UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q




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





For the
quarterly period ended December
31,
2008





 ̈
              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
                    (State
      or other jurisdiction of incorporation or organization)
                  87-0428526
                    (I.R.S. Employer Identification
      No.3880 East Eagle Drive, Anaheim,
      California
                    (Address
      of principal executive offices)
                  92807
                    (Zip
      Code)





Issuer’s
telephone number (714)
678-1000





(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. YesxNo ̈





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 February 19, 2009 the
number of shares of the registrant’s classes of common stock outstanding was
136,684,616.










Table of
Contents





Part
      I - Financial Information
                        
                        3Item
      1. Financial Statements
                        
                        3Balance
      Sheets as of December 31, 2008 (Unaudited) and September 30, 2008
      (Audited)
                        
                        3Statements
      of Income (Operations) (Unaudited) for the three month ended December 31,
      2008 and December 31, 2007 (Restated) and from inception (October 3, 1994)
      to December 31, 2008
                        
                        4Statement
      of Stockholders Equity (Deficit) (Unaudited) for the period from inception
      (October 3, 1994) to December 31, 2008
                        
                        5-7Statements
      of Cash Flows (Unaudited) for the three months ended December 31, 2008 and
      December 31, 2007 (Restated) and from inception (October 3, 1994) to
      December 31, 2008
                        
                        8Notes
      to unaudited 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
                        
                        66Item
      4T. Controls and Procedures
                        
                        66Part
      II – Other Information
                        
                        67Item
      1. Legal Proceedings
                        
                        67Item
      1A. Risk Factors
                        
                        67Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
                        
                        67Item
      3. Defaults Upon Senior Securities
                        
                        68Item
      4. Submission of Matters to a Vote of Security Holders
                        
                        68Item
      5. Other Information
                        
                        68Item
      6. Exhibits
                        
                        68Signatures
                        
                        70




2


Part
I, Item 1.  Financial Statements.





Sionix
Corporation


A
Development Stage Company


Balance
Sheet (Unaudited)


December
31, 2008





December 31,
                                    
                                    
                                    September 30,2008
                                    
                                    
                                    2008ASSETSCURRENT
      ASSETSCash
      and cash equivalents
                                    
                                    $
                                    565,224
                                    
                                    
                                    $
                                    1,220,588Inventory
                                    
                                    
                                    318,474Due
      from officer
                                    
                                    
                                    125,000
                                    
                                    
                                    
                                    92,500Other
      current assets
                                    
                                    
                                    56,872
                                    
                                    
                                    
                                    46,395TOTAL
      CURRENT ASSETS
                                    
                                    
                                    1,065,570
                                    
                                    
                                    
                                    1,359,483PROPERTY
      AND EQUIPMENT, net
                                    
                                    
                                    175,318
                                    
                                    
                                    
                                    87,101DEPOSITS
                                    
                                    
                                    33,095
                                    
                                    
                                    
                                    33,095TOTAL
      ASSETS
                                    
                                    $
                                    1,273,983
                                    
                                    
                                    $
                                    1,479,679LIABILITIES
      AND STOCKHOLDERS' DEFICITCURRENT
      LIABILITIESAccounts
      payable
                                    
                                    $
                                    459,014
                                    
                                    
                                    $
                                    259,355Accrued
      expenses
                                    
                                    
                                    2,842,435
                                    
                                    
                                    
                                    2,721,970Customer
      deposits
                                    
                                    
                                    1,260,000
                                    
                                    
                                    
                                    1,260,000Liquidated
      damages liability
                                    
                                    
                                    153,750
                                    
                                    
                                    
                                    153,750Notes
      payable to related parties
                                    
                                    
                                    114,000
                                    
                                    
                                    
                                    114,000Convertible
      notes, net
                                    
                                    
                                    2,004,333
                                    
                                    
                                    
                                    2,041,44310%
      subordinated notes payable, net
                                    
                                    
                                    425,000
                                    
                                    
                                    
                                    400,796Warrant
      and option liability
                                    
                                    
                                    1,844,207
                                    
                                    
                                    
                                    3,446,823Beneficial
      conversion feature
                                    
                                    
                                    
                                    
                                    
                                    
                                    26,000TOTAL
      CURRENT LIABILITIES
                                    
                                    
                                    9,102,739
                                    
                                    
                                    
                                    10,424,137STOCKHOLDERS'
      DEFICITCommon
      Stock (150,000,000 shares
      authorized; 136,684,616 shares issued; 136,202,716 shares
      outstanding)
                                    
                                    
                                    136,202
                                    
                                    
                                    
                                    134,274Additional
      paid-in capital
                                    
                                    
                                    12,979,393
                                    
                                    
                                    
                                    12,688,495Shares
      to be issued
                                    
                                    
                                    400
                                    
                                    
                                    
                                    126,429Deficit
      accumulated during development stage
                                    
                                    
                                    (20,944,751
                                    )
                                    
                                    
                                    (21,893,656
                                    )TOTAL
      STOCKHOLDERS' DEFICIT
                                    
                                    
                                    (7,828,756
                                    )
                                    
                                    
                                    (8,944,458
                                    )TOTAL
      LIABILITIES AND STOCKHOLDERS' DEFICIT
                                    
                                    $
                                    1,273,983
                                    
                                    
                                    $
                                    1,479,679





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


3


Sionix
Corporation


A
Development Stage Company


Statements
of Income (Operations) (Unaudited)





For the three months
                                                        
                                                        
                                                        Cummulative fromended December 31,
                                                        
                                                        
                                                        Inception2007
                                                        
                                                        
                                                        (October 3, 1994)2008
                                                        
                                                        
                                                        (As Restated)
                                                        
                                                        
                                                        to December 31, 2008Operating
      expensesGeneral
      and administrative
                                                        
                                                        $
                                                        621,543
                                                        
                                                        
                                                        $
                                                        5,064,569
                                                        
                                                        
                                                        $
                                                        21,396,823Research
      and development
                                                        
                                                        
                                                        178,963
                                                        
                                                        
                                                        
                                                        236,904
                                                        
                                                        
                                                        
                                                        3,215,836Depreciation
      and amortization
                                                        
                                                        
                                                        12,359
                                                        
                                                        
                                                        
                                                        8,157
                                                        
                                                        
                                                        
                                                        569,734Total
      operating expenses
                                                        
                                                        
                                                        812,865
                                                        
                                                        
                                                        
                                                        5,309,630
                                                        
                                                        
                                                        
                                                        25,182,393Loss
      from Operations
                                                        
                                                        
                                                        (812,865
                                                        )
                                                        
                                                        
                                                        (5,309,630
                                                        )
                                                        
                                                        
                                                        (25,182,393
                                                        )Other
      income (expense)Interest
      income
                                                        
                                                        
                                                        3,591
                                                        
                                                        
                                                        
                                                        917
                                                        
                                                        
                                                        
                                                        69,965Interest
      expense
                                                        
                                                        
                                                        (94,765
                                                        )
                                                        
                                                        
                                                        (506,726
                                                        )
                                                        
                                                        
                                                        (2,774,323
                                                        )Decrease
      in warrant liability
                                                        
                                                        
                                                        1,851,368
                                                        
                                                        
                                                        
                                                        759,773
                                                        
                                                        
                                                        
                                                        7,069,608Decrease
      (increase) in beneficialconversion
      features liability
                                                        
                                                        
                                                        26,000
                                                        
                                                        
                                                        
                                                        208,149
                                                        
                                                        
                                                        
                                                        1,426,767Impairment
      of intangibles
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (1,267,278
                                                        )Inventory
      obsolesence
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (365,078
                                                        )Legal
      settlement
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        344,949Loss
      on settlement of debt
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (484,577
                                                        )Write-off
      of property and equipment
                                                        
                                                        
                                                        (24,424
                                                        )
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (24,424
                                                        )Write-off
      of beneficial conversion
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (125,015
                                                        )feature
      and discount
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        380,440
                                                        
                                                        
                                                        
                                                        380,440Total
      Other Income (Expense)
                                                        
                                                        
                                                        1,761,770
                                                        
                                                        
                                                        
                                                        842,553
                                                        
                                                        
                                                        
                                                        4,251,034Loss
      before income taxes
                                                        
                                                        
                                                        948,905
                                                        
                                                        
                                                        
                                                        (4,467,077
                                                        )
                                                        
                                                        
                                                        (20,931,359
                                                        )Income
      Taxes
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        900
                                                        
                                                        
                                                        
                                                        13,392Net
      Income (Loss)
                                                        
                                                        $
                                                        948,905
                                                        
                                                        
                                                        $
                                                        (4,467,977
                                                        )
                                                        
                                                        $
                                                        (20,944,751
                                                        )Basic
      income (loss) per share
                                                        
                                                        $
                                                        0.01
                                                        
                                                        
                                                        $
                                                        (0.04
                                                        )Dilutive
      income (loss) per share
                                                        
                                                        $
                                                        0.01
                                                        
                                                        
                                                        $
                                                        (0.04
                                                        )Basic
      and dilutive wighted average nubmer ofshares
      of Common Stock outstanding
                                                        
                                                        
                                                        135,582,425
                                                        
                                                        
                                                        
                                                        106,635,201





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


4


SIONIX
CORPORATION


(A
DEVELOPMENT STAGE COMPANY)


STATEMENTS
OF STOCKHOLDERS’ EQUITY (DEFICIT)


FOR
THE PERIOD FROM INCEPTION (OCTOBER 3, 1994) TO DECEMBER 31, 2008


(UNAUDITED)





Deficit
                                                                                              
                                                                                              
                                                                                              TotalCommon Stock
                                                                                              
                                                                                              
                                                                                              Additional
                                                                                              
                                                                                              
                                                                                              Stock
                                                                                              
                                                                                              
                                                                                              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 cashOctober
      3, 1994
                                                                                              
                                                                                              
                                                                                              10,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              10
                                                                                              
                                                                                              
                                                                                              $
                                                                                              90
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              $
                                                                                              100Net
      loss from October 3,1994,
      to December 31, 1994
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (1,521
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (1,521
                                                                                              )Balance
      at December 31, 1994
                                                                                              
                                                                                              
                                                                                              10,000
                                                                                              
                                                                                              
                                                                                              
                                                                                              10
                                                                                              
                                                                                              
                                                                                              
                                                                                              90
                                                                                              
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              (1,521
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (1,421
                                                                                              )Shares
      issued forassignment
      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 forsubscription
      receivable
                                                                                              
                                                                                              
                                                                                              414,200
                                                                                              
                                                                                              
                                                                                              
                                                                                              414
                                                                                              
                                                                                              
                                                                                              
                                                                                              1,652,658
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (1,656,800
                                                                                              )
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (3,728
                                                                                              )Shares
      issued forproductions
      costs
                                                                                              
                                                                                              
                                                                                              112,500
                                                                                              
                                                                                              
                                                                                              
                                                                                              113
                                                                                              
                                                                                              
                                                                                              
                                                                                              674,887
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (675,000
                                                                                              )
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              -Net
      loss for the year endedDecember
      31, 1995
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (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 for the year endedSeptember
      30, 1996
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (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 for the year endedSeptember
      30, 1997
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (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 for the year endedSeptember
      30, 1998
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (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 for the year endedSeptember
      30, 1999
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (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 for the year endedSeptember
      30, 2000
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              (2,414,188
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (2,414,188
                                                                                              )


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


5


SIONIX
CORPORATION


(A
DEVELOPMENT STAGE COMPANY)


STATEMENTS
OF STOCKHOLDERS’ EQUITY (DEFICIT) – Continued


FOR
THE PERIOD FROM INCEPTION (OCTOBER 3, 1994) TO DECEMBER 31, 2008


(UNAUDITED)





Deficit
                                                                  
                                                                  
                                                                  TotalCommon Stock
                                                                  
                                                                  
                                                                  Additional
                                                                  
                                                                  
                                                                  Stock
                                                                  
                                                                  
                                                                  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)Balance
      at September 30, 2000
                                                                  
                                                                  
                                                                  54,166,322
                                                                  
                                                                  
                                                                  
                                                                  54,166
                                                                  
                                                                  
                                                                  
                                                                  8,104,350
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  (8,168,751
                                                                  )
                                                                  
                                                                  
                                                                  (10,235
                                                                  )Shares
      issued for servicesand
      prepaid expenses
                                                                  
                                                                  
                                                                  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 fordebt
      (639,509 shares)
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  103,295
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  103,295Net
      loss for the year endedSeptember
      30, 2001
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  (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 servicesand
      prepaid expenses
                                                                  
                                                                  
                                                                  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 forservices
      related to raisingequity
      (967,742 shares)
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  (300,000
                                                                  )
                                                                  
                                                                  
                                                                  300,000
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  -Cancellation
      of shares
                                                                  
                                                                  
                                                                  (7,533,701
                                                                  )
                                                                  
                                                                  
                                                                  (7,534
                                                                  )
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  (7,534
                                                                  )Net
      loss for the year endedSeptember
      30, 2002
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  (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 servicesand
      prepaid expenses
                                                                  
                                                                  
                                                                  2,467,742
                                                                  
                                                                  
                                                                  
                                                                  2,468
                                                                  
                                                                  
                                                                  
                                                                  651,757
                                                                  
                                                                  
                                                                  
                                                                  (300,000
                                                                  )
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  354,225Shares
      issued for capitalequity
      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 for the year endedSeptember
      30, 2003
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  (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 capitalequity
      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 relatedto
      2004 stock purchase
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  24,366
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  24,366Net
      loss for the year endedSeptember
      30, 2004
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  (1,593,136
                                                                  )
                                                                  
                                                                  
                                                                  (1,593,136
                                                                  )


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


6




SIONIX
CORPORATION


(A
DEVELOPMENT STAGE COMPANY)


STATEMENTS
OF STOCKHOLDERS’ EQUITY (DEFICIT) - Continued


FOR
THE PERIOD FROM INCEPTION (OCTOBER 3, 1994) TO DECEMBER 31, 2008


(UNAUDITED)




Deficit
                                                                                    
                                                                                    
                                                                                    TotalCommon Stock
                                                                                    
                                                                                    
                                                                                    Additional
                                                                                    
                                                                                    
                                                                                    Stock
                                                                                    
                                                                                    
                                                                                    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)Balance
      at September 30, 2004,Restated
                                                                                    
                                                                                    
                                                                                    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 for the year endedSeptember
      30, 2005
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (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 for the year endedSeptember
      30, 2006
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (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
                                                                                    )Shares
      issued for services
                                                                                    
                                                                                    
                                                                                    4,592,915
                                                                                    
                                                                                    
                                                                                    
                                                                                    4,593
                                                                                    
                                                                                    
                                                                                    
                                                                                    80,336
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    84,929Reclassification
      of 2001Executive
      Option Planas
      of July 17, 2007
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (2,271,879
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (2,271,879
                                                                                    )Reclassification
      ofbeneficial
      conversionfeatures
      liability related toadvisory
      boardcompensation
      as of July 17, 2007
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (269,851
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (269,851
                                                                                    )Reclassification
      of warrantsrelated
      to 2004 stockpurchase
      agreementas
      of July 17, 2007
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (70,029
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (70,029
                                                                                    )Net
      loss for the year endedSeptember
      30, 2007
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (2,168,226
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (2,168,226
                                                                                    )Balance
      at September 30, 2007,
                                                                                    
                                                                                    
                                                                                    106,635,201
                                                                                    
                                                                                    
                                                                                    
                                                                                    106,635
                                                                                    
                                                                                    
                                                                                    
                                                                                    10,762,982
                                                                                    
                                                                                    
                                                                                    
                                                                                    43,900
                                                                                    
                                                                                    
                                                                                    
                                                                                    -
                                                                                    
                                                                                    
                                                                                    
                                                                                    -
                                                                                    
                                                                                    
                                                                                    
                                                                                    -
                                                                                    
                                                                                    
                                                                                    
                                                                                    (18,020,836
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (7,107,319
                                                                                    )Shares
      issued for services
                                                                                    
                                                                                    
                                                                                    1,539,750
                                                                                    
                                                                                    
                                                                                    
                                                                                    1,540
                                                                                    
                                                                                    
                                                                                    
                                                                                    254,330
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    255,870Shares
      to be issued for services
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    126,029
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    126,029Shares
      converted from debt
                                                                                    
                                                                                    
                                                                                    17,149,359
                                                                                    
                                                                                    
                                                                                    
                                                                                    17,149
                                                                                    
                                                                                    
                                                                                    
                                                                                    886,633
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    903,782Shares
      issued for cash
                                                                                    
                                                                                    
                                                                                    8,950,003
                                                                                    
                                                                                    
                                                                                    
                                                                                    8,950
                                                                                    
                                                                                    
                                                                                    
                                                                                    784,550
                                                                                    
                                                                                    
                                                                                    
                                                                                    (43,500
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    750,000Net
      loss for the year endedSeptember
      30, 2008
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (3,872,820
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (3,872,820
                                                                                    )Balance
      at September 30, 2008
                                                                                    
                                                                                    
                                                                                    134,274,313
                                                                                    
                                                                                    
                                                                                    
                                                                                    134,274
                                                                                    
                                                                                    
                                                                                    
                                                                                    12,688,495
                                                                                    
                                                                                    
                                                                                    
                                                                                    126,429
                                                                                    
                                                                                    
                                                                                    
                                                                                    -
                                                                                    
                                                                                    
                                                                                    
                                                                                    -
                                                                                    
                                                                                    
                                                                                    
                                                                                    -
                                                                                    
                                                                                    
                                                                                    
                                                                                    (21,893,656
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (8,944,458
                                                                                    )Shares
      issued for services
                                                                                    
                                                                                    
                                                                                    600,139
                                                                                    
                                                                                    
                                                                                    
                                                                                    600
                                                                                    
                                                                                    
                                                                                    
                                                                                    125,429
                                                                                    
                                                                                    
                                                                                    
                                                                                    (126,029
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    -Shares
      converted from debt
                                                                                    
                                                                                    
                                                                                    494,930
                                                                                    
                                                                                    
                                                                                    
                                                                                    495
                                                                                    
                                                                                    
                                                                                    
                                                                                    41,302
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    41,797Shares
      issued for propertyand
      equipment
                                                                                    
                                                                                    
                                                                                    833,333
                                                                                    
                                                                                    
                                                                                    
                                                                                    833
                                                                                    
                                                                                    
                                                                                    
                                                                                    124,167
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    125,000Net
      income for the three months endedDecember 31,
      2008
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    948,905
                                                                                    
                                                                                    
                                                                                    
                                                                                    948,905136,202,715
                                                                                    
                                                                                    
                                                                                    $
                                                                                    136,202
                                                                                    
                                                                                    
                                                                                    $
                                                                                    12,979,393
                                                                                    
                                                                                    
                                                                                    $
                                                                                    400
                                                                                    
                                                                                    
                                                                                    $
                                                                                    -
                                                                                    
                                                                                    
                                                                                    $
                                                                                    -
                                                                                    
                                                                                    
                                                                                    $
                                                                                    -
                                                                                    
                                                                                    
                                                                                    $
                                                                                    (20,944,751
                                                                                    )
                                                                                    
                                                                                    $
                                                                                    (7,828,756
                                                                                    )





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


7


Sionix
Corporation


A
Development Stage Company


Statement
of Cash Flows (Unaudited)





CummulativeFor the Three Months
                                      
                                      
                                      fromEnded Deceember 31,
                                      
                                      
                                      Inception2007
                                      
                                      
                                      (October 3, 1994) to2008
                                      
                                      
                                      (As Restated)
                                      
                                      
                                      December 31,2008Operating
      activities:Net
      income (loss)
                                      
                                      $
                                      948,905
                                      
                                      
                                      $
                                      (4,494,289
                                      )
                                      
                                      $
                                      (20,944,751
                                      )Adjustments
      to reconcile net loss to net cash used inoperating
      activities:Depreciation
                                      
                                      
                                      12,359
                                      
                                      
                                      
                                      8,157
                                      
                                      
                                      
                                      656,651Amortization
      of beneficial conversion features discount andwarrant
      discount
                                      
                                      
                                      27,094
                                      
                                      
                                      
                                      405,651
                                      
                                      
                                      
                                      2,074,433Stock
      based compensation expense - employee
                                      
                                      
                                      238,244
                                      
                                      
                                      
                                      1,791,360
                                      
                                      
                                      
                                      3,917,146Stock
      based compensation expense - consultant
                                      
                                      
                                      10,508
                                      
                                      
                                      
                                      3,038,421
                                      
                                      
                                      
                                      6,661,099Impairment
      of assets
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      514,755Write-down
      of obsolete assets
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      38,862Impairment
      of intangible assets
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      1,117,601Loss
      on settlement of debt
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      384,577Loss
      on lease termination
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      125,015Write-off
      of property and equipment
                                      
                                      
                                      57,581
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      57,581Write-off
      of beneficial conversion features
                                      
                                      
                                      
                                      
                                      
                                      
                                      (380,440
                                      )
                                      
                                      
                                      (576,000
                                      )Stock
      issued for services and rent
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      114,850Accrual
      of liquidating damages
                                      
                                      
                                      
                                      
                                      
                                      
                                      46,125
                                      
                                      
                                      
                                      153,750Other
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (799,044
                                      )(Increase)
      decrease in assets:Inventory
                                      
                                      
                                      (318,474
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (318,474
                                      )Due
      from officer
                                      
                                      
                                      (32,500
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      (125,000
                                      )Other
      current assets
                                      
                                      
                                      (10,477
                                      )
                                      
                                      
                                      (650
                                      )
                                      
                                      
                                      (56,872
                                      )Other
      assets
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (133,095
                                      )Increase
      (decrease) in liabilities:Accounts
      payable
                                      
                                      
                                      199,660
                                      
                                      
                                      
                                      187,455
                                      
                                      
                                      
                                      615,179Accrued
      expenses
                                      
                                      
                                      122,261
                                      
                                      
                                      
                                      79,331
                                      
                                      
                                      
                                      2,859,973Customer
      deposits
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      1,260,000Warrant
      liability
                                      
                                      
                                      (1,851,368
                                      )
                                      
                                      
                                      (765,855
                                      )
                                      
                                      
                                      (7,069,608
                                      )Beneficial
      conversion feature liability
                                      
                                      
                                      (26,000
                                      )
                                      
                                      
                                      (208,149
                                      )
                                      
                                      
                                      (1,426,768
                                      )Net
      cash used in operating activities
                                      
                                      
                                      (622,207
                                      )
                                      
                                      
                                      (292,883
                                      )
                                      
                                      
                                      (10,898,140
                                      )Investing
      activities:Acquisition
      of property and equipment
                                      
                                      
                                      (3,157
                                      )
                                      
                                      
                                      (26,666
                                      )
                                      
                                      
                                      (471,164
                                      )Acquisition
      of patents
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (154,061
                                      )Net
      cash used in investing activities
                                      
                                      
                                      (3,157
                                      )
                                      
                                      
                                      (26,666
                                      )
                                      
                                      
                                      (625,225
                                      )Financing
      activities:Payment
      on notes payable to officer
                                      
                                      
                                      
                                      
                                      
                                      
                                      (19,260
                                      )
                                      
                                      
                                      (218,502
                                      )Proceeds
      from notes payable, related party
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      442,433Payments
      on notes payable to related party
                                      
                                      
                                      
                                      
                                      
                                      
                                      (5,000
                                      )
                                      
                                      
                                      428,664Receipt
      from (payments to) equity line of credit
                                      
                                      
                                      
                                      
                                      
                                      
                                      (27,336
                                      )Proceeds
      from convertible notes payable
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      3,286,000Issuance
      of common stock
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      8,179,594Receipt
      of cash for stock to be issued
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      400Net
      cash provided by (used in) financing activities
                                      
                                      
                                      -
                                      
                                      
                                      
                                      (51,596
                                      )
                                      
                                      
                                      12,118,589Net
      increase (decrease) in cash and cash equivalents
                                      
                                      
                                      (625,364
                                      )
                                      
                                      
                                      (371,145
                                      )
                                      
                                      
                                      595,224Cash
      and cash equivalents balances:Beginning
      of period
                                      
                                      
                                      1,220,588
                                      
                                      
                                      
                                      372,511End
      of month
                                      
                                      $
                                      595,224
                                      
                                      
                                      $
                                      1,366
                                      
                                      
                                      $
                                      595,224Cash
      and cash equivalents paid for:Interest
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -Income
      taxes
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -





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


8




Sionix
Corporation


A
Development Stage Company


December
31, 2008




Notes
to Financial Statements (Unaudited)




Note 1
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
SUMMARY OF 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 collectibility 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.




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.




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. Total advertising costs were $0 and
$2,474 for the three months ended December 31, 2008 and 2007,
respectively.




9




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).




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




For the Three Months Ended December 31,2008
                                
                                
                                2007Net
                                
                                
                                
                                
                                
                                Per
                                
                                
                                Net
                                
                                
                                
                                
                                
                                PerIncome
                                
                                
                                Shares
                                
                                
                                Share
                                
                                
                                Loss
                                
                                
                                Shares
                                
                                
                                ShareBasic
      Earnings Per ShareNet
      Income (Loss) Availableto Stockholders
                                
                                $
                                948,905
                                
                                
                                
                                113,727,973
                                
                                
                                $
                                0.01
                                
                                
                                $
                                4,467,977
                                
                                
                                
                                106,635,201
                                
                                
                                $
                                0.04Effect
      of Dilutive Securities
                                
                                
                                (203,523
                                )
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -Diluted
      Earnings Per Share
                                
                                $
                                745,382
                                
                                
                                
                                113,727,973
                                
                                
                                $
                                0.01
                                
                                
                                $
                                4,467,977
                                
                                
                                
                                106,635,201
                                
                                
                                $
                                0.04




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




As of
December 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.




RECLASSIFICATIONS




Certain
items in the prior 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:




10




December 31,
                    
                    
                    September 30,2008
                    
                    
                    2008(Unaudited)
                    
                    
                    (Audited)Machinery
      and equipment
                    
                    $
                    367,003
                    
                    
                    $
                    243,712Furniture
      and fixtures
                    
                    
                    41,176
                    
                    
                    
                    41,176Leasehold
      improvement
                    
                    
                    1,695
                    
                    
                    
                    24,408TOTAL
      PROPERTY AND EQUIPMENT
                    
                    
                    409,874
                    
                    
                    
                    309,296Less
      accumulated depreciation
                    
                    
                    (234,556
                    )
                    
                    
                    (222,195
                    )NET
      PROPERTY AND EQUIPMENT
                    
                    $
                    175,318
                    
                    
                    $
                    87,101




Depreciation
expenses for the three months ended December 31, 2008 and 2007 were $12,359 and
$8,157, respectively.




Note 4
ACCRUED EXPENSES




Accrued
expenses consisted of the following at:




December 31,
                  
                  
                  September 30,2008
                  
                  
                  2008(Unaudited)
                  
                  
                  (Audited)Accrued
      salaries
                  
                  $
                  1,571,867
                  
                  
                  $
                  1,493,444Advisory
      board compensation
                  
                  
                  576,000
                  
                  
                  
                  576,000Auto
      allowance accruals
                  
                  
                  100,634
                  
                  
                  
                  94,408Interest
      payable
                  
                  
                  337,890
                  
                  
                  
                  272,016Other
      accruals
                  
                  
                  256,044
                  
                  
                  
                  286,102TOTAL
      ACCRUED EXPENSES
                  
                  $
                  2,842,435
                  
                  
                  $
                  2,721,970




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 December 31, 2008, customer deposits were
$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 December 31, 2008 and
September 30, 2008, notes payable amounted to $114,000. Accrued interest on the
notes amounted to $77,470 and 74,482 at December 31, 2008 and September 30,
2008, respectively, and is included in accrued expenses. Interest expenses on
these notes for the quarters ended December 31, 2008 and 2007 amounted to $2,987
and $3,239, respectively.




11




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 December 31, 2008 the conversion
price was $0.04 per share.




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 Sholes valuation modelwith the following
assumptions: risk free rate of return of 2.02% to 5.09%; volatility of 268% to
275%; dividend yield of 0% and an 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
December 31, 2008, 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.




For the
three months ended December 31, 2008, interest expense was $13,556, which was
included in the other income (expense) section of the statement of income
(operations).




For the
three months ended December 31, 2007, interest expense was $19,375, and
amortization expense for the embedded beneficial conversion feature discount was
$125,000, which was included in interest expense in the other income (expense)
section of the statement of income (operations).




12




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 matured on December
31, 2008. 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.




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 Sholes valuation model with the following assumptions:
risk free rate of return of 4.96%; volatility of 259.58%; dividend yield of 0%
and an 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
December 31, 2008, the outstanding principal amount of the convertible notes was
$26,000 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.




For the
three months ended December 31, 2008, interest expense was $667, 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 income (operations).




13




For the
three months ended December 31, 2007, interest expense was $2,191, and
amortization expense for the embedded beneficial conversion feature discount was
$14,313, which was included in interest expense in the other income (expense)
section of the statement of income (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, which have not been paid as
of December 31, 2008. As of and for the three months ended December 31,2008 and
2007, the Company recorded $0 and $61,500 as liquidated damages, respectively.
No derivative liability is recorded as the amount of liquidated damage is fixed
with a maximum ceiling.




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 Sholes valuation model with the following assumptions: risk free rate of
return of 4.96% to 5.02%; volatility of 219.89% to 226.04%; dividend yield of 0%
and an 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.




14




The fair
value of the embedded beneficial conversion features was $594,811 at the date of
issuance using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 4.96% to 5.02%; volatility of 219.89%
to 226.04%; dividend yield of 0% and an 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-Sholes 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 five years.




As of
December 31, 2008, the outstanding principal amount of the convertible notes was
$455,000, 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, $30,000 of principal has been
converted into 200,000 shares of Common Stock and the Company has not repaid the
remaining outstanding principal amount or accrued interest of the convertible
notes.




For the
three months ended December 31, 2008, interest expense was $9,495, which was
included in the other income (expense) section of the statement of income
(operations).




For the
three months ended December 31, 2007, interest expense was $20,119, amortization
expense for the warrant discount was $107,547, 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
$148,702, which was also included in interest expense in the other income
(expense) section of the statement of income (operations).




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 orsooner
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.


15




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
December 31, 2008, the principal outstanding totaled $1,000,000.




For the
three months ended December 31, 2008, interest expense was $30,247.




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-Sholes valuation model, using the following
assumptions: risk free rate of return of 2.64% to 3.26%, volatility of 97.08% to
98.27%, dividend yield of 0% and expected life of six years. As a result, the
relative fair value of the warrants was determined to be $96,814.




As of
December 31, 2008, 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.




For the
three months ended December 31, 2008, interest expense was $10,719, 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
income (operations).




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 contractsthat
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.




16


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 Sholes valuation model with the
following assumptions: risk free rate of return of 5.02%; volatility of 219.89%;
dividend yield of 0%; and an 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the options issued remained derivatives as of
December 31, 2008. 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 $232,514 as of December 31, 2008, calculated using the
Black Sholes valuation model with the following assumptions: risk free rate of
return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 2.25 years.




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




For the
three months ended December 31, 2008, the decrease in the fair value of the
options was recorded by decreasing warrant liability on the balance sheet by
$251,926.




For the
three months ended December 31, 2007, the decrease in the fair value of the
options was recorded by decreasing warrant liability on the balance sheet by
$703,326.




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
contractsthat 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 Sholes valuation modelwith the following
assumptions: risk free rate of return of 4.96% to 5.02%; volatility of 219.89%
to 226.04%; dividend yield of 0% and an 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the options issued remained derivatives as of
December 31, 2008. 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 $80,691 ($66,613 attributable to the
holders of the Convertible Notes 3 and $14,078 attributable to the placement
fee) as of December 31, 2008, which was calculated using the Black Sholes
valuation model with the following assumptions: risk free rate of return of
0.37%; volatility of 88.62%; dividend yield of 0%; and an expected term of 3.42
to 3.50 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 Sholes model with the
following assumptions: risk free rate of return of 1.78%; volatility of 84.94%;
dividend yield of 0%; and an expected term of 3.67 to 3.75 years.




The
decrease in the fair value of the warrants for the three months ended December
31, 2008 was recorded by decreasing warrant liabilities on the balance sheet by
$73,098 ($58,827 attributable to the holders of the Convertible Notes 3 and
$14,271 attributable to the placement fee).




The
decrease in the fair value of the warrants for the three months ended December
31, 2007 was recorded by decreasing warrant liabilities on the balance sheet by
$178,155 ($125,228 attributable to the holders of the Convertible Notes 3 and
$52,927 attributable to the placement fee).




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
contractsthat 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 $32,394 at the date of issuance and was calculated
using the Black Sholes 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.




18


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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the options issued remained derivatives as of
December 31, 2008. 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 $5,447 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 3.75 years.




The
decrease in the fair value of the warrant was $5,061 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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 four 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 contractsthat 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 Sholes 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the options issued remained derivatives as of
December 31, 2008. 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 $325,098 as of December 31, 2008,
using the Black Sholes valuation model with the following assumptions: risk free
rate of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an
expected term of 3.92 years.




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




19


The
decrease in the fair value of the warrant was $295,356 for the three months
ended December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




The
decrease in the fair value of the warrants was $24,404 for the three months
ended December 31, 2007, and recorded by decreasing the warrant liability on the
balance sheet.




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
contractsthat 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 Sholes 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the option remained a derivative as of December 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. 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 $37,627 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 3.92 years.




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




The
decrease in the fair value of the option was $34,184 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




The
increase in the fair value of the option was $5,945 for the three months ended
December 31, 2007, and recorded by decreasing the warrant liability on the
balance sheet.




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.




20


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
contractsthat 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 Sholes 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the option remained a derivative as of December 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. 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 $37,627 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 3.92 years.




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




The
decrease in the fair value of the option was $34,185 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




The
increase in the fair value of the option was $5,945 for the three months ended
December 31, 2007, and recorded by decreasing the warrant liability on the
balance sheet.




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




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 contractsthat 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
liabilityinstruments. 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.




21


The fair
value of the option was $1,448,321 at the date of issuance, which was calculated
using the Black Sholes model with the following assumptions: risk free rate of
return of 3.26%; volatility of 98.01%; dividend yield of 0%; and an 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the option remained a derivative as of December 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. 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 $110,380 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 3.92 years.




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




The
decrease in the fair value of the option was $502,843 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




The
increase in the fair value of the option was $67,111 for the three months ended
December 31, 2007, and recorded by increasing the warrant liability 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 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.




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
contractsthat 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 Sholes 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.




22


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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrant remained a derivative as of December 31,
2008. 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 $321,308 as of December 31, 2008,
using the Black Sholes valuation model with the following assumptions: risk free
rate of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an
expected term of 3.92 years.




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




The
decrease in the fair value of the warrant was $291,915 for the three months
ended December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




The
increase in the fair value of the warrant was $67,111 for the three months ended
December 31, 2007, and recorded by increasing the warrant liability on the
balance sheet.




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 contractsthat 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 $96,814 at the date of issuance,
which was calculated using the Black-Sholes 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrants issued remained derivatives as of
December 31, 2008. 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.




23


The fair
value of the warrants was determined to be $30,091 as of December 31, 2008,
using the Black Sholes valuation model with the following assumptions: risk free
rate of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an
expected term of 5.08 years.




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




The
decrease in the fair value of the warrants was $22,518 for the three months
ended December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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 contractsthat 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 Sholes valuation model, using the following
assumptions: risk free rate of return of 1.32% to 2.17%, volatility of 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrants issued remained derivatives as of
December 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. 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 $344,033 as of December 31, 2008,
using the Black Sholes valuation model with the following assumptions: risk free
rate of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an
expected term of 2.17 to 2.33 years.




The
decrease in the fair value of the warrants was $124,046 for the three months
ended December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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.




24


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
contractsthat 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 Sholes 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrant remained a derivative as of December 31,
2008. 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 $22,294 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 5.42 years.




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




The
decrease in the fair value of the warrant was $16,508 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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
contractsthat 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 Sholes 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.




25


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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrant issued remained a derivative as of
December 31, 2008. 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 $20,957 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 4.50 years.




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




The
decrease in the fair value of the warrant was $17,802 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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
contractsthat 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 Sholes 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrant remained a derivative as of December 31,
2008. 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 $20,957 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 4.50 years.




26


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




The
decrease in the fair value of the warrant was $17,802 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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
contractsthat 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 Sholes 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.




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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrant remained a derivative as of December 31,
2008. 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 $35,994 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 5.50 years.




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




The
decrease in the fair value of the warrant was $26,518 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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.




27


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
contractsthat 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 Sholes 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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the warrant remained a derivative as of December 31,
2008. 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 $64,589 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 4.67 years.




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




The
decrease in the fair value of the warrant was $53,962 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




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 contractsthat 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
liabilityinstruments. 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 Sholes valuation model with the following assumptions: risk free
rate of return of 1.16%; volatility of 89.31%; dividend yield of 0%; and an
expected term of 5 years.




28


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 December 31, 2008 by following the guidance of SFAS 133,
paragraph 6 to ascertain if the option remained a derivative as of December 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. 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 $154,600 as of December 31, 2008, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 0.37%; volatility of 88.62%; dividend yield of 0%; and an expected
term of 3.92 years.




The
decrease in the fair value of the option was $83,644 for the three months ended
December 31, 2008, and recorded by decreasing the warrant liability on the
balance sheet.




Note 10
BENEFICIAL CONVERSION FEATURES LIABILITY




The
Company issued convertible notes between October 17, 2006 and July 17, 2007 that
matured or mature 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.




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 Sholes valuation modelwith the following
assumptions: risk free rate of return of 2.02% to 5.09%; volatility of 108.5% to
274.86%; dividend yield of 0% and an 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  weredetermined 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.




29


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




The
decrease in the fair value of the embedded beneficial conversion feature for the
three months ended December 31, 2008 of $26,000 was recorded by decreasing
beneficial conversion features liability on the balance sheet.




Note 11
STOCKHOLDERS’ EQUITY




COMMON
STOCK




The
Company has 150,000,000 authorized shares, par value $0.001 per
share.  As of September 30, 2008 and 2007, the Company had 134,756,213
and 107,117,101 shares of Common Stock issued, and 134,274,313 and 106,635,201
shares of Common Stock outstanding, respectively.




During
the three months ended December 31, 2008 the Company issued 494,930 shares of
common stock for $40,000 of convertible debt and $1,796 of accrued interest at
conversion prices between $0.04 and $0.15. Additionally, the Company issued
833,333 shares of common stock for $125,000 for machinery and equipment from RJ
Metals Co. Lastly, the Company issued 600,139 shares of common stock to legal
counsel for $126,029, the fair value of the stock on the date of
issuance.




The
Company has not issued 13,333 shares of Common Stock representing $400 to
certain investors pursuant to the terms of an offering undertaken by the Company
in 2004. The investment was made and funds deposited into the Company’s bank
accounts between February 9, 2004, and August 25, 2004.  The
investment has been recorded on the Company’s balance sheet in the Stockholders’
Deficit section as “Shares to be Issued”.




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
                                      
                                      
                                      
                                      11,967,666
                                      
                                      
                                      $
                                      -Granted
                                      
                                      
                                      0.25
                                      
                                      
                                      
                                      3,500,000
                                      
                                      
                                      
                                      -Expired
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Forfeited
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Exercised
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Outstanding
      at December 31, 2008
                                      
                                      $
                                      0.20
                                      
                                      
                                      
                                      15,467,666
                                      
                                      
                                      $
                                      -
  Options
outstanding as of December 31, 2008:
  WeightedAverageRemaining
                                                                                                                        
                                                                                                                        Weighted AverageExercise
                                                                                                                        
                                                                                                                        Options
                                                                                                                        
                                                                                                                        Options
                                                                                                                        
                                                                                                                        Contractual
                                                                                                                        
                                                                                                                        Exercise PricePrice
                                                                                                                        
                                                                                                                        Outstanding
                                                                                                                        
                                                                                                                        Exercisable
                                                                                                                        
                                                                                                                        Life
                                                                                                                        
                                                                                                                        Outstanding
                                                                                                                        
                                                                                                                        Exercisable$0.15 - $0.25
                                                                                                                        
                                                                                                                        15,467,666
                                                                                                                        
                                                                                                                        15,467,666
                                                                                                                        
                                                                                                                        3.37
                                                                                                                        
                                                                                                                        $
                                                                                                                        0.20
                                                                                                                        
                                                                                                                        $
                                                                                                                        0.20




30




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
                  
                  
                  
                  2.25Director
                  
                  
                  1,000,000
                  
                  
                  
                  0.25
                  
                  
                  
                  1,000,000
                  
                  
                  
                  0.25
                  
                  
                  
                  3.92Former
      Chief Financial Officer
                  
                  
                  1,000,000
                  
                  
                  
                  0.25
                  
                  
                  
                  1,000,000
                  
                  
                  
                  0.25
                  
                  
                  
                  3.92Former
      Chief Executive Officer
                  
                  
                  2,933,526
                  
                  
                  
                  0.25
                  
                  
                  
                  2,933,526
                  
                  
                  
                  0.25
                  
                  
                  
                  3.92Former
      Chief Executive Officer
                  
                  
                  3,500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  3,500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  4.83




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
                      
                      
                      
                      39,365,766
                      
                      
                      $
                      -Granted
                      
                      
                      0.25
                      
                      
                      
                      150,000
                      
                      
                      
                      -Expired
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Forfeited
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Exercised
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Outstanding
      at December 31, 2008
                      
                      $
                      0.20
                      
                      
                      
                      39,515,766
                      
                      
                      $
                      -




Warrants
outstanding as of December 31, 2008:




WeightedAverageRemaining
                                                  
                                                  
                                                  Weighted AverageExercise
                                                  
                                                  Warrants
                                                  
                                                  Options
                                                  
                                                  Contractual
                                                  
                                                  
                                                  Exercise PricePrice
                                                  
                                                  Outstanding
                                                  
                                                  Exercisable
                                                  
                                                  Life
                                                  
                                                  
                                                  Outstanding
                                                  
                                                  
                                                  Exercisable$0.10
      - $0.40
                                                  
                                                  39,515,766
                                                  
                                                  39,515,766
                                                  
                                                  3.37
                                                  
                                                  $
                                                  0.20
                                                  
                                                  $
                                                  0.20




31




WeightedAverageOutstanding
                  
                  
                  Exercisable
                  
                  
                  RemainingWarrant
                  
                  
                  
                  
                  Exercise
                  
                  
                  
                  
                  
                  Exercise
                  
                  
                  ContractualHolder
                  
                  Amount
                  
                  
                  Price
                  
                  
                  Amount
                  
                  
                  Price
                  
                  
                  LifeConvertible
      Notes 3
                  
                  
                  2,795,454
                  
                  
                  $
                  0.30
                  
                  
                  
                  2,795,454
                  
                  
                  $
                  0.30
                  
                  
                  
                  3.50Richarson
      & Patel LLP
                  
                  
                  150,000
                  
                  
                  
                  0.25
                  
                  
                  
                  150,000
                  
                  
                  
                  0.25
                  
                  
                  
                  3.75Advisory
      Board Members
                  
                  
                  8,640,000
                  
                  
                  
                  0.25
                  
                  
                  
                  8,640,000
                  
                  
                  
                  0.25
                  
                  
                  
                  3.92Consultant
                  
                  
                  8,539,312
                  
                  
                  
                  0.25
                  
                  
                  
                  8,539,312
                  
                  
                  
                  0.25
                  
                  
                  
                  3.9210%
      Subordinated Notes Payable
                  
                  
                  850,000
                  
                  
                  
                  0.40
                  
                  
                  
                  850,000
                  
                  
                  
                  0.40
                  
                  
                  
                  5.08Stockholders
                  
                  
                  15,000,000
                  
                  
                  
                  0.10
                  
                  
                  
                  15,000,000
                  
                  
                  
                  0.10
                  
                  
                  
                  2.27Richarson
      & Patel LLP
                  
                  
                  400,000
                  
                  
                  
                  0.15
                  
                  
                  
                  400,000
                  
                  
                  
                  0.15
                  
                  
                  
                  5.42Director
                  
                  
                  500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  4.50Director
                  
                  
                  500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  4.50Richarson
      & Patel LLP
                  
                  
                  641,000
                  
                  
                  
                  0.15
                  
                  
                  
                  641,000
                  
                  
                  
                  0.15
                  
                  
                  
                  5.50Advisory
      Board Member
                  
                  
                  1,500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  1,500,000
                  
                  
                  
                  0.25
                  
                  
                  
                  4.67




Note 12
GOING CONCERN




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 December 31, 2008, the Company has incurred
cumulative losses of $20,944,751 including net income for the three months ended
December 31, 2008 of $948,905. 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.




32




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




On
February 19, 2007 the Company entered into a two year lease agreement beginning
March 1, 2007. According to the terms of the agreement, at the beginning of each
lease year, the then most recently published Consumer Price Index (CPI) figure
shall be determined and the monthly rental payable for the succeeding lease year
will be calculated. The future aggregate minimum annual lease payments arising
from the lease agreement are as follows.




For
      the Year Ended September 30,2009
                      
                      $
                      17,250




Total
rent expense under the operating lease was approximately $55,200 for the year
ended September 30, 2008.





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
                      
                      $
                      78,3682010
                      
                      
                      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 494,930 shares of Common Stock for the conversion of notes
payable and related accrued interest of $41,797.




The
Company issued 833,333 shares of Common Stock for property and equipment of
$125,000.




The
Company issued 600,139 shares of Common Stock for legal services of
$126,029.




33




Note 15
RESTATEMENT




On
December 11, 2007 the Company received a letter from the Securities &
Exchange Commission relating to a registration statement on Form SB-2 filed by
the Company on November 14, 2007. In responding to the letter, the Company
recalculated the number of shares of Common Stock available for issuance and
determined that as of September 30, 2007, the number of shares of Common Stock
that would be required to be issued if all of the Company’s convertible
securities, including debt securities, options and warrants were converted or
exercised, exceeded the number of shares of authorized Common Stock. The
difference between the original calculation and the recalculation is illustrated
below.




AsOriginally
                    
                    
                    AsCalculated
                    
                    
                    RecalculatedAuthorized
      shares per Articles of Incorportion
                    
                    
                    150,000,000
                    
                    
                    
                    150,000,000Outstanding
      shares
                    
                    
                    (106,635,201
                    )
                    
                    
                    (106,635,201
                    )Available
      shares
                    
                    
                    43,364,799
                    
                    
                    
                    43,364,799Securities
      convertible or exercisable into common stock shares:2001
      Executive Officers Stock Option Plan
                    
                    
                    7,343,032
                    
                    
                    
                    7,034,140Advisory
      Board Compensation
                    
                    
                    
                    
                    
                    
                    11,520,0002004
      Stock Purchase Agreement
                    
                    
                    
                    
                    
                    
                    1,463,336Warrants
      Related to 2004 Stock Purchase Agreement
                    
                    
                    
                    
                    
                    
                    1,463,336Warrants
      Issued for Services
                    
                    
                    
                    
                    
                    
                    1,010,000Beneficial
      Conversion Features
                    
                    
                    32,009,087
                    
                    
                    
                    36,606,318Warrants
      Related to $1,025,000 of Subordinated Convertible
    Debentures
                    
                    
                    2,159,088
                    
                    
                    
                    2,795,45441,511,207
                    
                    
                    
                    61,892,584




Adjustments
to the original calculation included the following:




1.
            In
      2001, the Company adopted the 2001 Executive Officers Stock Option Plan.
      The plan has issued options to purchase 7,034,140 shares of Common Stock.
      The original calculation included options to purchase 7,343,032 shares of
      Common Stock, an overstatement of 308,892 shares of Common
      Stock.




2.
            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 into Common Stock
      at $0.05 per share ($576,000/$.05 = 11,520,000 shares of Common Stock).
      The accrued expense related to converting the shares into Common Stock was
      not included in the original
calculation.




3.
            Under
      the terms of a 2004 Stock Purchase Agreement, the Company was to issue
      1,463,336 shares of Common Stock to certain investors that had previously
      remitted funds to the Company from February 9, 2004 to August 25, 2004.
      The shares were not included in the original
  calculation.




4.
            Under
      the terms of a 2004 Stock Purchase Agreement, the Company issued warrants
      to purchase 1,463,336 shares of Common Stock to these investors at an
      exercise price of $0.03 per share. The warrants were not included in the
      original calculation.




5.
            On
      November 14, 2006, the Company entered into agreements for services
      pursuant to which it issued warrants to purchase a total of 1,010,000
      shares of Common Stock.  850,000 shares may be purchased at an
      exercise price of $0.05 per share and 160,000 shares may be purchased at
      an exercise price of $0.25 per share.  The warrants expire on
      November 13, 2011. The warrants were not included in the original
      calculation.




34


6.
            As
      of September 30, 2007, the Company had Convertible Bridge Notes
      outstanding totaling $1,861,000 that included embedded beneficial
      conversion features that allowed for the conversion of the notes into
      shares of Common Stock at rates between $0.01 and $0.22, and matured
      between June 2008 and December 2008. The Bridge Notes accrue interest at
      rates between 8% and 10%, and any accrued but unpaid interest is also
      convertible into shares of Common Stock. The original calculation of the
      beneficial conversion feature did not include accrued interest of $209,843
      that could be converted into 4,597,231 shares of Common Stock at
      maturity.




7.
            On
      July 17, 2007 the Company completed an offering of $1,025,000 of
      Subordinated Convertible Debentures (the “Convertible Notes 3”) to a group
      of institutional and accredited investors. As part of this offering the
      Company issued warrants to purchase 2,795,454 shares of Common Stock at a
      price of $0.50 per share.  The number of warrant shares in the
      original calculation was 2,159,088.




Based on
the result of the recalculation, the Company analyzed the effect on the balance
sheet and the statements of operations and cash flows for the classification and
valuation for all outstanding securities and contracts that were exercisable or
convertible into shares of Common Stock as of September 30, 2007. The Company
applied Emerging Issues Task Force (EITF) 00-19, “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock”, and Financial
Accounting Standard Board (FASB) Statement No. 133, “Accounting for Derivative Instruments
and Hedging Activities”and determined that the
financial statements were required to be restated.




The
Company performed an analysis on the classification and valuation of all
outstanding securities and contracts that were exercisable or convertible into
shares of Common Stock as of December 31, 2007, in accordance with EITF 00-19,
paragraph 10 which states that the classification of all contracts should be
reassessed at each balance sheet date.




The
analysis and results were as follows:




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. EITF 00-19, paragraphs 7 and 8 were then
applied to determine the classification. These paragraphs state that
contractsthat
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 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 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 Notes 3 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 Sholes
valuation model with the following assumptions: risk free rate of return of
5.02%; volatility of 219.89%; dividend yield of 0%; and an expected term of 3.67
years.


35




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 fair
value of the options was determined to be $1,926,914 as of September 30, 2007
and was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 4.05%; volatility of 126.94%; dividend
yield of 0%; and an expected term of 3.5 years.




The
Company began the analysis for the restatement by applying FASB 133,paragraph 6 to ascertain if
the options remained derivatives as of December 31, 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 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 $1,223,588 as of December 31, 2007 and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 3.25 years.




The
decrease in the fair value of the options was $703,326 for the three months
ended December 31, 2007, 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 December 31,
2007 was $703,326 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 was the result of the change in the fair
value of the options of $703,326.




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. 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 September 30, 2007, no payments
have been made to any advisory board members; and there has been no conversion
by any advisory board members of the accrued liability into shares of Common
Stock.




36




Balance
Sheet




The
Company began the analysis for the restatement by applying paragraph 6 of 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 calculated
using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 2.28% to 5.21%; volatility of 144.19%
to 270.5%; dividend yield of 0% and an expected term of 5 years. The sum of the
monthly accrued expenses and embedded beneficial conversion features from
October 1, 2004 to September 30, 2006 was $480,000 and $210,149, respectively,
and considered earned prior to October 1, 2006. Therefore, $480,000 was recorded
to accrued expenses and deficit accumulated during development stage, $210,149
was recorded to beneficial conversion features liability and netted against
accrued expenses as a discount, and $49,192 was recorded to accrued expenses and
deficit accumulated during development stage for the amortization of the
beneficial conversion features discount as of September 30, 2006.




The fair
value of the monthly embedded beneficial conversion features was determined to
be $480,000 as of September 30, 2006, and was calculated using the Black Sholes
valuation model with the following assumptions: risk free rate of return of
4.91%; volatility of 270.5%; dividend yield of 0%; and an expected term of 3.08
to 5 years. The increase in the fair value of the embedded beneficial conversion
feature was recorded by increasing beneficial conversion feature liability and
deficit accumulated during development stage on the balance sheet by
$269,851.




During
the year ended September 30, 2007, the Company incurred and recorded to accrued
expenses $96,000 for advisory board compensation until February 22, 2007, the
date the Company’s Board of Directors renegotiated the
compensation.




The
Company began the analysis of the beneficial conversion features for the
restatement as of and for the year ended September 30, 2007 by applying FASB
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. FASB 133,
paragraph 12 was applied to determine if the embedded beneficial conversion
features should be separated from the advisory board compensation. All of the
criteria in the original analysis were met, and the embedded beneficial
conversion features were separated from the advisory board compensation. 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. The change in the determination of the classification from
equity to a liability was based on the rights of the advisory board members 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 beneficial conversion features.  Paragraph 9 of EITF
00-19 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.


37


The fair
value of the monthly embedded beneficial conversion features was calculated
using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 4.94% to 5.09%; volatility of 268.59%
to 277.2%; dividend yield of 0% and an expected term of 5 years. The sum of the
embedded beneficial conversion features from October 1, 2006 to February 22,
2007 was $91,956 and was recorded to beneficial conversion features liability
and netted against accrued expenses. Total amortization for the beneficial
conversion features discount was $106,546 ($49,192 from October 1, 2004 to
September 30, 2006 and $57,354 for the year ended September 30, 2007) as of
September 30, 2007, and recorded to accrued expenses.




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 Sholes
valuation model with the following assumptions: risk free rate of return of
4.05%; volatility of 126.94%; dividend yield of 0%; and an expected term of 2.08
to 4.42 years.




The
Company began the analysis for the restatement as of and for the three months
ended December 31, 2007 by applying FASB 133,paragraph 6 to ascertain if
the beneficial conversion features remained derivatives subsequent to the date
of issuance. All of the criteria in the original analysis were met, and the
beneficial conversion features were determined to be within the scope and
definition of a derivative. Next, FASB 133, paragraph 12 was applied to
determine if the embedded beneficial conversion features should be separated
from the accrued expense. All of the criteria in the original analysis were met,
and the beneficial conversion features were separated from the accrued
liability. 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 (the 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 of the embedded beneficial conversion
features.  Paragraph 9 of EITF 00-19 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 fair
value of the monthly embedded beneficial conversion features was determined to
be $576,000 as of December 31, 2007 and was calculated using the Black Sholes
valuation model with the following assumptions: risk free rate of return of
3.34%; volatility of 98.01%; dividend yield of 0%; and an expected term of 1.92
to 4.25years.




The
beneficial conversion features discount amortization was $15,104 for the three
months ended December 31, 2007, 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 months ended December 31, 2007.




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 months ended
December 31, 2007.




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 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.


38




Balance
Sheet




The
Company began the analysis by applying FASB 133,paragraph 6to 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 contractswhich
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 $24,367 at the date of issuance which
was calculated using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 1.21% to 2.14%; volatility of 141.91%
to 170.27%; dividend yield of 0% and an expected term of 5 years. The warrants
were considered an expense prior to October 1, 2006. Therefore, $24,367 was
recorded to additional paid-in capital and deficit accumulated during
development stage.




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
Notes 3 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 Sholes valuation
model with the following assumptions: risk free rate of return of 5.02%;
volatility of 219.89%; dividend yield of 0%; and an 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 December 31, 2007.




Statement
of Operations




There was
no change in the fair value of the warrants for the three months ended December
31, 2007, due to their expiration.




Statement
of Cash Flows




There was
no change in the statement of cash flows for the three months ended December 31,
2007.




Beneficial Conversion
Features




As of
December 31, 2007, the Company had Convertible Bridge Notes outstanding totaling
$1,861,000 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




39




Balance
Sheet




On the
date of issuance, the Company applied FASB 133, paragraph
6 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. Next,
FASB 133, paragraph 12 was applied to determine if the embedded beneficial
conversion features should be separated from the convertible bridge notes. The
Company determined that the economic characteristics of the embedded beneficial
conversion features are not clearly and closely related to the convertible
bridge notes; the embedded beneficial conversion features and convertible bridge
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 FASB
133, paragraphs 6-11. Therefore, the embedded beneficial conversion features
were separated from the convertible bridge notes to determine the classification
and valuation. EITF 00-19, paragraphs 7 and 8 were then applied to determine the
classification. Paragraphs 7 and 8 state that contractswhich
require settlement in shares are equity instruments. EITF 00-19, paragraph 9 was
applied to determine the value of the embedded beneficial conversion features.
Paragraph 9 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. Based on the analysis at the date of issuance, the
embedded beneficial conversion features were recorded in additional paid-in
capital at fair value on the date of issuance.




The fair
value of the embedded beneficial conversion features was determined to be
$1,021,570 at the date of issuance and was computed using the Black Sholes
valuation modelwith the following
assumptions: risk free rate of return of 6%; volatility of 122.67% to 195.97%;
dividend yield of 0% and an expected term of 1 to 1.5 years.  The
embedded beneficial conversion features discount was $706,186 as of September
30, 2007, net of amortization of $315,383, prior to the
restatement.




The
Company began the analysis of the beneficial conversion features for the
restatement as of and for the year ended September 30, 2007 by applying FASB
133, paragraph 6toascertain 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 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 beneficial 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. Therefore, share settlement is
not controlled by the Company. EITF 00-19, paragraph 9 was applied to determine
the value. 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 embedded beneficial conversion features was recalculated and was
determined to be $1,430,811 at the date of issuance. The fair value was computed
using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 2.02% to 5.09%; volatility of 108.5% to
274.86%; dividend yield of 0% and an expected term of 1 to 1.5 years. Based on
the recalculation, the embedded beneficial conversion features discount was
$491,264, net of accumulated amortization of $939,547 as of December 31,
2007.




The fair
value of the embedded beneficial conversion features was determined to be
$1,430,811 as of September 30, 2007 and was calculated using the Black Sholes
valuation modelwith the following
assumptions: risk free rate of return of 4.05%; volatility of 126.94%; dividend
yield of 0% and an expected term of .58 to 1.25 years.




40




The
Company began the analysis for the restatement as of and for the three months
ended December 31, 2007 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.




The fair
value of the monthly embedded beneficial conversion features was determined to
be $1,222,663 as of December 31, 2007, which was calculated using the Black
Sholes valuation model with the following assumptions: risk free rate of return
of 3.34%; volatility of 98.01%; dividend yield of 0%; and an expected term of
..33 to 1 year.




The
decrease in the fair value of the beneficial conversion features was determined
to be $208,149 for the three months ended December 31, 2007, and was recorded in
beneficial conversion features liability on the balance sheet.




The
amortization of the beneficial conversion features discount was $56,038 for the
three months ended December 31, 2007, 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 $208,149 for the three months ended December 31, 2007, 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 $56,038 for the
three months ended December 31, 2007, 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 were the result of the decrease in the fair value
of the beneficial conversion features liability of $208,150 and the amortization
of the beneficial conversion features discounts of $56,038 on the statement of
operations.




Warrants related to
$1,025,000 of Convertible Bridge 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, 465,908 shares of Common Stock as a
placement fee) at an exercise price of $0.50 per share.




41




Balance
Sheet




On the
grant date, the Company applied FASB 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. EITF
00-19, paragraphs 7 and 8 were then applied to determine the classification.
Paragraphs 7 and 8 state that contractswhich
require settlement in shares are equity instruments. EITF 00-19, paragraph 9 was
applied to determine the value of the warrants. Paragraph 9 states that
contracts which require the company to deliver shares as part of a physical
settlement or net-share settlement must be initially measured at fair value. In
accordance with EITF 00-19, the warrants were recorded in additional paid-in
capital at fair value on the date of issuance.




The fair
value of the warrants was calculated as $340,585 ($304,259 related to the
holders of the Convertible Notes 3, and $36,326 related to the placement
fee)at the date
of issuance using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 6%; volatility of 122.67% to 195.97%;
dividend yield of 0% and an expected term of 5 years.




The
Company began the analysis for the restatement of the financial statements as of
and for the year ended September 30, 2007 by applying FASB 133, paragraph 6 to
ascertain if the warrants remained derivatives as of September 30, 2007. 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. 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.




Based on
the change in the determination of the classification of the warrants, $340,585
was reclassified from additional paid-in capital to warrant
liabilities.




The fair
value of the warrants was recalculated and was determined to be $554,249
($430,189 related to the holders of the Convertible Notes 3, and $124,060
related to the placement fee) at the date of issuance using the Black Sholes
valuation modelwith the following
assumptions: risk free rate of return of 4.96% to 5.02%; volatility of 219.89%
to 226.04%; dividend yield of 0% and an expected term of 5 years.




The fair
value of the warrants was determined to be $499,932 ($379,672 related to the
holders of the Convertible Notes 3, and $120,260 related to the placement fee)
as of September 30, 2007. The fair value was calculated using the Black Sholes
valuation model with the following assumptions: risk free rate of return of
4.05%; volatility of 126.94%; dividend yield of 0%; and an expected term of 4.67
to 4.75 years.




The
Company began the analysis for the restatement as of December 31, 2007 by
applying FASB 133,paragraph 6 to ascertain if the warrants remained derivatives as of
December 31, 2007. 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. EITF 00-19, paragraph 8, which states that if share settlement is
not controlled by the company the contract is required to be classified as a
liability, was applied. Paragraph 9 of EITF 00-19, 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 warrants was determined to be $321,778 as of December 31, 2007, and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 4.5 years.




The
decrease in the fair value of the warrants was determined to be $178,154 for the
three months ended December 31, 2007, and recorded by decreasing warrant
liabilities on the balance sheet by $178,154 ($125,228 related to the holders of
the Convertible Notes 3, and $52,926 related to the placement fee).


42




The
amortization of the warrant discount was $30,065 for the three months ended
December 31, 2007, 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 $178,154 for the
three months ended December 31, 2007, 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 were the result of the decrease in the amount of
$178,154 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.




Table 1
shows the effect of each of the changes discussed above on the Company’s balance
sheet, statement of operation, statement of equity (deficit), and statement of
cash flows for the three months ended December 31, 2007.




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 7 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.




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
contractsthat 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 Sholes 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 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.


43




The fair
value of the warrant was determined to be $1,515,432 as of December 31, 2007,
and was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 4.92 years.
  The
increase in the fair value of the option was $67,111 for the three months ended
December 31, 2007, and was recorded by decreasing the warrant liability on the
balance sheet.
  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 was not exercisable until the notes dated June 6, 2007 (Convertible
Notes 2 as discussed in Note 7 to our financial statements) are eligible for
conversion into shares of Common Stock. The option was 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 contractsthat 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 determined to be $1,448,321 at the date of issuance, and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.26%; volatility of 98.01%; dividend
yield of 0%; and an 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 December 31, 2007 by applying FASB 133,paragraph 6 to ascertain if
the option remained a derivative as of December 31, 2007. 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 $1,515,432 as of December 31, 2007, and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 4.92 years.
  The
increase in the fair value of the option was $67,111 for the three months ended
December 31, 2007, and was recorded by decreasing the warrant liability on the
balance sheet.
  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.


44




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
contractsthat 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 Sholes 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 December 31, 2007. 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 $177,465 as of December 31, 2007, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 3.34%; volatility of 98.01%; dividend yield of 0%; and an expected
term of 4.92 years.




The
increase in the fair value of the option was $5,945 for the three months ended
December 31, 2007, and recorded by decreasing the warrant liability on the
balance sheet.




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.




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
contractsthat 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 Sholes 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.




45




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 December 31, 2007. 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 $177,465 as of December 31, 2007, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 3.34%; volatility of 98.01%; dividend yield of 0%; and an expected
term of 4.92 years.




The
increase in the fair value of the option was $5,945 for the three months ended
December 31, 2007, and recorded by decreasing the warrant liability on the
balance sheet.




Table 1 -
2007


46




Beneficial
                                        
                                        WarrantConversion
                                        
                                        Related to
                                        
                                        
                                        
                                        Option IssuedFeatures
                                        
                                        $1,025,000 of
                                        
                                        Warrant Issued
                                        
                                        to Chief Executive2001
                                        
                                        
                                        
                                        Warrants
                                        
                                        
                                        
                                        and
                                        
                                        Convertible
                                        
                                        to Consultant
                                        
                                        Officer for theExecutive
                                        
                                        
                                        
                                        Related to
                                        
                                        Warrant
                                        
                                        Beneficial
                                        
                                        Bridge Notes
                                        
                                        for the Three
                                        
                                        Three MonthAs
                                        
                                        Officers
                                        
                                        Advisory
                                        
                                        2004 Stock
                                        
                                        Issued
                                        
                                        Conversion
                                        
                                        and
                                        
                                        Months Ended
                                        
                                        Period Ended
                                        
                                        
                                        
                                        Warrant IssuedPreviously
                                        
                                        Option
                                        
                                        Board
                                        
                                        Purchase
                                        
                                        for
                                        
                                        Features
                                        
                                        Warrant
                                        
                                        December 31,
                                        
                                        December 31,
                                        
                                        Warrant Issued
                                        
                                        to Chief
                                        
                                        
                                        
                                        AsStated
                                        
                                        Plan
                                        
                                        Compensation
                                        
                                        Agreement
                                        
                                        Services
                                        
                                        Discount
                                        
                                        Discount
                                        
                                        2007
                                        
                                        2007
                                        
                                        to Director
                                        
                                        Financial Officer
                                        
                                        Reclassifications
                                        
                                        RestatedStatement
      of Operations (for the three
      months ended December 31, 2007)General
      and administrative
                                        
                                        $
                                        1,367,677
                                        
                                        
                                        
                                        
                                        $
                                        1,557,705
                                        
                                        
                                        
                                        
                                        $
                                        (33,773
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        1,033,412
                                        
                                        $
                                        1,033,412
                                        
                                        $
                                        171,520
                                        
                                        $
                                        171,520
                                        
                                        $
                                        (236,904
                                        )
                                        $
                                        5,064,569Research
      and development
                                        
                                        
                                        -
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        236,904
                                        
                                        
                                        236,904Interest
      expense
                                        
                                        
                                        (188,625
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (288,036
                                        )
                                        
                                        (30,065
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (506,726
                                        )Decrease
      (increase) in warrant liability
                                        
                                        
                                        
                                        
                                        
                                        703,326
                                        
                                        
                                        24,405
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        178,154
                                        
                                        
                                        (67,111
                                        )
                                        
                                        (67,111
                                        )
                                        
                                        (5,945
                                        )
                                        
                                        (5,945
                                        )
                                        
                                        
                                        
                                        
                                        759,773Increase
      in beneficial conversion feature liability
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        208,149
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        208,149Beneficial
      conversion feature expense
                                        
                                        
                                        (231,998
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        231,998
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        -Basic
      and dilutive loss per share
                                        
                                        
                                        (0.02
                                        )
                                        
                                        
                                        
                                        
                                        (0.01
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (0.01
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (0.04
                                        )Statement
      of Cash Flows (for the three
      months ended December 31, 2007)Net
      loss
                                        
                                        $
                                        (1,796,440
                                        )
                                        $
                                        703,326
                                        
                                        $
                                        (1,533,300
                                        )
                                        
                                        
                                        
                                        $
                                        33,773
                                        
                                        $
                                        152,111
                                        
                                        $
                                        148,089
                                        
                                        $
                                        (1,100,523
                                        )
                                        $
                                        (1,100,523
                                        )
                                        $
                                        (177,465
                                        )
                                        $
                                        (177,465
                                        )
                                        
                                        
                                        
                                        $
                                        (4,848,417
                                        )Amortization
      of beneficial conversion features discount and warrant
      discount
                                        
                                        
                                        231,998
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        56,038
                                        
                                        
                                        30,065
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        87,550
                                        
                                        
                                        405,651Stock
      based compensation expense-  employee
                                        
                                        
                                        414,909
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        1,033,411
                                        
                                        
                                        171,520
                                        
                                        
                                        171,520
                                        
                                        
                                        
                                        
                                        
                                        1,791,360Stock
      based compensation expense-   consultant
                                        
                                        
                                        414,909
                                        
                                        
                                        
                                        
                                        
                                        1,557,706
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        3,998,381
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        5,970,996(Decrease)
      increase in warrant liability
                                        
                                        
                                        
                                        
                                        
                                        (703,326
                                        )
                                        
                                        (24,405
                                        )
                                        
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        
                                        
                                        (178,154
                                        )
                                        
                                        67,111
                                        
                                        
                                        67,111
                                        
                                        
                                        5,945
                                        
                                        
                                        5,945
                                        
                                        
                                        
                                        
                                        
                                        (759,773
                                        )Increase
      in beneficial conversion feature liaiblity
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (208,149
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (208,149
                                        )Write-off
      of beneficial conversion feature
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (380,440
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (380,440
                                        )Accrued
      expenses
                                        
                                        
                                        135,529
                                        
                                        
                                        
                                        
                                        
                                        98,051
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (46,125
                                        )
                                        
                                        187,455Accrual
      of liquidating damages
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        46,125
                                        
                                        
                                        46,125Beneficial
      conversion feature
                                        
                                        
                                        231,998
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (231,998
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        -Warrants
      issued for consulting services
                                        
                                        
                                        111,255
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (111,255
                                        )
                                        
                                        -





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;


47





·
            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 three months ended December 31, 2008. 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 plan to include shipping and handling costs in revenue and cost of
sales.


48


Support
Services. The Company plans to provide support services to customers primarily
through service contracts, and it will recognize support service 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 Sholes 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.




Restatement
for the Three Months Ended December 31, 2007




On
December 11, 2007 the Company received a letter from the Securities &
Exchange Commission relating to a registration statement on Form SB-2 filed by
the Company on November 14, 2007. In responding to the letter, the Company
recalculated the number of shares of Common Stock available for issuance and
determined that as of September 30, 2007, the number of shares of Common Stock
that would be required to be issued if all of the Company’s convertible
securities, including debt securities, options and warrants were converted or
exercised, exceeded the number of shares of authorized Common Stock. The
difference between the original calculation and the recalculation is illustrated
below.


49




AsOriginally
                      
                      
                      AsCalculated
                      
                      
                      RecalculatedAuthorized
      shares per Articles of Incorportion
                      
                      
                      150,000,000
                      
                      
                      
                      150,000,000Outstanding
      shares
                      
                      
                      (106,635,201
                      )
                      
                      
                      (106,635,201
                      )Available
      shares
                      
                      
                      43,364,799
                      
                      
                      
                      43,364,799Securities
      convertible or exercisable into common stock shares:2001
      Executive Officers Stock Option Plan
                      
                      
                      7,343,032
                      
                      
                      
                      7,034,140Advisory
      Board Compensation
                      
                      
                      
                      
                      
                      
                      11,520,0002004
      Stock Purchase Agreement
                      
                      
                      
                      
                      
                      
                      1,463,336Warrants
      Related to 2004 Stock Purchase Agreement
                      
                      
                      
                      
                      
                      
                      1,463,336Warrants
      Issued for Services
                      
                      
                      
                      
                      
                      
                      1,010,000Beneficial
      Conversion Features
                      
                      
                      32,009,087
                      
                      
                      
                      36,606,318Warrants
      Related to $1,025,000 of Subordinated Convertible
    Debentures
                      
                      
                      2,159,088
                      
                      
                      
                      2,795,45441,511,207
                      
                      
                      
                      61,892,584




Adjustments
to the original calculation included the following:




1.
            In
      2001, the Company adopted the 2001 Executive Officers Stock Option Plan.
      The plan has issued options to purchase 7,034,140 shares of Common Stock.
      The original calculation included options to purchase 7,343,032 shares of
      Common Stock, an overstatement of 308,892 shares of Common
      Stock.




2.
            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 into Common
      Stock at $0.05 per share ($576,000/$.05 = 11,520,000 shares of Common
      Stock). The accrued expense related to converting the shares into Common
      Stock was not included in the original
  calculation.




3.
            Under
      the terms of a 2004 Stock Purchase Agreement, the Company was to issue
      1,463,336 shares of Common Stock to certain investors that had previously
      remitted funds to the Company from February 9, 2004 to August 25, 2004.
      The shares were not included in the original
  calculation.




4.
            Under
      the terms of the 2004 Stock Purchase Agreement, the Company issued
      warrants to purchase 1,463,336 shares of Common Stock to these investors
      at an exercise price of $0.03 per share. The warrants were not included in
      the original calculation.




5.
            On
      November 14, 2006, the Company entered into agreements for services
      pursuant to which it issued warrants to purchase a total of 1,010,000
      shares of Common Stock.  850,000 shares may be purchased at an
      exercise price of $0.05 per share and 160,000 shares may be purchased at
      an exercise price of $0.25 per share.  The warrants expire on
      November 13, 2011. The warrants were not included in the original
      calculation.




6.
            As
      of September 30, 2007, the Company had Convertible Bridge Notes
      outstanding totaling $1,861,000 that included embedded beneficial
      conversion features that allowed for the conversion of the notes into
      shares of Common Stock at rates between $0.01 and $0.22, and matured
      between June 2008 and December 2008. The Bridge Notes accrue interest at
      rates between 8% and 10%, and any accrued but unpaid interest is also
      convertible into shares of Common Stock. The original calculation of the
      beneficial conversion feature did not include accrued interest of $209,843
      that could be converted into 4,597,231 shares of Common Stock at
      maturity.


50


7.
            On
      July 18, 2007 the Company completed an offering of $1,025,000 of
      Subordinated Convertible Debentures (the “Convertible Notes 3”) to a group
      of institutional and accredited investors. As part of this offering the
      Company issued warrants to purchase 2,795,454 shares of Common Stock at a
      price of $0.50 per share.  The number of warrant shares in the
      original calculation was 2,159,088.




Based on
the result of the recalculation, the Company analyzed the effect on the balance
sheet and the statements of operations and cash flows for the classification and
valuation for all outstanding securities and contracts that were exercisable or
convertible into shares of Common Stock as of September 30, 2007. The Company
applied Emerging Issues Task Force (EITF) 00-19, “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock”, and Financial Accounting Standard Board (FASB) Statement No. 133, “Accounting for Derivative Instruments
and Hedging Activities” and determined that the financial statements were
required to be restated.




The
Company performed an analysis on the classification and valuation of all
outstanding securities and contracts that were exercisable or convertible into
shares of Common Stock as of December 31, 2007, in accordance with EITF 00-19,
paragraph 10 which states that the classification of all contracts should be
reassessed at each balance sheet date.




The
analysis and results were as follows:




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. EITF 00-19, paragraphs 7 and 8 were then
applied to determine the classification. These paragraphs state that
contractsthat
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 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 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 Notes 3 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 Sholes
valuation model with the following assumptions: risk free rate of return of
5.02%; volatility of 219.89%; dividend yield of 0%; and an expected term of 3.67
years.


51


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 fair
value of the options was determined to be $1,926,914 as of September 30, 2007
and was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 4.05%; volatility of 126.94%; dividend
yield of 0%; and an expected term of 3.5 years.




The
Company began the analysis for the restatement by applying FASB 133,paragraph 6 to ascertain if
the options remained derivatives as of December 31, 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 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 $1,223,588 as of December 31, 2007 and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 3.25 years.




The
decrease in the fair value of the options was $703,326 for the three months
ended December 31, 2007, 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 December 31,
2007 was $703,326 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 was the result of the change in the fair
value of the options of $703,326.




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. 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 September 30, 2007, no payments
have been made to any advisory board members; and there has been no conversion
by any advisory board members of the accrued liability into shares of Common
Stock.




Balance
Sheet




The
Company began the analysis for the restatement by applying paragraph 6 of 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.


52


The fair
value of the monthly embedded beneficial conversion features was calculated
using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 2.28% to 5.21%; volatility of 144.19%
to 270.5%; dividend yield of 0% and an expected term of 5 years. The sum of the
monthly accrued expenses and embedded beneficial conversion features from
October 1, 2004 to September 30, 2006 was $480,000 and $210,149, respectively,
and considered earned prior to October 1, 2006. Therefore, $480,000 was recorded
to accrued expenses and deficit accumulated during development stage, $210,149
was recorded to beneficial conversion features liability and netted against
accrued expenses as a discount, and $49,192 was recorded to accrued expenses and
deficit accumulated during development stage for the amortization of the
beneficial conversion features discount as of September 30, 2006.




The fair
value of the monthly embedded beneficial conversion features was determined to
be $480,000 as of September 30, 2006, and was calculated using the Black Sholes
valuation model with the following assumptions: risk free rate of return of
4.91%; volatility of 270.5%; dividend yield of 0%; and an expected term of 3.08
to 5 years. The increase in the fair value of the embedded beneficial conversion
feature was recorded by increasing beneficial conversion feature liability and
deficit accumulated during development stage on the balance sheet by
$269,851.




During
the year ended September 30, 2007, the Company incurred and recorded to accrued
expenses $96,000 for advisory board compensation until February 22, 2007, the
date the Company’s Board of Directors renegotiated the
compensation.




The
Company began the analysis of the beneficial conversion features for the
restatement as of and for the year ended September 30, 2007 by applying FASB
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. FASB 133,
paragraph 12 was applied to determine if the embedded beneficial conversion
features should be separated from the advisory board compensation. All of the
criteria in the original analysis were met, and the embedded beneficial
conversion features were separated from the advisory board compensation. 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. The change in the determination of the classification from
equity to a liability was based on the rights of the advisory board members 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 beneficial conversion features.  Paragraph 9 of EITF
00-19 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 monthly embedded beneficial conversion features was calculated
using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 4.94% to 5.09%; volatility of 268.59%
to 277.2%; dividend yield of 0% and an expected term of 5 years. The sum of the
embedded beneficial conversion features from October 1, 2006 to February 22,
2007 was $91,956 and was recorded to beneficial conversion features liability
and netted against accrued expenses. Total amortization for the beneficial
conversion features discount was $106,546 ($49,192 from October 1, 2004 to
September 30, 2006 and $57,354 for the year ended September 30, 2007) as of
September 30, 2007, and recorded to accrued expenses.


53


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 Sholes
valuation model with the following assumptions: risk free rate of return of
4.05%; volatility of 126.94%; dividend yield of 0%; and an expected term of 2.08
to 4.42 years.




The
Company began the analysis for the restatement as of and for the three months
ended December 31, 2007 by applying FASB 133,paragraph 6 to ascertain if
the beneficial conversion features remained derivatives subsequent to the date
of issuance. All of the criteria in the original analysis were met, and the
beneficial conversion features were determined to be within the scope and
definition of a derivative. Next, FASB 133, paragraph 12 was applied to
determine if the embedded beneficial conversion features should be separated
from the accrued expense. All of the criteria in the original analysis were met,
and the beneficial conversion features were separated from the accrued
liability. 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 (the 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 of the embedded beneficial conversion
features.  Paragraph 9 of EITF 00-19 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 fair
value of the monthly embedded beneficial conversion features was determined to
be $576,000 as of December 31, 2007 and was calculated using the Black Sholes
valuation model with the following assumptions: risk free rate of return of
3.34%; volatility of 98.01%; dividend yield of 0%; and an expected term of 1.92
to 4.25years.




The
beneficial conversion features discount amortization was $15,104 for the three
months ended December 31, 2007, 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 months ended December 31, 2007.




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 months ended
December 31, 2007.




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 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.


54


Balance
Sheet




The
Company began the analysis by applying FASB 133,paragraph 6to 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 contractswhich
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 $24,367 at the date of issuance which
was calculated using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 1.21% to 2.14%; volatility of 141.91%
to 170.27%; dividend yield of 0% and an expected term of 5 years. The warrants
were considered an expense prior to October 1, 2006. Therefore, $24,367 was
recorded to additional paid-in capital and deficit accumulated during
development stage.




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
Notes 3 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 Sholes valuation
model with the following assumptions: risk free rate of return of 5.02%;
volatility of 219.89%; dividend yield of 0%; and an 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 December 31, 2007.




Statement
of Operations




There was
no change in the fair value of the warrants for the three months ended December
31, 2007, due to their expiration.




Statement
of Cash Flows




There was
no change in the statement of cash flows for the three months ended December 31,
2007.




Beneficial Conversion
Features




As of
December 31, 2007, the Company had Convertible Bridge Notes outstanding totaling
$1,861,000 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


55


Balance
Sheet




On the
date of issuance, the Company applied FASB 133, paragraph
6 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. Next,
FASB 133, paragraph 12 was applied to determine if the embedded beneficial
conversion features should be separated from the convertible bridge notes. The
Company determined that: the economic characteristics of the embedded beneficial
conversion features are not clearly and closely related to the convertible
bridge notes; the embedded beneficial conversion features and convertible bridge
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 FASB
133, paragraphs 6-11. Therefore, the embedded beneficial conversion features
were separated from the convertible bridge notes to determine the classification
and valuation. EITF 00-19, paragraphs 7 and 8 were then applied to determine the
classification. Paragraphs 7 and 8 state that contractswhich
require settlement in shares are equity instruments. EITF 00-19, paragraph 9 was
applied to determine the value of the embedded beneficial conversion features.
Paragraph 9 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. Based on the analysis at the date of issuance, the
embedded beneficial conversion features were recorded in additional paid-in
capital at fair value on the date of issuance.




The fair
value of the embedded beneficial conversion features was determined to be
$1,021,570 at the date of issuance and was computed using the Black Sholes
valuation modelwith the following
assumptions: risk free rate of return of 6%; volatility of 122.67% to 195.97%;
dividend yield of 0% and an expected term of 1 to 1.5 years.  The
embedded beneficial conversion features discount was $706,186 as of September
30, 2007, net of amortization of $315,383, prior to the
restatement.




The
Company began the analysis of the beneficial conversion features for the
restatement as of and for the year ended September 30, 2007 by applying FASB
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 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 beneficial 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. Therefore, share settlement is not controlled by the Company. EITF 00-19,
paragraph 9 was applied to determine the value. 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 embedded beneficial conversion features was recalculated and was
determined to be $1,430,811 at the date of issuance. The fair value was computed
using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 2.02% to 5.09%; volatility of 108.5% to
274.86%; dividend yield of 0% and an expected term of 1 to 1.5 years. Based on
the recalculation, the embedded beneficial conversion features discount was
$491,264, net of accumulated amortization of $939,547 as of December 31,
2007.




The fair
value of the embedded beneficial conversion features was determined to be
$1,430,811 as of September 30, 2007 and was calculated using the Black Sholes
valuation modelwith the following
assumptions: risk free rate of return of 4.05%; volatility of 126.94%; dividend
yield of 0% and an expected term of .58 to 1.25 years.


56


The
Company began the analysis for the restatement as of and for the three months
ended December 31, 2007 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 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.




The fair
value of the monthly embedded beneficial conversion features was determined to
be $1,222,663 as of December 31, 2007, which was calculated using the Black
Sholes valuation model with the following assumptions: risk free rate of return
of 3.34%; volatility of 98.01%; dividend yield of 0%; and an expected term of
..33 to 1 year.




The
decrease in the fair value of the beneficial conversion features was determined
to be $208,149 for the three months ended December 31, 2007, and was recorded in
beneficial conversion features liability on the balance sheet.




The
amortization of the beneficial conversion features discount was $56,038 for the
three months ended December 31, 2007, 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 $208,149 for the three months ended December 31, 2007, 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 $56,038 for the
three months ended December 31, 2007, 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 were the result of the decrease in the fair value
of the beneficial conversion features liability of $208,150 and the amortization
of the beneficial conversion features discounts of $56,038 on the statement of
operations.




Warrants related to
$1,025,000 of 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, 465,908 shares of Common Stock as a
placement fee) at an exercise price of $0.50 per share.


57


Balance
Sheet




On the
grant date, the Company applied FASB 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. EITF
00-19, paragraphs 7 and 8 were then applied to determine the classification.
Paragraphs 7 and 8 state that contractswhich
require settlement in shares are equity instruments. EITF 00-19, paragraph 9 was
applied to determine the value of the warrants. Paragraph 9 states that
contracts which require the company to deliver shares as part of a physical
settlement or net-share settlement must be initially measured at fair value. In
accordance with EITF 00-19, the warrants were recorded in additional paid-in
capital at fair value on the date of issuance.




The fair
value of the warrants was calculated as $340,585 ($304,259 related to the
holders of the Convertible Notes 3, and $36,326 related to the placement
fee)at the date
of issuance using the Black Sholes valuation modelwith the following
assumptions: risk free rate of return of 6%; volatility of 122.67% to 195.97%;
dividend yield of 0% and an expected term of 5 years.




The
Company began the analysis for the restatement of the financial statements as of
and for the year ended September 30, 2007 by applying FASB 133,paragraph 6 to ascertain if
the warrants remained derivatives as of September 30, 2007. 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. 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.




Based on
the change in the determination of the classification of the warrants, $340,585
was reclassified from additional paid-in capital to warrant
liabilities.




The fair
value of the warrants was recalculated and was determined to be $554,249
($430,189 related to the holders of the Convertible Notes 3, and $124,060
related to the placement fee) at the date of issuance using the Black Sholes
valuation modelwith the following
assumptions: risk free rate of return of 4.96% to 5.02%; volatility of 219.89%
to 226.04%; dividend yield of 0% and an expected term of 5 years.




The fair
value of the warrants was determined to be $499,932 ($379,672 related to the
holders of the Convertible Notes 3, and $120,260 related to the placement fee)
as of September 30, 2007. The fair value was calculated using the Black Sholes
valuation model with the following assumptions: risk free rate of return of
4.05%; volatility of 126.94%; dividend yield of 0%; and an expected term of 4.67
to 4.75 years.




The
Company began the analysis for the restatement as of December 31, 2007 by
applying FASB 133,paragraph 6 to ascertain if the warrants remained derivatives as of
December 31, 2007. 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. EITF 00-19, paragraph 8, which states that if share settlement is
not controlled by the company the contract is required to be classified as a
liability, was applied. Paragraph 9 of EITF 00-19, 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 warrants was determined to be $321,778 as of December 31, 2007, and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 4.5 years.




The
decrease in the fair value of the warrants was determined to be $178,154 for the
three months ended December 31, 2007, and recorded by decreasing warrant
liabilities on the balance sheet by $178,154 ($125,228 related to the holders of
the Convertible Notes 3, and $52,926 related to the placement fee).


58


The
amortization of the warrant discount was $30,065 for the three months ended
December 31, 2007, 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 $178,154 for the
three months ended December 31, 2007, 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 were the result of the decrease in the amount of
$178,154 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.




Table 1
shows the effect of each of the changes discussed above on the Company’s balance
sheet, statement of operation, statement of equity (deficit), and statement of
cash flows for the three months ended December 31, 2007.




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 7 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.




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
contractsthat 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 Sholes 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 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.


59


The fair
value of the warrant was determined to be $1,515,432 as of December 31, 2007,
and was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 4.92 years.




The
increase in the fair value of the warrant was $67,111 for the three months ended
December 31, 2007, and was recorded by decreasing the warrant liability on the
balance sheet.




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 was not exercisable until the notes dated June 6, 2007 (Convertible
Notes 2 as discussed in Note 7 to our financial statements) are eligible for
conversion into shares of Common Stock. The option was 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 contractsthat 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 determined to be $1,448,321 at the date of issuance, and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.26%; volatility of 98.01%; dividend
yield of 0%; and an 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 December 31, 2007 by applying FASB 133,paragraph 6 to ascertain if
the option remained a derivative as of December 31, 2007. 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 $1,515,432 as of December 31, 2007, and
was calculated using the Black Sholes valuation model with the following
assumptions: risk free rate of return of 3.34%; volatility of 98.01%; dividend
yield of 0%; and an expected term of 4.92 years.




The
increase in the fair value of the option was $67,111 for the three months ended
December 31, 2007, and was recorded by decreasing the warrant liability on the
balance sheet.




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


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
contractsthat 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 Sholes 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 December 31, 2007. 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 $177,465 as of December 31, 2007, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 3.34%; volatility of 98.01%; dividend yield of 0%; and an expected
term of 4.92 years.




The
increase in the fair value of the option was $5,945 for the three months ended
December 31, 2007, and recorded by decreasing the warrant liability on the
balance sheet.




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.




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
contractsthat 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 Sholes 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.


61


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 December 31, 2007. 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 $177,465 as of December 31, 2007, using
the Black Sholes valuation model with the following assumptions: risk free rate
of return of 3.34%; volatility of 98.01%; dividend yield of 0%; and an expected
term of 4.92 years.




The
increase in the fair value of the option was $5,945 for the three months ended
December 31, 2007, and recorded by decreasing the warrant liability on the
balance sheet.




Table 1 –
2007


62




Beneficial
                                      
                                      WarrantConversion
                                      
                                      Related to
                                      
                                      
                                      
                                      Option IssuedFeatures
                                      
                                      $1,025,000 of
                                      
                                      Warrant Issued
                                      
                                      to Chief Executive2001
                                      
                                      
                                      
                                      Warrants
                                      
                                      
                                      
                                      and
                                      
                                      Convertible
                                      
                                      to Consultant
                                      
                                      Officer for theExecutive
                                      
                                      
                                      
                                      Related to
                                      
                                      Warrant
                                      
                                      Beneficial
                                      
                                      Bridge Notes
                                      
                                      for the Three
                                      
                                      Three MonthAs
                                      
                                      Officers
                                      
                                      Advisory
                                      
                                      2004 Stock
                                      
                                      Issued
                                      
                                      Conversion
                                      
                                      and
                                      
                                      Months Ended
                                      
                                      Period Ended
                                      
                                      
                                      
                                      Warrant IssuedPreviously
                                      
                                      Option
                                      
                                      Board
                                      
                                      Purchase
                                      
                                      for
                                      
                                      Features
                                      
                                      Warrant
                                      
                                      December 31,
                                      
                                      December 31,
                                      
                                      Warrant Issued
                                      
                                      to Chief
                                      
                                      
                                      
                                      AsStated
                                      
                                      Plan
                                      
                                      Compensation
                                      
                                      Agreement
                                      
                                      Services
                                      
                                      Discount
                                      
                                      Discount
                                      
                                      2007
                                      
                                      2007
                                      
                                      to Director
                                      
                                      Financial Officer
                                      
                                      Reclassifications
                                      
                                      RestatedStatement
      of Operations (for the three
      months ended December 31, 2007)General
      and administrative
                                      
                                      $
                                      1,367,677
                                      
                                      
                                      
                                      
                                      $
                                      1,557,705
                                      
                                      
                                      
                                      
                                      $
                                      (33,773
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      1,033,412
                                      
                                      $
                                      1,033,412
                                      
                                      $
                                      171,520
                                      
                                      $
                                      171,520
                                      
                                      $
                                      (236,904
                                      )
                                      $
                                      5,064,569Research
      and development
                                      
                                      
                                      -
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      236,904
                                      
                                      
                                      236,904Interest
      expense
                                      
                                      
                                      (188,625
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (288,036
                                      )
                                      
                                      (30,065
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (506,726
                                      )Decrease
      (increase) in warrant liability
                                      
                                      
                                      
                                      
                                      
                                      703,326
                                      
                                      
                                      24,405
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      178,154
                                      
                                      
                                      (67,111
                                      )
                                      
                                      (67,111
                                      )
                                      
                                      (5,945
                                      )
                                      
                                      (5,945
                                      )
                                      
                                      
                                      
                                      
                                      759,773Increase
      in beneficial conversion feature liability
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      208,149
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      208,149Beneficial
      conversion feature expense
                                      
                                      
                                      (231,998
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      231,998
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      -Basic
      and dilutive loss per share
                                      
                                      
                                      (0.02
                                      )
                                      
                                      
                                      
                                      
                                      (0.01
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (0.01
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (0.04
                                      )Statement
      of Cash Flows (for the three
      months ended December 31, 2007)Net
      loss
                                      
                                      $
                                      (1,796,440
                                      )
                                      $
                                      703,326
                                      
                                      $
                                      (1,533,300
                                      )
                                      
                                      
                                      
                                      $
                                      33,773
                                      
                                      $
                                      152,111
                                      
                                      $
                                      148,089
                                      
                                      $
                                      (1,100,523
                                      )
                                      $
                                      (1,100,523
                                      )
                                      $
                                      (177,465
                                      )
                                      $
                                      (177,465
                                      )
                                      
                                      
                                      
                                      $
                                      (4,848,417
                                      )Amortization
      of beneficial conversion features discount and warrant
      discount
                                      
                                      
                                      231,998
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      56,038
                                      
                                      
                                      30,065
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      87,550
                                      
                                      
                                      405,651Stock
      based compensation expense-  employee
                                      
                                      
                                      414,909
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      1,033,411
                                      
                                      
                                      171,520
                                      
                                      
                                      171,520
                                      
                                      
                                      
                                      
                                      
                                      1,791,360Stock
      based compensation expense-   consultant
                                      
                                      
                                      414,909
                                      
                                      
                                      
                                      
                                      
                                      1,557,706
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      3,998,381
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      5,970,996(Decrease)
      increase in warrant liability
                                      
                                      
                                      
                                      
                                      
                                      (703,326
                                      )
                                      
                                      (24,405
                                      )
                                      
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      
                                      
                                      (178,154
                                      )
                                      
                                      67,111
                                      
                                      
                                      67,111
                                      
                                      
                                      5,945
                                      
                                      
                                      5,945
                                      
                                      
                                      
                                      
                                      
                                      (759,773
                                      )Increase
      in beneficial conversion feature liaiblity
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (208,149
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (208,149
                                      )Write-off
      of beneficial conversion feature
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (380,440
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (380,440
                                      )Accrued
      expenses
                                      
                                      
                                      135,529
                                      
                                      
                                      
                                      
                                      
                                      98,051
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (46,125
                                      )
                                      
                                      187,455Accrual
      of liquidating damages
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      46,125
                                      
                                      
                                      46,125Beneficial
      conversion feature
                                      
                                      
                                      231,998
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (231,998
                                      )
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      -Warrants
      issued for consulting services
                                      
                                      
                                      111,255
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      (111,255
                                      )
                                      
                                      -




Results
of Operations




Three
Months Ended December 31, 2008 Compared To Three Months Ended December 31,
2007




Revenues
for the three months ended December 31, 2008 and 2007 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 $812,865 during the three months ended
December 31, 2008, a decrease of $4,496,765 or approximately 85%, as compared to
$5,309,630 for the three months ended December 31, 2007.  General and
administrative expenses were $621,543 during the three months ended December 31,
2008, a decrease of $4,443,026 or approximately 88%, as compared to $5,064,569
for the three months ended December 31, 2007.  The decrease in general
and administrative expenses contributed to the significant decrease in operating
expenses. During the three months ended December 31, 2007, options and warrants
having a value of $4,797,385 were issued to employees and consultants. During
the three months ended December 31, 2008, options and warrants accounted for
$248,752 of the total general and administrative expenses.. Research and
development expenses were $178,963 during the three months ended December 31,
2008, a decrease of $57,941 or approximately 24%, as compared to $236,904 for
the three months ended December 31, 2007.  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 2008 fiscal
year.


63


Other
income (expense) totaled $1,761,770 during the three months ended December 30,
2008, an increase of $919,217 or approximately 109%, as compared to $842,553 for
the three months ended December 31, 2007. The Company earned interest income of
$3,591 during the three months ended December 31, 2008, an increase of $2,674 or
292%, as compared to $917 during the three months ended December 31,
2007.  The Company incurred interest expense of $94,765 during the
three months ended December 31, 2008, a decrease of $411,961 or approximately
81%, as compared to $506,726 for the three months ended December 31, 2007. The
decrease in interest expense was due primarily to the amortization of the
beneficial conversion features discount and warrant discount of the convertible
debt securities during the three months ended December 31, 2007. Decrease in
warrant liability was $1,851,368 during the three months ended December 31,
2008, an increase of $1,091,595 or approximately 144%, as compared to $759,773
during the three months ended December 31, 2007. The increase in decrease in
warrant liability was due to the decrease in the expected term of the options
and warrants and the trading price of the common stock. Decrease in beneficial
conversion features liability was $26,000 during the three months ended December
31, 2008, a decrease of $182,149 or approximately 88%, as compared to $208,149
decrease in beneficial conversion features liability during the three months
ended December 31, 2007. The decrease in beneficial conversion features
liability was due to the expiration of the expected term of the beneficial
conversion feature. During the three months ended December 31, 2008 the Company
recorded a write-off of property and equipment in the amount of $24,424. There
were no comparable expenses recorded during the three months ended December 31,
2007. During the three months ended December 31, 2007 the Company recorded a
write-off of beneficial conversion feature and discount of $380,440 related to
the advisory board compensation.  There were no comparable expenses
recorded during the three months ended December 31, 2008.




As a
result of these items, net income for the three months ended December 31, 2008
was $948,905, an increase of $5,416,882 or approximately 121% over the loss of
$4,467,977 incurred for the three months ended December 31, 2007.




Liquidity
and Capital Resources




The
Company had cash and cash equivalents of $565,224 at December 31, 2008. 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.  The Company has no binding commitments for financing
and, with the exception of the orders it received during the 2008 fiscal year,
for the sale of water treatment systems.  There can be no assurance
that sales of the Company’s securities or 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 December 31, 2008, a total of
$1,648,449 in principal and accrued interest of certain promissory notes issued
by the Company were due.  The Company has not yet paid the notes and
no demand for payment has been made.




Operating
Activities




During
the three months ended December 31, 2008, the Company used $655,364 of cash in
operating activities.  Non-cash adjustments included $12,359 for
depreciation, $27,094 for amortization of warrant and beneficial conversion
feature, $24,424 for write-off of property and equipment. Cash provided by
operating activities included $199,660 in accounts payable, and $122,261 in
accrued liabilities. Cash used in operating activities included $318,474 for
inventory, $42,977 for other current assets, $1,851,368 for warrant liability,
and $26,000 for beneficial conversion feature liability. Stock based
compensation to employees was $238,244 and stock based compensation to
nonemployees was $10,508.


64


During
the three months ended December 31, 2007, the Company used $292,883 of cash in
operating activities. Non-cash adjustments included $8,157 for depreciation,
$405,651 for amortization of warrant and beneficial conversion feature, $576,000
for a write-off of beneficial conversion feature, and $46,125 for accrual of
liquidating damages. Cash provided by operating activities included $187,455 in
accounts payable and $274,891 in accrued expenses. Cash used in operating
activities included $650 in other current assets, and $765,855 in warrant
liability. Stock based compensation to employees was $1,791,360 and
non-employees was $3,038,421.




Investing
Activities




During
the three months ended December 31, 2007, the Company acquired property and
equipment totaling $26,666. There were no such acquisitions or other investing
activities during the three months ended December 31, 2008.




Financing
Activities




During
the three months ended December 31, 2007, the Company used $51,596 in financing
activities.  The Company made payments of $19,260 to officers for a
loan payable, $5,000 to a related party for a note payable and $27,336 on an
equity line of credit.During the three months ended December 31, 2008, cash was
not provided by or used in financing activities.




As of
December 31, 2008, the Company had an accumulated deficit of $20,944,751.
Management anticipates that future operating results will continue to be subject
to many of the problems, expenses, delays and risks inherent in the
establishment of a developmental business enterprise, many of which the Company
cannot control.




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.




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 December 31, 2008, the Company has incurred
cumulative losses of $20,944,751, including income for the three months ended
December 31, 2008 of $948,905. 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.


65


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 December 31, 2008, 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:





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.


66





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 three months ended December
31, 2008 the Company has not made any changes to 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
October 9, 2008, the Company issued 600,139 shares of common stock to our legal
counsel, Richardson & Patel LLP, for the payment of legal services having a
value of $126,029.  We relied on section 4(2) of the Securities Act of
1933 to issue the securities inasmuch as we did not engage in general
solicitation or advertising in making this offering and the offeree occupied an
insider status relative to us that afforded it effective access to the
information registration would otherwise provide.





On
October 13, 2008, the Company issued 833,333 shares of common stock to RJ Metals
Co. for the payment of property and equipment having a value of
$125,000.  RJ Metals Co. is controlled by Rodney Anderson, one of our
directors, and his son. We relied on section 4(2) of the Securities Act of 1933
to issue the securities inasmuch as we did not engage in general solicitation or
advertising in making this offering and the offeree occupied an insider status
relative to us that afforded it effective access to the information registration
would otherwise provide.





During
the three months ended December 31, 2008, the Company issued 494,930 shares
of common stock in exchange for $40,000 in principal amount and $1,797 in
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.


67


Part
II, Item 3.  Defaults upon Senior Securities.





Under the
terms of a Registration Rights Agreement executed in connection with an offering
that closed on July 18, 2007, we were 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 certain units we sold consisting of
Subordinated Convertible Debentures and Warrants. The units had a value of
$1,025,000. If we did not file a registration statement with respect to the
these 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 of the closing, then we are required to pay to each
purchaser damages equal to 1.5% of the purchase price paid by the purchaser for
the Subordinated Convertible Debentures for each 30 days that transpires after
these deadlines. The amount of the aggregate damages payable by us is limited to
15% of the purchase price. We had until August 31, 2007 to file the registration
statement. We filed the registration statement on November 14, 2007, incurring a
penalty for 78 days which amounted to $38,437.50. The registration statement has
not been declared effective as of the date of this report, therefore we have
incurred an additional penalty for 85 days totaling $153,750.




As of
December 31, 2008, a total of $1,648,449 in principal and accrued interest of
certain promissory notes issued by the Company were due.  The Company
has not yet paid the notes and no demand for payment has been made.




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





During
the quarter ended December 31, 2008, no matters were submitted to a vote of
security holders.





Part
II, Item 5.  Other Information.





Not
applicable.





Part
II, Item 6.  Exhibits.





Exhibit
      No.
              Description
      of Exhibit3.1
              Articles
      of Incorporation(1)3.2
              Bylaws(1)10.1
              Letter
      dated October 14, 2008 to RJ Metal Co. re: equipment
      purchase(2)10.2
              Notice
      of Grant of Stock Option to David Ross(2)10.3
              Stock
      Option Agreement/David Ross(2)10.4
              Notice
      of Grant of Stock Option to Rodney Anderson(2)10.5
              Stock
      Option Agreement/Rodney Anderson(2)10.6
              Termination,
      Separation and Release Agreement dated November 11, 2008 between the
      registrant and Richard Papalian(3)10.7
              Notice
      of Grant of Stock Option to Richard Papalian(3)10.8
              Stock
      Option Agreement/Richard Papalian(3)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*




68


* 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.


(2)
Incorporated by reference from our Current Report on Form 8-K filed with the
Securities and Exchange Commission on October 23, 2008 as file number
002-95626-D.


(3)
Incorporated by reference from our Current Report on Form 8-K filed with the
Securities and Exchange Commission on November 17, 2008 as file number
002-95626-D.


69


SIGNATURES





In
accordance with the requirements of the Securities Exchange Act of 1934, Sionix
Corporation has caused this report to be signed on its behalf by the
undersigned, duly authorized.





February
23, 2009





SIONIX
      CORPORATIONBy:
            /s/ James J. HoutzJames
      J. Houtz, PresidentBy:
            /s/ Rodney AndersonRodney
      Anderson, Chief Financial
Officer


70