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****UNITED STATES****

****SECURITIES ANDEXCHANGE COMMISSION****

****Washington, D.C. 20549****

 

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****FORM 10-K****

 

**(Mark One)**

**x****   ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the fiscal year ended June 30,2008**

 

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

 

**For transition period from        to        **

 

**Commission File Number******001-10647****

 

****PRECISION OPTICS CORPORATION, INC.****

(Exact name of registrant as specified in its charter)

 

| ****Massachusetts****                                          | **** **** | ****04-279-5294****                 |
|----------------------------------------------------------------|----------------|-------------------------------------|
| (State or other jurisdictionof incorporation or  organization) |           | (I.R.S. EmployerIdentification No.) |

 

****22 East Broadway****

****Gardner, Massachusetts 01440****

(Address of principal executive offices) (Zip Code)

 

****(978) 630-1800****

(Registrant’s telephone number, including area code)

 

Securities registeredpursuant to Section 12(b) of the Act:     ****None****

 

Securities registered pursuant to Section 12(g) of the Act:  ****Common Stock,$0.01 par value****

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. o Yes x No

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or 15(d) of the Act.    o Yes x No

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. xYes o No

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K (§229.405 of this chapter) is not contained herein, and will notbe contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

 
| Large accelerated filer o                                         |   | Accelerated filer o    |   |
|------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                   |   |                        |   |
| Non-accelerated filer (Do not check if a smaller  reporting company) o |   | Smaller reporting company x |   |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act). o Yes x No

 

Statethe aggregate market value of the voting and non-voting common equity,consisting solely of common stock, held by non-affiliates computed by referenceto the price at which the common equity was last sold, or the average bid andasked price of such common equity, as of the last business day of theregistrant’s most recently completed second fiscal quarter: $989,042 (based ona total of 7,064,585 shares of the registrant’s common stock held bynon-affiliates on December 31, 2007, at the closing price of $0.14 pershare).

 

Thenumber of shares of outstanding common stock of the registrant as of August 31,2008 was 25,458,212.

 

****DOCUMENTS INCORPORATED BYREFERENCE****

 

Theregistrant’s Proxy Statement for the 2008 Annual Meeting of Stockholders to beheld on November 25, 2008 is incorporated by reference into Part IIIof this Form 10-K. 

 

 

 

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**PRECISION OPTICS CORPORATION, INC.**

**FORM 10-K**

 

**TABLE OFCONTENTS**

** **
| ** **        | ** **  | ** **                                                                                                           | **PAGE** |
|-------------------|-------------|----------------------------------------------------------------------------------------------------------------------|----------|
| PART  I |        |                                                                                                                 |     |
|              | ITEM 1.     | Business.                                                                                                            | 3        |
|              | ITEM 1A.    | Risk Factors.                                                                                                        | 7        |
|              | ITEM 2.     | Properties.                                                                                                          | 11       |
|              | ITEM 3.     | Legal Proceedings.                                                                                                   | 11       |
|              | ITEM 4.     | Submission  of Matters to a Vote of Security Holders.                                                                | 12       |
| PART  II     |        |                                                                                                                 |     |
|              | ITEM 5.     | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities. | 12       |
|              | ITEM 6.     | Selected  Financial Data.                                                                                            | 13       |
|              | ITEM 7.     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations.                         | 13       |
|              | ITEM 7A.    | Quantitative  and Qualitative Disclosures About Market Risk.                                                         | 18       |
|              | ITEM 8.     | Financial  Statements and Supplementary Data.                                                                        | 18       |
|              | ITEM 9.     | Changes in  and Disagreements With Accountants on Accounting and Financial Disclosure.                               | 37       |
|              | ITEM 9A(T). | Controls and  Procedures.                                                                                            | 37       |
|              | ITEM 9B.    | Other Information.                                                                                                   | 38       |
| PART  III    |        |                                                                                                                 |     |
|              | ITEM 10.    | Directors,  Executive Officers and Corporate Governance.                                                             | 38       |
|              | ITEM 11.    | Executive  Compensation.                                                                                             | 38       |
|              | ITEM 12.    | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters.                    | 38       |
|              | ITEM 13.    | Certain  Relationships and Related Transactions, and Director Independence.                                          | 38       |
|              | ITEM 14.    | Principal  Accounting Fees and Services.                                                                             | 38       |
|              | ITEM 15.    | Exhibits,  Financial Statement Schedules.                                                                            | 38       |

 

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****PART I****

 

**ThisAnnual Report contains forward-looking statements as defined under the federalsecurities laws. Actual results could vary materially. Factors that could causeactual results to vary materially are described herein and in other documentswe file from time to time with the Securities and Exchange Commission. Althoughwe believe expectations reflected in such forward-looking statements arereasonable based upon the assumptions in this Annual Report, they may prove tobe inaccurate and consequently our actual results could differ materially fromour expectations set out in this annual report.**

 

****ITEM 1.****  ****BUSINESS.****

 

****HISTORY****

 

Weincorporated in Massachusetts in December 1982 and have beenpublicly-owned since November 1990. References to our Company containedherein include our two wholly-owned subsidiaries, Precise Medical, Inc.and Wood’s Precision Optics Corporation, Limited, except where the contextotherwise requires.

 

****OUR BUSINESS****

 

Wehave been a developer and manufacturer of advanced optical instruments since1982.  We design and produce high-qualitymedical instruments, optical thin film coatings, micro-optics withcharacteristic dimensions less than 1 mm and other advanced optical systems.Our medical instrumentation line includes laparoscopes, arthroscopes andendocouplers and a line of world-class 3-D endoscopes for use in minimallyinvasive surgical procedures. We are registered to the ISO 9001:2000, ISO13485:2003, and Canadian Medical Devices Conformity Assessment System, or CMDCAS,Quality Standards, and comply with the FDA Good Manufacturing Practices and theEuropean Union Medical Device Directive for CE marking of our medical products.Our website is www.poci.com. Information contained on our website does notconstitute part of this annual report.

 

****Principal Products and Services and Methods of Distribution********.****

 

MedicalProducts: Endoscopes and Image Couplers. We have manufactured, since 1982, medicalproducts including endoscopes, as well as image couplers, beamsplitters andadapters, all of which are used as accessories to endoscopes. We have developedand sold endoscopes incorporating various optical technologies for use in avariety of minimally invasive surgical and diagnostic procedures. Our currentline of specialized endoscopes include arthroscopes, which are used in jointsurgery, laryngoscopes, which are used in the diagnosis of diseases of thelarynx, laparoscopes, which are used in abdominal surgery, ENT scopes, whichare used for ear, nose and throat procedures, and stereo endoscopes andcameras, which are used in cardiac and general surgery and enable surgeons tovisualize the surgical field in 3-D imagery.

 

Weproduce autoclavable endoscopes for various applications, which are CE markcertified for European use, and have been designed and tested to withstandsterilization by autoclave which is sterilization in a superheated steam underpressure, as well as all other commonly used medical sterilization means. Themajor benefits of instruments that can be autoclaved include increased patientsafety, quick turnaround, and elimination of hazardous sterilant and by-productmaterials, all of which provide increased value to the user compared toalternative sterilization methods.

 

Since1985, we developed, manufactured and sold a proprietary product line ofinstrumentation to couple endoscopes to video cameras. Included in this productline are imaging couplers. For example, the Series 200 Parfocal ZoomCouplers and the Series 950 Universal Couplers, which physically connectthe endoscope to a video camera system and transmit the image viewed throughthe scope to the video camera. Our Series 800 Beamsplitters perform thesame function while preserving for the viewer an eye port for direct,simultaneous viewing through the endoscope. These devices are sold primarily toendoscope and video camera manufacturers and suppliers for resale under ourcustomers’ names. All of the image couplers and beamsplitters that wemanufacture are approved for surgery-approved sterilization. We believe we areone of only a few manufacturers of autoclavable image couplers worldwide.

 

MedicalProducts: Next Generation Lenslock TM Endoscopes. We continue to develop and ship our nextgeneration endoscopes that incorporate our leading proprietary Lenslock TM technology (patent pending). Since December 2005, we have shippedover 400 ENT endoscopes with diameter of 2.7 mm that incorporate Lenslock TM technology. We recentlycompleted prototypes of our 4 mm Lenslock TM sinuscope, and 5 mm Lenslock TM laproscope, and are 

 

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activelypursuing development of our new 4 mm Lenslock TM wide field arthroscope. We believe that LenslockTM technology has advantages over competitiveproducts due to ease of manufacture and repair, superior image quality,significant cost effectiveness and quality of repair and that furtherincorporating this into our endoscope product line could lead to increasedsales of this product.

 

MedicalProducts: Sub-millimeter optics & endoscopes. Utilizing recently developed proprietarytechniques, including patent pending micro-precision TM lens fabrication technology, we design andmanufacture ultra-small lenses, prisms and assemblies with sizes as small as0.2 mm. Assemblies range in complexity from the combination of two lenselements to entire imaging systems utilizing multiple micro-optical elements incombination with larger, conventional optics. Developments in medicalprocedures requiring minimally invasive visualization in very small spaces, insuch specialties as spinal surgery, neurosurgery, cardiothoracic surgery,cardiology and pulmonology, have led to products requiring lenses andendoscopes as small as 0.2 millimeters in diameter. Utilizing our proprietarytechnology, we currently manufacture a number of products with length and/ordiameter less than 1 mm and are actively expanding our product line in thisarea.

 

MedicalProducts: Custom design & device production. We design prototypes and manufacture customoptical medical products to satisfy our customers’ specific requirements.During fiscal year 2007, we completed development and began shipments of anadvanced surgical visualization system to a significant new customer. We havereceived initial follow-on orders for delivery in fiscal year 2009.  The size and extent of future follow-onorders will depend on market acceptance and other considerations.

 

IndustrialProducts. In additionto our medical products, we also sell components and assemblies such as imagecouplers and beamsplitters specially designed for industrial use, including thevideo-monitored examination of a variety of industrial cavities and interiors,as well as specialized borescopes for industrial applications. Utilizingmicro-precision TM technology, we also design and manufacturesub-millimeter optical components and assemblies for industrial use.

 

NightVision Optics. Wecontinue to pursue a partnership effort for the proprietary development of anew class of color night vision devices including a new patent-pending eyepiecelens. With a second round of prototypes nearing completion, it is expected thatthe product incorporating our new night vision lenses will be evaluated by theU.S. government in the near future. We cannot control the timing of currentevaluations and cannot therefore predict when, if ever, these night visionlenses might begin to generate revenue.

 

OpticalSystem Design and Development Services. We are able to provide customers with advanced lens design, imaginganalysis, optical system design, structural design and analysis, prototypeproduction and evaluation, optics testing, and optical system assembly. Some ofour efforts have led to optical system production business for our Company, andwe believe our prototype development service may lead to new product productionfrom time to time.

 

****Competition and Markets********.****

 

Wesell our products in a highly competitive market and we compete for businesswith both foreign and domestic manufacturers. Many of our current competitorsare larger and have substantially greater resources than we do. In addition,there is an ongoing risk that other domestic or foreign companies who do notcurrently service or manufacture products for our target markets, some withgreater experience in the optics industry and greater financial resources than wehave, may seek to produce products or services that compete directly with ours.

 

Webelieve that competition for sales of our medical products and services, whichhave been principally sold to medical device companies who incorporate ourproducts into their systems, is based on performance and other technicalfeatures, as well as other factors, such as scheduling and reliability, inaddition to competitive pricing. We market and sell our endoscopes to customersfor incorporation into their own product lines and for resale under their ownname. A number of domestic and foreign competitors also sell endoscopes to tothese customers and our share of the endoscope market is nominal. We believethat, while our resources are substantially more limited than those of ourcompetitors, we can compete successfully in this market on the basis of productquality, price, delivery and innovation.

 

Wecurrently sell our image couplers, beamsplitters and adapters to a market thatconsists of approximately 30 to 35 potential customers who manufacture and sellvideo cameras, endoscopes and video-endoscopy systems. In the past, we havebeen successful in marketing and selling our products to approximatelytwo-thirds of these customers, and currently estimate that we maintainapproximately 20% to 30% of the market share in these products. We plan tocontinue to focus our sales and marketing efforts in this area, and to work toincrease our market share. However, a challenge we face is customers’ ownin-house capabilities to manufacture such products.  We estimate that 

 

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approximately50% of the market demand for image couplers, beamsplitters and adapters is metby these “captive” facilities. In general, and despite in-house capacity, webelieve that many customers continue to purchase products from us in order todevote their own technical resources to their primary products, such as camerasor endoscopes.

 

**Marketing****.**

 

InMay 2006, we initiated efforts to update our sales and marketingactivities.  As part of these efforts, wegenerated new marketing materials for recently developed products, including anewly designed website, www.poci.com. Since initiating these efforts, we have taken a much more comprehensiveview of trade show opportunities, targeting those with specific relevance torecently developed products. Coupled with the recently renewed efforts forselect key trade show attendance by our Chief Scientific Officer as well as ouroverall sales and marketing staff, we believe we have a greater opportunity toreach and follow up a broader customer base than we have previously been ableto achieve. These efforts have contributed to recent year-over-year revenueincreases, and continue to generate prospects for our leading technologiesincluding, Lenslock TM,micro-precision TM,and custom applications of our core optical capabilities. This includes renewedinterest in some of our well-developed products such as our “classic”autoclavable endoscopes and endocouplers, as well as new applications with ourmicro (fiberoptic) endoscopes.

 

**International Business****.**

 

Wehave had negligible direct export sales to date. However, our medical productshave received the CE Mark Certification, which permits sales into the Europeanmarketplace. We may establish or use production facilities overseas to producekey components for our business, such as lenses. Since the 1990s we havemaintained a Hong Kong subsidiary to support business and quality controlactivities as required throughout Asia. We believe that the cost savings fromsuch production may be essential to our ability to compete on a price basis inthe medical products area particularly and to our profitability generally.

 

****Research and Development********.****

 

Webelieve that our future success depends to a large degree on our ability tocontinue to conceive and develop new optical products and services to enhancethe performance characteristics and methods of manufacture of existingproducts. Accordingly, we expect to continue to seek to obtain product-relateddesign and development contracts with customers and to invest our own funds onresearch and development. We spent $757,852 and $1,312,240 of our own funds,net of reimbursements, during fiscal years 2008 and 2007, respectively, onresearch and development.

 

Weare currently incorporating our Lenslock TM technology(patent pending) into our line of endoscopes. This proprietary technologyensures lower cost, easier reparability and enhanced durability. We are alsoaggressively pursuing the design, development and manufacture of ultra-smallinstruments, some with lenses less than one millimeter in diameter, utilizingits micro-precision TM lens technology (patent pending).

 

****Raw Materials and Principal Suppliers********.****

 

Thebasic raw material of the majority of our product line is precision gradeoptical glass, which we obtain from a few suppliers, principally Schott andOhara. For optical thin film coatings, the basic raw materials we utilize aremetals and dielectric compounds, which we obtain from a variety of chemicalsuppliers. Certain of the thin film coatings utilized in our products arecurrently procured from an outside supplier, but most thin film coatings areproduced in-house. We believe that our demand for these raw materials and thinfilm coating services is small relative to the total supply, and that thematerials and services required for the production of our products arecurrently available in sufficient production quantities and will be availablefor fiscal year 2009. We believe, however, that there are relatively fewsuppliers of the high quality lenses and prisms, which our endoscopes require.In response, we have established our own optical shop for producing ultra-highquality prisms, micro-optics and other specialized optics for a variety ofmedical and industrial applications.

 

****Patents and Trademarks********.****

 

Werely, in part, upon patents, trade secrets and proprietary knowledge as well aspersonnel policies and employee confidentiality agreements concerninginventions and other creative efforts to develop and to maintain our 

 

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competitiveposition. We do not believe that our business is dependent upon any patent,patent pending or license, although we believe that trade secrets andconfidential know-how may be important to our scientific and commercialsuccess.

 

Weplan to file for patents, copyrights and trademarks in the United States and inappropriate countries to protect our intellectual property rights to the extentpracticable. We hold the rights to several United States and foreign patentsand have several patent applications pending, including those for our newgeneration of 3-D endoscopes, our Lenslock TM endoscopetechnology and our innovative micro-precision TM lenstechnology. These patents have expiration dates ranging from June 2009 to June 2028.  We know of no infringements of our patents.We plan to protect our patents from infringement in each instance where wedetermine that doing so would be economical in light of the expense involvedand the level and availability of our financial resources. While we believethat our pending applications relate to patentable devices or concepts, therecan be no assurance that patents will be issued or that any patents issued canbe successfully defended or will effectively limit the development ofcompetitive products and services.

 

****Employees********.****

 

Asof June 30, 2008, we had 17 full-time employees and 7 part-time employees.There were 13 employees in manufacturing, 6 in engineering/research anddevelopment, 1 in sales and marketing and 4 in finance and administration.  We are not a party to any collectivebargaining agreements.  We believe ourrelations with our employees are good.

 

****Customers********.****

 

Revenuesfrom our largest customers, as a percentage of total revenues, for fiscal years2008 and 2007 were as follows:

 
| **** **** | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|----------------|----------------|--------------|----------------|--------------|----------------|
| Customer A     |           | 25           | %              | 27           | %              |
| Customer B     |           | 20           |           | 22           |           |
| Customer C     |           | 11           |           | 10           |           |
| All Others     |           | 44           |           | 41           |           |
|           |           | 100          | %              | 100          | %              |

 

Noother customer accounted for more than 10% of our revenues in fiscal years 2008and 2007. At June 30, 2008, receivables from our largest customers were27%, 25% and 17% of the total accounts receivable.

 

****Environmental Matters********.****

 

Ouroperations are subject to a variety of federal, state and local laws andregulations relating to the discharge of materials into the environment orotherwise relative to the protection of the environment. From time to time weuse a small amount of hazardous materials in our operations. We believe that wecomply with all applicable environmental laws and regulations.

 

****Government Regulations on the Business********.****

 

DomesticRegulation. Wecurrently develop, manufacture and sell several medical products, the marketingof which is subject to governmental regulation in the United States. Medicaldevices are regulated in the United States by the Food and Drug Administration,or FDA, and, in some cases, by certain state agencies. The FDA regulates theresearch, testing, manufacture, safety, effectiveness, labeling, promotion anddistribution of medical devices in the United States. Generally, medicaldevices require clearance or approval prior to commercial distribution.Additionally, certain material changes to, and changes in intended use of,medical devices also are subject to FDA review and clearance or approval.Non-compliance with applicable requirements can result in failure of the FDA togrant pre-market clearance or approval, withdrawal or suspension of approval,suspension of production, or the imposition of various other penalties.

 

Wenotified the FDA of our intent to market our endoscopes, image couplers,beamsplitters, adapters and video ophthalmoscopes, and the FDA has determinedthat we may market such devices, subject to the general controls provisions ofthe Food, Drug and Cosmetic Act. This FDA permission was obtained without theneed to undergo a 

 

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lengthyand expensive approval process due to the FDA’s determination that such devicesmeet the regulatory standard of being substantially equivalent to an existingapproved device.

 

Inthe future, we plan to market additional endoscopes and related medical productsthat may require the FDA’s permission to market such products. We may alsodevelop additional products or seek to sell some of our current or futuremedical products in a manner that requires us to obtain the permission of theFDA to market such products, as well as the regulatory approval or license ofother federal, state and local agencies or similar agencies in other countries.The FDA has authority to conduct detailed inspections of manufacturing plantsin order to assure that “good manufacturing practices” are being followed inthe manufacture of medical devices, to require periodic reporting of productdefects to the FDA and to prohibit the sale of devices which do not comply withlaw.

 

ForeignRequirements. Salesof medical device products outside the United States are subject to foreignregulatory requirements that may vary from country to country. Our failure tocomply with foreign regulatory requirements would jeopardize our ability tomarket our products in foreign jurisdictions. The regulatory environment in theEuropean Union for medical device products differs from that in the UnitedStates. Medical devices sold in the European Economic Area must bear the CEmark. Devices are classified by manufacturers according to the risks they represent,with a classification of Class III representing the highest risk devicesand Class I representing the lowest risk devices. Once a device has beenclassified, the manufacturer can follow one of a series of conformityassessment routes, typically through a registered quality system, anddemonstrate compliance to a “European Notified Body.” The CE mark may then beapplied to the device. Maintenance of the system is ensured through annualon-site audits by the notified body and a post-market surveillance systemrequiring the manufacturer to submit serious complaints to the appropriategovernmental authority. All of our medical products are CE mark certified.

 

****ITEM 1A.  RISK FACTORS.****

 

Aninvestment in our common stock involves a substantial degree of risk.  Beforemaking an investment decision, you should give careful consideration to thefollowing risk factors in addition to the other information contained in thisannual report.  The following risk factors, however, may not reflect allof the risks associated with our business or an investment in our common stock. You should invest in our Company only if you can afford to lose yourentire investment.

 

**RISKS RELATED TO OUR BUSINESS**

 

****Our quarterly financial results depend on a large number offactors and therefore may vary quarter to quarter, As a result, we cannotpredict with a high degree of certainty our operating results in any particularfiscal quarter.****

 

Ourquarterly operating results may vary significantly depending upon factors suchas:

 

·                                         the timing of completion of significantorders;

 

·                                         the timing and amount of our research anddevelopment expenditures;

 

·                                         the costs of initial product production inconnection with new products;

 

·                                         the timing of new product introductions –both by us and by our competitors;

 

·                                         the timing and level of market acceptance ofnew products or enhanced versions of our existing products;

 

·                                         our ability to retain existing customers andcustomers’ continued demand for our products and services;

 

·                                         our customers’ inventory levels, and levelsof demand for our customers’ products and services; and

 

·                                         competitive pricing pressures.

 

Wecannot be certain whether we will be able to grow or sustain revenues orachieve or maintain profitability on a quarterly or annual basis or that levelsof revenue and/or profitability may not vary from one such period to another.

 

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***Our independent auditors have issueda going concern opinion and, if we do not generate enough cash from operationsto sustain our business, we may have to liquidate assets or curtail ouroperations.***

 

The accompanying financial statements have beenprepared assuming we will continue as a going concern.  During the years ended June 30, 2008 and2007, we incurred net losses of $1,623,354 and $2,889,829, respectively.  Our auditors have issued a going concernqualification in their opinion related to our financial statements issued withthis 2008 annual report on Form 10-K.  This opinion is based upon our history ofoperating losses, negative cash flows from operations, and our cash position asof June 30, 2008.

 

Conditions exist which raise substantial doubt aboutour ability to continue as a going concern. Our ability to continue as a going concern is dependent upon our abilityto generate sufficient cash flows to meet our obligations on a timely basis, toobtain additional financing as may be required, and ultimately to attainprofitable operations.  However, we maynot be able to obtain additional financing or achieve profitable operations orsufficient cash flows in the future.

 

***Our existing and future debtobligations could impair our liquidity and financial condition.***

** **

As of June 30, 2008, we had outstanding notespayable of $600,000, and we may incur additional debt in the future to fund allor part of our capital requirements. Effective June 25, 2008, we completed a financing whereby we issued10% senior secured convertible notes and warrants.  Our outstanding debt and future debtobligations could impair our liquidity and could:

 

·                 make it more difficult for us to satisfy our other obligations;

 

·                 require us to dedicate a substantial portion of any cash flow we maygenerate to payments on our debt obligations, which would reduce theavailability of our cash flow to fund working capital, capital expenditures andother corporate requirements;

 

·                 impede us from obtaining additionalfinancing in the future for working capital, capital expenditures, acquisitionsand general corporate purposes; and

 

·                 make us more vulnerable in the event of adownturn in our business prospects and limit our flexibility to plan for, orreact to, changes in our industry.

 

If we were to fail in the future to make any requiredpayment under agreements governing indebtedness, or equity issues, or fail tocomply with the financial and operating covenants contained in thoseagreements, we would be in default in regards to that financingtransaction.  A debt default couldsignificantly diminish the market value and marketability of our commonstock.  Our lenders would have theability to require that we immediately pay all outstanding indebtedness, and wemight not have sufficient assets to satisfy their demands.  In this event, we may be forced to seekprotection under bankruptcy laws, which could harm our future operations andoverall financial condition.

 

****We rely on a small number of customers and cannot be certainthey will consistently purchase our products in the future.****

 

Inthe fiscal year ended June 30, 2008, our three largest customersrepresented approximately 25%, 20% and 11%, respectively, of our totalrevenues. In the fiscal year ended June 30, 2007, our three largestcustomers represented approximately 27%, 22% and 10%, respectively, of ourtotal revenues. No other customer accounted for more than 10% of our revenuesduring those periods. At June 30, 2008, receivables from our three largestcustomers were 27%, 25% and 17%, respectively, of the total accountsreceivable.

 

Inthe future, a small number of customers may continue to represent a significantportion of our total revenues in any given period. We cannot be certain thatsuch customers will consistently purchase our products at any particular rateover any subsequent period.  A loss ofthese customers could adversely affect our financial performance.

 

****We rely heavily upon the talents of our Chief ExecutiveOfficer and Chief Scientific Officer, the loss of whom could severely damageour business.****

 

Ourperformance depends to a large extent on a small number of key scientific,technical, managerial and marketing personnel. In particular, we believe oursuccess is highly dependent upon the services and reputation of our ChiefExecutive Officer, Mr. Richard E. Forkey. Loss of Mr. Forkey’sservices could severely damage our business.

 

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Additionally,Dr. Joseph N. Forkey, our Executive Vice President and Chief ScientificOfficer, provides highly valuable contributions to our capabilities in opticalinstrument development, in management of new technology and in potentiallysignificant longer-term initiatives in biophysics and biomedicalinstrumentation. The loss of Dr. Forkey’s scientific contributions couldseverely damage our business.

 

****We must continue to be able to attract employees with thescientific and technical skills that our business requires and if we areunable to attract and retain such individuals, our business could be severelydamaged.****

 

Ourability to attract employees with a high degree of scientific and technicaltalent is crucial to the success of our business. There is intense competitionfor the services of such persons, and we cannot guarantee that we will be ableto attract and retain individuals possessing the necessary qualifications.

 

****We have a number of large, well-financed competitors who haveresearch and marketing capabilities that are superior to ours.****

 

Theindustries in which we compete are highly competitive. Many of our existing andpotential competitors have greater financial resources and manufacturingcapabilities, more established and larger marketing and sales organizations andlarger technical staffs than we have. Other companies, some with greaterexperience in the telecommunications, optics, semiconductor or medical productsindustries, are seeking to produce products and services that compete with ourproducts and services.

 

****We are subject to a high degree of regulatory oversight andwe cannot be certain that we will continue to receive the necessary regulatoryapprovals.****

 

TheFDA has allowed us to market the medical products we currently sell in theUnited States. However, prior FDA approval may be required before we can marketadditional medical products that we may develop in the future. We may also seekto sell current or future medical products in a manner that requires us toobtain FDA permission to market such products. We may also require theregulatory approval or license of other federal, state or local agencies orcomparable agencies in other countries.

 

Wecannot be certain that we will continue to receive the FDA’s permission tomarket our current products or obtain the necessary regulatory permission,approvals or licenses for the marketing of any of our future products. Also, wecannot predict the impact on our business of FDA regulations or determinationsarising from future legislation or administrative action.

 

****We face risks inherent in product development and productionunder fixed price purchase orders and we cannot be sure that these purchaseorders will be profitable over time.****

 

Aportion of our business has been devoted to research, development andproduction under fixed price purchase orders. For our purposes, a fixed pricepurchase order is any purchase order under which we will provide products orservices for a fixed price over an extended period of time, usually six monthsor longer.  Fixed price purchase ordersrepresented approximately 25% to 50% of our total revenues during the lastseveral years. We expect that revenues from fixed price purchase orders willcontinue to represent a significant portion of our total revenues in futurefiscal years.

 

Becausethey involve performance over time, we cannot predict with certainty theexpenses involved in meeting our obligations under fixed price purchase orders.Therefore, we can never be sure at the time we enter into any single fixedprice purchase order that such purchase order will be profitable for us.

 

****Third parties may infringe on our patents and as aresult, we could incur significant expense in protecting our patents or nothave sufficient resources to protect them.****

 

Wehold a number of patents that are important to our business. Although we arenot currently aware of any past or present infringements of our patents, weplan to protect these patents from infringement and obtain additional patentswhenever feasible. To this end, we have obtained confidentiality agreementsfrom our employees and consultants and others who have access to the design ofour products and other proprietary information. Protecting and obtainingpatents, however, is both time consuming and expensive. We therefore may nothave the resources necessary to assert all potential patent infringement claimsor pursue all patents that might be available to us.

 

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****Third parties may claim that we have infringed on theirpatents and as a result, we could be prohibited from using all or part ofany technology used in our products.****

 

Shouldthird parties claim a proprietary right to all or part of any technology thatwe use in our products, such a claim, regardless of its merit, could involve usin costly litigation. If successful, such a claim could also result in us beingunable to freely use the technology that was the subject of the claim, or sellproducts embodying such technology.

 

****We depend on the availability of certain key supplies andservices that are available from only a few sources; if we experiencedifficulty with a supplier, we may have difficulty finding alternative sourcesof supply.****

 

Certainkey supplies used in our products, particularly precision grade optical glass,are available from only a few sources, each of which is located outside theUnited States. Also, outside vendors grind and polish certain of our lenses andother optical components, such as prisms and windows. Based upon our orderingexperience to date, we believe the materials and services required for theproduction of our products are currently available in sufficient quantities.Our requirements are small relative to the total supply, and we are notcurrently encountering problems with availability. However, this does not meanthat we will continue to have timely access to adequate supplies of essentialmaterials and services in the future or that supplies of these materials andservices will be available on satisfactory terms when the need arises. Ourbusiness could be severely damaged if we become unable to procure essentialmaterials and services in adequate quantities and at acceptable prices.

 

Fromtime to time, subcontractors may produce certain of our products for us, andour business is subject to the risk that these subcontractors fail to maketimely delivery. Our products and services are also from time to time used ascomponents of the products and services of other manufacturers. We aretherefore subject to the risk that manufacturers that integrate our products orservices into their own products or services are unable to acquire essentialsupplies and services from third parties in a timely fashion.

 

****Our customers may claim that the products we sold them weredefective and if our insurance is not sufficient to cover a claim, wewould be liable for the excess.****

 

Likeany manufacturer, we are and always have been exposed to liability claimsresulting from the use of our products. We maintain product liability insuranceto cover us in the event of liability claims, and as of September 26,2008, no such claims have been asserted or threatened against us. However, wecannot be certain that our insurance will be sufficient to cover all possiblefuture product liabilities.

 

****We would be liable if our business operations harmed theenvironment and a failure to maintain compliance with environmental lawscould severely damage our business.****

 

Ouroperations are subject to a variety of federal, state and local laws andregulations relating to the protection of the environment.  From time to time, we use hazardous materialsin our operations. Although we believe that we are in compliance with allapplicable environmental laws and regulations, our business could be severelydamaged by any failure to maintain such compliance.

 

**RISKSRELATED TO OUR STOCK**

** **

***Trading in our common stock is limited and the price of our commonstock may be subject to substantial volatility.***

 

Our common stock wasdelisted from the NASDAQ Capital Market at the opening of business on December 27,2005, and is now traded on the Over-The-Counter Bulletin Board, or OTCBB, underthe ticker symbol “POCI.OB,” where we expect our common stock to remain for thenear future. Broker-dealers often decline to trade in OTCBB stocks given themarket for such securities is often limited, the stocks are more volatile andthe risk to investors is greater. These factors may reduce the potential marketfor our common stock by reducing the number of potential investors. This maymake it more difficult for investors in our common stock to sell shares tothird parties or to otherwise dispose of their shares. This could cause ourstock price to decline.

 

Additionally, the price ofour common stock may be volatile as a result of a number of factors, including,but not limited to, the following:

 

·                 our ability to successfully conceive and todevelop new products and services to enhance the performance characteristicsand methods of manufacture of existing products;

 

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·                 our ability to retain existing customers andcustomers’ continued demand for our products and services;

 

·                 the timing of our research and developmentexpenditures and of new product introductions;

 

·                 the timing and level of acceptance of newproducts or enhanced versions of our existing products; and

 

·                 price and volume fluctuations in the stockmarket at large which do not relate to our operating performance.

 

***“Pennystock” rules may make buying or selling our securities difficult which maymake our stock less liquid and make it harder for investors to buy and sell oursecurities.***

 

Trading in our securities is subject to the SEC’s “penny stock” rules and it is anticipated that trading in our securities will continue to be subject to the penny stock rules for the foreseeable future.  The SEC has adopted regulations that generally define a penny stock to be any equity security that has a market price of less than $5.00 per share, subject to certain exceptions. These rules require that any broker-dealer who recommends our securities to persons other than prior customers and accredited investors must, prior to the sale, make a special written suitability determination for the purchaser and receive the purchaser’s written agreement to execute the transaction.  Unless an exception is available, the regulations require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the risks associated with trading in the penny stock market.  In addition, broker-dealers must disclose commissions payable to both the broker-dealer and the registered representative and current quotations for the securities they offer.  The additional burdens imposed upon broker-dealers by these requirements may discourage broker-dealers from recommending transactions in our securities, which could severely limit the liquidity of our securities and consequently adversely affect the market price for our securities.

 

***We are contractually obligated to issueshares in the future, diluting your interest in us.***

 

Asof August 15, 2008, there were approximately 2,430,080 shares of ourcommon stock issuable upon exercise of stock options outstanding, at a weightedaverage exercise price of $0.63 per share. An additional 3,427,438 shares ofour common stock are reserved for issuance under our 2006 Equity Incentive Planas of August 15, 2008. Also outstanding as of August 15, 2008 arewarrants for the issuance of an additional 22,471,577 shares of our commonstock, at a weighted average exercise price of $0.17 per share.  Moreover, we expect to issue additionaloptions to purchase shares of our common stock to compensate employees, consultantsand directors, and we may issue additional shares to raise capital. Any suchissuances will have the effect of further diluting the interest of the holdersof our securities.

 

****ITEM 2.****  ****PROPERTIES.****

 

Weconduct our domestic operations at two facilities in Gardner, Massachusetts.The main Gardner facility is leased from a corporation owned by an individualwho is one of our officers, and who serves on our board of directors. The leaseterminated in December 1999 and we are currently a tenant-at-will. We rentthe other Gardner facility on a month-to-month basis. We rent office space inHong Kong for sales, marketing and supplier quality control and liaisonactivities of our Hong Kong subsidiary.

 

Webelieve these facilities are adequate for our current operations and adequatelycovered by insurance. Significant increases in production or the addition ofsignificant equipment additions or manufacturing capabilities in connectionwith the production of our line of endoscopes, optical thin films and otherproducts may, however, require the acquisition or lease of additionalfacilities. We may establish production facilities domestically or overseas toproduce key assemblies or components, such as lenses, for our products.Overseas facilities may subject us to the political and economic risks associatedwith overseas operations. The loss of or inability to establish or maintainsuch additional domestic or overseas facilities could materially adverselyaffect our competitive position and profitability.

 

****ITEM 3.****  ****LEGAL PROCEEDINGS.****

 

Wemay be involved from time to time in ordinary litigation, negotiation andsettlement matters that will not have a material effect on our operations orfinances. We are not aware of any pending or threatened litigation against usor our officers and directors in their capacity as such that could have amaterial impact on our operations or finances.

 

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****ITEM 4.****  ****SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS.****

 

Nomatters were submitted to a vote of our security holders during the fourthquarter of fiscal year 2008.

 

****PART II****

 

****ITEM 5.****  ****MARKET FOR REGISTRANT’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.****

 

**Market Information**

 

Ourcommon stock is quoted on the OTCBB under the symbol “POCI.OB.” The followingtable sets forth the high and low bid prices for our common stock for eachquarter during the last two fiscal years as quoted on the OTCBB. Such OTCBBmarket quotations reflect inter-dealer prices, without retail markup, markdownor commissions and may not necessarily represent actual transactions.

 
| **** **** | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|----------------|----------------|--------------|----------------|--------------|----------------|
| **Quarter**    | ** **     | **High**     | ** **     | **Low**      | ** **     | **High** | ** ** | **Low** | ** ** |
|           |           |         |           |         |           |   |   |   |   |
| First          |           | $            | 0.40           |         | $              | 0.20 |   | $ | 0.49 |   | $ | 0.25 |   |
|           |           |         |           |         |           |   |   |   |   |
| Second         |           | $            | 0.35           |         | $              | 0.12 |   | $ | 0.49 |   | $ | 0.25 |   |
|           |           |         |           |         |           |   |   |   |   |
| Third          |           | $            | 0.24           |         | $              | 0.11 |   | $ | 0.60 |   | $ | 0.32 |   |
|           |           |         |           |         |           |   |   |   |   |
| Fourth         |           | $            | 0.20           |         | $              | 0.10 |   | $ | 0.50 |   | $ | 0.32 |   |

 

**Holders**

 

Asof August 31, 2008, we had approximately 80 holders of record of ourcommon stock. Holders of record include nominees who may hold shares on behalfof multiple owners.

 

**Dividends**

 

Wehave not declared any dividends during the last two fiscal years. At present,we intend to retain our earnings, if any, to finance research and developmentand expansion of our business.

 

**Recent Sales of Unregistered Securities; Use of Proceeds fromRegistered Securities**

 

OnJune 25, 2008, we entered into a Purchase Agreement with institutional andother accredited investors pursuant to which we sold an aggregate of $600,000of 10% Senior Secured Convertible Notes, or Notes, which are convertible intoan aggregate of 12,000,000 shares of our common stock, par value $0.01 pershare, at a conversion price of $0.05 per share, and warrants to purchase anaggregate of 7,920,000 shares of our common stock at an exercise price of $0.07per share. The investors are current stockholders of our Company. Interestaccrues on the Notes at a rate of 10% per annum and is payable upon the earlierof conversion or maturity of the Notes. The Notes mature on June 25, 2010,and the warrants expire on June 25, 2015. The Notes and warrants are notconvertible or exercisable until we implement a reverse stock split, whichrequires the approval of our stockholders and the effectiveness of an amendmentto our Articles of Organization to effect the reverse stock split. The closingof the sale of the Notes and warrants occurred on June 25, 2008.

 

ThePurchase Agreement contains customary representations and warranties made by usand the investors, and the Notes contain customary covenants binding on ourCompany and customary events of default. If an event of default occurs and isuncured within the allowable grace period, if any, the investors may declare allamounts under the Notes immediately due and payable and may pursue any otheravailable remedies.

 

TheNotes are secured by a pledge of our assets under the terms of a Pledge andSecurity Agreement and the security documents ancillary thereto.

 

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Pursuantto a Registration Rights Agreement entered into with the investors on June 25,2008, we agreed to file a registration statement with the Securities andExchange Commission by the earlier of (i) two **** ****daysfollowing the effectiveness of the amendment to implement a reverse stock splitand (ii) December 15, 2008, to register the resale of the commonstock issuable upon the conversion of the Notes and the exercise of thewarrants, plus the common stock issuable in lieu of cash interest on the Notes.We also agreed to use our commercially reasonable efforts to have theregistration statement declared effective as soon as practicable after filingand agreed to take certain other actions related to the effectiveness of theregistration statement.

 

OnFebruary 1, 2007, we sold an aggregate of 10,000,000 shares of commonstock, par value $0.01 per share, at a price of $0.25 per share and warrants topurchase an aggregate of 10,000,000 shares of common stock at an exercise priceof $0.32 per share, which were immediately exercisable, raising gross proceedsof $2,500,000. In conjunction with our issuance of Notes and warrants on June 25,2008, certain anti-dilution provisions of the existing warrants were triggered.As a result, the number of existing warrants was increased from 10,000,000 to14,551,577 and the related exercise price was decreased from $0.32 per share to$0.22 per share. All of the following shares of common stock issued were issuedin a non-registered transaction:

 
| ****Purchaser****                             | **** **** | ****Common Stock********Purchased***** | **** **** |
|-----------------------------------------------|----------------|---------------------------------------------|----------------|
|                                          |           |                                        |           |
| Special Situations Fund III QP, L.P.          |           | 9,820,631                                   |           |
| Special Situations Private Equity Fund,  L.P. |           | 9,820,631                                   |           |
| Joel Pitlor (a)                               |           | 2,455,157                                   |           |
| Arnold Schumsky                               |           | 1,473,095                                   |           |
| LaPlace Group LLC                             |           | 982,063                                     |           |

 

* Includes shares of common stock and shares underlying outstandingwarrants

 

(a) Mr.Pitlor is one of our directors

 

The10,000,000 shares issued on February 1, 2007 and the 10,000,000 shares ofcommon stock issuable upon the exercise of the warrants issued on February 1,2007 were subsequently registered on a registration statement on a Form SB-2,which was declared effective by the Securities and Exchange Commission on March 23,2007.

 

Withrespect to the issuances of our securities described above, we relied on the Section 4(2) exemptionfrom securities registration under the federal securities laws for transactionsnot involving any public offering. No advertising or general solicitation wasemployed in offering the securities. The securities were issued to accreditedinvestors. The securities were offered for investment purposes only and not forthe purpose of resale or distribution and the transfer thereof was appropriatelyrestricted by us.

 

****ITEM 6.  SELECTEDFINANCIAL DATA.****

 

Becausewe are a smaller reporting company, we are not required to provide theinformation required by this Item.

 

****ITEM 7.****  ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS****

 

****Important Factors Regarding Forward-Looking Statements****

 

Thisannual report on Form 10-K contains forward-looking statements thatinvolve risks and uncertainties.  You should not place undue reliance onthese forward-looking statements.  Our actual results could differmaterially from those anticipated in the forward-looking statements for manyreasons, including the risks described in this report and other reports we filewith the Securities and Exchange Commission.  Although we believe theexpectations reflectedin the forward-looking statements are reasonable, theyrelate only to events as of the date on which the statements aremade.  We do not intend to update any of the forward-looking statements afterthe date of this document to conform these statements to actual results or tochanges in our expectations, except as required by law.

 

The following discussion and analysis should be read in conjunctionwith the Financial Statements and Notes thereto, and other financialinformation included elsewhere in this annual report on Form 10-K.

 

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****Overview****

 

Wehave been a developer and manufacturer of advanced optical instruments since1982.  We design and produce high-qualitymicro-optics, medical instruments and other advanced optical systems.  Our medical instrumentation line includeslaparoscopes, arthroscopes and endocouplers and a world-class product line of3-D endoscopes for use in minimally invasive surgical procedures.

 

Weare currently developing specialty instruments incorporating our Lenslock TM technology (patent pending) that ensures lower cost, easierreparability and enhanced durability as compared to other design approachesused in the industry.  We are alsoaggressively pursuing ultra-small instruments, some with lenses less than onemillimeter in diameter, utilizing micro-precision TM lenstechnology (patent pending).

 

Weare certified to the ISO 9001 and ISO 13485 Quality Standards and comply withthe FDA Good Manufacturing Practices and the European Union Medical DeviceDirective for CE marking of our medical products. Our internet website iswww.poci.com. Information contained on our website does not constitute part ofthis annual report.

 

Theareas in which we do business are highly competitive and include both foreignand domestic competitors. Many of our competitors are larger and havesubstantially greater resources than we do. Furthermore, other domestic orforeign companies, some with greater financial resources than we have, may seekto produce products or services that compete with ours. We routinely outsourcespecialized production efforts as required, both domestic and offshore, toobtain the most cost effective production. Over the years, we have achievedextensive experience with other optical specialists worldwide.

 

Sincethe 1990s we have maintained a Hong Kong subsidiary to support business andquality control activities as required throughout Asia. We believe that thecost savings from such production is essential to our ability to compete on aprice basis in the medical products area particularly and to our profitabilityin general.

 

Webelieve that competition for sales of our medical products and services, whichhave been principally sold to original equipment manufacturer, or OEM,customers, is based on performance and other technical features, as well asother factors, such as scheduling and reliability, in addition to competitiveprice.

 

Webelieve that our future success depends to a large degree on our ability tocontinue to conceive and to develop new optical products and services toenhance the performance characteristics and methods of manufacture of existingproducts. Accordingly, we expect to continue to seek to obtain product-relateddesign and development contracts with customers and to invest our own funds onresearch and development, to the extent funds are available.

 

****Critical Accounting Policies and Estimates****

 

****General****

 

Management’sdiscussion and analysis of financial condition and results of operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America, referred to as U.S. GAAP. The preparation of these consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses. We base ourestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

 

Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our consolidated financialstatements.

 

****Revenue Recognition****

 

Werecognize revenue in accordance with the Securities and Exchange CommissionStaff Accounting Bulletin (“SAB”) No. 104, **Revenue Recognition in FinancialStatements.**SAB No. 104 requires that four basic criteriamust be met before revenue can be recognized: (1) persuasive evidence ofan arrangement exists; (2) delivery has occurred or services rendered; (3) theprice to the buyer is fixed or determinable; and (4) collectability isreasonably assured. Determination of criteria (3) and (4) are basedon management’s judgments regarding the fixed nature of the price to the buyercharged for products delivered or services rendered and collectability of thesales price. We assess credit worthiness of customers based upon prior historywith the customer and assessment of financial condition. Our shipping terms arecustomarily Free On Board, or FOB, shipping point.

 

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****Bad Debt****

 

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. Allowances fordoubtful accounts are established based upon review of specific accountbalances and historical experience. If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to make futurepayments, additional allowances may be required.

 

****Inventories****

 

Weprovide for estimated obsolescence on unmarketable inventory based uponassumptions about future demand and market conditions. If actual demand andmarket 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 consideredpermanent adjustments to the carrying value of the inventory.

 

****Impairment of Long-Lived Assets and Long-Lived Assetsto be Disposed of****

 

Weaccount for impairment of long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, **Accounting for the Impairment or Disposalof Long-Lived Assets.**This statement requires that long-livedassets and certain identifiable intangibles be reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and used ismeasured by a comparison of the carrying amount of an asset to undiscountedfuture net cash flows expected to be generated by the asset. If such assets areconsidered to be impaired, the impairment to be recognized is measured by theamount by which the carrying amount of the assets exceeds the fair value of theassets. Assets to be disposed of are reported at the lower of the carryingamount or fair value less estimated costs to sell.

 

****Income Taxes****

 

Incometaxes are accounted for under the asset and liability method. Deferred taxassets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and operatingloss and tax credit carry forwards. Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period that includes the enactment date.

 

Inassessing the likelihood of utilization of existing deferred tax assets,management has considered historical results of operations and the currentoperating environment.

 

****Stock-Based Compensation****

 

OnJuly 1, 2006, we adopted SFAS No. 123(R), **Accounting for Stock-Based Compensation**(“SFASNo. 123(R)”), which requires the measurement and recognition of allcompensation costs for all stock-based awards made to employees and the Boardof Directors based upon fair value over the requisite service period for awardsexpected to vest. Prior to adoption, we accounted for stock options under theintrinsic value method set in accordance with Accounting Principles BoardOpinion No. 25, “ **Accounting for Stock Issued to Employees,**”and related interpretations, and provided the required pro forma disclosuresprescribed by SFAS No. 123, “ **Accounting for Share-based Compensation**“(“SFAS No. 123”), as amended.

 

SFAS123(R) requires us to estimate the fair value of share-based awards on thedate of grant using an option-pricing model. We adopted SFAS 123(R) usingthe modified prospective transition method which required the application ofthe accounting standard starting July 1, 2006, the first day of our fiscalyear 2007. Prior period information has not been restated to reflect the fairvalue method of expensing share-based awards.

 

**Recent Accounting Pronouncements**

 

InDecember 2007, the FASB issued SFAS No. 141 (revised 2007), *Business Combinations* (SFAS No. 141(R)),which replaces SFAS No. 141. SFAS No. 141(R) establishesprinciples and requirements for how an acquirer in a business combinationrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any controlling interest; recognizes andmeasures the goodwill acquired in the business combination or a gain from abargain purchase; and determines what information to disclose to enable usersof the 

 

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financialstatements to evaluate the nature and financial effects of the businesscombination. SFAS No. 141(R) is tobe applied prospectively to business combinations for which the acquisitiondate is on or after an entity’s fiscal year that begins after December 15,2008, or July 1, 2009 for our Company. The impact of this Statement on ourfinancial position, results of operations and cash flows will be dependent onthe terms, conditions and details of such acquisitions.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities*, which allows us to choose to measure selectedfinancial assets and financial liabilities at fair value. Unrealized gains andlosses on items for which the fair value option has been elected are reportedin earnings. SFAS No. 159 is effective for fiscal years beginning after November 15,2007, or July 1, 2008 for our Company. We are in the process of evaluatingthe impact of this authoritative guidance on our consolidated financialstatements.

 

InSeptember 2006, the FASB issued SFAS No. 157, Fair ValueMeasurements, which provides a single definition of fair value, and requiresadditional disclosure about the use of fair value to measure assets andliabilities. SFAS No. 157 emphasizes that fair value is a market-basedmeasurement defined as the price that would be received to sell an asset orliability in an orderly transaction between market participants at themeasurement date. Thus, SFAS No. 157 adheres to a definition of fair valuebased upon exit price as opposed to entry price, i.e. the price paid to acquirean asset or liability. This pronouncement is effective for fiscal years beginningafter November 15, 2007, or July 1, 2008 for our Company. We are inthe process of evaluating the impact of this authoritative guidance on ourconsolidated financial statements.

 

****Resultsof Operations for the Fiscal Year Ended June 30, 2008 Compared to theFiscal Year Ended June 30, 2007****

 

Duringthe latter part of fiscal year 2008, we implemented plans to reduce costs,including workforce reductions, and to streamline operations in an effort toreduce net losses. This has resulted in an increase in gross profit andsimultaneous decreases in operating expenses, thereby reducing losses,particularly in the third and fourth quarters of fiscal year 2008. Excludingthe effect of the gain on sale of product line in January 2008, operatingloss for the quarters ended March 31, 2008 and June 30, 2008 was thelowest of any quarter in the last nine years. We anticipate continuing measurestaken to contain costs, and to continue our review of other expense areas todetermine where additional reductions in discretionary spending can beachieved.

 

Totalrevenues for fiscal year 2008 were $2,902,219, an increase of $424,750, or17.1%, from fiscal year 2007 revenues of $2,477,469. The revenues for fiscal2008 represents the highest yearly sales level in seven years and was dueprincipally to shipments to a significant new customer of an advanced surgicalvisualization system, along with the introduction of a number of other newproducts. The design of the advanced surgical visualization system reliedheavily on our experience with medical optics technologies, specifically in thearea of advanced optical endoscopic instrumentation.

 

Revenuesfrom our largest customers, as a percentage of total revenues, were as follows:

 
| **** **** | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|----------------|----------------|--------------|----------------|--------------|----------------|
| Customer A     |           | 25           | %              | 27           | %              |
| Customer B     |           | 20           |           | 22           |           |
| Customer C     |           | 11           |           | 10           |           |
| All Others     |           | 44           |           | 41           |           |
|           |           | 100          | %              | 100          | %              |

 

Noother customer accounted for more than 10% of our revenues in fiscal years 2008and 2007.

 

Grossprofit for fiscal year 2008 reflected a favorable change of $316,729, comparedto fiscal year 2007. Gross profit as a percentage of revenues increased from19.2% in fiscal year 2007 to 27.3% in fiscal year 2008. The favorable change ingross profit was due primarily to increased sales volume, increasedmanufacturing efficiencies and elimination of 2007 start-up costs related toinitial production of the advanced surgical visualization system.

 

Researchand development expenses, net were $757,852 for fiscal year 2008 compared to$1,312,240 for fiscal year 2007. The decrease was due primarily to the recentimplementation of certain cost containment plans including workforcereductions, deferring certain development initiatives, increased reimbursementsfrom customers for product development activities and focusing on a limitednumber of products and technologies expected to provide 

 

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nearterm revenues. Research and development expenses were net of reimbursement ofrelated costs of $224,107 and $101,309 during fiscal years 2008 and 2007,respectively.

 

Selling,general and administrative expenses decreased by $230,866, or 11.0%, duringfiscal year 2008 compared to the previous year. The decrease was primarilyattributable to the recent implementation of certain cost containment plansincluding workforce reductions, as mentioned above.

 

Gainon sale of product line of $210,549 consists of the gain on the sale of ouroptical thin film product line recognized in the quarter ended March 31,2008. The purchase price was $250,000, and we will receive a royalty of 25% ofrevenues exceeding $300,000 annually from the purchased customer list for athree-year period.

 

Interestincome (expense), net decreased by $46,059 during fiscal year 2008 compared tothe previous year. The decrease was due to a lower base of cash and cashequivalents, partially offset by higher interest rates, and interest expenserecorded on the 10% senior convertible notes issued on June 25, 2008.

 

Theincome tax provisions in fiscal years 2008 and 2007 represent the minimumstatutory state income tax liability.

 

****Liquidity and Capital Resources****

 

Wecompete in a highly technical, very competitive, and in most cases, pricedriven segment of the medical instrument marketplace where products can takeyears to develop and introduce to distributors and end users. Furthermore,research and development, manufacturing, marketing and distribution activitiesare strictly regulated by FDA, ISO and other regulatory bodies that, whileintended to enhance the ultimate quality and functionality of productsproduced, can contribute to the significant cost and time needed to maintainexisting products and develop and introduce product enhancements and newproduct innovations.

 

Wehave traditionally funded working capital needs through product sales,management of working capital components of our business, and by cash receivedfrom public and private offerings of our common stock, warrants to purchaseshares of our common stock and convertible notes. We have incurred quarter toquarter operating losses during our efforts to develop current productsincluding endoscopes, image couplers, beamsplitters, thin film coatings, nightvision and micro-optic lenses, prisms and assemblies for various applicationsand utilizing a number of proprietary and patent-pending technologies includingLenslock TM endoscope and micro-precision TM lens technologies. Ourmanagement expects that such operating losses will continue through fiscal year2009 and until sales increase to breakeven and profitable levels. Ourmanagement also believes that the opportunities represented by these productshave the potential to generate sales increases to achieve breakeven andprofitable results.  Excluding the effectof the gain on sale of product line in January 2008, operating loss forthe quarters ended March 31, 2008 and June 30, 2008 was the lowest ofany quarter in the last nine years.

 

Ourcurrent financial condition may raise doubt among potential equity investors,customers and suppliers regarding our ability to continue as a going concern,as referenced by the Report of Independent Registered Public Accounting Firm onour financial statements for the year ended June 30, 2008, included inthis annual report on Form 10-K.  Wemay not be able to obtain working capital funds necessary in the time frameneeded and at satisfactory terms to correct the going concern issue.

 

As of June 30, 2008,cash and cash equivalents were $885,988, accounts receivable were $387,224 andcurrent liabilities were $869,235, resulting in a net liquid asset amount of$403,977. We believe that the introduction of several new products during thelast four fiscal years, along with new and on-going customer relationships,will continue to generate additional revenues, which are required in order forus to achieve profitability. If these additional revenues are not achieved on atimely basis, we will be required and are prepared to implement further costreduction measures, as necessary.

 

Capitalequipment expenditures during the fiscal year 2008 were $58,718, down from$139,667 for fiscal year 2007. Future capital equipment expenditures will bedependent upon future sales and success of on-going research and developmentefforts.

 

Contractualcash commitments for the fiscal years subsequent to June 30, 2008 aresummarized as follows:

 
| ** **             | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|------------------------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Operating Leases       |       | $        | 33,800     |     | $          | 5,600          |       | $         | 1,900      |   | $ | 41,300 |   |
| Principal and Interest |       | —   |       | 720,000  |       | —         |       | 720,000   |       |
| Totals                 |       | $        | 33,800     |     | $          | 725,600        |       | $         | 1,900      |   | $ | 761,300 |   |

 

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Wehave contractual cash commitments related to open purchase orders for fiscalyear 2009 of approximately $112,000.

 

InFebruary 2007, we completed a private placement, pursuant to which we soldan aggregate of 10,000,000 shares of common stock and warrants to purchase anaggregate of 10,000,000 shares of common stock at an exercise price of $0.32per share.  Our net cash proceeds, afteroffering costs of $123,784, were $2,376,216. In June 2008, we issued senior secured convertible notes andwarrants, raising cash proceeds of $600,000.

 

****Trends and Uncertainties That May Affect Future Results****

 

Fiscalyear 2008 revenues were the highest in seven years. This was due in large partto shipments of the advanced surgical visualization system discussed above, thedesign of which relies heavily on our world class medical optics technologies,specifically in the area of advanced optical endoscopic instrumentation. Thisproduct accounted for approximately one quarter of our total revenues forfiscal year 2008. We expect our recent pattern of quarter-to-quarter revenuefluctuations to continue, due to the introductory stage of many of our productsand the uncertain timing of orders from customers and their size in relation tototal revenues. We continue to move forward with new products and technicalinnovations, in particular:

 

·                 a new generation of endoscopes thatincorporate Lenslock TM technology (patent pending);

·                 new components and instruments utilizing ournew micro-precision TM lens technology (patent pending) for opticalcomponents and endoscopes under 1 mm;

·                 new custom medical products; and

·                 new night vision lenses.

 

Overthe past few years new product and technology development has undergonesignificant changes in shifting the emphasis of research and developmentefforts from the development of underlying technologies to market exploitationin the applications of these new technologies. These have already been realizedto some degree in a number of areas. Over the past two to three years thesedevelopments have produced revenues from new micro-precision TM lens products and new Lenslock TM endoscopes. Recent initiatives in the area of micro-precision TM lenses address specific customeropportunities in different medical specialty applications. In endoscopetechnologies we continue new product offerings in our Lenslock TM product line. Since December 2005, over 400 ENT endoscopes withdiameter of 2.7 mm that incorporate Lenslock TM technology have been shipped. We recentlycompleted prototypes of our 4 mm Lenslock TM sinuscope, and 5 mm Lenslock TM laproscope, and are activelypursuing development of our new 4 mm Lenslock TM wide field arthroscope. We believe thatLenslock TM technology has advantages over competitiveproducts due to ease of manufacture and repair, superior image quality,significant cost effectiveness and quality of repair and that furtherincorporating this into our endoscope product line will lead to increasedsales.

 

Goingforward, our expectations are aimed at applied development for revenue bearingproducts. An example beyond the new instruments mentioned above includes thelenses we developed for a new color Night Vision system that we are beginningto manufacture in pre-production quantities

 

Section 404of the Sarbanes-Oxley Act of 2002, requiring companies to report on theeffectiveness of our internal controls over financial reporting, first appliedto our annual report on Form 10-K for the fiscal year ended June 30,2008. We expect our operating expense may increase as a result of the costsassociated with the implementation of and maintaining compliance with Section 404.

 

****ITEM 7A.****  **QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

Becausewe are a smaller reporting company, we are not required to provide theinformation required by this Item.

 

**ITEM 8.  ****FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**********.****

 

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****Report of IndependentRegistered Public Accounting Firm****

 

Tothe Board of Directors and Shareholders of

PrecisionOptics Corporation, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Precision OpticsCorporation, Inc. and subsidiaries (the Company) as of June 30, 2008and the related consolidated statements of operations, stockholders’ equity andcash flows for the year then ended. These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrols over financial reporting. An audit includes consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudit provides a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofPrecision Optics Corporation, Inc. and subsidiaries as of June 30,2008  and the results of their operationsand their cash flows for the year then ended in conformity with accountingprinciples generally accepted in the United States of America.

 

Theaccompanying consolidated financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note 1 to theconsolidated financial statements, the Company has suffered recurring netlosses and negative cash flows from operations, which raises substantial doubtabout its ability to continue as a going concern. Management’s plans concerningthese matters are described in Note 1. The accompanying consolidated financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 
| /s/  Stowe & Degon |   |
|-----------------------------|--------|

 

Leominster,Massachusetts

September 23,2008

 

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****Report of IndependentRegistered Public Accounting Firm****

 

Tothe Board of Directors and Shareholders of

PrecisionOptics Corporation, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Precision OpticsCorporation, Inc. and subsidiaries (the Company) as of June 30, 2007and the related consolidated statements of operations, stockholders’ equity andcash flows for the year then ended. These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrols over financial reporting. An audit includes consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudit provides a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofPrecision Optics Corporation, Inc. and subsidiaries as of June 30, 2007and the results of their operations and their cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates of America.

 

Asdiscussed in Note 1 of the notes to the consolidated financial statements, effectiveJuly 1, 2006, the Company adopted Statement of Financial AccountingStandards No. 123(R), **Share-Based Payment.**

 

Theaccompanying consolidated financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note 1 to theconsolidated financial statements, the Company has suffered recurring netlosses and negative cash flows from operations, which raises substantial doubtabout its ability to continue as a going concern. Management’s plans concerningthese matters are described in Note 1. The accompanying consolidated financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 

/s/Vitale, Caturano and Company, Ltd.

 

VITALE, CATURANO & COMPANY, LTD.

 

Boston,Massachusetts

September 26, 2007

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Consolidated Balance Sheets at June 30, 2008 and 2007****

 
| **** ****                                                                                                                    | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|-----------------------------------------------------------------------------------------------------------------------------------|----------------|--------------|----------------|--------------|----------------|
| ****ASSETS****                                                                                                                    |           |         |           |         |           |
| Current Assets:                                                                                                                   |           |         |           |         |           |
| Cash and cash equivalents                                                                                                         |           | $            | 885,988        |         | $              | 840,179 |   |
| Accounts receivable (net of allowance for  doubtful accounts of approximately $7,400 and $11,159 in 2008 and 2007,  respectively) |           | 387,224      |           | 801,206      |           |
| Inventories                                                                                                                       |           | 608,431      |           | 904,736      |           |
| Prepaid expenses                                                                                                                  |           | 36,749       |           | 53,039       |           |
|                                                                                                                              |           |         |           |         |           |
| Total current assets                                                                                                              |           | 1,918,392    |           | 2,599,160    |           |
| Fixed Assets:                                                                                                                     |           |         |           |         |           |
| Machinery and equipment                                                                                                           |           | 2,352,634    |           | 3,559,384    |           |
| Leasehold improvements                                                                                                            |           | 553,596      |           | 553,596      |           |
| Furniture and fixtures                                                                                                            |           | 149,738      |           | 150,603      |           |
| Vehicles                                                                                                                          |           | 42,343       |           | 42,343       |           |
|                                                                                                                              |           |         |           |         |           |
|                                                                                                                              |           | 3,098,311    |           | 4,305,926    |           |
|                                                                                                                              |           |         |           |         |           |
| Less—Accumulated depreciation and  amortization                                                                              |           | 2,935,922    |           | 4,148,239    |           |
|                                                                                                                              |           |         |           |         |           |
| Net fixed assets                                                                                                                  |           | 162,389      |           | 157,687      |           |
| Other Assets:                                                                                                                     |           |         |           |         |           |
| Cash surrender value of life insurance  policies                                                                                  |           | 5,465        |           | 4,438        |           |
| Patents, net                                                                                                                      |           | 195,391      |           | 274,311      |           |
|                                                                                                                              |           |         |           |         |           |
| Total other assets                                                                                                                |           | 200,856      |           | 278,749      |           |
|                                                                                                                              |           |         |           |         |           |
|                                                                                                                              |           | $            | 2,281,637      |         | $              | 3,035,597 |   |
| ****LIABILITIES AND STOCKHOLDERS’ EQUITY****                                                                                 |           |         |           |         |           |
| Current Liabilities:                                                                                                              |           |         |           |         |           |
| Accounts payable                                                                                                                  |           | $            | 364,409        |         | $              | 343,730 |   |
| Customer advances                                                                                                                 |           | 91,105       |           | 2,690        |           |
| Accrued employee compensation                                                                                                     |           | 293,497      |           | 270,437      |           |
| Accrued professional services                                                                                                     |           | 94,312       |           | 75,616       |           |
| Accrued warranty expense                                                                                                          |           | 25,000       |           | 25,000       |           |
| Other accrued liabilities                                                                                                         |           | 912          |           | 914          |           |
|                                                                                                                              |           |         |           |         |           |
| Total current liabilities                                                                                                         |           | 869,235      |           | 718,387      |           |
|                                                                                                                              |           |         |           |         |           |
| 10% Senior secured convertible notes                                                                                              |           | 10,304       |           | —       |           |
|                                                                                                                              |           |         |           |         |           |
| Commitments (Note 3)                                                                                                              |           |         |           |         |           |
|                                                                                                                              |           |         |           |         |           |
| Stockholders’ Equity:                                                                                                        |           |         |           |         |           |
| Common stock, $0.01 par value-                                                                                                    |           |         |           |         |           |
| Authorized—50,000,000 shares                                                                                                 |           |         |           |         |           |
| Issued and outstanding— 25,458,212 shares  at June 30, 2008 and June 30, 2007                                      |           | 254,582      |           | 254,582      |           |
| Additional paid-in capital                                                                                                        |           | 37,905,257   |           | 37,197,015   |           |
| Accumulated deficit                                                                                                               |           | (36,757,741  | )              | (35,134,387  | )              |
|                                                                                                                              |           |         |           |         |           |
| Total stockholders’ equity                                                                                                   |           | 1,402,098    |           | 2,317,210    |           |
|                                                                                                                              |           |         |           |         |           |
|                                                                                                                              |           | $            | 2,281,637      |         | $              | 3,035,597 |   |

 

**The accompanying notes are an integral part of these consolidatedfinancial statements.**

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Consolidated Statements of Operations for the****

****Years Ended June 30, 2008 and 2007****

 
| **** ****                                                  | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|-----------------------------------------------------------------|----------------|--------------|----------------|--------------|----------------|
| Revenues                                                        |           | $            | 2,902,219      |         | $              | 2,477,469 |   |
|                                                            |           |         |           |         |           |
| Cost of Goods Sold                                              |           | 2,110,217    |           | 2,002,196    |           |
|                                                            |           |         |           |         |           |
| Gross profit                                                    |           | 792,002      |           | 475,273      |           |
|                                                            |           |         |           |         |           |
| Research and Development Expenses, net                          |           | 757,852      |           | 1,312,240    |           |
|                                                            |           |         |           |         |           |
| Selling, General and Administrative  Expenses                   |           | 1,867,093    |           | 2,097,959    |           |
|                                                            |           |         |           |         |           |
| Gain on Sale of Product Line                                    |           | (210,549     | )              | —       |           |
|                                                            |           |         |           |         |           |
| Total operating expenses                                        |           | 2,414,396    |           | 3,410,199    |           |
|                                                            |           |         |           |         |           |
| Operating loss                                                  |           | (1,622,394   | )              | (2,934,926   | )              |
|                                                            |           |         |           |         |           |
| Interest Income (Expense), net                                  |           | (48          | )              | 46,011       |           |
|                                                            |           |         |           |         |           |
| Loss before provision for income taxes                          |           | (1,622,442   | )              | (2,888,915   | )              |
|                                                            |           |         |           |         |           |
| Provision for Income Taxes                                      |           | 912          |           | 914          |           |
|                                                            |           |         |           |         |           |
| Net loss                                                        |           | $            | (1,623,354     | )            | $              | (2,889,829 | ) |
|                                                            |           |         |           |         |           |
| Loss per Share - Basic and Diluted                              |           | $            | (0.06          | )            | $              | (0.15 | ) |
|                                                            |           |         |           |         |           |
| Weighted Average Common Shares Outstanding  - Basic and Diluted |           | 25,458,212   |           | 19,624,879   |           |

 

**The accompanying notes are an integral part of these consolidatedfinancial statements.**

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Consolidated Statements of Stockholders’ Equity****

****forthe Years Ended June 30, 2008 and 2007****

 
| ** **                                                                                                  | ** ** | **Number  of Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** **  |
|-------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|---------------------------------------|-------------|
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Balance, June 30, 2006                                                                                 |       | 15,458,212                 |       | $                 | 154,582    |                             | $          | 34,729,873               |       | $                                     | (32,244,558 | ) | $ | 2,639,897 |   |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Proceeds from sale of common stock and  warrants, net                                                       |       | 10,000,000                 |       | 100,000           |       | 2,276,216                        |       | —                   |       | 2,376,216                             |        |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Stock-based compensation                                                                                    |       | —                     |       | —            |       | 190,926                          |       | —                   |       | 190,926                               |        |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Net loss                                                                                                    |       | —                     |       | —            |       | —                           |       | (2,889,829               | )          | (2,889,829                            | )           |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Balance, June 30, 2007                                                                                 |       | 25,458,212                 |       | $                 | 254,582    |                             | $          | 37,197,015               |       | $                                     | (35,134,387 | ) | $ | 2,317,210 |   |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Proceeds from issuance of senior  convertible notes and warrants allocated to warrants                      |       |                       |       |              |       | 399,000                          |       |                     |       | 399,000                               |        |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Proceeds from issuance of senior  convertible notes and warrants allocated to beneficial conversion feature |       |                       |       |              |       | 201,000                          |       |                     |       | 201,000                               |        |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Stock-based compensation                                                                                    |       |                       |       |              |       | 108,242                          |       |                     |       | 108,242                               |        |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Net loss                                                                                                    |       |                       |       |              |       |                             |       | (1,623,354               | )          | (1,623,354                            | )           |
|                                                                                                        |       |                       |       |              |       |                             |       |                     |       |                                  |        |
| Balance, June 30, 2008                                                                                 |       | 25,458,212                 |       | $                 | 254,582    |                             | $          | 37,905,257               |       | $                                     | (36,757,741 | ) | $ | 1,402,098 |   |

 

**The accompanying notes are an integral part of these consolidatedfinancial statements.**

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Consolidated Statements of Cash Flows for the****

****Years Ended June 30, 2008 and 2007****

 
| **** ****                                                                     | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|------------------------------------------------------------------------------------|----------------|--------------|----------------|--------------|----------------|
|                                                                               |           |         |           |         |           |
| Cash Flows from Operating Activities:                                              |           |         |           |         |           |
| Net loss                                                                           |           | $            | (1,623,354     | )            | $              | (2,889,829 | ) |
|  Adjustments to reconcile net loss to  net cash used in operating activities- |           |         |           |         |           |
| Depreciation and amortization                                                      |           | 161,169      |           | 120,404      |           |
| Gain on sale of product line                                                       |           | (210,549     | )              |         |           |
| Provision for inventory write-down                                                 |           | 39,059       |           | 31,100       |           |
| Stock-based compensation expense                                                   |           | 108,242      |           | 190,926      |           |
| Non-cash interest expense                                                          |           | 10,304       |           | —       |           |
| Changes in operating assets and  liabilities-                                      |           |         |           |         |           |
| Accounts receivable, net                                                           |           | 413,982      |           | (420,109     | )              |
| Inventories                                                                        |           | 237,141      |           | (490,034     | )              |
| Prepaid expenses                                                                   |           | 16,290       |           | (7,127       | )              |
| Accounts payable                                                                   |           | 20,679       |           | 125,072      |           |
| Customer advances                                                                  |           | 88,415       |           | (2,690       | )              |
| Accrued expenses                                                                   |           | 41,754       |           | 1,989        |           |
|                                                                               |           |         |           |         |           |
| Net cash used in operating activities                                              |           | (696,868     | )              | (3,334,918   | )              |
|                                                                               |           |         |           |         |           |
| Cash Flows from Investing Activities:                                              |           |         |           |         |           |
| Purchases of property and equipment                                                |           | (58,718      | )              | (139,667     | )              |
| Proceeds from sale of product line                                                 |           | 250,000      |           | —       |           |
| Product line sale costs                                                            |           | (19,051      | )              | —       |           |
| Increase in other assets                                                           |           | (29,554      | )              | (91,880      | )              |
|                                                                               |           |         |           |         |           |
| Net cash provided by (used in) investing activities                                |           | 142,677      |           | (231,547     | )              |
|                                                                               |           |         |           |         |           |
| Cash Flows from Financing Activities:                                              |           |         |           |         |           |
| Proceeds from issuance of senior  convertible notes and warrants                   |           | 600,000      |           | —       |           |
| Gross proceeds from private placement                                              |           | —       |           | 2,500,000    |           |
| Payment of offering costs                                                          |           | —       |           | (123,784     | )              |
|                                                                               |           |         |           |         |           |
| Net cash provided by financing activities                                          |           | 600,000      |           | 2,376,216    |           |
|                                                                               |           |         |           |         |           |
| Net increase (decrease) in cash and cash  equivalents                              |           | 45,809       |           | (1,190,249   | )              |
|                                                                               |           |         |           |         |           |
| Cash and cash equivalents, beginning of  year                                      |           | 840,179      |           | 2,030,428    |           |
|                                                                               |           |         |           |         |           |
| Cash and cash equivalents, end of year                                             |           | $            | 885,988        |         | $              | 840,179 |   |
|                                                                               |           |         |           |         |           |
| Supplemental Disclosure of Cash Flow  Information:                                 |           |         |           |         |           |
| Cash paid during the year for-                                                     |           |         |           |         |           |
| Income taxes                                                                       |           | $            | 912            |         | $              | 914 |   |
|                                                                               |           |         |           |         |           |
| Supplemental Disclosure of Non-Cash  Investing and Financing Activities:           |           |         |           |         |           |
| Cost of inventory sold as part of product  line disposal                           |           | $            | 20,105         |         | $              | — |   |

 

**The accompanying notes are an integral part of these consolidatedfinancial statements.**

 

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****PRECISION OPTICSCORPORATION, INC. AND SUBSIDIARIES****

****Notes to Consolidated Financial Statements****

 

****(1) ******SUMMARY******OF SIGNIFICANT ACCOUNTING POLICIES****

 

****(a) ****    ****Nature of Business and Liquidity****

 

PrecisionOptics Corporation, Inc. (the “Company”) designs, develops, manufacturesand sells specialized optical systems and components and optical thin-filmcoatings. The Company conducts business in one industry segment only and itscustomers are primarily domestic. The Company’s products and services fall intotwo principal areas: (i) medical products for use by hospitals andphysicians and (ii) advanced optical system design and developmentservices and products used by industrial customers.

 

TheCompany has sustained recurring net losses and negative cash flows fromoperations for several years. During the year ended June 30, 2008, theCompany incurred a net loss of $1,623,354 and used cash in operations of$696,868. As of June 30, 2008, cash and cash equivalents were $885,988,accounts receivable were $387,224 and current liabilities were $869,235,resulting in a net liquid asset amount of $403,977.  These factors raise substantial doubt aboutthe Company’s ability to continue as a going concern.  The accompanying consolidated financialstatements have been prepared assuming that the Company will continue as agoing concern, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business.  The financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or the amounts and classification of liabilities that might benecessary should the Company be unable to continue as a going concern.  During the latter part of fiscal year 2008,the Company implemented plans to reduce costs and to streamline operations inan effort to reduce net losses.  This hasresulted in an increase in gross profit and simultaneous decreases in operatingexpenses, thereby reducing losses substantially, particularly in the third andfourth quarters of fiscal year 2008.  TheCompany believes that the recent introduction of several new products, alongwith new and on-going customer relationships, will generate additionalrevenues, which are required in order for the Company to achieve profitability.If these additional revenues are not achieved on a timely basis, the Companywill be required and is prepared to implement further cost reduction measures,as necessary.

 

TheCompany has incurred quarter to quarter operating losses during its recentefforts to develop current products including endoscopes, image couplers,beamsplitters, thin film coatings, night vision and micro-optic lenses, prismsand assemblies for various applications and utilizing a number of proprietaryand patent-pending technologies including Lenslock TM endoscope andmicro-precision TM lens technologies. Management expects that suchoperating losses will continue through fiscal year 2009, and until salesincrease to breakeven and profitable levels. Management also believes that theopportunities represented by these products have the potential to generatesales increases to achieve breakeven and profitable results. The Company willcontinue its review of other expense areas to determine where additionalreductions in discretionary spending can be achieved. There can be no assurancethat the Company’s operating plans will be successful, and if so required, thatthe Company will be successful in obtaining the capital necessary to continueongoing operations.

 

InApril 2006 the Company completed a private placement, issuing 8,450,000shares of common stock. Net cash proceeds to the Company (after offering costsof $49,725) were $2,062,775. In February 2007 the Company completed aprivate placement, pursuant to which it sold an aggregate of 10,000,000 sharesof common stock and warrants to purchase an aggregate of 10,000,000 shares ofcommon stock at an exercise price of $0.32 per share. Net cash proceeds to theCompany (after offering costs of $123,784) were $2,376,216 (see Note 4). In June 2008the Company issued senior secured convertible notes and warrants, raising cashproceeds of $600,000.

 

Duringthe past year, the introduction of several new products, along with new andon-going customer relationships, has resulted in significant revenue growth.The Company believes that with continued promotion, theseopportunities have the potential to continue the general trend ofincreasing revenues, which, along with enhanced operations are required inorder for the Company to achieve profitability.

 

****(b) ****    ****Principles of Consolidation****

 

Theaccompanying consolidated financial statements include the accounts of theCompany and its two wholly owned subsidiaries. All inter-company accounts andtransactions have been eliminated in consolidation.

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

****(c) ****    ****Revenues****

 

The Company recognizedrevenue in accordance with Securities and Exchange Commission issued StaffAccounting Bulletin No. 104, **Revenue Recognition**(“SAB No. 104”)which requires that four basic criteria must be met before revenue can berecognized: (1) persuasive evidence of an arrangement exists; (2) deliveryhas occurred or services rendered; (3) the price to the buyer is fixed anddeterminable; and (4) collectability is reasonably assured. The Company’sshipping terms are customarily FOB shipping point. The Company’s revenuerecognition practices comply with the guidance in the bulletin.

 

The sales price ofproducts and services sold is fixed and determinable after receipt andacceptance of a customer’s purchase order or properly executed sales contract,typically before any work is performed. Management reviews each customerpurchase order or sales contract to determine that the work to be performed isspecified and there are no unusual terms and conditions that would raisequestions as to whether the sales price is fixed or determinable. The Company assessescredit worthiness of customers based upon prior history with the customer andassessment of financial condition. Accounts receivable are stated at the amountmanagement expects to collect from outstanding balances. An allowance fordoubtful accounts is provided for that portion of accounts receivableconsidered to be uncollectible, based upon historical experience and management’sevaluation of outstanding accounts receivable at the end of the year. Bad debtsare written off against the allowance when identified.

 

The Company’s revenuetransactions typically do not contain multiple deliverable elements for futureperformance obligations to customers, other than a standard one-year warrantyon materials and workmanship, the estimated costs for which are provided for atthe time revenue is recognized.

 

Revenues for industrialand medical products sold in the normal course of business are recognized uponshipment when delivery terms are FOB shipping point and all other revenuerecognition criteria have been met. Gross shipping charges reimbursable fromcustomers, to deliver product, are insignificant and are included in Revenues,while shipping costs are classified as the Selling, General and AdministrativeExpenses section of the Consolidated Statement of Operations.

 

****(d) ****    ****Cash and CashEquivalents****

 

The Company includes incash equivalents all highly liquid investments with original maturities ofthree months or less at the time of acquisition. Cash and cash equivalentsof $885,988 and $840,179 at June 30, 2008 and 2007, respectively, consistprimarily of cash at banks and money market funds. The Company maintainsits cash and cash equivalents in bank deposit accounts that, at times, mayexceed federally insured limits. The Company has not experienced any losses insuch accounts. The Company believes it is not exposed to any significant creditrisk on cash and cash equivalents.

 

****(e) ****    ****Inventories****

 

Inventories are stated atthe lower of cost (first-in, first-out) or market and include material, laborand manufacturing overhead. The components of inventories at June 30, 2008and 2007 are as follows:

 
| **** ****   | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|------------------|----------------|--------------|----------------|--------------|----------------|
| Raw material     |           | $            | 347,298        |         | $              | 511,588 |   |
| Work-in-progress |           | 177,464      |           | 349,936      |           |
| Finished goods   |           | 83,669       |           | 43,212       |           |
|             |           |         |           |         |           |
|             |           | $            | 608,431        |         | $              | 904,736 |   |

 

The Company provides forestimated obsolescence on unmarketable inventory based upon assumptions aboutfuture demand and market conditions. If actual demand and market conditions areless favorable than those projected by management, additional inventorywrite-downs may be required. Inventory, once written down, is not subsequentlywritten back up, as these adjustments are considered permanent adjustments tothe carrying value of the inventory.

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

During fiscal years 2008and 2007, the Company recorded pre-tax non-cash provisions for slow-moving andobsolete inventories of approximately $39,000 and $31,100, respectively.

 

****(f) ****   ****Property and Equipment****

 

Property and equipmentare recorded at cost. Maintenance and repair items are expensed as incurred.The Company provides for depreciation and amortization by charges tooperations, using the straight-line and declining-balance methods, whichallocate the cost of property and equipment over the following estimated usefullives:

 
| ****Asset Classification**** | **** **** | ****Estimated Useful Life****         |
|-----------------------------------|----------------|-------------------------------------------------|
| Machinery and equipment           |           | 2-7 years                                       |
| Leasehold improvements            |           | Shorter of lease term or  estimated useful life |
| Furniture and fixtures            |           | 5 years                                         |
| Vehicles                          |           | 3 years                                         |

 

Amortization of assetsunder capital leases is included in depreciation expense. Depreciation expensewas $53,720 and $57,911 for the years ended June 30, 2008 and 2007,respectively.

 

****(g) ****    ****SignificantCustomers and Concentration of Credit Risk****

 

Statement of FinancialAccounting Standards (“SFAS”) No. 105, **Disclosure of Information about FinancialInstruments with Off-Balance-Sheet Risk and Financial Instruments withConcentrations of Credit Risk,**requires disclosure of anysignificant off-balance sheet and credit risk.

 

Financial instrumentsthat subject the Company to credit risk consist primarily of cash equivalentsand trade accounts receivable. The Company places its investments with highlyrated financial institutions. The Company has not experienced any losses onthese investments to date. At June 30, 2008, receivables from the Company’slargest customers were 27%, 25% and 17% of the total accounts receivable. At June 30,2007, receivables from the Company’s largest customer were 61% of the totalaccounts receivable. No other customer accounted for more than 10% of theCompany’s receivables as of June 30, 2008 and 2007. The Company has notexperienced any material losses related to accounts receivable from individualcustomers. The Company generally does not require collateral or other securityas a condition of sale rather relying on credit approval, balance limitationand monitoring procedures to control credit risk of trade account financialinstruments. Management believes that allowances for doubtful accounts, whichare established based upon review of specific account balances and historicalexperience, are adequate.

 

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

 
| **** **** | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|----------------|----------------|--------------|----------------|--------------|----------------|
| Customer A     |           | 25           | %              | 27           | %              |
| Customer B     |           | 20           |           | 22           |           |
| Customer C     |           | 11           |           | 10           |           |
| All Others     |           | 44           |           | 41           |           |
|           |           | 100          | %              | 100          | %              |

 

No other customeraccounted for more than 10% of the Company’s revenues in fiscal years 2008 and2007.

 

****(h) ****    ****Loss per Share****

 

The Company calculatesearnings per share according to SFAS No. 128, **Earnings per Share.**Basicloss per share is computed by dividing net loss by the weighted average numberof shares of common stock outstanding during the period. For each of the twoyears in the periods ended June 30, 2008 and 2007, the effect of stockoptions was anti-dilutive; therefore, they were not included in the computationof diluted loss per share. The number of shares issuable upon the exercise ofoutstanding stock options and warrants that were excluded from the computation,as their effect would be anti-dilutive, was 24,901,657 and 12,532,583 duringfiscal 2008 and 2007, respectively.

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

****(i) ****    ****Stock-BasedCompensation****

 

On July 1, 2006, theCompany adopted SFAS No. 123(R), **Accounting for Stock-Based Compensation**(“SFASNo. 123(R)”), which requires the measurement and recognition of allcompensation costs for all stock based awards made to employees and the Boardof Directors based upon fair value over the requisite service period for awardsexpected to vest. Prior to adoption, the Company accounted for stock optionsunder the intrinsic value method set in accordance with Accounting PrinciplesBoard Opinion No. 25, “**Accounting for Stock Issued to Employees,**”and related interpretations, and provided the required pro forma disclosuresprescribed by SFAS No. 123, “ **Accounting for Share-based Compensation**“(“SFAS No. 123”), as amended.

 

SFAS 123(R) requiresthe Company to estimate the fair value of share-based awards on the date ofgrant using an option-pricing model. The Company adopted SFAS 123(R) usingthe modified prospective transition method which required the application ofthe accounting standard starting July 1, 2006, the first day of theCompany’s fiscal year 2007. Prior period information has not been restated toreflect the fair value method of expensing share-based awards. Stock-basedcompensation costs recognized for the year ended June 30, 2008 and 2007amounted to $108,242 and $190,926, respectively.

 

****(j)  ****  ****Foreign Currency Translation****

 

The Company translatescertain accounts and financial statements of its foreign subsidiary inaccordance with SFAS No. 52, **Foreign Currency Translation.**Thefunctional currency of the Company’s foreign subsidiary is the United Statesdollar. Transaction gains or losses are reflected in the accompanyingconsolidated statements of operations and have not been significant.

 

****(k) ****    ****Patents****

 

Patents are carried atcost, less accumulated amortization of $623,063 and $515,615 at June 30,2008 and 2007, respectively. Such costs are amortized using the straight-linemethod over the shorter of their legal or estimated useful lives, generallyfive to ten years. Amortization expense was $107,448 and $62,493 for the yearsended June 30, 2008 and 2007, respectively. Amortization expense isexpected to be approximately $30,000, $28,000, $27,000, $26,000 and $25,000,respectively, for the years ending June 30, 2009 through June 30,2013.

 

****(l)  ****  ****Financial Instruments****

 

SFAS No. 107, **DisclosureAbout Fair Value of Financial Instruments,** requires disclosuresabout the fair value of financial instruments. Financial instruments consistprincipally of cash equivalents, accounts receivable, accounts payable, andaccrued expenses. The estimated fair value of these financial instrumentsapproximates their carrying value due to the short-term nature of thesefinancial instruments.

 

****(m) ****    ****Long-Lived Assets****

 

The Company accounts forlong-lived assets in accordance with SFAS No. 144, **Accounting forthe Impairment or Disposal of Long-Lived Assets.**This statementrequires that long-lived assets and certain identifiable intangibles bereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to future undiscounted net cash flows expected to be generated bythe asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Assets to be disposed of are reported atthe lower of the carrying amount or fair value less costs to sell.

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

****(n) ****    ****Warranty Costs****

 

The Company does notincur future performance obligations in the normal course of business otherthan providing a standard one-year warranty on materials and workmanship to itscustomers. The Company provides for estimated warranty costs at the timeproduct revenue is recognized. Warranty costs have been included as a componentof cost of goods sold in the accompanying consolidated statements ofoperations. The following tables summarize warranty reserve activity for thetwo years ended June 30, 2008:

 
| **** ****                         | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|----------------------------------------|----------------|--------------|----------------|--------------|----------------|
|                                   |           |         |           |         |           |
| Balance at beginning of period         |           | $            | 25,000         |         | $              | 50,000 |   |
| Provision (credit) for warranty claims |           | 2,619        |           | (14,197      | )              |
| Warranty claims incurred               |           | (2,619       | )              | (10,803      | )              |
| Balance at end of period               |           | $            | 25,000         |         | $              | 25,000 |   |

 

****(o)  ****  ****Research and Development****

 

Research and developmentexpenses are charged to operations as incurred. The Company groups developmentand prototype costs and related reimbursements in research and development. Forthe years ended June 30, 2008 and 2007, research and development expenseis shown net of reimbursements of $224,107 and $101,309, respectively, in theaccompanying statements of operations.

 

****(p)  ****  ****Comprehensive Income****

 

SFAS No. 130, **ReportingComprehensive Income,** requires disclosure of all components ofcomprehensive income on an annual and interim basis. Comprehensive income isdefined as the change in equity of a business enterprise during a period fromtransactions and other events and circumstances from non-owners sources.

 

The Company’scomprehensive loss for the years ended June 30, 2008 and 2007 was equal toits net loss for the same periods.

 

****(q)    ****  ****Income Taxes****

 

Income taxes areaccounted for under the asset and liability method. Deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and operating loss and taxcredit carry-forwards. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin income in the period that includes the enactment date.

 

In assessing thelikelihood of utilization of existing deferred tax assets, management hasconsidered historical results of operations and the current operatingenvironment.

 

****(r) ****    ****SegmentReporting****

 

SFAS No. 131, **DisclosuresAbout Segments of an Enterprise and Related Information,**establishesstandards for reporting information regarding operating segments in annualfinancial statements and requires selected information for those segments to bepresented in interim financial reports issued to stockholders. SFAS No. 131also establishes standards for related disclosures about products and servicesand geographic areas. Operating segments are identified as components of anenterprise about which separate discrete financial information is available forevaluation by the chief operating decision maker, or decision-making group, inmaking decisions about how to allocate resources and assess performance. TheCompany’s chief decision-maker, as defined under SFAS No. 131, is theChief Executive Officer. To date, the Company has viewed its operations andmanages 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.

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

****(s) ****    ****Use ofEstimates****

 

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

 

****(t)     ****  ****RecentAccounting Pronouncements****

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations* (SFAS No. 141(R)), which replacesSFAS No. 141. SFAS No. 141(R) establishes principles andrequirements for how an acquirer in a business combination recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any controlling interest; recognizes and measures thegoodwill acquired in the business combination or a gain from a bargainpurchase; and determines what information to disclose to enable users of thefinancial statements to evaluate the nature and financial effects of thebusinesscombination.SFAS No. 141(R) is to be applied prospectively to businesscombinations for which the acquisition date is on or after an entity’s fiscalyear that begins after December 15, 2008 (July 1, 2009 for theCompany). The impact of this Statement on the Company’s financial position,results of operations and cash flows will be dependent on the terms, conditionsand details of such acquisitions.

 

In February 2007,the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities*, whichallows the Company to choose to measure selected financial assets and financialliabilities at fair value. Unrealized gains and losses on items for which thefair value option has been elected are reported in earnings. SFAS No. 159is effective for fiscal years beginning after November 15, 2007 (July 1,2008 for the Company). The Company is in the process of evaluating the impactof this authoritative guidance on its consolidated financial statements.

 

In September 2006,the FASB issued SFAS No. 157, Fair Value Measurements, which provides asingle definition of fair value, and requires additional disclosure about theuse of fair value to measure assets and liabilities. SFAS No. 157emphasizes that fair value is a market-based measurement defined as the pricethat would be received to sell an asset or liability in an orderly transactionbetween market participants at the measurement date. Thus, SFAS No. 157adheres to a definition of fair value based upon exit price as opposed to entryprice (i.e. the price paid to acquire an asset or liability). This pronouncementis effective for fiscal years beginning after November 15, 2007 (July 1,2008 for the Company). The Company is in the process of evaluating the impactof this authoritative guidance on its consolidated financial statements.

 

**** (2)  10% SENIOR SECURED CONVERTIBLE NOTES****

 

On June 25, 2008,the Company entered into a Purchase Agreement with institutional and otheraccredited investors pursuant to which it sold an aggregate of $600,000 of 10%Senior Secured Convertible Notes, which are convertible into an aggregate of12,000,000 shares of common stock, par value $0.01 per share, at a conversionprice of $0.05 per share, and warrants to purchase an aggregate of 7,920,000shares of common stock at an exercise price of $0.07 per share. The Investorsare current stockholders of the Company. Interest accrues on the Notes at arate of 10% per annum and is payable upon the earlier of conversion or maturityof the Notes. The Notes mature on June 25, 2010, and the Warrants expireon June 25, 2015. The Notes and Warrants are not convertible orexercisable until the Company implements a reverse stock split, which requiresthe approval of its stockholders and the effectiveness of an amendment (the “Amendment”)to its Articles of Organization to effect the reverse stock split. The closingof the sale of the Notes and Warrants occurred on June 25, 2008.

 

The Purchase Agreementcontains customary representations and warranties of the Company and theInvestors, and the Notes contain customary covenants binding on the Company andcustomary events of default. If an event of default occurs and is uncuredwithin the allowable grace period, if any, the Investors may declare allamounts under the Notes immediately due and payable and may pursue any otheravailable remedies.

 

The Notes are secured bya pledge of the Company’s assets under the terms of a Pledge and SecurityAgreement and the security documents ancillary thereto.

 

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 ****PRECISION OPTICSCORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

Pursuant to aRegistration Rights Agreement entered into with the Investors on June 25,2008, the Company has agreed to file a registration statement with theSecurities and Exchange Commission by the earlier of (i) two********daysfollowing the effectiveness of the Amendment and (ii) December 15,2008, to register the resale of the common stock issuable upon the conversionof the Notes and the exercise of the Warrants, plus the common stock issuablein lieu of cash interest on the Notes. The Company has also agreed to use itscommercially reasonable efforts to have the registration statement declaredeffective as soon as practicable after filing and has agreed to take certainother actions related to the effectiveness of the registration statement.

 

The 10% senior securedconvertible notes consist of the following:

 
| ** **                                                                                                                                                                                                                                      | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| 10 % Senior Secured Convertible Notes issued on June 25, 2008,  convertible into common stock at $0.05 per share, bearing interest at 10% per  annum. Outstanding principal and accrued interest are due at maturity,  June 25, 2010. |       | $                       | 600,000    |                    | $          | –– |   |
| Accrued interest – 10% coupon                                                                                                                                                                                                              |       | 833                     |       | ––            |       |
| Unamortized discount                                                                                                                                                                                                                            |       | (590,529                | )          | ––            |       |
|                                                                                                                                                                                                                                            |       | $                       | 10,304     |                    | $          | — |   |

 

Upon issuance of theNotes and Warrants, the proceeds of $600,000 were allocated between the Notesand  Warrants based on relative fairvalues. The value of the Warrants was recorded as a discount to the Notes, witha corresponding increase to additional paid-in capital.The fair value of theWarrants was determined using the Black-Scholes method, with the followingassumptions:

 
| Expected life           |   | 7  years |   |
|-------------------------|--------|----------|--------|
| Risk-free rate          |   | 4.84     | %      |
| Expected Dividends |   | 0.00     | %      |
| Volatility factor       |   | 154      | %      |

 

In accordance with EITF00-27,*Application of EITF Issue No. 98-5,“Accounting for Convertible Securities with Beneficial Conversion Features orContingently Adjustable Conversion Ratios,”* the proceeds from theissuance of the 10% senior secured convertible notes were first allocatedbetween the Notes and the Warrants. The value of the  conversion feature was then calculated, whichresulted in an effective conversion ratio that was less than the market priceof the Company’s common stock. The intrinsic value of this beneficialconversion feature was recorded as a further discount to the Notes, equal tothe difference between the effective conversion ratio and the market price ofthe Company’s common stock, with a corresponding increase to additional paid-incapital.

 

The following summarizesthe discount on 10% senior secured convertible notes as of June 30:

 
| ** **                                           | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Discount – beginning balance                    |       | $          | —     |       | $          | — |   |
| Proceeds allocated to warrants                       |       | 399,000    |       | —     |       |
| Beneficial conversion feature – intrinsic value |       | 201,000    |       | —     |       |
| Less: amortization of discount                       |       | (9,471     | )          | —     |       |
| Discount – ending balance                       |       | $          | 590,529    |       | $          | — |   |

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

****(3) ****  ****COMMITMENTS****

 

****(a)  Related Party Transactions****

 

The Company leases one ofits facilities from a corporation owned by an officer-director-shareholder ofthe Company. The Company is currently a tenant-at-will, paying rent of $9,000per month. Total rent expense paid to related parties was $108,000 in each offiscal years 2008 and 2007, and is included in the accompanying consolidatedstatements of operations.

 

The Company paid oraccrued fees to a director of $60,000 in each of fiscal years 2008 and 2007 forconsulting services.

 

Another director is aformer partner in a law firm that has performed legal services for the Companyduring fiscal 2008 and 2007 totaling approximately $151,000 and $217,000,respectively. This director retired from his position as a member of the Boardof Directors of the Company, effective at the close of business on June 28,2007.

 

**** (b)  ****  ****Operating Lease Commitments****

 

The Company has enteredinto operating leases for its office space and equipment that expire at variousdates through fiscal year 2009. Total future minimum rental payments under allnon-cancelable operating leases are approximately $33,800 in fiscal 2009 and$7,500 thereafter.

 

Rent expense on operatingleases, excluding the related party rent described above, was approximately$46,900 and $47,500 for the years ended June 30, 2008 and 2007,respectively.

 

****(4) ****  ****STOCKHOLDERS’ EQUITY****

 

****(a)    ****  ****Stock Options****

 

Stock-based compensationcosts recognized for the year ended June 30, 2008 and 2007, includedcompensation costs for awards granted prior to, but not yet vested as of July 1,2006 (adoption date), as well as any new grants issued after July 1, 2006.Total costs recognized during the year ended June 30, 2008 and 2007amounted to $108,242 and $190,926, respectively, and were included in theaccompanying consolidated statements of operations in: (1) selling,general and administrative expenses (2008 - $83,161; 2007 - $164,831), cost ofgoods sold (2008 - $18,635; 2007 - $19,435), and research and developmentexpenses, net (2008 - $6,446; 2007 - $6,660). No compensation has beencapitalized because such amounts would have been immaterial. There was no netincome tax benefit recognized related to such compensation for the years ended June 30,2008 or 2007, as the Company is currently in a loss position. The total amountof options granted during the year ended June 30, 2008 was 30,000.

 

As of June 30, 2008,the unrecognized compensation costs related to options vesting will beprimarily recognized over a period of approximately 3 years:

 
| ****OPTIONS****      | **** **** | ****2009**** | **** **** | ****2010**** | **** **** | ****2011**** | **** **** | ****TOT AL**** | **** **** |
|----------------------|----------------|--------------|----------------|--------------|----------------|--------------|----------------|---------------------|----------------|
| Compensation Expense |           | $            | 80,018         |         | $              | 16,930       |           | $                   | 16,930         |   | $ | 113,878 |   |
|                      |                |              |                |              |                |              |                |                     |                |  |  |  |  |

 

On November 10,2005, the FASB issued FASB Staff Position SFAS 123R-3, **Transition Election Related to Accountingfor Tax Effects of Share-Based Payment Awards.**The Company haselected to adopt the alternative transition method provided by the FASB StaffPosition for calculating the tax effects (if any) of stock-based compensationexpense pursuant to SFAS 123(R). The alternative transition method includessimplified methods to establish the beginning balance of the additional paid-incapital pool related to the tax effects of employee stock-based compensation,and to determine the subsequent impact to the additional paid-in capital pooland the consolidated statement of operation and cash flows of the tax effectsof employee stock-based compensation awards that are outstanding upon adoptionof SFAS 123(R).

 

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****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

 

Upon adoption of SFAS123(R), in accordance with Staff Accounting Bulletin No. 107, **Share-BasedPayment**the Company selected the Black-Scholes option-pricingmodel as the most appropriate method for determining the estimated fair valuefor the stock awards. The Black-Scholes method of valuation requires severalassumptions: (1) the expected term of the stock award, (2) theexpected future stock volatility over the expected term and (3) risk-freeinterest rate. The expected term represents the expected period of time theCompany believes the options will be outstanding based on historicalinformation. Estimates of expected future stock price volatility are based onthe historic volatility of the Company’s common stock and the risk freeinterest rate is based on the U.S. Zero-Bond rate. The Company utilizes aforfeiture rate based on an analysis of the Company’s actual experience. Thefair value of options at date of grant was estimated with the followingassumptions:

 
| **** ****                        | **** **** | ****Years Ended****    | **** **** |
|---------------------------------------|----------------|-----------------------------|----------------|
| **** ****                        | **** **** | ****June  30, 2008**** | **** **** | ****June  30, 2007**** | **** **** |
| Assumptions:                          |           |                        |           |   |   |
| Option life                           |           | 5.3  years                  |           | 5.3  years |   |
| Risk-free interest rate               |           | 4.84                        | %              | 4.67 | % |
| Stock volatility                      |           | 147                         | %              | 108 | % |
| Dividend yield                        |           | -0-                         |           | -0- |   |
| Weighted average fair value of grants |           | $                           | 0.29           |   | $ | 0.22 |   |
|                                       |                |                             |                |  |  |  |  |

 

****Stock Option andOther Compensation Plans:****

 

The type of share-basedpayments currently utilized by the Company is stock options.

 

The Company hasvarious stock option and other compensation plans for directors, officers, andemployees. The Company has the following stock option plans outstanding as of June 30,2008: Amended and Restated 1997 Incentive Plan and the 2006 Equity IncentivePlan. Vesting periods are at the discretion of the Board of Directors andtypically average five years. Options under these plans are granted at fairmarket value and have a term of ten years from the date of grant.

 

During fiscal 2007, thestockholders approved an equity incentive plan (the “2006 Incentive Plan”),which provides eligible participants (certain employees, directors,consultants, etc.) the opportunity to receive a broad variety of equity basedand cash awards. Options granted vest and are exercisable for periodsdetermined by the Board of Directors, not to exceed 10 years from the date ofgrant. A total of 3,497,438 shares of common stock have been reserved forissuance under the 2006 Incentive Plan. At June 30, 2008, a total of70,000 stock options are outstanding and 3,427,438 shares of common stock wereavailable for future grants under the 2006 Incentive Plan.

 

During fiscal 1998, thestockholders approved an incentive plan (the “1997 Incentive Plan”), whichprovided eligible participants (certain employees, directors, consultants,etc.) the opportunity to receive a broad variety of equity based and cashawards. Options granted vest and are exercisable for periods determined by theBoard of Directors, not to exceed 10 years from the date of grant. Options fora total of 2,360,080 shares of common stock are outstanding at June 30,2008 under the 1997 Incentive Plan, as amended and restated in fiscal year2006. Prior to the adoption of the 2006 Incentive Plan, 225,000 stockoptions were granted in fiscal year 2007 under the 1997 Incentive Plan.Upon the adoption of the 2006 Incentive Plan, no new awards were granted underthe 1997 Plan. No shares are available for future grants under the Company’s1997 Stock Option Plan.

 

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**** ****

****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes toConsolidated Financial Statements****

**** ****

The following tablessummarize stock option activity for the two years ended June 30, 2008:

 
| **** ****                             | **** **** | ****Options Outstanding**** | **** **** |
|--------------------------------------------|----------------|----------------------------------|----------------|
| **** ****                             | **** **** | ****Number of  Shares****   | **** **** | ****Weighted Average  Exercise Price**** | **** **** | ****Weighted Average  Contractual Life**** | **** **** |
| ****Outstanding at  June 30, 2006**** |           | 2,277,583                        |           | $ | 0.66 |   | 9.86  years |   |
| Grants                                     |           | 265,000                          |           | 0.27 |   |   |   |
| Exercises                                  |           | —                           |           |   |   |   |   |
| Cancellations                              |           | (10,000                          | )              | 0.55 |   |   |   |
|                                       |           |                             |           |   |   |   |   |
| ****Outstanding at  June 30, 2007**** |           | 2,532,583                        |           | $ | 0.62 |   | 8.57  years |   |
| Grants                                     |           | 30,000                           |           | 0.31 |   |   |   |
| Exercises                                  |           | —                           |           |   |   |   |   |
| Cancellations                              |           | (132,503                         | )              | 0.36 |   |   |   |
| ****Outstanding at  June 30, 2008**** |           | 2,430,080                        |           | $ | 0.63 |   | 7.56  years |   |

 

Information related tothe stock options outstanding as of June 30, 2008 is as follows:

 
| ****Range of  Exercise  Prices**** | **** **** | ****Number of  Shares**** | **** **** | ****Weighted-  Average  Remaining  Contractual  Life (years)**** | **** **** | ****Weighted-  Average  Exercise Price**** | **** **** | ****Exercisable  Number of  Shares**** | **** **** | ****Exercisable  Weighted-  Average  Exercise Price**** | **** **** |
|-----------------------------------------|----------------|--------------------------------|----------------|-----------------------------------------------------------------------|----------------|-------------------------------------------------|----------------|---------------------------------------------|----------------|--------------------------------------------------------------|----------------|
| $0.25                                   |           | 165,000                        |           | 8.27                                                                  |           | $                                               |  0.25     |                                        | 81,668         |                                                         | $              |  0.25 |   |
| $0.31                                   |           | 30,000                         |           | 9.42                                                                  |           | 0.31                                            |           | 30,000                                      |           | 0.31                                                         |           |
| $0.46                                   |           | 20,000                         |           | 7.42                                                                  |           | 0.46                                            |           | 20,000                                      |           | 0.46                                                         |           |
| $0.55                                   |           | 1,281,080                      |           | 7.86                                                                  |           | 0.55                                            |           | 999,881                                     |           | 0.55                                                         |           |
| $0.83                                   |           | 934,000                        |           | 6.96                                                                  |           | 0.83                                            |           | 934,000                                     |           | 0.83                                                         |           |
| $0.25-$0.83                             |           | 2,430,080                      |           | 7.56                                                                  |           | $                                               | 0.63           |                                        | 2,065,549      |                                                         | $              | 0.66 |   |

 

The aggregate intrinsicvalue of the Company’s “in-the-money” outstanding and exercisable options as ofJune 30, 2008 was $0 and $0, respectively.

 

On June 13,2005 the Company issued options to purchase 934,000 shares(“Performance Options”) of common stock at an exercise price of $0.83 pershare. At the date of issuance, 30% of the options vestedimmediately, and the remaining options were subject to vesting upon theachievement of certain financial milestones by the Company. During fiscal2007, certain of these milestones were met, and an additional 35% of theoptions vested as of July 31, 2007. During the first quarter of fiscalyear 2008, the additional milestones were met, and the remaining 35% of theoptions vested on October 31, 2007.

 

****(b) ****   ****Sale of Stock****

**** ****

In February 2007,the Company completed a private placement with institutional and otheraccredited investors pursuant to which it sold an aggregate of 10,000,000shares of common stock, at a price of $0.25 per share and warrants to purchasean aggregate of 10,000,000 shares of common stock at an exercise price of $0.32per share. In conjunction with the issuance by the Company of senior convertiblenotes and warrants on June 25, 2008, certain anti-dilution provisions ofthe existing warrants were triggered. As a result, the number of existingwarrants was increased from 10,000,000 to 14,551,577 and the related exerciseprice was decreased from $0.32 per share to $0.22 per share. Net cash proceedsto the Company (after offering costs of $123,784) were $2,376,216. On March 16,2007, in order to fulfill its contractual obligations, the Company filed aregistration statement with the Securities and Exchange Commission, under theSecurities Act of 1933, as amended, to register for resale the shares of commonstock issued and the shares of common stock issuable upon the exercise of thewarrants sold in this private placement. The Company’s registration statementon Form SB-2 covering the securities sold in the private placement wasdeclared effective on March 23, 2007. The Company is obligated to keep theregistration statement

 

34

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****Table of Contents****

**** ****

****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes to Consolidated Financial Statements****

**** ****

effective until theearlier of (i) such time as all of the shares covered by the prospectushave been sold or (ii) the date on which the shares may be resold pursuantto Rule 144(k) of the Securities Act of 1933 (the “Securities Act”).Except in the event of adverse market conditions and certain permitted delays,if the Company fails to maintain the effectiveness of the prospectus then itwill be required to pay liquidated damages to the holders of shares registeredthere under in an amount equal to 1.0% of the aggregate amount invested by suchholder for each 30-day period or pro rata for any portion thereof following thedate by which such prospectus should have been effective.

 

In April 2006, theCompany completed a private placement, issuing 8,450,000 shares of commonstock. Net cash proceeds (after offering costs of $49,725) to the Company were$2,062,775. On July 25, 2006, in order to fulfill its contractualobligations, the Company filed a registration statement with the Securities andExchange Commission, under the Securities Act of 1933, as amended, to registerfor resale the shares of common stock sold in this private placement. TheCompany’s registration statement on Form SB-2 covering the securities soldin this private placement was declared effective on August 14, 2006. TheCompany is obligated to keep the registration statement effective until theearlier of (i) two years after the date of the closing of the privateplacement, (ii) the date on which the shares may be resold by thepurchasers without registration by reason of Rule 144(k) under theSecurities Act or any other rule of similar effect; or (iii) suchtime as all shares purchased by such stockholders have been sold.

 

****(c)    Warrants****

 

In conjunction with thesale of the 10% Senior Secured Convertible Notes on June 25, 2008mentioned above,  the Company issuedwarrants to purchase an aggregate of 7,920,000 shares of Common Stock at anexercise price of $0.07 per share. The Warrants expire on June 25, 2015and are not exercisable until the Company implements a reverse stock split,which requires the approval of its stockholders and the effectiveness of anamendment to its Articles of Organization to effect the reverse stock split.

 

****(5) ****  ****INCOME TAXES****

**** ****

The provision for incometaxes in the accompanying consolidated statements of operations consists of theminimum statutory state income tax liability of $912 and $914 for the yearsended June 30, 2008 and 2007, respectively.

 

A reconciliation of thefederal statutory rate to the Company’s effective tax rate for the two yearsended June 30 is as follows:

 
| **** ****                                                                  | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|---------------------------------------------------------------------------------|----------------|--------------|----------------|--------------|----------------|
| Income tax benefit at federal statutory rate                               |           | (34.0        | )%             | (34.0        | )%             |
|                                                                            |           |         |           |         |           |
| Increase (decrease) in tax resulting from- State taxes, net of  federal benefit |           | (6.8         | )              | (5.6         | )              |
| Change in valuation allowance                                                   |           | 43.0         |           | 42.3         |           |
| Nondeductible items                                                             |           | 1.1          |           | 0.6          |           |
|                                                                            |           |         |           |         |           |
| Other                                                                           |           | (3.2         | )              | (3.3         | )              |
| Effective tax rate                                                              |           | 0.1          | %              | 0.0          | %              |

**** ****

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**** ****

****PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES****

****Notes to Consolidated Financial Statements****

 

The components ofdeferred tax assets and liabilities at June 30, 2008 and 2007 areapproximately as follows:

 
| **** ****                                          | **** **** | ****2008**** | **** **** | ****2007**** | **** **** |
|---------------------------------------------------------|----------------|--------------|----------------|--------------|----------------|
| Deferred tax assets:                                    |           |         |           |         |           |
| Net operating loss carry forwards                       |           | $            | 2,035,000      |         | $              | 1,510,000 |   |
| Tax credit carry forwards                               |           | 96,000       |           | 58,000       |           |
| Reserves and accruals not yet deducted for tax purposes |           | 151,000      |           | 17,000       |           |
| Total deferred tax assets                               |           | 2,282,000    |           | 1,585,000    |           |
| Valuation allowance                                     |           | (2,282,000   | )              | (1,585,000   | )              |
|                                                    |           |         |           |         |           |
| Net deferred tax asset                                  |           | $            | ––   |         | $              | –– |   |

 

The Company has provideda valuation allowance to reduce the net deferred tax asset to an amount theCompany believes is “more likely than not” to be realized. The valuationallowance decreased in fiscal 2008 by approximately $697,000.

 

At June 30, 2008,the Company had federal and state net operating loss carry forwards ofapproximately $4,400,000 and $4,100,000, respectively, which will, if not used,expire at various dates from 2009 through 2027. In addition, the Company hadnet operating loss carry forwards from its Hong Kong operations ofapproximately $1,500,000, which carry forward indefinitely.

 

****(6)      ****  ****PROFIT SHARINGPLAN****

 

The Company has a definedcontribution 401K profit sharing plan. Employer profit sharing and matchingcontributions to the plan are discretionary. No employer profit sharingcontributions were made to the plan in fiscal years 2008 and 2007. Employermatching contributions to the plan amounted to $17,473 and $42,335 for fiscalyears 2008 and 2007, respectively.

 

****(7)      ****  ****CASH SURRENDERVALUE OF LIFE INSURANCE POLICIES****

**** ****

The Company maintains awhole life insurance policy for a senior executive, which policy is recorded atits cash surrender value. As of June 30, 2008 and June 30, 2007,the cash surrender value of these policies is $5,465 and $4,438, respectively.

 

**(8)****      ****** **SALE OF PRODUCT LINE**

 

On January 18, 2008,the Company entered into an Asset Purchase Agreement for the sale of its customoptical thin film product line and completed the sale on the same date. The assetssold include equipment, certain inventory, intellectual property, and acustomer list. The purchase price was $250,000, and the Company will alsoreceive a royalty of 25% of revenues exceeding $300,000 annually from thepurchased customer list for a three-year period. The Company recognized a gainof $210,549 from the sale of the product line, recorded in the quarter ended March 31,2008.

**** ****

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**** ****

****ITEM 9.   CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.****

 

None.

 

****ITEM9A(T).   ****  ****CONTROLSAND PROCEDURES.****

**** ****

***Evaluation of Disclosure Controls andProcedures***

*** ***

Our Chief ExecutiveOfficer and our Chief Financial Officer evaluated the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisannual report on Form 10-K. Based on this evaluation, our Chief ExecutiveOfficer and our Chief Financial Officer have concluded that our disclosurecontrols and procedures, including internal control over financial reporting,were not effective as of June 30, 2008, to ensure that information we arerequired to disclose in reports that we file or submit under the SecuritiesExchange Act of 1934, as amended (i) is recorded, processed, summarized,and reported within the time periods specified in Securities and ExchangeCommission rules and forms, and (ii) is accumulated and communicatedto our management, including our Chief Executive Officer and our ChiefFinancial Officer, as appropriate to allow timely decisions regarding requireddisclosure. Our disclosure controls and procedures are intended to be designedto provide reasonable assurance that such information is accumulated andcommunicated to our management.

 

***Management’s Annual Report on Internal Control OverFinancial Reporting***

* *

Our disclosure controlsand procedures include components of our internal control over financialreporting. In designing and evaluating our disclosure controls and proceduresmanagement recognizes that any controls, no matter how well designed andoperated, can provide only reasonable, but not absolute, assurance thatmisstatements due to error or fraud will not occur or that all control issuesand instances of fraud, if any, with our Company have been detected.

 

Our management identifieda control deficiency during the 2008 fiscal year because we lacked sufficientstaff to segregate accounting duties.

 

A “material weakness” isdefined as a significant deficiency, or a combination of significantdeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.  A “significant deficiency” is a controldeficiency, or a combination of control deficiencies, that adversely affects acompany’s ability to initiate, authorize, record, process or report externalfinancial data reliably in accordance with generally accepted accountingprinciples such that there is more than a remote likelihood that a misstatementof the annual or interim financial statements that is more than inconsequentialwill not be prevented or detected.

 

Under the supervision andwith the participation of our management, including our Chief Executive Officerand our Chief Financial Officer, we conducted an assessment of theeffectiveness of our internal control over financial reporting as of June 30,2008. In making this assessment, management used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in *Internal Control*—*Integrated Framework.*

* *

Based on this assessment,we believe the control deficiency resulted primarily because we have theequivalent of one and one-half persons performing all accounting-relatedon-site duties.  As a result, we did not maintain adequate segregation ofduties within our critical financial reporting applications, the relatedmodules and financial reporting processes.  This control deficiency couldresult in a misstatement of balance sheet and income statement accounts in ourinterim or annual consolidated financial statements that would not be detected.Accordingly, management has determined that this control deficiency constitutesa material weakness.

 

Our management is in theprocess of actively addressing and remediating the material weakness ininternal control over financial reporting described above. During the fiscalyear ending June 30, 2009, we intend to undertake actions to remediate thematerial weakness identified to allow for appropriate checks and reviews ofinternal control record-keeping and reporting.

 

We believe that the stepoutlined above will strengthen our internal control over financial reportingand address the material weakness described above. As part of our 2009assessment of internal control over financial reporting, our management willtest and evaluate these additional controls to be implemented to assess whetherthey are operating effectively.

 

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We intend to continue toremediate material weaknesses and enhance our internal controls but cannotguarantee that our efforts will result in remediation of our material weaknessor that new issues will not be exposed in this process.

 

This annual report doesnot include an attestation report of our registered public accounting firmregarding internal control over financial reporting.  Management’s reportwas not subject to attestation by our registered public accounting firmpursuant to the temporary rules of the Securities and Exchange Commissionthat permit us to provide only management’s report in this annual report.

 

***Changes in Internal Control over Financial Reporting***

*** ***

There was no change inour internal control over financial reporting that occurred during the fourthquarter of our fiscal year covered by this annual report on Form 10-K thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

****ITEM9B.   ****  ****OTHERINFORMATION.****

**** ****

None.

 

****PART III****

 

****ITEM10.   ****  ****DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.****

**** ****

We will furnish to theSecurities and Exchange Commission a definitive Proxy Statement not later than120 days after the close of our fiscal year ended June 30, 2008. Theinformation required by this item, other than with respect to our CorporateCode of Ethics and Conduct, is incorporated herein by reference to the ProxyStatement.

 

A copy of our CorporateCode of Ethics and Conduct applicable to all employees, officers and directorsof our Company, including our principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions, is included as Exhibit 14.1 to this report and can beobtained free of charge by contacting our Clerk, c/o Precision OpticsCorporation, 22 East Broadway, Gardner, Massachusetts 01440.

 

****ITEM 11.   ****  ****EXECUTIVE COMPENSATION.****

 

The information requiredby this item is incorporated herein by reference to the Proxy Statement.

 

****ITEM 12.   ****  ****SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT AND RELATED STOCKHOLDER MATTERS.****

**** ****

The information requiredby this item is incorporated herein by reference to the Proxy Statement.

 

****ITEM 13.   ****  ****CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, ANDDIRECTOR INDEPENDENCE.****

 

The information requiredby this item is incorporated herein by reference to the Proxy Statement.

 

****ITEM 14.   ****  ****PRINCIPAL ACCOUNTING FEES AND SERVICES.****

**** ****

The information required by this item is incorporatedherein by reference to the Proxy Statement.

**** ****

****ITEM 15.   ****  ****EXHIBITS, FINANCIAL STATEMENT SCHEDULES.****

 

a.               The following documents are filed as part of this 10-K:

 

1.  FINANCIAL STATEMENTS

 

The following documentsare filed in Part II, Item 8 of this annual report on Form 10-K:

 

Report of IndependentRegistered Public Accounting Firm

 

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Report of IndependentRegistered Public Accounting Firm

Consolidated BalanceSheets at June 30, 2008 and 2007

Consolidated Statementsof Operations for the years ended June 30, 2008 and 2007

Consolidated Statementsof Stockholders’ Equity for the years ended June 30, 2008 and 2007

Consolidated Statementsof Cash Flows for the years ended June 30, 2008 and 2007

Notes to ConsolidatedFinancial Statements

 

2.  FINANCIAL STATEMENT SCHEDULES

 

All financial statementschedules have been omitted as they are not required, not applicable, or therequired information is otherwise included.

 

3.  EXHIBITS

 

The exhibits listed beloware filed with or incorporated by reference in this report.

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                        |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1         |       | Asset Purchase  Agreement between the Company and Optometrics Corporation, dated  January 18, 2008 (included as Exhibit 2.1 to the Form SB-2  filed March 16, 2007 and incorporated herein by reference).          |
|        |       |                                                                                                                                                                                                                                   |
| 3.1         |       | Articles of  Organization of the Company, as amended (included as Exhibit 3.1 to the  Form SB-2 filed March 16, 2007 and incorporated herein by  reference).                                                            |
|        |       |                                                                                                                                                                                                                                   |
| 3.2         |       | Bylaws of Precision  Optics Corporation incorporated herein by reference to the Company’s 1991  Annual Report on Form 10-KSB.                                                                                                |
|        |       |                                                                                                                                                                                                                                   |
| 4.1         |       | Specimen Common Stock  certificate incorporated herein by reference to the Company’s Registration  Statement on Form S-18 (No. 33-36710-B).                                                                             |
|        |       |                                                                                                                                                                                                                                   |
| 4.2         |       | Registration Rights  Agreement, dated March 17, 2000 (included as Exhibit 4.4 to the  Form S-3 filed April 28, 2000 and incorporated herein by  reference).                                                        |
|        |       |                                                                                                                                                                                                                                   |
| 4.3         |       | Registration Rights  Agreement, dated June 30, 1998 (included as Exhibit 4.9 to the  Form 10-KSB filed September 29, 1998 and incorporated herein by  reference).                                                  |
|        |       |                                                                                                                                                                                                                                   |
| 4.4         |       | Registration Rights Agreement,  dated August 5, 1999 (included as Exhibit 4.7 to the  Form 10-KSB filed September 28, 1999 and incorporated herein by  reference).                                                 |
|        |       |                                                                                                                                                                                                                                   |
| 4.5         |       | Registration Rights  Agreement, dated February 1, 2007 (included as Exhibit 4.1 to the  Form 8-K filed February 2, 2007 and incorporated herein by  reference).                                                    |
|        |       |                                                                                                                                                                                                                                   |
| 4.6         |       | Form of Warrant to  Purchase Shares of Common Stock (included as Exhibit 4.2 to the  Form 8-K filed February 2, 2007 and incorporated herein by  reference).                                                       |
|        |       |                                                                                                                                                                                                                                   |
| 4.7         |       | Registration Rights  Agreement by and among the Company and each investor named therein, dated  June 25, 2008 (included as Exhibit 4.1 to the Form 8-K filed  June 27, 2008 and incorporated herein by reference). |
|        |       |                                                                                                                                                                                                                                   |
| 4.8         |       | Form of Warrant,  dated June 25, 2008 (included as Exhibit 4.2 to the Form 8-K  filed June 27, 2008 and incorporated herein by reference).                                                                    |
|        |       |                                                                                                                                                                                                                                   |
| 4.9         |       | Form of 10% Senior  Secured Convertible Note, dated June 25, 2008 (included as  Exhibit 4.2 to the Form 8-K filed June 27, 2008 and  incorporated herein by reference).                                       |
|        |       |                                                                                                                                                                                                                                   |
| 10.1        |       | Precision Optics  Corporation, Inc. 1989 Stock Option Plan, as amended, incorporated  herein by reference to the Company’s 1994 Annual Report on Form 10-KSB  (No. 001-10647).                                     |
|        |       |                                                                                                                                                                                                                                   |
| 10.2        |       | Three separate life  insurance policies on the life of Richard E. Forkey, incorporated herein by  reference to the Company’s Registration Statement on Form S-18  (No. 33-36710-B).                                     |

 

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| 10.3   |   | Precision Optics  Corporation, Inc. 1997 Incentive Plan, as amended and restated (included  as Exhibit 10.1 to the Form 10-QSB filed November 13, 2003 and  incorporated herein by reference).                      |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                    |
| 10.4   |   | Securities Purchase  Agreement between the Company and investors, dated March 13, 2000  (included as Exhibit 2.1 to the Form S-3 filed April 28, 2000  and incorporated herein by reference).                       |
|   |   |                                                                                                                                                                                                                                    |
| 10.5   |   | Form of Securities  Purchase Agreement between the Company and investors (included as  Exhibit 10.1 to the Form 8-K filed April 19, 2006 and  incorporated herein by reference).                               |
|   |   |                                                                                                                                                                                                                                    |
| 10.6   |   | Employment Offer Letter  from the Company to Michael T. Pieniazek, dated September 15, 2006  (included as Exhibit 10.1 to the Form 8-K filed September 21,  2006 and incorporated herein by reference).             |
|   |   |                                                                                                                                                                                                                                    |
| 10.7   |   | Precision Optics  Corporation, Inc. 2006 Equity Incentive Plan (included as  Exhibit 99.1 to the Form 8-K filed December 4, 2006 and  incorporated herein by reference).                                            |
|   |   |                                                                                                                                                                                                                                    |
| 10.8   |   | Purchase Agreement  between the Company and investors, dated February 1, 2007 (included as  Exhibit 10.1 to the Form 8-K filed February 2, 2007 and  incorporated herein by reference).                             |
|   |   |                                                                                                                                                                                                                                    |
| 10.9   |   | Form of Incentive  Stock Option Certificate (included as Exhibit 10.1 to the  Form 10-QSB filed February 14, 2007 and incorporated herein by  reference).                                                           |
|   |   |                                                                                                                                                                                                                                    |
| 10.10  |   | Form of  Nonstatutory Stock Option Certificate (included as Exhibit 10.2 to the  Form 10-QSB filed February 14, 2007 and incorporated herein by  reference).                                                        |
|   |   |                                                                                                                                                                                                                                    |
| 10.11  |   | Purchase Agreement by  and among the Company and each investor named therein, dated June 25,  2008 (included as Exhibit 10.1 to the Form 8-K filed June 27,  2008 and incorporated herein by reference).            |
|   |   |                                                                                                                                                                                                                                    |
| 10.12  |   | Pledge and Security  Agreement by and among the Company and each investor named therein, dated June 25,  2008 (included as Exhibit 10.2 to the Form 8-K filed June 27,  2008 and incorporated herein by reference). |
|   |   |                                                                                                                                                                                                                                    |
| 10.13  |   | Consulting Agreement  between the Company and Jack P. Dreimiller, dated as of August 15, 2008  (included as Exhibit 10.1 to the Form 8-K filed August 18,  2008 and incorporated herein by reference).              |
|   |   |                                                                                                                                                                                                                                    |
| 14.1   |   | Precision Optics  Corporation, Inc. Corporate Code of Ethics and Conduct (filed herewith).                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                    |
| 21.1   |   | Subsidiaries of the  Registrant (filed herewith).                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                    |
| 23.1   |   | Consent of Independent  Registered Public Accounting Firm (filed herewith).                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                    |
| 23.2   |   | Consent of Independent  Registered Public Accounting Firm (filed herewith).                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                    |
| 31.1   |   | Certification of the  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                          |
|   |   |                                                                                                                                                                                                                                    |
| 31.2   |   | Certification of the  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                          |
|   |   |                                                                                                                                                                                                                                    |
| 32.1   |   | Certification of  Officers pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                         |

 

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**** ****

****SIGNATURES****

 

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

 

 
| Date:  September 26, 2008 | PRECISION OPTICS  CORPORATION, INC. |
|--------------------------------|-------------------------------------|
|                           |                                |
|                           |                                |
|                           | By:                                 | /s/ Richard E. Forkey |
|                           |                                |   |
|                           |                                | Richard E. Forkey |
|                           |                                | Chairman of the Board, |
|                           |                                | Chief Executive  Officer, President |
|                           |                                | and Treasurer |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| ****Signature****      | **** **** | ****Title****                                | **** **** | ****Date****            | **** **** |
|------------------------|----------------|----------------------------------------------|----------------|-------------------------|----------------|
|                   |           |                                         |           |                    |           |
| /s/ Richard E. Forkey  |           | Chairman of the Board,  Chief Executive      |           | September 26, 2008 |           |
| Richard E. Forkey      |           | Officer, President and  Treasurer (Principal |           |                    |           |
|                   |           | Executive Officer)                           |           |                    |           |
|                   |           |                                         |           |                    |           |
| /s/ Joseph N. Forkey   |           | Executive Vice President,  Chief Scientific  |           | September 26, 2008 |           |
| Joseph N. Forkey       |           | Officer and Director                         |           |                    |           |
|                   |           |                                         |           |                    |           |
| /s/ Donald A. Major    |           | Director                                     |           | September 26, 2008 |           |
| Donald A. Major        |           |                                         |           |                    |           |
|                   |           |                                         |           |                    |           |
| /s/ Richard B. Miles   |           | Director                                     |           | September 26, 2008 |           |
| Richard Miles          |           |                                         |           |                    |           |
|                   |           |                                         |           |                    |           |
| /s/ Joel R. Pitlor     |           | Director                                     |           | September 26, 2008 |           |
| Joel R. Pitlor         |           |                                         |           |                    |           |
|                   |           |                                         |           |                    |           |
| /s/ Jack P. Dreimiller |           | Senior Vice President and  Chief Financial   |           | September 26, 2008 |           |
| Jack P. Dreimiller     |           | Officer (Principal  Financial Officer and    |           |                    |           |
|                   |           | Principal Accounting  Officer)               |           |                    |           |

 

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