**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:  September
30, 2005
 
 
 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:  000-19301
 
 
 **COMMUNICATION
INTELLIGENCE CORPORATION**
 (Exact
name of registrant as specified in its charter)
 
 Delaware
    
    94-2790442(State
      or other jurisdiction of
    
    (I.R.S.
      Employerincorporation
      or organization)
    
    Identification
      No.)
 
  275
Shoreline Drive, Suite 500, Redwood Shores, CA 94065-1413
 (Address
of principal executive offices) (Zip Code)
 
 Registrant's
telephone number, including area code: (650)
802-7888
 
 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
 
 Number of
shares outstanding of the issuer's Common Stock as of November 10, 2005:
106,542,561.
 
 
  
  
 INDEX
 
 PART
      I. FINANCIAL INFORMATION
    Page
      No.Item
      1.Financial
      StatementsCondensed
      Consolidated Balance Sheets at September 30, 2005 (unaudited) and December
      31, 2004
    3Condensed
      Consolidated Statements of Operations for the Three and Nine-Month Periods
      Ended September 30, 2005 and 2004 (unaudited)
    4Condensed
      Consolidated Statements of Changes in Stockholders’ Equity for the Three
      and Nine-Month Periods Ended September 30, 2005
(unaudited)
    5Condensed
      Consolidated Statements of Cash Flows for the Nine-Month Periods Ended
      September 30, 2005 and 2004 (unaudited)
    6Notes
      to Unaudited Condensed Consolidated Financial Statements
    7Item
      2.Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
    18Item
      3.Quantitative
      and Qualitative Disclosures About Market Risk
    29Item
      4A.Controls
      and Procedures
    29PART
      II. OTHER INFORMATIONItem
      1.Legal
      Proceedings
    29Item
      2.Change
      in Securities and Use of proceeds
    29Item
      3.Defaults
      Upon Senior Securities
    29Item
      4.Submission
      of Matters to a Vote of Security Holders
    29Item
      5.Other
      Information
    29Item
      6.Exhibits
      and Reports on Form 8-K
    30(a)Exhibits
    30Signatures
    31
 
   - 2
-
   **Communication
Intelligence Corporation**
 **and
Subsidiary**
 **Condensed
Consolidated Balance Sheets**
 (In
thousands)
 
 September
      30,
    
    December
      31,2005
    
    2004UnauditedAssetsCurrent
      assets:Cash
      and cash equivalents
    
    $
    3,091
    
    $
    4,736Accounts
      receivable, net
    
    
    794
    
    
    356Deferred
      financing costs - current portion
    
    
    125
    
    
    272Prepaid
      expenses and other current assets
    
    
    203
    
    
    105Total
      current assets
    
    
    4,213
    
    
    5,469Property
      and equipment, net
    
    
    107
    
    
    123Patents
      and trademarks
    
    
    4,380
    
    
    4,663Capitalized
      software development costs
    
    
    265
    
    
    32Deferred
      financing costs - long term
    
    
    136
    
    
    502Other
      assets
    
    
    30
    
    
    30Total
      assets
    
    $
    9,131
    
    $
    10,819Liabilities
      and Stockholders’ equityCurrent
      liabilities:Short-term
      debt - related party
    
    $
    -
    
    $
    8Short-term
      debt - other
    
    
    -
    
    
    36Accounts
      payable
    
    
    287
    
    
    241Accrued
      compensation
    
    
    228
    
    
    258Other
      accrued liabilities
    
    
    388
    
    
    400Deferred
      revenue
    
    
    673
    
    
    458Total
      current liabilities
    
    
    1,576
    
    
    1,401Long-term
      debt - related party
    
    
    -
    
    
    5Convertible
      notes, net of unamortized fair value assigned to
      the
      beneficial conversion feature and warrants of $798 and $2,410
      at
      September 30, 2005 and December 31, 2004, respectively
    
    
    1,120
    
    
    1,785Total
      Liabilities
    
    
    2,696
    
    
    3,191Minority
      interest
    
    
    78
    
    
    97Commitments
      and contingencies
    
    
    -
    
    
    -Stockholders’
      equity:Common
      stock
    
    
    1,064
    
    
    1,014Additional
      paid-in capital
    
    
    89,444
    
    
    87,231Accumulated
      deficit
    
    
    (84,035
    )
    
    (80,544
    )Accumulated
      foreign currency translation adjustment
    
    
    (116
    )
    
    (170
    )Total
      stockholders’ equity
    
    
    6,357
    
    
    7,531Total
      liabilities and stockholders' equity
    
    $
    9,131
    
    $
    10,819
 
  The
accompanying notes form an integral part of these Condensed Consolidated
Financial Statements
 
 - 3  -
  **Communication
Intelligence Corporation**
 **and
Subsidiary**
 **Condensed
Consolidated Statements of Operations**
 **Unaudited**
 (In
thousands, except per share amounts)
 
 Three
      Months Ended
    
    Nine
      Months EndedSeptember
      30,
    
    September
      30,2005
    
    2004
    
    2005
    
    2004Sales:Online/retail
    
    $
    -
    
    $
    21
    
    $
    27
    
    $
    109Corporate
    
    
    575
    
    
    3,645
    
    
    2,179
    
    
    6,465China
    
    
    32
    
    
    3
    
    
    189
    
    
    154Total
      sales
    
    
    607
    
    
    3,669
    
    
    2,395
    
    
    6,728Operating
      costs and expenses:Cost
      of sales:Corporate
    
    
    28
    
    
    6
    
    
    78
    
    
    17China
    
    
    -
    
    
    -
    
    
    1
    
    
    33Research
      and development
    
    
    283
    
    
    326
    
    
    828
    
    
    918Sales
      and marketing
    
    
    307
    
    
    394
    
    
    944
    
    
    1,031General
      and administrative
    
    
    666
    
    
    690
    
    
    1,734
    
    
    1,848Total
      operating costs and expenses
    
    
    1,284
    
    
    1,416
    
    
    3,585
    
    
    3,847Income
      (loss) from operations
    
    
    (677
    )
    
    2,253
    
    
    (1,190
    )
    
    2,881Other
      income (expense)Interest
      and other income (expense), net
    
    
    (24
    )
    
    2
    
    
    (33
    )
    
    -Interest
      expense
    
    
    (37
    )
    
    (117
    )
    
    (178
    )
    
    (262
    )Amortization
      of loan discount anddeferred
      financing cost (Note 8)
    
    
    (837
    )
    
    -
    
    
    (2,109
    )
    
    -Minority
      interest
    
    
    6
    
    
    7
    
    
    19
    
    
    15Net
      Income (loss)
    
    $
    (1,569
    )
    $
    2,145
    
    $
    (3,491
    )
    $
    2,634Basic
      and diluted income (loss) per common share
    
    $
    (0.01
    )
    $
    0.02
    
    $
    (0.03
    )
    $
    0.03Weighted
      average common shares outstanding - basic
    
    
    106,093
    
    
    101,368
    
    
    103,401
    
    
    100,751Weighted
      average common shares outstanding - diluted
    
    
    106,093
    
    
    101,819
    
    
    103,401
    
    
    101,202
 
  The
accompanying notes form an integral part of these Condensed Consolidated
Financial Statements
 
 - 4 -
  **Communication
Intelligence Corporation**
 **and
Subsidiary**
 **Consolidated
Statements of Changes in Stockholders' Equity**
 **Unaudited**
 (In
thousands, except share amounts)
 
 **Shares**
      **Outstanding**
    
    **Common**
      **Stock**
    
    **Additional**
      **Paid-In**
      **Capital**
    
    **Accumulated**
      **Deficit**
    
    **Accumulated**
      **Other**
      **Comprehensive**
      **Loss**
    
    **Total**Balances
      as of December 31, 2004
    
    
    101,412
    
    $
    1,014
    
    $
    87,231
    
    $
    (80,544
    )
    $
    (170
    )
    $
    7,531Shares
      issued on conversion of notes
    
    
    838
    
    
    9
    
    
    379
    
    
    -
    
    
    -
    
    
    388Comprehensive
      lossNet
      loss
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,088
    )
    
    -
    
    
    (1,088
    )Foreign
      currency translation adjustment
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    2
    
    
    2Total
      comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,086
    )Balances
      as of March 31, 2005
    
    
    102,250
    
    $
    1,023
    
    $
    87,610
    
    $
    (81,632
    )
    $
    (168
    )
    $
    6,833Shares
      issued on conversion of notes
    
    
    1,618
    
    $
    16
    
    $
    701
    
    
    
    
    
    
    
    $
    717Shares
      issued for services
    
    
    24
    
    
    
    
    
    10
    
    
    
    
    
    
    
    
    10Comprehensive
      lossNet
      loss
    
    
    
    
    
    
    
    
    
    
    
    (834
    )
    
    
    
    
    (834
    )Foreign
      currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7
    
    
    7Total
      comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (827
    )Balances
      as of June 30, 2005
    
    
    103,892
    
    $
    1,039
    
    $
    88,321
    
    $
    (82,466
    )
    $
    (161
    )
    $
    6,733Shares
      issued on conversion of notes
    
    
    2,474
    
    
    25
    
    
    1,118
    
    
    
    
    
    
    
    
    1,143Shares
      issued on exercise of stock options
    
    
    14
    
    
    -
    
    
    5
    
    
    
    
    
    
    
    
    5Comprehensive
      lossNet
      loss
    
    
    
    
    
    
    
    
    
    
    
    (1,569
    )
    
    
    
    
    (1,569
    )Foreign
      currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45
    
    
    45Total
      comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,524
    )Balances
      as of September 30, 2005
    
    
    106,380
    
    $
    1,064
    
    $
    89,444
    
    $
    (84,035
    )
    $
    (116
    )
    $
    6,357
 
  The
accompanying notes form an integral part of these Condensed Consolidated
Financial Statements
 
 - 5  -
  **Communication
Intelligence Corporation**
 **and
Subsidiary**
 **Condensed
Consolidated Statements of Cash Flows**
 **Unaudited**
 (In
thousands)
 Nine
      Months Ended
      September
      30,2005
    
    
    2004Cash
      flows from operating activities:Net
      income (loss)
    
    $
    (3,491
    )
    $
    2,634Adjustments
      to reconcile net income (loss) to net cash providedby/
      (used for) operating activities:Depreciation
      and amortization
    
    
    353
    
    
    333Amortization
      of discount on convertible notes
    
    
    1,612
    
    
    -Deferred
      financing costs
    
    
    513Provision
      for doubtful accounts
    
    
    -
    
    
    178Loss
      on disposal of fixed assets
    
    
    38
    
    
    4Changes
      in operating assets and liabilities:Accounts
      receivable, net
    
    
    (438
    )
    
    (3,299
    )Inventories
    
    
    
    
    
    47Prepaid
      expenses and other current assets
    
    
    (98
    )
    
    (125
    )Accounts
      payable
    
    
    46
    
    
    (86
    )Accrued
      compensation
    
    
    (30
    )
    
    140Other
      accrued liabilities
    
    
    (12
    )
    
    (128
    )Deferred
      revenue
    
    
    215
    
    
    342Net
      cash (used for) provided by operating activities
    
    
    (1,292
    )
    
    40Cash
      flows from investing activities:
      Acquisition
      of property and equipment
    
    
    (57
    )
    
    (32
    )Capitalized
      software development costs
    
    
    (233
    )
    
    -Net
      cash used for investing activities
    
    
    (290
    )
    
    (32
    )Cash
      flows from financing activities:Proceeds
      from issuance of short-term debt
    
    
    -
    
    
    3,537Proceeds
      from the exercise of stock options
    
    
    5
    
    
    40Payments
      on short-term debt
    
    
    (44
    )
    
    (3,000
    )Payments
      on long-term debt
    
    
    (5
    )
    
    (7
    )Offering
      Costs
    
    
    -
    
    
    (60
    )Principal
      payments on capital lease obligations
    
    
    (7
    )
    
    (6
    )Net
      cash (used for) provided by financing activities
    
    
    (51
    )
    
    504Effect
      of exchange rate changes on cash
    
    
    (12
    )
    
    2Net
      (decrease) increase in cash and cash equivalents
    
    
    (1,645
    )
    
    510Cash
      and cash equivalents at beginning of period
    
    
    4,736
    
    
    1,039Cash
      and cash equivalents at end of period
    
    $
    3,091
    
    $
    1,549
 
 Supplemental
Disclosure of Non Cash Financing Activities
 Pay
      off of short-term debt through issuance of common stock
    
    $
    -
    
    $
    750Convertible
      Notes converted to common stock
    
    $
    2,277
    
    $
    -Supplementary
      disclosure of cash flow informationInterest
      paid
    
    $
    144
    
    $
    262Income
      taxes
    
    $
    39
    
    $
    2
 
   The
accompanying notes form an integral part of these Condensed Consolidated
Financial Statements
 
 - 6  -
   1.  Interim
financial statements and basis of presentation
 
 The
financial information contained herein should be read in conjunction with the
Company's consolidated audited financial statements and notes thereto included
in its Annual Report on Form 10-K for the year ended December 31,
2004.
 
 The
accompanying unaudited condensed consolidated financial statements of
Communication Intelligence Corporation and its subsidiary (the “Company” or
“CIC”) have been prepared pursuant to the rules and regulations of the
Securities and Exchange Commission. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America (“GAAP”) for complete consolidated financial
statements. In the opinion of management, the unaudited condensed consolidated
financial statements included in this quarterly report reflect all adjustments
(consisting only of normal recurring adjustments) that the Company considers
necessary for a fair presentation of its financial position at the dates
presented and the Company’s results of operations and cash flows for the periods
presented. The Company’s interim results are not necessarily indicative of the
results to be expected for the entire year.
 
 The
Company develops and markets electronic signature software, biometric
verification software for handwritten signatures and handwritten data entry
software solutions aimed at emerging, large potential markets such as
e-commerce, workflow automation, corporate security, smart handheld devices such
as handheld computers & smartphones and the Palm OS
aftermarket.
 
 The
Company’s core software technologies include electronic signature, biometric
signature verification, cryptography, electronic ink recording tools
(SignatureOneTM, InkTools®, Sign-it®, iSign® and Sign-On®), operating systems
extensions that enable pen input (PenXTM) and multilingual handwriting
recognition systems (Jot®) and the Handwriter® Recognition System.
 
 Other
consumer and original equipment manufacturer (“OEM”) products include electronic
notetaking (QuickNotes® and InkSnap®) and predictive text input,
(WordComplete Ò ). These
products are designed to increase the ease of use, functionality and security of
electronic devices with a primary focus on smart handheld devices such as
handheld computers and smartphones.
 
 The
Company offers a wide range of multi-platform software products that enable or
enhance pen-based computing. The Company's core technologies are classified into
two broad categories: "transaction and communication enabling technologies" and
"natural input technologies".
 
 Transaction
and communication enabling technologies have been fundamental to the Company’s
development of software for electronic signatures, handwritten biometric
signature verification, data security, data compression, and electronic ink
capture. These technologies are designed to provide a cost-effective means for
securing electronic transactions, providing network and device access control,
and enabling workflow automation of traditional paper form processing. CIC
believes that these technologies offer more efficient methods for conducting
electronic transactions while providing greater functional user authentication,
heightened data security, and increased user productivity.
 
 Natural
input technologies are designed to allow users to interact with handheld
devices, including PDA’s and smartphones, by using an electronic pen or "stylus"
as the primary input device or in conjunction with a keyboard. CIC's natural
input offerings include multilingual handwriting recognition systems, software
keyboards, and predictive text entry technologies.
  - 7  -
 
 **Communication
Intelligence Corporation**
 **And
Subsidiary**
 **Notes
to Unaudited Condensed Consolidated Financial Statements**
 **(In
thousands, except per share amounts)**
 **Form
10-Q**
  *Going
Concern*
 
 The
accompanying condensed consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. The Company has
suffered recurring losses from operations that raise a substantial doubt about
its ability to continue as a going concern. At September 30, 2005, the Company’s
accumulated deficit was approximately $84,035 and the Company had working
capital of $2,637. The Company filed a registration statement with the
Securities and Exchange Commission that was declared effective January 2005,
pursuant to a financing of convertible notes (See Note 8 of the condensed
consolidated financial statements). There can be no assurance that the Company
will have adequate capital resources to fund planned operations or that
additional funds will be available to the Company when needed, or if available,
will be available on favorable terms or in amounts required by the Company. If
the Company is unable to obtain adequate capital resources to fund operations,
it may be required to delay, scale back or eliminate some or all of its
operations, which may have a material adverse effect on the Company's business,
results of operations and ability to operate as a going concern. The
accompanying condensed consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
 
 *Recent
Pronouncements*
 
 In March
2004, the FASB approved the consensus reached on the Emerging Issues Task Force
(EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments.” The objective of this Issue is to provide
guidance for identifying impaired investments. EITF 03-1 also provides new
disclosure requirements for investments that are deemed to be temporarily
impaired. In September 2004, the FASB issued a FASB Staff Position (FSP) EITF
03-1-1 that delays the effective date of the measurement and recognition
guidance in EITF 03-1 until after further deliberations by the FASB. The
disclosure requirements are effective only for annual periods ending after June
15, 2004. The Company has evaluated the impact of the adoption of the disclosure
requirements of EITF 03-1 and does not believe it will have an impact to the
Company's overall consolidated results of operations or consolidated financial
position. Once the FASB reaches a final decision on the measurement and
recognition provisions, the Company will evaluate the impact of the adoption of
EITF 03-1.
 
 In
September 2004, the EITF delayed the effective date for the recognition and
measurement guidance previously discussed under EITF Issue No. 03-01, “The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments” (“EITF 03-01”) as included in paragraphs 10-20 of the proposed
statement. The proposed statement will clarify the meaning of
other-than-temporary impairment and its application to investments in debt and
equity securities, in particular investments within the scope of FASB Statement
No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and
investments accounted for under the cost method. The Company is currently
evaluating the effect of this proposed statement on its financial position and
results of operations.
 
 In July
2004, the EITF issued a draft abstract for EITF Issue No. 04-08, “The Effect of
Contingently Convertible Debt on Diluted Earnings per Share” (“EITF 04-08”).
EITF 04-08 reflects the Task Force's tentative conclusion that contingently
convertible debt should be included in diluted earnings per share computations
regardless of whether the market price trigger has been met. If adopted, the
consensus reached by the Task Force in this Issue will be effective for
reporting periods ending after December 15, 2004. Prior period earnings per
share amounts presented for comparative purposes would be required to be
restated to conform to this consensus and the Company would be required to
include the shares issuable upon the conversion of the Notes in the diluted
earnings per share computation for all periods during which the Notes are
outstanding. Management does not expect the implementation of this new standard
to have a material impact on its historical or future computations of diluted
earnings per share.
  - 8  -
 
 **Communication
Intelligence Corporation**
 **And
Subsidiary**
 **Notes
to Unaudited Condensed Consolidated Financial Statements**
 **(In
thousands, except per share amounts)**
 **Form
10-Q**
  In
December 2004, the FASB issued a revision to SFAS 123, “Share-Based Payment, an
amendment of FASB Statements Nos. 123 and 95,” that addresses the accounting for
share-based payment transactions in which a Company receives employee services
in exchange for either equity instruments of the Company or liabilities that are
based on the fair value of the Company's equity instruments or that may be
settled by the issuance of such equity instruments. This statement would
eliminate the ability to account for share-based compensation transactions using
the intrinsic method that the Company currently uses and generally would require
that such transactions be accounted for using a fair-value-based method and
recognized as expense in the consolidated statement of operations. The effective
date of this standard is for periods beginning after December 15, 2005. The
Company has determined that the adoption of SFAS 123R will result in the Company
having to recognize additional compensation expense related to the options or
warrants granted to employees, and it will have an impact on the Company’s net
earnings in the future. This standard requires expensing the fair value of stock
option grants and stock purchases under employee stock purchase plan.
 
 In March
2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment”
(“SAB 107”), which provides interpretive guidance related to the interaction
between SFAS 123(R) and certain SEC rules and regulations. It also provides the
SEC staff's views regarding valuation of share-based payment arrangements. In
April 2005, the SEC amended the compliance dates for SFAS 123(R), to allow
companies to implement the standard at the beginning of their next fiscal year,
instead of the next reporting period beginning after June 15, 2005. Management
is currently evaluating the impact SAB 107 will have on the Company’s
consolidated financial statements.
 
 On August
31, 2005, the FASB issued FASB Staff Position FSP FAS 123R-1, "Classification
and Measurement of Freestanding Financial Instruments Originally Issued in
Exchange for Employee Services under FASB Statement No. 123R *."* In this
FSP, the FASB decided to defer the requirements in FASB Statement No. 123
(Revised 2004), Share-Based Payment, that make a freestanding financial
instrument subject to the recognition and measurement requirements of other GAAP
when the rights conveyed by the instrument are no longer dependent on the holder
being an employee. The guidance in this FSP should be applied upon initial
adoption of Statement 123R. The FSP includes transition guidance for those
entities that have already adopted Statement 123R in their financial
statements.
 
 In
December 2004, the FASB issued two Staff Positions (FSP) that provide accounting
guidance on how companies should account for the effect of the American Jobs
Creation Act of 2004 that was signed into law on October 22, 2004. In FSP FAS
109-1, "Application of FASB Statement No. 109, Accounting for Income Taxes, to
the Tax Deduction on Qualified Production Activities Provided by the American
Jobs Creation Act of 2004", the FASB concluded that the special tax deduction
for domestic manufacturing, created by the new legislation, should be accounted
for as a "special deduction" instead of a tax rate reduction. As such, the
special tax deduction for domestic manufacturing is recognized no earlier than
the year in which the deduction is taken on the tax return. FSP FAS 109-2,
"Accounting and Disclosure Guidance for the Foreign Earnings Repatriation
Provision within the American Jobs Creation Act of 2004", allows additional time
to evaluate the effects of the new legislation on any plan for reinvestment or
repatriation of foreign earnings for purposes of applying FASB Statement No.
109. The Company does not anticipate that this legislation will impact its
results of operations or financial condition. Accordingly, FSP FAS 109-1 and FSP
FAS 109-2 are not currently expected to have any material impact on its
consolidated financial statements. These FSPs were effective December 21,
2004.
 
 In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 154, Accounting Changes and Error
Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS
No. 154 requires retrospective application to prior periods' financial
statements of changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the
change. SFAS No. 154 also requires that retrospective application of a change in
accounting principle be limited to the direct effects of the change Indirect
effects of a change in accounting principle, such as a change in
nondiscretionary profit-sharing payments resulting from an accounting change,
should be recognized in the period of the accounting change. SFAS No. 154 also
requires that a change in depreciation, amortization or depletion method for
long-lived, non-financial assets be accounted for as a change in accounting
estimate effected by a change in accounting principle.
 
 -
9 -
 **Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**

SFAS No. 154 is effective for accounting changes and corrections
of errors made in fiscal years beginning after December 15, 2005. Early adoption
is permitted for accounting changes and corrections of errors made in fiscal
years beginning after the date this Statement is issued. Management does not
expect the implementation of this new standard to have a material impact on the
Company’s financial position, results of operations and cash flows.

2.Cash
and cash equivalents

The
Company considers all highly liquid investments with original maturities of up
to 90 days to be cash equivalents.

Cash and
cash equivalents consist of the following:

September
      30,
      2005
    
    December
      31,
      2004UnauditedCash
      in bank
    
    $
    185
    
    $
    1,734Money
      market
    
    
    2,906
    
    
    3,002$
    3,091
    
    $
    4,736

3.Accounts
receivable concentration

For the
nine months ended September 30, 2005, four customers accounted for 82% of net
accounts receivable. For the nine months ended September 30, 2004, one customer
accounted for 91% of net accounts receivable.

4.Patents

The
Company performs intangible asset impairment analyses on a quarterly basis in
accordance with the guidance in Statement of Financial Accounting Standards No.
142, “Goodwill and Other Intangible Assets” ("SFAS 142") and Statement of
Financial Accounting Standards No. 144, “Accounting for the Impairment or
Disposal of Long Lived Assets” ("SFAS 144"). The Company follows SFAS 144 in
response to changes in industry and market conditions that affect its patents.
The Company then determines if an impairment of its assets has occurred. The
Company reassesses the lives of its patents and tests for impairment quarterly
in order to determine whether the book value of each patent exceeds the fair
value of each patent. Fair value is determined by estimating future cash flows
from the products that are and will be protected by the patents and considering
the additional factors listed in Critical Accounting Policies.

Management
recognizes that revenues have declined based on the comparable prior periods.
Management believes that the change is temporary based upon historical
experience of the time involved to close large sales transactions. While the
Company believes that as of September 30, 2005 there was no impairment on the
carrying values of the patents, management has decided to obtain an independent
valuation to confirm their assertion. Amortization of patent costs was $95 for
each of the three month, and $284 for each of the nine month periods ended
September 30, 2005 and 2004.
5.Short and
Long-term debt - related party

In June
2003, the Company’s 90% owned joint venture, Communication Intelligence Computer
Corporation, Ltd., (the “Joint Venture’) borrowed from one of its directors
approximately $24 denominated in U. S. dollars to purchase equipment used in the
Company’s operations. The notebore
interest at the rate of 5% per annum, and-10-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**5.Short
and Long-term debt - related party (continued)

was due
in June 2006.In June
2005, the equipment was sold and the remaining principal balance was paid off.
Principal payments on related party debt for the three months ended September
30, 2005, and 2004 was $0, and $2, respectively. For the nine months ended
September 30, 2005 and 2004, principal payments on related party debt were $13
and $6, respectively.

6**.**Short-term
debt - other

On April
20, 2004, the Company’s Joint Venture borrowed the aggregate equivalent of $36,
denominated in Chinese currency, from a Chinese bank. The unsecured loan bore
interest at 5.3% per annum. The note was paid in April 2005.

7.Deferred
revenue

Deferred
revenue is recorded for post-contract support and is recognized as revenue when
costs are incurred or over the support period, generally twelve months,
whichever is longer.

8.Convertible
Notes

In
November 2004, the Company entered into an unsecured Note and Warrant Purchase
Agreement (the “Purchase Agreement”) and a Registration Rights Agreement (the
“Registration Rights Agreement”), each dated as of October 28, 2004. The
financing, a combination of debt and equity instruments, closed November 2,
2004. The proceeds to the Company were approximately $3,885, net of $310 in
commissions and legal expenses. H.C. Wainwright & Co., Inc. (“Wainwright”)
acted as placement agent. As placement agent for the Company, at closing
Wainwright received $731 in commissions, reimbursement of its legal fees and
warrants. The commissions of approximately $285 and legal fees of $25 were paid
in cash. The Company issued warrants to Wainwright to acquire 1,218 shares of
the Company’s common stock. Of the warrants issued, 870 are exercisable at
$0.462 and 348 are exercisable at $0.508. The Company has ascribed the value of
$421 to the Wainwright warrants, which is recorded as deferred financing costs
in the balance sheet. The fair value ascribed to the Wainwright warrants was
estimated on the commitment date using the Black-Scholes pricing model with the
following assumptions: risk-free interest rate of 3.21%; expected life of 3
years; expected volatility of 100%; and expected dividend yield of 0%. The
Company is using the proceeds of the financing for working capital
purposes.

Under the
terms of the financing, the Company issued to certain accredited investors
convertible promissory notes in the aggregate principal amount of
$4,195****and
warrants to acquire 3,632 shares of the Company’s common stock at an exercise
price of $0.508 per share**.**The notes
accrue interest at the rate of 7% per annum, payable semi-annually, and are
convertible into shares of the Company’s common stock at the rate of $0.462 per
share. The Company has ascribed a value of $982 to the investor warrants, which
is recorded as a discount to notes payable in the balance sheet. The fair value
ascribed to the warrants was estimated on the commitment date using the
Black-Scholes pricing model with the following assumptions: risk-free interest
rate of 3.21%; expected life of 3 years; expected volatility of 100%; and
expected dividend yield of 0%. In addition to the fair value ascribed to the
warrants, the Company has ascribed $1,569 to the beneficial conversion feature
in the convertible notes, which is recorded as a discount to notes payable in
the balance sheet. The values ascribed to the warrants and beneficial conversion
feature follow the guidance of the EITF Issue No. 98-5, “Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios”, and ETIF Issue No. 00-27, “Application of Issue
No. 98-5 to Certain Convertible Instruments” of the FASB’s Emerging Issues Task
Force. The fair value of the warrants and beneficial conversion feature is
amortized to expense over the life of the convertible notes or upon earlier
conversion using the effective interest method. During the three and nine months
ended September 30, 2005, the Company had amortized to interest
expense

-
11 -**Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**

8.Convertible
Notes (continued)

approximately$837 and
$2,109, respectively, of the loan discount and deferred financing costs. The
balance due under the convertible notes is shown net of the remaining $798
unamortized discount on the accompanying consolidated balance sheet. During the
three and nine months ended September 30, 2005, the investors converted $1,143
and $2,277, respectively, of the notes in exchange for 2,474 and 4,930,
respectively, shares of the Company’s common stock. If the remaining aggregate
principal amount owing under the notes is converted, the Company will issue
4,151****shares of
its common stock. If the notes are not converted, all remaining principal and
accrued but unpaid interest will be due October 28, 2007. The Company may pay
accrued interest in cash or in shares of Company common stock, issued at the
market price for the common stock calculated prior to the interest payment. The
Company does not currently intend to pay accrued interest with shares of its
common stock. The Company paid approximately $142 of accrued interest associated
with the convertible notes in May 2005.

The
warrants discussed above expire on October 28, 2009. The Company may call the
warrants if the Company’s common stock trades at $1.00 or above for 20
consecutive trading days after the date that is 20 days following the
effectiveness of a registration statement providing for the resale of the shares
issued upon the conversion of the notes and exercise of the warrants. Wainwright
will be paid approximately $28****in the
aggregate if all of the investor warrants are exercised. The Company will
receive proceeds of approximately $1,845 if all of the warrants are
exercised.

The
Company also was required to file a registration statement providing for the
resale of the shares that are issuable upon the conversion of the notes and the
exercise of the warrants. The registration statement was filed on December 22,
2004 and was declared effective on January 26, 2005.

Total
interest paid during the three and nine months ended September 30, 2005 was $0,
and $144, respectively. Total interest paid during the three and nine months
ended September 30, 2004 was $287, and $471, respectively.

9.Net
income (loss) per share

The
Company calculates net income (loss) per share under the provisions of Statement
of Financial Accounting Standards No. 128, “Earnings Per Share” (“SFAS 128”).
SFAS 128 requires the disclosure of both basic net income (loss) per share,
which is based on the weighted average number of shares outstanding, and diluted
income (loss) per share, which is based on the weighted average number of shares
and dilutive potential shares outstanding. For the three-month period ended
September 30, 2005, 6,343 shares of common stock subject to outstanding options,
4,151 shares issuable upon the conversion of the convertible notes and 4,850
warrants were excluded from the calculation of dilutive earnings per share
because the exercise or conversion of such options and warrants would be
anti-dilutive. For the three month period ended September 30, 2004, 4,937 of
shares of common stock subject to outstanding options were excluded from the
calculation of dilutive earnings per share because the exercise price of such
options was greater than the average market price of the Company’s common
stock.-12-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**9.Net
income (loss) per share (continued)

Three
      Months EndedSeptember
      30, 2005
    
    September
      30, 2004Net
      Loss
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      Amount
    
    Net
      Income
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      AmountBasic
      income (loss) per share:Income
      (loss) available to stockholders
    
    $
    (1,569
    )
    
    106,903
    
    $
    (0.01
    )
    $
    2,145
    
    
    101,368
    
    $
    0.02Effect
      of dilutive securitiesStock
      options
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    451
    
    
    -Diluted
      income (loss)
    
    $
    (1,569
    )
    
    106,093
    
    $
    (0.01
    )
    $
    2,145
    
    
    101,819
    
    $
    0.02


For the
nine-month period ended September 30, 2005, 6,343 shares of common stock subject
to outstanding options, 4,151 shares issuable upon the conversion of the
convertible notes and 4,850 warrants were excluded from the calculation of
dilutive earnings per share because the exercise or conversion of such options
and warrants would be anti-dilutive. For the Nine-month period ended September
30, 2004, 4,937 shares ofcommon
stock subject to outstanding options, were excluded from the calculation of
dilutive earnings per share because the exercise price of such options was
greater than the average market price of the Company’s common
stock.

Nine
      Months EndedSeptember
      30, 2005
    
    September
      30, 2004Net
      Loss
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      Amount
    
    Net
      Income
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      AmountBasic
      income (loss) per share:Income
      (loss) available to stockholders
    
    $
    (3,491
    )
    
    103,401
    
    $
    (0.03
    )
    $
    2,634
    
    
    100,751
    
    $
    0.03Effect
      of dilutive securitiesStock
      options
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    451
    
    
    -Diluted
      income (loss)
    
    $
    (3,491
    )
    
    103,401
    
    $
    (0.03
    )
    $
    2,634
    
    
    101,202
    
    $
    0.03
-13-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**10.Common
Stock Options

The
Company has adopted Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123") as amended by
Financial Accounting Standards Board Statement No. 148. The Company has elected
to continue to use the intrinsic value based method of Accounting Principles
Board Opinion No. 25, as allowed under SFAS 123, to account for its
employee stock-based compensation plans. No stock based employee compensation
expense is reflected in the consolidated statement of operations as all options
granted had an exercise price equal to the market value of the Company’s common
stock on the date of grant. The Company complies with the disclosure provisions
of SFAS 123.

Had
compensation cost for the Company's option plans been determined based on the
fair value of the options at the date of grant, as prescribed by SFAS 123, the
Company's net income (loss) available to common stockholders and basic and
diluted net income (loss) per share available to stockholders would have been as
follows:

Three
      Months EndedSeptember
      30,
    
    September
      30,2005
    
    2004Net
      income (loss) available to stockholders:As
      reported
    
    $
    (1,569
    )
    $
    2,145Add:
      Stock-based employee compensation expense included in reported results of
      operations, net of related tax effect
    
    
    -
    
    
    -Deduct:
      Total stock based employee compensation expense determined under fair
      value based method, net of tax
    
    
    (334
    )
    
    (108
    )Pro
      forma
    
    $
    (1,903
    )
    $
    2,037

Basic
      and diluted net income (loss) per share available to
      stockholders:As
      reported
    
    $
    (0.01
    )
    $
    0.02Pro
      forma
    
    $
    (0.02
    )
    $
    0.02

Nine
      Months EndedSeptember
      30,
    
    September
      30,2005
    
    2004Net
      income (loss) available to stockholders:As
      reported
    
    $
    (3,491
    )
    $
    2,634Add:
      Stock-based employee compensation expense included in reported results of
      operations, net of related tax effect
    
    
    -
    
    
    -Deduct:
      Total stock based employee compensation expense determined under fair
      value based method, net of tax
    
    
    (502
    )
    
    (219
    )Pro
      forma
    
    $
    (3,993
    )
    $
    2,415-14-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**10.Common
Stock Options (continued)

Nine Months
      EndedSeptember
      30,
    
    
    September
      30,2005
    
    
    2004

Basic
      and diluted net income (loss) per share available to
      stockholders:As
      reported
    
    $
    (0.03
    )
    $
    0.03Pro
      forma
    
    $
    (0.04
    )
    $
    0.02

The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions used for grants during the applicable periods:
·
    risk-free
      interest rate of 4.10% for 2005, and 2.29% for
2004;
·
    an
      expected life of 7.0 years for 2005, and 6.2 years for
  2004
·
    expected
      volatility of 86% for 2005 and 100% for 2004; and
·
    dividend
      yield of 0% for all periods.

The
Company expects to make additional option grants. The Company believes the above
pro forma disclosures may not be representative of the pro forma effects on
reported results of operations to be expected in future periods due to changes
in interest rates, expected lives of current and future option grants and
changes in the volatility of the price of the Company’s common stock in the
market.

11.Comprehensive
income (loss)

Total
comprehensive income (loss) was as follows:
Three
      Months Ended
      September
      30,
    
    Nine
      Months Ended September 30,2005
    
    2004
    
    2005
    
    2004Net
      income (loss)
    
    $
    (1,569
    )
    $
    2,145
    
    $
    (3,491
    )
    $
    2,634Other
      comprehensive income:Cumulative
      translation adjustment
    
    
    45
    
    
    13
    
    
    54
    
    
    16Total
      comprehensive income (loss)
    
    $
    (1,524
    )
    $
    2,158
    
    $
    (3,437
    )
    $
    2,650

12.Segment
Information

The
Company identifies reportable segments by classifying revenues into two
categories: handwriting recognition and system integration. Handwriting
recognition software is an aggregate of two revenue categories; eSignature and
natural input/original equipment manufacturers (“OEM”). All handwriting
recognition software is developed around the Company’s core technology. System
integration represents the sale and installation of third party computer
equipment and systems that utilize the Company’s products. The Company made the
decision in late 2003 to not continue in or expand this low margin, labor
intensive business, which would require significant increases in base costs to
provide turn-key capabilities. All sales represent sales to external customers.

The
accounting policies followed by the segments are the same as those described in
the “Critical Accounting Policies.” Segment data includes revenues and allocated
costs charged to each of the operating segments.-15-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**12.Segment
Information (continued)

The
tables below present information about reporting segments for the periods
indicated:

Three
      Months Ended September 30,2005
    
    2004Handwriting
      Recognition
    
    Systems
      Integration
    
    Total
    
    Handwriting
      Recognition
    
    Systems
      Integration
    
    TotalRevenues
    
    $
    607
    
    $
    -
    
    $
    607
    
    $
    3,669
    
    $
    -
    
    $
    3,669Income
      (loss) from Operations
    
    $
    (677
    )
    $
    -
    
    $
    (677
    )
    $
    2,253
    
    
    
    
    $
    $2,253Significant
      change in total long lived assets from year end
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -

Nine
      Months Ended September 30,2005
    
    2004Handwriting
      Recognition
    
    Systems
      Integration
    
    Total
    
    Handwriting
      Recognition
    
    Systems
      Integration
    
    TotalRevenues
    
    $
    2,395
    
    $
    -
    
    $
    2,395
    
    $
    6,691
    
    $
    37
    
    $
    6,728Income
      (loss) from Operations
    
    $
    (1,190
    )
    $
    -
    
    $
    (1,190
    )
    $
    2,873
    
    $
    8
    
    $
    2,881Significant
      change in total long lived assets from year end
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -

For the
three months ended September 30, 2005 and 2004, two customers accounted for 48%
and one customer accounted for 96% of total handwriting recognition segment
revenue, respectively. For the nine months ended September 30, 2005 and 2004,
two customers accounted for 44% and one customer accounted for 49% of total
handwriting recognition segment revenue, respectively.

For the
three and nine months ended September 30, 2005 there was no system integration
revenues recorded. For the three and nine months ended September 30, 2004, one
customer accounted for 0% and 40% of system integration revenues,
respectively.

13.Commitments
and contingencies

In
February of 2005, Valyd, Inc. filed a complaint against the Company seeking a
declaratory judgment that Valyd is not infringing certain of the Company’s
patents, that such patents are invalid or unenforceable, that CIC is equitably
estopped from asserting infringement of such patents against Valyd, Inc., that
the Company tortiously interfered with a contract between Valyd, Inc. and
Interlink Electronics, Inc. by delivering an infringement notice to Interlink
Electronics, Inc., and that the Company has engaged in unfair competition under
California law. No specific monetary claim is set forth in the complaint. On
March 3, 2005, the Company

-
16 -
**Communication
Intelligence Corporation**
**And
Subsidiary**
**Notes
to Unaudited Condensed Consolidated Financial Statements**
**(In
thousands, except per share amounts)**
**Form
10-Q**13.Commitments
and contingencies (continued)

responded
to the complaint, denying all allegations, and filed counterclaims against
Valyd, Inc. The counterclaims assert that Valyd, Inc. is infringing certain of
the Company’s patents and asked for treble damages, alleging that the
infringement is willful, deliberate and in conscious disregard of CIC’s rights.
Valyd, Inc. has withdrawn its allegation that certain of the Company's patents
are unenforceable. The ultimate outcome of this litigation cannot presently be
determined. However, in management’s opinion, the likelihood of a material
adverse outcome is remote and any liability that might be incurred would not
have a material adverse effect on the Company’s financial position or its
results of operations. Accordingly, adjustments, if any that might result from
the resolution of this matter have not been reflected in the financial
statements.

14.
    Subsequent
      event

Since
September 30, 2005, note holders have converted $75 into 162 shares of common
stock. Since the closing on November 2, 2004, note holders have converted an
aggregate of $2,352 of notes into 5,091 shares of the Company’s common stock. As
of September 30, 2005 $1,917 of convertible notes remain outstanding,
representing 4,151 shares of the Company’s common stock.


- 17
-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q*****Forward
Looking Statements***

Certain
statements contained in this quarterly report on Form 10-Q, including without
limitation, statements containing the words “believes”, “anticipates”, “hopes”,
“intends”, “expects”, and other words of similar import, constitute “forward
looking” statements within the meaning of the Private Securities Litigation
Reform Act of 1995. Such statements involve known and unknown risks,
uncertainties and other factors which may cause actual events to differ
materially from expectations. Such factors include those set fourth in the
Company’s Annual Report on Form 10-K for the year ended December 31, 2004 and
delineated as follows:

**·**
    Technological,
      engineering, manufacturing, quality control or other circumstances which
      could delay the sale or shipment of products;
**·**
    Economic,
      business, market and competitive conditions in the software industry and
      technological innovations which could affect the Company’s
      business;
**·**
    The
      Company’s inability to protect its trade secrets or other proprietary
      rights, operate without infringing upon the proprietary rights of others
      and prevent others from infringing on the proprietary rights of the
      Company; and
**·**
    General
      economic and business conditions and the availability of sufficient
      financing.

The
Company undertakes no obligation to publicly update or revise any
forward-looking statements, as a result of new information, future events or
otherwise.

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

The
following discussion and analysis should be read in conjunction with the
Company’s unaudited condensed consolidated financial statements and notes
thereto included in Part 1, Item 1 of this quarterly report on Form 10-Q and
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” set forth in the Company’s Annual report on Form 10-K for the fiscal
year ended December 31, 2004.

***Overview***

The
Company was incorporated in Delaware in October 1986. In each year since its
inception, except for 2004, the Company has incurred losses. For the five-year
period ended December 31, 2004, operating losses aggregated approximately $7,792
and at December 31, 2004 the Company's accumulated deficit was approximately
$80,544. At September 30, 2005, the Company’s accumulated deficit was
approximately $84,035, an increase of $3,491.

Total
revenue of $607 for the quarter ended September 30, 2005 decreased 83% compared
to revenues of $3,669 in the corresponding quarter of the prior year. The
decrease in revenue was primarily attributable to a $3,250 follow-on deployment
by State Farm in the third quarter of last year. Total revenues of $2,395 for
the nine months ended September 30, 2005, decreased 64% compared to revenues of
$6,728 in the corresponding nine months of the prior year.Total
eSignature revenue, of $1,654 for the nine months ended September 30, 2005
decreased 72% compared to total eSignature revenue of $5,817 in the
corresponding nine months of the prior year.However,
$5,250 of the corresponding prior period’s eSignature revenue was attributable
to two large orders (Wells Fargo and State Farm), the remaining $567 is
attributable to other eSignature accounts closed during that nine months period.
It is important to note that the $1,654 of eSignature revenue for the nine
months ending September 30, 2005 is almost tripled (292%) the $567. This
represents both an increase in the quantity and average price of orders over the
corresponding nine months period of the prior year.

Sales for
the current quarter and nine months do not reflect any significant follow-on
deployment revenue from our eSignature worldwide installed base of hundreds of
pilot and proof of concept stage installations. These installations, over the
past five years, accounted for revenues in excess of $15 million.
We
anticipated, and still expect to benefit from, further full deployments from
within our installed base of handwritten signature verification products
initially supplied to early adopters. However, our experience year-to-date
suggests that some full follow-on deployments from our established customer
base, as well as future orders from new financial services accounts, will
require SignatureOne technology and other CIC product offerings that we have
already shared with key customers. SignatureOne addresses the growing market
demand for an architecture


-
18 -

**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**that embraces multiple eSignature methods,
including handwritten signature verification. This customer demand for, and
evaluation of, our newer products is causing the expected delays inherent within
such a transition.

We
believe our SignatureOne product will enhance our leadership position by
accelerating acceptance in the financial services market, opening up new
markets, extending our product differentiation and playing to our maximum
intellectual property strength.

In
addition to strengthening our leadership position, we further believe this
transition heightens pent-up demand, driving our market towards accelerated
eSignature adoption into market takeoff, thereby providing excellent potential
for sustained sales growth in the future.

The net
loss for the quarter ended September 30, 2005 was $1,569, which included $837 in
non-cash charges to interest expense for prepaid financing costs and loan
discount amortization related to the convertible notes, compared with a net
income of $2,145 in the corresponding prior year period. Operating expenses
decreased approximately 9%, or $132, from $1,416 to $1,284 for the three months
ended September 30, 2005, compared to the prior year period. The decrease in
operating expense primarily reflects the decrease in commissions due to lower
sales in the quarter and lower administrative expenses. The net loss for the
nine months ended September 30, 2005 of $3,491, which includes $2,109 in
non-cash charges to interest expense for prepaid financing costs and loan
discount amortization related to the convertible notes, is due to the lower
sales during the nine months and the non-cash charges discussed
above.

***Critical
Accounting Policies***

The
preparation of financial statements and related disclosures in conformity with
accounting principles generally accepted in the United States of America
requires management to make judgments, assumptions and estimates that affect the
amounts reported in our consolidated financial statements and the accompanying
notes. The amounts of assets and liabilities reported in our balance sheets and
the amounts of revenues and expenses reported for each period presented are
affected by these estimates and assumptions which are used for, but not limited
to, accounting for product returns, allowance for doubtful accounts, and
intangible asset impairments. Actual results may differ from these estimates.
The following critical accounting policies are significantly affected by
judgments, assumptions and estimates used by our management in the preparation
of the consolidated financial statements.

Revenue
is recognized when earned in accordance with applicable accounting standards,
including AICPA Statement of Position ("SOP") No. 97-2, Software Revenue
Recognition, as amended, Staff Accounting Bulletins 104 ("SAB 104") and the
interpretive guidance issued by the Securities and Exchange Commission and EITF
issue 00-21 of the FASB Emerging Issues Task Force. We recognize revenues from
sales of software products upon shipment, provided that persuasive evidence of
an arrangement exists, collection is determined to be probable and no
significant obligations remain. Revenue from service subscriptions is recognized
as costs are incurred or over the service period, which ever is
longer.

In
December 2003, the Securities and Exchange Commission (“SEC”) issued Staff
Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” The adoption of
SAB 104 did not impact the consolidated financial statements.

Revenue
from software license agreements is recognized upon delivery of the software
provided that persuasive evidence of an arrangement exists, collection is
determined to be probable and no significant obligations remain. Deferred
revenue is recorded for post-contract support and is recognized as costs are
incurred or over the support period which ever is longer. Vendor specific
objective evidence of the fair value of the elements contained in these software
license agreements is based on the price determined by management having the
relevant authority when the element is not yet sold separately.

-
19 -
**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**Revenue from system integration activities is
recognized upon installation provided that persuasive evidence of an arrangement
exists, no significant obligations remain and the collection of the resulting
receivable is probable.

Deferred
revenue is recorded for post-contract support and is recognized as revenue when
costs are incurred or over the support period, generally twelve months,
whichever is longer.

The
allowance for doubtful accounts is based on our assessment of the collectibility
of specific customer accounts and an assessment of international, political and
economic risk as well as the aging of the accounts receivable. If there is a
change in actual defaults from our historical experience, our estimates of
recoverability of amounts due us could be affected and we will adjust the
allowance accordingly.
The
Company performs intangible asset impairment analyses on a quarterly basis in
accordance with the guidance in Statement of Financial Accounting Standards No.
142, “Goodwill and Other Intangible Assets” ("SFAS 142") and Statement of
Financial Accounting Standards No. 144, “Accounting for the Impairment or
Disposal of Long Lived Assets” ("SFAS 144"). The Company follows SFAS 144 in
response to changes in industry and market conditions that affect its patents.
The Company then determines if an impairment of its assets has occurred. The
Company reassesses the lives of its patents and tests for impairment quarterly
in order to determine whether the book value of each patent exceeds the fair
value of each patent. Fair value, while subjective, is determined by estimating
future cash flows from the products that are and will be protected by the
patents, considering the following additional factors:

·
    whether
      there are legal, regulatory or contractual provisions known to it that
      limit the useful life of each patent to less than the assigned useful
      life;

·
    whether
      the Company needs to incur material costs or make modifications in order
      for it to continue to be able to realize the protection afforded by the
      patents;

·
    whether
      any effects of obsolescence or significant competitive pressure on the
      Company's current or future products are expected to reduce the
      anticipated cash flow from the products covered by the
      patents;

·
    whether
      demand for products utilizing the patented technology will diminish,
      remain stable or increase; and

·
    whether
      the current markets for the products based on the patented technology will
      remain constant or will grow over the useful lives assigned to the
      patents.

Management
recognizes that revenues have declined based on the comparable prior periods.
Management believes that the change is temporary based upon historical
experience of the time involved to close large sales transactions. While the
Company believes that as of September 30, 2005 there was no impairment on the
carrying values of the patents, management has decided to obtain an independent
valuation to confirm their assertion.
Sources
of Revenues. To date, the Company's revenues have been derived principally from
end-users, manufacturers, retailers and distributors of computer products in
North America, Europe and the Pacific Rim. The Company performs periodic credit
evaluations of its customers and does not require collateral. The Company
maintains reserves for potential credit losses. Historically, such losses have
been insignificant and within management's expectations.

Software
Development Costs. Software development costs are accounted for in accordance
with Statement of Financial Accounting Standards No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed" ("SFAS
86"). Under SFAS 86, capitalization of software development costs begins upon
the establishment of technological feasibility, subject to net realizable value
considerations. In the Company's case, capitalization commences upon the
completion of a working model and generally ends upon the release of the
product. The capitalized costs are amortized to cost of sales on a straight line
basis over the estimated life of the product, generally three years.

Research
and Development. Research and development costs are charged to expense as
incurred.

Foreign
Currency Translation. We consider the functional currency of the Joint Venture
to be the respective local currency and, accordingly, gains and losses from the
translation of the local foreign currency financial statements are included as a
component of "accumulated other comprehensive loss" in our consolidated balance
sheets. Foreign currency assets and liabilities are translated into U.S. dollars
at exchange rates prevailing at the end of the period, except for non-monetary
assets and liabilities that are translated at historical exchange rates.
Revenues and expenses are translated at the average exchange rates in effect
during each period, except for those expenses included in balance sheet
accounts, which are translated at historical exchange rates.

Net
foreign currency transaction gains and losses are included as components of
“interest income and other income (expense), net" in the Company's consolidated
statements of operations. Due to the stability of the currency in China, net
foreign currency transaction gains and losses were not material for the three
and nine months ended September 30, 2005 and 2004, respectively. The Company
believes that the recent change in the method China uses to value its currency
will not have a material impact on the Company’s financial
statements.

Net
Operating Loss Carryforwards. Utilization of the Company's net operating losses
may be subject to an annual limitation due to the ownership change limitations
provided by the Internal Revenue Code of 1986 and similar state provisions. As a
result, a portion of the Company's net operating loss carryforwards may not be
available to offset future taxable income. The Company has provided a full
valuation allowance for deferred tax assets at September 30, 2005 based upon the
Company's history of losses.

-
20 -
*****Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**Segments***

We report
in two segments: handwriting recognition and systems integration. Handwriting
recognition includes online/retail revenues and corporate sales, including
eSignature and natural input/original equipment manufacturers ("OEM") revenues.
Handwriting recognition represents the sale ofsoftware
for electronic signatures, handwritten biometric signature verification, data
security, data compression, and electronic ink capture. It also includes the
sale of natural input technologies that are designed to allow users to interact
with handheld devices.All
handwriting recognition software is developed around our core technology.
Handwriting recognition product revenues are generated through our direct sales
force to individual or enterprise end users (see discussion under revenues -
Handwriting recognition). We also license a version of our handwriting
recognition software to OEMs. The handwriting recognition software is included
as part of the OEMs’ product offerings. From time to time, we are required to
develop an interface (port) for our software to run on a new customer's hardware
platform or within the customer's software operating system. The development
contract revenues are included in the handwriting recognition
segment.

System
integration represents the sale and installation of third party computer
equipment and systems that utilize our products. System integration sales are
derived through a direct sales force which then develops a system to utilize our
software based on the customer’s requirements. Systems integration sales are
accomplished solely through our Joint Venture.The
system integration business has become highly competitive with a low barrier to
entry. It is increasingly comprised of small Chinese owned businesses with
virtually no differentiation in service offerings and primarily competing on
price and relationships. The Company made the decision in late 2003 not to
continue in or expand this low margin, labor intensive business, which would
have required significant increases in base costs to provide turn-key
capabilities.

***Results
of Operations***

The
following table provides unaudited financial information for each of our two
segments.

Three
      Months Ended
    
    Nine
      Months EndedSeptember
      30,
    
    September
      30,2005
    
    2004
    
    2005
    
    2004Segment
      revenues:Handwriting
      recognitionOnline/retail
    
    $
    −
    
    $
    21
    
    $
    27
    
    $
    109Corporate
    
    
    575
    
    
    3,645
    
    
    2,179
    
    
    6,465China
    
    
    32
    
    
    3
    
    
    189
    
    
    117Total
      handwriting recognition
    
    $
    607
    
    $
    3669
    
    $
    2,395
    
    $
    6,728Systems
      integration
    
    
    −
    
    
    −
    
    
    −
    
    
    37Total
      revenues
    
    $
    607
    
    $
    3,669
    
    $
    2395
    
    $
    6,728Cost
      of SalesHandwriting
      recognition
    
    $
    28
    
    $
    6
    
    $
    79
    
    $
    21Systems
      integration
    
    
    -
    
    
    −
    
    
    -
    
    
    29Total
      cost of sales
    
    $
    28
    
    $
    6
    
    $
    79
    
    $
    50Operating
      cost and expensesResearch
      and development
    
    $
    283
    
    $
    326
    
    $
    828
    
    $
    918Sales
      and Marketing
    
    
    307
    
    
    394
    
    
    944
    
    
    1,031General
      and administrative
    
    
    666
    
    
    690
    
    
    1,734
    
    
    1,848-
21-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**
Three
      Months Ended
    Nine
      Months EndedSeptember
      30,
    September
      30,2005
    2004
    2005
    2004

Total
      operating costs and expenses
    
    $
    1,284
    
    $
    1,416
    
    $
    3,585
    
    $
    3,847Interest
      and other income (expense), net
    
    $
    (18
    )
    $
    9
    
    $
    (14
    )
    $
    15Interest
      expense
    
    
    (874
    )
    
    (117
    )
    
    (2,287
    )
    
    (262
    )Net
      income (loss)
    
    $
    (1,569
    )
    $
    2,145
    
    $
    (3,491
    )
    $
    2,634Amortization
      of intangible assetsCost
      of sales
    
    $
    12
    
    $
    9
    
    $
    32
    
    $
    9General
      and administrative
    
    
    95
    
    
    95
    
    
    284
    
    
    284Total
      amortization of intangible assets
    
    $
    107
    
    $
    104
    
    $
    316
    
    $
    293
*Sales*

*Handwriting
recognition.*

Handwriting
recognition segment revenues include online/retail, corporate and China software
sales. Handwriting recognition segment revenues decreased 83%, or $3,062, to
$607 for the three months ended September 30, 2005, as compared to $3,669 in the
prior year period. For the nine month period ended September 30, 2005,
handwriting recognition revenues decreased 64%, or $4,296, to $2,395, as
compared to $6,728 in the prior year period. The changes to handwriting
recognition revenues are discussed more fully below.

Online/retail
revenues decreased 100%, or $21, to $0 for the three months ended September 30,
2005, as compared to $21 in the prior year period. For the nine months ended
September 30, 2005, online/retail revenues decreased 75%, or $82, to $27, as
compared to $109 in the prior year period. In early 2003, PalmSource announced
that it had licensed CIC’s Jot® handwriting recognition software to replace
Graffiti® as the standard and only handwriting software on all new Palm Powered®
devices. The embedding of Jot on Palm related devices had a negative impact on
the online/retail sales by limiting the number of units that would be upgraded
to older units. The transition to Jot based PalmSource operating systems by
OEM’s was completed in the third quarter of 2004 and the Company no longer
offers its products through online/retail outlets. CIC has phased out the
consumer offering of its Palm OS products. Jot continues to be embedded in the
PalmSource OS that is used by many leading handheld computer and smartphones
suppliers. In addition, major device manufacturers, such as Sony-Ericsson,
continue to embed Jot in their products. These events dramatically reduced the
demand for our text entry products sold directly to end users via retail and
online outlets.

Corporate
revenues decreased 84%, or $3,070, to $575 for the three months ended September
30, 2005, as compared to $3,645 in the prior year period. For the nine months
ended September 30, 2005 corporate revenues declined 66%, or $4,286, to 2,179,
as compared to $6,465 in the prior year period. The changes to corporate
revenues are discussed below.

OEM and
channel partner sales included in corporate revenues, increased 30%, or $76, to
$327, for the three months ended September 30, 2005 compared to $251 in the
prior year period. For the nine months ended September 30 2005, OEM and channel
partner sales increased 31%, or $244, to $1,030, compared to $786 in the prior
year period. The increase in OEM and channel partner sales for the three and
nine months ended September 30, 2005, is due primarily toorders in
the second and third quarters from one of its resellers for CIC’s Sign-it® for
Acrobat product for use by a major telecommunications company’s and additional
Jot licenses purchased by Sony Ericsson.The
Company expects channel partner and OEM sales to increase in the future as new
channel partners and OEM customers are identified and new agreements are signed.
eSignature revenues included in corporate sales decreased 93%, or $3,394, to
$248, for the three months ended September 30, 2005, as compared to $3,394 in
the prior year period. The decrease in sales for the three months ended
September 30, 2005 was due primarilytoasale to a
large national insurance company in the prior year period. For the
nine months ended September 30, 2005 eSignature sales decreased 80% or $4,530,
to $1,149, ascompared
to $5,679 in the prior year period. The decrease in eSignature sales for the
nine months ended September 30, 2005 was due primarily to the sale of the
Company’s eSignature products to Wells Fargo Bank anda large
national insurance companyin the
first and third quarters in the prior year.The
Company has made an investment in new sales personal during the second and third
quarters of 2005.The
Company believes thatthis
investment will increasecorporate
eSignature revenues in the near termthrough
a stronger focus and presents in its target markets. In addition,the
Company believes that the salesofsmaller
pilotdeploymentsof its
productsto
customers will lead to greater sales in future periods as the customers roll out
their applications on a wider scale.However,the
timing of customer product roll outs is difficult to project due to many factors
beyond the Company’s control. The Company views eSignature as a high potential
revenue market and intends to continue to place increasing focus on this
market.

-
22 -
**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**Software sales in China increased 967% or $29, to
$32, for the three months ended September 30, 2005, as compared to $3 in the
prior year period. For the nine months ended September 30, 2005, software sales
in China increased 62%, or $72 to $189, as compared to $117 in the prior year
period. The increase in China software sales was due to a new agreement witheCom Asia
Pacific Pty Ltd(“eCom”).
The new
agreement appoints eCom as exclusive master reseller for CIC products to end
users and resellers with the authority and responsibility to create optimal
distribution channels within the People’s Republic of China. This agreement
provides for guaranteed minimum quarterly royalties over a two-year period. eCom
is one of the world’s most experienced eSignature solutions providers and has
been a proven reseller and integrator of CIC eSignature products in the Asia
Pacific region for over six years. eCom has highly visible deployments including
Prudential Plc in Singapore, Malaysia and Hong Kong. The partnership with eCom
is targeted to achieve our objective of establishing enhanced sales coverage in
China leveraging our new SignatureOne*TM*technology
with a trusted and proven partner.The
Company believes that the channel partner strategy will deliver increasing and
sustained sales growth.

*Systems
Integration.*

There
were no system integration segment revenues for the three months ended September
30, 2005, and 2004. For the nine months ended September 30, 2005, System
integration segment revenue declined 100%, or $37, to $0, as compared to $37 in
the prior year period. The decline in system integration revenue reflects the
decision made in late 2003 not to continue in or expand this low margin, labor
intensive business, which would require significant increases in base costs to
provide turn-key capabilities. The system integration business has become highly
competitive with a low barrier to entry. It is increasingly comprised of small
Chinese-owned businesses with virtually no differentiation in service offerings
and primarily competing on price and relationships. Our focus in China is on the
emerging high potential workflow/office automation market leveraging our
eSignature technology and strategic channel partners.

***Cost
of Sales***

*Handwriting
recognition.*

Handwriting
recognition segment cost of sales includes online/retail, corporate and China
software sales costs. Such costs are comprised of royalty and import tax
payments, third party hardware costs, direct mail costs, engineering direct
costs and amortization of intangible assets excluding patents. Cost of sales for
the handwriting recognition segment increased 367%, or $22, to $28, for the
three months ended September 30, 2005, as compared to $6 in the prior year
period. For the nine months ended September 30, 2005, handwriting recognition
cost of sales increased 276%, or $58, to $79, as compared to $21 in the prior
year period. The increase is primarily due to the increase in development
contract work completed during the three and nine months ended September 30,
2005 compared to the prior year periods. Cost of sales may increase in the
future depending on the amount of engineering labor included in cost of sales
associated with custom software development and third party hardware sold with
the Company’s software as a complete package.

-
23 -
Online/retail
cost of sales decreased 100% during the three and nine month periods ended
September 30, 2005, as compared to the prior year periods. The Company no longer
offers its products through online/retail outlets.

eSignature
and OEM cost of sales increased 367%, or $22, to $28 for the three months ended
September 30, 2005, as compared to $6 in the prior year period. The increase was
due to direct engineering labor charges associated with contract development
revenues. For the nine months ended September 30, 2005, OEM and eSignature cost
of sales increased 359%, or $61, to $78, as compared to $17 in the prior year
period. The increase is primarily due to engineering labor cost as discussed
above. Handwriting recognition cost of sales will be influenced in the future
periods by third party hardware costs that could be sold with the Company’s
software solutions, engineering direct labor associated with contract
development revenues and the amortization of capitalized software development
costs.

China
handwriting recognition segment cost were $0 for the three months ended
September 30, 2005, and 2004. For the nine month period ended September 30,
2005, China handwriting recognition cost of sales decreased 75%, or $3, to $1,
as compared to $4 in the prior year period. The decrease is due to less third
party hardware sold with the Company’s software products during the three and
nine months ended September 30, 2005. It is expected that cost of sales will
remain low for the foreseeable future as the current trend has been to sell
software solutions through channel partners with little third party hardware
costs.

***Systems
Integration.***

System
integration segment costs of sales were $0 for the three months ended September
30, 2005, and 2004. For the nine months ended September 30, 2005, cost of sales
decreased 100%, or $29, to $0, as compared to $29 in the prior year period. The
decline in system integration revenue reflects the decision made in late 2003 to
not continue in or expand this low margin, labor intensive business, which would
have required significant increases in base costs to provide turn-key
capabilities. The system integration business has become highly competitive with
a low barrier to entry. It is increasingly comprised of small Chinese-owned
businesses with virtually no differentiation in service offerings and primarily
competing on price and relationships. Our focus in China is on the emerging high
potential workflow/office automation market leveraging our eSignature technology
and strategic channel partners.

***Operating
expenses***

*Research
and Development Expenses*.
Research and Development expense decreased 13%, or $43, to $283 for the three
months ended September 30, 2005, as compared to $326 in the prior year period.
For the nine months ended September 30, 2005, engineering expenses decreased
10%, or $90, to $828 as compared to $918 in the prior year. Engineering expenses
consists primarily of salaries and related costs, outside engineering,
maintenance items, and allocated facilities expenses. Salaries and related
expense increased 39%, or $85, to $304 for the three months ended September 30,
2005, as compared to $219 in the prior year period. For the nine months ended
September 30, 2005, engineering salaries increased 28%, or $183, to $832, as
compared to $649 in the prior year period. The increase is due primarily to the
increase of two engineers compared to the prior year periods. Outside
engineering cost and expenses increased to $10 for the three months ended
September 30, 2005, compared to $0 in the prior year period. For the nine months
ended September 30, 2005 outside engineering costs increased to $66, as compared
to $0 in the prior year period. The increase was due primarily to the
utilization of outside engineering services to complete several projects
compared to the prior year. The Company maintains a relationship with an outside
engineering group familiar with its products and may draw on its services, as
required, which could have a material effect on the amount of outside
engineering expense reported.

Facilities
allocation increased 15%, or $9, to $69 for the three months ended September 30,
2005, compared to $60 in the prior year period. For the nine months ended
September 30, 2005, facilities allocation increased 22%, or $37, to $209, as
compared to $172 in the prior year period. Increased engineering head count is
the primary reason for the increased facilities allocation. Capitalized software
development costs increased to $72, and $261 for the three and nine month
periods ended September 30, 2005, as compared to $0 in the prior year
periods.

-
24 -
**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**The increase in capitalized software development
was due to new product development and significant upgrades and enhancements
being made to the Company’s natural input and eSignature products.
Capitalization of software development costs is expected to be consistent with
the increased amounts reported for the three and nine months ended September 30,
2005 for the foreseeable future. Engineering costs transferred to cost of sales
increased to $6 for the three months ended September 30, 2005, compared to $0 in
the prior year period. For the nine months ended September 30, 2005, engineering
costs transferred to cost of sales increased to $27, as compared to $0 in the
prior year. The increase is due to development services purchased by a customer
in the current three and nine month periods.

*Sales
and Marketing Expenses*. Sales
and marketing expenses decreased 22%, or $87, to $307 for the three months ended
September 30, 2005, compared to $394 in the prior year period. For the nine
months ended September 30, 2005, sales and marketing expense decreased 8%, or
$87, to $944, as compared to $1,031 in the prior year period. Sales and
marketing expenses consists of salaries, commissions and related expenses,
professional services, advertising and promotion, general office and allocated
facilities expenses. Salaries and related expense increased 48%, or $56, to $173
for the three months ended September 30, 2005, as compared to $117 in the prior
year period. For the nine months ended September 30, 2005, sales and marketing
salaries increased 20%, or $74, to $453, as compared to $379 in the prior year
period. The increase in salaries and related expense was due primarily to the
increase of two sales employees and, to a lesser extent, increases in employee
salaries.

Recruiting
expense increased to $4 for the three months ended September 30, 2005, compared
to $0 in the prior year period. For the nine months ended September 30, 2005,
recruiting expenses increased 135%, or $46, to $80, as compared to $34 in the
prior year period. The Company expects that recruiting expense will remain at an
increased level compared to the prior year as it continues staffing the sales
and marketing departments. Professional service expense increased to $2 for the
three months ended September 30, 2005, compared to $0 in the prior year period.

Professional
services increased to $23 for the nine months ended September 30, 2005, compared
to $0 in the prior year period. The increase is due to the sponsoring of health
care focus groups for the eSignature market.

Commission
expense decreased 75%, or $134, to $44 for the three months ended September 30,
2005, compared to $178 in the prior year period. The decrease in commission
expense was due primarily to the decrease in sales compared to the prior year.
For the nine months ended September 30, 2005, commission expense decreased 60%,
or $184, to $122, as compared to $306 in the prior year. Other expense,
including general office and allocated facilities and engineering support
expenses declined 52%, or $51, to $48 for the three months ended September 30,
2005, compared to $99 in the prior year period. For the nine months ended
September 30, 2005, other expenses decreased 43%, or $135, to $177, as compared
to $312 in the prior year period. The decrease is due to reductions in selling
costs of the Joint Venture. The Company anticipates that sales and marketing
expenses will increase in the near term as the Company strengthens its sales
efforts through increasing headcount to pursue new opportunities in the
eSignature market space.

*General
and Administrative Expenses*. General
and administrative expenses decreased 3%, or $24, to $666, for the three months
ended September 30, 2005, compared to $690 in the prior year period. For the
nine months ended September 30, 2005, general and administrative expenses
decreased 6%, or $114, to $1,734 as compared to $1,848 in the prior year period.

General
and administrative expense consists of salaries, professional fees, investor
relations expenses, patent amortization and office and allocated facilities
costs. Salaries and wages were flat for the three months ended September 30,
2005, at $189 for both the current and the prior year period. For the nine
months ended September 30, 2005, salaries expense increased 3%, or $16, to $568
as compared to $552 in the prior year period. The increase was due primarily to
increases in employee salaries.

Professional
service expenses, which include consulting, legal and outside accounting fees,
increased 36%, or $56, to $212 for the three months ended September 30, 2005,
compared to $156 in the prior year period. The increase was due primarily to an
increase in legal fees, associated with the infringement litigation, incurred by
the Company in protecting its patented intellectual property compared to the
prior year. For the nine months ended September 30, 2005 professional services
increases 36% or $133, to $500, as compared to $367 in the prior year. The
increase was due to the patent infringement litigation previously mentioned.

-
25 -
The
Company’s bad debt expense decreased 96%, or $27, to $1 for the three months
ended September 30, 2005, compared to $28 in the prior year period. For the nine
months ended September 30, 2005, bad debt expense decreased 68%, or $23, to $11,
as compared to $34 in the prior year period. The decrease was due to adequate
coverage for the slow payment cycle of channel partner receivables of the Joint
Venture. At this time, the Company believes that its provision for bad debts is
adequate.

Insurance
expense increased 17%, or $4, to $28 for the three months ended September 30,
2005, compared to $24 in the prior year period. For the nine months ended
September 30, 2005, insurance expense decreases 23%, or $22, to $74, as compared
to $96 the prior year period. The decrease is due to reduced premiums for the
Company’s general and D&O insurance policies compared to the prior year. The
Company increased the D&O insurance limits when the policies were renewed.
The increased limits were obtained at approximately the same cost as the prior
year amounts.

Other
administrative expenses decreased 40%, or $117, to $176 for the three months
ended September 30, 2005, as compared to $293 in the prior year period. For the
nine months ended September 30, 2005, other expenses decreased 27%, or $218, to
$581, as compared to $799 in the prior year period. The decrease was due
primarily to spending reductions by the joint venture and reduced allocations
due to increases in the head count in other areas of the Company. The Company
believes that its General and Administrative expenses will remain fairly stable
for the near term.

*Interest
and other income (expense), net*

Interest
and other income (expense), netdecreased
$26, to an expense of $24 for the three months ended September 30, 2005,
compared to the same prior year period. The increase in expense was primarily
due to the disposal of fixed assets by the Joint Venture. For the nine months
ended September 30, 2005, interest and other income (expense), net increased $33
as compared to the prior year. This increase is primarily due to the disposal of
fixed assed discussed above.

*Interest
expense*

Interest
expense, including $837 in non cash charges related to the convertible notes,
increased 647%, or $757, to $874 for the three months ended September 30, 2005,
compared to $117 in the prior year period. The increase was primarily due to the
non-cash charges for the amortization of prepaid financing costs, warrant and
beneficial conversion feature costs associated with the convertible notes (See
Note 8 of the condensed consolidated financial statements). For the nine months
ended September 30, 2005, interest expense, including non cash charges related
to the convertible notes increased 773%, or $2,025, to $2,287, as compared to
$262 in the prior year period. The increase is primarily due to the non-cash
charges discussed above. The Company will be required to amortize an additional
$1,059 to interest expense over the life of the convertible notes or sooner if
the notes are converted before the due date.
-26-

**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q*****Liquidity
and Capital Resources***

At
September 30, 2005, cash and cash equivalents totaled $3,091 compared to cash
and cash equivalents of $4,736 at December 31, 2004. The decrease in cash was
primarily due to cash used in operating activities of $1,308, acquisition of
property and equipment amounting to $57, capitalization of software development
costs of $233 and payments of long term debt and capital lease obligations of
$56. Total current assets were $4,213 at September 30, 2005, compared to $5,469
at December 31, 2004. As of September 30, 2005, the Company's principal sources
of funds included its cash and cash equivalents aggregating $3,091.

Accounts
receivable increased $351 for the nine months ended September 30, 2005, compared
to the December 31, 2004 balance, due primarily to the increase in recurring
maintenance billings compared to the prior year.The
Company expects the development of the eSignature market will result in more
consistent revenue on a quarter to quarter basis and therefore, less fluctuation
in accounts receivable from quarter to quarter.

Deferred
financing costs, including the current and non-current portion, decreased $513
over the nine months ended September 30, 2005 as the result of amortization to
interest expense.

Prepaid
expenses and other current assets increased $98 for the nine months ended
September 30, 2005, compared to December 31, 2004, due to annual fees or
maintenance and support costs added to the prepaid accounts over the nine
months. Generally, annual insurance premiums and maintenance and support fees
are prepaid in December and June of each year and, therefore, the balances
typically begin to decrease in the second and fourth quarters as the prepaid
balances are amortized.

Accounts
payable increased $46 for the nine months ended September 30, 2005, compared to
December 31, 2004, due to increased legal fees for associated with the patent
infringement litigation during the quarter. Accounts payable balances typically
increase in the second and fourth quarters when the insurance and annual
maintenance and support fees are incurred. Materials used in cost of sales may
impact accounts payable depending on the amount of third party hardware sold as
part of the software solution.

Current
liabilities, which include deferred revenue, were $1,576 at September 30, 2005,
compared to $1,401 at December 31, 2004. Deferred revenue, totaling $673 at
September 30, 2005, compared to $458 at December 31, 2004, primarily reflects
advance payments for products and maintenance fees from the Company's licensees
which are generally recognized as revenue by the Company when all obligations
are met or over the term of the maintenance agreement.

On
November 2, 2004, the Company closed the issuance of debt and equity instruments
pursuant to an unsecured Note and Warrant Purchase Agreement (the “Purchase
Agreement”) and a Registration Rights Agreement (the “Registration Rights
Agreement”), each dated as of October 28, 2004. The financing, a combination of
debt and equity instruments, closed November 2, 2004. The proceeds to the
Company were approximately $3,885, net of $310 in commissions and legal
expenses. H.C. Wainwright & Co., Inc. (“Wainwright”) acted as placement
agent. As placement agent for the Company, at closing Wainwright received $731
in commissions, reimbursement of legal fees and warrants. The commissions of
approximately $285 and legal fees of $25 were paid in cash. The Company issued
warrants to Wainwright to acquire 1,218 shares of the Company’s common stock. Of
the warrants issued, 870 are exercisable at $0.462 and 348 are exercisable at
$0.508. The Company has ascribed the value of $421 to the Wainwright warrants,
which is recorded as deferred financing costs in the balance sheet. The fair
value ascribed to the Wainwright warrants was estimated on the commitment date
using the Black-Scholes pricing model with the following assumptions: risk-free
interest rate of 3.21%; expected life of 3 years; expected volatility of 100%;
and expected dividend yield of 0%. The Company is using the proceeds of the
financing for working capital purposes.

-
27 -
**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**Under the terms of the financing, the Company
issued to certain accredited investors convertible promissory notes in the
aggregate principal amount of $4,195****and
warrants to acquire 3,632 shares of the Company’s common stock at an exercise
price of $0.508 per share**.**The notes
accrue interest at the rate of 7% per annum, payable semi-annually, and are
convertible into shares of the Company’s common stock at the rate of $0.462 per
share. The Company has ascribed a value of $982 to the investor warrants, which
is recorded as a discount to notes payable in the balance sheet. The fair value
ascribed to the warrants was estimated on the commitment date using the
Black-Scholes pricing model with the following assumptions: risk-free interest
rate of 3.21%; expected life of 3 years; expected volatility of 100%; and
expected dividend yield of 0%. In addition to the fair value ascribed to the
warrants, the Company has ascribed $1,569 to the beneficial conversion feature
in the convertible notes, which is recorded as a discount to notes payable in
the balance sheet. The values ascribed to the warrants and beneficial conversion
feature follow the guidance of the EITF Issue No. 98-5, “Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios”, and ETIF Issue No. 00-27, “Application of Issue
No. 98-5 to Certain Convertible Instruments” of the FASB’s Emerging Issues Task
Force. The fair value of the warrantsand
beneficial conversion feature is amortized to expense over the life of the
convertible notes or upon earlier conversion using the effective interest
method. During the three and nine months ended September 30, 2005, the Company
had amortized to interest expense approximately $837 and $2,109, respectively,
of the loan discount and deferred financing costs. The balance due under the
convertible notes is shown net of the remaining $798 unamortized discount on the
accompanying consolidated balance sheet. During the three and nine months ended
September 30, 2005, the investors converted $1,143 and $2,277, respectively, of
the notes in exchange for 2,474 and 4,930, respectively, shares of the Company’s
common stock. If the remaining aggregate principal amount owing under the notes
is converted, the Company will issue 4,151****shares of
its common stock. If the notes are not converted, all remaining principal and
accrued but unpaid interest will be due October 28, 2007. The Company may pay
accrued interest in cash or in shares of Company common stock, issued at the
market price for the common stock calculated prior to the interest payment. The
Company does not currently intend to pay accrued interest with shares of its
common stock. The Company paid approximately $142 of accrued interest associated
with the convertible notes in May 2005.

The above
warrants expire on October 28, 2009. The Company may call the warrants if the
Company’s common stock trades at $1.00 or above for 20 consecutive trading days
after the date that is 20 days following the effectiveness of a registration
statement providing for the resale of the shares issued upon the conversion of
the notes and exercise of the warrants. Wainwright will be paid approximately
$28****in the
aggregate if all of the investor warrants are exercised. The Company will
receive proceeds of approximately $1,845 if all of the warrants are
exercised.

The
Company also was required to file a registration statement providing for the
resale of the shares that are issuable upon the conversion of the notes and the
exercise of the warrants. The registration statement was filed on December 22,
2004 and was declared effective on January 26, 2005.

The
Company has the following material commitments as of September 30,
2005:

Payments
      due by periodsContractual
      obligations
    
    
    
    Total
    
    Less
      than one year
    
    One
      to three years
    
    Four
      to five yearsLong-term
      debt (1)
    
    
    
    
    $
    1,120
    
    $
    -
    
    $
    1,120
    
    
    -Capital
      Lease Obligations
    
    
    
    
    
    6
    
    
    6
    
    
    -
    
    
    -Operating
      lease commitments (2)
    
    
    
    
    
    429
    
    
    330
    
    
    99
    
    
    -Total
      contractual cash obligations
    
    
    
    
    $
    1,555
    
    $
    336
    
    $
    1,219
    
    $
    -

1.
    Long-term
      debt is net of approximately $798 in discounts representing the fair value
      of warrants issued to the investors and the beneficial conversion feature
      associated with the convertible notes.

2.
    The
      operating lease commenced on November 1, 2002. The cost of the lease
      increases approximately 3% per annum over the term of the lease, which
      expires on October 31, 2006.

The
Company has suffered recurring losses from operations that raise a substantial
doubt about its ability to continue as a going concern. There can be no
assurance that the Company will have adequate capital resources to fund planned
operations or that any additional funds will be available to it when needed, or
if available, will be available on favorable terms or in amounts required by it.
If the Company is unable to obtain adequate capital resources to fund
operations, it may be required to delay, scale back or eliminate some or all of
its operations, which may have a material adverse effect on its business,
results of operations and ability to operate as a going concern. The financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.

-
28 -
**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**Item 3.Quantitative
and Qualitative Disclosures About Market Risk

Interest
Rate Risk

The
Company has an investment portfolio of fixed income securities that are
classified as cash equivalents. These securities, like all fixed income
instruments, are subject to interest rate risk and will fall in value if the
market interest rates increase. The Company attempts to limit this exposure by
investing primarily in short term securities. The Company did not enter into any
short-term security investments during the three and nine months ended September
30, 2005.

Foreign
Currency Risk

From time
to time, the Company makes certain capital equipment or other purchases
denominated in foreign currencies. As a result, the Company’s cash flows and
earnings are exposed to fluctuations in interest rates and foreign currency
exchange rates. The Company attempts to limit these exposures through
operational strategies and generally has not hedged currency
exposures.

Future
Results and Stock Price Risk

The
Company's stock price is subject to significant volatility. The public stock
markets have experienced significant volatility in stock prices in recent years.
The stock prices of technology companies have experienced particularly high
volatility, including, at times, severe price changes that are unrelated or
disproportionate to the operating performance of such companies. The trading
price of the Company's common stock could be subject to wide fluctuations in
response to, among other factors, quarter-to-quarter variations in operating
results, announcements of technological innovations or new products by the
Company or its competitors, announcements of new strategic relationships by the
Company or its competitors, general conditions in the computer industry or the
global economy in general, or market volatility unrelated to the Company's
business and operating results.

Item 4.Controls
and Procedures

Under the
supervision and with the participation of the Company’s management, including
the Company’s Chief Executive Officer and Chief Financial Officer, the Company
has evaluated the effectiveness of the design and operation of its disclosure
controls and procedures pursuant to Exchange Act Rule 13a-14(c)as of the
end of the period covered by this quarterly report. Based
on that evaluation, the Chief Executive Officer and Chief Financial Officer have
concluded that these disclosure controls and procedures are effective. There
were no significant changes in the Company’s internal controls or in other
factors that could significantly affect internal controls subsequent to the date
of their evaluation.

Part
II-Other Information

Item
1.Legal
Proceedings

In
February of 2005, Valyd, Inc. filed a complaint against the Company seeking a
declaratory judgment that Valyd is not infringing certain of the Company’s
patents, that such patents are invalid or unenforceable, that the Company is
equitably estopped from asserting infringement of such patents against Valyd,
Inc., that the Company tortiously interfered with a contract between Valyd, Inc.
and Interlink Electronics, Inc. by delivering an infringement notice to
Interlink Electronics, Inc., and that the Company has engaged in unfair
competition under California law. No specific monetary claim is set forth in the
complaint. On March 3, 2005, the Company responded to the complaint, denying all
allegations, and filed counterclaims against Valyd, Inc. The counterclaims
assert that Valyd, Inc. is infringing certain of the Company’s patents and asked
for treble damages, alleging that the infringement is willful, deliberate and in
conscious disregard of the Company’s rights. Valyd, Inc. has withdrawn its
allegation that certain of the Company's patents are unenforceable. The ultimate
outcome of this litigation cannot presently be determined. However, in
management’s opinion, the likelihood of a material adverse outcome is remote and
any liability that might be incurred would not have a material adverse effect on
the Company’s financial position or its results of operations. Accordingly,
adjustments, if any that might result from the resolution of this matter have
not been reflected in the financial statements.

-
29 -
**Communication
Intelligence Corporation**
**And
Subsidiary**
**(In
thousands, except per share amounts)**
**Form
10-Q**Item 2.Change
in Securities and Use of Proceeds

None

Item
3.Defaults
Upon Senior Securities

None

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

None

Item
5.Other
Information

None

Item
6.Exhibits
and Reports on Form 8-K

(a)Exhibits

EXHIBIT
31 - Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

EXHIBIT
32 - Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 18 USC Section 1750, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.

- 30
-
**SIGNATURES**

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





COMMUNICATION
      INTELLIGENCE CORPORATIONRegistrant


November
      10, 2005
    
    /s/
      Francis V. DaneDate
    
    Francis
      V. Dane(Principal
      Financial Officer and Officer Duly Authorized to Sign on Behalf of the
      Registrant)

-31-