**UNITED
STATES**
 **SECURITIES
AND EXCHANGE COMMISSION**
 Washington,
D.C. 20549
 
 
 
 **FORM
10-Q**
 
 
 X
    QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For the
quarterly period ended:  June
30, 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 August 11, 2005:
106,349,128.
 
 
  
  
 INDEX
 
 PART
      I. FINANCIAL INFORMATION
    Page
      No.Item
      1.Financial
      StatementsCondensed
      Consolidated Balance Sheets at June 30, 2005 (unaudited) and December 31,
      2004
    3Condensed
      Consolidated Statements of Operations for the Three and Six-Month Periods
      Ended
      June
      30, 2005 and 2004 (unaudited)
    4Condensed
      Consolidated Statements of Changes in Stockholders’ Equity for the Three
      and Six-Month
      Periods
      Ended June 30, 2005 (unaudited)
    5Condensed
      Consolidated Statements of Cash Flows for the Six-Month Periods Ended June
      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
    17Item
      3.Quantitative
      and Qualitative Disclosures About Market Risk
    27Item
      4A.Controls
      and Procedures
    28PART
      II. OTHER INFORMATIONItem
      1.Legal
      Proceedings
    28Item
      2.Change
      in Securities and Use of proceeds
    28Item
      3.Defaults
      Upon Senior Securities
    28Item
      4.Submission
      of Matters to a Vote of Security Holders
    28Item
      5.Other
      Information
    29Item
      6.Exhibits
      and Reports on Form 8-K
    29(a)Exhibits
    29Signatures
    30
 
   -2-
   **Communication
Intelligence Corporation**
 **and
Subsidiary**
 **Condensed
Consolidated Balance Sheets**
 (In
thousands)
 
 June
      30,
    
    December
      31,2005
    
    2004UnauditedAssetsCurrent
      assets:Cash
      and cash equivalents
    
    $
    3,980
    
    $
    4,736Accounts
      receivable, net
    
    
    420
    
    
    356Deferred
      financing costs - current portion
    
    
    201
    
    
    272Prepaid
      expenses and other current assets
    
    
    134
    
    
    105Total
      current assets
    
    
    4,735
    
    
    5,469Property
      and equipment, net
    
    
    99
    
    
    123Patents
      and trademarks
    
    
    4,474
    
    
    4,663Capitalized
      software development costs
    
    
    213
    
    
    32Deferred
      financing costs - long term
    
    
    268
    
    
    502Other
      assets
    
    
    30
    
    
    30Total
      assets
    
    $
    9,819
    
    $
    10,819Liabilities
      and Stockholders’ equityCurrent
      liabilities:Short-term
      debt - related party
    
    $
    -
    
    $
    8Short-term
      debt - other
    
    
    -
    
    
    36Accounts
      payable
    
    
    267
    
    
    241Accrued
      compensation
    
    
    257
    
    
    258Other
      accrued liabilities
    
    
    337
    
    
    400Deferred
      revenue
    
    
    510
    
    
    458Total
      current liabilities
    
    
    1,371
    
    
    1,401Long-term
      debt - related party
    
    
    -
    
    
    5Convertible
      notes, net of unamortized fair value assigned to
      the
      beneficial feature and warrants of $1,428 and $2,410
      at
      June 30, 2005 and December 31, 2004, respectively
    
    
    1,632
    
    
    1,785Total
      Liabilities
    
    
    3,003
    
    
    3,191Minority
      interest
    
    
    83
    
    
    97Commitments
      and contingencies
    
    
    -
    
    
    -Stockholders’
      equity:Common
      stock
    
    
    1,039
    
    
    1,014Additional
      paid-in capital
    
    
    88,321
    
    
    87,231Accumulated
      deficit
    
    
    (82,466
    )
    
    (80,544
    )Accumulated
      foreign currency translation adjustment
    
    
    (161
    )
    
    (170
    )Total
      stockholders’ equity
    
    
    6,733
    
    
    7,531Total
      liabilities and stockholders' equity
    
    $
    9,819
    
    $
    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
    
    Six
      Months EndedJune
      30,
    
    June
      30,2005
    
    2004
    
    2005
    
    2004Sales:Online/retail
    
    $
    3
    
    $
    47
    
    $
    27
    
    $
    88Corporate
    
    
    1,050
    
    
    468
    
    
    1,604
    
    
    2,820China
    
    
    156
    
    
    115
    
    
    157
    
    
    151Total
      sales
    
    
    1,209
    
    
    630
    
    
    1,788
    
    
    3,059Operating
      costs and expenses:Cost
      of sales:Corporate
    
    
    29
    
    
    4
    
    
    50
    
    
    11China
    
    
    -
    
    
    7
    
    
    1
    
    
    33Research
      and development
    
    
    242
    
    
    273
    
    
    545
    
    
    592Sales
      and marketing
    
    
    328
    
    
    305
    
    
    637
    
    
    637General
      and administrative
    
    
    559
    
    
    654
    
    
    1,068
    
    
    1,158Total
      operating costs and expenses
    
    
    1,158
    
    
    1,243
    
    
    2,301
    
    
    2,431Income
      (loss) from operations
    
    
    51
    
    
    (613
    )
    
    (513
    )
    
    628Other
      income (expense)Interest
      and other income (expense), net
    
    
    (10
    )
    
    (1
    )
    
    (9
    )
    
    (2
    )Interest
      expense
    
    
    (881
    )
    
    (62
    )
    
    (1,413
    )
    
    (145
    )Minority
      interest
    
    
    6
    
    
    (2
    )
    
    13
    
    
    8Net
      Income (loss)
    
    $
    (834
    )
    $
    (678
    )
    $
    (1,922
    )
    $
    489Basic
      and diluted income (loss) per common share
    
    $
    (0.01
    )
    $
    (0.01
    )
    $
    (0.02
    )
    $
    0.01Weighted
      average common shares outstandingbasic
    
    
    102,382
    
    
    100,776
    
    
    102,034
    
    
    100,439Weighted
      average common shares outstandingdiluted
    
    
    102,382
    
    
    100,776
    
    
    102,034
    
    
    100,842
 
  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
    )
    $
    6,733
 
  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)
 
 Six
      Months Ended
      June
      30,2005
    
    2004Cash
      flows from operating activities:Net
      income (loss)
    
    $
    (1,922
    $)
    $
    489Adjustments
      to reconcile net income (loss) to net cash providedby/
      (used for) operating activities:Depreciation
      and amortization
    
    
    531
    
    
    217Amortization
      of discount on convertible notes
    
    
    952
    
    
    -Provision
      for doubtful accounts
    
    
    11
    
    
    48Loss
      on disposal of fixed assets
    
    
    38
    
    
    3Changes
      in operating assets and liabilities:Accounts
      receivable, net
    
    
    (64
    )
    
    195Inventories
    
    
    -
    
    
    47Prepaid
      expenses and other current assets
    
    
    (29
    )
    
    (32
    )Accounts
      payable
    
    
    26
    
    
    27Accrued
      compensation
    
    
    (1
    )
    
    (103
    )Other
      accrued liabilities
    
    
    (68
    )
    
    (146
    )Deferred
      revenue
    
    
    52
    
    
    177Net
      cash provided by (used for) operating activities
    
    
    (474
    )
    
    922Cash
      flows from investing activities:
      Acquisition
      of property and equipment
    
    
    (35
    )
    
    (34
    )Capitalized
      software development costs
    
    
    (193
    )
    
    -Net
      cash used for investing activities
    
    
    (228
    )
    
    (34
    )Cash
      flows from financing activities:Proceeds
      from issuance of short-term debt
    
    
    -
    
    
    37Proceeds
      from the exercise of stock options
    
    
    -
    
    
    10Payments
      on short-term debt
    
    
    (6
    )
    
    (2
    )Payments
      on long-term debt
    
    
    (3
    )
    
    -Principal
      payments on capital lease obligations
    
    
    (5
    )
    
    (3
    )Net
      cash provided by (used for) financing activities
    
    
    (54
    )
    
    42Effect
      of exchange rate changes on cash
    
    
    -
    
    
    -Net
      increase (decrease) in cash and cash equivalents
    
    
    (756
    )
    
    930Cash
      and cash equivalents at beginning of period
    
    
    4,736
    
    
    1,039Cash
      and cash equivalents at end of period
    
    $
    3,980
    
    $
    1,969
 
 Supplemental
Disclosure of Non Cash Financing Activities
 Pay
      off of short-term debt through issuance of common stock
    
    $
    −
    
    $
    750Offering
      cost related to short-term debt
    
    $
    −
    
    $
    60
 
   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) which 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, referred to
as HRSTM.
 
 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 more 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 June 30, 2005, the Company’s
accumulated deficit is approximately $82,466 and the Company has working capital
of $3,364. 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 computation 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.
 
 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. 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.
  - 9  -
 
 **Communication
Intelligence Corporation**
 **And
Subsidiary**
 **Notes
to Unaudited Condensed Consolidated Financial Statements**
 **(In
thousands, except per share amounts)**
 **Form
10-Q**
  
 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:
 
 June
      30,
      2005
    
    December
      31,
      2004Cash
      in bank
    
    $
    931
    
    $
    1,734Money
      market
    
    
    3,049
    
    
    3,002$
    3,980
    
    $
    4,736
 
 
 3. Accounts
receivable concentration
 
 For the
six months ended June 30, 2005, one customer accounted for 38% of net accounts
receivable. For the six months ended June 30, 2004, the same customer accounted
for 41% 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. The Company
believes that as of June 30, 2005 no impairment of the carrying values of the
patents existed. Amortization of patent costs was $94 for each of the three
months, and $189 for each of the six months ended June 30, 2005 and 2004,
respectively.
  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 note bore interest at the rate of 5% per annum, and
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 June 30,
2005, and 2004 was $11, and $2, respectively. For the six months ended June 30,
2005 and 2004, principal payments on related party debt were $13 and $2,
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 bears
interest at 5.3% per annum. The note was paid in April 2005.
  - 10 -
 
 **Communication
Intelligence Corporation**
 **And
Subsidiary**
 **Notes
to Unaudited Condensed Consolidated Financial Statements**
 **(In
thousands, except per share amounts)**
 **Form
10-Q**
  
 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 six months
ended June 30, 2005, the Company had amortized to interest expense approximately
$812 and $1,272, respectively, of the loan discount and deferred financing
costs. The balance due under the convertible notes is shown net of the remaining
$1,428 unamortized discount on the accompanying consolidated balance sheet.
During the three and six months ended June 30, 2005, the investors converted
$748 and $1,135, respectively, of the notes in exchange for 1,618 and 2,456,
respectively, shares of the Company’s common stock. If the remaining aggregate
principal amount owing under the notes is converted, the Company will issue
6,624 **** 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.
 
 
 -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)
 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 six months ended June 30, 2005 was $143, and
$144, respectively. Total interest paid during the three and six months ended
June 30, 2004 was $100, and $184, 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 June
30, 2005, 5,778 shares of common stock subject to outstanding options, 6,624
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 ant-dilutive. For
the three month period ended June 30, 2004, 6,183 of shares of common stock
subject to outstanding options were excluded from the calculation of dilutive
earnings per share as the effect of these options is not dilutive.
 
 Three
      Months EndedJune
      30, 2005
    
    June
      30, 2004Net
      Loss
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      Amount
    
    Net
      Loss
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      AmountBasic
      income (loss) per share:Income
      available to stockholders
    
    $
    (834
    )
    
    102,382
    
    $
    (0.01
    )
    $
    (678
    )
    
    100,776
    
    $
    (0.01
    )Effect
      of dilutive securitiesStock
      options
    
    
    -
    
    
    
    
    
    -
    
    
    -
    
    
    
    
    
    -Diluted
      income (loss)
    
    $
    (834
    )
    
    102,382
    
    $
    (0.01
    )
    $
    (678
    )
    
    100,776
    
    $
    (0.01
    )
 
 For the
six-month period ended June 30, 2005, 5,778 shares of common stock subject to
outstanding options, 6,624 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 six month period ended June 30,
2004, 5,392 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)
 
 Six
      Months EndedJune
      30, 2005
    
    June
      30, 2004Net
      Loss
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      Amount
    
    Net
      Income
    
    Weighted
      Average
      Shares
      Outstanding
    
    Per-Share
      AmountBasic
      income (loss) per share:Income
      available to stockholders
    
    $
    (1,922
    )
    
    102,034
    
    $
    (0.02
    )
    $
    489
    
    
    100,439
    
    $
    0.01Effect
      of dilutive securitiesStock
      options
    
    
    -
    
    
    
    
    
    -
    
    
    -
    
    
    403
    
    
    -Diluted
      income (loss)
    
    $
    (1,922
    )
    
    102,034
    
    $
    (0.02
    )
    $
    489
    
    
    100,842
    
    $
    0.01
 
 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 EndedJune
      30,
    
    June
      30,2005
    
    2004Net
      income (loss) available to stockholders:As
      reported
    
    $
    (834
    )
    $
    (678
    )Add:
      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
    
    
    (116
    )
    
    (73
    )Pro
      forma
    
    $
    (950
    )
    $
    (751
    )Basic
      and diluted net income (loss) per share available to
      stockholders:As
      reported
    
    $
    (0.01
    )
    $
    (0.01
    )Pro
      forma
    
    $
    (0.01
    )
    $
    (0.01
    )
  
 -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 (continued)
 Six
      Months EndedJune
      30,
    
    
    June
      30,2005
    
    
    2004Net
      income (loss) available to stockholders:As
      reported
    
    $
    (1,922
    )
    $
    489Add:
      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
    
    
    (168
    )
    
    (111
    )Pro
      forma
    
    $
    (2,090
    )
    $
    378Basic
      and diluted net income (loss) per share available to
      stockholders:As
      reported
    
    $
    (0.02
    )
    $
    0.01Pro
      forma
    
    $
    (0.02
    )
    $
    0.01
 
 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 3.91 for 2005, and 2.37% for
    2004;
 ·
    an expected life of 6.4 years for 2005, and 6.6 years for
    2004
 ·
    expected volatility of 90% 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
      June
      30,
    
    Six
      Months Ended
      June
      30,2005
    
    2004
    
    2005
    
    2004Net
      income (loss)
    
    $
    (834
    )
    $
    (678
    )
    $
    (1,922
    )
    $
    489Other
      comprehensive income:Cumulative
      translation adjustment
    
    
    7
    
    
    2
    
    
    9
    
    
    3Total
      comprehensive income (loss)
    
    $
    (827
    )
    $
    (676
    )
    $
    (1,913
    )
    $
    492
 
  - 14  -
 
 **Communication
Intelligence Corporation**
 **And
Subsidiary**
 **Notes
to Unaudited Condensed Consolidated Financial Statements**
 **(In
thousands, except per share amounts)**
 **Form
10-Q**
  
 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 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. 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.
 
 The
tables below present information about reporting segments for the periods
indicated:
 
 Three
      Months Ended June 30,2005
    
    2004Handwriting
      Recognition
    
    Systems
      Integration
    
    Total
    
    Handwriting
      Recognition
    
    Systems
      Integration
    
    TotalRevenues
    
    $
    1,209
    
    $
    -
    
    $
    1,209
    
    $
    624
    
    $
    6
    
    $
    630Income
      (loss) from Operations
    
    $
    51
    
    $
    -
    
    $
    51
    
    $
    (616
    )
    $
    3
    
    $
    (613
    )Significant
      change in total long lived assets from year end
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
 
 Six
      Months Ended June 30,2005
    
    2004Handwriting
      Recognition
    
    Systems
      Integration
    
    Total
    
    Handwriting
      Recognition
    
    Systems
      Integration
    
    TotalRevenues
    
    $
    1,788
    
    $
    -
    
    $
    1,788
    
    $
    3,022
    
    $
    37
    
    $
    3,059Income
      (loss) from Operations
    
    $
    (513
    )
    $
    -
    
    $
    (513
    )
    $
    620
    
    $
    8
    
    $
    628Significant
      change in total long lived assets from year end
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
 
 For the
three months ended June 30, 2005 and 2004, one customer accounted for 40% and
29% of total handwriting recognition segment revenue, respectively. For the six
months ended June 30, 2005 and 2004, one customer accounted for 27% and 66% of
total handwriting recognition segment revenue, respectively.
  -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)
 
 For the
three and six months ended June 30, 2005 there was no system integration
revenues recorded. For the three and six months ended June 30, 2004, one
customer accounted for 70% 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, and that the Company
tortiously interfered with a contract between Valyd, Inc. and Interlink
Electronics, Inc. by delivering an infringement notice to Interlink Electronics,
Inc. The complaint also alleged 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 CIC’s rights. 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
June 30, 2005, the note holders have converted $1,135 of additional
notes into 2,457 shares of common stock. Since the closing on November 2, 2004,
the note holders have converted an aggregate of $2,270 of notes into
5,021 shares of the Company’s common stock. There are $1,925 of convertible
notes remaining representing 4,059 shares of the Company’s common
stock.
 
 
   - 16  -
 
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
   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 June 30, 2005, the Company’s accumulated deficit was approximately
$82,466.
 
 Total
revenue of $1,209 for the quarter ended June 30, 2005 increased 92% compared to
revenues of $630 in the corresponding quarter of the prior year. The increase in
revenue is due primarily to license
agreements, with Snap-On Credit LLC and Software House International, Inc.
aggregating approximately $ 576.
Total revenues of $1,788 for the six months ended June 30, 2005, decreased 42%
compared to revenues of $3,059 in the corresponding six months of the prior
year. Total revenue for eSignature solutions of $1,761 for the six months ended
June 30, 2005, decreased 29% or $732, compared to eSignature revenue of $ 2,493
in the corresponding six months of the prior year. This
decrease in revenue is primarily attributable to a $2,000 order from Wells Fargo
in the first quarter of the prior year. Total revenue of $1,788 for the six
months ended June 30, 2005 is primarily attributable to American General Life,
Bell South, Duncan Management, eCom Asia Pacific, Everypath, GE, Integrasis, JB
Hunt Transport, Misys Healthcare, PalmSource, Prudential, Snap-On Credit, State
Farm and Wells Fargo.
 
 Revenues
for the six months ended June 30, 2005 include new markets and applications that
the Company’s SignatureOne product platform has made possible. SignatureOne,
recipient of the BiometriTech 2004 product of the year award in June 2005,
provides patented technology that supports a wide range of eSignature methods in
addition to our handwritten biometric signature verification. These orders
include new applications with end users as well as new applications with
partners embedding our software into their total software solutions which will
provide us an ongoing stream of quarterly royalty revenues. SignatureOne, by
meeting the need for accommodating the various eSignature methods, is now the
focal point for continued penetration and deployments in the financial services
industry. In addition, SignatureOne played a key role in the new eCom Asia
agreement enabling a return to profitability for CIC China in the 2 nd quarter
2005 and the potential for continued sales growth in that emerging market. Deploying
and maintaining the worldwide market presence and sales coverage necessary to
achieve sustained sales and earnings growth is the company’s primary
challenge.
 
 The net
loss for the quarter ended June 30, 2005 was $834, which included $812 in
non-cash charges to interest expense for prepaid financing costs and loan
discount amortization related to the convertible notes, compared with a net loss
of $678 in the corresponding prior year period. Operating expenses decreased
approximately 8% or $103, from $1,232 to $1,129 for the three months ended June
30, 2004, compared to the prior year period. The decrease primarily reflects the
decrease in administrative expenses. The net loss for the six months ended June
30, 2005 of $1,922, which included $1,272 in non-cash charges to interest
expense for prepaid financing costs and loan discount amortization related to
the convertible notes, represents an increase of $2,411 compared to the net
income of $489 in the corresponding six months of the prior year. The increase
in the net loss is primarily due to the non-cash amortization expenses and lower
revenues.
 
 Key
growth drivers have merged to accelerate the deployment of electronic
transactions worldwide, including both the increasing awareness and reality of
the significant benefits of the paperless environment, increasing competitive
and cost pressures on companies and government agencies, and most recently, the
emerging economic recovery increasing pent-up demand for IT expenditures. The
intuitively obvious, non-intrusive nature of handwritten eSignatures has emerged
as a key factor in achieving the significant benefits that can be derived from
secure, signature dependent, legally binding eTransactions in the financial
service industry and is beginning to penetrate Healthcare, ePrescriptions and
other industry segments. The introduction of SignatureOne and updated Sign-it
products, in the first quarter of 2004, significantly expands CIC‘s market
 
 -17-
 **Communication Intelligence Corporation**
**And Subsidiary**
**Notes to Unaudited Condensed Consolidated Financial
Statements**
**(In thousands, except per share amounts)**
**Form 10-Q** ***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.
 
 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.
 
 We
perform intangible asset impairment analysis on a quarterly basis in accordance
with the guidance in Statement of Financial Accounting Standard No. 142,
Goodwill and Other Intangible Assets ("SFAS No. 142") and Financial Accounting
Standard No. 144, Accounting for the Impairment or Disposal of Long Lived Assets
("SFAS No. 144"). We use SFAS 144 in response to changes in industry and market
conditions that affect our patents, we then determine if an impairment of our
assets has occurred. Based on the impairment analysis of the intangible assets,
no impairment existed as of June 30, 2005.
 
  -18-
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 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 six months ended June 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 June 30, 2005 based upon the
Company's history of losses.
 
 ***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 of software
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.
 
 -19-
 
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 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
    
    Six
      Months EndedJune
      30,
    
    June
      30,2005
    
    2004
    
    2005
    
    2004Segment
      sales:Handwriting
      recognitionOnline/retail
    
    $
    3
    
    $
    47
    
    $
    27
    
    $
    88Corporate
    
    
    1,050
    
    
    468
    
    
    1,604
    
    
    2,820China
    
    
    156
    
    
    109
    
    
    157
    
    
    114Total
      handwriting recognition
    
    $
    1,209
    
    $
    624
    
    $
    1,788
    
    $
    3,022Systems
      integration
    
    
    −
    
    
    6
    
    
    −
    
    
    37Total
      sales
    
    $
    1,209
    
    $
    630
    
    $
    1,788
    
    $
    3,059Cost
      of SalesHandwriting
      recognition
    
    $
    29
    
    $
    8
    
    $
    51
    
    $
    15Systems
      integration
    
    
    -
    
    
    3
    
    
    -
    
    
    29Total
      cost of sales
    
    $
    29
    
    $
    11
    
    $
    51
    
    $
    44Operating
      cost and expensesResearch
      and development
    
    $
    242
    
    $
    273
    
    $
    545
    
    $
    592Sales
      and Marketing
    
    
    328
    
    
    305
    
    
    637
    
    
    637General
      and administrative
    
    
    559
    
    
    654
    
    
    1,068
    
    
    1,158Total
      operating costs and expenses
    
    $
    1,129
    
    $
    1,232
    
    $
    2,250
    
    $
    2,387Interest
      and other income (expense), net
    
    $
    (4
    )
    $
    (3
    )
    $
    4
    
    $
    6Interest
      expense
    
    
    (881
    )
    
    (62
    )
    
    (1,413
    )
    
    (145
    )Net
      income (loss)
    
    $
    (834
    )
    $
    (678
    )
    $
    (1,922
    )
    $
    489Amortization
      of intangible assetsCost
      of sales
    
    $
    17
    
    $
    -
    
    $
    20
    
    $
    -General
      and administrative
    
    
    94
    
    
    94
    
    
    189
    
    
    189Total
      amortization of intangible assets
    
    $
    112
    
    $
    94
    
    $
    209
    
    $
    189
 *Sales*
 
 *Handwriting
recognition.*
 
 Handwriting
recognition segment revenues include online/retail, corporate and China software
sales. Handwriting recognition segment revenues increased 94%, or $585, to
$1,209 for the three months ended June 30, 2005, as compared to $624 in the
prior year period. For the six month period ended June 30, 2005, Handwriting
recognition revenues decreased 41% or $1,234, to $1,788, as compared to $3,022
in the prior year period. The changes to Handwriting recognition revenues are
discussed more fully below.
  -20-
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 Online/retail
revenues decreased 94%, or $44, to $3 for the three months ended June 30, 2005,
as compared to $47 in the prior year period. For the six months ended June 30,
2005, online/retail revenues decreased 69%, or $61, to $27, as compared to $88
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 the de facto standard, 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 increased 124%, or $582, to $1,050 for the three months ended June 30,
2005, as compared to $468 in the prior year period. For the six months ended
June 30, 2005 corporate revenues declined 43%, or $1,216, to 1,604, as compared
to $2,820 in the prior year period. The changes to corporate revenues are
discussed below.
 
 OEM and
channel partner sales included in corporate revenues, increased 86%, or $221, to
$478, for the three months ended June 30, 2005 compared to $257 in the prior
year period. For the six months ended June 30 2005, OEM and channel partner
sales increased 31%, or $168, to $703, compared to $535 in the prior year
period. The increase in OEM and channel partner sales for the three and six
months ended June 30, 2005, is due primarily to an order in
the second quarter from one of its resellers for CIC’s Sign-it® for Acrobat
product for use by a major telecommunications company. 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 increased 171%, or $361, to
$572, for the three months ended June 30, 2005, as compared to $211 in the prior
year period. The increase in sales for the three months ended June 30, 2005 was
due primarily to a one year,
renewable license agreement, with Snap-On Credit LLC , that
focuses on enabling mobile workforces . For the
six months ended June 30, 2005 eSignature sales decreased 61% or $1,384, to
$901, as compared to $2,285 in the prior year period. The decrease in eSignature
sales for the six months ended June 30, 2005 compared to the prior period was
due primarily to the sale of the Company’s eSignature products to Wells Fargo
Bank in the first quarter ended March 31, 2004. The Company believes that the
sales of smaller pilot deployments to customers, of its products, will lead to
greater sales in future periods as the customers roll out their applications on
a wider scale. The Company believes that corporate eSignature revenues will
increase in the near term as the customers begin their roll outs and corporate
IT spending increases as the economy strengthens. 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.
 
 Software
sales in China increased 43% or $47, to $156, for the three months ended June
30, 2005, as compared to $109 in the prior year period. For the six months ended
June 30, 2005, software sales in China increased 38%, or $43 to $157, as
compared to $114 in the prior year period. The increase in China software sales
was due to a new agreement with eCom Asia
Pacific Pty Ltd (“eCom”).
T he 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 through the third quarter of 2005 and beyond.
 
 -21-
 
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 *Systems
Integration.*
 
 System
integration segment revenue declined 100%, or $6, to $0, for the three months
ended June 30, 2005, as compared to $6 in the prior year period. For the six
months ended June 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 263%, or $21, to $29, for the
three months ended June 30, 2005, as compared to $8 in the prior year period.
For the six months ended June 30, 2005, handwriting recognition cost of sales
increased 240% or $36, to $51, as compared to $15 in the prior year period. The
increase is primarily due to the increase in development contract work completed
during the three and six months ended June 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.
 
 Online/retail
cost of sales remained flat during the three and six month periods ended June
30, 2005, as compared to the prior year periods. The Company does not anticipate
a material increase is costs associated with the online/retail
sales.
 
 eSignature
and OEM cost of sales increased 625%, or $25, to $29 for the three months ended
June 30, 2005, as compared to $4 in the prior year period. The increase was due
to direct engineering labor charges associated with contract development
revenues. For the six months ended June 30, 2005, OEM and eSignature cost of
sales increased 355%, or $39, to $50, as compared to $11 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 decreased 100%, or $4, to $0 for the three
months ended June 30, 2005, as compared to $4 in the prior year period. For the
six month period ended June 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 six months ended June 30, 2005. It is
expected that cost of sales will remain low for the foreseeable future as the
current trend has been in the sale of software solutions through channel
partners with little third party hardware costs.
 
 -22-
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 ***Systems
Integration.***
 
 System
integration segment cost of sales declined 100%, or $3, to $0 for the three
months ended June 30, 2005, as compared to $3 in the prior year. For the six
months ended June 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 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. 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 11%, or $31, to $242 for the three
months ended June 30, 2005, as compared to $273 in the prior year period. For
the six months ended June 30, 2005, engineering expenses decreased 8%, or $47,
to $545 as compared to $592 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 32%,
or $68, to $279 for the three months ended June 30, 2005, as compared to $211 in
the prior year period. For the six months ended June 30, 2005, engineering
salaries increased 23%, or $98, to $528, as compared to $430 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 100%,
or $1, to $1 for the three months ended June 30, 2005, compared to $0 in the
prior year period. For the six months ended June 30, 2005 outside engineering
costs increased 100%, or $56 to $56, 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 25%, or $14, to $70 for the three months ended June 30,
2005, compared to $56 in the prior year period. For the six months ended June
30, 2005, facilities allocation increased 25%, or $28, as compared to $112 in
the prior year period. Increased engineering head count is the primary reason
for the increased facilities allocation. Capitalized software development costs
increased 100%, or $90 and $189 for the three and six month periods ended June
30, 2005, as compared to $0 in the prior year periods. 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
six months ended June 30, 2005 for the foreseeable future. Engineering costs
transferred to cost of sales increased 100%, or $10, to $10 for the three months
ended June 30, 2005, compared to $0 in the prior year period. For the six months
ended June 30, 2005, engineering costs transferred to cost of sales increased
100% or $21 to $21, as compared to $0 in the prior year. The increase is due to
development services purchased by a customer in the current three and six month
periods.
 
 *Sales
and Marketing Expenses* . Sales
and marketing expenses increased 8%, or $23, to $328 for the three months ended
June 30, 2005, compared to $305 in the prior year period. For the six months
ended June 30, 2005, sales and marketing expense was flat. 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 1%, or $2, to $150 for the
three months ended June 30, 2005, as compared to $148 in the prior year period.
For the six months ended June 30, 2005, sales and marketing salaries increased
7%, or $18, to $280, as compared to $262 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 decreased 43%, or $6, to $8 for the three months ended June 30, 2005,
compared to $14 in the prior year period. For the six months ended June 30,
2005, recruiting expenses increased 124%, or $42, to $76, 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 100%, or
$1, to $1 for the three months ended June 30, 2005, compared to $0 in the prior
year period. Professional services increased 100%, or $21, to $21 for the six
months ended June 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 379%, or $53, to $67 for the three months
ended June 30, 2005, compared to $14 in the prior year period. The increase in
commission expense was due primarily to the increase in revenues compared to the
prior year. For the six months ended June 30, 2005, commission expense decreased
39%, or $50, to $78, as compared to $128 in the prior year. The decrease in the
revenue over the six month period is due to lower sales. Other expense,
including general office and allocated facilities expenses declined 21%, or $27,
to $102 for the three months ended June 30, 2005, compared to $129 in the prior
year period. For the six months ended June 30, 2005, other expenses decreased
15%, or $31, to $182, as compared to $213 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 continue to increase in the
near term as the Company strengthens its sales efforts through increasing
headcount to pursue new opportunities in the eSignature market space. The
Company continues to pursue a channel strategy for its eSignature products. The
Company believes the channel strategy, along with its current and potential
partners, will produce increasing revenues in the near term.
  -23-
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 *General
and Administrative Expenses* . General
and administrative expenses decreased 15%, or $95, to $559, for the three months
ended June 30, 2005, compared to $654 in the prior year period. For the six
months ended June 30, 2005, general and administrative expenses decreased 8%, or
$90, to $1,068 as compared to $1,158 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 increased 5%, or $9, to $194 for the three months
ended June 30, 2005, compared to $185 in the prior year period. For the six
months ended June 30, 2005, salaries expense increased 4%, or $15, to $378 as
compared to $363 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 $77, to $288
for the six months ended June 30, 2005, compared to $211 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 during the six months ended June 30, 2005,
compared to the prior year. The Company’s bad debt expense decreased 61%, or
$17, to $11 for the three months ended June 30, 2005, compared to $28 in the
prior year period. For the six months ended June 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 decreased 36%,
or $13, to $23 for the three months ended June 30, 2005, compared to $36 in the
prior year period. For the six months ended June 30, 2005, insurance expense
decreases 35%, or $25, as compared to 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. Other administrative expenses decreased 29%, or $74,
to $180 for the three months ended June 30, 2005, as compared to $254 in the
prior year period. For the six months ended June 30, 2005, other expenses
decreased 28%, or $134, to $344, as compared to $478 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), net increased
900%, or $9, to $10 for the three months ended June 30, 2005, compared to the
same prior year period. The increase was due to the disposal of fixed assets in
the Joint Venture offset by higher cash balances earning interest than in the
prior year period. For the Six months ended June 30, 2005, interest and other
income (expense), net increased $7 as compared to the prior year. This increase
is primarily due to the disposal of fixed assed discussed above.
 
 *Interest
expense*
 
 Interest
expense increased 1320%, or $819, to $881 for the three months ended June 30,
2005, compared to $62 in the prior year period. The increase was primarily due
to non-cash charges for the amortization of prepaid financing costs, and warrant
and beneficial conversion feature costs associated with the convertible notes
(See Note 8 of the condensed consolidated financial statements). For the six
months ended June 30, 2005, interest expense increased 874%, or $1,268, to
$1,413, as compared to $145 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 $1,897 to interest expense over the life of the
convertible notes or sooner if the notes are converted before the due
date.
 
 -24-
 
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 ***Liquidity
and Capital Resources***
 
 At June
30, 2005, cash and cash equivalents totaled $3,980 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 $474, acquisition of property and
equipment amounting to $35, capitalization of software development costs of $193
and payments of long term debt and capital lease obligations of $54. Total
current assets were $4,735 at June 30, 2005, compared to $5,469 at December 31,
2004. As of June 30, 2005, the Company's principal sources of funds included its
cash and cash equivalents aggregating $3,980.
 
 Accounts
receivable increased $64 for the six months ended June 30, 2005 compared to the
December 31, 2004 balance, due primarily to the increase in recurring
maintenance billings and sales compared to the prior quarter. 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 $305
over the six months ended June 30, 2005 as the result of amortization to
interest expense.
 
 Prepaid
expenses and other current assets increased $29 for the six months ended June
30, 2005, compared to December 31, 2004, due to annual fees or maintenance and
support costs added to the prepaid accounts over the six 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 first and third quarters as the prepaid balances are
amortized.
 
 Accounts
payable increased $26 for the six months ended June 30, 2005, compared to
December 31, 2004, due to increased professional fees for engineering and
recruiting utilized 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 $1,371 at June 30, 2005,
compared to $1,401 at December 31, 2004. Deferred revenue, totaling $510 at June
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 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.
 
 -25-
 
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (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 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 six months
ended June 30, 2005, the Company had amortized to interest expense approximately
$812 and $1,272, respectively, of the loan discount and deferred financing
costs. The balance due under the convertible notes is shown net of the remaining
$1,428 unamortized discount on the accompanying consolidated balance sheet.
During the three and six months ended June 30, 2005, the investors converted
$748 and $1,135, respectively, of the notes in exchange for 1,618 and 2,456,
respectively, shares of the Company’s common stock. If the remaining aggregate
principal amount owing under the notes is converted, the Company will issue
6,624 **** 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 June 30, 2005:
 Payments
      due by periodsContractual
      obligations
    
    
    Total
    
    Less
      than one year
    
    One
      to three years
    
    Four
      to five yearsLong-term
      debt (1)
    
    
    $
    1,632
    
    $
    -
    
    $
    1,632
    
    $
    -Capital
      Lease Obligations
    
    
    
    9
    
    
    9
    
    
    -
    
    
    -Operating
      lease commitments (2)
    
    
    
    549
    
    
    380
    
    
    169
    
    
    -Total
      contractual cash obligations
    
    
    $
    2,190
    
    $
    389
    
    $
    1,801
    
    $
    -
 1.
    Long-term
      debt is net of approximately $1,428 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 will
      increase approximately 3% per annum over the term of the lease, which
      expires on October 31, 2006.
  -26-
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 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.
 
 ***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
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 six months ended June 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 may be 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.
 
 -27-
 
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 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 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 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.
  
 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
 
 The
Company held its Annual Meeting of Stockholders on June 27, 2005. The number of
shares of common stock with voting rights as of the record date represented at
the meeting either in person or by proxy was 96,984,564 shares, or 94.85% of the
eligible outstanding Common Stock of the Company. One proposal was voted upon by
the stockholders. The proposal and the voting results are as
follows:
 
 -28-
 
 Communication Intelligence Corporation
 And Subsidiary
 Notes to Unaudited Condensed Consolidated Financial
Statements
 (In thousands, except per share amounts)
 Form 10-Q
 Proposal
1
 
 The five
persons listed below received the most votes in favor of election at the annual
meeting and, accordingly were elected as directors to serve until the next
Annual Meeting or until his successor is elected or appointed.
 Name
    
    ForGuido
      DiGregorio
    
    95,417Michael
      Farese
    
    95,699Louis
      P. Panetta
    
    95,693C.
      B. Sung
    
    96,173David
      E. Welch
    
    95,736
 
 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.
 
  - 29 -
 
 **Communication
Intelligence Corporation**
 **And
Subsidiary**
 **(In
thousands, except per share amounts)**
 **Form
10-Q**
  **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
 
 
 August
      11, 2005
    
    /s/
      Francis V. DaneDate
    
    Francis
      V. Dane(Principal
      Financial Officer and Officer Duly Authorized to Sign on Behalf of the
      Registrant)
 
   - 30 -