next followed the guidance of EITF
00-19, paragraph 19, which states that if a company is required to obtain
shareholder approval to increase the company’s authorized shares in order to
net-share or physically settle a contract, share settlement is not controlled by
the company, and the contract is required to be classified as a
liability.





24








The fair
value of the warrants was determined to be $348,642 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free
rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and
expected term of 1.92 to 2.08 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrants was recorded by increasing (decreasing) warrant liability
on the balance sheet by $4,609 and $(119,437), respectively.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
warrants was recorded by decreasing warrant liability on the balance sheet by
$8,754.





Warrant
Issued to Legal Counsel





On June
24, 2008, the Company entered into an agreement with its legal counsel to issue
600,139 shares of Common Stock and a six year warrant to purchase up to 400,000
shares of Common Stock at an exercise price of $0.15 per share for services
previously rendered.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrant, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require a company to deliver shares as part
of a physical settlement or net-share settlement should be initially measured at
fair value.





The fair
value of the warrant was $60,645 at the date of issuance and was calculated
using the Black-Scholes valuation model with the following assumptions: risk
free interest rate of 2.36%, expected volatility of 74.90%, dividend yields of
0% and expected term of 6 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrant as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrant remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
warrant was determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the warrant was determined to be $23,910 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free
rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and
expected term of 5.17 years.





The fair
value of the warrant was determined to be $38,802 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free
rate of return of 1.78%; volatility of 84.94%; dividend yield of 0%; and
expected term of 5.75 years.


25


For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrant was recorded by increasing (decreasing) warrant liability
on the balance sheet by $1,616 and $(14,891), respectively.





Warrant
Issued to Director (John Pavia)





On July
11, 2008, the Company’s Board of Directors approved the issuance of a five year
warrant to a director to purchase a total of 500,000 shares of the Company’s
Common Stock at an exercise price of $0.25 per share.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments.  In order to determine
the value of the warrant, the Company followed the guidance of EITF 00-19,
paragraph 9, which states that contracts which require a company to deliver
shares as part of a physical settlement or net-share settlement should be
initially measured at fair value.





The fair
value of the warrant was $51,582 at the date of issuance and was calculated
using the Black-Scholes valuation model with the following assumptions: risk
free interest rate of 2.30%, expected volatility of 71.69%, dividend yield of 0%
and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrant as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrant issued remained a
derivative as of March 31, 2009. All of the criteria in the original analysis
were met, and the warrant issued was determined to be within the scope and
definition of a derivative. The Company next followed the guidance of EITF
00-19, paragraph 19, which states that if a company is required to obtain
shareholder approval to increase the company’s authorized shares in order to
net-share or physically settle a contract, share settlement is not controlled by
the company, and the contract is required to be classified as a
liability.





The fair
value of the warrant was determined to be $24,136 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free
rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and
expected term of 4.25 years.





The fair
value of the warrant was determined to be $38,759 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free
rate of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term
of 4.75 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrant was recorded by increasing (decreasing) warrant liability
on the balance sheet by $3,179 and $(14,623), respectively.





Warrant
Issued to Director (Marcus Woods)





On July
11, 2008, the Company’s Board of Directors approved the issuance of a five year
warrant to a director to purchase a total of 500,000 shares of the Company’s
Common Stock at an exercise price of $0.25 per share.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrant, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require a company to deliver shares as part
of a physical settlement or net-share settlement should be initially measured at
fair value.


26


The fair
value of the warrant was $51,582 at the date of issuance and was calculated
using the Black-Scholes valuation model with the following assumptions: risk
free interest rate of 2.30%, expected volatility of 71.69%, dividend yield of 0%
and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrant as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrant remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
warrant was determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the warrant was determined to be $24,136 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free
rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and
expected term of 4.25 years.





The fair
value of the warrant was determined to be $38,759 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free
rate of return of 1.78%; volatility of 84.94%; dividend yield of 0%; and
expected term of 4.75 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrant was recorded by increasing (decreasing) warrant liability
on the balance sheet by $3,179 and $(14,623), respectively.





Warrant
Issued to Legal Counsel





On July
22, 2008, the Company entered into an agreement with its legal counsel to issue
641,000 shares of Common Stock and a six year warrant to purchase up to 641,000
shares of Common Stock at an exercise price of $0.15 per share for services
previously rendered.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrant, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require a company to deliver shares as part
of a physical settlement or net-share settlement should be initially measured at
fair value.





The fair
value of the warrant was $82,779 at the date of issuance and was calculated
using the Black-Scholes valuation model with the following assumptions: risk
free interest rate of 2.27%, expected volatility of 70.18%, dividend yield of 0%
and expected term of 6 years.


27





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrant as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrant remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
warrant was determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the warrant was determined to be $38,571 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free
rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and
expected term of 5.25 years.





The fair
value of the warrant was determined to be $62,512 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free
rate of 1.78%; volatility of 84.94%; dividend yield of 0%; and expected term
of 5.75 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrant was recorded by increasing (decreasing) warrant liability
on the balance sheet by $2,577 and $(23,941), respectively.





Warrant
Issued to Advisory Board Member





On
September 23, 2008, the Company issued a five year warrant to a member of the
Company’s advisory board to purchase 1,500,000 shares of the Company’s Common
Stock at an exercise price of $0.25 per share.





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments.  In order to determine
the value of the warrant, the Company followed the guidance of EITF 00-19,
paragraph 9, which states that contracts which require a company to deliver
shares as part of a physical settlement or net-share settlement should be
initially measured at fair value.





The fair
value of the warrant was $144,641 at the date of issuance and was calculated
using the Black-Scholes valuation model with the following assumptions: risk
free interest rate of 2.01%, expected volatility of 78.92%, dividend yield of 0%
and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the warrant as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the warrant remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
warrant was determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the warrant was determined to be $74,171 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free
rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and
expected term of 4.42 years.





The fair
value of the warrant was determined to be $118,551 as of September 30, 2008,
using the Black-Scholes model with the following assumptions: risk free
rate of return of 1.78%; volatility of 84.94%; dividend yield of 0%; and
expected term of 4.83 years.


28


For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the warrant was recorded by increasing (decreasing) warrant liability
on the balance sheet by $9,582 and $(44,380), respectively.





Option
Issued to Former Chief Executive Officer





On
November 11, 2008 the Company’s Board of Directors approved the issuance to the
Chief Executive Officer of a five year option to purchase a total of 3,500,000
shares of the Company’s common stock at an exercise price of $0.25 per
share.





On the
grant date, the Company applied FASB 133, paragraph 6 to determine if the option
was within the scope and definition of a derivative. The option had one or more
underlings and one or more notional amounts, required no initial investment, and
required or permitted net settlement. Therefore, the option was determined to be
a derivative. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability  instruments. In order
to determine the value of the option, the Company applied EITF 00-19, paragraph
9, which states that contracts that require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the option was $238,244 at the date of issuance, which was calculated
using the Black-Scholes valuation model with the following assumptions:
risk free rate of return of 1.16%; volatility of 89.31%; dividend yield of 0%;
and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the option as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the option remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
option was determined to be within the scope and definition of a derivative. The
Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the option was determined to be $177,019 as of March 31, 2009, using
the Black-Scholes valuation model with the following assumptions: risk free
rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%; and
expected term of 4.58 years.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the option was recorded by increasing (decreasing) warrant liability on
the balance sheet by $22,418 and $(61,225), respectively.





Option
Issued to Director (Rodney Anderson)





On March
30, 2009 the Company issued an option to a director to purchase a total of
1,380,114 shares of the Company’s common stock at an exercise price of $0.15 per
share. The right to purchase 690,057 shares of Common Stock vested on the date
of grant and the right to purchase 172,514 shares of Common Stock vests on June
30, September 30, December 31, 2009 and March 31, 2010,
respectively.





On the
grant date, the Company applied FASB 133, paragraph 6 to determine if the
options were within the scope and definition of a derivative. The options had
one or more underlings and one or more notional amounts, required no initial
investment, and required or permitted net settlement. Therefore, the options
were determined to be a derivative. In order to determine how to classify the
options, the Company followed the guidance of EITF 00-19, paragraphs 7 and 8,
which state that contracts   that require net-cash settlement (including a
requirement to net cash settle the contract if an event occurs and if that event
is outside the control of the company) are liability  instruments. In order
to determine the value of the options, the Company applied EITF 00-19, paragraph
9, which states that contracts that require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.


29








The fair
value of the vested options was $41,847 at the date of issuance, which was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 0.58%; volatility of 109.22%; dividend
yield of 0%; and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the options as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the options remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
options were determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the vested options was determined to be $40,392 as of March 31, 2009,
using the Black-Scholes valuation model with the following assumptions:
risk free rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%;
and expected term of 4.58 years.





For the
three and six months ended March 31, 2009, the decrease in the fair value of the
vested options was recorded by decreasing warrant liability on the balance sheet
by $1,455.





Option
Issued to Director (Robert Hasson)





On March
30, 2009 the Company issued an option to a director to purchase a total of
958,412 shares of the Company’s common stock at an exercise price of $0.15 per
share. The right to purchase 479,206 shares of Common Stock vested on the date
of grant and the right to purchase 119,802 shares of Common Stock vests on June
30, September 30, December 31, 2009 and March 31, 2010,
respectively.





On the
grant date, the Company applied FASB 133, paragraph 6 to determine if the
options were within the scope and definition of a derivative. The options had
one or more underlings and one or more notional amounts, required no initial
investment, and required or permitted net settlement. Therefore, the options
were determined to be a derivative. In order to determine how to classify the
options, the Company followed the guidance of EITF 00-19, paragraphs 7 and 8,
which state that contracts   that require net-cash settlement (including a
requirement to net cash settle the contract if an event occurs and if that event
is outside the control of the company) are liability  instruments. In order
to determine the value of the options, the Company applied EITF 00-19, paragraph
9, which states that contracts that require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the vested options was $29,060 at the date of issuance, which was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 0.58%; volatility of 109.22%; dividend
yield of 0%; and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the options as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the options remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
options were determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.








30










The fair
value of the vested options was determined to be $28,050 as of March 31, 2009,
using the Black-Scholes valuation model with the following assumptions:
risk free rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%;
and expected term of 4.58 years.





For the
three and six months ended March 31, 2009, the decrease in the fair value of the
vested options was recorded by decreasing warrant liability on the balance sheet
by $1,010.





Option
Issued to Employee





On March
30, 2009 the Company issued an option to an employee to purchase a total of
1,495,124 shares of the Company’s common stock at an exercise price of $0.15 per
share. The right to purchase 747,562 shares of Common Stock vested on the date
of grant and the right to purchase 186,891 shares of Common Stock vests on June
30, September 30, December 31, 2009 and March 31, 2010,
respectively.





On the
grant date, the Company applied FASB 133, paragraph 6 to determine if the
options were within the scope and definition of a derivative. The options had
one or more underlings and one or more notional amounts, required no initial
investment, and required or permitted net settlement. Therefore, the options
were determined to be a derivative. In order to determine how to classify the
options, the Company followed the guidance of EITF 00-19, paragraphs 7 and 8,
which state that contracts   that require net-cash settlement (including a
requirement to net cash settle the contract if an event occurs and if that event
is outside the control of the company) are liability  instruments. In order
to determine the value of the options, the Company applied EITF 00-19, paragraph
9, which states that contracts that require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the vested options was $45,334 at the date of issuance, which was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 0.58%; volatility of 109.22%; dividend
yield of 0%; and expected term of 5 years.





The
Company followed the guidance of EITF 00-19, paragraph 9, which states that all
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities. 
The Company analyzed the options as of March 31, 2009 by following the guidance
of SFAS 133, paragraph 6 to ascertain if the options remained a derivative as of
March 31, 2009. All of the criteria in the original analysis were met, and the
options were determined to be within the scope and definition of a derivative.
The Company next followed the guidance of EITF 00-19, paragraph 19, which states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability.





The fair
value of the vested options was determined to be $43,758 as of March 31, 2009,
using the Black-Scholes valuation model with the following assumptions:
risk free rate of return of 0.57%; volatility of 109.22%; dividend yield of 0%;
and expected term of 4.58 years.





For the
three and six months ended March 31, 2009, the decrease in the fair value of the
vested options was recorded by decreasing warrant liability on the balance sheet
by $1,576.





NOTE
10 BENEFICIAL CONVERSION FEATURES LIABILITY





The
Company issued convertible notes between October 17, 2006 and July 17, 2007 that
matured between June 17, 2008 and December 31, 2008, and included embedded
beneficial conversion features that allowed the holders of the convertible notes
to convert their notes into Common Stock shares at rates between $.01 and $.22.
The convertible notes accrue interest at rates between 8% and 10%, and any
accrued but unpaid interest is also convertible by the holder of the convertible
notes into shares of Common Stock at the same rate.








31










The
Company followed the guidance of SFAS 133, paragraph 6, to ascertain if the
embedded beneficial conversion features were derivatives at the date of issue.
The embedded beneficial conversion features had one or more underlings and one
or more notional amounts, required no initial investment and required or
permitted net settlement. Therefore, the embedded beneficial conversion features
were determined to be derivatives. In order to determine the classification of
the embedded conversion features, the Company applied paragraph 19 of EITF
00-19, which states that if a company is required to obtain shareholder approval
to increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability. In order to determine the
value of the embedded conversion features, the Company followed the guidance of
EITF 00-19, paragraph 9, which states that all contracts classified as
liabilities are to be measured at fair value at each balance sheet date, with
changes in fair value reported in earnings and disclosed in the financial
statements as long as the contracts remain classified as
liabilities.





The fair
value of the embedded beneficial conversion features was $1,430,811 at the date
of issuance using the Black-Scholes valuation model  with the following
assumptions: risk free rate of return ranging from 2.02% to 5.09%; volatility
ranging from 108.5% to 274.86%; dividend yield of 0%; and expected term of 1 to
1.5 years.


The
Company followed the guidance of SFAS 133, paragraph 6, to ascertain if the
embedded beneficial conversion features remained derivatives as of September 30,
2007. All of the criteria in the original analysis were met, and the embedded
beneficial conversion features were determined to be within the scope and
definition of a derivative. The Company followed the guidance of SFAS 133,
paragraph 12, to determine if the embedded beneficial conversion features should
be separated from the convertible notes. All of the criteria in the original
analysis were met, and the embedded beneficial conversion features were
separated from the convertible notes. In order to determine the classification
of the embedded conversion features, the Company applied paragraph 19 of EITF
00-19, which states that if a company is required to obtain shareholder approval
to increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability. In order to determine the
value of the embedded conversion features, the Company followed the guidance of
EITF 00-19, paragraph 9, which states that all contracts classified as
liabilities are to be measured at fair value at each balance sheet date, with
changes in fair value reported in earnings and disclosed in the financial
statements as long as the contracts remain classified as
liabilities.





The fair
value of the embedded beneficial conversion features was $26,000 as of September
30, 2008, which was calculated using the Black-Scholes model with the following
assumptions: risk free rate of return of 1.78%; volatility of 84.94%; dividend
yield of 0% and expected term of .25.





For the
three and six months ended March 31, 2009, the increase (decrease) in the fair
value of the option was recorded by increasing (decreasing) warrant liability on
the balance sheet by $22,418 and $(61,225), respectively.





For the
three and six months ended March 31, 2009, the decrease in the fair value of the
embedded beneficial conversion feature was recorded by decreasing beneficial
conversion features liability on the balance sheet by $26,000.





For the
three and six months ended March 31, 2008, the decrease in the fair value of the
embedded beneficial conversion feature was recorded by decreasing beneficial
conversion features liability on the balance sheet by $347,740 and $555,929,
respectively.





NOTE
11 STOCKHOLDERS’ EQUITY





COMMON
STOCK




The
Company has 150,000,000 authorized shares of Common Stock, par value $0.001 per
share.  As of March 31, 2009 and September 30, 2008, the Company had
142,303,907 and 134,756,213 shares of Common Stock issued and outstanding,
respectively. As of March 31, 2009, there are 481,900 shares of Common Stock
subject to cancellation. Subsequent to cancellation, the total issued and
outstanding shares of Common Stock would be 141,822,007.





The
Company has 150,000,000 authorized shares of Common Stock, par value $0.001 per
share.  As of March 31, 2009 and September 30, 2008, the Company had
142,303,906 and 134,756,213 shares of Common Stock issued, respectively. As of
September 30, 2009 and 2008, there were 481,900 shares of Common Stock subject
to cancellation. Subsequent to cancellation, the total outstanding shares of
Common Stock would be 141,822,006 and 134,274,313, respectively.




During
the six months ended March 31, 2009 the Company issued 5,614,221 shares of
Common Stock for the payment of $263,000 of debt, $54,672 of accrued interest,
$7 of late fees and penalties and $75,000 of liquidated damages at conversion
prices between $0.04 and $0.15. The Company also issued 500,000 shares of Common
Stock for the settlement of outstanding debt due to a related party of $7,000 in
principal and accrued interest of $1,816 and the receipt of $5,000 in cash.
Additionally, the Company issued 833,333 shares of common stock for $125,000 for
machinery and equipment from RJ Metal Co. Lastly, the Company issued 600,139
shares of Common Stock to legal counsel for services having a value of
$60,014.  The fair value of the Common Stock on the date of issuance
was $126,029.


32








STOCK
OPTIONS




A summary
of the Company’s option activity is listed below:





WeightedAverage
            
            
            
            
            
            AggregateExercise
            
            
            Number
            
            
            IntrinsicPrice
            
            
            of
      Options
            
            
            ValueOutstanding
      at October 1, 2008
            
            $
            0.19
            
            
            
            17,573,452
            
            
            $
            -Granted
            
            
            0.15
            
            
            
            7,333,650
            
            
            
            -Expired
            
            
            -
            
            
            
            -
            
            
            
            -Forfeited
            
            
            0.25
            
            
            
            (5,605,786)
            
            
            
            -Exercised
            
            
            -
            
            
            
            -
            
            
            
            -Outstanding
      at March 31, 2009
            
            $
            0.19
            
            
            
            19,301,316
            
            
            $
            -





Options
outstanding as of March 31, 2009:





WeightedAverageRemaining
            Weighted
      AverageExercise
            Options
            Options
            Contractual
            Exercise
      PricePrice
            Outstanding
            Exercisable
            Life
            Outstanding
            
            Exercisable$0.15
      - $0.25
            19,301,316
            17,384,491
            3.47
            
            $0.19
            
            
            $0.20


33








WeightedAverageOutstanding
            
            
            Exercisable
            
            
            RemainingOption
            
            
            
            
            Exercise
            
            
            
            
            
            Exercise
            
            
            ContractualHolder
            
            Amount
            
            
            Price
            
            
            Amount
            
            
            Price
            
            
            Life2001
      Executive Officers Stock Option Plan
            
            
            7,034,140
            
            
            $
            0.15
            
            
            
            7,034,140
            
            
            $
            0.15
            
            
            
            2.00Director
            
            
            1,000,000
            
            
            
            0.25
            
            
            
            1,000,000
            
            
            
            0.25
            
            
            
            3.67Former
      Chief Financial Officer
            
            
            1,000,000
            
            
            
            0.25
            
            
            
            1,000,000
            
            
            
            0.25
            
            
            
            3.67Former
      Chief Executive Officer
            
            
            2,933,526
            
            
            
            0.25
            
            
            
            2,933,526
            
            
            
            0.25
            
            
            
            3.67Former
      Chief Executive Officer
            
            
            3,500,000
            
            
            
            0.25
            
            
            
            3,500,000
            
            
            
            0.25
            
            
            
            4.58Director
            
            
            1,380,114
            
            
            
            0.15
            
            
            
            690,057
            
            
            
            0.15
            
            
            
            4.92Director
            
            
            958,412
            
            
            
            0.15
            
            
            
            479,206
            
            
            
            0.15
            
            
            
            4.92Employee
            
            
            1,495,124
            
            
            
            0.15
            
            
            
            747,562
            
            
            
            0.15
            
            
            
            4.92





STOCK
WARRANTS




A summary
of the Company’s warrant activity is listed below:





WeightedAverage
            
            
            
            
            
            AggregateExercise
            
            
            Number
            
            
            IntrinsicPrice
            
            
            of
      Options
            
            
            ValueOutstanding
      at October 1, 2008
            
            $
            0.20
            
            
            
            42,849,099
            
            
            $
            -Granted
            
            
            -
            
            
            
            -
            
            
            
            -Expired
            
            
            -
            
            
            
            -
            
            
            
            -Forfeited
            
            
            -
            
            
            
            -
            
            
            
            -Exercised
            
            
            -
            
            
            
            -
            
            
            
            -Outstanding
      at March 31, 2009
            
            $
            0.20
            
            
            
            42,849,099
            
            
            $
            -





Warrants
outstanding as of March 31, 2009:





WeightedAverageRemaining
            Weighted
      AverageExercise
            Warrants
            Options
            Contractual
            Exercise
      PricePrice
            Outstanding
            Exercisable
            Life
            Outstanding
            
            Exercisable$0.10
      - $0.40
            42,849,099
            39,515,766
            3.12
            
            $0.20
            
            
            $0.20








34








WeightedAverageOutstanding
            
            
            Exercisable
            
            
            RemainingWarrant
            
            
            
            
            Exercise
            
            
            
            
            
            Exercise
            
            
            ContractualHolder
            
            Amount
            
            
            Price
            
            
            Amount
            
            
            Price
            
            
            LifeConvertible
      Notes 3
            
            
            2,795,454
            
            
            $
            0.30
            
            
            
            2,795,454
            
            
            $
            0.30
            
            
            
            3.25Richardson
      & Patel LLP
            
            
            150,000
            
            
            
            0.25
            
            
            
            150,000
            
            
            
            0.25
            
            
            
            3.50Advisory
      Board Members
            
            
            8,640,000
            
            
            
            0.25
            
            
            
            8,640,000
            
            
            
            0.25
            
            
            
            3.67Consultant
            
            
            8,539,312
            
            
            
            0.25
            
            
            
            8,539,312
            
            
            
            0.25
            
            
            
            3.6710%
      Subordinated Notes Payable
            
            
            850,000
            
            
            
            0.40
            
            
            
            850,000
            
            
            
            0.40
            
            
            
            4.83Stockholders
            
            
            15,000,000
            
            
            
            0.10
            
            
            
            15,000,000
            
            
            
            0.10
            
            
            
            2.02Richardson
      & Patel LLP
            
            
            400,000
            
            
            
            0.15
            
            
            
            400,000
            
            
            
            0.15
            
            
            
            5.17Director
            
            
            500,000
            
            
            
            0.25
            
            
            
            500,000
            
            
            
            0.25
            
            
            
            4.25Director
            
            
            500,000
            
            
            
            0.25
            
            
            
            500,000
            
            
            
            0.25
            
            
            
            4.25Richardson
      & Patel LLP
            
            
            641,000
            
            
            
            0.15
            
            
            
            641,000
            
            
            
            0.15
            
            
            
            5.25Advisory
      Board Member
            
            
            1,500,000
            
            
            
            0.25
            
            
            
            1,500,000
            
            
            
            0.25
            
            
            
            4.42Debt
      Financing
            
            
            3,333,333
            
            
            
            0.30
            
            
            
            -
            
            
            
            0.30
            
            
            
            4.33





NOTE
12 GOING CONCERN (Restated)




The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. This basis of accounting contemplates the
recovery of the Company’s assets and the satisfaction of its liabilities in the
normal course of business. Through March 31, 2009, the Company has incurred
cumulative losses of $27,532,596 including net income for the six months ended
March 31, 2009 of $6,382,139. As the Company has no cash flow from
operations,  its  ability to transition from a development
stage company to an operating company is entirely dependent upon obtaining
adequate cash to finance its overhead, research and development activities, and
acquisition of production equipment. It is unknown when, if ever, the Company
will achieve a level of revenues adequate to support its costs and expenses. In
order for the Company to meet its basic financial obligations, including rent,
salaries, debt service and operations, it plans to seek additional equity or
debt financing. Because of the Company’s history and current debt levels, there
is considerable doubt that the Company will be able to obtain financing. The
Company’s ability to meet its cash requirements for the next twelve months
depends on its ability to obtain such financing. Even if financing is obtained,
any such financing will likely involve additional fees and debt service
requirements which may significantly reduce the amount of cash we will have for
our operations. Accordingly, there is no assurance that the Company will be able
to implement its plans.





The
Company expects to continue to incur substantial operating losses for the
foreseeable future, and it cannot predict the extent of the future losses or
when it may become profitable, if ever. The Company expects to incur increasing
sales and marketing, research and development and general and administrative
expenses. Also, the Company has a substantial amount of short-term debt, which
will need to be repaid or refinanced, unless it is converted into equity. As a
result, if the Company begins to generate revenues from operations, those
revenues will need to be significant in order to cover current and anticipated
expenses. These factors raise substantial doubt about the Company's ability to
continue as a going concern unless it is able to obtain substantial additional
financing in the short term and generate revenues over the long term. If the
Company is unable to obtain financing, it would likely discontinue its
operations.





As
mentioned in Notes 7 and 8, the Company has convertible notes and subordinated
notes payable that have matured. The Company is in the process of renegotiating
the terms of the notes with the note holders to extend the maturity date. If the
Company is unsuccessful in extending the maturity date, the Company may not be
able to continue as a going concern.





35








Management
expects an order for 14 additional water treatment systems from the customer who
purchased two water treatment systems. Additionally, management will continue to
identify new markets and demonstrate the water treatment unit to potential
customers. Management will closely monitor and evaluate expenses to identify
opportunities to reduce operating expenses.





NOTE
13 COMMITMENTS





As of
August 1, 2008, we entered into a 36 month lease for an industrial site
consisting of approximately 12,000 square feet of administrative offices and a
manufacturing facility.  Monthly lease payments for the period from
August 1, 2008 through July 31, 2009 are $8,650 plus common area maintenance
charges; monthly lease payments for the period from August 1, 2009 through July
31, 2010 are $8,995 plus common area maintenance charges and monthly lease
payments for the period from August 1, 2010 through July 31, 2011 are $9,355
plus common area maintenance charges.  The lease agreement includes an
option to extend the lease for an additional 36 months. If the option is
exercised, monthly payments over the three year term would be $9,730 plus common
area maintenance charges from August 1, 2011 through July 31, 2012, $10,118 plus
common area maintenance charges from August 1, 2012 through July 31, 2012, and
$10,523 plus common area maintenance charges from August 1, 2013 through July
31, 2014. The future aggregate minimum annual lease payments arising from
this lease agreement are as follows.





For
      the Fiscal Year Ended September 30,2009
            
            $
            52,5902010
            
            
            108,6602011
            
            
            93,550





Total
rent expense under the operating lease was approximately $18,470 for the year
ended September 30, 2008.





NOTE
14 SUPPLEMENTAL CASH FLOW INFORMATION




The
Company had the following noncash transactions.





The
Company issued 6,114,221 shares of Common Stock for the payment of $270,000 of
debt, $6,909 of accrued interest, $77,979 of late fees and penalties and $75,000
of liquidated damages at conversion prices between $0.04 and $0.15.





The
Company issued 833,333 shares of Common Stock for the purchase of machinery and
equipment from RJ Metal, Co. having a value of $125,000.





The
Company issued 600,139 shares of Common Stock for legal services having a value
of $60,014.  The fair value of the Common Stock on the date of
issuance was $126,029.





NOTE
15 SUBSEQUENT EVENT




On May
13, 2009, convertible note holders converted a total of $11,632 of accrued
interest into 290,798 shares of Common Stock.





On May
13, 2009, the Company entered into a letter of understanding regarding the
issuance of a total of $300,000 in principal amount of notes payable of which
notes having a principal value of $35,000 will mature on May 22, 2009 and notes
having a principal value of $265,000 will mature on August 21, 2009. The notes
will include a provision that will permit the holders, upon the occurrence of a
default, to convert the outstanding principal and unpaid accrued interest into
shares of Common Stock at $0.10 per share. The Company will issue to the
placement agent compensation consisting of five year warrants to purchase a
total of 600,000 shares of Common Stock at $0.20 to $0.30 per share and $47,500
in cash. Terms of the warrants include a cashless exercise option and
anti-dilution provisions.  The securities being offered will not be or
have not been registered under the Securities Act of 1933, as amended, and may
not be offered or sold in the United States absent registration or an applicable
exemption from registration requirements.





36








NOTE
16 RESTATEMENT





Subsequent
to filing Form 10-QSB for the six months ended March 31, 2008, the Company
determined that the beneficial conversion feature discounts and warrant
discounts related to the issuance of the convertible notes payable were not
properly accounted for, and certain warrants and options were omitted. As a
result, the Company recorded the following adjustments.





2001 Executive Officers
Stock Option Plan





In
October 2000, the Company amended its employment agreements with each of the
executive officers. A result of the amendments was that the Company adopted
the 2001 Executive Officers Stock Option Plan. The plan has reserved 7,576,680
shares of Common Stock and has issued options to purchase 7,034,140 shares of
Common Stock that expire 5 years from the date of issuance.





Balance
Sheet





On the
grant date, the Company applied FASB 133, paragraph 6 to determine if the
options were within the scope and definition of a derivative. The options: had
one or more underlings and one or more notional amounts, required no initial
investment, and required or permitted net settlement. Therefore, the options
were determined to be derivatives. Emerging Issue Task Force, paragraphs 7 and 8
were then applied to determine the classification. These paragraphs state that
contracts  that
require settlement in shares are equity instruments. EITF 00-19, paragraph 9 was
applied to determine the value of the options. This paragraph states that
contracts that require the company to deliver shares as part of a physical
settlement or net-share settlement should be initially measured at fair value.
In accordance with EITF 00-19, the options were recorded in additional paid-in
capital at fair value on the date of issuance.





The
Company began the analysis for the restatement as of and for the fiscal year
ended September 30, 2007 by applying FASB 133, paragraph 6 to ascertain if the
options remained derivatives as of September 30, 2007. All of the criteria in
the original analysis were met, and the options were determined to be within the
scope and definition of a derivative. EITF 00-19, paragraph 19 was applied next,
which states that if a company is required to obtain shareholder approval to
increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability. EITF 00-19, paragraph 10
was then applied. Paragraph 10 states that if classification changes as the
result of an event, the contract should be reclassified as of the date of the
event at fair value. The event responsible for the change in classification was
the issuance of the $1,025,000 Convertible Bridge Notes on July 17,
2007.





In
accordance with EITF 00-19, the options were reclassified as of July 17, 2007
from additional paid-in capital to warrant liabilities on the balance sheet, at
the fair value of $2,271,879. The value was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
5.02%; volatility of 219.89%; dividend yield of 0%; and expected term
of 3.67 years.





EITF
00-19, paragraph 9 was then applied, which states that all contracts classified
as liabilities should be measured at fair value at each balance sheet date, with
changes in fair value reported in earnings and disclosed in the financial
statements as long as the contracts remain classified as
liabilities.





The
Company began the analysis for the restatement by applying FASB 133, paragraph 6
to ascertain if the options remained derivatives as of March 31, 2008. All of
the criteria in the original analysis were met, and the options were determined
to be within the scope and definition of a derivative. EITF 00-19, paragraph 8
was applied which states that if share settlement is not controlled by the
company, the contract is required to be classified as a liability. Paragraph 9,
which states that contracts classified as liabilities should be measured at fair
value at each balance sheet date, with changes in fair value reported in
earnings and disclosed in the financial statements as long as the contracts
remain classified as liabilities, was also applied.





The fair
value of the options was determined to be $457,114 as of March 31, 2008 and was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%; dividend
yield of 0%; and expected term of 3 years.




37





The
decrease in the fair value of the options was $766,474 for the three months
ended March 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.





The
decrease in the fair value of the options was $1,469,800 for the six months
ended March 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Operations





EITF
00-19, paragraph 9 was applied which requires all contracts classified as
liabilities to be measured at fair value, with changes in fair value reported in
earnings as long as the contracts remain classified as liabilities.





The
change in the fair value of the options for the three months ended March 31,
2008 was $766,474 and included in decrease in warrant liability in the other
income (expense) section of the statement of operations.





The
change in the fair value of the options for the six months ended March 31, 2008
was $1,469,800 and included in decrease in warrant liability in the other income
(expense) section of the statement of operations.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the options of
$1,469,800.





Advisory Board
Compensation





On
October 1, 2004, the Company formed an advisory board consisting of four
members. Each member was to receive $5,000 monthly from October 1, 2004 to
February 22, 2007 for a total of $576,000, convertible by the advisory board
members into 11,520,000 shares of Common Stock at a rate of $0.05 per share. On
December 13, 2007 the advisory board members agreed to forfeit the ability to
convert their compensation into shares of Common Stock in exchange for warrants
exercisable at $0.25 per share. The Company determined that the accrued expense,
embedded beneficial conversion feature, embedded beneficial conversion feature
discount, and related amortization expense were not recorded at the date of
issuance, or prior to the restatement of the financial statements as of March
31, 2008, no payments have been made to any advisory board members, there has
been no conversion by any Advisory Board members of the accrued liability into
shares of Common Stock, and no warrant has been exercised.





Balance
Sheet





The
Company began the analysis for the restatement by applying paragraph 6 of
Financial Accounting Standard Board (FASB) Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities, to ascertain if the embedded
beneficial conversion features were derivatives at the date of issuance. The
embedded beneficial conversion features had one or more underlings and one or
more notional amounts; required no initial investment; and required or permitted
net settlement. Therefore, the embedded beneficial conversion features were
determined to be within the scope and definition of a derivative at the date of
issuance. Next, FASB 133, paragraph 12 was applied to determine if the embedded
beneficial conversion features should be separated from the accrued expense. The
Company determined that the economic characteristics of the embedded beneficial
conversion features are not clearly and closely related to the accrued expense;
the embedded beneficial conversion features and accrued expense are not
remeasured at fair value at each balance sheet date; and a separate contract
with the same terms would be a derivative pursuant to FASB 133, paragraphs 6-11.
Therefore, the embedded beneficial conversion features were separated from the
accrued expense to determine the classification and valuation. EITF 00-19,
paragraphs 7 and 8 were applied to determine the classification. Paragraph 7
states that contracts which require net-cash settlement are liabilities, and
paragraph 8 states that contracts which give the counterparty (advisory board
members) a choice of net-cash settlement or settlement in shares are
liabilities. Therefore, the embedded conversion features were determined to be
liabilities. EITF 00-19, paragraph 9 was applied to determine the value.
Paragraph 9 of EITF 00-19 states all contracts classified as liabilities should
be measured at fair value at each balance sheet date, with changes in fair value
reported in earnings and disclosed in the financial statements as long as the
contracts remain classified as liabilities.





38


The fair
value of the monthly embedded beneficial conversion features was determined to
be $576,000 as of September 30, 2007, and was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
4.05%; volatility of 126.94%; dividend yield of 0%; and expected term of 2.08 to
4.42 years.





On
December 13, 2007 the advisory board members agreed to forfeit the ability to
convert their compensation into shares of common stock in exchange for warrants.
As a result, the beneficial conversion feature of $576,000 and the unamortized
beneficial conversion feature discount of $195,560 were written off for a net of
$380,440.





The
beneficial conversion features discount amortization was $15,104 for the three
and six months ended March 31, 2008, which increased accrued
expenses.





Statement
of Operations





EITF
00-19, paragraph 9 was applied which requires all contracts classified as
liabilities to be measured at fair value, with changes in fair value reported in
earnings as long as the contracts remain classified as liabilities.





There was
no increase in the fair value of the beneficial conversion features for the
three or six months ended March 31, 2008.





The
beneficial conversion feature discount amortization was determined to be $15,104
and has been included in general and administrative expenses in the operating
expenses section of the statement of operations for the three and six months
ended March 31, 2008.





The
beneficial conversion feature of $576,000 and the beneficial conversion feature
discount of $195,560 were written off for a net of $380,440 and has been
included in the other income (expense) section of the statement of income
(operations) for the three and six months ended March 31, 2008.





Statement
of Cash Flows





Changes
in the statement of cash flows were the result of the amortization of the
beneficial conversion features discount of $15,104, and the net write off of
beneficial conversion feature and beneficial conversion feature discount of
$380,440 on the statement of operations.





Warrants Related to 2004
Stock Purchase Agreement





Under the
terms of a 2004 Stock Purchase Agreement, the Company issued warrants to
purchase 1,463,336 shares of Common Stock at an exercise price of $0.03 which
expire from February 9, 2007 to August 25, 2007. The Company determined that the
warrants and related expense were not recorded at the date of issuance or prior
to the restatement and there has been no exercise of the warrants into shares of
Common Stock.





Balance
Sheet





The
Company began the analysis by applying FASB 133, paragraph 6 to determine if the
warrants were within the scope and definition of a derivative at the date of
issuance. The warrants: had one or more underlings, and one or more notional
amounts; required no initial investment; and required or permitted net
settlement. Therefore, the warrants were determined to be derivatives at the
date of issuance. EITF 00-19, paragraphs 7 and 8 were then applied to determine
classification. These paragraphs state that contracts   which
require settlement in shares are equity instruments. EITF 00-19, paragraph 9 was
applied to determine the value of the options. Paragraph 9 of EITF 00-19 states
that contracts which require the company to deliver shares as part of a physical
settlement or net-share settlement should be initially measured at fair
value.





The fair
value of the warrants was determined to be $24,366 at the date of issuance which
was calculated using the Black-Scholes valuation model  with the following
assumptions: risk free rate of return ranging from 1.21% to 2.14%; volatility
ranging from 141.91% to 170.27%; dividend yield of 0%; and expected term
of 5 years. The warrants were considered an expense prior to October 1,
2006. Therefore, $24,366 was recorded to additional paid-in capital and deficit
accumulated during development stage.  39


EITF
00-19, paragraph 19 was applied next. Paragraph 19 states that if a company is
required to obtain shareholder approval to increase the company’s authorized
shares in order to net-share or physically settle a contract, share settlement
is not controlled by the company and the contract is required to be classified
as a liability. EITF 00-19, paragraph 10 was then applied. This paragraph states
that if classification changes as the result of an event, the contract should be
reclassified as of the date of the event at fair value. The event responsible
for the change in classification was the issuance of the
$1,025,000 Convertible Bridge Notes on July 17, 2007.





In
accordance with EITF 00-19, the warrants were reclassified as of July 17, 2007
from additional paid-in capital to warrant liabilities on the balance sheet at
the fair value of $70,029, which was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
5.02%; volatility of 219.89%; dividend yield of 0%; and expected term
of .08 years.





EITF
00-19, paragraph 9 was also applied in the analysis. Paragraph 9 states that all
contracts classified as liabilities must be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities.





The fair
value of the warrants was $0 as of September 30, 2007, due to their
expiration.





The
decrease in the fair value of the warrants was $70,029 for the year ended
September 30, 2007, which was recorded to warrant liability and accumulated
deficit during development stage as of March 31, 2008.





Statement
of Operations





There was
no change in the fair value of the warrants for the three months ended March 31,
2008, due to their expiration.





Statement
of Cash Flows





There was
no change in the statement of cash flows for the three months ended March 31,
2008.





Beneficial Conversion
Features





As of
March 31, 2008, the Company had Convertible Bridge Notes outstanding totaling
$1,811,000, which were issued between October 17, 2006 and July 17, 2007. The
bridge notes included an embedded beneficial conversion feature that allowed the
holders of the convertible notes to convert their notes into shares of Common
Stock at rates between $0.01 and $0.22. The bridge notes mature between June 17,
2008 and December 31, 2008. The bridge notes accrue interest at rates between 8%
and 10%, and any accrued but unpaid interest is also convertible by the holder
of the bridge notes into shares of Common Stock at the same rate.





Balance
Sheet





The
Company began the analysis for the restatement as of and for the six months
ended March 31, 2008 by applying FASB 133, paragraph 6 to ascertain if the
embedded beneficial conversion features remained derivatives subsequent to the
date of issuance. All of the criteria in the original analysis were met, and the
embedded beneficial conversion features issued were determined to be within the
scope and definition of a derivative. FASB 133, paragraph 12 was applied to
determine if the embedded beneficial conversion features should be separated
from the convertible bridge notes. All of the criteria in the original analysis
were met, and the embedded beneficial conversion features were separated from
the convertible bridge notes. EITF 00-19, paragraphs 7 and 8 were applied to
determine the classification. Paragraph 7 states that contracts which require
net-cash settlement are liabilities, and paragraph 8 states that contracts which
give the counterparty (holders of the convertible notes) a choice of net-cash
settlement or settlement in shares are liabilities. Therefore the embedded
conversion features were determined to be liabilities. The change in the
determination of the classification from equity to a liability was based on the
rights of the holders of the convertible notes to convert the notes into shares
of Common Stock. Therefore, share settlement is not controlled by the Company.
EITF 00-19, paragraph 9 was applied to determine the value of the embedded
beneficial conversion features. Paragraph 9 states that all contracts classified
as liabilities must be measured at fair value at each balance sheet date, with
changes in fair value reported in earnings and disclosed in the financial
statements as long as the contracts remain classified as
liabilities.


40





The fair
value of the monthly embedded beneficial conversion features was determined to
be $874,882 as of March 31, 2008, which was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
1.56%; volatility of 72.53%; dividend yield of 0%; and expected term of .08
to .33 years.





The
decrease in the fair value of the beneficial conversion features was determined
to be $347,850 for the three months ended March 31, 2008, and was recorded in
beneficial conversion features liability on the balance sheet.





The
decrease in the fair value of the beneficial conversion features was determined
to be $555,929 for the six months ended March 31, 2008, and was recorded in
beneficial conversion features liability on the balance sheet.





The
amortization of the beneficial conversion features discount was $285,610 for the
three months ended March 31, 2008, which increased convertible
notes.





The
amortization of the beneficial conversion features discount was $573,646 for the
six months ended March 31, 2008, which increased convertible notes.





Statement
of Operations





The
beneficial conversion features were analyzed in accordance with EITF 00-19,
paragraph 9, which requires all contracts classified as liabilities to be
measured at fair value, with changes in fair value reported in earnings as long
as the contracts remain classified as liabilities.





The
decrease in the fair value of the beneficial conversion features was determined
to be $347,850 for the three months ended March 31, 2008, and was recorded in
increase (decrease) in beneficial conversion features liability, in the other
income (expense) section of the statement of operations.





The
decrease in the fair value of the beneficial conversion features was determined
to be $555,929 for the six months ended March 31, 2008, and was recorded in
increase (decrease) in beneficial conversion features liability, in the other
income (expense) section of the statement of operations.





The
amortization of the beneficial conversion features discount was $285,610 for the
three months ended March 31, 2008, and was recorded in interest expense in the
other income (expense) section of the statement of operations.





The
amortization of the beneficial conversion features discount was $573,646 for the
six months ended March 31, 2008, and was recorded in interest expense in the
other income (expense) section of the statement of operations.





Statement
of Cash Flows





Changes
in the statement of cash flows for the three months ended March 31, 2008 were
the result of the decrease in the fair value of the beneficial conversion
features liability of $347,850 and the amortization of the beneficial conversion
features discounts of $285,610 on the statement of operations.





Changes
in the statement of cash flows for the six months ended March 31, 2008 were the
result of the decrease in the fair value of the beneficial conversion features
liability of $555,929 and the amortization of the beneficial conversion features
discounts of $573,646 on the statement of operations.





Warrants related to
$1,025,000 of Convertible Bridge
Notes





On July
17, 2007 the Company completed an offering of $1,025,000 of convertible notes to
a group of institutional and accredited investors which included warrants to
purchase 2,795,454 shares of Common Stock (2,329,546 shares of Common
Stock to holders of the convertible bridge notes, 465,908 shares of Common Stock
as a placement fee) at an exercise price of $0.50 per share. An amendment to the
convertible notes dated March 13, 2008 reduced the exercise price to $0.30 per
share.








41





Balance
Sheet





The
Company began the analysis for the restatement of the financial statements as of
and for the six months ended March 31, 2008 by applying FASB 133, paragraph 6 to
ascertain if the warrants issued remained derivatives as of March 31, 2008. All
of the criteria in the original analysis were met, and the warrants issued were
determined to be within the scope and definition of a derivative. EITF 00-19,
paragraph 19 was applied next to determine classification. Paragraph 19 states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability. EITF 00-19, paragraph 9 was applied to
determine the value of the warrants. Paragraph 9 states that all contracts
classified as liabilities must be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The fair
value of the warrants was determined to be $135,950 as of March 31, 2008, and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%; dividend
yield of 0%; and expected term of 4.17 to 4.25 years.





The
decrease in the fair value of the warrants was determined to be $185,827 for the
three months ended March 31, 2008, and recorded by decreasing warrant
liabilities on the balance sheet by $185,827 ($143,242 related to the holders of
the convertible bridge notes, and $42,585 related to the placement
fee).





The
decrease in the fair value of the warrants was determined to be $363,982 for the
six months ended March 31, 2008, and recorded by decreasing warrant liabilities
on the balance sheet by $363,982 ($268,470 related to the holders of the
convertible bridge notes, and $95,512 related to the placement
fee).





The
amortization of the warrant discount was $213,353 for the six months ended March
31, 2008, which increased convertible notes.





Statement
of Operations





EITF
00-19, paragraph 9 was applied which requires all contracts classified as
liabilities to be measured at fair value, with changes in fair value reported in
earnings as long as the contracts remain classified as liabilities.





The
decrease in the fair value of the warrants was determined to be $185,827 for the
three months ended March 31, 2008, and recorded in decrease in warrants in the
other income (expense) section of the statement of operations.





The
decrease in the fair value of the warrants was determined to be $363,982 for the
six months ended March 31, 2008, and recorded in decrease in warrants in the
other income (expense) section of the statement of operations.





The
increase in the amortization of the warrant discount of $30,065 is included in
interest expense in the other income (expense) section of the statement of
operations.





Statement
of Cash Flows





Changes
in the statement of cash flows for the six months ended March 31, 2008 were the
result of the decrease in the amount of $363,982 in the fair value of the
warrants at the date of issuance on the statement of operations, and the
increase in the amortization of the warrant discount of $30,065 on the balance
sheet.





Warrant Issued to
Consultant





On
December 19, 2007, the Company entered into a one year Consulting Agreement with
Mark Maron pursuant to which Mr. Maron was appointed as Special Adviser to the
Company. As compensation for his services, the Company granted Mr. Maron a five
year warrant to purchase up to 8,539,312 shares of the Company’s Common Stock at
an exercise price of $0.25 per share. As per the terms of the warrant agreement,
the right to purchase 340,000 shares of Common Stock is not exercisable until
the notes dated June 6, 2007 (Convertible Notes 2 as discussed in Note 6 to our
financial statements) are eligible for conversion into shares of Common
Stock.  The warrant was not issued from the 2001 Executive
Officers Stock Option Plan.


42





Balance
Sheet





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrant, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the warrant was determined to be $1,448,321 at the date of issuance and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free interest rate of 3.26%, expected volatility of 98.01%,
dividend yields of 0% and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the warrant by applying FASB 133, paragraph 6 to ascertain if
the warrant remained a derivative as of December 31, 2007. All of the criteria
in the original analysis were met, and the warrant issued was determined to be
within the scope and definition of a derivative. EITF 00-19, paragraph 8 was
applied which states that if share settlement is not controlled by the company,
the contract is required to be classified as a liability. Paragraph 9 was also
applied, which states that contracts classified as liabilities should be
measured at fair value at each balance sheet date, with changes in fair value
reported in earnings and disclosed in the financial statements as long as the
contracts remain classified as liabilities.





The fair
value of the warrant was determined to be $543,267 as of March 31, 2008, and was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%;
dividend yield of 0%; and expected term of 4.67 years.





The
decrease in the fair value of the warrant was $972,165 for the three months
ended March 31, 2008, and was recorded by decreasing the warrant liability on
the balance sheet.





The
decrease in the fair value of the warrant was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Operations





The
decrease in the fair value of the warrant was $972,165 for the three months
ended March 31, 2008, and was recorded by decreasing the warrant liability on
the balance sheet.





The
decrease in the fair value of the warrant was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the warrant of
$905,054.


43


Option Issued to Chief
Executive Officer





On
December 19, 2007, the Company entered into a one year Employment Agreement with
Richard H. Papalian pursuant to which Mr. Papalian had been appointed as the
Company’s Chief Executive Officer. As compensation for his services, the Company
granted to Mr. Papalian a five year option to purchase up to 8,539,312 shares of
the Company’s Common Stock at an exercise price of $0.25 per share. As per the
terms of the stock option agreement, the right to purchase 340,000 shares of
Common Stock is not exercisable until the notes dated June 6, 2007 (Convertible
Notes 2 as discussed in Note 6 to our financial statements) are eligible for
conversion into shares of Common Stock. These options were not issued from the
2001 Executive Officers Stock Option Plan.   On the grant date, the Company
applied FASB 133, paragraph 6 to determine if the option was within the scope
and definition of a derivative. The option had one or more underlings and one or
more notional amounts, required no initial investment, and required or permitted
net settlement. Therefore, the option was determined to be a derivative. In
order to determine how to classify the option, the Company followed the guidance
of EITF 00-19, paragraphs 7 and 8, which state that contracts   that
require net-cash settlement (including a requirement to net cash settle the
contract if an event occurs and if that event is outside the control of the
company) are liability instruments. In order to determine the value of the
option, the Company applied EITF 00-19, paragraph 9, which states that contracts
that require the company to deliver shares as part of a physical settlement or
net-share settlement should be initially measured at fair value.





Balance
Sheet





The fair
value of the option was determined to be $1,448,321 at the date of issuance, and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 3.26%; volatility of 98.01%; dividend
yield of 0%; and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the option as of March 31, 2008 by applying FASB 133, paragraph
6 to ascertain if the option remained a derivative as of March 31, 2008. All of
the criteria in the original analysis were met, and the option was determined to
be within the scope and definition of a derivative. EITF 00-19, paragraph 8 was
applied which states that if share settlement is not controlled by a company,
the contract is required to be classified as a liability. Paragraph 9, which
states that contracts classified as liabilities should be measured at fair value
at each balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities, was also applied.





The fair
value of the option was determined to be $543,267 as of March 31, 2008, and was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%;
dividend yield of 0%; and expected term of 4.67 years.





The
decrease in the fair value of the option was $972,165 for the three months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





The
decrease in the fair value of the option was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Operations





The
decrease in the fair value of the option was $972,165 for the three months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





The
decrease in the fair value of the option was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the option of
$905,054.


44





Option Issued to
Director





On
December 13, 2007, the Company’s Board of Directors approved the issuance to a
director of a five year option to purchase a total of 1,000,000 shares of the
Company’s common stock at an exercise price of $0.25 per share.





Balance
Sheet





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
option was within the scope and definition of a derivative at the date of
issuance. The option had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the option was determined to be a derivative at the date
of issuance. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the option, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the option was determined to be $171,520 at the date of issuance and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free interest rate of 3.22%; expected volatility of 99.86%;
dividend yield of 0%; and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the option by applying FASB 133, paragraph 6 to ascertain if
the option remained a derivative as of March 31, 2008. All of the criteria in
the original analysis were met, and the option was determined to be within the
scope and definition of a derivative. EITF 00-19, paragraph 8 was applied which
states that if share settlement is not controlled by the company, the contract
is required to be classified as a liability. Paragraph 9, which states that
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities, was also applied.





The fair
value of the option was determined to be $63,620 as of March 31, 2008, using the
Black-Scholes valuation model with the following assumptions: risk free
rate of return of 1.56%; volatility of 72.53%; dividend yield of 0%; and
expected term of 4.67 years.





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Operations





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the option of
$107,900.


45





Option Issued to Chief
Financial Officer





On
December 13, 2007, the Company’s Board of Directors approved the issuance to the
Chief Financial Officer of a five year option to purchase a total of 1,000,000
shares of the Company’s common stock at an exercise price of $0.25 per
share.





Balance
Sheet





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
option was within the scope and definition of a derivative at the date of
issuance. The option had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the option was determined to be a derivative at the date
of issuance. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the option, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the option was determined to be $171,520 at the date of issuance and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free interest rate of 3.22%; expected volatility of 99.86%;
dividend yield of 0%; and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the option by applying FASB 133, paragraph 6 to ascertain if
the option remained a derivative as of March 31, 2008. All of the criteria in
the original analysis were met, and the option issued was determined to be
within the scope and definition of a derivative. EITF 00-19, paragraph 8 was
applied which states that if share settlement is not controlled by the company,
the contract is required to be classified as a liability. Paragraph 9, which
states that contracts classified as liabilities should be measured at fair value
at each balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities, was also applied.





The fair
value of the option was determined to be $63,620 as of March 31, 2008 using the
Black-Scholes valuation model with the following assumptions: risk free
rate of return of 1.56%; volatility of 72.53%; dividend yield of 0%; and
expected term of 4.67 years.





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Operations





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the option of
$107,900.





Table 1 -
2008





46








Beneficial
            
            
            WarrantConversion
            
            
            Related
      toFeatures
            
            
            $1,025,000
      of2001
            
            
            
            
            
            Warrants
            
            
            and
            
            
            ConvertibleExecutive
            
            
            
            
            
            Related
      to
            
            
            Beneficial
            
            
            Bridge
      NotesAs
            
            
            Officers
            
            
            Advisory
            
            
            2004
      Stock
            
            
            Conversion
            
            
            and
            
            
            
            
            
            Option
      Issued
            
            
            
            
            
            Warrant
      Issued
            
            
            
            
            
            Warrants
      RelatedPreviously
            
            
            Option
            
            
            Board
            
            
            Purchase
            
            
            Features
            
            
            Warrant
            
            
            Warrant
      Issued
            
            
            to
      Chief Executive
            
            
            Warrant
      Issued
            
            
            to
      Chief
            
            
            10%
      Subordinated
            
            
            to
      $750,000
            
            
            
            
            
            AsStated
            
            
            Plan
            
            
            Compensation
            
            
            Agreement
            
            
            Discount
            
            
            Discount
            
            
            to
      Consultant
            
            
            Officer
            
            
            to
      Director
            
            
            Financial
      Officer
            
            
            Notes
      Payable
            
            
            Stock
      Issuance
            
            
            Other
            
            
            RestatedBalance
      SheetCash
      and cash equivalent
            
            $
            102,604
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            151
            
            
            $
            102,755Accounts
      payable
            
            
            470,137
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            32,987
            
            
            
            503,124Accrued
      expenses
            
            
            1,847,254
            
            
            
            
            
            
            576,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,423,254Convertible
      Notes, net
            
            
            1,306,593
            
            
            
            
            
            
            
            
            
            
            
            
            
            12,913
            
            
            
            206,465
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,525,97110%
      subordinated notes payable
            
            
            332,182
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            20,169
            
            
            
            
            
            
            38
            
            
            
            352,389Warrant
      liability
            
            
            974,632
            
            
            
            457,114
            
            
            
            549,672
            
            
            
            
            
            
            
            
            
            
            36,522
            
            
            
            128,358
            
            
            
            128,358
            
            
            
            63,620
            
            
            
            63,620
            
            
            
            
            
            
            
            156,268
            
            
            
            
            
            
            
            2,558,164Beneficial
      conversion feature liability
            
            
            857,678
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            17,204
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            874,882Additional
      paid-in capital
            
            
            12,815,792
            
            
            
            (2,271,879
            )
            
            
            (269,848
            )
            
            
            (45,663
            )
            
            
            473,797
            
            
            
            135,406
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            10,837,605Deficit
      accumulated during development stage
            
            
            (19,149,208
            )
            
            
            1,814,765
            
            
            
            (855,824
            )
            
            
            45,663
            
            
            
            (503,914
            )
            
            
            (378,393
            )
            
            
            (128,358
            )
            
            
            (128,358
            )
            
            
            (63,620
            )
            
            
            (63,620
            )
            
            
            (20,169
            )
            
            
            (156,268
            )
            
            
            (32,874
            )
            
            
            (19,620,178
            )Statement
      of Operations (for the three months ended March 31,
    2008)General
      and administrative
            
            $
            395,890
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            165,022
            
            
            $
            32,540
            
            
            $
            593,452Research
      and development
            
            
            328,694
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            334
            
            
            
            329,028Interest
      expense
            
            
            (492,546
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            16,677
            
            
            
            (78,022
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (20,169
            )
            
            
            
            
            
            
            
            
            
            
            (574,060
            )Decrease
      (increase) in warrant liability
            
            
            273,778
            
            
            
            766,474
            
            
            
            983,628
            
            
            
            
            
            
            
            
            
            
            
            (36,522
            )
            
            
            972,165
            
            
            
            972,165
            
            
            
            113,845
            
            
            
            113,845
            
            
            
            
            
            
            
            8,754
            
            
            
            
            
            
            
            4,168,132Increase
      in beneficial conversion feature liability
            
            
            364,944
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (17,204
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            347,740Basic
      and dilutive loss per share
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Statement
      of Operations (for the six months ended March 31,
    2008)General
      and administrative
            
            $
            1,526,663
            
            
            
            
            
            
            $
            1,557,705
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            1,033,412
            
            
            $
            1,033,412
            
            
            $
            171,520
            
            
            $
            171,520
            
            
            
            
            
            
            $
            165,022
            
            
            $
            32,540
            
            
            $
            5,691,794Research
      and development
            
            
            565,598
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            334
            
            
            
            565,932Interest
      expense
            
            
            (906,150
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            32,816
            
            
            
            (167,287
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (20,169
            )
            
            
            
            
            
            
            
            
            
            
            (1,060,790
            )Decrease
      (increase) in warrant liability
            
            
            427,991
            
            
            
            1,469,800
            
            
            
            1,008,033
            
            
            
            
            
            
            
            
            
            
            
            (12,580
            )
            
            
            905,054
            
            
            
            905,054
            
            
            
            107,900
            
            
            
            107,900
            
            
            
            
            
            
            
            8,754
            
            
            
            
            
            
            
            4,927,906Increase
      in beneficial conversion feature liability
            
            
            637,688
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (81,759
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            555,929Write-off
      of beneficial conversion feature
            
            
            
            
            
            
            
            
            
            
            380,440
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            380,440Basic
      and dilutive loss per share
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Statement
      of Cash Flows (for the six months ended March 31,
    2008)Net
      loss
            
            $
            (2,077,833
            )
            
            $
            1,469,800
            
            
            $
            (169,232
            )
            
            
            
            
            
            $
            (48,943
            )
            
            $
            (179,867
            )
            
            $
            (128,358
            )
            
            $
            (128,358
            )
            
            $
            (63,620
            )
            
            $
            (63,620
            )
            
            $
            (20,169
            )
            
            $
            (156,268
            )
            
            $
            (32,874
            )
            
            $
            (1,599,342
            )Amortization
      of beneficial conversion features discount and warrant
      discount
            
            
            669,025
            
            
            
            
            
            
            
            10,072
            
            
            
            
            
            
            
            (32,816
            )
            
            
            167,287
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            20,169
            
            
            
            
            
            
            
            38
            
            
            
            833,775Stock
      based compensation expense-employee
            
            
            414,908
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,033,412
            
            
            
            
            
            
            
            171,520
            
            
            
            171,520
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,791,360Stock
      based compensation expense-consultant
            
            
            439,909
            
            
            
            
            
            
            
            1,557,705
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,008,413
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            165,022
            
            
            
            
            
            
            
            3,171,049(Decrease)
      increase in warrant liability
            
            
            (427,991
            )
            
            
            (1,469,800
            )
            
            
            (1,008,033
            )
            
            
            
            
            
            
            
            
            
            
            12,580
            
            
            
            (905,054
            )
            
            
            (905,054
            )
            
            
            (107,900
            )
            
            
            (107,900
            )
            
            
            
            
            
            
            (8,754
            )
            
            
            
            
            
            
            (4,927,906
            )Increase
      in beneficial conversion feature liaiblity
            
            
            (637,688
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            81,759
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (555,929
            )Write-off
      of beneficial conversion feature
            
            
            
            
            
            
            
            
            
            
            (380,440
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (380,440
            )Accounts
      payable
            
            
            312,738
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            32,987
            
            
            
            345,725Accrued
      expenses
            
            
            159,581
            
            
            
            
            
            
            
            576,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            735,581Cash
      and cash equivalents
            
            
            102,604
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            151
            
            
            
            102,755








47




NOTE
17 RESTATEMENT





As
discussed in Note 16 – RESTATEMENT, the Company restated its September 30, 2007
financial statements in response to a comment letter from the Securities and
Exchange Commission.  However, the restatement did not properly
account for certain derivative transactions, as discussed below, which resulted
in the Company restating its September 30, 2007 financial statements for a third
time and restating its September 30, 2008 financial statements.  Due
to the items discussed below, the Company is also restating its March 31, 2009
financial statements.





The
Company issued 25 secured convertible promissory notes between October 17, 2006
and February 27, 2007 for total proceeds to the Company of $750,000
(“Convertible Notes 1”). Convertible Notes 1 could be converted into shares of
the Company’s common stock at a conversion price of $0.05 per share. Convertible
Notes 1 contained a provision that would automatically adjust the conversion
price if equity securities or instruments convertible into equity securities
were issued at a conversion price of less than $0.05.





On June
6, 2007, the Company issued 5 convertible promissory notes for a total of
$86,000 (“Convertible Notes 2”).  No warrants were issued in
connection with Convertible Notes 2. Convertible Notes 2 mature on December 31,
2008 and are convertible into common stock at $0.01 per share.





As a
result of the issuance of Convertible Notes 2, the conversion price for
Convertible Notes 1 was adjusted down from $0.05 to $0.01.  The
decrease in the conversion price increased the potential dilutive shares from
15,000,000 to 75,000,000, and this subsequently increased the total outstanding
and potential dilutive shares over the authorized common share limit of
150,000,000.  Because there were insufficient authorized shares to
fulfill all potential conversions, the Company should have classified all
potentially dilutive securities as derivative liabilities as of June 6,
2007.  The Company researched its debt and equity instruments and
determined that the potentially dilutive securities are as follows:





·
            Warrants
      and Options


·
            Beneficial
      Conversion Features





The
Company analyzed the effect of the recalculation on the balance sheet and the
statements of operations and cash flows as of March 31, 2009. The analysis and
results were as follows:





Warrants and Options
Liability





As of
March 31, 2009, the Company had 42,849,099 warrants outstanding and 17,384,491
options outstanding that were vested at that date.





Balance
Sheet





The
Company determined that because there were not sufficient authorized shares
available that the embedded conversion feature met the definition of a
derivative based on Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities", (SFAS 133) as of June 6,
2007.





At March
31, 2009, the Company determined the fair value of all warrants and options to
be $2,763,660 and $1,207,255, respectively, using the Black-Scholes model with
the following assumptions:





·
            risk
      free rate of return between 0.57% and
1.67%;


·
            volatility
      between 153% and 260%;


·
            dividend
      yield of 0%; and


·
            expected
      term between 1.95 years and 5.24
years.





Statement
of Operations





For the
three and six months ended March 31, 2009, the Company recorded $837,506 and an
additional $1,490,193, respectively, as a gain on change in fair value of
warrant and option liability.





Statement
of Cash Flows





Changes
in the statement of cash flows were the result of the decrease in fair value of
the warrant and option liability of $1,490,193.





Beneficial Conversion
Liability





As of
March 31, 2009, the Company had $781,333 in convertible notes that could be
converted into 67,006,499 shares.  During the period ended March 31,
2009, certain investors converted $11,797 of convertible notes into 294,930
common shares at $0.04 per share; however, the conversion rate should have been
$0.01.  At March 31, 2009, the Company owes an additional 12,248,173
shares to the investors related to the $11,797 converted during the period ended
March 31, 2009 and the $151,512 converted during the period ended September 30,
2008.  The Company recorded a liability of $979,854, which is recorded
in accrued expenses in the accompanying financial statements.  The
change in the fair value of the shares will be recorded as a change in fair
value of beneficial conversion liability.





48


Balance
Sheet





The
Company determined that because there were not sufficient authorized shares
available that the embedded conversion feature met the definition of a
derivative based on SFAS 133 as of June 6, 2007.





At March
31, 2009, the Company determined the fair value of the embedded conversion
options to be $4,740,412 using the Black-Scholes model with the following
assumptions:





·
            risk
      free rate of return of 0.57%;


·
            volatility
      between of 180%;


·
            dividend
      yield of 0%; and


·
            expected
      term of 0.75 years.





Statement
of Operations





For the
three and six months ended March 31, 2009, the Company recorded $907,549 and an
additional $4,742,622, respectively, as a gain on change in beneficial
conversion liability.





Statement
of Cash Flows





Changes
in the statement of cash flows were the result of the $4,742,622 change in fair
value of the beneficial conversion liability.





The
following table shows the effect of each of the changes discussed above on the
Company’s balance sheet, statement of operation, and statement of cash flows for
the three and six months ended March 31, 2009.  49


As
      Previously Stated
              
              
              Beneficial
      Conversion
              
              
              Warrants
      and
              
              
              
              
              
              As
      RestatedMarch
      31, 2009
              
              
              Options
              
              
              Options
              
              
              Reclassifications
              
              
              March
      31, 2009Balance
      SheetOther
      assets
              
              $
              34,165
              
              
              $
              -
              
              
              $
              -
              
              
              $
              155,000
              
              
              $
              189,165Accrued
      expenses
              
              
              2,734,069
              
              
              
              979,854
              
              
              
              -
              
              
              
              155,000
              
              
              
              3,868,923Warrant
      and option liability
              
              
              2,180,429
              
              
              
              -
              
              
              
              1,790,486
              
              
              
              -
              
              
              
              3,970,915Beneficial
      conversion liability
              
              
              -
              
              
              
              4,740,412
              
              
              
              -
              
              
              
              -
              
              
              
              4,740,412Additional
      paid-in capital
              
              
              13,383,049
              
              
              
              -
              
              
              
              (1,847,488
              )
              
              
              -
              
              
              
              11,535,561Deficit
      accumulated during developmental stage
              
              
              (21,869,332
              )
              
              
              (5,720,266
              )
              
              
              57,002
              
              
              
              -
              
              
              
              (27,532,596
              )Statement
      of Operations (for the three months ended March 31, 2009)Gain
      (loss) on change in fair value of warrant and option
    liability
              
              $
              (219,981
              )
              
              $
              -
              
              
              $
              837,506
              
              
              $
              -
              
              
              $
              617,525Gain
      on change in fair value of beneficial conversion liability
              
              
              -
              
              
              
              907,549
              
              
              
              -
              
              
              
              -
              
              
              
              907,549Statement
      of Operations (for the six months ended March 31, 2009)Gain
      on change in fair value of warrant and option liability
              
              $
              1,631,387
              
              
              $
              -
              
              
              $
              1,490,193
              
              
              $
              -
              
              
              $
              3,121,580Gain
      on change in fair value of beneficial conversion liability
              
              
              26,000
              
              
              
              4,742,622
              
              
              
              -
              
              
              
              -
              
              
              
              4,768,622Statement
      of Operations (since inception)Gain
      on change in fair value of warrant and option liability
              
              $
              6,849,627
              
              
              $
              -
              
              
              $
              516,466
              
              
              $
              -
              
              
              $
              7,366,093Gain
      on change in fair value of beneficial conversion liability
              
              
              1,426,767
              
              
              
              29,000,652
              
              
              
              -
              
              
              
              -
              
              
              
              30,427,419General
      and administrative expense
              
              
              21,740,171
              
              
              
              3,787,032
              
              
              
              83,855
              
              
              
              -
              
              
              
              25,611,058Interest
      expense and financing costs
              
              
              (2,457,641
              )
              
              
              (30,536,702
              )
              
              
              (897,793
              )
              
              
              -
              
              
              
              (33,892,136
              )Statement
      of Cash Flows (for the six months ended March 31, 2009)Net
      income
              
              $
              149,324
              
              
              $
              4,742,622
              
              
              $
              1,490,193
              
              
              $
              -
              
              
              $
              6,382,139Gain
      on change in fair value of warrant and option liability
              
              
              (1,631,387
              )
              
              
              -
              
              
              
              (1,490,193
              )
              
              
              -
              
              
              
              (3,121,580
              )Gain
      on change in fair value of beneficial conversion liability
              
              
              (26,000
              )
              
              
              (4,742,622
              )
              
              
              -
              
              
              
              -
              
              
              
              (4,768,622
              )Statement
      of Cash Flows (since inception)Net
      loss
              
              $
              (21,744,332
              )
              
              $
              (5,323,082
              )
              
              $
              (465,182
              )
              
              $
              -
              
              
              $
              (27,532,596
              )Gain
      on change in fair value of warrant and option liability
              
              
              (6,849,627
              )
              
              
              -
              
              
              
              (516,466
              )
              
              
              -
              
              
              
              (7,366,093
              )Gain
      on change in fair value of beneficial conversion liability
              
              
              (1,426,768
              )
              
              
              (29,000,652
              )
              
              
              -
              
              
              
              -
              
              
              
              (30,427,420
              )Non-cash
      compensation expense
              
              
              -
              
              
              
              3,787,032
              
              
              
              83,855
              
              
              
              -
              
              
              
              3,870,887Non-cash
      financing costs
              
              
              -
              
              
              
              30,536,702
              
              
              
              897,793
              
              
              
              -
              
              
              
              31,434,495


50


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





The
information in this quarterly report on Form 10-Q contains forward-looking
statements.  These forward-looking statements involve risks and
uncertainties, including statements regarding our capital needs, business
strategy and expectations.  Any statements contained in this report
that are not statements of historical facts may be deemed to be forward-looking
statements.  In some cases, you can identify forward-looking
statements by terminology such as may, will, should, expect, plan, intend,
anticipate, believe, estimate, predict, potential or continue, the negative of
such terms or other comparable terminology.  Actual events or results
may differ materially from those events or results included in the
forward-looking statements.  In evaluating these statements, you
should consider various factors, including the risks outlined from time to time
in the reports we file with the Securities and Exchange
Commission.  Some, but not all, of these risks include, among other
things:





·
            our
      inability to obtain the financing we need to continue our
      operations;




·
            changes
      in regulatory requirements that adversely affect our
    business;





·
            loss
      of our key personnel; and





·
            risks
      over which we have no control, such as the general global downturn in the
      economy which may adversely affect spending by government
      agencies.





We do not
intend to update forward-looking statements.  You should refer to and
carefully review the information in future documents we file with the Securities
and Exchange Commission.





Overview





Sionix
Corporation (referred to as “the Company”, “we”, “us” or “our”) is a development
stage company as defined in Statement of Financial Accounting Standards (“SFAS”)
No. 7, Accounting and
Reporting by Development Stage Enterprises.  The Company is
based in Anaheim, California.  Its business is the design, development
and marketing of automatic water filtration systems primarily for small water
districts.  The Company received an order for two water filtration
systems in June, 2008.  The Company anticipates that the water
treatment systems will be manufactured and delivered within the next few months.
Subsequent to the delivery of the water treatment systems, revenue will be
recognized and the Company will no longer meet the definition of a development
stage company.





Until
additional orders and customer deposits are received, we anticipate that most of
our capital needs will need to be funded by debt or equity
financing.  To date we have earned no revenues.





Application
of Critical Accounting Policies and Estimates





The
preparation of our financial statements in accordance with U.S. GAAP requires
management to make judgments, assumptions and estimates that affect the amounts
reported. A critical accounting estimate is an assumption about highly uncertain
matters and could have a material effect on the consolidated financial
statements if another, also reasonable, amount were used or a change in the
estimate is reasonably likely from period to period. We base our assumptions on
historical experience and on other estimates that we believe are reasonable
under the circumstances. Actual results could differ significantly from these
estimates. There were no changes in accounting policies or significant changes
in accounting estimates during the three and six months ended March 31, 2009.
Management believes the following critical accounting policies reflect its more
significant estimates and assumptions.





Revenue
Recognition. Although the Company has yet to complete sales, it plans to follow
the guidance provided by SAB 104 for recognition of revenues. The Company does
not plan to recognize revenue unless there is persuasive evidence of an
arrangement, title and risk of loss has passed to the customer, delivery has
occurred or the services have been rendered, the sales price is fixed or
determinable and collection of the related receivable is reasonably assured. In
general, the Company plans to require a deposit from a customer before a unit is
fabricated and shipped.  It is the Company's policy to require an
arrangement with its customers, either in the form of a written contract or
purchase order containing all of the terms and conditions governing the
arrangement, prior to the recognition of revenue. Title and risk of loss will
generally pass to the customer at the time of delivery of the product to a
common carrier. At the time of the transaction, the Company will assess whether
the sales price is fixed or determinable and whether or not collection is
reasonably assured. If the sales price is not deemed to be fixed or
determinable, revenue will be recognized as the amounts become due from the
customer. The Company does not plan to offer a right of return on its products
and the products will generally not be subject to customer acceptance rights.
The Company plans to assess collectability based on a number of factors,
including past transaction and collection history with a customer and the
creditworthiness of the customer. The Company plans to perform ongoing credit
evaluations of its customers' financial condition. If the Company determines
that collectability of the sales price is not reasonably assured, revenue
recognition will be deferred until such time as collection becomes reasonably
assured, which is generally upon receipt of payment from the customer. The
Company plans to include shipping and handling costs in revenue and cost of
sales.








51
 Support
Services. The Company plans to provide support services to customers primarily
through service contracts, and it will recognize support services revenue
ratably over the term of the service contract or as services are
rendered.





Warranties.  The
Company's products are generally subject to warranty, and related costs will be
provided for in cost of sales when revenue is recognized. Once the Company has a
history of sales, the Company's warranty obligation will be based upon
historical product failure rates and costs incurred in correcting a product
failure. If actual product failure rates or the costs associated with fixing
failures differ from historical rates, adjustments to the warranty liability may
be required in the period in which determined.





Allowance
for Doubtful Accounts. The Company will evaluate the adequacy of its allowance
for doubtful accounts on an ongoing basis through detailed reviews of its
accounts and notes receivables.  Estimates will be used in determining
the Company's allowance for doubtful accounts and will be based on historical
collection experience, trends including prevailing economic conditions and
adverse events that may affect a customer's ability to repay, aging of accounts
and notes receivable by category, and other factors such as the financial
condition of customers. This evaluation is inherently subjective because
estimates may be revised in the future as more information becomes available
about outstanding accounts.





Inventory
Valuation. Inventories will be stated at the lower of cost or market, with costs
generally determined on a first-in first-out basis. We plan to utilize both
specific product identification and historical product demand as the basis for
determining excess or obsolete inventory reserve. Changes in market conditions,
lower than expected customer demand or changes in technology or features could
result in additional obsolete inventory that is not saleable and could require
additional inventory reserve provisions.





Goodwill
and other Intangibles. Goodwill and intangible assets with indefinite lives will
be tested annually for impairment in accordance with the provisions of Financial
Accounting Standards Board Statement No. 142 “Goodwill and Other Intangible
Assets” (FAS 142). We will use our judgment in assessing whether assets may have
become impaired between annual impairment tests. We perform our annual test for
indicators of goodwill and non-amortizable intangible asset impairment in the
fourth quarter of our fiscal year or sooner if indicators of impairment
exist.





Legal
Contingencies. From time to time we may be a defendant in litigation. As
required by Financial Accounting Standards Board Statement No. 5  “Accounting for
Contingencies” (FAS 5), we are required to determine whether an estimated loss
from a loss contingency should be accrued by assessing whether a loss is deemed
probable and the loss amount can be reasonably estimated, net of any applicable
insurance proceeds. Estimates of potential outcomes of these contingencies are
developed in consultation with outside counsel. While this assessment is based
upon all available information, litigation is inherently uncertain and the
actual liability that may be incurred to fully resolve litigation cannot be
predicted with any assurance of accuracy. Final settlement of these matters
could possibly result in significant effects on our results of operations, cash
flows and financial position.





Warrant
Liability. The Company calculates the fair value of warrants and options using
the Black-Scholes valuation model. Assumptions used in the calculation include
the risk free interest rate, volatility of the stock price, and dividend yield.
Estimates used in the calculation include the expected term of the warrants or
options.





Accrued
Derivative Liabilities.




Restatement
for the Six Months Ended March 31, 2008





Subsequent
to filing Form 10-QSB for the six months ended March 31, 2008, the Company
determined that the beneficial conversion feature discounts and warrant
discounts related to the issuance of the convertible notes payable were not
properly accounted for, and certain warrants and options were omitted. As a
result, the Company recorded the following adjustments.


52





2001 Executive Officers
Stock Option Plan





In
October 2000, the Company amended its employment agreements with each of the
executive officers. A result of the amendments was that the Company adopted
the 2001 Executive Officers Stock Option Plan. The plan has reserved 7,576,680
shares of Common Stock and has issued options to purchase 7,034,140 shares of
Common Stock that expire 5 years from the date of issuance.





Balance
Sheet





On the
grant date, the Company applied FASB 133, paragraph 6 to determine if the
options were within the scope and definition of a derivative. The options: had
one or more underlings and one or more notional amounts, required no initial
investment, and required or permitted net settlement. Therefore, the options
were determined to be derivatives. Emerging Issue Task Force, paragraphs 7 and 8
were then applied to determine the classification. These paragraphs state that
contracts  that
require settlement in shares are equity instruments. EITF 00-19, paragraph 9 was
applied to determine the value of the options. This paragraph states that
contracts that require the company to deliver shares as part of a physical
settlement or net-share settlement should be initially measured at fair value.
In accordance with EITF 00-19, the options were recorded in additional paid-in
capital at fair value on the date of issuance.





The
Company began the analysis for the restatement as of and for the fiscal year
ended September 30, 2007 by applying FASB 133, paragraph 6 to ascertain if the
options remained derivatives as of September 30, 2007. All of the criteria in
the original analysis were met, and the options were determined to be within the
scope and definition of a derivative. EITF 00-19, paragraph 19 was applied next,
which states that if a company is required to obtain shareholder approval to
increase the company’s authorized shares in order to net-share or physically
settle a contract, share settlement is not controlled by the company, and the
contract is required to be classified as a liability. EITF 00-19, paragraph 10
was then applied. Paragraph 10 states that if classification changes as the
result of an event, the contract should be reclassified as of the date of the
event at fair value. The event responsible for the change in classification was
the issuance of the $1,025,000 Convertible Bridge Notes on July 17,
2007.





In
accordance with EITF 00-19, the options were reclassified as of July 17, 2007
from additional paid-in capital to warrant liabilities on the balance sheet, at
the fair value of $2,271,879. The value was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
5.02%; volatility of 219.89%; dividend yield of 0%; and expected term
of 3.67 years.





EITF
00-19, paragraph 9 was then applied, which states that all contracts classified
as liabilities should be measured at fair value at each balance sheet date, with
changes in fair value reported in earnings and disclosed in the financial
statements as long as the contracts remain classified as
liabilities.





The
Company began the analysis for the restatement by applying FASB 133, paragraph 6
to ascertain if the options remained derivatives as of March 31, 2008. All of
the criteria in the original analysis were met, and the options were determined
to be within the scope and definition of a derivative. EITF 00-19, paragraph 8
was applied which states that if share settlement is not controlled by the
company, the contract is required to be classified as a liability. Paragraph 9,
which states that contracts classified as liabilities should be measured at fair
value at each balance sheet date, with changes in fair value reported in
earnings and disclosed in the financial statements as long as the contracts
remain classified as liabilities, was also applied.





The fair
value of the options was determined to be $457,114 as of March 31, 2008 and was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%; dividend
yield of 0%; and expected term of 3 years.





The
decrease in the fair value of the options was $766,474 for the three months
ended March 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.


53








The
decrease in the fair value of the options was $1,469,800 for the six months
ended March 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Operations





EITF
00-19, paragraph 9 was applied which requires all contracts classified as
liabilities to be measured at fair value, with changes in fair value reported in
earnings as long as the contracts remain classified as liabilities.





The
change in the fair value of the options for the three months ended March 31,
2008 was $766,474 and included in decrease in warrant liability in the other
income (expense) section of the statement of operations.





The
change in the fair value of the options for the six months ended March 31, 2008
was $1,469,800 and included in decrease in warrant liability in the other income
(expense) section of the statement of operations.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the options of
$1,469,800.





Advisory Board
Compensation





On
October 1, 2004, the Company formed an advisory board consisting of four
members. Each member was to receive $5,000 monthly from October 1, 2004 to
February 22, 2007 for a total of $576,000, convertible by the advisory board
members into 11,520,000 shares of Common Stock at a rate of $0.05 per share. On
December 13, 2007 the advisory board members agreed to forfeit the ability to
convert their compensation into shares of Common Stock in exchange for warrants
exercisable at $0.25 per share. The Company determined that the accrued expense,
embedded beneficial conversion feature, embedded beneficial conversion feature
discount, and related amortization expense were not recorded at the date of
issuance, or prior to the restatement of the financial statements as of March
31, 2008, no payments have been made to any advisory board members, there has
been no conversion by any Advisory Board members of the accrued liability into
shares of Common Stock, and no warrant has been exercised.





Balance
Sheet





The
Company began the analysis for the restatement by applying paragraph 6 of
Financial Accounting Standard Board (FASB) Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities,   to ascertain if the embedded
beneficial conversion features were derivatives at the date of issuance. The
embedded beneficial conversion features had one or more underlings and one or
more notional amounts; required no initial investment; and required or permitted
net settlement. Therefore, the embedded beneficial conversion features were
determined to be within the scope and definition of a derivative at the date of
issuance. Next, FASB 133, paragraph 12 was applied to determine if the embedded
beneficial conversion features should be separated from the accrued expense. The
Company determined that the economic characteristics of the embedded beneficial
conversion features are not clearly and closely related to the accrued expense;
the embedded beneficial conversion features and accrued expense are not
remeasured at fair value at each balance sheet date; and a separate contract
with the same terms would be a derivative pursuant to FASB 133, paragraphs 6-11.
Therefore, the embedded beneficial conversion features were separated from the
accrued expense to determine the classification and valuation. EITF 00-19,
paragraphs 7 and 8 were applied to determine the classification. Paragraph 7
states that contracts which require net-cash settlement are liabilities, and
paragraph 8 states that contracts which give the counterparty (advisory board
members) a choice of net-cash settlement or settlement in shares are
liabilities. Therefore, the embedded conversion features were determined to be
liabilities. EITF 00-19, paragraph 9 was applied to determine the value.
Paragraph 9 of EITF 00-19 states all contracts classified as liabilities should
be measured at fair value at each balance sheet date, with changes in fair value
reported in earnings and disclosed in the financial statements as long as the
contracts remain classified as liabilities.





The fair
value of the monthly embedded beneficial conversion features was determined to
be $576,000 as of September 30, 2007, and was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
4.05%; volatility of 126.94%; dividend yield of 0%; and expected term of
2.08 to 4.42 years.


54





On
December 13, 2007 the advisory board members agreed to forfeit the ability to
convert their compensation into shares of common stock in exchange for warrants.
As a result, the beneficial conversion feature of $576,000 and the unamortized
beneficial conversion feature discount of $195,560 were written off for a net of
$380,440.





The
beneficial conversion features discount amortization was $15,104 for the three
and six months ended March 31, 2008, which increased accrued
expenses.





Statement
of Operations





EITF
00-19, paragraph 9 was applied which requires all contracts classified as
liabilities to be measured at fair value, with changes in fair value reported in
earnings as long as the contracts remain classified as liabilities.





There was
no increase in the fair value of the beneficial conversion features for the
three or six months ended March 31, 2008.





The
beneficial conversion feature discount amortization was determined to be $15,104
and has been included in general and administrative expenses in the operating
expenses section of the statement of operations for the three and six months
ended March 31, 2008.





The
beneficial conversion feature of $576,000 and the beneficial conversion feature
discount of $195,560 were written off for a net of $380,440 and has been
included in the other income (expense) section of the statement of income
(operations) for the three and six months ended March 31, 2008.





Statement
of Cash Flows





Changes
in the statement of cash flows were the result of the amortization of the
beneficial conversion features discount of $15,104, and the net write off of
beneficial conversion feature and beneficial conversion feature discount of
$380,440 on the statement of operations.





Warrants Related to 2004
Stock Purchase Agreement





Under the
terms of a 2004 Stock Purchase Agreement, the Company issued warrants to
purchase 1,463,336 shares of Common Stock at an exercise price of $0.03 which
expire from February 9, 2007 to August 25, 2007. The Company determined that the
warrants and related expense were not recorded at the date of issuance or prior
to the restatement and there has been no exercise of the warrants into shares of
Common Stock.





Balance
Sheet





The
Company began the analysis by applying FASB 133, paragraph 6 to determine if the
warrants were within the scope and definition of a derivative at the date of
issuance. The warrants: had one or more underlings, and one or more notional
amounts; required no initial investment; and required or permitted net
settlement. Therefore, the warrants were determined to be derivatives at the
date of issuance. EITF 00-19, paragraphs 7 and 8 were then applied to determine
classification. These paragraphs state that contracts which require settlement
in shares are equity instruments. EITF 00-19, paragraph 9 was applied to
determine the value of the options. Paragraph 9 of EITF 00-19 states that
contracts which require the company to deliver shares as part of a physical
settlement or net-share settlement should be initially measured at fair
value.





The fair
value of the warrants was determined to be $24,366 at the date of issuance which
was calculated using the Black-Scholes valuation model  with the following
assumptions: risk free rate of return ranging from 1.21% to 2.14%; volatility
ranging from 141.91% to 170.27%; dividend yield of 0%; and expected term
of 5 years. The warrants were considered an expense prior to October 1,
2006. Therefore, $24,366 was recorded to additional paid-in capital and deficit
accumulated during development stage.


55





EITF
00-19, paragraph 19 was applied next. Paragraph 19 states that if a company is
required to obtain shareholder approval to increase the company’s authorized
shares in order to net-share or physically settle a contract, share settlement
is not controlled by the company and the contract is required to be classified
as a liability. EITF 00-19, paragraph 10 was then applied. This paragraph states
that if classification changes as the result of an event, the contract should be
reclassified as of the date of the event at fair value. The event responsible
for the change in classification was the issuance of the
$1,025,000 Convertible Bridge Notes on July 17, 2007.





In
accordance with EITF 00-19, the warrants were reclassified as of July 17, 2007
from additional paid-in capital to warrant liabilities on the balance sheet at
the fair value of $70,029, which was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
5.02%; volatility of 219.89%; dividend yield of 0%; and expected term
of .08 years.





EITF
00-19, paragraph 9 was also applied in the analysis. Paragraph 9 states that all
contracts classified as liabilities must be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities.





The fair
value of the warrants was $0 as of September 30, 2007, due to their
expiration.





The
decrease in the fair value of the warrants was $70,029 for the year ended
September 30, 2007, which was recorded to warrant liability and accumulated
deficit during development stage as of March 31, 2008.





Statement
of Operations





There was
no change in the fair value of the warrants for the three months ended March 31,
2008, due to their expiration.





Statement
of Cash Flows





There was
no change in the statement of cash flows for the three months ended March 31,
2008.





Beneficial Conversion
Features





As of
March 31, 2008, the Company had Convertible Bridge Notes outstanding totaling
$1,811,000 which were issued between October 17, 2006 and July 17, 2007. The
bridge notes included an embedded beneficial conversion feature that allowed the
holders of the convertible notes to convert their notes into shares of Common
Stock at rates between $0.01 and $0.22. The bridge notes mature between June 17,
2008 and December 31, 2008. The bridge notes accrue interest at rates between 8%
and 10%, and any accrued but unpaid interest is also convertible by the holder
of the bridge notes into shares of Common Stock at the same rate.





Balance
Sheet





The
Company began the analysis for the restatement as of and for the six months
ended March 31, 2008 by applying FASB 133, paragraph 6 to ascertain if the
embedded beneficial conversion features remained derivatives subsequent to the
date of issuance. All of the criteria in the original analysis were met, and the
embedded beneficial conversion features issued were determined to be within the
scope and definition of a derivative. FASB 133, paragraph 12 was applied to
determine if the embedded beneficial conversion features should be separated
from the convertible bridge notes. All of the criteria in the original analysis
were met, and the embedded beneficial conversion features were separated from
the convertible bridge notes. EITF 00-19, paragraphs 7 and 8 were applied to
determine the classification. Paragraph 7 states that contracts which require
net-cash settlement are liabilities, and paragraph 8 states that contracts which
give the counterparty (holders of the convertible notes) a choice of net-cash
settlement or settlement in shares are liabilities. Therefore the embedded
conversion features were determined to be liabilities. The change in the
determination of the classification from equity to a liability was based on the
rights of the holders of the convertible notes to convert the notes into shares
of Common Stock. Therefore, share settlement is not controlled by the Company.
EITF 00-19, paragraph 9 was applied to determine the value of the embedded
beneficial conversion features. Paragraph 9 states that all contracts classified
as liabilities must be measured at fair value at each balance sheet date, with
changes in fair value reported in earnings and disclosed in the financial
statements as long as the contracts remain classified as
liabilities.


56





The fair
value of the monthly embedded beneficial conversion features was determined to
be $874,882 as of March 31, 2008, which was calculated using the Black-Scholes
valuation model with the following assumptions: risk free rate of return of
1.56%; volatility of 72.53%; dividend yield of 0%; and expected term
of .08 to .33 years.





The
decrease in the fair value of the beneficial conversion features was determined
to be $347,850 for the three months ended March 31, 2008, and was recorded in
beneficial conversion features liability on the balance sheet.





The
decrease in the fair value of the beneficial conversion features was determined
to be $555,929 for the six months ended March 31, 2008, and was recorded in
beneficial conversion features liability on the balance sheet.





The
amortization of the beneficial conversion features discount was $285,610 for the
three months ended March 31, 2008, which increased convertible
notes.





The
amortization of the beneficial conversion features discount was $573,646 for the
six months ended March 31, 2008, which increased convertible notes.





Statement
of Operations





The
beneficial conversion features were analyzed in accordance with EITF 00-19,
paragraph 9 which requires all contracts classified as liabilities to be
measured at fair value, with changes in fair value reported in earnings as long
as the contracts remain classified as liabilities.





The
decrease in the fair value of the beneficial conversion features was determined
to be $347,850 for the three months ended March 31, 2008, and was recorded in
increase (decrease) in beneficial conversion features liability, in the other
income (expense) section of the statement of operations.





The
decrease in the fair value of the beneficial conversion features was determined
to be $555,929 for the six months ended March 31, 2008, and was recorded in
increase (decrease) in beneficial conversion features liability, in the other
income (expense) section of the statement of operations.





The
amortization of the beneficial conversion features discount was $285,610 for the
three months ended March 31, 2008, and was recorded in interest expense in the
other income (expense) section of the statement of operations.





The
amortization of the beneficial conversion features discount was $573,646 for the
six months ended March 31, 2008, and was recorded in interest expense in the
other income (expense) section of the statement of operations.





Statement
of Cash Flows





Changes
in the statement of cash flows for the three months ended March 31, 2008 were
the result of the decrease in the fair value of the beneficial conversion
features liability of $347,850 and the amortization of the beneficial conversion
features discounts of $285,610 on the statement of operations.





Changes
in the statement of cash flows for the six months ended March 31, 2008 were the
result of the decrease in the fair value of the beneficial conversion features
liability of $555,929 and the amortization of the beneficial conversion features
discounts of $573,646 on the statement of operations.





Warrants related to
$1,025,000 of Convertible Bridge
Notes





On July
17, 2007 the Company completed an offering of $1,025,000 of convertible notes to
a group of institutional and accredited investors which included warrants to
purchase 2,795,454 shares of Common Stock (2,329,546 shares of Common
Stock to holders of the convertible bridge notes, 465,908 shares of Common Stock
as a placement fee) at an exercise price of $0.50 per share. An amendment to the
convertible notes dated March 13, 2008 reduced the exercise price to $0.30 per
share.  57





Balance
Sheet





The
Company began the analysis for the restatement of the financial statements as of
and for the six months ended March 31, 2008 by applying FASB 133, paragraph 6 to
ascertain if the warrants issued remained derivatives as of March 31, 2008. All
of the criteria in the original analysis were met, and the warrants issued were
determined to be within the scope and definition of a derivative. EITF 00-19,
paragraph 19 was applied next to determine classification. Paragraph 19 states
that if a company is required to obtain shareholder approval to increase the
company’s authorized shares in order to net-share or physically settle a
contract, share settlement is not controlled by the company, and the contract is
required to be classified as a liability. EITF 00-19, paragraph 9 was applied to
determine the value of the warrants. Paragraph 9 states that all contracts
classified as liabilities must be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The fair
value of the warrants was determined to be $135,950 as of March 31, 2008, and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%; dividend
yield of 0%; and expected term of 4.17 to 4.25 years.





The
decrease in the fair value of the warrants was determined to be $185,827 for the
three months ended March 31, 2008, and recorded by decreasing warrant
liabilities on the balance sheet by $185,827 ($143,242 related to the holders of
the convertible bridge notes, and $42,585 related to the placement fee) .





The
decrease in the fair value of the warrants was determined to be $363,982 for the
six months ended March 31, 2008, and recorded by decreasing warrant liabilities
on the balance sheet by $363,982 ($268,470 related to the holders of the
convertible bridge notes, and $95,512 related to the placement fee) .





The
amortization of the warrant discount was $213,353 for the six months ended March
31, 2008, which increased convertible notes.





Statement
of Operations





EITF
00-19, paragraph 9 was applied which requires all contracts classified as
liabilities to be measured at fair value, with changes in fair value reported in
earnings as long as the contracts remain classified as liabilities.





The
decrease in the fair value of the warrants was determined to be $185,827 for the
three months ended March 31, 2008, and recorded in decrease in warrants in the
other income (expense) section of the statement of operations.





The
decrease in the fair value of the warrants was determined to be $363,982 for the
six months ended March 31, 2008, and recorded in decrease in warrants in the
other income (expense) section of the statement of operations.





The
increase in the amortization of the warrant discount of $30,065 is included in
interest expense in the other income (expense) section of the statement of
operations.





Statement
of Cash Flows





Changes
in the statement of cash flows for the six months ended March 31, 2008 were the
result of the decrease in the amount of $363,982 in the fair value of the
warrants at the date of issuance on the statement of operations, and the
increase in the amortization of the warrant discount of $30,065 on the balance
sheet.





Warrant Issued to
Consultant





On
December 19, 2007, the Company entered into a one year Consulting Agreement with
Mark Maron pursuant to which Mr. Maron was appointed as Special Adviser to the
Company. As compensation for his services, the Company granted Mr. Maron a five
year warrant to purchase up to 8,539,312 shares of the Company’s Common Stock at
an exercise price of $0.25 per share. As per the terms of the warrant agreement,
the right to purchase 340,000 shares of Common Stock is not exercisable until
the notes dated June 6, 2007 (Convertible Notes 2 as discussed in Note 6 to our
financial statements) are eligible for conversion into shares of Common
Stock.  The warrant was not issued from the 2001 Executive
Officers Stock Option Plan.





58








Balance
Sheet





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
warrant was within the scope and definition of a derivative at the date of
issuance. The warrant had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the warrant was determined to be a derivative at the date
of issuance. In order to determine how to classify the warrant, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the warrant, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the warrant was determined to be $1,448,321 at the date of issuance and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free interest rate of 3.26%; expected volatility of 98.01%;
dividend yields of 0%; and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the warrant by applying FASB 133, paragraph 6 to ascertain if
the warrant remained a derivative as of December 31, 2007. All of the criteria
in the original analysis were met, and the warrant issued was determined to be
within the scope and definition of a derivative. EITF 00-19, paragraph 8 was
applied which states that if share settlement is not controlled by the company,
the contract is required to be classified as a liability. Paragraph 9 was also
applied, which states that contracts classified as liabilities should be
measured at fair value at each balance sheet date, with changes in fair value
reported in earnings and disclosed in the financial statements as long as the
contracts remain classified as liabilities.





The fair
value of the warrant was determined to be $543,267 as of March 31, 2008, and was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%;
dividend yield of 0%; and expected term of 4.67 years.





The
decrease in the fair value of the warrant was $972,165 for the three months
ended March 31, 2008, and was recorded by decreasing the warrant liability on
the balance sheet.





The
decrease in the fair value of the warrant was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Operations





The
decrease in the fair value of the warrant was $972,165 for the three months
ended March 31, 2008, and was recorded by decreasing the warrant liability on
the balance sheet.





The
decrease in the fair value of the warrant was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the warrant of
$905,054.





59








Option Issued to Chief
Executive Officer





On
December 19, 2007, the Company entered into a one year Employment Agreement with
Richard H. Papalian pursuant to which Mr. Papalian had been appointed as the
Company’s Chief Executive Officer. As compensation for his services, the Company
granted to Mr. Papalian a five year option to purchase up to 8,539,312 shares of
the Company’s Common Stock at an exercise price of $0.25 per share. As per the
terms of the stock option agreement, the right to purchase 340,000 shares of
Common Stock is not exercisable until the notes dated June 6, 2007 (Convertible
Notes 2 as discussed in Note 6 to our financial statements) are eligible for
conversion into shares of Common Stock. These options were not issued from the
2001 Executive Officers Stock Option Plan.   On the grant date, the Company
applied FASB 133, paragraph 6 to determine if the option was within the scope
and definition of a derivative. The option had one or more underlings and one or
more notional amounts, required no initial investment, and required or permitted
net settlement. Therefore, the option was determined to be a derivative. In
order to determine how to classify the option, the Company followed the guidance
of EITF 00-19, paragraphs 7 and 8, which state that contracts   that
require net-cash settlement (including a requirement to net cash settle the
contract if an event occurs and if that event is outside the control of the
company) are liability instruments. In order to determine the value of the
option, the Company applied EITF 00-19, paragraph 9, which states that contracts
that require the company to deliver shares as part of a physical settlement or
net-share settlement should be initially measured at fair value.





Balance
Sheet





The fair
value of the option was determined to be $1,448,321 at the date of issuance, and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 3.26%; volatility of 98.01%; dividend
yield of 0%; and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the option as of March 31, 2008 by applying FASB 133, paragraph
6 to ascertain if the option remained a derivative as of March 31, 2008. All of
the criteria in the original analysis were met, and the option was determined to
be within the scope and definition of a derivative. EITF 00-19, paragraph 8 was
applied which states that if share settlement is not controlled by a company,
the contract is required to be classified as a liability. Paragraph 9, which
states that contracts classified as liabilities should be measured at fair value
at each balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities, was also applied.





The fair
value of the option was determined to be $543,267 as of March 31, 2008, and was
calculated using the Black-Scholes valuation model with the following
assumptions: risk free rate of return of 1.56%; volatility of 72.53%;
dividend yield of 0%; and expected term of 4.67 years.





The
decrease in the fair value of the option was $972,165 for the three months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





The
decrease in the fair value of the option was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Operations





The
decrease in the fair value of the option was $972,165 for the three months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





The
decrease in the fair value of the option was $905,054 for the six months ended
March 31, 2008, and was recorded by decreasing the warrant liability on the
balance sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the option of
$905,054.





Option Issued to
Director





On
December 13, 2007, the Company’s Board of Directors approved the issuance to a
director of a five year option to purchase a total of 1,000,000 shares of the
Company’s common stock at an exercise price of $0.25 per share.


60





Balance
Sheet





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
option was within the scope and definition of a derivative at the date of
issuance. The option had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the option was determined to be a derivative at the date
of issuance. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the option, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the option was determined to be $171,520 at the date of issuance and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free interest rate of 3.22%; expected volatility of 99.86%;
dividend yield of 0%; and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the option by applying FASB 133, paragraph 6 to ascertain if
the option remained a derivative as of March 31, 2008. All of the criteria in
the original analysis were met, and the option was determined to be within the
scope and definition of a derivative. EITF 00-19, paragraph 8 was applied which
states that if share settlement is not controlled by the company, the contract
is required to be classified as a liability. Paragraph 9, which states that
contracts classified as liabilities should be measured at fair value at each
balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities, was also applied.





The fair
value of the option was determined to be $63,620 as of March 31, 2008, using the
Black-Scholes valuation model with the following assumptions: risk free
rate of return of 1.56%; volatility of 72.53%; dividend yield of 0%; and
expected term of 4.67 years.





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Operations





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the option of
$107,900.





Option Issued to Chief
Financial Officer





On
December 13, 2007, the Company’s Board of Directors approved the issuance to the
Chief Financial Officer of a five year option to purchase a total of 1,000,000
shares of the Company’s common stock at an exercise price of $0.25 per
share.


61








Balance
Sheet





The
Company followed the guidance of FASB 133, paragraph 6, to determine if the
option was within the scope and definition of a derivative at the date of
issuance. The option had one or more underlings and one or more notional
amounts, required no initial investment and required or permitted net
settlement. Therefore, the option was determined to be a derivative at the date
of issuance. In order to determine how to classify the option, the Company
followed the guidance of EITF 00-19, paragraphs 7 and 8, which state that
contracts   that require net-cash settlement (including a requirement to
net cash settle the contract if an event occurs and if that event is outside the
control of the company) are liability instruments. In order to determine the
value of the option, the Company followed the guidance of EITF 00-19, paragraph
9, which states that contracts which require the company to deliver shares as
part of a physical settlement or net-share settlement should be initially
measured at fair value.





The fair
value of the option was determined to be $171,520 at the date of issuance and
was calculated using the Black-Scholes valuation model with the following
assumptions: risk free interest rate of 3.22%; expected volatility of 99.86%;
dividend yield of 0%; and expected term of 5 years.





The
Company then applied EITF 00-19, paragraph 9, which states that all contracts
classified as liabilities are to be measured at fair value at each balance sheet
date, with changes in fair value reported in earnings and disclosed in the
financial statements as long as the contracts remain classified as
liabilities.





The
Company analyzed the option by applying FASB 133, paragraph 6 to ascertain if
the option remained a derivative as of March 31, 2008. All of the criteria in
the original analysis were met, and the option issued was determined to be
within the scope and definition of a derivative. EITF 00-19, paragraph 8 was
applied which states that if share settlement is not controlled by the company,
the contract is required to be classified as a liability. Paragraph 9, which
states that contracts classified as liabilities should be measured at fair value
at each balance sheet date, with changes in fair value reported in earnings and
disclosed in the financial statements as long as the contracts remain classified
as liabilities, was also applied.





The fair
value of the option was determined to be $63,620 as of March 31, 2008 using the
Black-Scholesvaluation model with the following assumptions: risk free rate
of return of 1.56%; volatility of 72.53%; dividend yield of 0%; and expected
term of 4.67 years.





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Operations





The
decrease in the fair value of the option was $113,845 for the three months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





The
decrease in the fair value of the option was $107,900 for the six months ended
March 31, 2008, and recorded by decreasing the warrant liability on the balance
sheet.





Statement
of Cash Flows





The
change in the statement of cash flows for the six months ended March 31, 2008
was the result of the change in the fair value of the option of
$107,900.





Table 1 –
2008





62








WarrantBeneficial
              Conversion
            
            
            Related to
              $1,025,000
              of2001
            
            
            
            
            
            Warrants
              Related to
            
            
            Features
              and
            
            
            Convertible
              BridgeAs
            
            
            Executive
              Officers
            
            
            Advisory
            
            
            2004
              Stock
            
            
            Beneficial
              Conversion
            
            
            Notes
              and
            
            
            Warrant
              Issued
            
            
            Option Issued
              to Chief
            
            
            
            
            
            Warrant Issued
              to Chief
            
            
            10%
            
            
            Warrants
              RelatedPreviously
              Stated
            
            
            Option
              Plan
            
            
            Board
              Compensation
            
            
            Purchase
              Agreement
            
            
            Features
              Discount
            
            
            Warrant
              Discount
            
            
            to
              Consultant
            
            
            Executive
              Officer
            
            
            Warrant Issued
              to Director
            
            
            Financial
              Officer
            
            
            Subordinated
              Notes Payable
            
            
            to $750,000
              Stock Issuance
            
            
            Other
            
            
            As
              RestatedBalance
      SheetCash
      and cash equivalent
            
            $
            102,604
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            151
            
            
            $
            102,755Accounts
      payable
            
            
            470,137
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            32,987
            
            
            
            503,124Accrued
      expenses
            
            
            1,847,254
            
            
            
            
            
            
            576,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,423,254Convertible
      Notes, net
            
            
            1,306,593
            
            
            
            
            
            
            
            
            
            
            
            
            
            12,913
            
            
            
            206,465
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,525,97110%
      subordinated notes payable
            
            
            332,182
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            20,169
            
            
            
            
            
            
            38
            
            
            
            352,389Warrant
      liability
            
            
            974,632
            
            
            
            457,114
            
            
            
            549,672
            
            
            
            
            
            
            
            
            
            
            36,522
            
            
            
            128,358
            
            
            
            128,358
            
            
            
            63,620
            
            
            
            63,620
            
            
            
            
            
            
            
            156,268
            
            
            
            
            
            
            
            2,558,164Beneficial
      conversion feature liability
            
            
            857,678
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            17,204
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            874,882Additional
      paid-in capital
            
            
            12,815,792
            
            
            
            (2,271,879
            )
            
            
            (269,848
            )
            
            
            (45,663
            )
            
            
            473,797
            
            
            
            135,406
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            10,837,605Deficit
      accumulated during development stage
            
            
            (19,149,208
            )
            
            
            1,814,765
            
            
            
            (855,824
            )
            
            
            45,663
            
            
            
            (503,914
            )
            
            
            (378,393
            )
            
            
            (128,358
            )
            
            
            (128,358
            )
            
            
            (63,620
            )
            
            
            (63,620
            )
            
            
            (20,169
            )
            
            
            (156,268
            )
            
            
            (32,874
            )
            
            
            (19,620,178
            )Statement
      of Operations (for the three months ended March 31,
    2008)General
      and administrative
            
            $
            395,890
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            165,022
            
            
            $
            32,540
            
            
            $
            593,452Research
      and development
            
            
            328,694
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            334
            
            
            
            329,028Interest
      expense
            
            
            (492,546
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            16,677
            
            
            
            (78,022
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (20,169
            )
            
            
            
            
            
            
            
            
            
            
            (574,060
            )Decrease
      (increase) in warrant liability
            
            
            273,778
            
            
            
            766,474
            
            
            
            983,628
            
            
            
            
            
            
            
            
            
            
            
            (36,522
            )
            
            
            972,165
            
            
            
            972,165
            
            
            
            113,845
            
            
            
            113,845
            
            
            
            
            
            
            
            8,754
            
            
            
            
            
            
            
            4,168,132Increase
      in beneficial conversion feature liability
            
            
            364,944
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (17,204
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            347,740Basic
      and dilutive loss per share
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Statement
      of Operations (for the six months ended March 31,
    2008)General
      and administrative
            
            $
            1,526,663
            
            
            
            
            
            
            $
            1,557,705
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            1,033,412
            
            
            $
            1,033,412
            
            
            $
            171,520
            
            
            $
            171,520
            
            
            
            
            
            
            $
            165,022
            
            
            $
            32,540
            
            
            $
            5,691,794Research
      and development
            
            
            565,598
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            334
            
            
            
            565,932Interest
      expense
            
            
            (906,150
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            32,816
            
            
            
            (167,287
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (20,169
            )
            
            
            
            
            
            
            
            
            
            
            (1,060,790
            )Decrease
      (increase) in warrant liability
            
            
            427,991
            
            
            
            1,469,800
            
            
            
            1,008,033
            
            
            
            
            
            
            
            
            
            
            
            (12,580
            )
            
            
            905,054
            
            
            
            905,054
            
            
            
            107,900
            
            
            
            107,900
            
            
            
            
            
            
            
            8,754
            
            
            
            
            
            
            
            4,927,906Increase
      in beneficial conversion feature liability
            
            
            637,688
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (81,759
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            555,929Write-off
      of beneficial conversion feature
            
            
            
            
            
            
            
            
            
            
            380,440
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            380,440Basic
      and dilutive loss per share
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Statement
      of Cash Flows (for the six months ended March 31, 2008)Net
      loss
            
            $
            (2,077,833
            )
            
            $
            1,469,800
            
            
            $
            (169,232
            )
            
            
            
            
            
            $
            (48,943
            )
            
            $
            (179,867
            )
            
            $
            (128,358
            )
            
            $
            (128,358
            )
            
            $
            (63,620
            )
            
            $
            (63,620
            )
            
            $
            (20,169
            )
            
            $
            (156,268
            )
            
            $
            (32,874
            )
            
            $
            (1,599,342
            )Amortization
      of beneficial conversion features discount and warrant
      discount
            
            
            669,025
            
            
            
            
            
            
            
            10,072
            
            
            
            
            
            
            
            (32,816
            )
            
            
            167,287
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            20,169
            
            
            
            
            
            
            
            38
            
            
            
            833,775Stock
      based compensation expense- employee
            
            
            414,908
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,033,412
            
            
            
            
            
            
            
            171,520
            
            
            
            171,520
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,791,360Stock
      based compensation expense- consultant
            
            
            439,909
            
            
            
            
            
            
            
            1,557,705
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,008,413
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            165,022
            
            
            
            
            
            
            
            3,171,049(Decrease)
      increase in warrant liability
            
            
            (427,991
            )
            
            
            (1,469,800
            )
            
            
            (1,008,033
            )
            
            
            
            
            
            
            
            
            
            
            12,580
            
            
            
            (905,054
            )
            
            
            (905,054
            )
            
            
            (107,900
            )
            
            
            (107,900
            )
            
            
            
            
            
            
            (8,754
            )
            
            
            
            
            
            
            (4,927,906
            )Increase
      in beneficial conversion feature liaiblity
            
            
            (637,688
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            81,759
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (555,929
            )Write-off
      of beneficial conversion feature
            
            
            
            
            
            
            
            
            
            
            (380,440
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (380,440
            )Accounts
      payable
            
            
            312,738
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            32,987
            
            
            
            345,725Accrued
      expenses
            
            
            159,581
            
            
            
            
            
            
            
            576,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            735,581Cash
      and cash equivalents
            
            
            102,604
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            151
            
            
            
            102,755





63





Second
Restatement for the Three and Six Months Ended March 31, 2009





The
Company restated its September 30, 2007 financial statements in response to a
comment letter from the Securities and Exchange Commission.  However,
the restatement did not properly account for certain derivative transactions, as
discussed below, which resulted in the Company restating its September 30, 2007
financial statements for a third time and restating its September 30, 2008
financial statements.  Due to the items discussed below, the Company
is restating its March 31, 2009 financial statements.





The
Company issued 25 secured convertible promissory notes between October 17, 2006
and February 27, 2007 for total proceeds to the Company of $750,000
(“Convertible Notes 1”). Convertible Notes 1 could be converted into shares of
the Company’s common stock at a conversion price of $0.05 per share. Convertible
Notes 1 contained a provision that would automatically adjust the conversion
price if equity securities or instruments convertible into equity securities
were issued at a conversion price less than $0.05.





On June
6, 2007, the Company issued 5 convertible promissory notes for a total of
$86,000 (“Convertible Notes 2”).  No warrants were issued in
connection with Convertible Notes 2. Convertible Notes 2 mature on December 31,
2008, and are convertible into common stock at $0.01 per share.





As a
result of the issuance of Convertible Notes 2, the conversion price for
Convertible Notes 1 was adjusted down from $0.05 to $0.01.  The
decrease in the conversion price increased the potential dilutive shares from
15,000,000 to 75,000,000, and this subsequently increased the total outstanding
and potential dilutive shares over the authorized common share limit of
150,000,000.  Because there were insufficient authorized shares to
fulfill all potential conversions, the Company should have classified all
potentially dilutive securities as derivative liabilities as of June 6,
2007.  The Company researched its debt and equity instruments and
determined that the potentially dilutive securities are as follows:





·
            Warrants
      and Options


·
            Beneficial
      Conversion Features





The
Company analyzed the effect of the recalculation on the balance sheet and the
statements of operations and cash flows as of March 31, 2009. The analysis and
results were as follows:





Warrants and Options
Liability





As of
March 31, 2009, the Company had 42,849,099 warrants outstanding and 17,384,491
options outstanding that were vested at that date.





Balance
Sheet





The
Company determined that because there were not sufficient authorized shares
available that the embedded conversion feature met the definition of a
derivative based on Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities", (SFAS 133) as of June 6,
2007.





At March
31, 2009, the Company determined the fair value of all warrants and options to
be $2,763,660 and $1,207,255, respectively, using the Black-Scholesmodel with
the following assumptions:





·
            risk
      free rate of return between 0.57% and
1.67%;


·
            volatility
      between 153% and 260%;


·
            dividend
      yield of 0%; and


·
            expected
      term between 1.95 years and 5.24
years.





Statement
of Operations





For the
three and six months ended March 31, 2009, the Company recorded $837,506 and an
additional $1,490,193, respectively, as a gain on change in fair value of
warrant and option liability.








64


Statement
of Cash Flows





Changes
in the statement of cash flows were the result of the decrease in fair value of
the warrant and option liability of $1,490,193.





Beneficial Conversion
Liability





As of
March 31, 2009, the Company had $781,333 in convertible notes that could be
converted into 67,006,499 shares. During the period ended March 31, 2009,
certain investors converted $11,797 of convertible notes into 294,930 common
shares at $0.04 per share; however, the conversion rate should have been
$0.01.  At March 31, 2009, the Company owes an additional 12,248,173
shares to the investors related to the $11,797 converted during the period ended
March 31, 2009 and the $151,512 converted during the period ended September 30,
2008.  The Company recorded a liability of $979,854, which is recorded
in accrued expenses in the accompanying financial statements.  The
change in the fair value of the shares will be recorded as a change in fair
value of beneficial conversion liability.





Balance
Sheet





The
Company determined that because there were not sufficient authorized shares
available that the embedded conversion feature met the definition of a
derivative based on SFAS 133 as of June 6, 2007.





At March
31, 2009, the Company determined the fair value of the embedded conversion
options to be $4,740,412 using the Black-Scholesmodel with the following
assumptions:





·
            risk
      free rate of return of 0.57%;


·
            volatility
      between of 180%;


·
            dividend
      yield of 0%; and


·
            expected
      term of 0.75 years.





Statement
of Operations





For the
three and six months ended March 31, 2009, the Company recorded $907,549 and an
additional $4,742,622, respectively, as a gain on change in beneficial
conversion liability.





Statement
of Cash Flows





Changes
in the statement of cash flows were the result of the $4,742,622 change in fair
value of the beneficial conversion liability.





The
following table shows the effect of each of the changes discussed above on the
Company’s balance sheet, statement of operation, and statement of cash flows for
the three and six months ended March 31, 2009.
   65
  As
      Previously Stated
              
              
              Beneficial
      Conversion
              
              
              Warrants
      and
              
              
              
              
              
              As
      RestatedMarch
      31, 2009
              
              
              Options
              
              
              Options
              
              
              Reclassifications
              
              
              March
      31, 2009Balance
      SheetOther
      assets
              
              $
              34,165
              
              
              $
              -
              
              
              $
              -
              
              
              $
              155,000
              
              
              $
              189,165Accrued
      expenses
              
              
              2,734,069
              
              
              
              979,854
              
              
              
              -
              
              
              
              155,000
              
              
              
              3,868,923Warrant
      and option liability
              
              
              2,180,429
              
              
              
              -
              
              
              
              1,790,486
              
              
              
              -
              
              
              
              3,970,915Beneficial
      conversion liability
              
              
              -
              
              
              
              4,740,412
              
              
              
              -
              
              
              
              -
              
              
              
              4,740,412Additional
      paid-in capital
              
              
              13,383,049
              
              
              
              -
              
              
              
              (1,847,488
              )
              
              
              -
              
              
              
              11,535,561Deficit
      accumulated during developmental stage
              
              
              (21,869,332
              )
              
              
              (5,720,266
              )
              
              
              57,002
              
              
              
              -
              
              
              
              (27,532,596
              )Statement
      of Operations (for the three months ended March 31, 2009)Gain
      (loss) on change in fair value of warrant and option
    liability
              
              $
              (219,981
              )
              
              $
              -
              
              
              $
              837,506
              
              
              $
              -
              
              
              $
              617,525Gain
      on change in fair value of beneficial conversion liability
              
              
              -
              
              
              
              907,549
              
              
              
              -
              
              
              
              -
              
              
              
              907,549Statement
      of Operations (for the six months ended March 31, 2009)Gain
      on change in fair value of warrant and option liability
              
              $
              1,631,387
              
              
              $
              -
              
              
              $
              1,490,193
              
              
              $
              -
              
              
              $
              3,121,580Gain
      on change in fair value of beneficial conversion liability
              
              
              26,000
              
              
              
              4,742,622
              
              
              
              -
              
              
              
              -
              
              
              
              4,768,622Statement
      of Operations (since inception)Gain
      on change in fair value of warrant and option liability
              
              $
              6,849,627
              
              
              $
              -
              
              
              $
              516,466
              
              
              $
              -
              
              
              $
              7,366,093Gain
      on change in fair value of beneficial conversion liability
              
              
              1,426,767
              
              
              
              29,000,652
              
              
              
              -
              
              
              
              -
              
              
              
              30,427,419General
      and administrative expense
              
              
              21,740,171
              
              
              
              3,787,032
              
              
              
              83,855
              
              
              
              -
              
              
              
              25,611,058Interest
      expense and financing costs
              
              
              (2,457,641
              )
              
              
              (30,536,702
              )
              
              
              (897,793
              )
              
              
              -
              
              
              
              (33,892,136
              )Statement
      of Cash Flows (for the six months ended March 31, 2009)Net
      income
              
              $
              149,324
              
              
              $
              4,742,622
              
              
              $
              1,490,193
              
              
              $
              -
              
              
              $
              6,382,139Gain
      on change in fair value of warrant and option liability
              
              
              (1,631,387
              )
              
              
              -
              
              
              
              (1,490,193
              )
              
              
              -
              
              
              
              (3,121,580
              )Gain
      on change in fair value of beneficial conversion liability
              
              
              (26,000
              )
              
              
              (4,742,622
              )
              
              
              -
              
              
              
              -
              
              
              
              (4,768,622
              )Statement
      of Cash Flows (since inception)Net
      loss
              
              $
              (21,744,332
              )
              
              $
              (5,323,082
              )
              
              $
              (465,182
              )
              
              $
              -
              
              
              $
              (27,532,596
              )Gain
      on change in fair value of warrant and option liability
              
              
              (6,849,627
              )
              
              
              -
              
              
              
              (516,466
              )
              
              
              -
              
              
              
              (7,366,093
              )Gain
      on change in fair value of beneficial conversion liability
              
              
              (1,426,768
              )
              
              
              (29,000,652
              )
              
              
              -
              
              
              
              -
              
              
              
              (30,427,420
              )Non-cash
      compensation expense
              
              
              -
              
              
              
              3,787,032
              
              
              
              83,855
              
              
              
              -
              
              
              
              3,870,887Non-cash
      financing costs
              
              
              -
              
              
              
              30,536,702
              
              
              
              897,793
              
              
              
              -
              
              
              
              31,434,495
  66










67




Results
of Operations





Three
Months Ended March 31, 2009 Compared To Three Months Ended March 31,
2008





Revenues
for the three months ended March 31, 2009 and 2008 were
zero.  Although we received an order and deposit for two water
treatment systems during the 2008 fiscal year, revenue from this order has not
been recognized because the units have not been completed and delivered. The
Company incurred operating expenses of $499,935 during the three months ended
March 31, 2009, a decrease of $464,474 or approximately 48%, as compared to
$964,409 for the three months ended March 31, 2008.  General and
administrative expenses were $314,055 during the three months ended March 31,
2009, a decrease of $313,169 or approximately 49%, as compared to $627,224 for
the three months ended March 31, 2008.  The decrease in general and
administrative expenses contributed to the significant decrease in operating
expenses. During the three months ended March 31, 2008, warrants having a
relative fair value of $165,022 were issued to the purchasers of common stock
and classified as general and administrative expenses. Research and development
expenses were $178,265 during the three months ended March 31, 2009, a decrease
of $150,763 or approximately 46%, as compared to $329,028 for the three months
ended March 31, 2008.  The decrease in research and development
expenses resulted primarily from the reallocation of personnel for the design of
the two water treatment systems ordered during the 2009 fiscal
year.





Other
income (expense) totaled $1,445,409 during the three months ended March 31,
2009, a decrease of $10,725,641 or approximately 88%, as compared to $12,171,050
for the three months ended March 31, 2008. The Company earned interest income of
$277 during the three months ended March 31, 2009, a decrease of $89 or 24%, as
compared to $366 during the three months ended March 31, 2008.  The
Company incurred interest expense of $63,758 during the three months ended March
31, 2009, a decrease of $490,307 or approximately 88%, as compared to $554,065
for the three months ended March 31, 2008. The significant interest expense we
incurred during the three months ended March 31, 2008 was due primarily to the
amortization of the beneficial conversion features discount and warrant discount
of the convertible debt securities, while during the three months ended March
31, 2009 there was a decrease in outstanding debt principal, which resulted in
lower interest expenses. Gain on change in fair value of warrant and option
liability was $617,525 for the three months ended March 31, 2009, a decrease of
$1,147,813 or approximately 65%, as compared to $1,765,338 during the three
months ended March 31, 2008. The gain on change in fair value for the three
months ended March 31, 2009 represents the decrease in the fair value of the
warrant and option liability. Gain on change in fair value of the beneficial
conversion liability was $907,549 for the three months ended March 31, 2009, a
decrease of $10,181,028 or approximately 92% as compared to $11,088,577 for the
three months ended March 31, 2008. The decrease in the gain on change in
beneficial conversion liability was due to the expiration of the expected term
of the beneficial conversion feature and decrease in convertible notes that were
outstanding as of March 31, 2009 compared to March 31, 2008. During the three
months ended March 31, 2009 the Company recorded a loss on settlement of debt in
the amount of $16,184 related to the conversion of notes payable and accrued
interest into Common Stock. There were no comparable expenses recorded during
the three months ended March 31, 2008. During the three months ended March 31,
2008 the Company recorded a loss on lease termination for $129,166 related to
the termination of lease. There were no comparable expenses recorded during
the three months ended March 31, 2009.





As a
result of these items, net income for the three months ended March 31, 2009 was
$945,474, a decrease of $10,261,167 or approximately 92% over the net
income of $11,206,641 for the three months ended March 31,
2008.





Six
Months Ended March 31, 2009 Compared To Six Months Ended March 31,
2008





Revenues
for the six months ended March 31, 2009 and 2008 were zero.  Although
we received an order and deposit for two water treatment systems during the 2008
fiscal year, revenue from this order has not been recognized because the units
have not been completed and delivered. The Company incurred operating expenses
of $1,337,224 during the six months ended March 31, 2009, a decrease of
$4,936,816 or approximately 79%, as compared to $6,274,040 for the six months
ended March 31, 2008.  General and administrative expenses were
$964,891 during the six months ended March 31, 2009, a decrease of $4,726,903 or
approximately 83%, as compared to $5,691,794 for the six months ended March 31,
2008.  The decrease in general and administrative expenses contributed
to the significant decrease in operating expenses. The significant general and
administrative expenses incurred during the six months ended March 31, 2008 were
primarily due to the issuance of warrants having a fair value of $5,010,748.
During the six months ended March 31, 2009, the Company issued warrants having a
fair value of $238,244. Research and development expenses were $357,229 during
the six months ended March 31, 2009, a decrease of $208,703 or approximately
37%, as compared to $565,932 for the six months ended March 31,
2008.  The decrease in research and development expenses resulted
primarily from the reallocation of personnel for the design of the two water
treatment systems ordered during the 2009 fiscal year.


68








Other
income totaled $7,719,363 during the six months ended March 31, 2009, a decrease
of $14,339,121 or approximately 65%, as compared to $22,058,484 for the six
months ended March 31, 2008. The Company earned interest income of $3,868 during
the six months ended March 31, 2009, an increase of $2,589 or 202%, as compared
to $1,279 during the six months ended March 31, 2008.  The Company
incurred interest expense of $158,523 during the six months ended March 31,
2009, a decrease of $521,827 or approximately 77%, as compared to $680,350 for
the six months ended March 31, 2008. The significant interest expense we
incurred during the six months ended March 31, 2008 was due primarily to the
amortization of the beneficial conversion features discount and warrant discount
of the convertible debt securities, while during the six months ended March 31,
2009 there was a decrease in outstanding debt principal, which resulted in lower
interest. Gain on change in fair value of warrant and option liability was
$3,121,580 for the six months ended March 31, 2009, a decrease of $822,263 or
approximately 21%, as compared to $3,943,843 during the six months ended March
31, 2008. The decrease in gain on change in fair value of the warrant and option
liability was due to the increase in the trading price of our Common Stock,
resulting in a higher Black-Scholesvaluation model valuation calculation of the
warrant and option liability. Gain on change in fair value of the beneficial
conversion liability was $4,768,622 for the six months ended March 31, 2009, a
decrease of $14,154,256 or approximately 75% as compared to $18,922,878 for the
six months ended March 31, 2008. The decrease in gain on change in beneficial
conversion liability was due to the amortization expiration of the expected term
of the beneficial conversion features of our convertible debt. During the six
months ended March 31, 2009 the Company recorded a loss on settlement of debt of
$16,184 related to the conversion of notes payable and accrued interest into
Common Stock. During the three months ended March 31, 2008, the Company recorded
a loss on lease termination for $129,166 related to the termination of
lease.





As a
result of these items, net income for the six months ended March 31, 2009 was
$6,382,139, a decrease of $9,401,405 or approximately 60% over net
income of $15,783,544 for the six months ended March 31, 2008.





Liquidity
and Capital Resources





The
Company had cash and cash equivalents of $25,613 at March 31, 2009. The
Company’s source of liquidity has been the sale of its securities and deposits
received from orders for two water treatment systems. The Company expects to
receive additional orders for water treatment systems, but if it does not
receive additional orders or if these orders do not satisfy its capital needs,
the Company expects to sell its securities or obtain loans to meet its capital
requirements.  On May 13, 2009, the Company entered into a letter of
understanding regarding the issuance of a total of $300,000 in principal amount
of notes payable of which notes having a principal value of $35,000 will mature
on May 22, 2009 and notes having a principal value of $265,000 will mature on
August 21, 2009. The notes will include a provision that will permit the
holders, upon the occurrence of a default, to convert the outstanding principal
and unpaid accrued interest into shares of Common Stock at $0.10 per
share.  The securities being offered will not be or have not been
registered under the Securities Act of 1933, as amended, and may not be offered
or sold in the United States absent registration or an applicable exemption from
registration requirements. There can be no assurance that sales of the
Company’s securities or the sale of its water treatment systems, if such sales
occur, will provide sufficient capital for its operations or that the Company
will not encounter unforeseen difficulties that may deplete its capital
resources more rapidly than anticipated. As of March 31, 2009, a total of
$2,476,389 in principal and accrued interest related to certain promissory notes
issued by the Company was due.  The Company has not yet paid the notes
and no demand for payment has been made.





Operating
Activities





During
the six months ended March 31, 2009, the Company used $1,194,429 of cash in
operating activities.  Non-cash adjustments included $15,104 for
depreciation, $27,094 for amortization of warrant and beneficial conversion
feature, and $16,184 for loss on settlement of debt. Cash provided by
operating activities included $12,230 in other current assets, $92,508 in
accounts payable, $189,486 in accrued liabilities, and $200,000 in customer
deposits. Cash used in operating activities included $608,565 for inventory,
$150,400 in other assets, $3,121,580 for warrant and option liability, and
$4,768,622 for beneficial conversion liability. Stock based compensation to
nonemployees was $248,752.




69








During
the six months ended March 31, 2008, the Company used $896,996 of cash in
operating activities. Non-cash adjustments included $16,314 for depreciation,
$833,775 for amortization of warrant and beneficial conversion
feature, $129,166 for loss on termination of lease, $380,440 for write-off
of beneficial conversion features, and $138,375 for accrual of liquidated
damages. Cash provided by operating activities included $345,724 in accounts
payable, and $174,508 in accrued liabilities. Cash used in operating
activities included $33,650 for other current assets, $3,943,843 for warrant and
option liability, and $18,922,878 for beneficial conversion liability. Stock
based compensation to employees was $1,791,360 and stock based compensation to
nonemployees was $3,171,049.





Investing
Activities





During
the six months ended March 31, 2009, the Company acquired $5,546 of property and
equipment. During the six months ended March 31, 2008, the Company acquired
$29,164 of property and equipment.





Financing
Activities





During
the six months ended March 31, 2009, the Company received $5,000 for the
purchase of common stock.





During
the six months ended March 31, 2008 the Company used $656,404 in financing
activities. Cash provided from financing activities for the six months
ended March31, 2008 consisted of proceeds of $425,000 from the issuance of 10%
subordinated notes payable and $283,000 for the purchase of Common Stock. Cash
used in financing activities for the six months ended March 31, 2008 included a
payment of $5,000 toward a note payable, payments of $27,336 toward notes
payable under an equity line of credit, and payments totaling $19,260 to
officers for loans made to us.





On March
31, 2009, the Company had cash and cash equivalents of $25,613. The sole source
of liquidity has been borrowings from affiliates and the sales of our
securities. While the Company has a commitment for $300,000 in financing through
the sale of promissory notes, this amount is not likely to be adequate to
finance the Company’s operations through the end of its fiscal
year.  Furthermore, there is no certainty that the Company will be
able to generate revenues from operations during the fiscal year. As of March
31, 2009, the Company had an accumulated deficit of $27,532,596. We expect that
our future operating results will continue to be subject to many of the
problems, expenses, delays and risks, which we often cannot control, inherent in
the establishment of a developmental business enterprise.





Off-Balance
Sheet Arrangements





We have
no off-balance sheet arrangements, special purpose entities or financing
partnerships.





Capital
Expenditures





The
Company currently has no commitments for capital expenditures.





Material
Trends, Events or Uncertainties





We are
not certain how the current economic downturn may affect our
business.  Because of the global recession, government agencies and
private industry may not have the funds to purchase our water treatment
systems.  It may also be more difficult for us to raise capital in the
current economic environment. Other than as discussed herein, the Company does
not know of any material trends, events or uncertainties that may impact its
operations in the future.





70





Going
Concern Opinion





The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. This basis of accounting contemplates the
recovery of the Company’s assets and the satisfaction of its liabilities in the
normal course of business. Through March 31, 2009, the Company has incurred
cumulative losses of $27,532,596 including net income for the six months ended
March 31, 2009 of $6,382,139. As the Company has limited cash flow from
operations, its ability to transition from a development stage company to an
operating company is entirely dependent upon obtaining adequate financing to pay
for its overhead, research and development activities, and acquisition of
production equipment. It is unknown when, if ever, the Company will achieve a
level of revenues adequate to support its costs and expenses. In order for the
Company to meet its basic financial obligations, including rent, salaries, debt
service and operations, it plans to undertake additional equity or debt
financing. Because of the Company’s history and current debt levels, there is
considerable doubt that the Company will be able to obtain financing. The
Company’s ability to meet its cash requirements for the next twelve months
depends on its ability to obtain such financing. Even if financing is obtained,
any such financing will likely involve additional fees and debt service
requirements, which may significantly reduce the amount of cash the Company will
have for its operations. Accordingly, there is no assurance that the Company
will be able to implement its plans.





The
Company expects to continue to incur substantial operating losses for the
foreseeable future, and it cannot predict the extent of the future losses or
when it may become profitable, if ever. It expects to incur increasing sales and
marketing, research and development and general and administrative expenses.
Also, the Company has a substantial amount of short-term debt, which will need
to be repaid or refinanced, unless it is converted into equity. As a result, as
it begins to generate revenues from operations, those revenues will need to be
significant in order to cover current and anticipated expenses. These factors
raise substantial doubt about the Company's ability to continue as a going
concern unless it is able to obtain substantial additional financing in the
short term and generate significant revenues over the long term. If the Company
is unable to obtain financing, it would likely discontinue
operations.





As
mentioned in Notes 7 and 8, the Company has convertible notes and subordinated
notes payable that have matured. The Company is in the process of renegotiating
the terms of the notes with the note holders to extend the maturity date. If the
Company is unsuccessful in extending the maturity date, the Company may not be
able to continue as a going concern.





Part
I, Item 3.  Quantitative and Qualitative Disclosures about Market
Risk.





As a
smaller reporting company, we are not required to provide this
disclosure.





Part
I, Item 4T.  Controls and Procedures.





(a)
Disclosure Controls and Procedures





Regulations
under the Securities Exchange Act of 1934 require public companies to maintain
“disclosure controls and procedures,” which are defined to mean a company’s
controls and other procedures that are designed to ensure that information
required to be disclosed in the reports that it files or submits under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported,
within the time periods specified in the Commission’s rules and
forms.





We
conducted an evaluation, with the participation of our Chief Executive Officer
and Chief Financial Officer, of the effectiveness of the design and operation of
our disclosure controls and procedures as of the period covered by this
report.  Based on that evaluation, our Chief Executive Officer and
Chief Financial Officer have concluded that as of March 31, 2009, our disclosure
controls and procedures were not effective at the reasonable assurance level due
to the material weaknesses described below.





A
material weakness is a control deficiency (within the meaning of the Public
Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies that result in more than a remote likelihood
that a material misstatement of the annual or interim financial statements will
not be prevented or detected.  Management has identified the following
three material weaknesses in our disclosure controls and
procedures:





71








1.           We
do not have written documentation of our internal control policies and
procedures.  Written documentation of key internal controls over
financial reporting is a requirement of Section 404 of the Sarbanes-Oxley
Act.  Management evaluated the impact of our failure to have written
documentation of our internal controls and procedures on our assessment of our
disclosure controls and procedures and has concluded that the control deficiency
that resulted represented a material weakness.





2.           We
do not have sufficient segregation of duties within accounting functions, which
is a basic internal control.  Due to our size and nature, segregation
of all conflicting duties may not always be possible and may not be economically
feasible.  However, to the extent possible, the initiation of
transactions, the custody of assets and the recording of transactions should be
performed by separate individuals.  Management evaluated the impact of
our failure to have segregation of duties on our assessment of our disclosure
controls and procedures and has concluded that the control deficiency that
resulted represented a material weakness.





3.           We
do not have review and supervision procedures for financial reporting functions.
The review and supervision function of internal control relates to the accuracy
of financial information reported. The failure to review and supervise could
allow the reporting of inaccurate or incomplete financial information. Due to
our size and nature, review and supervision may not always be possible or
economically feasible.  Management evaluated the impact of our
significant number of audit adjustments and has concluded that the control
deficiency that resulted represented a material weakness.





To
address these material weaknesses, management performed additional analyses and
other procedures to ensure that the financial statements included herein fairly
present, in all material respects, our financial position, results of operations
and cash flows for the periods presented.





(b)
Changes in internal control over financial reporting





During
the quarter covered by this report, there was no change in our internal control
over financial reporting that has materially affected, or is reasonably likely
to materially affect, our internal control over financial
reporting.





Part
II, Item 1.  Legal Proceedings.





Not
applicable.





Part
II, Item 1A.  Risk Factors.





As a
smaller reporting company we are not required to provide this
information.





Part
II, Item 2.  Unregistered Sales of Equity Securities and Use of
Proceeds.





On
January 19, 2009, the Company issued 166,666 shares of common stock in exchange
for $25,000 in principal owed to holders of our convertible notes. We relied on
section 3(9) of the Securities Act of 1933 to issue the securities inasmuch as
the notes were exchanged by us with our existing security holders exclusively,
and no commission or other remuneration was paid or given directly or indirectly
for soliciting the exchange.





On
February 17, 2009, the Company issued 200,000 shares of common stock in exchange
for $30,000 in principal owed to holders of our convertible notes. We relied on
section 3(9) of the Securities Act of 1933 to issue the securities inasmuch as
the notes were exchanged by us with our existing security holders exclusively,
and no commission or other remuneration was paid or given directly or indirectly
for soliciting the exchange.





72








On
February 24, 2009, the Company issued 1,000,000 shares of common stock in
exchange for $150,000 in principal owed to holders of our convertible notes. We
relied on section 3(9) of the Securities Act of 1933 to issue the securities
inasmuch as the notes were exchanged by us with our existing security holders
exclusively, and no commission or other remuneration was paid or given directly
or indirectly for soliciting the exchange.





On March
25, 2009, the Company issued 2,129,600 shares of common stock in exchange for
$18,000 in principal and $3,301 in accrued interest owed to holders of our
convertible notes. We relied on section 3(9) of the Securities Act of 1933 to
issue the securities inasmuch as the notes were exchanged by us with our
existing security holders exclusively, and no commission or other remuneration
was paid or given directly or indirectly for soliciting the
exchange.





On March
30, 2009, the Company issued 2,123,025 shares of common stock in exchange for
$5,000 cash, $7,000 in principal, $1,816 in accrued interest, $75,000 of
liquidated damages, and $28,400 of late fees owed to holders of our convertible
notes. We relied on section 3(9) of the Securities Act of 1933 to issue the
common stock for principal, interest, liquidated damages and late fees inasmuch
as the notes were exchanged by us with our existing security holders
exclusively, and no commission or other remuneration was paid or given directly
or indirectly for soliciting the exchange.  We relied on section 4(2)
of the Securities Act of 1933 to issue the common stock in exchange for cash, as
the common stock was issued without any form of general solicitation or general
advertising and the acquirers were accredited investors.





On March
30, 2009, we issued options to three individuals to purchase a total of
3,833,650 shares of our Common Stock at $0.15 per share.  The options
expire five years from the date of grant.  We relied on section 4(2)
of the Securities Act of 1933 to issue the options , as the options were issued
without any form of general solicitation or general advertising and the each of
the acquirers occupied an insider status relative to us that afforded him
effective access to the information registration would otherwise
provide.





Part
II, Item 3.  Defaults upon Senior Securities.





Between
October 2006 and February 2007 we issued Secured Convertible Promissory Notes in
the aggregate principal amount of $750,000.  These notes were due to
be paid on the earlier of the first anniversary of the date of issuance, an
Event of Default (as defined in the note) or on the closing of any equity
financing in which we received gross proceeds of at least $2.5
million.  Payment of these notes became due on the first anniversary
of the date of issuance.  We have not paid the notes and, as of May
15, 2009, we owed a total of $523,333 in principal and $108,932 in accrued
interest.





On June
6, 2007 we issued Convertible Promissory Notes in the aggregate principal amount
of $86,000.  These notes became due and payable upon the earlier of
(i) the occurrence of an Event of Default or (ii) the Maturity Date unless,
prior to such time, the notes were converted into shares of our common
stock.  “Maturity Date” is defined in these notes as a business day
that is not sooner than December 31, 2008, as the holder of the note may specify
in written notice delivered to us not less than 30 days prior to such specified
date.  No holder has given us written notice of a Maturity Date,
however, we have determined that an Event of Default may have occurred under the
provisions of the notes defining an Event of Default.  As of May 15,
2009 we owed a total of $8,000 in principal and $3,261 in accrued
interest.





On July
17, 2007 we issued Subordinated Notes Payable in the aggregate principal amount
of $1,025,000.  We were required to pay the principal and accrued
interest monthly in cash or in shares of our common stock.  We have
not paid these notes in accordance with their terms and, as of May 15, 2009, we
owed a total of $250,000 in principal and $37,776 in accrued
interest.


73








In
January 2008 we completed an offering of $425,000 in principal amount of
Subordinated Debentures to a group of institutional and accredited
investors.  The Subordinated Debentures bear interest at the rate of
10% per annum, principal and interest were due to be paid monthly and they
matured on December 31, 2008.  We did not repay the Subordinated
Debentures in accordance with their terms and, as of May 15, 2009, we owed a
total of $425,000 in principal and $58,658 in accrued interest.





Part
II, Item 4.  Submission of Matters to a Vote of Security
Holders.





During
the quarter ended March 31, 2009, no matters were submitted to a vote of
security holders.





Part
II, Item 5.  Other Information.





On March
30, 2009, we issued 3,833,650 options to purchase Common Stock at $0.15 per
share to 2 executive officers and an employee, all of whom were related to
each other. The options expire five years from the date of grant. The
options were determined to have a fair value of $232,483 using the
Black-Scholesvaluation model. Rodney Anderson, our interim Chief Executive
Officer, received 1,380,114 options to purchase our Common Stock, Joe
Anderson, an employee and Mr. Anderson’s son, received 1,495,124 options to
purchase our Common Stock, and Robert Hasson, our interim Chief Financial
Officer, received 958,412 options to purchase our Common Stock.





Part II, Item
6.  Exhibits.





Exhibit
      No.
            
            Description
      of Exhibit3.1
            Articles of Incorporation (1)3.2
            Bylaws (1)10.1
            Option agreement issued to Rodney Anderson on March 30,
    2009*10.2
            Option agreement issued to Joe Anderson on March 30,
  2009*10.3
            Option agreement issued to Robert Hasson on March 30,
  2009*31.1
            Certification pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002*31.2
            Certification pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002*32
            Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002*


* Filed
herewith.


(1)
Incorporated by reference from our Current Report on Form 8-K filed with the
Securities and Exchange Commission on July 15, 2003 as file number
002-95626-D.





74





SIGNATURES





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








SIONIX
      CORPORATIONJanuary
      13, 2010
              By:
              /s/ David
      R. WellsDavid
      R. WellsPresident,
      Chief Financial Officer, Principal Financial and Accounting
      Officer