UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q





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


FOR THE
QUARTERLY PERIOD ENDED JUNE 30, 2010





or





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


FOR THE
TRANSITION PERIOD FROM               
TO





COMMISSION
FILE NUMBER:             
 001-09727





PATIENT
SAFETY TECHNOLOGIES, INC.


(Exact
name of registrant as specified in its charter)





Delaware
            
            13-3419202(State 
      or other jurisdiction of incorporation or organization)
            
            (I.R.S.
      Employer Identification No.)5
      Caufield Place, Suite 102, Newtown, PA 18940(Address
      of principal executive offices) (Zip
Code)





Registrant’s
telephone number, including area code: (215) 579-7789





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





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).    Yes  ̈    No 
 ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,” “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 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   ̈    No 
x




The
number of outstanding shares of the registrant’s common stock, par value $0.33
per share, as of August 13, 2010 was 23,456,063.





PATIENT
SAFETY TECHNOLOGIES, INC.





FORM
10-Q FOR THE QUARTER


ENDED
JUNE 30, 2010





TABLE
OF CONTENTS





PageCAUTIONARY
      NOTE REGARDING FORWARD-LOOKING STATEMENTS
                  
                  
                  iHELPFUL
      INFORMATION
                  
                  
                  iPART
      I – FINANCIAL INFORMATION
                  
                  
                  1ITEM
      1.  FINANCIAL STATEMENTS
                  
                  
                  1Condensed
      Consolidated Balance Sheets
                  
                  
                  1Condensed
      Consolidated Statements of Operations
                  
                  
                  2Condensed
      Consolidated Statements of Cash Flows
                  
                  
                  3ITEM
      2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF OPERATIONS
                  
                  
                  17ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
    RISK
                  
                  
                  28ITEM
      4. CONTROLS AND PROCEDURES
                  
                  
                  28PART
      II – OTHER INFORMATION
                  
                  
                  29ITEM
      1. LEGAL PROCEEDINGS
                  
                  
                  29ITEM
      1A. RISK FACTORS
                  
                  
                  29ITEM
      1A. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS
                  
                  
                  29ITEM
      3. DEFAULTS UPON SENIOR SECURITIES
                  
                  
                  29ITEM
      4. (REMOVED AND RESERVED)
                  
                  
                  29ITEM
      5. OTHER INFORMATION
                  
                  
                  29ITEM
      6. EXHIBITS
                  
                  
                  30SIGNATURES
                  
                  
                  31







CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS





Some of
the statements in this quarterly report on Form 10-Q are forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as
amended.  You can sometimes identify forward-looking statements by our use
of forward-looking words like “may,” “should,” “expects,” “intends,” “plans,”
“anticipates,” “believes,” “estimates,” “seeks,” “predicts,” “potential,” or
“continue” or the negative of these terms and other similar expressions. 
Our forward-looking statements relate to future events or our future performance
and include, but are not limited to, plans, objectives, expectations and
intentions. Other statements contained in this report that are not historical
facts are also forward-looking statements.





We claim
the protection of the safe harbor contained in the Private Securities Litigation
Reform Act of 1995. Although we believe that the plans, objectives, expectations
and intentions reflected in or suggested by our forward-looking statements are
reasonable, those statements are based only on the current beliefs and
assumptions of our management and on information currently available to us and,
therefore, they involve uncertainties and risks as to what may happen in the
future.  Accordingly, we cannot guarantee that our plans, objectives,
expectations or intentions will be achieved.  Our actual results,
performance (financial or operating) or achievements could differ from those
expressed in or implied by any forward-looking statement in this report as a
result of many known and unknown factors, many of which are beyond our ability
to predict or control.  These factors include, but are not limited to,
those described under the caption “Risk Factors” in our annual report on Form
10-K for the year ended December 31, 2009 filed on March 31, 2010 and amended on
April 30, 2010, including without limitation the following:





·
            our
      need for additional financing to support our
  business;





·
            the
      early stage of adoption of our Safety-Sponge® System and the need to
      expand adoption of our Safety-Sponge®
System;





·
            any
      failure of our new management team and Board of Directors to operate
      effectively;





·
            our
      reliance on third-party manufacturers, some of whom are sole-source
      suppliers, and on our exclusive distributor;
and





·
            any
      inability to successfully protect our intellectual property
      portfolio.





The risks
included in our filings are not exhaustive, and additional factors could
adversely affect our business and financial performance. We operate in a
competitive and rapidly changing environment. New risk factors emerge from time
to time, and it is not possible for management to predict all such risk factors,
nor can it assess the impact of all such risk factors on our business or the
extent to which any factor, or combination of factors, may cause actual results
to differ materially from those contained in any forward-looking
statements.





All
written and oral forward-looking statements attributable to us are expressly
qualified in their entirety by these cautionary statements.





Our
forward-looking statements speak only as of the date they are made and should
not be relied upon as representing our plans, objectives, expectations and
intentions as of any subsequent date.  Although we may elect to update or
revise forward-looking statements at some time in the future, we specifically
disclaim any obligation to do so, even if our plans, objectives, expectations or
intentions change.





HELPFUL
INFORMATION





As used
throughout this quarterly report on Form 10-Q, the terms the “Company,” “the
registrant,” “we,” “us,” and “our” mean Patient Safety Technologies, Inc., a
Delaware corporation, together with its consolidated subsidiary, SurgiCount
Medical Inc., a California Corporation, unless the context otherwise
requires.




Unless
otherwise indicated, all statements presented in this quarterly report on Form
10-Q regarding cumulative number of surgical sponges used and numbers of
procedures are internal estimates only.





Safety-Sponge®,
SurgiCounterTM and CitadelTM, among others, are registered or unregistered
trademarks of Patient Safety Technologies, Inc. (including its
subsidiary).




i


PART
I – FINANCIAL INFORMATION





ITEM
1.  FINANCIAL STATEMENTS





PATIENT
SAFETY TECHNOLOGIES, INC.


Condensed
Consolidated Balance Sheets





June
      30,
                            2010
                          
                          
                          December
      31,
                            2009(Unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
                          
                          $
                          4,591,755
                          
                          
                          $
                          3,446,726Restricted
      cash
                          
                          
                          651,223
                          
                          
                          
                          —Accounts
      receivable
                          
                          
                          532,798
                          
                          
                          
                          906,136Inventories,
      net
                          
                          
                          1,179,826
                          
                          
                          
                          565,823Prepaid
      expenses
                          
                          
                          122,445
                          
                          
                          
                          207,598Total
      current assets
                          
                          
                          7,078,047
                          
                          
                          
                          5,126,283Property
      and equipment, net
                          
                          
                          873,131
                          
                          
                          
                          744,646Goodwill
                          
                          
                          1,832,027
                          
                          
                          
                          1,832,027Patents,
      net
                          
                          
                          2,951,554
                          
                          
                          
                          3,114,025Long-term
      investment
                          
                          
                          666,667
                          
                          
                          
                          666,667Other
      assets
                          
                          
                          42,671
                          
                          
                          
                          43,246Total
      assets
                          
                          $
                          13,444,097
                          
                          
                          $
                          11,526,894Liabilities
      and Stockholders’ Equity (Deficit)Current
      liabilitiesAccounts
      payable
                          
                          $
                          1,726,325
                          
                          
                          $
                          2,043,166Convertible
      note
                          
                          
                          1,424,558
                          
                          
                          
                          1,424,558Capital
      lease-current portion
                          
                          
                          —
                          
                          
                          
                          19,330Warrant
      derivative liability
                          
                          
                          996,388
                          
                          
                          
                          3,666,336Deferred
      revenue
                          
                          
                          6,416,818
                          
                          
                          
                          8,099,144Accrued
      liabilities
                          
                          
                          1,334,277
                          
                          
                          
                          1,242,876Total
      current liabilities
                          
                          
                          11,898,366
                          
                          
                          
                          16,495,410Capital
      lease, less current portion
                          
                          
                          —
                          
                          
                          
                          58,274Deferred
      tax liability
                          
                          
                          740,622
                          
                          
                          
                          805,768Total
      liabilities
                          
                          
                          12,638,988
                          
                          
                          
                          17,359,452Commitments
      and contingencies (Note 20)Stockholders’
      equity:Series
      A preferred stock, $1.00 par value, cumulative 7% dividend: 1,000,000
      shares authorized; 10,950 issued and outstanding at June 30, 2010 and
      December 31, 2009;(Liquidation preference of $1.2 million at June 30,
      2010 and December 31, 2009)
                          
                          
                          10,950
                          
                          
                          
                          10,950Series
      B convertible preferred stock, $1.00 par value, cumulative 7% dividend:
      150,000 shares authorized; 60,067 issued and outstanding at June 30, 2010
      and 0 issued and outstanding at December 31, 2009;(Liquidation
      preference of $6.0 million at June 30, 2010 and $0 at December 31,
      2009)
                          
                          
                          60,067
                          
                          
                          
                          −Common
      stock, $0.33 par value: 100,000,000 shares authorized; 23,456,063 shares
      issued and outstanding at June 30, 2010 and December 31,
    2009
                          
                          
                          7,740,501
                          
                          
                          
                          7,740,501Additional
      paid-in capital
                          
                          
                          51,113,594
                          
                          
                          
                          44,834,321Accumulated
      deficit
                          
                          
                          (58,120,003
                          )
                          
                          
                          (58,418,330
                          )Total
      stockholders’ equity (deficit)
                          
                          
                          805,109
                          
                          
                          
                          (5,832,558
                          )Total
      liabilities and stockholders’ equity (deficit)
                          
                          $
                          13,444,097
                          
                          
                          $
                          11,526,894





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


1


PATIENT
SAFETY TECHNOLOGIES, INC.
 Condensed
Consolidated Statements of Operations
 (Unaudited)


Three
      Months Ended
                  
                  
                  Six
      Months EndedJune
      30,
                  
                  
                  June
      30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Revenues
                  
                  $
                  3,765,517
                  
                  
                  $
                  1,027,605
                  
                  
                  $
                  6,130,337
                  
                  
                  $
                  1,963,605Cost
      of revenue
                  
                  
                  1,790,360
                  
                  
                  
                  618,562
                  
                  
                  
                  2,879,248
                  
                  
                  
                  1,167,562Gross
      profit
                  
                  
                  1,975,157
                  
                  
                  
                  409,043
                  
                  
                  
                  3,251,089
                  
                  
                  
                  796,043Operating
      expenses:Research
      and development
                  
                  
                  97,972
                  
                  
                  
                  85,581
                  
                  
                  
                  131,302
                  
                  
                  
                  198,581Sales
      and marketing
                  
                  
                  828,445
                  
                  
                  
                  553,225
                  
                  
                  
                  1,822,562
                  
                  
                  
                  1,202,225General
      and administrative
                  
                  
                  2,076,776
                  
                  
                  
                  1,359,848
                  
                  
                  
                  3,728,638
                  
                  
                  
                  3,910,848Total
      operating expenses
                  
                  
                  3,003,193
                  
                  
                  
                  1,998,654
                  
                  
                  
                  5,682,502
                  
                  
                  
                  5,311,654Operating
      loss
                  
                  
                  (1,028,036
                  )
                  
                  
                  (1,589,611
                  )
                  
                  
                  (2,431,413
                  )
                  
                  
                  (4,515,611
                  )Other
      income (expense)Interest
      expense
                  
                  
                  (796
                  )
                  
                  
                  (219,733
                  )
                  
                  
                  (13,042
                  )
                  
                  
                  (439,733
                  )Gain
      (loss) on change in fair value of warrant derivative
    liability
                  
                  
                  951,210
                  
                  
                  
                  (2,155,119
                  )
                  
                  
                  2,669,949
                  
                  
                  
                  (2,570,119
                  )Other
      income (expense)
                  
                  
                  (5,075
                  )
                  
                  
                  —
                  
                  
                  
                  52,782
                  
                  
                  
                  —Total
      other income (expense)
                  
                  
                  945,339
                  
                  
                  
                  (2,374,852
                  )
                  
                  
                  2,709,689
                  
                  
                  
                  (3,009,852
                  )Income
      (loss) before income taxes
                  
                  
                  (82,697
                  )
                  
                  
                  (3,964,463
                  )
                  
                  
                  278,276
                  
                  
                  
                  (7,525,463
                  )Income
      tax benefit
                  
                  
                  32,573
                  
                  
                  
                  30,719
                  
                  
                  
                  65,146
                  
                  
                  
                  64,719Net
      income (loss)
                  
                  
                  50,124
                  
                  
                  
                  (3,933,744
                  )
                  
                  
                  343,422
                  
                  
                  
                  (7,460,744
                  )Preferred
      dividends
                  
                  
                  (25,932
                  )
                  
                  
                  (19,325
                  )
                  
                  
                  (45,095
                  )
                  
                  
                  (38,325
                  )Net
      income (loss) applicable to common shareholders
                  
                  $
                  (76,056
                  )
                  
                  $
                  (3,953,069
                  )
                  
                  $
                  298,327
                  
                  
                  $
                  (7,499,069
                  )Income
      (loss) per common shareBasic
                  
                  $
                  (0.00
                  )
                  
                  $
                  (0.23
                  )
                  
                  $
                  0.01
                  
                  
                  $
                  (0.44
                  )Diluted
                  
                  $
                  (0.00
                  )
                  
                  $
                  (0.23
                  )
                  
                  $
                  0.01
                  
                  
                  $
                  (0.44
                  )Weighted
      average common shares outstanding:Basic
                  
                  
                  23,456,063
                  
                  
                  
                  17,197,872
                  
                  
                  
                  23,456,063
                  
                  
                  
                  17,197,872Diluted
                  
                  
                  23,456,063
                  
                  
                  
                  17,197,872
                  
                  
                  
                  24,895,607
                  
                  
                  
                  17,197,872





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


2


PATIENT
SAFETY TECHNOLOGIES, INC.


Condensed
Consolidated Statements of Cash Flows


(Unaudited)





Six
      Months Ended June 30,2010
                
                
                2009Operating
      activities:Net
      income (loss)
                
                $
                343,422
                
                
                $
                (7,460,744
                )Adjustments
      to reconcile net income (loss) to net cash used in operating
      activities:Depreciation
                
                
                277,779
                
                
                
                170,360Amortization
      of patents
                
                
                162,471
                
                
                
                162,471Amortization
      of debt discount
                
                
                —
                
                
                
                247,124Stock
      based compensation
                
                
                804,525
                
                
                
                571,782Gain
      on reduction of contingent tax liability
                
                
                (427,700
                )
                
                
                —Loss
      on abandonment of lease
                
                
                371,942
                
                
                
                —Loss
      on capital lease write-off
                
                
                3,917
                
                
                
                —Non-cash
      expense related to issuance of additional warrants
                
                
                —
                
                
                
                1,297,200Non-cash
      interest
                
                
                —
                
                
                
                61,000(Gain)
      loss on change in fair value of warrant derivative
    liability
                
                
                (2,669,949
                )
                
                
                2,569,000Change
      in deferred tax liability
                
                
                (65,146
                )
                
                
                (64,319
                )Inventory
      valuation allowance
                
                
                —
                
                
                
                106,059Changes
      in operating assets and liabilities:Accounts
      receivable
                
                
                373,338
                
                
                
                230,352Inventories
                
                
                (614,003
                )
                
                
                (563,059
                )Prepaid
      expenses
                
                
                85,153
                
                
                
                (32,243
                )Other
      assets
                
                
                575
                
                
                
                7,826Accounts
      payable
                
                
                683,158
                
                
                
                860,630Accrued
      liabilities
                
                
                147,158
                
                
                
                (155,410
                )Deferred
      revenue
                
                
                (1,682,326
                )
                
                
                —Net
      cash used in operating activities
                
                
                (2,205,686
                )
                
                
                (1,991,971
                )Investing
      activities:Purchase
      of property and equipment
                
                
                (472,226
                )
                
                
                (14,768
                )Net
      cash used in investing activities
                
                
                (472,226
                )
                
                
                (14,768
                )Financing
      activities:Proceeds
      from issuance of notes payable
                
                
                —
                
                
                
                2,000,000Proceeds
      from issuance of  convertible preferred stock
                
                
                5,000,000
                
                
                
                —Payments
      for stock issuance costs
                
                
                (471,955
                )Capital
      lease principle payments
                
                
                (15,556
                )
                
                
                —Payments
      of preferred dividends
                
                
                (38,325
                )
                
                
                (38,325
                )Transfer
      to restricted cash in connection with tax escrow account
                
                
                (651,223
                )
                
                
                —Net
      cash provided by financing activities
                
                
                3,822,941
                
                
                
                1,961,675Net
      increase (decrease) in cash and cash equivalents
                
                
                1,145,029
                
                
                
                (45,064
                )Cash
      and cash equivalents at beginning of period
                
                
                3,446,726
                
                
                
                296,185Cash
      and cash equivalents at end of period
                
                $
                4,591,755
                
                
                $
                251,121Supplemental
      disclosures of cash flow information:Cash
      paid during the period for interest
                
                $
                —
                
                
                $
                36,000Cash
      paid during the period for taxes
                
                $
                16,113
                
                
                $
                —Non
      cash investing and financing activities:Issuance
      of convertible preferred stock for accounts payable
                
                $
                1,000,000
                
                
                $
                —Dividends
      accrued
                
                $
                45,028
                
                
                $
                38,325Reduction
      of fixed assets based on write-off of capital lease
                
                $
                62,048
                
                
                $
                —Reclassification
      of accrued interest to notes payable
                
                $
                —
                
                
                $
                94,000Debt
      discount recorded in connection with issuance of notes
    payable
                
                $
                —
                
                
                $
                1,311,311Reclassification
      of warrant equities to derivative liability
                
                $
                —
                
                
                $
                4,240,000





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


3


1.
DESCRIPTION OF BUSINESS





Patient
Safety Technologies, Inc. is a Delaware corporation, and its operations are
conducted through its wholly-owned operating subsidiary, SurgiCount Medical,
Inc. (“SurgiCount”), a
California corporation. References to the "Company" include references
Patient Safety Technologies, Inc. and SurgiCount, unless the context otherwise
requires.





The
Company’s operating focus is the development, marketing and sales of products
and services focused in the medical patient safety markets.  The SurgiCount
Safety-Sponge®System
is a patented system of bar-coded surgical sponges, SurgiCounterTM scanners, and
software applications integrated to form a comprehensive counting and
documentation system.  This system is designed to reduce the number of
retained surgical sponges unintentionally left inside of patients during
surgical procedures by allowing faster and more accurate counting of surgical
sponges.





2.
LIQUIDITY AND GOING CONCERN





The
accompanying condensed consolidated interim financial statements have been
prepared assuming that the Company will continue as a going concern. At June 30,
2010, the Company has an accumulated deficit of $58,120,003 and a working
capital deficit of $4,820,319.  For the six month period ended June 30,
2010, the Company incurred an operating loss of $2,431,413 and generated
negative cash flow from operating activities of $2,205,686.  The most
recent report dated March 31, 2010 by the Company’s independent registered
public accounting firm on our consolidated financial statements as of and for
the years ended December 31, 2009 and 2008 includes an explanatory paragraph in
which our independent registered public accounting firm states that the
significant recurring net losses through December 31, 2009 and the significant
working capital deficit as of December 31, 2009 raise substantial doubt about
the Company’s ability to continue as a going concern.





Management
believes existing cash resources, as augmented by the Company’s June 2010
financing, combined with projected cash flow from operations, will be sufficient
to fund the Company’s working capital requirements into the first quarter of
2011and in order to continue to operate as a going concern it will be necessary
to raise additional funds.  The Company believes that it will be
able to obtain such financing and that, if necessary, additional cost-cutting
measures could be implemented to extend the Company’s ability to
operate its core business even if financing is not timely available. 
However, no assurances can be made that the Company will be successful in
obtaining a sufficient amount of financing on acceptable terms (or any
financing) to continue to fund its operations or that it will achieve profitable
operations and positive cash flow.  In addition, no assurance can be made
that any additional cost cutting measures, if implemented, would materially
extend the Company’s ability to operate without procuring additional
financing.  The accompanying condensed consolidated interim financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.





3.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES





Basis
of Presentation





The
accompanying unaudited condensed consolidated interim financial statements have
been prepared in accordance with the instructions to Form 10-Q and applicable
sections of Regulation S-X and do not include all the information and
disclosures required by accounting principles generally accepted in the United
States of America. The condensed consolidated interim financial information is
unaudited but reflects all normal adjustments that are, in the opinion of
management, necessary to make the financial statements not misleading. The
condensed consolidated balance sheet as of December 31, 2009 was derived from
the Company’s audited financial statements. The condensed consolidated interim
financial statements should be read in conjunction with the consolidated
financial statements in the Company’s Annual Report on Form 10-K for the year
ended December 31, 2009.  Results of the three and six months ended June
30, 2010 are not necessarily indicative of the results to be expected for the
full year ending December 31, 2010.





Principles
of Consolidation





The
accompanying condensed consolidated interim financial statements for 2010
include the accounts of the Company and its subsidiary.  All significant
intercompany balances and transactions have been eliminated in
consolidation.




4


Use
of Estimates





The
condensed consolidated interim financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America (“GAAP”). 
The preparation of these financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the dates of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.  These estimates and assumptions include, but are not limited
to, assessing the following: the valuation of accounts receivable and inventory,
impairment of goodwill and other intangible assets, the fair value of
stock-based compensation and derivative liabilities, valuation allowance related
to deferred tax assets, warranty obligations, provisions for returns and
allowances and the determination of assurance of the collection of revenue
arrangements.





Reclassifications





Certain
prior year amounts have been reclassified to conform to the 2010 presentation.
These reclassifications had no effect on previously reported results of
operations or accumulated deficit.





Revenue
Recognition





The
Company recognizes revenue from the sale of products to end-users and
distributors when persuasive evidence of a sale exists, the product is complete,
tested and has been shipped which coincides with transfer of title and risk of
loss, the sales price is fixed and determinable, collection of the resulting
receivable is reasonably assured, there are no material contingencies and the
Company does not have significant obligations for future performance.  When
collectability is not reasonably assured, the Company defers the revenue until
cash payment is received.Provisions for
estimated future product returns and allowances are recorded in the period of
the sale based on the historical and anticipated future rate of returns. 
The Company records shipping and handling costs charged to customers as revenue
and shipping and handling costs to cost of revenue as incurred.  Revenue is
recorded net of any discounts or trade-in allowances given to the
buyer.





·
            Hardware Cost Reimbursement
      Revenues:  Beginning with the third quarter of 2009, the
      Company modified its business model and began to offer its SurgiCounterTM
      scanners and related hardware and software to all hospitals at no cost
      when they adopt its Safety-Sponge® System.  Prior to the third
      quarter of 2009, the Company’s business model included the sale of its
      SurgiCounterTM scanners and related hardware and software used in its
      Safety-Sponge® System to most hospitals that adopted the Company’s
      system.  Under the supply and distribution agreement with Cardinal
      Health entered into in November 2009, the Company is reimbursed an agreed
      upon percentage of the cost of the scanners provided by the Company to
      hospitals that receive their surgical sponges and towels through Cardinal
      Health. Reimbursements received from Cardinal Health are initially
      deferred and are recognized as revenue on a pro-rata basis over the life
      of the specific hospital contract.  Because the Company no longer
      engages primarily in direct SurgiCounterTM scanner and related
      hardware sales, except in certain customer specific situations, it
      generally anticipates only recognizing revenues associated with its
      SurgiCounterTM scanners in connection with reimbursement arrangements under
      its agreement with Cardinal Health.





·
            Hardware, Software and
      Maintenance Agreement Revenues: Because the software included in
      the Company’s SurgiCounterTM scanner is not incidental to the product being
      sold, the sale of the software falls within the scope of Accounting Standards
      Codification(“ASC”)ASC 985-605,
      formerly Statement of Position (“SOP”) 97-2.  The
      SurgiCounterTM scanner is considered to be a software-related element, as
      defined in ASC 985-605, because the software is essential to the
      functionality of the scanner, and the maintenance agreement, which
      provides for product support including unspecified product upgrades and
      enhancements developed by the Company during the period covered by the
      agreement, is considered to be post-contract customer support (“PCS”) as defined in ASC
      985-605.  These items are considered to be separate deliverables
      within a multiple-element arrangement, and based on the fact that there is
      vendor specific objective evidence for the non-delivered element the total
      price of this arrangement is allocated to each respective deliverable
      based on the residual fair value of each element, and recognized as
      revenue as each element is delivered. For the hardware and software
      elements, delivery is generally considered to be at the time of shipment
      where terms are FOB shipping point.  In the event that terms of the
      sale are FOB customer, the delivery is considered to occur at the time
      that delivery to the customer has been completed.  Delivery with
      respect to the initial one-year maintenance agreement is considered to
      occur on a monthly basis over the term of the one-year period, and
      revenues related to this element are recognized on a pro-rata basis during
      this period.




5




·
            Surgical Sponge
      Revenues:The surgical products (sponges and towels) used in
      the Company’s Safety-Sponge® System are sold separately from the hardware
      and software described above, and those products are not considered to be
      part of a multiple-element arrangement.  Accordingly, revenues
      related to the sale of products used in the Company’s Safety-Sponge®
      System are recognized in accordance with ASC 605-25 that addresses revenue
      recognition for multiple-element arrangements. Generally revenues from the
      sale of surgical products used in the Safety-Sponge® System are recognized
      upon shipment as most surgical products used in the Safety-Sponge® System
      are sold FOB shipping point.  In the event that terms of the sale are
      FOB customer, revenue is recognized at the time delivery to the customer
      has been completed. Advanced payments are classified as deferred revenue
      and recognized as product is shipped to the
  customer.




Recent
Accounting Pronouncements





In
October 2009, the Financial Accounting Standards Board (“FASB”) issued
Accounting Standards Update (“ASU”) 2009-13, Multiple Deliverable Revenue
Arrangements, which addresses the accounting for multiple deliverable
arrangements to enable vendors to account for products and services
(deliverables) separately rather than as a combined unit. The amendments in ASU
2009-13 are effective prospectively for revenue arrangements entered into or
materially modified in the fiscal years beginning on or after June 15, 2010.
Early adoption is permitted. The impact of this accounting update on the
Company’s consolidated financial statements has not been evaluated.





In
October 2009, the FASB issued ASU 2009-14, Certain Revenue Arrangements That
Include Software Elements, which changes the accounting model for revenue
arrangements that include both tangible products and software elements that are
“essential to the functionality,” and scopes these products out of current
software revenue guidance. The new guidance will include factors to help
companies determine what software elements are considered “essential to the
functionality.” The amendments included in ASU 2009-14 are effective
prospectively for revenue arrangements entered into or materially modified in
the fiscal years beginning on or after June 15, 2010. Early adoption is
permitted. The impact of this accounting update on the Company’s consolidated
financial statements has not been evaluated.





In
January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and
Disclosures (Topic 20): Improving Disclosures about Fair Value Measurements.”
This ASU provides clarification regarding existing disclosures and requires
additional disclosures regarding fair value measurements. Specifically, the
guidance now requires reporting entities to disclose the amounts of significant
transfers between levels and the reasons for the transfers. In addition, the
reconciliation should present separate information about purchases, sales,
issuances and settlements. A reporting entity should provide disclosures about
the valuation techniques and inputs used to measure fair value. The new standard
was effective for reporting periods beginning after December 15, 2009 except for
disclosures about purchases, sales, issuances and settlements which is not
effective until reporting periods beginning after December 15, 2010. There were
no transfers into or out of Level 1 or Level 2 of the fair value hierarchy
during the six months ended June 30, 2010. Adoption of the not yet effective
section of this guidance is not expected to have a material impact on our
Consolidated Financial Statements.





4.
RESTRICTED CASH





Restricted
cash at June 30, 2010 consists of cash held in an escrow account pursuant to the
Tax Escrow Agreement which was established during the quarter ended June 30,
2010 in connection with the Convertible Preferred Stock financing transaction
(See Note 20).  Cash held in the escrow account is invested in the escrow
agent’s insured money market account and any income earned on such funds is
added to the balance held in escrow. In accordance with the terms of the Tax
Escrow Agreement, funds held in the escrow account may be released to pay tax
claims by federal or state taxing authorities, or in the event that the
Company’s estimated contingent tax liability, as reflected in its periodic
reporting on either Form 10-Q or 10-K, is reduced for reasons other than actual
payment of tax claims, subject to compliance with specific provisions of the
agreement.  During the quarter ended June 30, 2010 the contingent tax
liability was reduced by $427,700 based primarily on the expiration of the
federal statute of limitations relating to certain 2006 income.  Based on
this reduction in the contingent tax liability, the Company expects that
$427,700 will be released from the escrow account during the quarter ending
September 30, 2010.




6


5. EARNINGS (LOSS)
PER COMMON SHARE





Earnings
(loss) per common share is determined by dividing the earnings (loss) applicable
to common shareholders by the weighted average number of common shares
outstanding. The Company complies with FASB Accounting Standards Codification
(“ASC”) 260-10 Earnings Per
Share(previously SFAS No. 128, Earnings per Share), which requires dual
presentation of basic and diluted earnings (loss) per share on the face of the
condensed consolidated statements of operations. Basic loss per common share
excludes dilution and is computed by dividing loss attributable to common
stockholders by the weighted-average common shares outstanding for the period.
Diluted earnings per common share reflects the potential dilution that could
occur if convertible preferred stock or notes, options and warrants were to be
exercised or converted or otherwise resulted in the issuance of common stock
that then shared in the earnings of the entity.





For the
three and six months ended June 30, 2010, the shares associated with the
convertible note plus only the warrants and options that have a
conversion/exercise price in excess of the average stock price during the three
and six month periods ending June 30, 2010, respectively, are included in
calculating diluted earnings per share. Because the effects of outstanding
options, warrants and the convertible note that have conversion/exercise prices
in excess of the average stock price during the three and six month periods
ended June 30, 2010, are anti-dilutive, shares of common stock underlying these
instruments as shown below have been excluded from the computation of loss per
common share for the three and six months ended June 30, 2009,
respectively.





The
following table sets forth the computation of basic and diluted earnings (loss)
per share:





Three
      Months Ended
                    
                    
                    Six
      Months EndedJune
      30,
                    
                    
                    June
      30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009BasicIncome
      (loss) available to common stockholders
                    
                    $
                    (76,056
                    )
                    
                    $
                    (3,953,069
                    )
                    
                    $
                    298,327
                    
                    
                    $
                    (7,499,069
                    )Weighted
      average common shares outstanding (basic)
                    
                    
                    23,456,063
                    
                    
                    
                    17,197,872
                    
                    
                    
                    23,456,063
                    
                    
                    
                    17,197,872Basic
      income (loss) per common share
                    
                    $
                    (0.00
                    )
                    
                    $
                    (0.23
                    )
                    
                    $
                    0.01
                    
                    
                    $
                    (0.44
                    )DilutedIncome
      (loss) available to common stockholders
                    
                    $
                    (76,056
                    )
                    
                    $
                    (3,953,069
                    )
                    
                    $
                    298,327
                    
                    
                    $
                    (7,499,069
                    )Weighted
      average common shares outstanding
                    
                    
                    23,456,063
                    
                    
                    
                    17,197,872
                    
                    
                    
                    23,456,063
                    
                    
                    
                    17,197,872Assumed
      issuance of restricted stock
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    75,000
                    
                    
                    
                    —Assumed
      exercise of options
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    695,335
                    
                    
                    
                    —Assumed
      exercise of warrants
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    169,209
                    
                    
                    
                    —Assumed
      conversion of debt
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    500,000
                    
                    
                    
                    —Common
      and potential common shares
                    
                    
                    23,456,063
                    
                    
                    
                    17,197,872
                    
                    
                    
                    24,895,607
                    
                    
                    
                    17,197,872Diluted
      income (loss) per common share
                    
                    $
                    (0.00
                    )
                    
                    $
                    (0.23
                    )
                    
                    $
                    0.01
                    
                    
                    $
                    (0.44
                    )Potentially
      dilutive securities outstanding at period end excluded from diluted
      computation as they were anti-dilutive
                    
                    
                    8,241,917
                    
                    
                    
                    19,742,109
                    
                    
                    
                    7,933,917
                    
                    
                    
                    19,530,756




7


6.
INVENTORY





Inventory
consists of the following:




June
      30,
                          
                          
                          December
      31,2010
                          
                          
                          2009Finished
      goods
                          
                          $
                          1,348,822
                          
                          
                          $
                          734,819Reserve
      for obsolescence
                          
                          
                          (168,996
                          )
                          
                          
                          (168,996
                          )Total
      inventory, net
                          
                          $
                          1,179,826
                          
                          
                          $
                          565,823





7.
PROPERTY AND EQUIPMENT





Property
and equipment consists of the following:





June
      30,
                    
                    
                    December
      31,2010
                    
                    
                    2009Computer
      software and equipment
                    
                    $
                    1,100,003
                    
                    
                    $
                    1,097,181Furniture
      and equipment
                    
                    
                    226,586
                    
                    
                    
                    298,333Hardware
      for customer use
                    
                    
                    858,409
                    
                    
                    
                    394,861Property
      and equipment, gross
                    
                    
                    2,184,998
                    
                    
                    
                    1,790,375Less:
      accumulated depreciation
                    
                    
                    (1,311,867
                    )
                    
                    
                    (1,045,729
                    )Property
      and equipment, net
                    
                    $
                    873,131
                    
                    
                    $
                    744,646





At June
30, 2010, based on the Company’s decision to close the Newtown, PA office, the
Company wrote off the remaining capital lease of $65,963 pertaining to office
furniture acquired as part of the Newtown, PA sublease. Depreciation expense for
the three and six months ended June 30, 2010 was $135,548 and $277,779,
respectively. Depreciation expense for the three and six months ended June 30,
2009 was $84,769 and $170,360, respectively.





8.
GOODWILL AND PATENTS





The
Company recorded goodwill in the amount of $1,700,000 in connection with its
acquisition of SurgiCount in February 2005.  During the year ended December
31, 2007, cumulative gross revenues of SurgiCount exceeded $1,000,000 and as
such the Company issued 100,000 shares of common stock, valued at approximately
$145,000 to the SurgiCount founders, as contingent consideration, which was
recorded as additional goodwill.  In addition, in connection with the
SurgiCount acquisition, the Company recorded patents acquired that were valued
at $4,700,000.




The
Company performs its annual impairment analysis of goodwill in the fourth
quarter of each year according to the provisions of ASC 350 Valuation Analysis(formerly
SFAS 142, Goodwill and Other
Intangible Assets). This statement requires that the Company perform a
two-step impairment test on goodwill. In the first step, the Company compares
the fair value of each reporting unit to its carrying value. If the fair value
of the reporting unit exceeds the carrying value of the net assets assigned to
the reporting unit, goodwill is not impaired and the Company is not required to
perform further testing. If the carrying value of the net assets assigned to the
reporting unit exceeds the fair value of the reporting unit, then the Company
must perform the second step of the impairment testing to determine the implied
fair value of the reporting unit’s goodwill. The implied fair value of goodwill
is calculated by deducting the fair value of all tangible and intangible assets
of the reporting unit, excluding goodwill, from the fair value of the reporting
unit as determined in the first step. If the carrying value of a reporting
unit’s goodwill exceeds its implied fair value, then an impairment loss equal to
the difference would be recorded.




During
2009, the Company conducted its annual test for impairment at year-end and
determined goodwill was not impaired.




8






June 30,
                    2010
                  
                  
                  December 31,
                    2009Patents
                  
                  $
                  4,684,576
                  
                  
                  $
                  4,684,576Accumulated amortization
                  
                  
                  (1,733,022
                  )
                  
                  
                  (1,570,551
                  )Patents,
      net
                  
                  $
                  2,951,554
                  
                  
                  $
                  3,114,025





The patents
are subject to amortization over their estimated useful life of 14.4
years.  Amortization expense for the three and six months ended June 30,
2010 and 2009 was $81,235 and $162,471, respectively.





9.
LONG-TERM INVESTMENTS





Long-term
investments consists of the following:





June 30,
                    2010
                  
                  
                  December 31,
                    2009Alacra,
      Inc.
                  
                  $
                  666,667
                  
                  
                  $
                  666,667Total
                  
                  $
                  666,667
                  
                  
                  $
                  666,667





At June
30, 2010 and December 31, 2009, the Company had an investment in shares of
Series F convertible preferred stock of Alacra, Inc. (“Alacra”), a global provider
of business and financial information in New York, recorded at its cost of
$666,667.  The Company has the right, to the extent that Alacra has
sufficient available capital, to have the Series F convertible preferred stock
redeemed by Alacra for face value beginning on December 31, 2006. During the
year ended December 31, 2007, Alacra redeemed one-third of the Series F
convertible preferred stock.





10.
CONVERTIBLE NOTE PAYABLE





Effective
June 1, 2007, the  Company restructured the entire unpaid principal
and interest under promissory notes issued to Ault Glazer Capital Partners, LLC
(“Ault Glazer”), into a new
Convertible Secured Promissory Note (the "AG Capital Partners Convertible
Note") in the principal amount of $2.5 million. The AG Capital Partners
Convertible Note bears interest at the rate of 7% per annum and is due on the
earlier of December 31, 2010, or the occurrence of an event of
default.





On
September 5, 2008, the Company entered into an Amendment and Early Conversion of
the Secured Convertible Promissory Note (the “Amendment”) to modify the
terms of the AG Capital Partners Convertible Note.  Under
the Amendment, the Company agreed to pay Ault Glazer $450,000 in cash and,
contingent upon satisfaction of certain conditions by Ault Glazer, convert the
remaining balance of the convertible secured note into 1,300,000 shares of the
Company’s common stock.  One condition was that Ault Glazer transfers
certain leases from the Company’s name into its name.  The Company made the
$450,000 cash payment on September 5, 2008.





On
September 12, 2008, the parties executed an Agreement for the Advancement of
Common Stock Prior to Close of the Amendment and Early Conversion of Secured
Convertible Promissory Note, dated September 5, 2008 (the “Advancement”).  Pursuant
to the Advancement, the Company agreed to issue 300,000 shares of the Company’s
common stock to Ault Glazer on September 12, 2008, in advance of the
satisfaction of the conditions for conversion in the Amendment, with the
understanding that Ault Glazer would satisfy the conditions stated in the
Amendment prior to September 19, 2008.





Ault
Glazer failed to satisfy the conditions by the September 19, 2008
deadline.  Although the conditions remained unsatisfied, the Company made
two additional issuances of shares to Ault Glazer pursuant to the Amendment as
follows: the Company issued another 250,000 shares on October 10, 2008 and
another 250,000 shares on November 6, 2008.   As of June 30, 2010 and
December 31, 2009, there remain 500,000 shares issuable to Ault Glazer upon Ault
Glazer meeting the conditions of the Amendment.





During
the three and six months ended June 30, 2010 and the year ended December 31,
2009, in light of the failure to satisfy the conditions of the
Amendment and the Advancement, the Company did not accrue interest
expense on the AG Capital Partners Convertible Note.


9





11.
ACCRUED LIABILITIES





Accrued
liabilities consists of the following:




June 30,
                    2010
                  
                  
                  December 31,
                    2009Accrued
      lease liability
                  
                  $
                  7,547
                  
                  
                  $
                  7,547Accrued
      dividends on preferred stock
                  
                  
                  114,976
                  
                  
                  
                  114,976Accrued
      severance
                  
                  
                  370,981
                  
                  
                  
                  47,449Accrued
      office lease
                  
                  
                  371,942
                  
                  
                  
                  —Accrued
      director’s fees
                  
                  
                  —
                  
                  
                  
                  162,500Contingent
      tax liability
                  
                  
                  223,523
                  
                  
                  
                  740,726Accrued
      commissions
                  
                  
                  —
                  
                  
                  
                  13,200Accrued
      financing expenses
                  
                  
                  88,000
                  
                  
                  
                  —Other
                  
                  
                  157,308
                  
                  
                  
                  156,478Total
      accrued liabilities
                  
                  $
                  1,334,277
                  
                  
                  $
                  1,242,876





12.
DEFERRED REVENUE





Deferred
revenue consists of the following:





June 30,
                    2010
                  
                  
                  December 31,
                    2009Cardinal
      Health advance payment on purchase order
                  
                  $
                  6,117,324
                  
                  
                  $
                  8,000,000Scanner
      reimbursement revenue
                  
                  
                  295,328
                  
                  
                  
                  99,144Maintenance
      agreements
                  
                  
                  4,166
                  
                  
                  
                  —Total
                  
                  $
                  6,416,818
                  
                  
                  $
                  8,099,144





On
November 19, 2009, the Company entered into a new Supply and Distribution
Agreement with Cardinal Health (which replaced the parties' previous
distribution agreement).  This agreement has a five-year term and names
Cardinal Heath as the exclusive distributor in the United States, Puerto Rico
and Canada of current products used in the Company’s Safety-Sponge® System. In
connection with the execution of this agreement, Cardinal Health issued a
$10,000,000 purchase order for products used in the Company’s Safety-Sponge®
System, calling for deliveries over the 12-month period ending November 2010,
paid the Company $8,000,000 upon execution of the agreement as partial
pre-payment for such products, and agreed to pay up to $2,000,000 directly to
the Company’s supplier upon delivery of invoices for product delivered under the
purchase order.  As of June 30, 2010, the Company shipped $3,396,870 of
product covered under the $10,000,000 purchase order from Cardinal Health and
Cardinal Health has directly paid our supplier $1,514,194.





Prior to
the third quarter of 2009, the Company’s business model included the sale of its
SurgiCounterTM scanners and related software used in the Company’s Safety-Sponge®
System to most hospitals that adopted its system.  Beginning with the third
quarter of 2009, the Company modified its business model and began to offer to
provide its SurgiCounterTM scanners and related hardware and software to all
hospitals at no cost when they adopt its Safety-Sponge® System. Under the
new supply and distribution agreement with Cardinal Health entered into in
November 2009, the Company is reimbursed an agreed upon percentage of the cost
of the scanners provided by the Company to hospitals that receive their surgical
sponges and towels through Cardinal. Reimbursements received from Cardinal are
initially deferred and are recognized as revenue on a pro-rata basis over the
life of the specific hospital contract.  Because the Company no longer
engages primarily in direct SurgiCounterTM scanner and related hardware
sales, except in certain customer specific situations, it generally anticipates
only recognizing revenues associated with its SurgiCounterTM scanners in
connection with reimbursement arrangements under its agreement with Cardinal
Health.




10


13.
SERIES B CONVERTIBLE PREFERRED STOCK





On June
24, 2010 the Company entered into a Convertible Preferred Stock Purchase
Agreement with several accredited investors, as defined under Rule 501(a) of the
Securities Act of 1933, as amended.  The accredited investors included A
Plus International, Inc. and Catalysis Partners, LLC.  Wenchen (Wayne) Lin,
a member of the Company’s Board of Directors, is a founder and significant
beneficial owner of A Plus International, Inc and John P. Francis, a member of
the Company’s Board of Directors, has voting and investment control over
securities held by Francis Capital Management, LLC, which acts as the investment
manager for Catalysis Partners, LLC. Pursuant to the Convertible Preferred Stock
Purchase Agreement, the Company issued an aggregate of 60,000 shares of its
Series B Convertible Preferred Stock (“Series B Preferred”), at a purchase price
of $100 per share, or $6,000,000 in the aggregate, payable in cash or as a
reduction of indebtedness or a combination of both.  The Company authorized
150,000 shares of Series B Preferred, with a par value of $1.00 per share. 
Holders of the Series B Preferred are entitled to receive quarterly cumulative
dividends at a rate of 7.00% per annum, beginning on July 1, 2010. All dividends
due on or prior to December 31, 2011 are payable in kind in the form of
additional shares of Series B Preferred, and all dividends payable after
December 31, 2011 are payable solely in cash.





14.
STOCKHOLDERS’ EQUITY:





The
following table summarizes changes in components of stockholders’ equity during
the six months ended June 30, 2010:




Preferred
      Stock
                      Series
      A
                    
                    
                    Convertible
                      Preferred
      Stock
                      Series
      B
                    
                    
                    Common
      Stock Issued
                    
                    
                    Paid
      – In
                    
                    
                    Accumulated
                    
                    
                    Total
                      Stockholders’Shares
                    
                    
                    Amount
                    
                    
                    Shares
                    
                    
                    Amount
                    
                    
                    Shares
                    
                    
                    Amount
                    
                    
                    Capital
                    
                    
                    Deficit
                    
                    
                    Equity
      (Deficit)BALANCES,
      December 31, 2009
                    
                    
                    10,950
                    
                    
                    $
                    10,950
                    
                    
                    
                    −
                    
                    
                    
                    −
                    
                    
                    
                    23,456,063
                    
                    
                    $
                    7,740,501
                    
                    
                    $
                    44,834,321
                    
                    
                    $
                    (58,418,330
                    )
                    
                    $
                    (5,832,558
                    )Preferred
      dividends
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    67
                    
                    
                    
                    67
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    6,703
                    
                    
                    
                    (45,095
                    )
                    
                    
                    (38,325
                    )Issuance
      of convertible preferred stock, net of transaction costs
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    60,000
                    
                    
                    
                    60,000
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    5,468,045
                    
                    
                    
                    —
                    
                    
                    
                    5,528,045Stock-based
      compensation
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    804,525
                    
                    
                    
                    
                    
                    
                    
                    804,525Net
      income
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    343,422
                    
                    
                    
                    343,422BALANCES,
                      June
      30, 2010
                    
                    
                    10,950
                    
                    
                    $
                    10,950
                    
                    
                    
                    60,067
                    
                    
                    $
                    60,067
                    
                    
                    
                    23,456,063
                    
                    
                    $
                    7,740,501
                    
                    
                    $
                    51,113,594
                    
                    
                    $
                    (58,120,003
                    )
                    
                    $
                    805,109





15.
WARRANTS AND WARRANT DERIVATIVE LIABILITY





The
following table summarizes warrants to purchase common stock activity for the
period ended June 30, 2010:





Amount
                  
                  
                  Range
      of Exercise
                    PriceWarrants
      outstanding December 31, 2009
                  
                  
                  8,064,978
                  
                  
                  $0.75
      − 6.05Issued
                  
                  
                  —
                  
                  
                  −Cancelled/Expired
                  
                  
                  (515,125
                  )
                  
                  $1.25
      – 6.05Warrants
      outstanding June 30, 2010
                  
                  
                  7,549,853
                  
                  
                  $0.75
      – 4.50




11


At June
30, 2010, stock purchase warrants will expire as follows:





# of
                        Warrants
                      
                      
                      Range of
                        Exercise
                        Price2010
                      
                      
                      —
                      
                      
                      
                      —2011
                      
                      
                      2,301,419
                      
                      
                      $
                      0.75
      − 4.50
                      *2012
                      
                      
                      818,000
                      
                      
                      $
                      2.002013
                      
                      
                      1,786,267
                      
                      
                      $
                      0.75
      − 1.40
                      *2014
                      
                      
                      1,890,000
                      
                      
                      $
                      1.82
      − 4.002015
                      
                      
                      754,167
                      
                      
                      $
                      1.25Total
                      
                      
                      7,549,853
                      
                      
                      $
                      0.75 – 4.50





*
Includes warrants that contain anti-dilution rights if the Company grants or
issues securities for less than the exercise price.





Warrant
Derivative Liability





At June
30, 2010, a total of  2,567,686 warrants are classified as a derivative
liability pursuant to guidance codified in FASB ASC 815-40, Derivatives and Hedging,
Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock(previously EITF 07-5).





At June
30, 2010, the estimated fair value of these warrants, based on a Black-Scholes
option pricing model was $996,388, which is included in current liabilities in
the accompanying condensed consolidated balance sheet. Based on the change in
fair value of the warrant derivative liability, the Company recorded non-cash
income of $951,210 and $2,669,948 for the three and six months ended June 30,
2010, respectively. The warrant fair values at June 30, 2010 were
determined using the Black-Scholes valuation model using the closing price stock
price at each date, volatility rate of 112-118%, risk free interest rates of
0.53-1.69%, and contractual lives equal to the remaining term of the warrants
expiring as of each measurement date.





16.
FAIR VALUE MEASUREMENTS





Fair
Value Hierarchy





Fair
value is defined in ASC 820 as the price that would be received upon sale of an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. Fair value measurements are to be
considered from the perspective of a market participant that holds the assets or
owes the liability. ASC 820 also establishes a fair value hierarchy, which
requires an entity to maximize the use of observable inputs and minimize the use
of unobservable inputs when measuring fair value.





The
standard describes three levels of inputs that may be used to measure fair
value:





Level 1:
Quoted prices in active markets for identical or similar assets and
liabilities.





Level 2:
Quoted prices for identical or similar assets and liabilities in markets that
are not active or observable inputs other than quoted prices in active markets
for identical or similar assets and liabilities.





Level 3:
Unobservable inputs that are supported by little or no market activity and that
are significant to the fair value of the assets or liabilities.





Financial
Instruments Measured at Fair Value on a Recurring Basis





ASC 820
requires disclosure of the level within the fair value hierarchy used by the
Company to value financial assets and liabilities that are measured at fair
value on a recurring basis. At June 30, 2010, the Company had outstanding
warrants to purchase common shares of its stock that are classified as warrant
derivative liabilities with a fair value of $996,388. The warrants are valued
using Level 3 inputs because there are significant unobservable inputs
associated with them (See Note 15).


12





The table
below sets forth a summary of changes in the fair value of the Company’s warrant
derivative liability for the period ended June 30, 2010:





January 1, 2010
                          
                          
                          Gain on change
                            in fair value
                            included in
                            earnings
                          
                          
                          June 30, 2010Warrant
      DerivativeLiability
                          
                          $
                          (3,666,336
                          )
                          
                          $
                          2,669,948
                          
                          
                          $
                          (996,388
                          )





Other
Financial Instruments





The
carrying amounts of cash and cash equivalents, restricted cash, accounts
receivable, accounts payable, accrued liabilities and deferred revenue
approximate their respective fair values because of the short-term nature of
these financial instruments.





The fair
value of the Company's convertible debt is estimated to be $330,000 and $950,000
at June 30, 2010 and December 31, 2009, respectively, which is less than the
carrying value of $1,424,558 at each of these dates.  As described in Note
10, the current terms of the agreements relating to the convertible debt provide
for the full settlement of the outstanding balance of the debt. 
Accordingly, the fair values noted above were estimated based on market value of
500,000 shares of the Company’s common stock at June 30, 2010 and December 31,
2009.





The fair
value of long-term investments reported using the cost method for which there
are no quoted market prices has not been determined as a reasonable estimate of
fair value could not be made without incurring excessive costs (See Note
9).





17.
STOCK COMPENSATION





In
September 2005, the Board of Directors of the Company approved the Amended and
Restated 2005 Stock Option and Restricted Stock Plan (the “2005 SOP”) and the Company’s
stockholders approved the 2005 SOP in November 2005. The 2005 SOP reserves
2,000,000 shares of common stock for grants of incentive stock options,
nonqualified stock options, warrants and restricted stock awards to employees,
non–employee directors and consultants performing services for the
Company.  The Company has stopped granting stock options under the 2005
SOP.





On March
11, 2009, the Board of Directors of the Company approved the 2009 Stock Option
Plan (the “2009 SOP”),
and the Company’s stockholders approved the 2009 SOP August 6, 2009. An
aggregate of 3,000,000 shares of common stock have been reserved under the 2009
SOP for grants of incentive stock options, nonqualified stock options, warrants
and restricted stock awards to employees, non–employee directors and consultants
performing services for the Company.





Options
granted under the 2005 SOP and 2009 SOP have an exercise price equal to or
greater than the fair market value of the underlying common stock at the date of
grant and become exercisable based on a vesting schedule determined at the date
of grant. The options generally expire 10 years from the date of grant.
Restricted stock awards granted under the 2005 SOP and 2009 SOP are subject to a
vesting period determined at the date of grant.





In June
2010, the Company entered into a Release and Separation Agreement with the
Company’s former CEO and former members of the board of directors pursuant to
which their respective stock option grants were modified.  In connection
with these modifications, the Company recorded incremental stock based
compensation expense, based on the change in fair value of the modified options,
of $147,082 during the quarter ended June 30, 2010.  In addition, based on
the continued vesting of certain of the modified stock options that were
modified, the Company expects to record additional stock based compensation
expense totaling approximately $112,000 ratably over the next 12
months.





All
options that the Company granted during the six months ended June 30, 2010 were
granted at the per share fair market value on the grant date. Vesting of options
differs based on the terms of each option. The Company utilized the
Black-Scholes option pricing model and the assumptions used for each period are
as follows:


13





Six
      Months EndedJune 30,2010
                
                
                2009Weighted
      average risk free interest rate
                
                
                2.76
                %
                
                
                2.42
                %Weighted
      average life (in years)
                
                6.0
                years
                
                5.99
                yearsVolatility
                
                
                123
                %
                
                
                149
                %Expected
      dividend yield
                
                
                0
                %
                
                
                0
                %Weighted
      average grant-date fair value per share of options granted
                
                $
                1.39
                
                
                $
                0.91





A summary
of stock option activity for the six months ended June 30, 2010 is presented
below:





Outstanding
      OptionsWeightedAverageWeighted
                                              
                                              
                                              Remaining
                                              
                                              
                                              AggregateAverage
                                              
                                              
                                              Contractual
                                              
                                              
                                              IntrinsicNumber
      of
                                              
                                              
                                              Exercise
                                              
                                              
                                              Life
                                              
                                              
                                              ValueShares
                                              
                                              
                                              Price
                                              
                                              
                                              (years)
                                              
                                              
                                              (1)Balance
      at December 31, 2009(2)
                                              
                                              
                                              5,821,000
                                              
                                              
                                              $
                                              1.37
                                              
                                              
                                              
                                              6.10
                                              
                                              
                                              $
                                              4,301,385Options
      Granted
                                              
                                              
                                              680,000
                                              
                                              
                                              $
                                              1.39
                                              
                                              
                                              
                                              9.58Exercised
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Forfeited
                                              
                                              
                                              (1,603,333
                                              )
                                              
                                              $
                                              1.09Cancelled
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Balance
      at June 30, 2010
                                              
                                              
                                              4,897,667
                                              
                                              
                                              $
                                              1.47
                                              
                                              
                                              
                                              6.60Vested
      and exercisable as of     June 30, 2010
                                              
                                              
                                              2,550,062
                                              
                                              
                                              $
                                              1.66
                                              
                                              
                                              
                                              5.89
                                              
                                              
                                              
                                              —Unvested
      as of June 30, 2010
                                              
                                              
                                              2,347,605
                                              
                                              
                                              $
                                              1.25
                                              
                                              
                                              
                                              7.37
                                              
                                              
                                              $
                                              —





1)
            The
      aggregate intrinsic value is calculated as the difference between the
      exercise price of the underlying awards and the closing stock prices of
      $0.66 and $1.90 of the Company’s common stock at June 30, 2010 and
      December 31, 2009, respectively.


2)
            Includes
      3,150,000 non-qualified options that were issued outside the 2005 and 2009
      stock option plans.





The total
grant date fair value of stock options granted during the three and six months
ended June 30, 2010 was $0 and $833,579, respectively.  For the three and
six months ended June 30, 2010, stock based compensation was $447,409 and
$735,575, respectively, that included $54,750 for 75,000 shares of restricted
stock authorized but not issued to a consultant. For the three and six months
ended June 30, 2009, stock based compensation was $346,737 and $571,782,
respectively.





As of
June 30, 2010, there was $1,683,718 of unrecognized compensation costs related
to outstanding employee stock options. This amount is expected to be recognized
over a weighted average period of 2.98 years. To the extent the forfeiture rate
is different from what the Company anticipated; stock-based compensation related
to these awards will be different from the Company’s expectations.





18.
RELATED PARTY TRANSACTIONS





A
Plus International, Inc.





During
the three and six months ended June 30, 2010 the Company recognized cost of
revenues of $1,709,839 and $2,740,910 in connection with the manufacture of
surgical products used in the Safety-Sponge® System by A Plus International or A
Plus.At June 30, 2010,
the Company’s accounts payable included $1,380,749 owed to A Plus in connection
with the purchase of surgical products used in the Safety-Sponge® System,
$13,656 of which will be paid directly to A Plus by Cardinal Health pursuant to
the new Supply and Distribution Agreement dated November 19, 2009.  Wenchen
Lin, a Director and significant beneficial owner of the Company is a founder and
significant owner of A Plus. On June 24, 2010, A Plus converted $1,000,000 of
accounts payable owed to A Plus into 10,000 shares of Series B Convertible
Preferred Stock (see Note 13).


14




Francis
Capital Management




On June
24, 2010, Catalysis Partners, LLC, invested $1,000,000 in the Series B
Convertible Preferred Stock transaction (see Note 13).  John P. Francis, a
member of our Board of Directors, has voting and investment control over
securities held by Francis Capital Management, LLC, which acts as the investment
manager for Catalysis Partners, LLC.




Release
and Separation Agreements




In
connection with the Series B Convertible Preferred Stock financing (see Note
13), Steven H. Kane, the Company’s former CEO, resigned as a Director, President
and Chief Executive Officer, and Howard E. Chase, Loren McFarland, Eugene A
Bauer, MD, and William M. Hitchcock also resigned as members of our Board of
Directors (the “Board”) and received certain severance benefits.




In
connection with Mr. Kane’s resignation, we entered into a Separation Agreement
and Mutual General Release with Steven Kane (the “Kane Release”).  Under
the Kane Release, Mr. Kane will receive, subject to compliance with its terms,
12 months of salary and health payments, and waived his rights to any bonus
payment, or payment for excise taxes.  The Kane Release also provided for
the payment to Mr. Kane, in cash, of an aggregate $234,573 as payment in full
for all accrued Director Fees and salary, accrued vacation, and accrued
severance benefits of $349,113 as of June 30, 2010 as provided in his employment
agreement.  The Kane Release contains other provisions, including
provisions relating to stock options and other matters.




In
connection with the resignation of Messrs. Chase, McFarland, Hitchcock and Dr.
Bauer as members of our Board, effective as of June 24, 2010, we entered into a
Separation Agreement and Mutual General Release with such individuals (the
“Director Release”).  The Director Release provided for the payment, in
cash, of the following unpaid Director’s fees not previously approved by the
Compensation Committee:  $83,488 to Mr. Chase, $64,912 to Mr. McFarland,
$10,025 to Mr. Hitchcock and $10,025 to Dr. Bauer.  The Director Release
contains other provisions, including provisions relating to stock options and
other matters.




19.MAJOR CUSTOMERS,
SUPPLIERS, SEGMENT AND RELATED INFORMATION




Major
Customers




During
the three and six months ended June 30, 2010, due to its exclusive distribution
agreement with Cardinal Health, the Company had one customer that represented in
excess of 97% and 98% of total revenues, respectively, compared with 89% and 80%
for the same respective periods in 2009.  No other single customer
accounted for more than 10% of total revenues in either period.





Suppliers





The
Company relies primarily on a third-party supplier, A Plus, to supply all the
surgical sponges and towels used in its Safety-Sponge® System. The Company also
relies on a number of third parties to manufacture certain other components of
its Safety-Sponge® System.  If A Plus or any of the Company’s other
third-party manufacturers cannot, or will not, manufacture its products in the
required volumes, on a cost-effective basis, in a timely manner, or at all, the
Company will have to secure additional manufacturing capacity.  Any
interruption or delay in manufacturing could have a material adverse effect on
the Company’s business and operating results.





Furthermore,
all products obtained from A Plus are manufactured in China.  As such, the
supply of product from A Plus is subject to various political, economic, and
other risks and uncertainties inherent in importing products from this country,
including among other risks, export/import duties, quotas and embargoes;
domestic and international customs and tariffs; changing taxation policies;
foreign exchange restrictions; and political conditions and governmental
regulations.


15




Segment
and Related Information




The
Company presents its business as one reportable segment due to the similarity in
nature of products marketed, financial performance measures, methods of
distribution and customer markets. The Company’s chief operating decision making
officer reviews financial information on the Company’s products on a
consolidated basis.  All revenues earned during the three and six months
ended June 30, 2010 relate to customers based in the United States.




The
following table summarizes revenues by product line.





Three Months Ended June 30,
                                  
                                  2010
                                  
                                  
                                  2009Revenues:Surgical
      sponges and towels
                                  
                                  $
                                  3,733,098
                                  
                                  
                                  $
                                  992,735Scanners
      and related products
                                  
                                  
                                  32,419
                                  
                                  
                                  
                                  34,870Total
      revenues
                                  
                                  $
                                  3,765,517
                                  
                                  
                                  $
                                  1,027,605Six Months Ended June 30,
                                  
                                  2010
                                  
                                  
                                  2009Revenues:Surgical
      sponges and towels
                                  
                                  $
                                  6,072,585
                                  
                                  
                                  $
                                  1,723,084Scanners
      and related products
                                  
                                  
                                  57,752
                                  
                                  
                                  
                                  240,521Total
      revenues
                                  
                                  $
                                  6,130,337
                                  
                                  
                                  $
                                  1,963,605





20. 
COMMITMENTS AND CONTINGENCIES





Operating
and Capital Leases





In
November 2007, the Company entered into a 36 month lease agreement for
approximately 4,000 square feet of office space in Temecula, CA which expires
December 31, 2010.  Monthly lease payments for the remaining lease term of
this lease are $9,757.  In December 2009, the Company entered into a 40
month sublease agreement for office space in Newtown, PA which expires in April
2013, at a fixed monthly total lease payment for the entire term of the lease of
$11,576.  In connection with the Newtown, PA office sublease, the Company
acquired certain office furniture valued at $100,000 from the building landlord
for a nominal one-time payment.  Accordingly, a portion of the total
monthly lease payment for this facility has been allocated to the acquisition of
this furniture and recorded as a capital lease at December 31,
2009.





In June
2010, the Company made the decision to close the Newtown, PA corporate
office.  Per FASB Accounting Standards Codification 420, Exit or Disposal Cost
Obligations, the Company expensed the net present value of the remaining
lease obligation along with an accrual for utilities through April 2013. 
The Company did not offset the lease accrual by any potential sublease, since it
is unlikely that a tenant will be found during the remaining sublease term due
to local commercial real estate market conditions.  This assumption will be
reviewed at the end of each quarter and any adjustments to the calculation will
be made as needed.  Accordingly, the Company wrote-off the remaining
capital lease asset and capital lease obligation which was recorded when the
Company acquired office furniture for a nominal one-time payment in December
2009.





Contingent
Tax Liability





In the
process of preparing the Company’s federal tax returns for prior years, the
Company’s management found there had been errors in reporting income to the
recipients and the respective taxing authorities, related to stock grants made
to certain employees and consultants.  In addition, the Company determined
that required tax withholding relating to these stock grants had not been made,
reported or remitted, as required in 2006 and 2007. Due to the Company’s failure
to properly report this income and withhold/remit required amounts, the Company
may be held liable for the amounts that should have been withheld, plus related
penalties and interest. The Company has estimated its contingent liability based
on the estimated required federal and state withholding amounts, the employee
and employer portion of social security taxes as well as the possible penalties
and interest associated with the error, and has submitted documentation to the
Internal Revenue Service reporting the previously unreported income. Although
the Company’s liability may ultimately be reduced based either on the expiration
of applicable statutes of limitations, or if it can prove that the taxes due on
this income were paid on a timely basis by some or all of the recipients, the
estimated liability including estimated interest and penalties, originally
accrued by the Company was based on the assumption that it will be liable for
the entire amounts due to the uncertainty with respect to whether or not the
recipients made such payments.


16





On June
24, 2010, in connection with the Series B Convertible Preferred Stock Purchase
Agreement, the Company entered into a Tax Escrow Agreement and transferred
$651,223 into a tax escrow account. The Tax Escrow Agreement was entered into by
and among the Company, Marc L. Rose, the Company’s Chief Financial Officer, as
representative of the present and former members of the Company’s Board of
Directors and U.S. Bank National Association, a national banking association, in
its capacity as escrow agent.   Under the Tax Escrow Agreement, the
escrow agent is required to use the escrowed funds to pay specified tax claims
to taxing authorities and/or to release escrowed funds to the extent the
Company’s tax reserve for the contingent tax liability has been reduced, subject
to compliance with certain procedures.





During
the quarter ended June 30, 2010, the Company reduced the tax escrow account by
$427,700 based on the expiration of the statue of limitations during the quarter
for certain amounts relating the tax year 2006.  The Company anticipates
receiving the $427,700 from the escrow account in the third quarter of
2010.  As of June 30, 2010, the remaining contingent tax liability, which
is included in accrued liabilities, is $223,523.





Legal
Proceedings





On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit against the Company, Sunshine Wireless, LLC, and four other
defendants affiliated with Winstar Communications, Inc.  This lawsuit
alleged that the Winstar defendants conspired to commit fraud and breached their
fiduciary duty to the plaintiffs in connection with the acquisition of the
plaintiff's radio production and distribution business.  The complaint
further alleged that the Company and Sunshine joined the alleged
conspiracy.  On February 25, 2003, the case against the Company and
Sunshine was dismissed.  However, on October 19, 2004, Jeffrey A. Leve and
Jeffrey Leve Family Partnership, L.P. exercised their right to appeal.  On
June 1, 2005, the United States Court of Appeals for the Second Circuit affirmed
the February 25, 2003 judgment of the district court dismissing the claims
against the Company.





On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed
another lawsuit against the Company, Sunshine Wireless LLC and four other
defendants affiliated with Winstar Communications to collect a federal default
judgment of $5 million entered against two entities, Winstar Radio Networks, LLC
and Winstar Global Media, Inc., by attempting to enforce the judgment against
the Company and others under the doctrine of de factomerger.  The
action was tried before the Los Angeles County Superior Court in 2008.  On
August 5, 2009, the Superior Court issued a statement of decision in the
Company’s favor, and on October 8, 2009, the Superior Court entered judgment in
the Company’s favor, and judged plaintiffs’ responsible for $2,708.70 of the
Company’s court costs.  On November 6, 2009, the plaintiff filed a notice
of appeal in the Superior Court of the State of California, County of Los
Angeles Central District.  The Company has engaged appellate counsel,
believes the plaintiff’s case is without merit and intends to continue to defend
the case vigorously. As loss is not deemed to be probable, no accruals have been
made as of June 30, 2010.





21.
SUBSEQUENT EVENTS





On August
9, 2010, the Company entered into an employment agreement and appointed John A.
Hamilton as Chief Operating Officer and Vice President of the
Company.





ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our unaudited condensed
consolidated interim financial statements and the related notes thereto
appearing elsewhere in this quarterly report on Form 10-Q and our audited
consolidated financial statements and related notes thereto and the description
of our business appearing in our annual report on Form 10-K for the year ended
December 31, 2009.    This discussion contains forward-looking
statements that involve risks and uncertainties. See “Cautionary Note Regarding
Forward-Looking Statements.”  Known and unknown risks, uncertainties and
other factors could cause our actual results to differ materially from those
projected in any forward-looking statements.  In evaluating these
statements, you should specifically consider various factors, including, but not
limited to, those set forth under the caption “Risk Factors” in our annual
report on Form 10-K for the year ended December 31, 2009.


17





Overview





We focus
on the development, marketing and sales of products and services in the medical
patient safety markets. Our proprietary Safety-Sponge® System is a patented
system of bar-coded surgical sponges, SurgiCounterTM scanners, and software
applications integrated to form a comprehensive counting and documentation
system.  This system is designed to eliminate the possibility of retained
surgical sponges being unintentionally left inside of patients during surgical
procedures by allowing faster and more accurate counting of surgical
sponges.  At June 30, 2010, we reached a milestone of having had a
cumulative total of an estimated 32,500,000 sponges used in 1,300,000 procedures
without a single undetected sponge left inside a surgical patient. We sell our
Safety-Sponge® System to hospitals through our direct sales force, but rely on
an exclusive distributor for the ongoing supply of our proprietary surgical
sponge products to hospitals that have adopted our system.  Our business
model consists of selling our unique surgical sponge products, which are
manufactured for us by an exclusive supplier, on a recurring basis to those
hospitals that have adopted our Safety-Sponge® System. One of the ways in which
we differentiate our products from other competing products is by working
closely with hospital personnel through education and implementation services.
We currently sell our Safety-Sponge® System only in the United States and we had
revenues of $3,765,517 and $6,130,337 for the three and six months ended June
30, 2010, which included $2,322,361 and $3,396,870, respectively, shipped to
Cardinal Health under the First Forward Order which does not necessarily
represent sales of that product to end user hospitals (see “Factors Affecting
Future Results —Cardinal Health Supply Agreement”).





Sources
of Revenues and Expenses





Revenues





Surgical Sponge
Revenues.  We generate revenues primarily from the sale of surgical
sponges used in our Safety-Sponge® System to our exclusive distributor, who then
sells directly and through sub-distributors to hospitals that have adopted our
Safety-Sponge® System.  We expect hospitals that adopt our Safety-Sponge®
System to commit to its use and thus provide a recurring source of revenues from
ongoing sales of surgical sponges and other products used in our system. We
recognize revenues from the sale of surgical sponges upon shipment to our
distributor because most of our surgical sponge sales are to our distributor,
FOB shipping point.  Note that because of the way our sales cycle works
there is a gap between the time we begin incurring costs associated with our new
customer arrangements and when we begin generating revenues from such
arrangements.





Hardware, Software and Maintenance
Agreement Revenues.  We also generate revenues from the sale of
related hardware and software to hospitals that have adopted our Safety-Sponge®
System.  The sale of our Safety-Sponge® System includes hardware (the
SurgiCounterTM scanners and certain related hardware), our proprietary file
management software (CitadelTM) and an initial one-year maintenance agreement
(which may be renewed).  All of these items are considered to be separate
deliverables within a multiple-element arrangement and, accordingly, we allocate
the total price of this arrangement among each respective deliverable, and
recognize revenue as each element is delivered. For the hardware and software
elements of our Safety-Sponge® System, we recognize revenues on delivery, which
is the time of shipment (if terms are FOB shipping point) or upon receipt by the
customer (if terms are FOB destination).  Delivery with respect to our
initial one-year maintenance agreements is considered to occur on a monthly
basis over the term of the one-year period; we recognize revenues related to
this element on a pro-rata basis during this period.  Because of the change
in our business model discussed below under “—Factors Affecting Future Results,”
we do not expect these sales to represent a significant portion of our revenues
going forward.





Prior to
the third quarter of 2009, our business model included the sale of our
SurgiCounterTM scanners and related software used in our Safety-Sponge® System to
most hospitals that adopted our system.  Beginning with the third quarter
of 2009, we modified our business model and began to provide our SurgiCounterTM
scanners and related software to all hospitals at no cost when they adopt our
Safety-Sponge® System.  Because we no longer engage primarily in direct
SurgiCounterTM scanner sales, we generally anticipate only recognizing revenues
associated with our SurgiCounterTM scanners in connection with reimbursement
arrangements under our agreement with Cardinal Health.  Therefore, we do
not expect that our SurgiCounterTM scanners and related hardware will represent a
sizable source of future revenues for us. Deferred scanner revenue associated
with the reimbursement from Cardinal Health, will be recognized over the life of
the specific hospital contract.


18





Cost
of revenues





Our cost
of revenues consists primarily of our direct product costs for surgical sponges
and products from our exclusive third-party manufacturer.  We also include
a reserve expense for obsolete and slow moving inventory in cost of
revenues.  In addition, when we provide scanners to hospitals for their use
(rather than sell), we include only the depreciation expense of the scanners in
cost of revenues (not the full product cost).  We estimate the useful life
of the scanners to be three years. However, should we sell the scanners to
hospitals, our cost of revenues include the full product cost when
shipped.





Research
and development expenses





Our
research and development expenses consist of costs associated with the design,
development, testing and enhancement of our products.  We also include
salaries and related employee benefits, research-related overhead expenses and
fees paid to external service providers in our research and development
expenses.





Sales
and marketing expenses





Our sales
and marketing expenses consist primarily of salaries and related employee
benefits, sales commissions and support costs, professional service fees,
travel, education, trade show and marketing costs.





General
and administrative expenses





Our
general and administrative expenses consist primarily of salaries and related
employee benefits, professional service fees, expenses related to being a public
entity, and depreciation and amortization expense.





Total
other income (expense)





Our total
other income (expense) primarily reflects changes in the fair value of warrants
classified as derivative liabilities.  Under applicable accounting rules
(discussed below under “—Critical Accounting Policies—Warrant Derivative
Liability”), we are required to make estimates of the fair value of our warrants
each quarter, and to record the change in fair value each period in our
statement of operations.  As a result, changes in our stock price from
period to period result in other income (when our stock price decreases) or
other expense (when our stock price increases) on our income
statement.





Critical
Accounting Policies and Estimates





The
preparation of financial statements in conformity with U.S. generally accepted
accounting principles requires the use of estimates and assumptions that affect
the reported amounts of assets and liabilities, revenues and expenses, and
related disclosures in the financial statements.  Critical accounting
policies are those accounting policies that may be material due to the levels of
subjectivity and judgment necessary to account for highly uncertain matters or
the susceptibility of such matters to change, and that have a material impact on
financial condition or operating performance. While we base our estimates and
judgments on our experience and on various other factors that we believe to be
reasonable under the circumstances, actual results may differ from these
estimates under different assumptions or conditions.  We believe the
following critical accounting policies used in the preparation of our financial
statements require significant judgments and estimates.  For additional
information relating to these and other accounting policies, see Note 3 to our
condensed consolidated interim financial statements, appearing elsewhere in this
quarterly report on Form 10-Q.





Warrant
Derivative Liability





Under
applicable accounting guidance, an evaluation of outstanding warrants is made to
determine whether warrants issued are required to be classified as either equity
or a liability. Because certain warrants we have issued in connection with past
financings contain certain provisions that may result in an adjustment to their
exercise price, we classify them as derivative liabilities, and accordingly, we
are then required to estimate the fair value of such warrants, at the end of
each fiscal quarter.  We use the Black-Scholes option pricing model to
estimate such fair value, which requires the use of numerous assumptions,
including, among others, expected life (turnover), volatility of the underlying
equity security, a risk-free interest rate and expected dividends. The use of
different values by management in connection with these assumptions in the Black
Scholes option pricing model could produce substantially different
results.  Because we record changes in the fair value of warrants
classified as derivative liabilities in total other income (expense), materially
different results could have a material effect on our results of
operations.


19





Goodwill





Our
goodwill represents the excess of the purchase price over the estimated fair
values of the net tangible and intangible assets of SurgiCount Medical, Inc.,
which we acquired in February 2005. We review goodwill for impairment at least
annually in the fourth quarter, as well as whenever events or changes in
circumstances indicate its carrying value may not be recoverable.  We are
required to perform a two-step impairment test on goodwill. In the first step,
we will compare the fair value to its carrying value.  If the fair value
exceeds the carrying value, goodwill will not be considered impaired, and we are
not required to perform further testing.  If the carrying value exceeds the
fair value, then we must perform the second step of the impairment test in order
to determine the implied fair value of goodwill and record an impairment loss
equal to the difference. Determining the implied fair value involves the use of
significant estimates and assumptions. These estimates and assumptions include
revenue growth rates and operating margins used to calculate projected future
cash flows, risk-adjusted discount rates, future economic and market conditions
and determination of appropriate market comparables. We base our fair value
estimates on assumptions we believe to be reasonable but that are unpredictable
and inherently uncertain. Actual future results may differ from those estimates.
To the extent additional events or changes in circumstances occur, we may
conclude that a non-cash goodwill impairment charge against earnings is
required, which could have an adverse effect on our financial condition and
results of operations.





Stock-Based
Compensation





We
recognize compensation expense in an amount equal to the estimated grant date
fair value of each option grant, or stock award over the estimated period of
service and vesting.  This estimation of the fair value of each stock-based
grant or issuance on the date of grant involves numerous assumptions by
management. Although we calculate the fair value under the Black Scholes option
pricing model, which is a standard option pricing model, this model still
requires the use of numerous assumptions, including, among others, the expected
life (turnover), volatility of the underlying equity security, a risk free
interest rate and expected dividends. The model and assumptions also attempt to
account for changing employee behavior as the stock price changes and capture
the observed pattern of increasing rates of exercise as the stock price
increases.  The use of different values by management in connection with
these assumptions in the Black Scholes option pricing model could produce
substantially different results.





Impairment
of Long-Lived Assets





Our
management reviews our long-lived assets with finite useful lives for impairment
whenever events or changes in circumstances indicate that the carrying amount of
such assets may not be recoverable. We recognize an impairment loss when the sum
of the future undiscounted net cash flows expected to be realized from the asset
is less than its carrying amount. If an asset is considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the asset exceeds its fair value. Considerable judgment is necessary
to estimate the fair value of the assets and accordingly, actual results could
vary significantly from such estimates. Our most significant estimates and
judgments relating to the long-lived asset impairments include the timing and
amount of projected future cash flows.





Accounting
for Income Taxes





Deferred
income taxes result primarily from temporary differences between financial and
tax reporting. Deferred tax assets and liabilities are determined based on the
difference between the financial statement basis and tax basis of assets and
liabilities using enacted tax rates. Future tax benefits are subject to a
valuation allowance when management is unable to conclude that our deferred tax
assets will more-likely-than-not be realized from the results of operations. Our
estimate for the valuation allowance for deferred tax assets requires management
to make significant estimates and judgments about projected future operating
results. If actual results differ from these projections, or if management’s
expectations of future results change, it may be necessary to adjust the
valuation allowance.




20





Since
January 1, 2007, we have measured and recorded uncertain tax positions in
accordance with rules that took effect on such date that prescribe a threshold
for the financial statement recognition and measurement of a tax position taken
or expected to be taken in a tax return.  Accordingly, we now only
recognize (or continue to recognize) tax positions meeting the
more-likely-than-not recognition threshold (or that met such threshold on the
effective date).  Accounting for uncertainties in income tax positions
involves significant judgments by management.  If actual results differ
from management’s estimates, we may need to adjust the provision for income
taxes.





Recent
Accounting Pronouncements





For
additional discussion regarding these, and other recent accounting
pronouncements, see Note 3 to our condensed consolidated interim financial
statements, appearing elsewhere in this quarterly report on Form
10-Q.





Internal
Control Over Financial Reporting





In
connection with our assessment of internal controls over financial reporting as
of December 31, 2009, we identified the following material weaknesses in our
internal control over financial reporting due to:





·
            Ineffective
      control environment due to the following identified
      weaknesses:


o
            Failure
      to retain individuals competent in the application of generally accepted
      accounting principles (“GAAP”) to complex accounting
      transactions.


o
            Failure
      to establish sufficiently detailed accounting policies and procedures and
      to properly train accounting department
staff.


·
            Ineffective
      internal control policies and procedures relating to the period end close
      process including lack of controls relating to journal entries, post
      closing adjustments and management review of conclusions regarding
      accounting and financial reporting
matters.


·
            Ineffective
      internal control policies and procedures designed to provide reasonable
      assurance regarding the accuracy and integrity of spreadsheets used in the
      financial reporting system.





To remedy
these material weaknesses, we are implementing policies and procedures to
formalize our period end close process as well as to address the application of
our accounting policies to ensure conformity with GAAP.  We are also
seeking to hire qualified personnel, or engage outside resources, as applicable,
with appropriate knowledge/experience in the application of GAAP to complex
accounting transactions and we are strengthening internal policies and
procedures designed to ensure the accuracy and integrity of spreadsheets used in
the financial reporting system.





For
information regarding our evaluation of the effectiveness of our disclosure
controls and procedures as well as any changes in our internal control over
financial reporting as of the end of the period covered by this report, see
“Controls and Procedures” below.





Factors
Affecting Future Results





Cardinal Health Supply
Agreement.   On November 19, 2009 we entered into a Supply and
Distribution Agreement with Cardinal Health (which replaced our prior agreement
with Cardinal Health) under which Cardinal Health is the exclusive distributor
of current products used in our proprietary Safety-Sponge® System in the United
States, Puerto Rico and Canada.  In connection with the execution of this
distribution agreement, Cardinal Health issued a $10,000,000 stocking purchase
order ("First Forward Order"), paid us $8,000,000 in cash as a partial
prepayment of the First Forward Order and agreed to pay $2,000,000 directly to A
Plus International, Inc. ("A Plus"), our exclusive manufacturer, upon delivery
of product to Cardinal Health.  We did not ship any product pursuant to the
First Forward Order in 2009, and accordingly, all $10,000,000 of revenue from
the First Forward Order is expected to be recognized in 2010.  As of June
30, 2010, we had recognized $3,396,870 in revenue from the First Forward
Order.  In addition, Cardinal Health agreed to issue a $5,000,000 stocking
purchase order ("Second Forward Order") before the end of the third quarter of
2010 if certain milestones are achieved.  If the Second Forward
Order is issued, Cardinal Health will pay us $4,000,000 in cash as a partial
prepayment of the Second Forward Order and pay $1,000,000 directly to A Plus
upon delivery of product to Cardinal Health.  If the Second Forward Order
is issued and we meet our delivery requirements, we expect to have minimum
incremental revenue of $10,500,000 in 2010, with the remaining $4,500,000 in
revenue from the Second Forward Order recognized when product is shipped in
2011.  As of the date of the report, we do not anticipate reaching the
milestones in order to qualify for the Second Forward Order.


21





Because
of this arrangement, we expect that our revenues for 2010 will be significantly
higher than the actual sales of our product by our exclusive distributor to its
end-user hospital customers.  In contrast, we anticipate that our revenues
for 2011 and 2012 will be lower than actual sales of our product by our
exclusive distributors to its end-user hospital customers, because we anticipate
that Cardinal Health will satisfy customer demand for our products, in part, by
using the inventory shipped to it during 2010.





Effect of Stocking Sales and Backlog
on Revenues.  Our revenues reflect primarily the sale of surgical
sponges to our exclusive distributor.  Because we recognize revenues when
we ship product, (1) the timing of orders by our distributor and the management
of its inventory may affect the comparability of revenues between periods and
(2) to the extent there is a backlog in receipt of products from our exclusive
supplier of our surgical sponges, we may not always be able to recognize
revenues in the same period in which a product order is received. In addition,
our exclusive distributor may be required to sell down its inventory more than
it anticipated, which could result in a larger than normal product order. 
 Thus, certain changes in our revenues between periods are not necessarily
reflective of actual hospital demand for our surgical sponge
products.





Reduction in Hardware Sales – Effect
on Revenues and Cost of Revenues.  Prior to the third quarter of
2009, our business model included the sale of our SurgiCounterTM scanners and
related hardware and software used in our Safety-Sponge® System to most
hospitals that adopted our system.  Beginning with the third quarter of
2009, we modified our business model and began to offer to provide our
SurgiCounterTM scanners and related hardware and software to all hospitals at no
cost when they adopt our Safety-Sponge® System.  Because we no longer
engage primarily in direct SurgiCounterTM scanner
sales and generally anticipate only recognizing revenues associated
with our SurgiCounterTM scanners in connection with reimbursement arrangements
under our agreement with Cardinal Health, we do not expect our
SurgiCounterTM scanners to continue to represent a sizable source of
revenues for our company.  For the three and six months ended June 30,
2010, surgical sponge sales accounted for 99.1% and 99.1%, respectively,
compared to 96.7% and 87.8%, respectively, for the same period in 2009. 
This change in our business model also affected our costs of revenues because
rather than recognizing the full product cost for all SurgiCounterTM scanners at
the time of shipment in our cost of revenues, we now recognize only the
depreciation expense for those SurgiCounterTM scanners and related hardware that
we have provided to certain hospitals for their use at no cost.  This
business model change led to a significant improvement in our gross
margin in the year ended December 31, 2009 based on the shift in product mix
resulting in a significantly higher percentage of surgical sponge sales, which
are sold at a higher margin than our SurgiCounterTM scanners included in our cost
of revenue.  Going forward, we anticipate that the shift in product
mix and anticipated increase in volume of surgical sponge sales will more
than offset the effects of including depreciation expense for the
scanners in cost of revenue without generating the corresponding
revenue from the sale of the scanner.





Results
of Operations





Three
Months Ended June 30, 2010 Compared to Three Months Ended June 30,
2009





Revenues





We had
revenues of $3,765,517, which included $2,322,361 shipped to Cardinal Health
under the First Forward Order (see “Factors Affecting Future Results —Cardinal
Health Supply Agreement”) for the three months ended June 30, 2010. 
Therefore, estimated hospital consumption revenue which is defined as total
revenue less the First Forward Order was $1,443,156 for the three months ended
June 30, 2010, an increase of 40.4% compared to $1,027,605 for the same period
in 2009.   In the three months ended June 30, 2010, surgical sponge
sales accounted for 99.1% of revenues, and sales of hardware accounted for 0.9%,
compared to 96.7% and 3.3% for the same period in 2009, respectively.  The
primary reason for the increase in revenues was an increase in sales of surgical
sponges used in our Safety-Sponge® System and the shipment of product to
Cardinal Health. The increase in sales activity was attributable to a number of
factors, including increased industry recognition of our product offering, along
with changes made in our sales program, including the indemnification program
and providing scanners and associated hardware and software at no additional
cost to our end-user hospital customers.




22


Cost
of revenues





Cost of
revenues increased by $1,171,798 or 189.4%, to $1,790,360 for the three months
ended June 30, 2010 from $618,562 for the same period in 2009.  The
increase was primary due to an increase in sales of our products used in our
Safety-Sponge® System, reflecting an increase in the number of hospitals that
have adopted and implemented our system, along with $1,069,301 associated with
the shipment of product to Cardinal Health (see “Factors Affecting Future
Results —Cardinal Health Supply Agreement”).  The increase in costs
associated with the increase in sales of products more than offset the decrease
in costs that resulted from the change in our business model with respect to the
provision of our SurgiCounterTM scanners, which resulted in approximately
$858,000 of cost now being depreciated and recognized over the life of the
hardware.





Gross
profit





We had
gross profit of $1,975,157 for the three months ended June 30, 2010, an increase
of $1,566,114, or 382.9%, compared to $409,043 in the same period in 2009. 
The primary reason for the increase in gross profit during the three months
ended June 30, 2010, was the higher revenue
growth achieved, combined with the shift in product mix,
resulting in a significantly higher percentage of surgical sponge sales, which
are sold at a higher margin than our SurgiCounterTM scanners.  We had
gross margin of 52.4% for the three months ended June 30, 2010, compared to
39.8% for the same period in 2009, which improvement is primarily attributable
to our change in business model, and partially offset by the increase in
customer rebates that did not exist in the same period in 2009.





Operating
expenses





We had
total operating expenses of $3,003,193 for the three months ended June 30, 2010,
an increase of $1,004,539, or 50.3%, compared to $1,998,654 for the same period
in 2009.  This increase was due to an increase in general and
administrative expenses and sales and marketing expenses, which are discussed
below.





Research
and development expenses





We had
research and development expenses of $97,972 for the three months ended June 30,
2010, an increase of $12,391, or 14.5%, compared to $85,581 in the same period
in 2009.  The primary reason for the increase was an acceleration of third
party development expenses, offset by a reclassification of certain
personnel-related expenses into sales and marketing expenses.





Sales
and marketing expenses





We had
sales and marketing expenses of $828,445 for the three months ended June 30,
2010, an increase of $275,220, or 49.7%, compared to $553,225 in the same period
in 2009.  The primary reason for the increase in sales and marketing
expenses was an increase in personnel, travel and trade show related expenses,
along with increased clinical implementation related expenses, which increased
in connection with expanded adoption of our Safety-Sponge® System.





General
and administrative expenses





We had
general and administrative expenses of $2,076,776 for the three months ended
June 30, 2010, an increase of $716,928, or 52.7%, compared to $1,359,848 in the
same period in 2009.  The increase in general and administrative expense
was primarily due employee severance, board compensation for resigning directors
including modifications to their respective stock option grants, professional
services, and the accrued cost of closing the Newtown, PA office offset by a
$427,700 gain resulting from an adjustment to the contingent tax liability based
on the fact that that statute of limitation expired for the 2006 tax
year.





Total
other income (expense)





We had
total other income of $945,339 for the three months ended June 30, 2010,
compared to total other expense of $2,374,852 in the same period in 2009. 
The primary reason for the change was a significant decrease in the fair value
of our warrant derivative liability, which resulted in income of $951,210 in the
three months ended June 30, 2010, compared to a loss of $2,155,119 in the same
period in 2009.  This liability, and the related expense, increases and
decreases as a direct result of fluctuations in the price of our common stock,
which trades on the over the counter market.  Excluding the effects of the
changes in the fair value of our warrant derivative liability, our other expense
decreased, primarily due to a significant decrease in our interest expense,
which decreased due to the reduction in our outstanding indebtedness at June 30,
2010 compared to the same period in 2009.




23


Provision
for income taxes





We had a
$32,573 tax benefit for the three months ended June 30, 2010, compared to a
$30,719 tax benefit for the same period in 2009.  The tax benefit relates
to the amortization of the Company’s patent portfolio.





Net
loss





For the
foregoing reasons, we had a net loss of $76,056 for the three months ended June
30, 2010 compared to a net loss of $3,953,069 for the same period in
2009.





Six
Months Ended June 30, 2010 Compared to Six Months Ended June 30,
2009





Revenues





We had
revenues of $6,130,337, which included $3,396,870 shipped to Cardinal Health
under the First Forward Order (see “Factors Affecting Future Results —Cardinal
Health Supply Agreement”) for the six months ended June 30, 2010. 
Therefore, estimated hospital consumption revenue which is defined as total
revenue less the First Forward Order was $2,733,467 for the six months ended
June 30, 2010, an increase of 39.2% compared to $1,963,605 for the same period
in 2009.   In the six months ended June 30, 2010, surgical sponge
sales accounted for 99.1% of revenues, and sales of hardware accounted for 0.9%,
compared to 87.8% and 12.2% for the same period in 2009, respectively.  The
primary reason for the increase in revenues was an increase in sales of surgical
sponges used in our Safety-Sponge® System and the shipment of product to
Cardinal Health. The increase in sales activity was attributable to a number of
factors, including increased industry recognition of our product offering, along
with changes made in our sales program, including the indemnification program
and providing scanners and associated hardware software at no additional cost to
our end-user hospital customers.





Cost
of revenues





Cost of
revenues increased by $1,711,686 or 146.6%, to $2,879,248 for the six months
ended June 30, 2010 from $1,167,562 for the same period in 2009.  This
increase was primarily due to an increase in sales of our products used in our
Safety-Sponge® System, reflecting an increase in the number of hospitals that
have adopted and implemented our system, and $1,536,415 in costs associated with
the shipment of product to Cardinal Health (see “Factors Affecting Future
Results —Cardinal Health Supply Agreement”).  The increase in costs
associated with the increase in sales of products more than offset the decrease
in costs that resulted from the change in our business model with respect to the
provision of our SurgiCounterTM scanners, which resulted in approximately
$858,000 of cost now being depreciated and recognized over the life of the
hardware.





Gross
profit





We had
gross profit of $3,251,089 for the six months ended June 30, 2010, an increase
of $2,455,046, or 308.4%, compared to $796,043 in the same period in 2009. 
The primary reason for the increase in gross profit during the six months ended
June 30, 2010, was the higher revenue growth achieved, combined with
the shift in product mix, resulting in a significantly higher percentage of
surgical sponge sales, which are sold at a higher margin than our
SurgiCounterTM scanners.  We had gross margin of 53.0% for the six months
ended June 30, 2010, compared to 40.5% for the same period in 2009, which
improvement is primarily attributable to our change in business model, and
partially offset by the increase in customer rebates that did not exist in the
same period in 2009.





Operating
expenses





We had
total operating expenses of $5,682,502 for the six months ended June 30, 2010,
an increase of $370,848, or 6.9%, compared to $5,311,654 for the same period in
2009.  The increase in operating expense was due to an increase in general
and administrative expenses and an increase in sales and marketing expenses,
which are discussed below, offset by a decrease of $1,297,200 for warrant
expense relating to our January 2009 debt financing included in the six months
ended June 30, 2009, which was not present in the 2010 period.  Also,
during the six months ended June 30, 2010, we had a $427,700 gain resulting from
an adjustment to the contingent tax liability based on the fact that that
statute of limitation expired for the 2006 tax year, which was not present in
the 2009 period.




24


Research
and development expenses





We had
research and development expenses of $131,302 for the six months ended June 30,
2010, a decrease of $67,279, or 33.9%, compared to $198,581 in the same period
in 2009.  The primary reason for the decrease was a reduction in overall
third party development expenses and a reclassification of certain
personnel-related expenses into sales and marketing expenses.





Sales
and marketing expenses





We had
sales and marketing expenses of $1,822,562 for the six months ended June 30,
2010, an increase of $620,337, or 51.6%, compared to $1,202,225 in the same
period in 2009.  The primary reason for the increase in sales and marketing
expenses was an increase in personnel, travel and trade show related expenses,
along with increased clinical implementation related expenses, which increased
in connection with expanded adoption of our Safety-Sponge® System.





General
and administrative expenses





We had
general and administrative expenses of $3,728,638 for the six months ended June
30, 2010, a decrease of $182,210, or 4.7%, compared to $3,910,848 for the same
period in 2009.  This decrease was primarily due to a $1,297,200 reduction
for warrant expense relating to our January 2009 debt financing included in the
six months ended June 30, 2009, which was not present in the 2010 period and a
$427,700 gain resulting from an adjustment to the contingent tax liability based
on the fact that that statute of limitation expired for the 2006 tax year,
offset by employee severance, board compensation for resigning directors
including modifications to their respective stock option grants, professional
services and the accrued cost of closing the Newtown, PA office in the 2010
period.





Total
other income (expense)





We had
total other income of $2,709,689 for the six months ended June 30, 2010,
compared to total other expense of $3,009,852 in the same period in 2009. 
The primary reason for the change was a significant decrease in the fair value
of our warrant derivative liability, which resulted in income of $2,669,949 in
the six months ended June 30, 2010, compared to a loss of $2,570,119 in the same
period in 2009.  This liability, and the related expense, increases and
decreases as a direct result of fluctuations in the price of our common stock,
which trades on the over the counter market.   Excluding the effects
of the changes in the fair value of our warrant derivative liability, our other
expense decreased, primarily due to a significant decrease in our interest
expense, which decreased due to the reduction in our outstanding indebtedness at
June 30, 2010 compared to the same period in 2009.





Provision
for income taxes





We had a
$65,146 tax benefit for the six months ended June 30, 2010, compared to a
$64,719 tax benefit for the same period in 2009.  The tax benefit relates
to the amortization of the Company’s patent portfolio.





Net
income (loss)





For the
foregoing reasons, we had net income of $298,327 for the six months ended June
30, 2010 compared to a net loss of $7,499,069 for the same period in
2009.





Financial
Condition, Liquidity and Capital Resources





We had
cash and cash equivalents of $4,591,755 at June 30, 2010 compared to $3,446,726
at December 31, 2009.  We had restricted cash of $651,223 at June 30, 2010
compared to $0 at December 31, 2009 due to the establishment of the Tax Escrow
Account (see Note 20 to our condensed consolidated interim financial statements
appearing elsewhere in this quarterly report on Form 10-Q). As of June 30, 2010
we had a working capital deficit of approximately $4,820,319, of which
$6,416,818 and $996,388 are associated with deferred revenue relating to the
partial prepayment from Cardinal Health and the warrant derivative liability,
respectively.




25


Our
principal sources of cash have included the issuance of equity and debt
securities. We expect that as our revenues grow, our operating expenses will
continue to grow and, as a result, we will need to generate significant
additional net revenues to achieve profitability and cash flow from
operations.  Our sales cycle requires that we incur significant expenses in
advance of the time we generate revenues from our new customer arrangements.
Thus, as our business grows and we expand our customer base, our cash needs will
increase prior to the time we generate cash from such new customer
arrangements.  We engaged in a financing transaction in June 2010 that
resulted in the receipt of $4,528,045, net of transaction costs and a $1,000,000
reduction in accounts payable.  Although management believes existing cash
resources, as augmented by this financing, combined with projected cash flow
from operations, will be sufficient to fund the Company’s working capital
requirements into the first quarter of 2011, in order to continue to operate as
a going concern it will be necessary to raise additional funds.  We believe
that we will be able to obtain such financing and that, if necessary,
additional cost-cutting measures could be implemented to extend our ability to
operate our core business even if financing is not timely available. 
However, no assurances can be made that we will be successful in obtaining a
sufficient amount of financing on acceptable terms (or any financing) to
continue to fund our operations or that we will achieve profitable operations
and positive cash flow.  In addition, no assurance can be made that
any additional cost cutting measures, if implemented, would materially
extend the Company’s ability to operate without procuring additional
financing.





Operating
activities





We used
$2,205,686 of net cash from operating activities in the six months ended June
30, 2010.  Non-cash adjustments to reconcile net income to net cash used in
operating activities plus changes in operating assets and liabilities used
$1,862,264 of cash for the six months ended June 30, 2010.  These
significant non-cash adjustments primarily reflect the stock and warrant based
compensation to employees and directors and adjustments to reflect the change in
fair value of our warrant derivative liability, contingent tax liability along
with activity relating to shipments to Cardinal Health.





Investing
activities





We used
$472,226 of net cash in investing activities during the six months ended June
30, 2010, primarily for the purchase of scanners and related hardware used in
our Safety Sponge® System.





Financing
activities





We
generated $3,822,941 of net cash from financing activities in the six months
ended June 30, 2010, primarily from the net proceeds of the $6,000,000 issuance
of Series B Convertible Preferred Stock, offset by the payment of preferred
stock dividends, the write-off of the capital lease obligations following the
closure of the Newtown, PA office.  See Note 20 to our condensed
consolidated interim financial statements appearing elsewhere in this quarterly
report on Form 10-Q.





On June
24, 2010, in connection with the Convertible Preferred Stock Purchase Agreement,
the Company entered into a Tax Escrow Agreement and transferred $651,223 into a
tax escrow account. The Tax Escrow Agreement was entered into by and among the
Company, Marc L. Rose, the Company’s Chief Financial Officer, as representative
of the present and former members of the Company’s Board of Directors and U.S.
Bank National Association, a national banking association, in its capacity as
escrow agent. Under the Tax Escrow Agreement, the escrow agent is required to
use the escrowed funds to pay specified tax claims to taxing authorities and/or
to release escrowed funds to the extent the Company’s tax reserve for the
contingent tax liability has been reduced, subject to compliance with certain
procedures.





Description
of Indebtedness





At June
30, 2010, we had aggregate indebtedness of $1,424,558 pertaining to the Ault
Glazer Capital Partners LLC note as described below.




26


Ault
Glazer Capital Partners, LLC





On
September 5, 2008, we entered into an Amendment and Early Conversion of Secured
Convertible Promissory Note ("Amendment"), with Ault Glazer Capital
Partners, LLC, or Ault Glazer, to modify the terms of our outstanding
$2,530,558 convertible secured promissory note (issued to Ault Glazer
effective as of June 1, 2007). This convertible secured note was to have matured
on December 31, 2010, bore interest at a rate of 7% per annum, was convertible
into shares of our common stock at $2.50 per share in certain circumstances, and
was secured by all of our assets.  Under the Amendment, we agreed to pay
Ault Glazer $450,000 in cash and, contingent upon satisfaction of certain
conditions by Ault Glazer, convert the remaining balance of the convertible
secured note into 1,300,000 shares of our common stock.  Notably, one
condition was that Ault Glazer transfers certain leases from our name into its
name.  On September 12, 2008, we entered into an Agreement for the
Advancement of Common Stock Prior to Close of the Amendment and Early Conversion
of Secured Convertible Promissory Note ("Advancement"), whereby we agreed to
issue shares of our common stock to Ault Glazer in advance of its
satisfaction of the conditions for the conversion of the convertible secured
note that were set out in the Amendment.  As of the date of this quarterly
report on Form 10-Q, we have paid Ault Glazer $450,000 in cash and issued Ault
Glazer an aggregate 800,0000 shares of our common stock in settlement of the
promissory note in advance of conversion of the note.  Ault Glazer has not
yet satisfied the conditions set out in the Amendment, and the
issuance of the remaining shares of our common stock to Ault Glazer remains
contingent upon its satisfaction of such conditions.  In light of the
Amendment and issuance of shares pursuant to the Advancement and Ault Glazer’s
failure to satisfy the conditions, we are no longer incurring interest expense
on this convertible secured promissory note.  As of June 30, 2010, the
outstanding principal balance on this note was $1,424,558.  For further
information relating to this note, see Note 10 to our condensed consolidated
interim financial statements appearing elsewhere in this quarterly report on
Form 10-Q.





Investment
Portfolio





At June
30, 2010, we had an investment in preferred stock of Alacra, Inc., with a
carrying value of $666,667, which represented 4.9% of our total assets at June
30, 2010.  In December 2007, we received proceeds of $333,000 from the
redemption of one-third of our initial $1,000,000 investment.  In
accordance with the terms of our investment, we have exercised our right to put
our remaining preferred stock to Alacra, and based on discussions with Alacra
management, we anticipate redemption and subsequent receipt of funds in the
fourth quarters of 2010 and 2011. As there is no readily determinable fair value
of the Alacra preferred stock, we account for this investment under the cost
method.  For additional information relating to this investment, see Note 9
to our condensed consolidated interim financial statements appearing elsewhere
in this quarterly report on Form 10-Q.





Related
Party Transactions





We have
an exclusive supply agreement for surgical sponges used in our Safety-Sponge®
System with A Plus International Inc. Wenchen Lin, a member of our Board of
Directors, is a founder and significant beneficial owner of A Plus.  In
addition, Mr. Lin has participated in prior equity financings of our
company.  During the three and six months ended June 30, 2010, our cost of
revenue included $1,709,839 and $2,740,910 in connection with this supply
arrangement, and our accounts payable included $1,380,749 at June 30, 2010,
payable to A Plus under this supply agreement, which includes $13,656 that will
be paid directly to A Plus by Cardinal Health (see “—Factors Affecting Future
Results—Cardinal Health Supply Agreement” above). On June 24, 2010, A Plus
converted $1,000,000 of accounts payable owed to A Plus into 10,000 shares of
Series B Convertible Preferred Stock.




On June
24, 2010, John P. Francis, a member of our Board of Directors, who has voting
and investment control over securities held by Francis Capital Management, LLC,
which acts as the investment manager for Catalysis Partners, LLC, invested
$1,000,000 in the Series B Convertible Preferred Stock transaction
..




In the
past, we used the services of an aircraft owning partnership principally owned
by Steven H. Kane, our former Chief Executive Officer for air travel. 
During the three and six months ended June 30, 2010, there were $18,660 and
$18,660, respectively, in expenses related to the use such air travel
services.  During the three and six months ended June 30, 2009, there were
no expenses related to the use such air travel services.





For
additional information relating to these and other related party transactions,
see Note 18 to our condensed consolidated interim financial statements appearing
elsewhere in this quarterly report on Form 10-Q.





Off-Balance
Sheet Arrangements





As of
June 30, 2010, we had no off-balance sheet arrangements.





Commitments
and Contingencies





As of
June 30, 2010, other than our office leases and employment agreements with key
executive officers and the litigation described in Item 1of Part II, we had no
material commitments or contingencies other than the liabilities reflected in
our condensed consolidated interim financial statements.


27




ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Not
applicable.





ITEM
4. CONTROLS AND PROCEDURES





Limitations
on the Effectiveness of Controls





We seek
to improve and strengthen our control processes to ensure that all of our
controls and procedures are adequate and effective. We believe that a control
system, no matter how well designed and operated, can only provide reasonable,
not absolute, assurance that the objectives of the control system are met. In
reaching a reasonable level of assurance, management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures. In addition, the design of any system of controls is
based in part upon certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions. Over time, a control may
become inadequate because of changes in conditions, or the degree of compliance
with policies or procedures may deteriorate. No evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within a company will be detected.





Evaluation
of Disclosure Controls and Procedures





As of the
end of the period covered by this report, we conducted an evaluation, under the
supervision and 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 defined in Rule 13a-15(e) and Rule
15d-15(e) of the Exchange Act.  Based upon that evaluation, our chief
executive officer and chief financial officer concluded that, as of the end of
the period covered by this report, our disclosure controls and procedures were
not effective because the material weaknesses in our internal control over
financial reporting described below identified in our assessment of internal
control over financial reporting as of December 31, 2009 had not been fully
remediated.





Material
Weaknesses in Internal Control Over Financial Reporting





In
connection with our assessment of internal controls over financial reporting as
of December 31, 2009, we identified the following material weaknesses in our
internal control over financial reporting due to:





·
            Ineffective
      control environment due to the following identified
      weaknesses:


o
            Failure
      to retain individuals competent in the application of generally accepted
      accounting principles (“GAAP”) to complex accounting
      transactions.


o
            Failure
      to establish sufficiently detailed accounting policies and procedures and
      to properly train accounting department
staff.


·
            Ineffective
      internal control policies and procedures relating to the period end close
      process including lack of controls relating to journal entries, post
      closing adjustments and management review of conclusions regarding
      accounting and financial reporting
matters.


·
            Ineffective
      internal control policies and procedures designed to provide reasonable
      assurance regarding the accuracy and integrity of spreadsheets used in the
      financial reporting system.





To remedy
these material weaknesses, we are implementing policies and procedures to
formalize our period end close process as well as to address the application of
our accounting policies to ensure conformity with GAAP.  We are also
seeking to hire qualified personnel, or engage outside resources, as applicable,
with appropriate knowledge/experience in the application of GAAP to complex
accounting transactions and we are strengthening internal policies and
procedures designed to ensure the accuracy and integrity of spreadsheets used in
the financial reporting system.




28


Changes
in Internal Control over Financial Reporting





There
have not been any changes in our internal control over financial reporting (as
such term is defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange
Act of 1934, as amended) during the most recent fiscal quarter that have
materially affected or are reasonably likely to materially affect our internal
control over financial reporting, other than the changes in our board of
directors that occurred in connection with the Series B Convertible Preferred
Stock financing on June 24, 2010 which resulted in the resignation of certain
directors who were deemed to be independent and certain directors who were on
the audit committee, including the former chairman of the audit committee who
was considered to be a financial expert.  Although it is the Company’s
intent to consider the appointment of new independent directors and audit
committee members with the requisite financial expertise, the current lack of
such directors may have a material effect on our internal control over financial
reporting.





PART
II – OTHER INFORMATION





ITEM
1.  LEGAL PROCEEDINGS





On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit against us, Sunshine Wireless, LLC, and four other defendants
affiliated with Winstar Communications.  This lawsuit alleged that the
Winstar defendants conspired to commit fraud and breached their fiduciary duty
to the plaintiffs in connection with the acquisition of the plaintiff's radio
production and distribution business.  The complaint further alleged that
the Company and Sunshine joined the alleged conspiracy.  On February 25,
2003, the case against the Company and Sunshine was dismissed.  However, on
October 19, 2004, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
exercised their right to appeal.  On June 1, 2005, the United States Court
of Appeals for the Second Circuit affirmed the February 25, 2003 judgment of the
district court dismissing the claims against the Company.





On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed
another lawsuit against the Company, Sunshine and four other defendants
affiliated with Winstar.  That lawsuit attempted to collect a federal
default judgment of $5 million entered against two entities, Winstar Radio
Networks, LLC and Winstar Global Media, Inc., by attempting to enforce the
judgment against the Company and others under the doctrine of de factomerger.  The
action was tried before a Los Angeles County Superior Court judge, without a
jury, in 2008.  On August 5, 2009, the Superior Court issued a statement of
decision in the Company’s favor, and on October 8, 2009, the Superior Court
entered judgment in the Company’s favor, and judged plaintiffs’ responsible for
$2,708.70 of the Company’scourt
costs.  On November 6, 2009, the plaintiffs filed a notice of appeal in the
Superior Court of the State of California, County of Los Angeles Central
District.  The Company has engaged appellate counsel, believes the
plaintiff’s case to be without merit and intends to continue to defend the case
vigorously.





ITEM
1A.  RISK FACTORS





Intentionally
omitted.





ITEM
2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS





The
Company filed a Current Report on Form 8-K on June 29, 2010 regarding the Series
B Convertible Preferred Stock financing.





ITEM
3.  DEFAULTS UPON SENIOR SECURITIES





Not
applicable





ITEM
4.  (REMOVED AND RESERVED)





ITEM
5.  OTHER INFORMATION





Not
applicable




29


ITEM
6.  EXHIBITS





Exhibit
                    Number
                  
                  Description10.1
                  
                  Form
      of Indemnification Agreement with Directors and Executive Officers dated
      effective as of June 1, 2010 (incorporated by reference to
      our current report on Form 8-K filed with the Securities and Exchange
      Commission ("SEC") on June 6, 2010)10.2
                  
                  Convertible
      Preferred Stock Purchase Agreement dated June 24, 2010, between the
      Company and the Buyers (incorporated by reference to
      our current report on Form 8-K filed with the SEC on June 28,
      2010)10.3
                  
                  Registration
      Rights Agreement dated June 24, 2010, between the Company and Holders
      (incorporated by
      reference to our current report on Form 8-K filed with the SEC on June 28,
      2010)10.4
                  
                  Separation
      Agreement and Mutual General Release dated June 24, 2010 between the
      Company and Steven Kane and the stockholder parties signatories thereto
      (incorporated by
      reference to our current report on Form 8-K filed with the SEC on June 28,
      2010)10.5
                  
                  Separation
      Agreement and Mutual General Release dated June 24, 2010 between the
      Company and Eugene A. Bauer, MD, Howard E. Chase, William M. Hitchcock and
      Loren McFarland and the stockholder parties signatories thereto (incorporated by reference to
      our current report on Form 8-K filed with the SEC on June 28,
      2010)10.6
                  
                  Amendment
      dated June 24, 2010 to Employment Agreement of Marc L. Rose (incorporated by reference to
      our current report on Form 8-K filed with the SEC on June 28,
      2010)10.7*
                  
                  Tax
      Escrow Agreement dated June 24, 2010 between Patient Safety Technologies,
      Inc., Marc L. Rose and U.S. Bank National Association.10.8
                  
                  Employment
      Agreement dated August 9, 2010 between Patient Safety Technologies, Inc.
      and Jack A. Hamilton (incorporated by reference to
      our current report on Form 8-K filed with the Securities and Exchange
      Commission ("SEC") on August 9, 2010)31.1*
                  
                  Certification
      of Chief Executive Officer required by Rule 13a-14(a) or Rule
      15d-14(a)*31.2*
                  
                  Certification
      of Chief Financial Officer required by Rule 13a-14(a) or Rule
      15d-14(a)*32.1*
                  
                  Certification
      of Chief Executive Officer and Chief Financial Officer required by Rule
      13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of
      the United States
Code*





*           Filed
herewith.


30





SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.





PATIENT
      SAFETY TECHNOLOGIES, INC.Date:
      August 16, 2010
            By: /s/ Brian E. StewartBrian
      E. Stewart, President and ChiefExecutive
      OfficerDate:
      August 16, 2010
            By: /s/ Marc L. RoseMarc
      L. Rose, Vice President,Chief
      Financial Officer, Treasurerand
      Corporate Secretary


31