SECURITIES AND EXCHANGE
COMMISSIONWashington, D.C. 20549

__________________________________



FORM 10-KSB/A(Amendment No.
1)



(Mark One)

[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year EndedJune 30, 2004

OR

[  ] TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For transition period from ____ to ____

Commission File Number001-10647

PRECISION OPTICS CORPORATION, INC.(Name of small business issuer in its charter)

MASSACHUSETTS
    
    04-279-5294(State or
      other jurisdiction
    
    (I.R.S.
      Employerof
      incorporation or organization)
    
    Identification
      No.)


22 East
BroadwayGardner, Massachusetts 01440(Address of principal executive offices) (Zip Code)

(978) 630-1800(Issuer’s telephone number, including area code)

Securities registered under Section
12(b) of the Act:

None

Securities registered under Section
12(g) of the Act:

Common Stock, $.01 par value

Check whether the
issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the
Exchange Act during the past 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 __

Check if no disclosure
of delinquent filers in response to Item 405 of Regulation S-B is contained in
this form, and no disclosure will be contained, to the best of registrant’s
knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.X

The issuer’s revenues
for its most recent fiscal year were $1,464,964.

The aggregate market
value of the voting stock, consisting solely of common stock, held by
non-affiliates of the issuer computed by reference to the closing price of such
stock was $3,325,138 as of August 31, 2004.

The number
of shares of outstanding common stock of the issuer as of August 31, 2004 was
7,008,212.

DOCUMENTS INCORPORATED BY REFERENCE

The issuer’s Proxy
Statement for the 2004 Annual Meeting of Shareholders to be held on November 9,
2004 is incorporated into Part III of this Form 10-KSB.

1


****




**EXPLANATORY
NOTE**









This
Amendment No. 1 on Form 10-KSB/A is filed by Precision Optics Corporation,
Inc. (the “Company”) as an amendment to the Company’s Annual Report on Form
10-KSB for the fiscal year ended June 30, 2004 (i) to amend Item 8A of the
Form 10-KSB, and (ii) to replace Exhibits 31.1 and 31.2 thereto with corrected
versions of those Exhibits submitted herewith. The original Exhibits 31.1 and
31.2 contained incorrect introductory language in paragraph 5 due to a
production error. This Amendment No. 1 speaks as of the original filing date of
the Company’s Annual Report on Form 10-KSB and has not been updated to reflect
events occurring subsequent to the original filing date.






PART I

ITEM 1.
    DESCRIPTION OF
      BUSINESS


BUSINESS
DEVELOPMENT

Precision Optics
Corporation, Inc. (the “Company”) was incorporated in Massachusetts in 1982 and
has been publicly owned since November 1990.

References to the
Company contained herein include its two wholly-owned subsidiaries, except where
the context otherwise requires.

BUSINESS OF
ISSUER

Precision Optics
Corporation, a developer and manufacturer of advanced optical instruments since
1982, designs and produces high-quality medical instruments, optical thin film
coatings, and other advanced optical systems. The Company’s medical
instrumentation line includes laparoscopes, arthroscopes and endocouplers and a
line of world-class 3-D endoscopes for use in minimally invasive surgical
procedures. Precision Optics Corporation is certified to the ISO 9001 Quality
Standard, and complies with the FDA Good Manufacturing Practices and the
European Union Medical Device Directive for CE Marking of its medical products.
The Company’s Internet Website iswww.poci.com.

Principal Products and Services and Methods of
Distribution.

Medical
Products. The Company’s medical products
include endoscopes, as well as image couplers, beamsplitters and adapters, all
of which are used as accessories to endoscopes.

Since January 1991, the
Company has developed and sold endoscopes using various optical technologies for
use in a variety of minimally invasive surgical and diagnostic procedures. The
Company’s current line of specialized endoscopes include arthroscopes (which are
used in joint surgery), laryngoscopes (which are used in the diagnosis of
diseases of the larynx), laparoscopes (which are used in abdominal surgery) and
stereo endoscopes and cameras (which are used in cardiac and general surgery,
and enable surgeons to visualize the surgical field in 3-D imagery, thus
facilitating greater finesse and minimizing surgical risk). In addition to its
existing line of endoscopes, the Company is continuing to develop different
types of endoscopes that incorporate varying types of construction and
technology for use in various medical specialties.

In March 2002, the
Company shipped the first production lot of autoclavable endoscopes to a major
orthopedic equipment supplier. These endoscopes, which are also CE Mark
certified for European use, have been designed and tested to withstand
sterilization by flash and standard autoclave, as well as all other commonly
used medical sterilization means. The major benefits of autoclavable instruments
include increased patient safety, quick turnaround, and elimination of hazardous
sterilant and by-product materials, all of which provide a much better value to
the user. The Company believes its autoclavable endoscope technology will
generate opportunities for endoscope revenue growth, particularly in Europe
where autoclaving is the preferred method of sterilization.

The Company developed
and has manufactured and sold since 1985 a proprietary product line of
instrumentation to couple endoscopes to video cameras. Included in this product
line are imaging couplers, which physically connect the endoscope to a video
camera system and transmit the image viewed through the scope to the video
camera. Another product, the beamsplitter, performs the same function while
preserving for the viewer an eyeport for direct, simultaneous viewing through
the endoscope. The Company has sold these devices primarily to endoscope and
video camera manufacturers and suppliers for resale under the Company’s
customers’ names.

2


The Company’s image
couplers and beamsplitters can withstand surgery-approved sterilization. The
Company also offers autoclavable image couplers, which are able to withstand
sterilization in superheated steam under pressure. Autoclavability is a
preferred method of sterilization because of its relative speed, safety, and
efficiency. The Company believes that it is one of the few companies in the
world that produces autoclavable image couplers.

Included in the
Company’s medical products sales are sales of image couplers and beamsplitters
for video-monitored examination of a variety of industrial cavities and
interiors. The Company has developed, and may develop in the future, specialized
borescopes for industrial applications.

Optical Thin Films.The Company designs and manufactures various
types of high quality thin film coatings for use in a wide range of optical
applications. Thin film coatings are produced in-house for the Company’s medical
instrumentation and other products. Presently, optical thin film manufacturing
not associated with the Company’s medical instruments and other products is
limited or very specialized.

Optical System Design and Development Services. The Company provides on a contract basis advanced lens
design, imaging analysis, optical system design, structural design and analysis,
prototype production and evaluation, optics testing, and optical system
assembly. Some of the Company’s development contracts have led to optical system
production business for the Company, and the Company believes its prototype
development service may lead to new product production from time to time.

Competition and Markets.

The areas in which the Company does business are highly
competitive and include both foreign and domestic competitors. Many of the
Company’s competitors are larger and have substantially greater resources than
the Company. Furthermore, other domestic or foreign companies, some with greater
experience in the optics industry and greater financial resources than the
Company, may seek to produce products or services that compete with those of the
Company. The Company may establish or use production facilities overseas to
produce key components for the Company’s business, such as lenses. The Company
believes that the cost savings from such production may be essential to the
Company’s ability to compete on a price basis in the medical products area
particularly and to the Company’s profitability generally.

The Company believes
that competition for sales of its medical products and services, which have been
principally sold to medical device companies, who incorporate the Company’s
products into their systems, is based on performance and other technical
features, as well as other factors, such as scheduling and reliability, in
addition to competitive price.

The Company has
marketed and sold its endoscopes to original equipment manufacturer (OEM) video
camera and video endoscopy suppliers for resale under the purchaser’s name. A
number of domestic and foreign competitors also sell endoscopes to such OEM
suppliers, and the Company’s share of the endoscope market is nominal. The
Company believes that, while its resources are substantially more limited than
its competitors, the Company can compete successfully in this market on the
basis of price and delivery.

The Company currently
sells its image couplers, beamsplitters, and adapters to a market that consists
of approximately 30 to 35 potential OEM customers. These potential customers
sell video cameras, endoscopes, or video-endoscopy systems. The Company has made
sales in the past to approximately two thirds of these customers. The Company
estimates that it has approximately 20% to 30% of the market share in these
products. The Company’s primary competition in this area is the customers’ own
in-house capabilities to manufacture such products. The Company believes that
these customers typically purchase products from the Company, despite their
in-house capabilities, because they choose to devote their own technical
resources to their primary products, such as cameras or endoscopes. However, the
Company estimates that approximately 50% of the market
demand for image couplers, beamsplitters, and adapters is met by “capt ive” or
in-house capabilities.

3


The Company offers
advanced optical design and development services not related to thin film
coatings to a wide range of potential customers and has numerous competitors.
The ability to supply design and development services to such customers is
highly dependent upon a company’s and its employees’ reputations and prior
experience.

The Company has had
negligible direct export sales to date. However, during fiscal year 2002, the
Company’s medical products received the CE Mark Certification, which permits
sales into the European marketplace.

Research and Development.

The Company believes that its future success depends to a
large degree on its ability to continue to conceive and to develop new optical
products and services to enhance the performance characteristics and methods of
manufacture of existing products. Accordingly, it expects to continue to seek to
obtain product-related design and development contracts with customers and to
invest its own funds on its research and development. The Company spent
approximately $1,319,000 and $1,235,000 of its own funds during fiscal years
2004 and 2003, respectively, on research and development.

The Company continues
to explore potential applications of single-molecule technology and
nanotechnology.

Raw Materials and Principal
Suppliers.

For all of the
Company’s products, except for thin film coatings, the basic raw material is
precision grade optical glass, which the Company obtains from several major
suppliers. Outside vendors grind and polish most of the Company’s lenses and
prisms. For optical thin film coatings, the basic raw materials are metals and
dielectric compounds, which the Company obtains from a variety of chemical
suppliers. Certain of the thin film coatings utilized in the Company’s products
are currently procured from an outside supplier, but most thin film coatings are
produced in-house. The Company believes that its demand for these raw materials
and thin film coating services is small relative to the total supply and that
materials and services required for the production of its products are currently
available in sufficient production quantities and will be available for fiscal
year 2005. The Company believes, however, that there are relatively few s
uppliers of the high quality lenses and prisms which its endoscopes require. The
Company has therefore established an in-house optical shop for producing
ultra-high quality prisms, micro-optics and other specialized optics for a
variety of medical and industrial applications.

The Company relies, in
part, upon patents, trade secrets, and proprietary knowledge as well as
personnel policies and employee confidentiality agreements concerning inventions
and other creative efforts to develop and to maintain its competitive position.
The Company does not believe that its business is dependent upon any patent,
patent pending, or license, although it believes that trade secrets and
confidential know-how may be important to the Company’s scientific and
commercial success.

The Company plans to
file for patents, copyrights, and trademarks in the United States and in
appropriate countries to protect its intellectual property rights to the extent
practicable. The Company holds the rights to several United States and foreign
patents and has several patent applications pending. The Company knows of no
infringements of its patents. The Company plans to protect its patents from
infringement in each instance where it determines that doing so would be
economical in light of the expense involved and the level and availability of
the Company’s financial resources. While the Company believes that its pending applications relate to patentable devices or concepts,
there can be no assurance that patents will be issued or that any patents issued
can be successfully defended or will effectively limit the development of
competitive products and services.

4


Employees.

As of June 30, 2004,
the Company had 30 full-time employees and 5 part-time employees. There were 17
employees in manufacturing, 11 in engineering, 2 in sales and marketing, and 5
in finance and administration.

Customers.

Revenues
from the Company’s largest customers, as a percentage of total revenues, were as
follows:

2004
    
    2003
    
    2002Customer
      A
    
    24
    %
    
    17
    %
    
    18
    %Customer B
    
    22
    
    
    2
    
    
    —Customer C
    
    —
    
    
    44
    
    
    —Customer D
    
    4
    
    
    5
    
    
    23All Others
    
    50
    
    
    32
    
    
    59100
    %
    
    100
    %
    
    100
    %


No other customer
accounted for more than 10% of the Company’s revenues in fiscal years 2004,
2003, and 2002.

Environmental Protection and the Effect of
Existing or Probable Government Regulations on the
Business.

The Company’s
operations are subject to a variety of federal, state, and local laws and
regulations relating to the discharge of materials into the environment or
otherwise relative to the protection of the environment. From time to time the
Company uses a small amount of hazardous materials in its operations. The
Company believes that it complies with all applicable environmental laws and
regulations.

Need for Government Approval of Principal
Products or Services and Effect of Existing or Probable Government Regulations
on the Business.

The Company currently
sells and markets several medical products, the marketing of which may require
the permission of the United States Food and Drug Administration (“FDA”).
Pursuant to the Company’s notification to the FDA of its intent to market its
endoscopes, image couplers, beamsplitters, and adapters, the FDA has determined
that the Company may market such devices, subject to the general controls
provisions of the Food, Drug and Cosmetic Act. This FDA permission was obtained
without the need to undergo a lengthy and expensive approval process, on account
of the FDA’s determination that such devices meet the regulatory standard of
being substantially equivalent to an existing approved device. Furthermore, the
Company plans to market additional endoscopes and related medical products that
may require the FDA’s permission to market such products. The Company may also
develop additional products or seek to sell some of its c urrent or future
medical products in a manner that requires the Company to obtain the permission
of the FDA to market such products, as well as the regulatory approval or
license of other federal, state, and local agencies or similar agencies in other
countries. The FDA has authority to conduct detailed inspections of
manufacturing plants in order to assure that “good manufacturing practices” are
being followed in the manufacture of medical devices, to require periodic
reporting of product defects to the FDA, and to prohibit the sale of devices
which do not comply with law.

5




ITEM 2.
    DESCRIPTION OF
  PROPERTY


The Company conducts
its domestic operations at twofacilities in Gardner, Massachusetts. The
main Gardner facility is leased from a corporation owned by an
officer-shareholder-director of the Company. The lease terminated in December
1999 and the Company is currently a tenant at will. The other Gardner facility
is being rented on a month-to-month basis. The Company rents office space in
Hong Kong for sales, marketing and supplier quality control and liaison
activities of its Hong Kong subsidiary.

The Company believes
these facilities are adequate for its current operations and adequately covered
by insurance. Significant increases in production or the addition of significant
equipment additions or manufacturing capabilities in connection with the
production of the Company’s line of endoscopes, optical thin films, and other
products may, however, require the acquisition or lease of additional
facilities. The Company may establish production facilities domestically or
overseas to produce key assemblies or components, such as lenses, for the
Company’s products. Overseas facilities may subject the Company to the political
and economic risks associated with overseas operations. The loss of or inability
to establish or maintain such additional domestic or overseas facilities could
materially adversely affect the Company’s competitive position and
profitability.

ITEM 3.
    LEGAL PROCEEDINGS


None.

ITEM 4.
    SUBMISSION OF MATTERS TO A VOTE OF
      SECURITY HOLDERS


No matters were
submitted to a vote of the Company’s security holders during the fourth quarter
of fiscal year 2004.

6


Directors and Executive Officers of
the Company

The Company’s executive
officers and directors are as follows:

Position with
      the CompanyName
    or Principal
      OccupationRichard E. Forkey
    Chairman of the Board, Chief ExecutiveOfficer, President, Treasurer andDirectorJack P.
      Dreimiller
    Senior Vice
      President, Finance,Chief Financial
      Officer and ClerkEdward A. Benjamin
    Director and Member of Audit Committee. Mr.Benjamin is a retired partner in the law firm ofRopes & Gray LLP, Boston, Massachusetts.Joel R.
      Pitlor
    Director. Mr.
      Pitlor is president of J.R. Pitlor, amanagement
      consulting firm based in Cambridge,Massachusetts.Robert R. Shannon
    Director and Member of Audit Committee. Mr.Shannon is a professor at the Optical SciencesCenter of the University of Arizona in Tucson,Arizona.







7


PART II

ITEM 5.
    MARKET FOR COMMON EQUITY AND RELATED
      STOCKHOLDER MATTERS


The Company’s common
stock is listed on the National Association of Securities Dealers Automated
Quotation (NASDAQ) System under the symbol “POCI.” Since January 1992, the
NASDAQ SmallCap Market has been the principal market in which the Company’s
stock is publicly traded. The high and low sales prices (as adjusted for the
1-for-6 reverse stock split that became effective on January 29, 2003) for the
Company’s stock for each full quarterly period within the two most recent fiscal
years were as follows as reported by NASDAQ.

2003
    
    2004Quarter
    
    High
    
    Low
    
    High
    
    LowFirst
    
    $
    3.42
    
    $
    1.32
    
    $
    2.80
    
    $
    1.90Second
    
    $
    4.56
    
    $
    .96
    
    $
    2.67
    
    $
    1.71Third
    
    $
    2.40
    
    $
    1.30
    
    $
    6.99
    
    $
    1.96Fourth
    
    $
    3.44
    
    $
    1.43
    
    $
    5.72
    
    $
    1.05


As of August 31, 2004,
there were approximately 203 holders of record of the Company’s common stock.
Holders of record include nominees who may hold shares on behalf of multiple
beneficial owners.

The Company has not
declared any dividends during the last two fiscal years. At present, the Company
intends to retain its earnings, if any, to finance research and development and
expansion of its business.

EQUITY COMPENSATION PLAN INFORMATION

The following table
provides information about the Company’s Common Stock that may be issued upon
the exercise of options, warrants and rights under all of our existing equity
compensation plans as of June 30, 2004, including, but not limited to, the 1989
Stock Option Plan and the 1997 Incentive Plan:

Number of
      securitiesto be issued
      upon
    
    Weighted-average
    
    Number of
      securities remainingexercise
      of
    
    exercise price
      of
    
    available for
      future issuance underoutstanding
      options,
    
    outstanding
      options,
    
    equity
      compensation plans (excludingwarrants and
      rights
    
    warrants and
      rights
    
    securities
      reflected in first column)Equity compensation
    
    131,953
    
    
    $11.79
    
    183,153
    (1)plans approved byshareholdersEquity
      compensation
    
    9,168
    (2)(3)(4)
    
    $8.08
    
    n/aplans not
      approvedby
      shareholdersTotal
    
    141,121
    
    
    $11.55
    
    183,153







8


(1) Includes 183,153 shares of Common Stock available
for future grants under the Company’s 1997 Incentive Plan. No shares are
available for future grants under the Company’s 1989 Stock Option
Plan.

(2) Includes 2,500 shares of Common Stock issuable
upon exercise of outstanding options granted to Mr. Benjamin in connection with
his service on the Board of Directors. These options may be exercised at a price
of $8.25 per share and expire on December 15, 2004.

(3) Includes 2,500 shares of Common Stock issuable
upon exercise of outstanding options granted to Mr. Shannon in connection with
his service on the Board of Directors. These options may be exercised at a price
of $8.25 per share and expire on December 15, 2004.

(4) Includes 4,168 shares of Common Stock issuable
upon exercise of outstanding options granted to Werner Thiel in connection with
his service as a consultant to the Company. Options exercisable for 3,334 shares
may be exercised at a price of $7.78125 and expire on July 13, 2005. Options
exercisable for 834 shares may be exercised at a price of $8.25 and expire on
December 15, 2004.

ITEM 6.
    MANAGEMENT’S DISCUSSION AND ANALYSIS
      OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


Important Factors Regarding Forward-Looking
Statements

When used in this
discussion, the words “believes”, “anticipates”, “intends to”, and similar
expressions are intended to identify forward-looking statements. Such statements
are subject to certain risks and uncertainties which could cause actual results
to differ materially from those projected. These risks and uncertainties, many
of which are not within the Company’s control, include, but are not limited to,
the uncertainty and timing of the successful development of the Company’s new
products, particularly in the optical thin films area, the risks associated with
reliance on a few key customers; the Company’s ability to maintain compliance
with requirements for continued listing on the Nasdaq SmallCap Market; the
Company’s ability to attract and retain personnel with the necessary scientific
and technical skills, the timing and completion of significant orders; the
timing and amount of the Company 46;s research and development expenditures; the
timing and level of market acceptance of customers’ products for which the
Company supplies components; performance of the Company’s vendors; the ability
of the Company to control costs associated with performance under fixed price
contracts; and the continued availability to the Company of essential supplies,
materials and services; which are described further in Exhibit 99.1 hereto.
Readers are cautioned not to place undue reliance on these forward looking
statements, which speak only as of the date hereof. The Company undertakes no
obligation to publicly release the result of any revision to these
forward-looking statements which may be made to reflect events or circumstances
after the date hereof or to reflect the occurrence of unanticipated events.

Overview

Precision Optics
Corporation, a developer and manufacturer of advanced optical instruments since
1982, designs and produces high-quality optical thin film coatings, medical
instruments, and other advanced optical systems. The Company’s medical
instrumentation line includes laparoscopes, arthroscopes and endocouplers and a
world-class product line of 3-D endoscopes for use in minimally invasive
surgical procedures.

The Company is
currently developing specialty instruments incorporating its patent-pending
LENSLOCKTMtechnology which ensures lower cost, easier repairability and enhanced
durability as well as ultra-small instruments (some with lenses less than one
millimeter in diameter) utilizing patent-pending micro-precisionTMlens technology. The Company is also exploring new
initiatives in single-molecule technology and nanotechnology for biomedical and
other applications.

9


Precision Optics Corporation is certified to the ISO
9001 Quality Standard, and complies with the FDA Good Manufacturing Practices
and the European Union Medical Device Directive for CE Marking of its medical
products. The Company’s Internet Website iswww.poci.com.

The areas in which the Company does business are
highly competitive and include both foreign and domestic competitors. Many of
the Company’s competitors are larger and have substantially greater resources
than the Company. Furthermore, other domestic or foreign companies, some with
greater experience in the optics industry and greater financial resources than
the Company, may seek to produce products or services that compete with those of
the Company. The Company uses production facilities overseas to produce key
components for the Company’s business, such as lenses. The Company believes that
the cost savings from such production is essential to the Company’s ability to
compete on a price basis in the medical products area particularly and to the
Company’s profitability generally.

The Company believes that competition for sales of
its medical products and services, which have been principally sold to original
equipment manufacturer (OEM) customers, is based on performance and other
technical features, as well as other factors, such as scheduling and
reliability, in addition to competitive price.

The Company believes that its future success depends
to a large degree on its ability to continue to conceive and to develop new
optical products and services to enhance the performance characteristics and
methods of manufacture of existing products. Accordingly, it expects to continue
to seek to obtain product-related design and development contracts with
customers and to invest its own funds on research and development, to the extent
funds are available.

The Company relies, in part, upon patents, trade
secrets and proprietary knowledge as well as personnel policies and employee
confidentiality agreements concerning inventions and other creative efforts to
develop and to maintain its competitive position. The Company does not believe
that its business is dependent upon any particular patent, patent pending, or
license, although it believes that trade secrets and confidential know-how may
be important to the Company’s scientific and commercial success.

The Company conducts its domestic operations at two
leased facilities in Gardner, Massachusetts. The Company rents office space in
Hong Kong for sales, marketing and supplier quality control and liaison
activities of its Hong Kong subsidiary. The Company believes these facilities
are adequate for its current operations. Significant increases in production or
the addition of significant equipment or manufacturing capabilities in
connection with the production for the Company’s line of endoscopes, optical
thin films, and other products may, however, require the acquisition or lease of
additional facilities.

Critical Accounting Policies and
Estimates

Management’s discussion
and analysis of financial condition and results of operations are based upon the
Company’s consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America (“U.S. GAAP”). The preparation of these consolidated financial
statements requires the Company to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses. The Company
bases its estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ from these estimates under different assumptions or
conditions.

The Company believes
the following critical accounting policies affect its more significant judgments
and estimates used in the preparation of its consolidated financial
statements.

10


Revenue Recognition

The Company recognizes
revenue in accordance with U.S. GAAP and SEC Staff Accounting Bulletin (“SAB”)
No. 104,Revenue Recognition in Financial
Statements.SAB No. 104 requires that four
basic criteria must be met before revenue can be recognized: (1) persuasive
evidence of an arrangement exists; (2) delivery has occurred or services
rendered; (3) the price to the buyer is fixed or determinable; and (4)
collectibility is reasonably assured. Determination of criteria (3) and (4) are
based on management’s judgments regarding the fixed nature of the price to the
buyer charged for products delivered or services rendered and collectibility of
the sales price. The Company assesses credit worthiness of customers based upon
prior history with the customer and assessment of financial condition. The
Company’s shipping terms are customarily FOB shipping point.

Bad Debt

The Company maintains allowances for doubtful
accounts for estimated losses resulting from the inability of its customers to
make required payments. Allowances for doubtful accounts are established based
upon review of specific account balances and historical experience. If the
financial condition of the Company’s customers were to deteriorate, resulting in
an impairment of their ability to make future payments, additional allowances
may be required.

The Company provides for estimated obsolescence on
unmarketable inventory based upon assumptions about future demand and market
conditions. If actual demand and market conditions are less favorable than those
projected by management, additional inventory write downs may be required.
Inventory, once written down, is not subsequently written back up, as these
adjustments are considered permanent adjustments to the carrying value of the
inventory.

Impairment of Long-Lived Assets and Long-Lived
Assets to be Disposed of

The Company accounts for impairment of long-lived
assets in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets.This statement requires that long-lived
assets and certain identifiable intangibles be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability of assets to be held and used is measured
by a comparison of the carrying amount of an asset to undiscounted future net
cash flows expected to be generated by the asset. If such assets are considered
to be impaired, the impairment to be recognized is measured by the amount by
which the carrying amount of the assets exceeds the fair value of the assets.
Assets to be disposed of through sale are reported at the lower of the carrying
amount or fair value less estimated costs to sell.

Fiscal Year 2004 Results of
Operations

Total revenues for
fiscal year 2004 of approximately $1,465,000 decreased by $934,000, or 38.9%,
from fiscal year 2003 revenues of approximately $2,399,000.

The revenue decrease
from the prior year was due principally to lower unit volume sales of medical
products (down 44%), partially offset by higher unit volume sales of non-medical
products (up 50%). Medical sales were lower due primarily to lower sales of
stereo endoscope products because of the loss of business from a major stereo
endoscope customer, as previously reported. Non-medical sales were higher due
primarily to higher sales of couplers for industrial use.

11


Revenues
from the Company’s largest customers, as a percentage of total revenues, were as
follows:



|                 |  | 2004 |   | 2003 |     | 2002
|---------------- |  | ---- | - | ---- | --- | ----
|                
|Customer
      A |  | 24   | % |      | 17  | %   
|Customer
      B |  | 22   |   |      | 2   |     
|Customer C       |  | —    |   |      | 44  |     
|Customer
      D |  | 4    |   |      | 5   |     
|All Others       |  | 50   |   |      | 32  |     
|                 |  |      |   |      |     |     
|                
|                 |  | 100  | % |      | 100 | %   
|                 |  |      |   |      |     |     

Gross profit (loss) for
fiscal year 2004 reflected an unfavorable change of approximately $925,000
compared to fiscal year 2003. Gross profit as a percentage of revenues decreased
from 13.6% in fiscal year 2003 to a negative 40.8% in fiscal year 2004. The
unfavorable change in gross profit (loss) was due primarily to lower sales
volume and provisions for slow moving and obsolete inventories, partially offset
by a lower manufacturing cost structure resulting from restructuring measures
implemented in fiscal year 2003.

Research and development expenses increased by approximately $84,000, or
6.8%, during fiscal year 2004 compared to the previous year. The increase was
due to a higher level of resources being devoted to product development
activities.

Selling, general and
administrative expenses decreased by approximately $149,600, or 8.0%, during
fiscal year 2004 compared to the previous year. The decrease was due primarily
to lower outside consulting and legal expenses and the effects of the workforce
reduction in January 2004.

The provision for asset impairment and restructuring in fiscal year 2004
of $52,208 consists of a provision for severance benefits paid in the quarter
ended March 31, 2004 related to the January 2004 workforce reduction of 15%, or
five employees. The provision for asset impairment and restructuring of $176,642
in fiscal year 2003, consists of a provision for severance benefits of $53,131
paid in the quarter ended December 31, 2002 related to the October 2002
workforce reduction of 16%, or six employees, and a provision for asset
impairment of $123,511 recorded in the quarter ended June 30, 2003, representing
a further writedown of assets held for sale which reflected the continuing
deterioration in the market for used telecommunications equipment.

12


The following table
sets forth the quarterly impacts and cash payments associated with the asset
impairment and restructuring provisions:

Provision
      For –Property &Equipment
    
    Patent
    
    Employee
    
    Idle
      LeaseWritedown
    
    Writedown
    
    Severance
    
    Space
    
    TotalProvision Balance, June 30, 2002
    
    $
    —
    
    
    $
    —
    
    $
    —
    
    
    $
    167,971
    
    
    $
    167,971Quarter Ended
      –December 31, 2002
    
    
    
    
    
    
    —
    
    
    53,131
    
    
    
    —
    
    
    
    53,131June 30, 2003
    
    
    123,511
    
    
    
    —
    
    
    —
    
    
    
    —
    
    
    
    123,511Total Provision
    
    
    123,511
    
    
    
    —
    
    
    53,131
    
    
    
    —
    
    
    
    176,642Non-cash
      Charges
    
    
    (123,511
    )
    
    
    —
    
    
    —
    
    
    
    —
    
    
    
    (123,511
    )Cash Payments
    
    
    —
    
    
    
    —
    
    
    (53,131
    )
    
    
    (167,971
    )
    
    
    (221,102
    )Provision Balance, June 30, 2003
    
    $
    —
    
    
    $
    —
    
    $
    —
    
    
    $
    —
    
    
    $
    —Quarter Ended –March 31, 2004
    
    
    —
    
    
    
    —
    
    
    52,208
    
    
    
    —
    
    
    
    52,208Total Provision
    
    
    —
    
    
    
    —
    
    
    52,208
    
    
    
    —
    
    
    
    52,208Cash
      Payments
    
    
    —
    
    
    
    —
    
    
    (52,208
    )
    
    
    —
    
    
    
    (52,208
    )Provision Balance, June 30, 2004
    
    $
    —
    
    
    $
    —
    
    $
    —
    
    
    $
    —
    
    
    $
    —


Interest income
decreased by approximately $47,400 or 72.4% during fiscal year 2004 compared to
the previous year. The decrease was due to the lower base of cash and cash
equivalents.

Interest expense
consists of interest on capital lease obligations and decreased due to the
liquidation of capital lease obligations during fiscal year 2004.

The income tax
provisions in fiscal years 2004 and 2003 represent the minimum statutory state
income tax liability.

Fiscal Year 2003 Results of
Operations

Total revenues for
fiscal year 2003 of approximately $2,399,000 increased by $625,000, or 35.2%,
from fiscal year 2002 revenues of $1,774,000.

The revenue increase
from the prior year was due principally to higher unit volume sales of medical
products (up 57%), partially offset by lower unit volume sales of non-medical
products (down 60%). Medical sales were higher due primarily to higher sales of
stereo endoscopes and cameras. Non-medical sales were lower due primarily to the
discontinuation during the last fiscal year of sales of telecommunication
products.

Gross profit for fiscal
year 2003 reflected a favorable change of approximately $1,676,000, compared to
fiscal year 2002. Gross profit as a percentage of revenues increased from a
negative 76.0% in fiscal year 2002 to 13.6 % in fiscal year 2003. The favorable
change in gross profit was due primarily to (1) a provision for excess and
obsolete inventories of DWDM filters and DWDM filter test instrumentation of
approximately $540,000 recorded in the quarter ended September 30,
2001;(2) lower fixed
manufacturing costsresulting from the cessation of operations in the
Company’s optical thin film technology facility and reductions in staff; and (3)
the higher overall sales volume.

13


Research and
development expenses decreased by approximately $1,036,000, or 45.6%, during
fiscal year 2003 compared to the previous year. During the fiscal year 2002,
research and development expenses consisted primarily of development efforts
related to DWDM filters used in telecommunications systems. The decrease in the
fiscal year 2003 was due to discontinuation of the development of DWDM filters,
as reflected in reductions in staff, and the remaining R&D resources being
redeployed toward development of new medical products.

Selling, general and
administrative expenses decreased by approximately $199,000, or 9.6%, during
fiscal year 2003 compared to the previous year. The decrease was due primarily
to lower sales and marketing expenses, partially offset by approximately $40,000
in expenses related to effecting a 1-for-6 reverse stock split in the quarter
ended March 31, 2003.

The provision for
asset impairment and restructuring of $176,642 in fiscal year 2003 consists of a
provision for severance benefits of $53,131 paid in the quarter ended December
31, 2002 related to the October 2002 workforce reduction of 16%, or six
employees, and a provision for asset impairment of $123,511 recorded in the
quarter ended June 30, 2003, representing a further writedown of assets held for
sale which reflects the continuing deterioration in the market for used
telecommunications equipment. The provision for asset impairment and
restructuring of $4,445,021 in fiscal year 2002 consists of (1) a provision for
restructuring costs of $402,065, representing the then - present value of future
lease payments related to idle space in the Company’s Optical Thin Films
Technology Center, and employee severance costs; and (2) a provision for asset
impairment of $4,042,956, representing a writedown to the lower of carrying
value or fair market va lue less estimated selling costs of certain of the
Company’s property and equipment invested in its optical thin films coating
product line, and the writeoff of certain patent costs.

The loss on sale of
assets held for sale of $19,171 in fiscal year 2003 represents the loss on sales
of a portion of the property and equipment held for sale, which formerly was
invested in the Company’s telecommunications product line. The Company received
net proceeds from these sales of approximately $553,000 in the year ended June
30, 2003.

Interest income
decreased by approximately $127,000, or 66.0%, during fiscal year 2003 compared
to the previous year. The decrease was due to the lower base of cash and cash
equivalents and lower interest rates.

Interest expense
consists of interest on capital lease obligations and, for fiscal year 2002,
imputed interest on accrued restructuring costs related to the present value of
future lease payments on idle space. Interest expense decreased by $13,069, or
65.5%, from fiscal year 2002 due primarily to the elimination of imputed
interest on restructuring costs which were paid in early fiscal year
2003.

The income tax
provisions in fiscal years 2003 and 2002 represent the minimum statutory state
income tax liability.

Liquidity and Capital
Resources

The Company has incurred significant operating losses during
the last eight fiscal years. This trend was primarily the result of the loss of
several significant customers, completion of several large nonrecurring
government contracts, and operating losses and provision for asset impairment,
restructuring, and inventory write-downs associated with the downturn in demand
for optical filters used in telecommunications systems. In fiscal 1998, the
Company began making significant investments in research and development and
capital purchases for new products. In August 1999 and March 2000, the Company
raised gross proceeds of approximately $16 million of additional cash through
the issuance of common stock.

14


In the past three
fiscal years, the Company has implemented a number of restructuring and cost
saving measures in an effort to align costs with revenues and strengthen
financial performance. Full-time employee headcount has been reduced from 78 at
June 30, 2001 to 30 at June 30, 2004. The Company has discontinued the
development and manufacturing of telecommunications products, canceled the lease
on its Optical Thin Films Technology Center, and written down and/or sold
certain of the property, equipment and inventories invested in its
telecommunications business, and has implemented other cost reduction measures.
As a result of these actions, the Company has incurred asset impairment,
restructuring and inventory write-down provisions of approximately $4,985,000,
$177,000 and $52,000 for the years ended June 30, 2002, 2003, and 2004
respectively, and has received net proceeds from the sale of assets held for
sale of approximately $553,000 during the yea r ended June 30, 2003. In
addition, the Company will continue its review of other expense areas to
determine where additional reductions in discretionary spending can be
achieved.

In July 2004, the
Company completed a rights offering to stockholders of record at June 7, 2004 by
issuing 5,256,159 shares of common stock. Net cash proceeds to the Company
(after offering expenses of $177,176) were $5,078,983.

For the year ended June
30, 2004, the Company’s cash and cash equivalents decreased by approximately
$3,161,000 to $343,000. The decrease in cash and cash equivalents was due to
cash used by operating activities of approximately $3,074,000, capital
expenditures of approximately $34,000, repayment of capital lease obligation and
other of approximately $4,000, expenditures for other assets (primarily patents)
of $31,000 and payment of deferred financing costs of $18,000. The Company
believes, based on its operating and strategic plans and the net proceeds
received in July 2004 from its rights offering to stockholders, that it will
have sufficient funds to conduct operations through at least the next fiscal
year.

Contractual cash
commitments for the fiscal years subsequent to June 30, 2004 are summarized as
follows:

2005
    
    Thereafter
    
    TotalOperating leases
    
    $
    27,454
    
    $
    2,183
    
    $
    29,637


Trends and Uncertainties That May Affect Future
Results

For the quarter ended June 30, 2004, cash and cash equivalents
decreased by approximately $602,000 compared to a decrease of approximately
$781,000 for the previous quarter ended March 31, 2004. Cash disbursements
during the quarter ended March 31, 2004 included approximately $52,000 paid for
employee severance costs.

Capital equipment
expenditures during the year ended June 30, 2004 were approximately $33,600, up
21% from the $28,000 for fiscal year 2003. Future capital equipment expenditures
will be dependent upon future sales and success of on-going research and
development efforts.

For the quarter ended
June 30, 2004, research and development expenses were approximately $339,000, up
1.8% from the $333,000 for the quarter ended June 30, 2003. It is anticipated
that the quarterly level of R&D expenses for the foreseeable future will
remain at this lower level, but is ultimately dependent upon the Company’s
assessment of new product opportunities.

The Company expects
its recent pattern of quarter-to-quarter revenue fluctuations to continue, due
to the uncertain timing of orders from customers and their size in relation to
total revenues. The Company continues to move forward with new products and
technical innovations, in particular, the development of a new generation
(patent pending) of its world-class product line of 3-D endoscopes, the
development of a new prototype 2.7 mm endoscope, and new instruments utilizing
the Company’s new micro-precisionTMlens technology (patent pending) for endoscopes under 1 mm. The Company
continues to explore potential applications of single-molecule technology and
nanotechnology.

15


The Company believes
that the recent introduction of several new products, along with new and ongoing
customer relationships, will generate additional revenues, which are required in
order for the Company to achieve profitability. If these additional revenues are
not achieved on a timely basis, the Company will be required and is prepared to
implement further cost reduction measures, as necessary.

ITEM 7.
    CONSOLIDATED FINANCIAL
      STATEMENTS: The Consolidated Financial
      Statements are filed on pages 17 through 36 of this Form 10-KSB.




16


PRECISION OPTICS CORPORATION, INC. AND
SUBSIDIARIES

Consolidated Financial Statementsas of June 30, 2004 and
2003Together with Independent Registered Public
Accounting Firm’s Report

17


Report of Independent Registered Public
Accounting Firm

The Board of Directors and ShareholdersPrecision
Optics Corporation, Inc.:

We have audited the accompanying consolidated balance
sheets of Precision Optics Corporation, Inc. and subsidiaries as of June 30,
2004 and 2003 and the related consolidated statements of operations,
stockholders’ equity and cash flows for each of the years in the three-year
period ended June 30, 2004. These consolidated financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these consolidated financial statements based on our
audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements
referred to above present fairly, in all material respects, the consolidated
financial position of Precision Optics Corporation, Inc. and subsidiaries as of
June 30, 2004 and 2003 and the results of their operations and their cash flows
for each of the years in the three-year period ended June 30, 2004 in conformity
with accounting principles generally accepted in the United States of America.

/s/ KPMG LLP

Boston, MassachusettsAugust 31, 2004



18


PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES
  Consolidated
Balance Sheets
 June
30, 2004 and 2003


ASSETS
    
    2004
    
    2003
    
    
    LIABILITIES
      AND STOCKHOLDERS' EQUITY
    
    2004
    
    2003Current
      Assets:
    
    
    
    
    
    
    
    
    Current
      Liabilities:Cash
      and cash equivalents
    
    $
    343,260
    
    $
    3,504,414
    
    
    Current portion of capital lease obligation
    
    $
    —
    
    $
    3,826Accounts payable
    
    
    235,050
    
    
    141,398Accounts
      receivable (net of allowance for doubtful accounts of  
      approximately $155,000 in 2004 and 2003).
    
    
    80,195
    
    
    191,669
    
    
    Accrued employee compensation
    
    
    230,110
    
    
    213,543Inventories
    
    
    917,998
    
    
    1,257,288
    
    
    Accrued professional services
    
    
    75,439
    
    
    118,284Prepaid
      expenses
    
    
    80,646
    
    
    91,213
    
    
    Accrued warranty expense
    
    
    50,000
    
    
    50,000Deferred
      financing costs
    
    
    171,885
    
    
    —
    
    
    Other accrued liabilities
    
    
    2,743
    
    
    6,966Assets
      held for sale
    
    
    —
    
    
    152,550Total current liabilities
    
    
    593,342
    
    
    534,017Total
      current assets
    
    
    1,593,984
    
    
    5,197,134Property
      and Equipment, at cost:
    
    
    
    
    
    
    
    
    Other
    
    
    —
    
    
    1,555Machinery
      and equipment
    
    
    3,507,065
    
    
    3,323,760Leasehold
      improvements
    
    
    553,596
    
    
    551,796
    
    
    Commitments
      (Note 2)Furniture
      and fixtures
    
    
    96,831
    
    
    95,781Vehicles
    
    
    42,343
    
    
    42,343
    
    
    Stockholders’
      Equity:Common stock, $0.01 par value-4,199,835
    
    
    4,013,680
    
    
    Authorized—20,000,000 sharesLess—Accumulated
      depreciation and amortization
    
    
    3,920,593
    
    
    3,723,350
    
    
    Issued and
      outstanding—1,752,053 shares
      at              
      June 30, 2004 and 2003
    
    
    17,521
    
    
    17,521279,242
    
    
    290,330
    
    
    Additional paid-in capital
    
    
    27,770,175
    
    
    27,770,175Accumulated
      deficit
    
    
    (
      26,283,724
    )
    
    (
      22,599,648
    )Other
      Assets:Cash
      surrender value of life insurance policies
    
    
    23,032
    
    
    39,384
    
    
    Total stockholders’ equity
    
    
    1,503,972
    
    
    5,188,048Patents,
      net
    
    
    201,056
    
    
    196,772Total
      other assets
    
    
    224,088
    
    
    236,156$
    2,097,314
    
    $
    5,723,620
    
    
    
    
    $
    2,097,314
    
    $
    5,723,620
 
 The
accompanying notes are an integral part of these consolidated financial
statements.


19
 PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES
 
 Consolidated
Statements of Operations
 for
the Years Ended June 30, 2004, 2003, and 2002


2004
    
    2003
    
    2002Revenues
    
    $
    1,464,964
    
    $
    2,399,217
    
    $
    1,774,283Cost
      of Goods Sold
    
    
    2,062,902
    
    
    2,072,238
    
    
    3,123,196Gross
      profit (loss)
    
    
    (597,938
    )
    
    326,979
    
    
    (1,348,913
    )Research
      and Development Expenses
    
    
    1,319,345
    
    
    1,235,252
    
    
    2,270,880Selling,
      General and Administrative Expenses
    
    
    1,731,713
    
    
    1,881,313
    
    
    2,079,994Provision
      for Asset Impairment and Restructuring
    
    
    52,208
    
    
    176,642
    
    
    4,445,021Loss
      on Sale of Assets Held for Sale
    
    
    —
    
    
    19,171
    
    
    —Total
      operating expenses
    
    
    3,103,266
    
    
    3,312,378
    
    
    8,795,895Operating
      loss
    
    
    (3,701,204
    )
    
    (2,985,399
    )
    
    (10,144,808
    )Interest
      Income
    
    
    18,089
    
    
    65,443
    
    
    192,241Interest
      Expense
    
    
    (49
    )
    
    (6,894
    )
    
    (19,963
    )Loss
      before provision for income taxes
    
    
    (3,683,164
    )
    
    (2,926,850
    )
    
    (9,972,530
    )Provision
      for Income Taxes
    
    
    912
    
    
    912
    
    
    912Net
      loss
    
    $
    (3,684,076
    )
    $
    (2,927,762
    )
    $
    (9,973,442
    )Basic
      and Diluted Loss per Share
    
    $
    (2.10
    )
    $
    (1.67
    )
    $
    (5.69
    )Weighted
      Average Common Shares Outstanding
    
    
    1,752,053
    
    
    1,752,053
    
    
    1,752,053
 
 The
accompanying notes are an integral part of these consolidated financial
statements .
   20
  PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES
 
 Consolidated
Statements of Stockholders’ Equity
 for
the Years Ended June 30, 2004, 2003 and 2002
 Number
      of Shares
    
    Common
      Stock
    
    Additional
      Paid-in Capital
    
    Accumulated
      Deficit
    
    Total
      Stockholders’ EquityBalance,
      June 30, 2001
    
    
    1,752,053
    
    $
    17,521
    
    $
    27,770,175
    
    $
    (9,698,444
    )
    $
    18,089,252Net
      loss
    
    
    —
    
    
    —
    
    
    —
    
    
    (9,973,442
    )
    
    (9,973,442
    )Balance,
      June 30, 2002
    
    
    1,752,053
    
    
    17,521
    
    
    27,770,175
    
    
    (19,671,886
    )
    
    8,115,810Net loss
    
    
    —
    
    
    —
    
    
    —
    
    
    (2,927,762
    )
    
    (2,927,762
    )Balance,
      June 30, 2003
    
    
    1,752,053
    
    
    17,521
    
    
    27,770,175
    
    
    (22,599,648
    )
    
    5,188,
      048Net loss
    
    
    —
    
    
    —
    
    
    —
    
    
    (3,684,076
    )
    
    (3,684,076
    )Balance,
      June 30, 2004
    
    
    1,752,053
    
    $
    17,521
    
    $
    27,770,175
    
    $
    (26,283,724
    )
    $
    1,503,972
 
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 21
  PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES
 
 Consolidated
Statements of Cash Flows for the
 Years
Ended June 30, 2004, 2003, and 2002
  2004
    
    2003
    
    2002Cash
      Flows from Operating Activities:Net
      loss
    
    $
    (3,684,076
    )
    $
    (2,927,762
    )
    $
    (9,973,442
    )Adjustments
      to reconcile net loss to net cash used in operating
      activities-Depreciation
      and amortization
    
    
    240,846
    
    
    265,102
    
    
    593,491Provision
      for asset impairment and restructuring
    
    
    —
    
    
    176,642
    
    
    4,445,021Provision
      for inventory write-down
    
    
    500,000
    
    
    —
    
    
    540,000Loss
      on sale of assets held for sale
    
    
    —
    
    
    19,171
    
    
    —Other
    
    
    —
    
    
    (6,872
    )
    
    (25,345
    )Changes
      in operating assets and liabilities-Accounts
      receivable, net
    
    
    111,474
    
    
    182,830
    
    
    628,997Inventories
    
    
    (160,710
    )
    
    (248,279
    )
    
    (24,890
    )Prepaid
      expenses
    
    
    10,567
    
    
    2,361
    
    
    16,186Refundable
      income taxes
    
    
    —
    
    
    13,849
    
    
    (13,849
    )Accounts
      payable
    
    
    (59,655
    )
    
    22,497
    
    
    (465,885
    )Accrued
      restructuring expense
    
    
    —
    
    
    (221,102
    )
    
    (234,094
    )Customer
      advances
    
    
    —
    
    
    (30,000
    )
    
    30,000Other
      accrued expenses
    
    
    (32,055
    )
    
    (13,533
    )
    
    (29,467
    )Net
      cash used in operating activities
    
    
    (3,073,609
    )
    
    (2,765,096
    )
    
    (4,513,277
    )Cash
      Flows from Investing Activities:Purchases
      of property and equipment
    
    
    (33,605
    )
    
    (27,719
    )
    
    (90,818
    )Net
      proceeds from sale of assets held for sale
    
    
    —
    
    
    553,091
    
    
    —Increase
      in other assets
    
    
    (31,536
    )
    
    (48,686
    )
    
    (56,798
    )Net
      cash provided by (used in) investing activities
    
    
    (65,141
    )
    
    476,686
    
    
    (147,616
    )Cash
      Flows from Financing Activities:Repayment
      of capital lease obligation and other
    
    
    (3,826
    )
    
    (32,777
    )
    
    (43,804
    )Payment
      of deferred financing costs
    
    
    (18,578
    )
    
    —
    
    
    —Net
      cash used in financing activities
    
    
    (22,404
    )
    
    (32,777
    )
    
    (43,804
    )Net
      Decrease in Cash and Cash Equivalents
    
    
    (3,161,154
    )
    
    (2,321,187
    )
    
    (4,704,697
    )Cash
      and Cash Equivalents, beginning of year
    
    
    3,504,414
    
    
    5,825,601
    
    
    10,530,298Cash
      and Cash Equivalents, end of year
    
    $
    343,260
    
    $
    3,504,414
    
    $
    5,825,601Supplemental
      Disclosure of Cash Flow Information:Cash
      paid during the year for-Interest
    
    $
    49
    
    $
    6,894
    
    $
    19,963Income
      taxes
    
    $
    —
    
    $
    1,
      824
    
    $
    912
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 22


PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES



Notes to
Consolidated Financial Statements




(1)    
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES




(a)     
Nature of Business and Liquidity




Precision
Optics Corporation, Inc. (the "Company") designs, develops, manufactures and
sells specialized optical systems and components and optical thin-film coatings.
The Company conducts business in one industry segment only and its customers are
primarily domestic. The Company’s products and services fall into two principal
areas: (i) medical products for use by hospitals and physicians and (ii)
advanced optical system design and development services and products used by
industrial customers.




The
Company has incurred significant operating losses during the last eight fiscal
years. This trend was primarily the result of the loss of several significant
customers, completion of several large nonrecurring government contracts, and
operating losses and provision for asset impairment, restructuring, and
inventory write-downs associated with the downturn in demand for optical filters
used in telecommunications systems. In fiscal 1998, the Company began making
significant investments in research and development and capital purchases for
new products. In August 1999 and March 2000, the Company raised gross
proceeds of approximately $16 million of additional cash through the
issuance of common stock.




In the
past three fiscal years, the Company has implemented a number of restructuring
and cost saving measures in an effort to align costs with revenues and
strengthen financial performance. Full-time employee headcount has been reduced
from 78 at June 30, 2001 to 30 at June 30, 2004. The Company has discontinued
the development and manufacturing of telecommunications products, canceled the
lease on its Optical Thin Films Technology Center, and written down and/or sold
certain of the property, equipment and inventories invested in its
telecommunications business. As a result of these actions, the Company has
incurred asset impairment, restructuring and inventory write-down provisions of
approximately $4,985,000, $177,000 and $52,000 for the years ended June 30,
2002, 2003, and 2004, respectively, and has received net pro ceeds from the sale
of assets held for sale of approximately $553,000 during the year ended June 30,
2003. In addition, the Company will continue its review of other expense areas
to determine where additional reductions in discretionary spending can be
achieved.




The
Company’s current sources of liquidity consist of its cash and cash equivalents
and accounts receivable. At June 30, 2004 the Company had $343,260 in cash and
cash equivalents and $80,195 in accounts receivable. In July 2004, the Company
completed a rights offering to stockholders of record at June 7, 2004 by issuing
5,256,159 shares of common stock. Net cash proceeds to the Company (after
offering costs of $177,176) were $5,078,983.




The
Company expects its recent pattern of quarter-to-quarter revenue fluctuations to
continue, due to the uncertain timing of individual orders and their size in
relation to total revenues. The Company remains confident in the value of its
technology and expertise both in medical and surgical applications and
elsewhere. In addition, despite strict controls on R&D spending, the Company
continues to move forward with new products and technical innovations.




The
Company believes that the recent introduction of several new products, along
with new and on-going customer relationships, will generate additional revenues,
which are required in order for the Company to achieve profitability. If these
additional revenues are not achieved on a timely basis, the Company will be
required and is prepared to implement further cost reduction measures, as
necessary. The Company believes, based on its operating and strategic plans,
that it will have sufficient funds to conduct operations through at least the
next fiscal year.


23


PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES


Notes to
Consolidated Financial Statements


(b)     
Principles of Consolidation




The
accompanying consolidated financial statements include the accounts of the
Company and its two wholly owned subsidiaries. All intercompany accounts and
transactions have been eliminated in consolidation. All shares and per share
data reflect the effects of a 1-for-6 reverse stock split that became effective
on January 29, 2003.




(c)     
Revenues




In
December 2003, the Securities and Exchange Commission issued Staff Accounting
Bulletin ("SAB") No. 104 which establishes guidance in applying generally
accepted accounting principles to revenue recognition in financial statements
and was effective for the Company’s fiscal year 2004. SAB No. 104 requires that
four basic criteria must be met before revenue can be recognized: (1) persuasive
evidence of an arrangement exists; (2) delivery has occurred or services
rendered; (3) the price to the buyer is fixed and determinable; and (4)
collectibility is reasonably assured. The Company’s shipping terms are
customarily FOB shipping point. The Company’s revenue recognition practices
comply with the guidance in the bulletin.




Revenues
for industrial and medical products sold in the normal course of business are
recognized upon shipment when delivery terms are FOB shipping point and all
other revenue recognition criteria have been met. Contract revenues including
revenues from customer-sponsored research and development contracts, are
recognized under the percentage-of-completion method. The percentage of
completion is determined by computing the percentage of the actual cost of work
performed to the anticipated total contract costs. When the estimate on a
contract indicates a loss, the Company’s policy is to record the entire
estimated loss in the current period.




(d)     
Cash and Cash Equivalents




The
Company includes in cash equivalents all highly liquid investments with original
maturities of three months or less at the time of acquisition. Cash equivalents
of $298,837 and $3,394,449 at June 30, 2004 and 2003, respectively, consist
primarily of overnight repurchase agreements, money market funds, and United
States Treasury bills.


24


PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements


(e)     
Inventories




Inventories
are stated at the lower of cost (first-in, first-out) or market and include
material, labor and manufacturing overhead. The components of inventories at
June 30, 2004 and 2003 are as follows:




2004
    
    2003Raw
      material
    
    $
    345,483
    
    $
    679,647Work-in-progress
    
    
    307,522
    
    
    379,636Finished
      goods
    
    
    264,993
    
    
    198,005$
    917,998
    
    $
    1,257,288




The
Company provides for estimated obsolescence on unmarketable inventory based upon
assumptions about future demand and market conditions. If actual demand and
market conditions are less favorable than those projected by management,
additional inventory write downs may be required. Inventory, once written down,
is not subsequently written back up, as these adjustments are considered
permanent adjustments to the carrying value of the inventory.





During
fiscal years 2004 and 2002, the Company recorded, in cost of goods sold, pretax
non-cash provisions for slow-moving and obsolete inventories of approximately
$500,000 and $540,000, respectively.





(f)     
Property and Equipment




Property
and equipment are recorded at cost. Maintenance and repair items are expensed as
incurred. The Company provides for depreciation and amortization by charges to
operations, using the straight-line and declining-balance methods, which
allocate the cost of property and equipment over the following estimated useful
lives:




Asset
      Classification
    
    
    Estimated
      Useful LifeMachinery
      and equipment
    
    
    3-7
      yearsLeasehold
      improvements
    
    
    Shorter
      of lease term or estimated useful lifeFurniture
      and fixtures
    
    
    5
      yearsVehicles
    
    
    3
      years




Amortization
of assets under capital leases is included in depreciation and amortization
expense. Depreciation and amortization expense was $197,242, $228,056, and
$552,116 for the years ended June 30, 2004, 2003 and 2002, respectively.




(g)     
Significant Customers and Concentration of Credit Risk




Statement
of Financial Accounting Standards (SFAS) No. 105, Disclosure of Information
about Financial Instruments with Off-Balance-Sheet Risk and Financial
Instruments with Concentrations of Credit Risk,requires disclosure of any
significant off-balance sheet and credit risk


25


PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES


Notes to
Consolidated Financial Statements


concentrations.
Financial instruments that subject the Company to credit risk consist primarily
of cash equivalents and trade accounts receivable. The Company places its
investments in highly rated financial institutions. The Company has not
experienced any losses on these investments to date. At June 30, 2004,
receivables from the Company’s largest customers were 47%, 18%, 13%, and 12% ,
respectively of the total accounts receivable. At June 30, 2003, receivables
from the Company’s largest customer were approximately 55% of the total accounts
receivable. No other customer accounted for more than 10% of the Company’s
receivables as of June 30, 2004 and 2003. The Company has not experienced any
material losses related to accounts receivable from individual customers. The
Company generally does not require c ollateral or other security as a condition
of sale rather relying on credit approval, balance limitation and monitoring
procedures to control credit risk of trade account financial instruments.
Management believes that allowances for doubtful accounts, which are established
based upon review of specific account balances and historical experience, are
adequate.




Revenues
from the Company’s largest customers, as a percentage of total revenues, were as
follows:




2004
    
    2003
    
    2002Customer A
    
    
    24
    %
    
    17
    %
    
    18
    %Customer
      B
    
    
    22
    
    
    2
    
    
    -Customer
      C
    
    
    -
    
    
    44
    
    
    -Customer
      D
    
    
    4
    
    
    5
    
    
    23All
      Others
    
    
    50
    
    
    32
    
    
    59100
    %
    
    100
    %
    
    100
    %





No other
customer accounted for more than 10 % of the Company’s revenues in fiscal years
2004, 2003 and 2002.




(h)    
Loss per Share




The
Company calculates earnings per share according to SFAS No. 128, Earnings per
Share. Basic loss per share is computed by dividing net loss by the weighted
average number of shares of common stock outstanding during the period. For each
of the three years in the period ended June 30, 2004, the effect of stock
options and warrants was antidilutive; therefore, they were not included in the
computation of diluted loss per share. The number of options and warrants that
were excluded from the computation, as their effect would be antidilutive, were
218,765, 202,817, and 201,533 during fiscal 2004, 2003, and 2002,
respectively.




(i)     
Stock-Based Compensation




The
company accounts for its stock-based compensation using the intrinsic value
method provided for under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees and related
interpretations. Under APB No. 25 and related interpretations,
compensation cost is recognized based on the difference, if any, on the date of
grant between the fair value of the Company’s stock and the amount an employee
must pay to acquire the stock. Statement of Financial Accounting Standards
("SFAS") No. 123, Accounting for Stock-Based Compensation, establishes a
fair-value-based method of accounting for stock-based compensation plans. The
Company has adopted the disclosure-only alternative under SFAS No. 123, which
requires the disclosure of the pro forma effects on net loss and net loss per
share as if the fair value accounting prescribed by SFAS No. 123 had been
adopted.


26

PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


No
stock-based employee compensation cost is reflected in net loss, as all options
granted had an exercise price equal to the market value of the underlying common
stock on the date of grant. The following table illustrates the effect on net
loss and net loss per share as if the Company had applied the fair value
recognition provisions of SFAS No. 123 to stock-based employee
compensation:




Year
      Ended2004
    
    2003
    
    2002Net
      loss, as reported
    
    $
    (3,684,076
    )
    $
    (2,927,762
    )
    $
    (9,973,442
    )Add:
      Total stock-based employee compensation expense determined under fair
      value based method for all awards
    
    
    (
      61,216
    )
    
    (
      82,304
    )
    
    (98,474
    )Pro
      forma net loss
    
    $
    (3,745,292
    )
    $
    (3,010,066
    )
    $
    (10,071,916
    )Net
      loss per share:
      As
      reported - basic and diluted
    
    $
    (2.10
    )
    $
    (1.67
    )
    $
    (5.69
    )Pro
      forma - basic and diluted
    
    $
    (2.14
    )
    $
    (1.72
    )
    $
    (5.75
    )




(j)      
Foreign Currency Translation




The
Company translates certain accounts and financial statements of its foreign
subsidiary in accordance with SFAS No. 52, Foreign Currency Translation.The functional currency of the Company’s foreign subsidiary is the United
States dollar. Transaction gains or losses are reflected in the accompanying
consolidated statements of operations and have not been
significant.




(k)     
Patents




Patents
are carried at cost, less accumulated amortization of approximately $334,000 and
$290,000 at June 30, 2004 and 2003, respectively. Such costs are amortized using
the straight-line method over the shorter of their legal or estimated useful
lives, generally five to ten years. Amortization expense was $43,604, $37,046,
and $41,375 for the years ended June 30, 2004, 2003, and 2002, respectively.
Amortization expense is expected to be approximately $45,000, $43,000, $36,000,
$25,000 and $18,000, respectively for the years ending June 30, 2005 through
June 30, 2009.




(l)      
Financial Instruments




SFAS No.
107, Disclosure About Fair Value of Financial Instruments, requires
disclosures about the fair value of financial instruments. Financial instruments
consist principally of cash equivalents, accounts receivable, accounts payable,
and accrued expenses. The estimated fair value of these financial instruments
approximates their carrying value due to the short-term nature of these
financial instruments.


27

PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements


(m)    
Long-Lived Assets




The
Company accounts for long-lived assets in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. This
statement requires that long-lived assets and certain identifiable intangibles
be reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to future net cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell.




(n)     
Warranty Costs




The
Company does not incur future performance obligations in the normal course of
business other than providing a standard one-year warranty on materials and
workmanship to its customers. The Company provides for estimated warranty costs
at the time product revenue is recognized. Warranty costs for the years ended
June 30, 2004, 2003, and 2002 have not been material to the consolidated
financial statements. Warranty costs were $15,615, $17,330, and $9,317 for the
years ended June 30, 2004, 2003, and 2002, respectively and have been included
as a component of cost of goods sold in the accompanying consolidated statements
of operations.




(o)     
Research and Development




Research
and development expenses are charged to operations as incurred.




(p)    
Comprehensive Income




SFAS
No. 130 requires disclosure of all components of comprehensive income on an
annual and interim basis. Comprehensive income is defined as the change in
equity of a business enterprise during a period from transactions and other
events and circumstances from nonowners sources.




The
Company’s comprehensive loss for the years ended June 30, 2004, 2003 and
2002 was equal to its net loss for the same periods.




(q)     
Income Taxes




Income
taxes are accounted for under the asset and liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.




In
assessing the likelihood of utilization of existing deferred tax assets,
management has considered historical results of operations and the current
operating environment.







28


PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements


(r)     
Segment Reporting




SFAS No. 131, Disclosures About Segments of an Enterprise and Related
Information, establishes standards for reporting information regarding
operating segments in annual financial statements and requires selected
information for those segments to be presented in interim financial reports
issued to stockholders. SFAS No. 131 also establishes standards for related
disclosures about products and services and geographic areas. Operating segments
are identified as components of an enterprise about which separate discrete
financial information is available for evaluation by the chief operating
decision maker, or decision making group, in making decisions about how to
allocate resources and assess performance. The Company’s chief decision-maker,
as defined under SFAS No. 131, is the Chief Exec utive Officer. To date, the
Company has viewed its operations and manages its business as principally one
segment. For all periods presented, over 90% of the Company’s sales have been to
customers in the United States.





(s)     
Use of Estimates




The
preparation of financial statements in conformity with accounting standards
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.




(2)
COMMITMENTS




(a)     
Related Party Transactions




The
Company leases one of its facilities from a corporation owned by an
officer-director-shareholder of the Company. The lease terminated in December
1999 and required lease payments of $9,000 per month. The Company is currently a
tenant at will paying rent of $9,000 a month. Total rent expense for related
parties included in the accompanying consolidated statements of operations
amounted to $108,000 in each of fiscal years 2004, 2003, and 2002.




The
Company paid or accrued fees to a director of approximately $24,000 per year for
services performed during fiscal 2004, 2003 and 2002. Another director is a
former partner in a law firm that has performed legal services for the Company
during fiscal 2004, 2003 and 2002 of approximately $170,000, $144,000, and
$117,0000, respectively. Another former director is the owner of a company that
provided approximately $1,650, $1,700, and $19,000 in software and consulting
services to the Company during fiscal 2004, 2003 and 2002,
respectively.




(b)     
Operating Lease Commitments




The
Company has entered into operating leases for its office space and equipment
that expire at various dates through fiscal year 2005. Total future minimum
rental payments under all non-cancelable operating leases are approximately
$29,600.




Rent
expense on operating leases, excluding the related party rent described above,
was approximately $55,600, $51,500, and $70,000 for the years ended June 30,
2004, 2003 and 2002, respectively.


29


PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(3) 
STOCKHOLDER'S EQUITY





(a)     
Reverse Stock Split




All
shares and per share data in the accompanying consolidated financial statements
reflect the effects of the 1-for-6 Reverse Stock Split that became effective on
January 29, 2003. In addition, capital stock has been decreased by $87,518, with
a corresponding increase to paid-in capital to reflect the adjusted number of
shares of $.01 par value common stock outstanding as a result of the 1-for-6
Reverse Stock Split.





(b)     
Warrants




As of June 30, 2004, the Company had 77,644 fully-exercisable warrants to
acquire common stock outstanding at a weighted average exercise price of
$160.38. The       warrants are immediately
exercisable and expire in March 2005.




(c)     
Stock Options




During fiscal 1989, the stockholders approved a stock option plan (the "1989
Plan") for key employees. The 1989 Plan, as amended, authorizes the grant of
options       of up to 185,000 shares of the
Company’s common stock at an exercise price of not less than 100% of the fair
market value per share at the date of grant.
Options       granted vest and are exercisable
for periods determined by the Board of Directors, not to exceed 10 years
from the date of grant.




During fiscal 1998, the stockholders approved an incentive plan (the "1997
Incentive Plan"), which provides eligible participants (certain employees,
directors,       consultants, etc.) the
opportunity to receive a broad variety of equity based and cash awards. Options
granted vest and are exercisable for periods determined by the
       Board of Directors, not to exceed 10
years from the date of grant. A total of 300,000 shares of common stock have
been reserved for issuance under the 1997
       Incentive Plan, as amended and restated
in fiscal year 2004. Upon the adoption of the 1997 Incentive Plan, no new awards
will be granted under the 1989 Plan. At      
June 30, 2004, 183,153 shares of common stock were available for future grants
under the 1997 Incentive Plan.


30





PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES




s
to Consolidated Financial Statements




The
following is a summary of transactions in the plans for the three years ended
June 30, 2004:




Number
      of Shares
    
    Option
      Price per Share
    
    Weighted
      Average Exercise PriceOptions
      outstanding, June 30, 2001
    
    
    118,669
    
    $
    6.00-75.00
    
    $
    16.38Granted
    
    
    30,084
    
    
    4.02-7.14
    
    $
    4.68Canceled
    
    
    (33,984
    )
    
    6.00-30.00
    
    $
    29.58Options
      outstanding, June 30, 2002
    
    
    114,769
    
    
    4.02-75.00
    
    $
    13.98Granted
    
    
    3,336
    
    
    1.74
    
    $
    1.74Canceled
    
    
    (2,003
    )
    
    4.02-23.064
    
    $
    9.54Options
      outstanding, June 30, 2003
    
    
    116,102
    
    
    1.74-75.00
    
    $
    13.68Granted
    
    
    18,336
    
    $
    1.97
    
    $
    1.97Canceled
    
    
    (2,485
    )
    $
    4.20-75.00
    
    $
    27.70Options
      outstanding, June 30, 2004
    
    
    131,953
    
    $
    1.74-75.00
    
    $
    11.79Options
      exercisable, June 30, 2004
    
    
    114,807
    
    $
    1.74-75.00
    
    $
    13.11Options
      exercisable, June 30, 2003
    
    
    103,897
    
    $
    1.74-75.00
    
    $
    14.34Options
      exercisable, June 30, 2002
    
    
    92,742
    
    $
    4.02-75.00
    
    $
    15.18




31




PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES




Notes
to Consolidated Financial Statements




The
following table summarizes information about stock options outstanding and
exercisable at June 30, 2004:




Options
      Outstanding
    
    Options
      ExercisableRange
      of Exercise Prices
    
    
    Options
      Outstanding
    
    
    Weighted
      Average Remaining Contractual Life
    
    
    Weighted
      
      Average
      Exercise Price
    
    Options
      Exercisable
    
    
    Weighted
      Average Exercise Price$1.74-$4.56
    
    
    45,096
    
    
    8.30
      years
    
    
    $3.13
    
    29,033
    
    
    $3.41$6.00
      - $8.25
    
    
    31,006
    
    
    2.25
      years
    
    
    $7.84
    
    29,923
    
    
    $7.87$9.38
      - $13.13
    
    
    18,504
    
    
    2.85
      years
    
    
    $10.93
    
    18,504
    
    
    $10.93$16.50
    
    
    1,042
    
    
    3.12
      years
    
    
    $16.50
    
    1,042
    
    
    $16.50$23.064
      - $33.00
    
    
    34,971
    
    
    3.95
      years
    
    
    $24.35
    
    34,971
    
    
    $24.35$75.00
    
    
    1,334
    
    
    6.17
      years
    
    
    $75.00
    
    1,334
    
    
    $75.00$1.74
      - $75.00
    
    
    131,953
    
    
    4.90
      years
    
    
    $11.79
    
    114,807
    
    
    $13.11




In
addition, the Company has granted options outside the plans, primarily to
directors and consultants at 100% of the fair market value per share at the date
of grant. The weighted average remaining contractual life of the options outside
the plans is .66 years as of June 30, 2004. The following is a summary of all
transactions outside the plans:




Number
      of Shares
    
    Option
      Price per Share
    
    Weighted
      Average Exercise PriceOptions
      outstanding and exercisable, June 30, 2002, 2003, and 2004
    
    
    9,168
    
    $
    7.80-8.25
    
    $
    8.08




32


PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES






The
Company has computed the pro forma disclosures required under SFAS
No. 123for fiscal 2004, 2003 and 2002 using the Black-Scholes
option pricing model prescribed by SFAS No. 123 (See Note
1(i)).




The
assumptions used for each of the three years in the period ended June 30, 2004
are as follows:




Year
      Ended2004
    
    2003
    
    2002Risk-free
      interest rates
    
    
    3.85
    %
    
    2.36
    %
    
    4.10
    %Expected
      dividend yield
    
    
    —
    
    
    —
    
    
    —Expected
      lives
    
    
    7
      years
    
    
    7
      years
    
    
    7
      yearsExpected
      volatility
    
    
    120
    %
    
    131
    %
    
    279
    %Weighted
      average fair value of grants
    
    
    $1.77
    
    
    $1.61
    
    
    $4.68


(4)


(4) INCOME
TAXES





The
provision for income taxes in the accompanying consolidated statements of
operations consists of the minimum statutory state income tax liability of $912
for each of the three years ended June 30, 2004.




A
reconciliation of the federal statutory rate to the Company’s effective tax rate
for the three years ended June 30, 2004 is as follows:




2004
    
    2003
    
    2002Income
      tax benefit at federal statutory rate
    
    
    (34.0
    )%
    
    (34.0
    )%
    
    (34.0
    )%Increase
      (decrease) in tax resulting from–State taxes, net of federal benefit
    
    
    (6.0
    )
    
    (6.0
    )
    
    (6.0
    )Tax credits
    
    
    (1.6
    )
    
    (3.9
    )
    
    (0.7
    )Change in valuation allowance
    
    
    30.6
    
    
    42.0
    
    
    40.0Expiration of tax credits
    
    
    7.3
    
    
    —
    
    
    —Other
    
    
    3.7
    
    
    1.9
    
    
    0.7Effective
      tax rate
    
    
    0.0
    %
    
    0.0
    %
    
    0.0
    %




The
components of deferred tax assets and liabilities at June 30, 2004 and 2003 are
approximately as follows:




2004
    
    2003Deferred
      tax assets:Net operating loss carryforwards
    
    $
    8,745,000
    
    $
    7,638,000Tax credit carryforwards
    
    
    497,000
    
    
    709,000Reserves and accruals not yet deducted for tax purposes
    
    
    3,849,000
    
    
    3,551,000Total
      deferred tax assets
    
    
    13,091,000
    
    
    11,898,000Valuation
      allowance
    
    
    (11,943,000
    )
    
    (10,818,000
    )Subtotal
    
    
    1,148,000
    
    
    1,080,000Deferred
      tax liabilities:Accumulated depreciation
    
    
    (1,148,000
    )
    
    (1,080,000
    )Net
      deferred taxes
    
    $
    —
    
    $
    —


33
  PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES




Notes to
Consolidated Financial Statements




The
Company has provided a valuation allowance to reduce the net deferred tax asset
to an amount the Company believes is "more likely than not" to be realized. The
valuation allowance increased in fiscal 2004 by approximately $1,125,000.
Approximately $2,241,000 of the valuation allowance at June 30, 2004
related to the exercise of stock options will be allocated to stockholders’
equity when recognized. As of June 30, 2004, the Company has net operating loss
carryforwards for U.S. federal and state income taxes of approximately
$22,208,000 and $19,908,000, respectively. The U.S. federal net operating loss
carryforwards expire approximately as follows: $697,000 in 2013, $1,511,000 in
2019, $7,154,000 in 2020, $5,554,000 in 2022, $4,054,000 in 2023 and $3,238,000
in 2024. The state net operating loss carryforwards expire approximately as
follows: $7,121,000 in 2005, $5,520,000 in 2007, $4,029,000 in 2008 and
$3,238,000 in 2009. The tax credit carryforwards expire in 2005 through 2024.
Pursuant to the Tax Reform Act of 1986, the utilization of net operating loss
carryforwards for tax purposes may be subject to an annual limitation if a
cumulative change of ownership of more than 50% occurs over a three-year period.
As a result of the Company’s stock offerings in fiscal years 1998, 2000, and
2005 (see Note 8), such a change in ownership may have occurred. In the event
that the Company has had a change in ownership, as defined, the utilization of
substantially all of the Company’s net operating loss carryforwards will be
significantly restricted.




(5) PROVISION
FOR ASSET IMPAIRMENT AND RESTRUCTURING





A   
Asset Impairment:





In June
2002, certain property and equipment previously invested in the Company’s
telecommunications product line (whose fair value less cost to sell was
estimated at approximately $848,000 at that time) was reclassified to the
category of "Assets Held for Sale" in the Company’s consolidated balance sheet.
During fiscal year 2003, the Company received net proceeds of approximately
$553,000 from the sale of a portion of these assets and incurred an impairment
charge of approximately $123,500 based on an updated independent appraisal of
fair market value for the remaining assets. As a cost saving measure, during the
quarter ended December 31, 2003, the Company deployed $21,400 of assets held for
sale and invested $6,300, largely to refurbish certain equipment used to produce
optical thin films for its medical inst rument product line.





In
accordance with Statement of Financial Accounting Standards ("SFAS") No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets, the
Company has reclassified the residual unsold portion of these assets (whose fair
value less cost to sell was estimated at $131,150 as of December 31, 2003) to
property and equipment at December 31, 2003 in the accompanying consolidated
balance sheets. The Company has resumed providing depreciation on these assets
beginning in January 2004, using the straight-line method and estimated life of
two years, and is continuing its efforts to sell such assets.





Restructuring:





In
January 2004, the Company reduced its full-time workforce by approximately 15%,
or five employees. As a result of this action, the Company recorded a pretax
charge to earnings in the quarter ended March 31, 2004 of $52,208 for employee
severance benefits that were paid in the quarter ended March 31, 2004.





In
October 2002, the Company reduced its full-time workforce by approximately 16%,
or six employees. As a result of this action, the Company recorded a pretax
charge to earnings in the quarter ended December 31, 2002 of $53,131 for
employee severance benefits that were paid in the quarter ended December 31,
2002.


34
  PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES





Notes to
Consolidated Financial Statements




The
following table sets forth the quarterly impacts and cash payments associated
with the asset impairment and restructuring provisions:




Provision
      For –Property &
      Equipment Writedown
    
    Patent
      Writedown
    
    Employee
      Severance
    
    Idle
      Lease Space
    
    TotalProvision
      Balance, June 30, 2001
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —Quarter Ended -September 30, 2001
    
    
    3,444,378
    
    
    —
    
    
    —
    
    
    —
    
    
    3,444,378December 31, 2001
    
    
    —
    
    
    —
    
    
    186,250
    
    
    482,000
    
    
    668,250June 30, 2002
    
    
    541,000
    
    
    57,578
    
    
    —
    
    
    (266,185
    )
    
    332,393Total
      Provision
    
    
    3,985,378
    
    
    57,578
    
    
    186,250
    
    
    215,815
    
    
    4,445,021Non-cash
      Charges
    
    
    (3,985,378
    )
    
    (57,578
    )
    
    —
    
    
    —
    
    
    (4,042,956
    )Cash
      Payments
    
    
    —
    
    
    —
    
    
    (186,250
    )
    
    (47,844
    )
    
    (234,094
    )Provision
      Balance, June 30, 2002
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    167,971
    
    $
    167,971Quarter Ended -December 31, 2002
    
    
    —
    
    
    —
    
    
    53,131
    
    
    —
    
    
    53,131June 30, 2003
    
    
    123,511
    
    
    —
    
    
    —
    
    
    —
    
    
    123,511Total
      Provision
    
    
    123,511
    
    
    —
    
    
    53,131
    
    
    —
    
    
    176,642Non-cash
      Charges
    
    
    (123,511
    )
    
    —
    
    
    —
    
    
    —
    
    
    (123,511
    )Cash
      Payments
    
    
    —
    
    
    —
    
    
    (53,131
    )
    
    (167,971
    )
    
    (221,102
    )Provision
      Balance, June 30, 2003
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —Quarter
      Ended -March 31, 2004
    
    
    —
    
    
    —
    
    
    52,208
    
    
    —
    
    
    52,208Total
      Provision
    
    
    —
    
    
    —
    
    
    52,208
    
    
    —
    
    
    52,208Cash
      Payments
    
    
    —
    
    
    —
    
    
    (52,208
    )
    
    —
    
    
    (52,208
    )Provision
      Balance, June 30, 2004
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —
    
    $
    —





(6)
PROVISION FOR INVENTORY WRITE-DOWN




The
Company determined that certain inventories of telecommunications and medical
products would not be sold within the Company’s business cycle or the products’
life cycle. Consequently, the Company recorded, in cost of goods sold, a
provision for excess and obsolete inventory of approximately $540,000 in fiscal
year 2002, and approximately $500,000 in fiscal year 2004.




(7)
PROFIT SHARING PLAN




The
Company has a defined contribution 401K profit sharing plan. Employer profit
sharing and matching contributions to the plan are discretionary. No employer
profit sharing contributions were made to the plan in fiscal years 2004, 2003,
or 2002. Employer matching contributions to the plan amounted to $29,972,
$34,608, and $32,354 for fiscal years 2004, 2003 and 2002,
respectively.








35





PRECISION OPTICS CORPORATION, INC. AND
SUBSIDIARIES


Notes to Consolidated Financial Statements

(8) SUBSEQUENT EVENT

In July 2004, the Company completed a rights offering to stockholders
of record at June 7, 2004 by issuing 5,256,159 shares of common stock at a price
of $1.00 per share. Net cash proceeds to the Company (after offering costs of
$177,176) were $5,078,983.

The costs of the rights offering estimated to have been incurred
through June 30, 2004 of $171,885, have been deferred and are included in the
caption "deferred financing costs" in the accompanying consolidated balance
sheets as of June 30, 2004.

As of June 30, 2004, the Company’s stockholders’ equity was
$1,503,972, which was less than the minimum level of stockholders’ equity
required under Nasdaq Marketplace Rules for companies listed on the Nasdaq
SmallCap Market. After receipt of net proceeds of $5,078,983 from the rights
offering in July, the Company believes it has regained compliance with the
stockholders’ equity requirement.
36

PRECISION OPTICS CORPORATION, INC. AND
SUBSIDIARIES

ITEM 8.    CHANGES IN AND DISAGREEMENTS WITH
ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE: None.


ITEM 8A. CONTROLS AND PROCEDURES:  As of the end of the
period covered by this annual report, the Company’s Chief Executive Officer and
Principal Financial Officer have conducted an evaluation of the Company’s
disclosure controls and procedures. Based on their evaluation, the Company’s
Chief Executive Officer and Principal Financial Officer have concluded that
the Company’s disclosure controls and procedures are effective to ensure that
information required to be disclosed by the  Company in reports that it
files or submits under the Securities Exchange Act of 1934 is (i) recorded,
processed, summarized and reported within the time periods specified in the
applicable Securities and Exchange Commission rules and forms and (ii)
accumulated and communicated to the Company’s management, including the
Company’s Chief Executive Officer and the Company’s Principal Financial Officer,
as appropriate to allow timely decisions regarding required disclosure.



There was no change in the Company’s internal control over financial reporting
during the Company’s most recently completed fiscal quarter that has
materially  affected, or is reasonably likely to materially affect, the
Company’s internal control over financial reporting.


PART III

ITEM 9.     DIRECTORS, EXECUTIVE OFFICERS, AND
CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT: The
Company will furnish to the Securities and Exchange Commission a definitive
Proxy Statement (the "Proxy Statement") not later than 120 days after the close
of its fiscal year ended June 30, 2004. The information required by this item,
other than with respect to the Company’s Corporate Code of Ethics and Conduct,
is incorporated herein by reference to the  Proxy Statement.

A copy of the
Company’s Corporate Code of Ethics and Conduct applicable to all employees,
officers and directors of the Company is being filed with the
Securities and Exchange Commission as Exhibit 14.1 to this report and can
be obtained free of charge by contacting the Company’s Clerk, c/o Precision
Optics Corporation, 22  East Broadway, Gardner, Massachusetts 01440.

ITEM 10.   EXECUTIVE COMPENSATION: The information
required by this item is incorporated herein by reference to the Proxy
Statement.

ITEM 11.    SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT: The information required by this item is
incorporated herein by reference to  the Proxy Statement.

ITEM 12.    CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS: The information required by this item is incorporated herein
by reference to the ProxyStatement.
37
PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K:

(a)
    Exhibits.
    The
      exhibits listed below are filed with or incorporated by reference in this
      report.

3.1
    Articles
      of Organization of the Company, as amended and corrected1
3.2
    By-laws
      of Precision Optics Corporation, Inc.2
4.1
    Specimen
      common stock certificate3
4.2
    Registration
      Rights Agreement dated as of March 17, 2000 by and among the Company
      and the Initial Investors as defined
therein4
4.3
    Registration
      Rights Agreement dated as of June 30, 1998 by and among the Company,
      Special Situations Private Equity Fund, L.P. and Special Situations
      Technology Fund, L.P.5
4.4
    Registration
      Rights Agreement dated as of August 5, 1999 by and among the Company,
      Special Situations Cayman Funds, L.P., Special Situations Fund III, L.P.,
      Special Situations Private Equity Fund, L.P. and Special Situations
      Technology Fund, L.P.6
4.5
    Form
      of Stock Purchase Warrant dated March 17, 2000 issued to each
      investor in March 17, 2000 private placement
      transaction4
4.6
    Warrant
      No. 1 dated March 17, 2000 issued to First Security Van
      Kasper4
4.7
    Warrant
      No. 2 dated March 17, 2000 issued to First Security Van
      Kasper4
10.1
    Precision
      Optics Corporation, Inc. 1989 Stock Option Plan amended to
      date7
10.2
    Three
      separate life insurance policies on the life of Richard E.
      Forkey.3
10.3
    Master
      Lease Finance Agreement dated November 3, 1993 between the Company and
      BancBoston Leasing7
10.4
    Lease
      dated March 1, 1999, between the Company and Philip A. Wood, as executor
      of the Estate of Alma L. Wood and as devisee under the Will of Alma L.
      Wood; Martha A. Mount, devisee under the Will of Alma L. Wood; and Nancy
      E. Popinchalk, devisee under the Will of Alma L. Wood for 21 Pleasant
      Street, Gardner, Massachusetts6
10.5
    Amended
      and Restated Precision Optics Corporation, Inc. 1997 Incentive
      Plan.9
10.6
    Securities
      Purchase Agreement dated as of March 13, 2000 by and among the
      Company and the Purchasers as defined therein (excluding exhibits)4
14.1
    Corporate
      Code of Ethics and Conduct
21
    Subsidiaries
      of Precision Optics Corporation, Inc.8
23
    Consent
      of KPMG LLP.
31.1
    Certification
      of Chief Executive Officer required by Rule
  13a-14(a)/15d-14(a)
31.2
    Certification
      of Chief Financial Officer required by Rule
  13a-14(a)/15d-14(a)
32.1
    Certification
      of Chief Executive Officer and Chief Financial Officer required by Rule
      13a-14(b) and 18 U.S.C. 1350.
99.1
    Important
      Factors Regarding Forward-Looking Statements.

1 Incorporated herein by reference to the Company’s
Quarterly Report for the quarter ended December 31, 2002 on Form 10-QSB (No.
001-10647).
2 Incorporated herein by reference to the Company’s 1991
Annual Report on Form 10-KSB (No. 001-10647).
3 Incorporated herein by reference to the Company’s
Registration Statement on Form S-18 (No. 33-36710-B).
4 Incorporated herein by reference to the Company’s
Registration Statement on Form S-3 (No. 333-35884).
5 Incorporated herein by reference to the Company’s
1998 Annual Report on Form 10-KSB (No. 001-10647).
6 Incorporated herein by reference to the Company’s
1999 Annual Report on Form 10-KSB (No. 001-10647).
7Incorporated herein by reference to the Company’s
1994 Annual Report on Form 10-KSB (No. 001-10647).
8Incorporated herein by reference to the Company’s
1996 Annual Report on Form 10-KSB (No. 001-10647).
9Incorporated herein by reference to the Company’s
Quarterly Report on Form 10-QSB for the quarter ended September 30, 2003 (No.
001-10647).
38
PRECISION
OPTICS CORPORATION, INC. AND SUBSIDIARIES

(b)   
Reports on Form 8-K.

The Company filed four Current Reports on Form 8-K during the
quarter ended June 30, 2004 as follows - On May 12, 2004, under Items 7 and 12,
the Company reported a press release issued May 12, 2004, reporting its
operating results for the quarter and nine months ended March 31, 2004. On May
12, 2004, under Items 5 and 7, the Company reported a press release issued May
12, 2004 announcing the filing of a registration statement on Form S-3 for a
rights offering to stockholders. On May 25, 2004, under Items 5 and 7, the
Company reported a press release issued May 24, 2004 announcing the record date
for its rights offering to stockholders. On June 15, 2004, under Items 5 and 7,
the Company reported a press release issued on June 14, 2004 announcing the
effectiveness of the Company’s registration statement on Form S-3 in connection
with a rights offering to stockholders.
39
PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

**PRECISION OPTICS CORPORATION,
      INC.**Date: March 18, 2005
    By:
    /s/ Richard E. ForkeyRichard
      E. ForkeyChairman of the Board,Chief Executive Officer,
      Presidentand Treasurer

In accordance with the Exchange Act, this report has been signed
below by the following persons on behalf of the registrant and in the capacities
and on the dates indicated.


By:
      /s/ Richard E. Forkey
    
    By:/s/
      Jack P. DreimillerRichard E. Forkey
    
    Jack P. DreimillerPresident, Treasurer and Director (principal
    
    Senior Vice President, Finance,executive officer)
    
    Chief Financial Officer and Clerk(principal financial and accounting officer)Date:
      March 18, 2005
    
    Date:
      March 18, 2005By:
      /s/ Joel R. Pitlor
    
    By:
      /s/ Edward A. BenjaminJoel R. Pitlor
    
    Edward A. BenjaminDirector
    
    DirectorDate:
      March 18, 2005
    
    Date:
      March 18, 2005By:
      /s/ Robert R. ShannonRobert R. ShannonDirectorDate:
      March 18, 2005