UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




Form
10-Q




(Mark
One)




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




For the
quarterly period ended September 30,
2008




or




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




For the
transition period
from                                                                                                
to




Commission
File Number: 0-28034









Implant
Sciences Corporation


(Exact
name of registrant as specified in its charter)




Massachusetts
              (State
      or other jurisdiction of
              incorporation
      or organization)
            
            04-2837126
              (I.R.S.
      Employer Identification No.)107
      Audubon Road, Wakefield, Massachusetts
              (Address
      of principal executive offices)
            
            01880
              (Zip
      Code)







(781)
246-0700


(Registrant’s
telephone number, including area code)







(Former
name, former address and former fiscal year, if changed since last
report)







Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.




Yes x  No q




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one):




q  Large
Accelerated
Filer                                                                                                           q  Accelerated
Filer




q  Non-accelerated
Filer                                                                                                                     x  Smaller
reporting company




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




As of
November 14, 2008, there were 14,135,155 shares of the registrant’s Common Stock
were outstanding.









Part
I.  Financial Information
 Item
1.  Financial Statements


IMPLANT SCIENCES
CORPORATION





TABLE
OF CONTENTS














PagePART
      I.
            FINANCIAL
      INFORMATIONItem
      1.
            Condensed
      Consolidated Financial Statements (unaudited)Condensed
      Consolidated Balance Sheets at September 30, 2008 and June 30,
      2008
            3Condensed
      Consolidated Statements of Operations for the three months
      ended
              September
      30, 2008 and 2007
            4Condensed
      Consolidated Statements of Cash Flows for the three months
      ended
              September
      30, 2008 and 2007
            5Notes
      to Condensed Consolidated Financial Statements
            6-20Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            21-28Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            28Item
      4.
            Controls
      and Procedures
            28-29PART
      II.
            OTHER
      INFORMATIONItem
      1.
            Legal
      Proceedings
            30Item
      1A.
            Risk
      Factors
            30-32Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            32Item
      3.
            Defaults
      Upon Senior Securities
            32Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            32Item
      5.
            Other
      Information
            32Item
      6.
            Exhibits
            32Signatures
            33















-2-
 Part
I.  Financial Information
 Item
1.  Financial Statements


Implant
      Sciences CorporationCondensed
      Consolidated Balance Sheets(unaudited)September
      30,
              
              
              June
      30,2008
              
              
              2008ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              2,013,000
              
              
              $
              412,000Restricted
      cash
              
              
              514,000
              
              
              
              514,000Accounts
      receivable-trade, net of allowance of $10,000 and
      $9,000,  respectively
              
              
              738,000
              
              
              
              667,000Accounts
      receivable, unbilled
              
              
              268,000
              
              
              
              152,000Inventories
              
              
              923,000
              
              
              
              725,000Prepaid
      expenses and other current assets
              
              
              238,000
              
              
              
              369,000Current
      assets held for sale
              
              
              1,736,000
              
              
              
              1,883,000Total
      current assets
              
              
              6,430,000
              
              
              
              4,722,000Property
      and equipment, net
              
              
              403,000
              
              
              
              443,000Amortizable
      intangible assets, net
              
              
              36,000
              
              
              
              54,000Other
      non-current assets
              
              
              1,206,000
              
              
              
              1,096,000Goodwill
              
              
              3,136,000
              
              
              
              3,136,000Non-current
      assets held for sale
              
              
              2,470,000
              
              
              
              2,645,000Total
      assets
              
              $
              13,681,000
              
              
              $
              12,096,000LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilities:Current
      maturities of long-term debt and obligations under capital
      lease
              
              $
              32,000
              
              
              $
              417,000Line
      of credit
              
              
              718,000
              
              
              
              477,000Notes
      payable
              
              
              81,000
              
              
              
              181,000Payable
      to Med-Tec
              
              
              74,000
              
              
              
              80,000Payable
      to Ion Metrics shareholders
              
              
              50,000
              
              
              
              2,514,000Accrued
      expenses
              
              
              3,137,000
              
              
              
              2,062,000Accounts
      payable
              
              
              2,792,000
              
              
              
              2,439,000Current
      portion of long-term lease liability
              
              
              322,000
              
              
              
              317,000Deferred
      revenue
              
              
              444,000
              
              
              
              66,000Current
      liabilities held for sale
              
              
              1,078,000
              
              
              
              1,079,000Total
      current liabilities
              
              
              8,728,000
              
              
              
              9,632,000Long-term
      liabilities:Long-term
      debt and obligations under capital lease, net of current
      maturities
              
              
              108,000
              
              
              
              113,000Long-term
      lease liability
              
              
              310,000
              
              
              
              446,000Long-term
      liabilities held for sale
              
              
              1,000
              
              
              
              1,000Total
      long-term liabilities
              
              
              419,000
              
              
              
              560,000Total
      liabilities
              
              
              9,147,000
              
              
              
              10,192,000Commitments
      and contingenciesSeries
      D Cumulative Redeemable Convertible Preferred Stock, $10 stated value;
      500,000 sharesauthorized,
      212,121 and 242,424 shares outstanding, respectively (liquidation
      value$2,121,000
      and $2,424,000, respectively)
              
              
              2,121,000
              
              
              
              2,269,000Stockholders'
      equity (deficit):Common
      stock; $0.10 par value; 50,000,000 shares authorized; 14,145,700
      and
                14,135,155
      and 12,114,553 and 12,104,008 shares issued and outstanding,
      respectively
              
              
              1,415,000
              
              
              
              1,211,000Additional
      paid-in capital
              
              
              60,723,000
              
              
              
              58,317,000Accumulated
      deficit
              
              
              (59,553,000
              )
              
              
              (59,720,000
              )Deferred
      compensation
              
              
              (1,000
              )
              
              
              (2,000
              )Accumulated
      other comprehensive loss
              
              
              (98,000
              )
              
              
              (98,000
              )Treasury
      stock, 10,545 common shares, respectively, at cost
              
              
              (73,000
              )
              
              
              (73,000
              )Total
      stockholders' equity (deficit)
              
              
              2,413,000
              
              
              
              (365,000
              )Total
      liabilities and stockholders' equity (deficit)
              
              $
              13,681,000
              
              
              $
              12,096,000The
      accompanying notes are an integral part of these financial
      statements.
     -3-


Implant
      Sciences CorporationCondensed
      Consolidated Statements of Operations(unaudited)For
      The Three Months EndedSeptember
      30,2008
              
              
              2007Security
      revenues
              
              $
              5,948,000
              
              
              $
              1,347,000Cost
      of revenues
              
              
              3,172,000
              
              
              
              821,000Gross
      margin
              
              
              2,776,000
              
              
              
              526,000Operating
      expenses:Research
      and development
              
              
              1,020,000
              
              
              
              651,000Selling,
      general and administrative
              
              
              2,366,000
              
              
              
              1,357,0003,386,000
              
              
              
              2,008,000Loss
      from operations
              
              
              (610,000
              )
              
              
              (1,482,000
              )Other
      income (expense), net:Interest
      income
              
              
              8,000
              
              
              
              101,000Interest
      expense
              
              
              (32,000
              )
              
              
              (34,000
              )Change
      in fair value of embedded derivatives related to
                preferred
      stock features
              
              
              -
              
              
              
              (150,000
              )Total
      other expense, net
              
              
              (24,000
              )
              
              
              (83,000
              )Loss
      from continuing operations
              
              
              (634,000
              )
              
              
              (1,565,000
              )Preferred
      distribution, dividends and accretion
              
              
              (189,000
              )
              
              
              (307,000
              )Loss
      from continuing operations applicable to common
    shareholders
              
              
              (823,000
              )
              
              
              (1,872,000
              )Income
      (loss) from discontinued operations
              
              
              990,000
              
              
              
              (637,000
              )Net
      income (loss) applicable to common shareholders
              
              $
              167,000
              
              
              $
              (2,509,000
              )Net
      income (loss)
              
              $
              356,000
              
              
              $
              (2,202,000
              )Loss
      per share from continuing operations, basic and diluted
              
              $
              (0.05
              )
              
              $
              (0.13
              )Loss
      per share from continuing operations applicable to common
                shareholders,
      basic and diluted
              
              $
              (0.06
              )
              
              $
              (0.16
              )Income
      (loss) per share from discontinued operations, basic and
      diluted
              
              $
              0.07
              
              
              $
              (0.05
              )Net
      income (loss) per share applicable to common shareholders, basic and
      diluted
              
              $
              0.01
              
              
              $
              (0.21
              )Net
      income (loss) per share
              
              $
              0.03
              
              
              $
              (0.19
              )Weighted
      average shares used in computing net income (loss) per common
                share,
      basic and diluted
              
              
              13,468,489
              
              
              
              11,837,768





























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


-4-
  Implant
      Sciences CorporationCondensed
      Consolidated Statements of Cash Flows(unaudited)For
      the Three Months EndedSeptember
      30,2008
              
              
              2007Cash
      flows from operating activities:Net
      income (loss)
              
              $
              356,000
              
              
              $
              (2,202,000
              )Less:  Net
      income (loss) from discontinued operations
              
              
              990,000
              
              
              
              (637,000
              )Loss
      from continuing operations
              
              
              (634,000
              )
              
              
              (1,565,000
              )Adjustments
      to reconcile net loss from continuing operations
                to
      net cash flows from operating activities:Depreciation
      and amortization
              
              
              72,000
              
              
              
              41,000Bad
      debt expense (recoveries)
              
              
              1,000
              
              
              
              (17,000
              )Share-based
      compensation expense
              
              
              114,000
              
              
              
              132,000Change
      in fair value of embedded derivatives
              
              
              -
              
              
              
              150,000Fair
      value of warrants issued to non-employees
              
              
              (9,000
              )
              
              
              26,000Warrant
      accretion on Bridge Bank loans
              
              
              7,000
              
              
              
              3,000Changes
      in assets and liabilities, net of effect of acquisition:Accounts
      receivable
              
              
              (188,000
              )
              
              
              (583,000
              )Inventories
              
              
              (198,000
              )
              
              
              63,000Prepaid
      expenses and other current assets
              
              
              131,000
              
              
              
              (42,000
              )Accounts
      payable
              
              
              353,000
              
              
              
              369,000Accrued
      expenses
              
              
              877,000
              
              
              
              (360,000
              )Deferred
      revenue
              
              
              578,000
              
              
              
              179,000Lease
      liability
              
              
              (131,000
              )
              
              
              (71,000
              )Net
      cash provided by (used in) operating activities of continuing
      operations
              
              
              973,000
              
              
              
              (1,675,000
              )Net
      cash provided by (used in) operating activities of discontinued
      operations
              
              
              223,000
              
              
              
              (37,000
              )Net
      cash provided by (used in) operating activities
              
              
              1,196,000
              
              
              
              (1,712,000
              )Cash
      flows from investing activities:Purchases
      of property and equipment
              
              
              (14,000
              )
              
              
              (3,000
              )Increase
      in other non-current assets
              
              
              (110,000
              )
              
              
              58,000Net
      cash (used in) provided by investing activities of continuing
      operations
              
              
              (124,000
              )
              
              
              55,000Net
      cash provided by (used in) investing activities of discontinued
      operations
              
              
              1,107,000
              
              
              
              (133,000
              )Net
      cash provided by (used in) investing activities
              
              
              983,000
              
              
              
              (78,000
              )Cash
      flows from financing activities:Proceeds
      from common stock issued in connection with exercise of stock options
      and
                employee
      stock purchase plan
              
              
              24,000
              
              
              
              26,000Dividends
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
              
              
              (34,000
              )
              
              
              (89,000
              )Payments
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
              
              
              (303,000
              )
              
              
              (150,000
              )Principal
      repayments of long-term debt and capital lease obligations
              
              
              (218,000
              )
              
              
              (474,000
              )Net
      borrowings (repayments) on line of credit
              
              
              (46,000
              )
              
              
              -Net
      cash used in financing activities of continuing operations
              
              
              (577,000
              )
              
              
              (687,000
              )Net
      cash used in discontinued operations
              
              
              (1,000
              )
              
              
              (1,000
              )Net
      cash used in financing activities
              
              
              (578,000
              )
              
              
              (688,000
              )Net
      change in cash and cash equivalents
              
              
              1,601,000
              
              
              
              (2,478,000
              )Cash
      and cash equivalents at beginning of period
              
              
              412,000
              
              
              
              9,621,000Cash
      and cash equivalents at end of period
              
              $
              2,013,000
              
              
              $
              7,143,000












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














-5-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1.
            Description
      of Business




Implant
Sciences Corporation (the “Company”) provides systems and sensors for the
homeland security market and related industries.  The Company has both
developed and acquired technologies using ion mobility spectrometry to develop a
product line for use in trace explosives detection.  The Company
currently markets and sells its existing trace explosives detector products
while continuing to make significant investments in developing the next
generation of these products.




Acquisition
of Ion Metrics




In April
10, 2008 (the “Closing Date”), the Company acquired all of the capital stock of
Ion Metrics, Inc, a California corporation (“Ion Metrics”).  Ion
Metrics is in the business of producing low cost mass sensor systems for the
detection and analysis of chemical compounds such as explosives, chemical
warfare agents, narcotics, and toxic industrial chemicals for the homeland
defense, forensic, environmental, and safety/security markets.  The
transaction was structured as a reorganization of Ion Metrics with and into a
newly formed, wholly-owned subsidiary of the Company.  The total
purchase price, including $564,000 of assumed liabilities, was approximately
$3,309,000.  As part of the transaction, the Company issued to the
former stockholders of Ion Metrics consideration consisting of 2,000,000 shares
of the Company’s common stock, par value $0.10 per
share.    The integration of the Ion Metrics technologies
into the Company’s Quantum Sniffer product line is expected to provide
opportunities to introduce smaller, lower cost, and higher performance security
solutions.  Please refer to Note 17 for further information relative
to the acquisition of Ion Metrics.




Sale
of Accurel




In May
2007, the Company sold substantially all of the assets of our Accurel Systems
subsidiary to Evans Analytical Group, LLC (“Evans”) for approximately
$12,705,000, including $1,000,000 held by an escrow agent as security for
certain representations and warranties.  In February 2008, Evans filed
suit in the Superior Court of the State of California, Santa Clara County,
requesting rescission of the asset purchase agreement, plus damages, based on
claims of misrepresentation and fraud.  In March 2008, Evans filed a
notice with the escrow agent prohibiting release of any portion of the escrow to
us pending resolution of the lawsuit.  More recently, Evans filed
motions to attach substantial portions of our assets prior to any final judgment
on the merits of Evans’ claims.  On November 7, 2008, the Court
denied Evans’ motions.  We are vigorously
defending ourselves against Evans’ claims.  No assurance can be given,
however, that we will be successful in our defense against Evans’ claims, and
any substantial final judgment in favor of Evans would have a material adverse
effect on our business, assets and results of operations and could require us to
file for protection under bankruptcy laws.  Moreover, we believe that
our litigation with Evans has made it extremely difficult to raise capital we
need to operate our business.




Sale
of Core




In February 2008, theCompany announced its plan to sell Core Systems (“Core” or “Core
Systems”), its wholly-owned semiconductor subsidiary and engaged Noblemen
Holdings, LLC to facilitate this plan.  Because this sale is more
likely than not to occur within the next 12 months, the Semiconductor Reporting
Unit is reported as discontinued operations in the accompanying financial
statements (See Note 19).




Sale
of Medical Reporting Unit




In June
2007, the Company sold certain of the assets related to its brachytherapy
products and divested the prostate seed and medical software
businesses.  In March 2008, the Company informed its medical coatings
customers of its intention to discontinue coating operations by the end of the
2008 calendar year.  In July 2008 and August 2008, under two separate
asset purchase agreements, the Company sold certain assets of our medical
coatings business, with proceeds aggregating to approximately
$1,145,000.  Further, in July 2008, the Company entered into a
definitive agreement to sell the remaining assets of our medical business,
conclusion of which is dependent upon receipt of the final
payment.  The Company has signed a non-binding term sheet to sell the
remaining medical coating assets.  Given that these transactions are
more likely than not to occur within the next 12 months, the Medical Reporting
Unit is reported as discontinued operations in the accompanying financial
statements.






-6-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




CorNova




The
Company has partnered with CorNova, Inc. (“CorNova”), a privately-held,
development stage company focused on the development of a next-generation
drug-eluting stent.  The Company owns common stock in CorNova
representing a 15% ownership interest in CorNova, (See Note 15).




Risks
and Uncertainties




While the
Company strives to bring new products to market, it is subject to a number of
risks similar to other technology-based companies, including risks related to:
(a) its dependence on key individuals and collaborative research partners; (b)
competition from substitute products and larger companies; (c) its ability to
develop and market commercially usable products and obtain regulatory approval
for its products under development; and (d) its ability to obtain substantial
additional financing necessary to adequately fund the development,
commercialization and marketing of its products.  For the three months
ended September 30, 2008, the Company reported net income applicable to
common shareholders of $167,000, loss from continuing operations of $634,000 and
provided $973,000 in cash from operating activities of continuing operations.
 As of September 30, 2008, the Company had an accumulated deficit of
approximately $59,553,000 and a working capital deficit of $2,298,000.
 Management continually evaluates plans to reduce its operating expenses
and increase its cash flow from operations.  Failure of the Company to
achieve its projections may require the Company to seek additional financing or
discontinue operations.




On June
27, 2008, the Company entered into an amendment to the Loan Agreement with
Bridge Bank, N.A. (the “Bank”), which amended and restated the terms of the
Company's credit facility and whereby the Bank waived certain existing and
anticipated events of default arising from the Company’s failure and anticipated
failure to comply with the required minimum current ratio and minimum tangible
net worth financial covenants and the failure to comply with planned revenue and
annual forecast for the quarter ended March 31, 2008 and June 30, 2008,
respectively.  The Company was in violation of the required minimum
current ratio and minimum tangible net worth covenants associated with this
facility at June 30, 2008, which noncompliance was also waived by the
bank.




The
Company entered into a Loan and Security Modification Agreement with the Bank on
August 29, 2008, which agreement amended and restated the terms of the Credit
Facility.  As amended, the credit facility was reduced to $1,500,000,
from $5,000,000 and provides for advances of up to 80% of the Company’s
eligible domestic accounts receivable and the lesser of $500,000 or 50% of
the Company’s eligible foreign accounts receivable, bears interest at the prime
rate, plus 2-1/4% per annum, and is collateralized by all assets of the
Company.




On
October 20, 2008, the Bank delivered a notice of default to the Company
requiring payment of all amounts outstanding under the credit facility, as a
consequence of the Company’s failure to achieve the required financial
performance measured on a rolling 90 day average for revenue and net income
(loss) and failure to complete the sale of assets.  The Company
entered into an Amendment to Amended and Restated Loan and Security Agreement on
October 24, 2008, whereby the Bank rescinded the demand for payment of all
amounts outstanding and waived the Company’s noncompliance.  As
amended, the maturity date is the earlier of November 30, 2008 or the date
that the Company receives the first proceeds from the sale of Core
Systems.  Further, the Company agreed to pay a forbearance fee to the
Bank equal to $75,000 on the earlier of November 30, 2008 or the date that the
Company receives the first proceeds from the sale of Core Systems.  As
of September 30, 2008, the unpaid balance due under the credit facility with the
Bank was $718,000.




Management
believes there are plans in place to sustain operations for the near
future.  These plans depend on current sales, expense and cash flow
projections, availability under the Company’s line of credit, a substantial
increase in sales of the Company’s handheld trace explosives detector product,
the sale of Core and other assets, and the ability of the Company to raise
additional capital.  To further sustain the Company, improve its cash
position, and enable it to grow while reducing debt, management will need to
seek additional capital through private financing sources during the next twelve
months.  However, there can be no assurance that management will be
successful in executing these plans.  Management will continue to
closely monitor and attempt to control costs at the Company and actively seek
needed capital through sales of its products, equity infusions, government
grants and awards, strategic alliances, and through its lending
institutions.




The
Company's condensed consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of
business.  The Company has suffered recurring losses from
operations.  The Company’s Series D Redeemable Convertible Preferred
Stock contains mandatory redemptions on a monthly basis.  These
mandatory redemptions are




-7-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




redeemable
in cash or shares of the Company’s common stock, at the Company’s option, so
long as the price of the Company’s stock does not fall below 110% of the fixed
conversion price.  The Company received a waiver of the monthly
amortization payments for the period December 2006 through August 2007, to the
mandatory redemption date.  The redemption payments resumed in
September 2007.  In September, 2008, the Company amended the
Securities Purchase Agreement with Laurus Master Fund, Ltd., under which the
Series D Preferred Stock was issued, extending the mandatory redemption date to
October 24, 2008, at which time redemption of the remaining shares of the Series
D Preferred Stock was required.  Our obligations to Laurus are secured
by a security interest in substantially all of our assets.  As of
September 30, 2008, the outstanding balance due to Laurus was approximately
$2,121,000.  The Company made a payment of $250,000 to Laurus,
inclusive of $22,000 of dividends, on October 2, 2008, and upon application of
this payment, the balance expected to be paid to Laurus on October 24, 2008 was
approximately $1,893,000.  The Company did not meet its redemption
obligation on October 24, 2008.




On
November 4, 2008, the Company again amended the Securities Purchase Agreement,
effective as of October 31, 2008.  Under the amendment the Company and
the Holders agreed that the amount necessary to redeem in full the Series D
Preferred Stock is approximately $2,461,000, together with accrued and unpaid
dividends.  The Company redeemed $268,000 of the $518,000 of Series D
Preferred Stock required to be redeemed as of the October 31, 2008 redemption
date by agreeing to issue 929,535 shares of its common stock, and redeemed the
balance with a cash payment of $250,000.  Subject to the terms and
conditions of the amendment to the Securities Purchase Agreement, the Company is
obligated to make monthly redemption payments through the new mandatory
redemption date of April 10, 2009.




There can
be no assurances that forecasted results will be achieved or that the Company’s
stock price will attain the fixed conversion price which would allow the Company
to redeem the outstanding shares of Series D Preferred Stock and accrued
dividends with shares of its common stock.  These conditions raise
substantial doubt about the Company's ability to continue as a going
concern.  The financial statements do not include any adjustments
relating to the recoverability and classification of asset amounts or the
amounts and classification of liabilities that might be necessary should the
Company be unable to continue as a going concern.




Security
product sales tend to have a long sale cycle, and are often subject to export
controls.  In an effort to identify new opportunities and stimulate
sales, the Company has expanded its sales staff and implemented a new sales tool
to assist in this effort.  However, there can be no assurance that
these efforts will increase revenue.  In addition, the Company
expanded its research and development staff to support internal research and
development programs including new product development.




The
Company has a history of being active in submitting proposals for government
sponsored grants and contracts and successful in being awarded grants and
contracts from government agencies. Management will continue to pursue these
grants and contracts to support its research and development efforts primarily
in the areas of trace explosives detection.




2.
            Interim
      Financial Statements and Basis of
Presentation




The
accompanying condensed consolidated financial statements of the Company have
been prepared in accordance with U.S. generally accepted accounting principles
(“U.S. GAAP”).  In the opinion of management, the accompanying
condensed consolidated financials statements include all adjustments (consisting
only of normal recurring adjustments), which the Company considers necessary for
a fair presentation of the financial position at such date and of the operating
results and cash flows for the periods presented.  The results of
operations and cash flows for the three months ended September 30, 2008 may not
necessarily be indicative of results that may be expected for any succeeding
quarter or for the entire fiscal year.  The information contained in
this Form 10-Q should be read in conjunction with the Company’s audited
financial statements, included in our Form 10-K, as amended, as of and for the
year ended June 30, 2008.




The
balance sheet at June 30, 2008 has been derived from our audited consolidated
financial statements at that date but does not include all of the information
and footnotes required by U.S. GAAP for complete financial
statements.




The
accompanying condensed consolidated financial statements include the accounts of
the Company reflecting its operations in Massachusetts and
California.




As a
result of the Company’s decision to dispose of Core, the assets and liabilities
of Core are presented in the accompanying condensed consolidated balance sheet
as assets and liabilities held for sale as of September 30, 2008






-8-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




and June
30, 2008 and the operating results of Core are presented in the accompanying
condensed consolidated statements of operations as discontinued operations for
the three months ended September 30, 2008 and 2007.




As a
result of the Company’s decision to dispose of the medical business unit, the
assets and liabilities of the medical business unit are presented in the
accompanying condensed consolidated balance sheet as assets and liabilities held
for sale as of September 30, 2008 and June 30, 2008, and the operating results
of the medical business unit are presented in the accompanying condensed
consolidated statements of operations as discontinued operations for the three
months ended September 30, 2008 and 2007.




Additionally,
the following notes to the condensed consolidated financial statements include
disclosures related to the Company’s continuing operations unless specifically
identified as disclosures related to discontinued operations.




Significant
accounting policies are described in Note 2 to the financial statements included
in Item 7 of the Company’s Form 10-K, as amended, as of June 30,
2008.  The preparation of financial statements in conformity with U.S.
GAAP requires management to make estimates and judgments, which are evaluated on
an ongoing basis, that affect the amounts reported in the Company's condensed
consolidated financial statements and accompanying notes.  Management
bases its estimates on historical experience and on various other assumptions
that it believes are reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities and the amounts of revenues and expenses that are not readily
apparent from other sources.  Actual results could differ from those
estimates and judgments.  In particular, significant estimates and
judgments include those related to revenue recognition, allowance for doubtful
accounts, useful lives of property and equipment, inventory reserves, valuation
for goodwill and acquired intangible assets, and realization of amounts held in
escrow.




Certain
reclassifications were made to the financial statements for the three months
ended September 30, 2007 to conform to the presentation for the three months
ended September 30, 2008.




3.
            Fair
      Value Measurement






The
Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 157,
“Fair Value Measurement,”on July 1, 2008.  SFAS No. 157 defines and establishes a
framework for measuring fair value and expands disclosure about fair value
measurements.  The standard creates a fair value hierarchy which
prioritizes the inputs to valuation techniques used to measure fair value into
three broad levels as follows: Level 1 inputs are quoted prices (unadjusted) in
active markets for identical assets or liabilities; Level 2 inputs are inputs
other than quoted prices included within Level 1 that are observable for the
asset or liability, either directly or indirectly; and Level 3 inputs are
unobservable inputs that reflect the Company’s own assumptions about the
assumptions market participants would use in pricing the asset or
liability.




Financial
assets and liabilities are classified in their entirety based on the lowest
level of input that is significant to the fair value
measurement.  Under SFAS No. 157, the Company’s cash and cash
equivalents, which had a balance of approximately $2,013,000, was required to be
measured at fair value at September 30, 2008 and the balance was included in
Level 1 inputs.




4.
              Restricted
      Cash
  As of
both September 30, 2008 and June 30, 2008, the Company had restricted cash of
$514,000.  As of both September 30, 2008 and June 30, 2008, restricted
cash consisted of $439,000 held in a money market account which collateralized
the Company’s performance under an irrevocable letter of credit issued on June
25, 2008, in the amount of $418,000.  The letter of credit provides
performance security equal to 10% of the contract amount for security product
which shipped in the first quarter of fiscal 2009.  At both September
30, 2008 and June 30, 2008, restricted funds included $75,000 deposited in
certificates of deposit, which collateralize two (2) credit cards issued by the
Company’s primary lender.
  5.
              Stock
      Based Compensation
  The
Company’s condensed consolidated statements of operations for the three months
ended September 30, 2008 and 2007 include $114,000 and $132,000, respectively,
of compensation costs and no income tax benefit related to the Company’s
stock-based compensation arrangements for employee and non-employee director
awards.  As of September 30, 2008, the total amount of unrecognized
stock-based compensation expense was approximately $824,000, which will be
recognized over a weighted average period of 2.9 years.




-9-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS






6.
            Related
      Party Transactions




SFAS No.
57, “Related Party
Disclosures,” specifies the nature of information that is required to be
disclosed in financial statements regarding related party
transactions.  The former chairman of Ion Metrics, Inc., (“Ion
Metrics”) which entity was acquired by the Company on April 10, 2008, serves as
a Managing Director of a merger and acquisition and management advisory company
(the “Advisory Company”), that has been engaged by the Company to market
the Company’s wholly-owned subsidiary, Core Systems.  During the three
months ended September 30, 2008 and 2007, the Advisory Company was paid $30,000
and $0, respectively.  As of September 30, 2008, the Company recorded
payables to the Advisory Company of $9,000.




In
connection with the acquisition of Ion Metrics, the Company entered into a Board
Observer Rights Agreement, effective as of April 10, 2008, providing for, among
other things, the right of one representative of Ion Metrics' shareholders
to attend meetings of the Company’s board of directors as an observer,
which role has been represented by the former chairman of Ion
Metrics.  On October 13, 2008, the Company and the former Ion Metrics'
shareholders agreed to terminate the Board Observers Rights Agreement and agreed
to terminate the Escrow Agreement, as further described in Note
17.  Further, the Company has entered into a Fixed Asset Lease
Agreement with Ferran Scientific, Inc., a firm owned by the father of the former
Ion Metrics chairman.




7.
            Inventories




Inventories
consist of the following:


September
      30,
              
              
              June
      30,2008
              
              
              2008Raw
      materials
              
              $
              300,000
              
              
              $
              400,000Work
      in progress
              
              
              32,000
              
              
              
              23,000Finished
      goods
              
              
              591,000
              
              
              
              302,000$
              923,000
              
              
              $
              725,000


8.
              Property
      and Equipment
  Property
and equipment consists of the following:
 September
      30,
                
                
                June
      30,2008
                
                
                2008Machinery
      and equipment
                
                $
                523,000
                
                
                $
                517,000Computers
      and software
                
                
                879,000
                
                
                
                871,000Furniture
      and fixtures
                
                
                164,000
                
                
                
                164,000Leasehold
      improvements
                
                
                369,000
                
                
                
                369,000Equipment
      under capital lease
                
                
                93,000
                
                
                
                93,0002,028,000
                
                
                
                2,014,000Less:  accumulated
      depreciation and amortization
                
                
                1,625,000
                
                
                
                1,571,000$
                403,000
                
                
                $
                443,000
 For the
three months ended September 30, 2008 and 2007, depreciation expense was $54,000
and $41,000, respectively.






-10-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS






9.
            Accrued
      Expenses




Accrued
expenses consist of the following:


September
      30,
              
              
              June
      30,2008
              
              
              2008Accrued
      compensation and benefits
              
              $
              845,000
              
              
              $
              807,000Accrued
      taxes
              
              
              289,000
              
              
              
              289,000Accrued
      legal and accounting
              
              
              330,000
              
              
              
              259,000Accrued
      interest
              
              
              57,000
              
              
              
              46,000Accrued
      warranty costs
              
              
              615,000
              
              
              
              104,000Accrued
      commissions
              
              
              460,000
              
              
              
              -Other
      accrued liabilities
              
              
              541,000
              
              
              
              557,000$
              3,137,000
              
              
              $
              2,062,000


10.
            Earnings
      Per Share




The
Company follows SFAS No. 128, “Earnings Per Share,” where basic earnings per
share is computed by dividing net income (loss) by the weighted average number
of common shares outstanding during the period.  Diluted earnings per
share are based upon the weighted average number of common shares outstanding
during the period plus additional weighted average common equivalent shares
outstanding during the period.  Common equivalent shares result from
the assumed exercise of outstanding stock options and warrants, the proceeds of
which are then assumed to have been used to repurchase outstanding common stock
using the treasury stock method.  In addition, the numerator is
adjusted for any changes in income or loss that would result from the assumed
conversion of potential shares.  As of September 30, 2008 and 2007,
potentially dilutive shares of 0 shares and 135,000 shares, respectively, were
excluded from the earnings per share calculation because their effect would be
antidilutive.  Shares deemed to be antidilutive include stock options
and warrants.




11.
            Long-Term
      Debt and Credit Arrangements




Med-Tec
Payment Obligation




On July
31, 2003, the Company entered into an Asset Purchase Agreement (the “Agreement”)
with Med-Tec Iowa, Inc (“Med-Tec”) its former exclusive distributor of prostate
seeds, to purchase Med-Tec’s customer lists and further to release each other
from further obligations under a January 2000 Distribution
Agreement.  The purchase price of $1,250,000 which was payable in
varying amounts over 28 months, with the final payment payable on December
1, 2005, was recorded at the present value of the future payment stream, using a
rate of 10.24%, which equaled $1,007,000.  This amount was recorded as
an intangible asset and is being amortized over its estimated useful life of 29
months.  The outstanding and past due principal balance
as of September 30, 2008 and June 30, 2008 was approximately $74,000, and
$80,000 respectively.




Revolving
Credit Facility and Term Note
  On June
1, 2005, the Company executed a revolving credit facility for $1,500,000 with
Silicon Valley based Bridge Bank, N.A. (the “Bank”).  On January 3,
2007, the Company executed an Amended and Restated Loan and Security Agreement
with the Bank increasing the revolving credit facility from $1,500,000 to
$5,000,000.
  On June
27, 2008, the Company entered into an amendment to the Loan Agreement with the
Bank, which amended and restated the terms of the credit
facility.  The Bank also waived certain existing and anticipated
events of default arising from the Company’s failure and anticipated failure to
comply with the required minimum current ratio and minimum tangible net worth
financial covenants and the failure to comply with planned revenue and annual
forecast for the quarter ended March 31, 2008 and June 30, 2008, respectively.
 The Company was in violation of the required minimum current ratio and
minimum tangible net worth covenants associated with this facility at June 30,
2008, which noncompliance was also waived by the bank.  Pursuant to
the amended Loan Agreement, the Company was required to pay a $10,000 default
fee and reimburse the bank for legal expenses of approximately $2,000 incurred
in connection with the amendment.  Further, the Bank consented to the
following transactions, contemplated by the Company: i) the sale of certain
assets of the Company’s medical business, ii) the sale of certain assets of the
Company’s brachytherapy business, and iii) the sale of the Company’s
semiconductor business, subject to minimum proceeds of
$3,000,000.




-11-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Pursuant
to the Loan Agreement, the Company issued to the Bank a seven-year warrant to
purchase up to 18,939 shares of the Company’s common stock at a price equal to
$2.64 per share.  The warrant was valued using the Black Scholes
model.  Pursuant to ABP No 14 “Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants”, the warrant was recorded at its
relative fair value of $28,000 and accreted  to the term note over the
life of the note.  As of September 30, 2008, approximately $28,000 has
been amortized.  Pursuant to the amended Loan Agreement, the Company
issued to the Bank a seven-year warrant to purchase up to 43,860 shares of the
Company’s common stock at a price equal to $1.14 per share.  The
warrant was valued using the Black Scholes model.  Pursuant to ABP No
14, the warrant was recorded at its relative fair value of $29,000 and was
charged to interest expense during the year ended June 30, 2008.




The
Company entered into a Loan and Security Modification Agreement with the Bank on
August 29, 2008, which agreement amended and restated the terms of the Credit
Facility.  As amended, the Credit Facility was reduced to $1,500,000,
from $5,000,000 and provides for advances of up to 80% of the Company’s eligible
domestic accounts receivable and the lesser of $500,000 or 50% of the Company’s
eligible foreign accounts receivable, bears interest at the prime rate, plus
2-1/4% per annum, and is collateralized by all assets of the
Company.




As of
September 30, 2008 and June 30, 2008, the Company’s obligation for borrowed
funds under the credit facility amounted to $718,000 and $862,000,
respectively.




On
October 20, 2008, the Bank delivered a notice of default to the Company
requiring payment of all amounts outstanding under the credit facility, as a
consequence of the Company’s failure to achieve the required financial
performance measured on a rolling 90 day average for revenue and net income
(loss) and failure to complete the sale of assets.  The Company
entered into an Amendment to Amended and Restated Loan and Security Agreement on
October 24, 2008, whereby the Bank rescinded the demand for payment of all
amounts outstanding and waived the Company’s noncompliance.  As
amended, the maturity date shall be the earlier of November 30, 2008 or the date
that the Company receives the first proceeds from the sale of Core
Systems.  Further, the Company agreed to pay a forbearance fee to the
Bank equal to $75,000 on the earlier of November 30, 2008 or the date that the
Company receives the first proceeds from the sale of Core Systems.




12.
              Redeemable
      Convertible Preferred Stock
  On
September 30, 2005, the Company issued 500,000 shares of Series D Redeemable
Convertible Preferred Stock (“Series D Preferred Stock”) having a stated value
of $10 per share, pursuant to a securities purchase agreement (the “Securities
Purchase Agreement”) with Laurus Master Fund, Ltd. (“Laurus”) for gross cash
proceeds of $5,000,000.  The Series D Preferred Stock has a dividend
equal to the prime rate plus one percent (1%) (6.00% at September 30, 2008) and
provided for redemption over a thirty-six month period, pursuant to an
amortization schedule,.
  On
December 28, 2006, Laurus consented to permit the Company to defer the December
2006 through August 2007 redemptions to September 30, 2008, the end of the term.
The monthly redemption of approximately $152,000 plus accrued dividends resumed
on September 1, 2007 and continued until the final payment date on September 30,
2008.  The amount due on September 29, 2008, including accrued
dividends, was $2,143,000.  Subject to certain conditions, including
the market price of the Company’s common stock being above $4.57 per share, the
Company has the option to pay this amount in cash or common stock at a fixed
conversion price of $4.15 per common share.
  On
September 30, 2008, the Company further amended the Securities Purchase
Agreement to extend the mandatory redemption date to October 24, 2008, at which
time the Company is required to redeem the shares of Series D Preferred Stock,
including unpaid dividends.  In consideration for extending the
mandatory redemption date, the Company agreed to pay an amount equal to no less
than $250,000, which payment shall be applied first to accrued and unpaid
dividends on the Series D Preferred Stock and then to any outstanding principal
balance.  The Company valued the Series D Preferred Stock at issuance
at its residual value of $2,700,000 based on the fair values of the financial
instruments issued in connection with this preferred stock financing, including
certain warrants, the embedded derivative instruments and offering
costs.  The amounts recorded in the financial statements represent the
amounts attributed to the sale of the Series D Preferred Stock, the amount
allocated to warrants, the value attributed to the embedded derivatives and
issuance costs.  The Company is accreting these discounts on the
carrying value of the Series D Preferred Stock to its redemption value at
September 29, 2008, or the actual conversion date, whichever is
earlier.  The accretion of these amounts is being recorded as a
preferred dividend in the period of accretion.  For the three months
ended September 30, 2008 and 2007, $155,000 and $218,000, respectively, was
amortized.  As of




-12-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




September
30, 2008 and June 30, 2008, the outstanding balance on the Series D Preferred
Stock was $2,121,000 and $2,424,000, respectively.




On
November 4, 2008, the Company again entered into an amendment to the
Securities Purchase Agreement, effective as of October 31,
2008.  Under the amendment the Company and the Holders agreed that the
amount necessary to redeem in full the Series D Preferred Stock is approximately
$2,461,000, together with accrued and unpaid dividends and the new mandatory
redemption date is April 10, 2009.




The
following table sets forth the redemption dates and amount due on said dates,
together with dividends accrued, to the extent such portions have not been
converted into shares of the Company’s common stock pursuant to the Securities
Purchase Agreement :


Repayment
      Date
              
              Redemption
                Amount
              
              
              Remaining
                Stated
      ValueOctober
      31, 2008
              
              $
              518,000
              
              
              $
              1,943,000November
      28, 2008
              
              
              800,000
              
              
              
              1,143,000December
      19, 2008
              
              
              250,000
              
              
              
              893,000January
      16, 2009
              
              
              250,000
              
              
              
              643,000February
      13, 2009
              
              
              250,000
              
              
              
              393,000March
      13, 2009
              
              
              250,000
              
              
              
              143,000April
      10, 2009
              
              
              143,000
              
              
              
              -


Notwithstanding
the foregoing, the Company also agreed that, within two business days of the
consummation of the sale of substantially all of the assets and/or equity of its
Core Systems subsidiary to any third party, the Company will redeem no less
than $800,000 of the Series D Preferred Stock.  The amount of such
redemption will first be applied to reduce accrued and unpaid dividends on the
Series D Preferred Stock and then to reduce the monthly redemption amounts set
forth above in chronological order of maturity.




The
Company redeemed $268,000 of the $518,000 of Series D Preferred Stock required
to be redeemed as of the October 31, 2008 Redemption Date by agreeing to issue
to the Holder 929,535 shares of its common stock (the “Payment Shares”), and
redeemed the balance with a cash payment of $250,000.  The Payment
Shares were valued at $0.28829 per share, which was equal to the volume-weighted
average price of the Company’s common stock as reported by Bloomberg, L.P. for
the 15-day period immediately preceding the date of the
amendment.  The Holder has agreed, with certain exceptions, not to
transfer any of the Payment Shares or any interest therein, directly or
indirectly, prior to April 30, 2009.  The Company has the right to
repurchase up to 50% of the Payment Shares prior to April 30, 2009 at a price
per share equal to 110% of volume-weighted average price of the Payment Shares
as reported by Bloomberg, L.P. for the 15-day period immediately preceding the
date upon which the Holder receives notice of the Company’s desire to repurchase
such Payment Shares.
  13.
              Stockholders’
      Equity
  Common
Stock Options and Warrants
  In
connection with various financing agreements and services provided by
consultants, the Company has issued warrants to purchase common stock of the
Company.  The fair value of warrants issued is determined using the
Black-Scholes option pricing model.  During the three months ended
September 30, 2008 and 2007, the Company issued no warrants to purchase shares
of the Company’s common stock.  As of September 30, 2008, there were
warrants outstanding to purchase 2,297,627 shares of the Company’s common stock
at exercise prices ranging from $1.14 to $12.45 expiring at various dates
between November 25, 2008 and June 27, 2015.
  The
Company issued no shares of common stock during the three months ended September
30, 2008 and 2007, as a result of the exercise of options by employees and
consultants.
  Employee
Stock Purchase Plan
  During
the three months ended September 30, 2008 and 2007, the Company issued 31,147
shares and 18,977 shares, respectively, of its common stock to its employees
pursuant to the terms of the 2006 Employee Stock Purchase
Plan.




-13-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Treasury
Stock and Other Transactions




In June
2004, the Board authorized the Company to repurchase up to 300,000 shares of the
Company’s common stock, from time to time in the open market, privately
negotiated transactions, block transactions or at time and prices deemed
appropriate by management.  As of September 30, 2008 and June 30,
2008, 10,545 shares were held in treasury at cost.  During the each of
the three months ended September 30, 2008 and 2007, the Company repurchased no
shares of the Company’s common stock.  As of September 30, 2008, the
maximum number of shares authorized to be repurchased were 289,455.




14.
            Income
      Taxes




The
Company uses the liability method of accounting for income taxes as set forth in
SFAS No. 109, “Accounting for
Income Taxes.”  Under this method, deferred taxes are
determined based on the difference between the financial statement and tax bases
of assets and liabilities using enacted tax rates in effect in the years in
which the differences are expected to reverse.  Deferred tax assets
are recognized and measured based on the likelihood of realization of the
related tax benefit in the future.




For the
three months ended September 30, 2008 and 2007, the Company provided for no
income taxes, other than state income taxes, as the Company has significant net
loss carryforwards.




15.
              Investment
      in CorNova
  As of
both September 30, 2008 and June 30, 2008, the Company had a 15% ownership
interest, respectively, in the common stock of CorNova.  During the
three months ended September 30, 2007, the Company recorded equity in
comprehensive income of CorNova of $7,000 (related to unrealized holding gains
on securities classified as available-for-sale).  As a result of the
cumulative net losses incurred, the Company’s investment in CorNova was $0 as of
September 30, 2008.
  The
Company has historically accounted for its investment in this unconsolidated
subsidiary under the equity method, due in part, to the significant influence
the Company had over CorNova resulting from Dr. Anthony J. Armini serving on
CorNova’s Board of Directors.  Dr. Armini served as the President and
Chief Executive Officer of the Company, resigning both positions on September
27, 2007.  As a result of Dr. Armini’s resignation from CorNova’s
board in September 2007, the equity method is no longer appropriate and the cost
method was used.  Therefore, no additional losses were recorded from
the Company’s equity ownership in CorNova in fiscal 2008.  The Company
has no additional obligation to contribute assets or additional common stock or
to assume any liabilities or to fund any losses that CorNova may
incur.
  16.
              Commitments
      and Contingencies
  The
Company leases manufacturing, research and office space in Wakefield,
Massachusetts, the lease of which expires on December 31, 2008.  Under
the terms of the lease, the Company is responsible for its proportionate share
of real estate taxes and operating expenses relating to this
facility.  The Company leases two facilities in Sunnyvale,
California.  The leases expire in December 2009 and September 2010,
respectively.  The Company has an option to extend each lease for five
additional years.  Effective with the sale of the assets of Accurel
Systems on May 1, 2007, the Company executed a sublease agreement for one of its
California facilities.  As a result of the Ion Metrics acquisition,
the Company assumed the obligation of a lease for research and office space in
San Diego, California, which lease expires on January 31, 2009.  In
addition, in March 2008, the Company entered into a six month lease for office
space in Beijing, China, to support the sales activities in the
region.  Total rent expense, including assessments for maintenance and
real estate taxes for the three months ended September 30, 2008 and 2007, for
both continuing and discontinued operations was $378,00 and $359,000,
respectively.
  In
conjunction with the acquisition of Accurel, in March 2005, the Company recorded
a lease liability of $829,000.  This liability reflected management’s
estimate of the excess of payments required under the Accurel facility lease, at
the date of acquisition, versus the fair market value of lease payments that
would have been required, had the lease been negotiated under current market
conditions.  Subsequently, as a result of the sale of Accurel, the
Company has recorded an additional liability of $487,000 representing that
portion of the lease in excess of the sublease arrangement with
Evans.  The balance of the lease liability on September 30, 2008 is
$631,000 of which $322,000 is current.
  In April
2007, in conjunction with the Company’s plans to conduct research, development
and minor manufacturing work in New Mexico, the Company executed an operating
lease which was initially to expire on




-14-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




May 1,
2010.  The lease allowed for early termination, which the Company
elected in February 2008.  As a result of the early termination, the
Company is responsible for reimbursing the landlord for certain leasehold
improvements over a 24 month period.  As of September 30, 2008, the
balance due is approximately $29,000 and is included in Accrued
Expenses.




The
Company is obligated under two license agreements, assumed in connection with
the acquisition of Ion Metrics, whereby the Company has been granted rights to
use certain intellectual property for safety, security and drug applications,
which the Company intends to incorporate into future security product
offerings.  Minimum royalty payments due in fiscal 2009 are $50,000
and no payments have been made in the three months ended September 30,
2008.




17.
            Acquisition




On April
10, 2008, the Company acquired all of the capital stock of Ion
Metrics.  The transaction was being structured as a reorganization of
Ion Metrics with and into a newly formed, wholly-owned subsidiary of the
Company.  The operating results of Ion Metrics have been included in
the Company’s statement of operations commencing on April 10, 2008.




The
aggregate purchase price of Ion Metrics, excluding assumed liabilities, was
$2,745,000.  As part of the Transaction,
the Company issued to the former stockholders of Ion Metrics consideration
consisting of 2,000,000 shares of the Company’s common stock, par value $0.10
per share.  The fair value of the Company's common stock was
determined based on the average market price of the Company's common stock over
a period of time before April 10, 2008, the date fair value is to be determined,
pursuant to Emerging Issues Task Force ("EITF") Issue No. 99-12, “Determination of the Measurement
Date for the Market Price of Acquirer Securities Issued in a Purchase Business
Combination.”  The Company issued the 2,000,000 shares of the
Company’s common stock to the IMI Stockholders in August 2008.  The
Company entered into an agreement with Ferran Scientific, Inc., a firm owned by
the father of the former Ion Metrics chairman, whereby the Company assumed
certain Ion Metrics obligations and rights.  In consideration for the
assignment of these obligations and rights, the Company agreed to a $50,000 fee
payable to the Ion Metrics shareholders for these assignments.  This
agreement also included modifications to these assumed obligations including the
deferral of payment obligations for a period up to 12 months from the closing
date.




The
former Ion Metrics stockholders have agreed not to sell any of their shares of
common stock for a period of 18 months from the closing date; provided however
for the period from six to 18 months after the closing date, each
holder may sell, in any three month period, the greater of (a) 1% of the
outstanding shares of the same class being sold or (b) if the class is listed on
a stock exchange or quoted on the American Stock Exchange, the greater of (i) 1%
of the outstanding shares of such class or (ii) the average reported weekly
trading volume during the four weeks preceding the sale.
  In
connection with this transaction, the Company entered into an escrow agreement
with Ion Metrics and ComputerShare Trust Company, as escrow
agent.  The Company deposited 400,000 shares of common stock,
representing 20% of the purchase price, into an escrow account.  Any
valid claims for indemnification made by the Company pursuant to the Merger
Agreement will be paid from the escrowed shares.  The escrow agreement
initially provided, subject to any claims of indemnifications, for a release of
the escrowed shares on April 10, 2009.  On October 13, 2008, the
Company agreed to the complete release of the escrowed shares.
  The
transaction also included board observer rights which permitted a designee of
the former IMI stockholders to attend meetings of the Company's board of
directors.  On October 13, 2008, the Company and the former Ion
Metrics shareholders mutually agreed to terminate these observers
rights.
  The
following table summarizes the purchase price:
 Cash
                
                $
                91,000Direct
      costs
                
                
                140,000Payable
      to Ion Metrics Shareholders
                
                
                2,514,000$
                2,745,000




-15-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS






The
following table summarizes the purchase price allocation to the fair value of
the assets acquired and liabilities assumed at the date of
acquisition:


Accounts
      receivable
              
              $
              7,000Other
      receivables
              
              
              3,000Prepaid
      expenses
              
              
              11,000Property,
      plant and equipment
              
              
              83,000Goodwill
              
              
              3,136,000Customer
      relationships
              
              
              69,000Accounts
      payable
              
              
              (241,000
              )Accrued
      interest
              
              
              (20,000
              )Accrued
      payroll
              
              
              (4,000
              )Accrued
      liabilities other
              
              
              (10,000
              )Notes
      payable
              
              
              (181,000
              )Current
      maturities of obligations under capitalized lease
              
              
              (11,000
              )Long-term
      obligations under capital lease, net of current maturities
              
              
              (97,000
              )$
              2,745,000


The
allocation of purchase price is the responsibility of management.  The
Company considered a number of factors,
including professional appraisals, for the valuation of equipment acquired, in
making its purchase price allocation determination.  The acquisition
of Ion Metrics resulted in goodwill of $3,136,000 and the identification of
$69,000 of intangible assets with finite lives.  The intangible assets
are being amortized over a period of twelve months, the estimated useful lives
of the assets, from the date of acquisition, April 10,
2008.  Amortization expense for the three months ended September 30,
2008 to the intangible assets was $18,000.




The
acquisition of Ion Metrics is accounted for as a purchase under SFAS No. 141,
“Business Combinations.”  Accordingly, the operating results of Ion
Metrics are included in the accompanying condensed consolidated financial
statements since the acquisition date as part of the Company's Security
segment.
  18.
              Financial
      Information By Segment
  SFAS No.
131, “Disclosures about Segments of an Enterprise and Related Financial
Information” (“SFAS No..131”), defines operating segments as components of an
enterprise about which separate financial information is available that is
regularly evaluated by the chief operating decision maker or decision making
group, in determining how to allocate resources and in accessing
performance.  The Company’s chief operating decision making group is
composed of the chief executive officer and members of senior
management.  Based on qualitative and quantitative criteria
established by SFAS No. 131, the Company has determined that it operates within
one reportable segment, which is the Security Products Segment.
  19.
              Discontinued
      Operations
  Core
Systems, Inc.
  In
accordance with SFAS No.144, “Accounting for the Impairment or
Disposal of Long-Lived Assets”, the accompanying condensed consolidated
balance sheets and statements of operations present the results of Core as
discontinued operations.  The Company’s Board of Directors approved a
plan to sell Core in February 2008.  The Company has (i) eliminated
Core’s financial results from its ongoing operations, (ii) determined that Core,
which operated as a separate subsidiary, was a separate component of its
aggregated business as, historically, management reviewed separately the Core
financial results and cash flows apart from its ongoing continuing operations,
and (iii) determined that it will have no further continuing involvement in the
operations of Core or cash flows from Core after the
sale.  Accordingly, the assets and liabilities of Core are classified
as held for sale as of September 30, 2008 and June 30, 2008.




-16-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS








Condensed
results of operations relating to Core for the three months ended September 30,
2008 and 2007 are as follows:


Three
      Months EndedSeptember
      30,2008
            
            
            2007Revenues
            
            $
            1,506,000
            
            
            $
            1,737,000Gross
      profit
            
            
            295,000
            
            
            
            (38,000
            )Operating
      income (loss)
            
            
            17,000
            
            
            
            (409,000
            )Income
      (loss) from discontinued operations
            
            
            16,000
            
            
            
            (410,000
            )




The
assets and liabilities of Core as of September 30, 2008 and June 30, 2008 are as
follows:
 September
      30,
                
                
                June
      30,2008
                
                
                2008Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
                
                $
                889,000
                
                
                $
                1,178,000Inventories
                
                
                278,000
                
                
                
                251,000Prepaid
      expenses and other current assets
                
                
                -
                
                
                
                -Total
      current assets of discontinued operations
                
                
                1,167,000
                
                
                
                1,429,000Non-current
      assets of discontinued operations:Property,
      plant and equipment, net
                
                
                850,000
                
                
                
                833,000Goodwill
                
                
                1,195,000
                
                
                
                1,195,000Other
      assets
                
                
                25,000
                
                
                
                25,000Intangible
      assets, net
                
                
                32,000
                
                
                
                32,000Total
      non-current assets of discontinued operations
                
                
                2,102,000
                
                
                
                2,085,000Total
      assets of discontinued operations
                
                $
                3,269,000
                
                
                $
                3,514,000Liabilities
      of Discontinued OperationsCurrent
      liabilities of discontinued operations:Current
      portion of long term debt and capital leases
                
                $
                4,000
                
                
                $
                5,000Accounts
      payable
                
                
                432,000
                
                
                
                517,000Accrued
      expenses
                
                
                411,000
                
                
                
                316,000Deferred
      revenue
                
                
                10,000
                
                
                
                10,000Total
      current liabilities of discontinued operations
                
                
                857,000
                
                
                
                848,000Non-current
      liabilities of discontinued operations:Long-term
      debt and obligations under capital lease, net of current
      maturities
                
                
                1,000
                
                
                
                1,000Total
      liabilities of discontinued operations
                
                $
                858,000
                
                
                $
                849,000
 Medical
Business Unit
  In
accordance with SFAS No.144, “Accounting for the Impairment or
Disposal of Long-Lived Assets”, the accompanying condensed consolidated
balance sheets and statements of operations present the results of the Medical
Business Unit as discontinued operations.








-17-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS






Condensed
results of operations relating to the Medical Business Unit for the three months
ended September 30, 2008 and 2007 are as follows:


Three
      Months EndedSeptember
      30,2008
            
            
            2007Revenues
            
            $
            357,000
            
            
            $
            134,000Gross
      profit
            
            
            43,000
            
            
            
            (178,000
            )Operating
      income (loss)
            
            
            43,000
            
            
            
            (227,000
            )Gain
      on sale of assets
            
            
            931,000
            
            
            
            -Income
      (loss) from discontinued operations
            
            
            974,000
            
            
            
            (227,000
            )




The
assets and liabilities of the Medical Business Unit as of September 30, 2008 and
June 30, 2008 are as follows:
 September
      30,
                
                
                June
      30,2008
                
                
                2008Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
                
                $
                272,000
                
                
                $
                149,000Inventories
                
                
                297,000
                
                
                
                305,000Total
      current assets of discontinued operations
                
                
                569,000
                
                
                
                454,000Non-current
      assets of discontinued operations:Property,
      plant and equipment, net
                
                
                368,000
                
                
                
                560,000Total
      non-current assets of discontinued operations
                
                
                368,000
                
                
                
                560,000Total
      assets of discontinued operations
                
                $
                937,000
                
                
                $
                1,014,000Liabilities
      of Discontinued OperationsCurrent
      liabilities of discontinued operations:Accounts
      payable
                
                $
                160,000
                
                
                $
                100,000Accrued
      expenses
                
                
                61,000
                
                
                
                131,000Total
      liabilities of discontinued operations
                
                $
                221,000
                
                
                $
                231,000
 20.
              Legal
      Proceedings
  From time
to time, we are subject to various claims, legal proceedings and investigations
covering a wide range of matters that arise in the ordinary course of our
business activities. Each of these matters is subject to various
uncertainties.
  Evans
Analytical Group LLC
  In May 1,
2007, the Company sold substantially all of the assets of our Accurel
Systems subsidiary to Evans Analytical Group, LLC ("Evans")
for approximately $12,705,000.
  In
connection with this transaction, we entered into an escrow agreement with
Evans, Accurel, and Zions First National Bank.  Pursuant to the escrow
agreement, Evans deposited $1,000,000 of the total purchase price for the assets
into an escrow account.  The escrow agreement provided, subject to any
claims of indemnifications, for a release of $500,000 on approximately each of
March 31, 2008 and March 31, 2009.
  Also in
connection with the transaction, we entered into a Non-competition and
Nondisclosure Agreement with Evans whereby we agreed not to engage in any
business that directly competes with the business of Accurel.  In
addition, this agreement prohibits us from disclosing any confidential
information concerning the business of Accurel.  This
agreement will remain in effect for five years from the date of its
execution.
  On
February 22, 2008, Evans filed suit requesting rescission of the asset purchase
agreement, plus damages, based on claims of misrepresentation and
fraud.  On March 28, 2008, Evans filed a formal claims notice with the
escrow agent prohibiting release of any portion of the escrow to the Company as
a result of the litigation.  As a




-18-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




result
that Company has classified the $1,000,000 escrow amount as a long term
asset.  More recently, Evans filed
motions to attach substantial portions of our assets prior to any final judgment
on the merits of Evans’ claims.  On November 7, 2008, theSuperior Court of the
State of California, Santa Clara County, deniedEvans’ motion.  Management
believes the Evans’ claims are without merit and, in addition, management does
not believe that potential liabilities, if any, are currently probable or
estimable. We are
vigorously defending ourselves against Evans’ claims.  No assurance
can be given, however, that we will be successful in our defense against Evans’
claims, and any substantial final judgment in favor of Evans would have a
material adverse effect on our business, assets and results of operations, and
could require us to file for protection under bankruptcy
laws.  Moreover, we believe that our litigation with Evans has made it
extremely difficult to raise capital we need to operate our
business.




Rapiscan
Systems, Inc.
 In March
2005, we entered into a Development, Distribution and Manufacturing Agreement
with Rapiscan Systems, Inc. (“Rapiscan”), in which we granted Rapiscan the
exclusive worldwide rights to market our Quantum SnifferTM
portable and benchtop trace detection devices under their private
label.  We also agreed to grant Rapiscan the exclusive worldwide
rights to distribute certain other new security products which we may develop in
the future with their funding, as well as rights, in some circumstances, to
manufacture certain components of the private-labeled Quantum SnifferTM
portable and benchtop trace detection devices.
  In March
2006, Rapiscan filed a complaint against the Company and its contract assembler,
Columbia Tech, alleging claims against the Company of breach of contract and
breach of warranty and requested specific performance, declaratory relief and
injunctive relief.  Rapiscan’s complaint against Columbia Tech alleged
tortuous interference with contractual relations and requested injunctive relief
and declaratory relief.  In April 2006, Rapiscan dismissed all claims
against Columbia Tech.
  On
January 4, 2008, the Company settled this litigation.  In addition to
the immediate dismissal of the litigation, other terms of the settlement
agreement include (i) the rescission of the original agreement with Rapiscan,
(ii) the payment by the Company of $200,000, in the form of 221,729 shares of
the Company’s common stock,  (iii) the granting of non-exclusive
distribution rights to Rapiscan, (iv) the payment by the Company of up to
$1,000,000 in technology transfer fees, payable over time at a rate of 2% of the
gross sales price received by the Company when and if a passenger portal is
sold, and (v) the opportunity for Rapiscan to supply certain components to the
Company.
  We may,
from time to time, be involved in other actual or potential proceedings that we
consider to be in the normal course of our business.  We do not
believe that any of these proceedings will have a material adverse effect on our
business.
  21.
              Subsequent
      Events
  On October 10, 2008, the Company received a notice of default on its credit
facility from Bridge Bank, N.A. (the “Bank”) with respect of violation of
depository accounts, financial reporting and failure to complete sale of an
asset.Further, on October 20, 2008, the Bank delivered a
notice of default to the Company requiring payment of all amounts outstanding
under the credit facility, as a consequence of the Company’s failure to achieve
the required financial performance measured on a rolling 90 day average for
revenue and net income (loss) and failure to complete the sale of assets.On October 24, 2008,
the Company executed an agreement with Bridge Bank, N.A., which cured these
events of default and amended the maturity date of the credit facility to be the
earlier of November 30, 2008 or the date that the Company receives the first
proceeds from the sale of Core Systems.  Please refer to Note 12 for
further information.
  On
November 4, 2008, the Company and LV Administrative Services, Inc., as
administrative and collateral agent (the “Agent”) for each of Laurus and Valens
Offshore SPV I, Ltd. (“Valens Offshore” and together with Laurus and the Agent,
the “Holders”), entered into an amendment, effective as of October 31, 2008, to
the Securities Purchase Agreement under which the Company had issued 500,000
shares of its Series D Redeemable Convertible Preferred Stock to
Laurus.  Under the amendment the Company and the Holders agreed that
the amount necessary to redeem in full the Series D Stock is approximately
$2,461,000, together with accrued and unpaid dividends.  The Company
redeemed $268,000 of the $518,000 of Series D Preferred Stock required to be
redeemed as of the October 31, 2008 redemption date by agreeing to issue to the
Holder 929,535 shares of its common stock, and redeemed the balance with a cash
payment of $250,000.  Subject to the terms and conditions of the
amendment to the Securities Purchase Agreement, the Company is obligated to make
monthly redemption payments through the mandatory redemption date of April 10,
2009.  Please refer to Note 11 for further
information.




-19-
 IMPLANT
SCIENCES CORPORATION
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS






On
November 4, 2008, the Company and Dr. Anthony Armini entered into an amendment
to the Transition Agreement dated as of September 27, 2007, between the Company
and Dr. Armini, pursuant to which the annual rate of compensation payable to Dr.
Armini will be reduced from $250,000 to $200,000 from November 4, 2008 and
through the expiration of the Transition Agreement.




On
November 7, 2008, the Superior Court of the State of California, Santa Clara
County, denied motions by Evans Analytical Group, LLC to attach our assets
prior to any final judgment on the merits of Evans’ claims.  Please refer
to Note 20 for further information.
  On
November 14, 2008, the Company and its wholly owned subsidiary C Acquisition
Corp. (which operates under the name Core Systems) signed a definitive agreement
to sell substantially all of Core Systems’ assets for a purchase price of
$3,000,000 plus the assumption of certain liabilities.  The buyer, an
entity newly formed by Core Systems’ general manager and certain other investors
(the "Buyer"), made an initial down payment of $250,000 prior to the
execution of the definitive agreement.  The balance of the purchase
price will be paid at the closing by delivery of $1,250,000 in cash and a
promissory note in the amount of $1,500,000.  The promissory note will
require the Buyer to pay $500,000 on or before December 24, 2008, and the
remaining principal balance, together with accrued interest, in equal monthly
installments over a period of 60 months commencing on February 1,
2009.  The note will be secured by a security interest in all of the
Buyer’s assets.
  The asset
purchase agreement contains customary representations, warranties, covenants and
conditions to closing, including representations, warranties and covenants of
the Company.  In addition, the Buyer’s obligation to complete the
transaction is subject to the consent of the Company’s lenders.  The
transaction is expected to close by November 21, 2008.  There can be
no assurance that the transaction will be completed. In the event that the
agreement is terminated by the Company or by the Buyer prior to the closing, the
Company will be required to return to the Buyer the $250,000 down payment,
without interest.




-20-





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




Cautionary
Note Regarding Forward-Looking Statements




This
Report on Form 10-Q contains certain statements that are “forward-looking”
within the meaning of the Private Securities Litigation Reform Act of 1995 (the
“Litigation Reform Act”).  These forward looking statements and other
information are based on our beliefs as well as assumptions made by us using
information currently available.




The words
“anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and
similar expressions, as they relate to us, are intended to identify
forward-looking statements.  Such statements reflect our current views
with respect to future events, are subject to certain risks, uncertainties and
assumptions, and are not guaranties of future performance.  Should one
or more of these risks or uncertainties materialize, or should underlying
assumptions prove incorrect, actual results may vary materially from those
described herein as anticipated, believed, estimated, expected, intended or
using other similar expressions.




In
accordance with the provisions of the Litigation Reform Act, we are making
investors aware that such forward-looking statements, because they relate to
future events, are by their very nature subject to many important factors that
could cause actual results to differ materially from those contemplated by the
forward-looking statements contained in this Report on Form
10-Q.  Important factors that could cause actual results to differ
from our predictions include those discussed under this “Management’s Discussion
and Analysis.”  Although we have sought to identify the most
significant risks to our business, we cannot predict whether, or to what extent,
any of such risks may be realized, nor can there be any assurance that we have
identified all possible issues which we might face.  In addition,
assumptions relating to budgeting, marketing, product development and other
management decisions are subjective in many respects and thus susceptible to
interpretations and periodic revisions based on actual experience and business
developments, the impact of which may cause us to alter our marketing, capital
expenditure or other budgets, which may in turn affect our financial position
and results of operations.  For all of these reasons, the reader is
cautioned not to place undue reliance on forward-looking statements contained
herein, which speak only as of the date hereof.  We assume no
responsibility to update any forward-looking statements as a result of new
information, future events, or otherwise except as required by law. We urge
readers to review carefully the risk factors described in this Quarterly Report,
in our Annual Report on Form 10-K, for the fiscal year ended June 30, 2008, as
amended, and in the other documents that we file with the Securities and
Exchange Commission.  You can read these documents atwww.sec.gov.




Overview




We
develop, manufacture and sell sophisticated sensors and systems for the
Security, Safety and Defense (“SS&D”) industries.  A variety of
technologies are currently used worldwide in security and inspection
applications.  In broad terms, these technologies focus on detection
in two major categories: (i) the detection of “bulk” contraband, which includes
materials that would be visible to the eye, such as weapons, explosives,
narcotics and chemical agents; and (ii) the detection of “trace” amounts of
contraband, which includes trace particles or vapors of explosives, narcotics
and chemical agents.  Technologies used in the detection of “bulk”
materials include computed tomography, transmission and backscatter x-ray, metal
detection, trace detection and x-ray, gamma-ray, passive millimeter wave, and
neutron analysis.  Trace detection techniques used include mass
spectrometry, gas chromatography, chemical luminescence, or ion mobility
spectrometry.




We have
developed proprietary technologies used in explosives trace detection (“ETD”)
applications and market and sell handheld and benchtop ETD systems which use our
proprietary ETD technologies.  Our products are marketed and sold to a
growing number of locations domestically and internationally.  These
systems are used by private companies and government agencies to screen baggage,
cargo, vehicles, people and other objects, for the detection of trace amounts of
explosives.




History




Since our
incorporation in August 1984, we have operated as a multi-faceted company
engaged in the development of ion-based technologies and providing commercial
services and products to the semiconductor, medical device and security
industries.  Beginning in March 2007,
we undertook steps to divest our semiconductor and medical business activities
in order to focus on our security business.




SemiconductorBusiness
Unit




Our
business began as a result of the development of our proprietary ion-beam
technology and application of this technology in services to the semiconductor
industry.  In October 2004, we acquired Core Systems Inc., a
privately-held semiconductor wafer processing company located in Sunnyvale,
California for $7,486,000 in cash


-21-
 
  and
common stock of the Company.  In February 2008, our Board approved a
formal plan to sell Core Systems as part of our strategic initiative to focus on
our security business.  As of September 30, 2008 and June 30, 2008,
the assets
and liabilities of Core have been recorded on our balance sheet as
held-for-sale.  For the three months ended September 30, 2008 and
2007, the operations of Core have been recorded in our statements of operations
as discontinued operations.




In March
2005, we acquired Accurel Systems International Corporation, a privately-held
semiconductor wafer analytical services company located in Sunnyvale, California
for $12,176,000 in cash and common stock.  In March 2007, our Board
approved a formal plan to sell Accurel Systems as part of our strategic
initiative to focus on our security business.  In May 2007, we
completed the sale of Accurel Systems to Evans Analytical Group LLC, in
exchange for $12,705,000 in cash of which $1,000,000 was placed in
escrow. In February 2008, Evans filed suit requesting rescission of the
acquisition agreement, plus damages, based on claims of misrepresentation and
fraud.  In March 2008, Evans filed a claims notice with the escrow
agent prohibiting release of any portion of the escrowed funds pending
resolution of the lawsuit.  As a result we have classified the
$1,000,000 of escrowed funds as a long term asset.  We have retained
legal counsel in defense of these claims.




Medical Business
Unit




We used
our ion beam technology to develop ion implantation and thin film coatings
applications for medical devices.  The primary medical related
businesses in which we engaged were (i) providing services to medical device
companies for surface modification of implantable devices, (ii) the development
of brachytherapy products, and (iii) the manufacture and sales of our
proprietary radioactive seeds for the treatment of prostate cancer.




In
further support of our strategic initiative to focus on our security business,
in June 2007, we sold certain assets associated with our prostate seed business
and discontinued the manufacturing of brachytherapy
products.  Management currently has plans in place to sell the
remaining medical segment assets and discontinue the surface modification
services provided to the medical device marketplace by the end of calendar
2008.  As of September 30, 2008 and June 30, 2008, the assets and
liabilities of the Medical Business Unit have been recorded on our balance sheet
as held-for-sale.  For the three months ended September 30, 2008 and
2007, the operations of the Medical Business Unit have been recorded in our
statements of operations as discontinued operations.




Security Business
Unit




Since May
1999, we have been performing research to improve ETD technology, and
development of ETD products which can be used for detection of trace amounts of
explosives.  At present, we have developed both portable and benchtop
systems, which have been marketed and sold both domestically and
internationally.  In order to reduce manufacturing costs and be
responsive to large quantity orders, we use a contract
manufacturer.  As we continue to sell and deliver our security
products, we work both independently and in conjunction with various government
agencies, to develop the next generation of trace explosives detectors and to
identify new applications for our proprietary technology.




In April 2008,weacquiredall of the capital stock
of Ion Metrics, Inc.,located in San
Diego,California.Ion Metrics’ develops mass sensor systems to
detect and analyze chemical compounds such as explosives, chemical warfare
agents, narcotics, and toxic industrial chemicals for the homeland defense,
forensic, environmental, and safety/security markets.  Ion Metrics’
miniaturized devices and system designs provide high performance and reliability
in combination with low manufacturing costs.The operating
results of Ion Metrics have been included inour condensed
consolidatedstatement of operations commencing on April 10, 2008.




Technology
and Intellectual Property




Since May
1999, we have performed research and development in the area of
ETD.  We have developed several proprietary technologies in key areas
of ETD which we believe improve the harvesting, collection and detection of
trace particles and vapors of explosives substances.  In addition, we
continue our development efforts to adapt this technology for the detection of
narcotics and other chemical agents.  Our intellectual property
portfolio contains 17 security-related patents and patents
pending:  six issued United States patents, 10 United States patents
pending, and one licensed patent.  We believe that our portfolio of
patents and patents pending provides extensive protection in sample harvesting
and detection.  A key to our past and future success is our ability to
innovate and offer differentiation in these areas.  We
compartmentalize ETD into four major areas: (i) harvest, (ii) transport, (iii)
analysis, and (iv) reporting.




Tiny
particles of explosives and narcotics are “sticky” and generally adhere to
surfaces.  Our competitors commonly swipe a surface to be interrogated
for explosives particles with a cloth or paper material.  We have




-22-
 
  developed
a patented method using an aerosol of fine dry ice particles mixed into an air
puff as a means of harvesting particles, which we believe could increase
collection sensitivity.  Our aerosol technology functions as a very
gentle version of “sandblasting” and is safe for almost all
surfaces.  We have two patents pending on this
methodology.




Once the
trace particle has been released from a surface, it has to be transported to a
collection point.  Vortex sampling was the first of our sampling
innovations.    Our vortex is similar to a miniature
tornado.  It is this vortex sampling technology that enables particles
released within the vortex, or blown into it, to be transported with high
efficiency to a collection filter.  We have three patents issued and
two patents pending in the area of vortex sampling methodology.




The
particles are transported to our innovative trapping filter, which is an
ultra-fine stainless steel woven mesh.  We believe the trapping filter
provides an innovative solution to the more costly consumables used by several
of our competitors engaged in ETD using contact methodology for sampling and
detection.




Through
flash desorption, an optical method for converting the chemistry of a particle,
such as the chemicals composing explosives or narcotics, into a vapor, analysis
can be accomplished for the discrimination of chemical properties.  In
conventional trace chemical detectors, a sample is slowly warmed in an oven
producing diluted vapor with low chemical concentrations.  Optical
flash vaporization heats a sample almost instantaneously, producing a high
sample concentration for detection.  Our spectrometers can be as much
as 10 times more sensitive when optical flash vaporization is
employed.  We have two patents issued and one patent pending in the
area of flash desorption methodology.




Unlike
conventional methods of turning molecules into ions that can be analyzed, which
use a radioactive beta source, we have developed two types of photonic,
non-radioactive ion sources for our instruments for applications requiring
either the ionization of positive ions or negative ions.  These ion
sources may be found individually or in combination within our products,
depending on the application for which the ETD equipment is to be
used.  We have two patents pending in the area of photonic
ionization.




Reporting
is the portion of the cycle that displays and stores information generated
during the analysis phase.  It is the information an operator sees and
indicates if an alarm condition exists or if the test is
clear.  Information can be displayed in both graphical and tabular
formats.




Products




Current
Products




The
Quantum Sniffer QS-H150 Portable Explosives Detector employs a patented vortex
collector for the simultaneous detection of explosives particulates and vapors
with or without physical contact and in real-time.  We believe our
advanced QS-H150 to be more sensitive than other detection
devices.  The QS-H150 can detect parts-per-trillion levels of
explosives vapor and nanogram quantities of explosives particulates for most
explosives substances considered to be threats.  Such substances
include, but are not limited to, military and commercial explosives, improvised
and homemade explosives, and propellants and taggants.




The
QS-B200 Benchtop Explosives Detector uses dual ion mobility spectrometry ("IMS")
with non radioactive ionization for the detection and identification of a wide
range of military, commercial, and improvised explosives.  The QS-B200
has automatic and continuous self-calibration.  It monitors its
environment, senses changes that would affect its accuracy, and re-calibrates
accordingly.  For detection, the sample is collected with a standard
trap, ionized, and analyzed via IMS.




Products Under
Development




With the
assistance of funding from the United States Department of Homeland Security, we
have developed a hand sampler detector which utilizes our proprietary jetted
vortex collector for non-contact collection of trace particulate
materials.  We believe the hand sampler, which will be a compact,
lightweight device, combined with a centralized trace explosives detection
system, such as the QS-B200 Benchtop Explosives Detector, could significantly
improve explosives detection capabilities.  This improved sampling
process has applicability for use in detecting trace amounts of explosives found
on a wide range of objects such as carry-on luggage, parcels, packages and
cargo.




We
believe that as market demand grows for greater precision of substance
identification and the list of substances to be detected increases, more
advanced detectors based on ion mobility spectrometry technology will be
required.  Our acquisition of Ion Metrics enabled us to obtain
miniaturized quadrupole mass spectrometry (“QMS”) QMS




-23-
 
  detector
technology.  The QMS detector senses the mass of a molecular ion
resulting in an “orthogonal” detection method in which a different unique
characteristic of a substance is sensed.  We believe that, because it
is unlikely that two substances would share the same mass and the same ion
mobility in air, QMS detector technology improves the accuracy of detection and
minimizes false alarms.  We are currently developing interfaces for
using the detector
in our advanced equipment.




Depending
on the application and the number of “interfering” background chemicals, it may
be necessary to incorporate additional “orthogonal” detection
methods.  The combination of these sensors in series is commonly known
as employing “hyphenated” detection methods.  A hyphenated system is
one in which a sequence of different types of detectors all must agree that an
alarm has occurred before a valid alarm is declared.  Our acquisition
of Ion Metrics also provided us miniature differential mobility spectrometer
(“DMS”) detector technology.  We are currently developing a fully
hyphenated system employing IMS, DMS, and QMS for the Department of Homeland
Security.  In addition, we have developed and applied for patents on
miniaturized pumping support hardware.




Manufacturing
Operations




We
manufacture our security products primarily through a sole source contract
manufacturer located locally in Worcester, Massachusetts.  We believe
our strategy to outsource manufacturing should reduce manufacturing costs,
improve scheduling flexibility, and allow us to focus our internal resources and
management on product development, marketing, sales and
distribution.  We also maintain an internal production group at our
corporate headquarters in Wakefield, Massachusetts responsible for
pre-production logistics, oversight of contract manufacturing, quality control
and inventory management.




Critical
Accounting Policies




Our
significant accounting policies are summarized in Note 2 to our consolidated
financial statements included in Item 7 of our Annual Report on Form 10-K, as
amended, for the fiscal year ended June 30, 2008.  However, certain of
our accounting policies require the application of significant judgment by our
management, and such judgments are reflected in the amounts reported in our
condensed consolidated financial statements.  In applying these
policies, our management uses its judgment to determine the appropriate
assumptions to be used in the determination of estimates.  Those
estimates are based on our historical experience, terms of existing contracts,
our observance of market trends, information provided by our strategic partners
and information available from other outside sources, as
appropriate.  Actual results may differ significantly from the
estimates contained in our condensed consolidated financial
statements.  There has been no change
to our critical accounting policies through the fiscal quarter ended September
30, 2008.




Results
of Operations




Three Months Ended September
30, 2008 vs. September 30, 2007




Revenues




Security
revenues for the three months ended September 30, 2008 were $5,948,000 as
compared with $1,347,000 for the comparable prior year period, an increase of
$4,601,000 or 341.6%.  Revenue from security products for the three
months ended September 30, 2008 was $5,302,000 as compared with $1,200,000 for
the comparable prior year period, an increase of $4,102,000 or
341.8%.  Revenue from government funded contracts for the three months
ended September 30, 2008 was $646,000 as compared with $147,000 for the
comparable prior year period, an increase of $499,000 or 339.5%.  The
increase in security revenue is primarily a result of an increase in the number
of units sold of our explosives detection products during the three months ended
September 30, 2008 as compared to comparable prior year period.  The
sales of security products in the three-month period ended September 30, 2008
included significant shipments of our handheld explosives detection equipment to
a customer in China aggregating approximately $4,169,000 in sales, which
shipments coincided with security preparations for the Beijing
Olympics.  In addition, we recorded increased revenue from government
contracts resulting primarily to an award from the Department of Homeland
Security.




Cost
of Revenues




Cost of
revenues for the three months ended September, 2008 were $3,172,000 as compared
with $821,000 for the comparable prior year period, an increase of $2,351,000 or
286.4%.  The increase in cost of revenues is primarily a result of the
increase in sales of security products and increase in government contract
revenue and the associated direct expenses of the contracts.






-24-




Gross
Margin
  Gross
margin for the three months ended September 30, 2008 was $2,776,000 or 46.7% of
security revenues as compared with $526,000 or 39.0% of security revenues for
the comparable prior year period.  The increase in gross margin is a
result of increased sales volume of our handheld explosives detection equipment;
design changes to our handheld explosives detectors which improved the
manufacturability; and overall cost efficiencies realized in the production
process, including efficiencies realized by our outsourced contract
manufacturer.




Research,
Development and Regulatory Expenses




Research
and development expense for the fiscal three months ended September 30, 2008 was
$1,020,000 as compared with $651,000 for the comparable prior year period, an
increase of $369,000 or 56.7%.  We continue to expend funds to expand
our staff to further the development of new products in the areas of explosives
detection, as well as to prepare for certain government laboratory acceptance
testing.  In addition, the increase in research and development
expenses relates to the volume and timing of customer funded programs, primarily
through government grants and contracts.  We focused additional
resources on our internally funded research and development programs during the
three month period ended September 30, 2008 as compared with the comparable
prior year period.  We charge our research and development personnel
to cost of revenues for work performed on these contracts and grants. 
Research and development expenses incurred prior to starting government
contracts are charged to operating expenses.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the three months ended September 30,
2008 was $2,366,000 as compared with $1,357,000 for the comparable prior year
period, an increase of $1,009,000, or 74.4%.  The increase is
primarily a result of costs associated with the additions to our senior
management team; increased expenditures in our sales and marketing efforts,
including increased selling expenses related to our China sales; and increased
legal expenses.




Other
Interest Income and Expense, Net




For the
three months ended September 30, 2008, we recorded other expense, net of $24,000
as compared with $83,000, for the comparable prior year period, a decrease of
$59,000 or 71.1%.  During the three months ended September 30, 2008 we
recorded interest income of $8,000 as compared with $101,000 for the comparable
prior year period.  The decrease in interest income is a result of a
lower average balance of cash available for investment in short-term investments
during the three month period ended September 30, 2008 as compared with the
comparable prior year period.  The reduction in interest income was
offset by a decrease in expenses to mark to market the embedded derivatives
associated with the Series D Redeemable Convertible Preferred
Stock.  There was no expense associated with this embedded derivative
during the three months ended September 30, 2008 as compared to expense of
$150,000 for the comparable prior year period.




Loss
from Continuing Operations




Loss from
continuing operations for the three months ended September 30, 2008 was $634,000
as compared with $1,565,000 for the comparable prior year period, a decrease of
$931,000, or 59.5%.  The decrease in loss from continuing operations
is primarily the result of increased sales of our handheld explosives detection
product and improved gross margins resulting from these sales; offset by of
increased spending for (i) research and development to enhance our technology
and bring new products to market, (ii) the addition of senior management to
execute upon our strategic repositioning and focus on the development and sale
of security products, and (iii) the addition of senior management and staff to
assess market requirements for security products and market and sell our current
products.




Preferred
Distribution, Dividends and Accretion




Preferred
distribution, dividends and accretion on the Series D Redeemable Convertible
Preferred Stock for the three months ended September 30, 2008 was $189,000 as
compared with $307,000 for the comparable prior year period, a decrease of
$118,000 or 38.4%.




Income
(Loss) from Discontinued Operations




Net
income from discontinued operations for the three months ended September 30,
2008 was $990,000 as compared with net loss from discontinued operations of
$637,000 for the comparable prior year period, an increase of
$1,627,000.  Income from discontinued operations for the three-month
period ended September 30, 2008 is composed of (i) operating income of $60,000
from our semiconductor and medical reporting units, which are being


-25-







Liquidity
and Capital Resources




As of
September 30, 2008, we had approximately $2,013,000 of cash and cash
equivalents, an increase of $1,601,000 when compared with a balance of $412,000
as of June 30, 2008.




During
the three months ended September 30, 2008 we had net cash inflows of $973,000
from operating activities of continuing operations as compared to net cash
outflows from operating activities of continuing operations of $1,675,000 for
the comparable prior year period.  The approximate $2,648,000 increase
in net cash inflows used in operating activities of continuing operations during
the three months ended September 30, 2008, as compared to the comparable prior
year period, was primarily a result of (i) cash provided by a decrease in the
loss from continuing operations, and (ii) increase in cash provided by changes
in accounts receivable, prepaid expenses and other assets, accounts payable and
accrued expenses.  These cash inflows were offset by increased cash
outflows for inventories.




During
the three months ended September 30, 2008 we had net cash outflows of $124,000
from investing activities of continuing operations as compared to net cash
inflows of $55,000 from investing activities of continuing operations for the
comparable prior year period.  The approximate increase in net cash
outflows used in investing activities of continuing operations during the three
months ended September 30, 2008, as compared to the comparable prior year
period, was primarily a result of increases in other current
assets.




During
the three months ended September 30, 2008 we had net cash outflows of $577,000
from financing activities of continuing operations as compared to net cash
outflows of $687,000 from financing activities of continuing operations for the
comparable prior year period.  The approximate $110,000 decrease in
net cash outflows used in financing activities of continuing operations during
the three months ended September 30, 2008, as compared to the comparable prior
year period, was primarily a result of decreased repayments of long-term debt
and capital lease obligations; offset by increased payments of principal and
dividends on the Series D Cumulative Redeemable Convertible Preferred
Stock.




On June
1, 2005, the Company executed a revolving credit facility for $1,500,000 with
Bridge Bank, N.A.  On January 3, 2007, the Company executed an Amended
and Restated Loan and Security Agreement increasing the revolving credit
facility from $1,500,000 to $5,000,000.  On June 27, 2008, the Company
entered into an amendment to the loan agreement, which amended and restated the
terms of the credit facility.  The bank also waived certain existing and
anticipated events of default arising from the Company’s failure and anticipated
failure to comply with the required minimum current ratio and minimum tangible
net worth financial covenants and the failure to comply with planned revenue and
annual forecast for the quarter ended March 31, 2008 and June 30, 2008,
respectively.  The Company was in violation of the required minimum
current ratio and minimum tangible net worth covenants associated with this
facility at June 30, 2008, which noncompliance was also waived by the
bank..  The Company entered into a Loan and Security Modification
Agreement with the bank on August 29, 2008, which agreement amended and restated
the terms of the credit facility.  As amended, the credit facility was
reduced to $1,500,000, from $5,000,000 and provides for advances of up to 80% of
the Company’s eligible domestic accounts receivable and the lesser of $500,000
or 50% of the Company’s eligible foreign accounts receivable, bears interest at
the prime rate, plus 2-1/4% per annum, and is collateralized by all assets of
the Company.  On October 20, 2008, the bank delivered a notice of
default to the Company requiring payment of all amounts outstanding under the
credit facility, as a consequence of the Company’s failure to achieve the
required financial performance measured on a rolling 90 day average for revenue
and net income (loss) and failure to complete the sale of
assets.  The Company entered into an amendment to Amended and Restated
Loan and Security Agreement on October 24, 2008, whereby the Bank rescinded the
demand for payment of all amounts outstanding and waived the Company’s
noncompliance.  As amended, the maturity date will be the earlier of
November 30, 2008 or the date that the Company receives the first proceeds from
the sale of Core Systems.  Further, the Company agreed to pay a
forbearance fee to the Bank equal to $75,000 on the earlier of November 30, 2008
or the date that the Company receives the first proceeds from the sale of Core
Systems.  As of September 30, 2008, the unpaid balance due under the
credit facility with the Bank was $718,000.








-26-


the
Company’s option, so long as the price of the Company’s stock does not fall
below 110% of the fixed conversion price.  The Company received a
waiver of the monthly amortization payments for the period December 2006 through
August 2007, to the mandatory redemption date.  The redemption
payments resumed in September 2007.  In September, 2008, the Company
amended the Securities Purchase Agreement under which the Series D Preferred
Stock was originally issued, extending the mandatory redemption date to October
24, 2008, at which time redemption of the remaining shares of the Series D
Redeemable Convertible Preferred Stock was required.  Our obligations
to Laurus are secured by a security interest in substantially all of our
assets.  As of September 30, 2008, the outstanding balance
due under the securities purchase agreement was approximately
$2,269,000.  We made a payment of $250,000 to Laurus, inclusive of
$22,000 of dividends, on October 2, 2008, and upon application of this payment,
the balance expected to be due on October 24, 2008 was approximately
$1,893,000.  The Company did not meet its redemption obligation on
October 24, 2008.




On
November 4, 2008, the Company and LV Administrative Services, Inc., as
administrative and collateral agent (the “Agent”) for each of Laurus and Valens
Offshore SPV I, Ltd. (“Valens Offshore” and together with Laurus and the Agent,
the “Holders”), entered into an amendment, effective as of October 31, 2008, to
the Securities Purchase Agreement.  Under the amendment the Company
and the Holders agreed that the amount necessary to redeem in full the Series D
Stock is approximately $2,461,000, together with accrued and unpaid
dividends.  The Company redeemed $268,000 of the $518,000 of Series D
Preferred Stock required to be redeemed as of the October 31, 2008 redemption
date by agreeing to issue to the Holder 929,535 shares of its common stock, and
redeemed the balance with a cash payment of $250,000.  Subject to the
terms and conditions of the amendment to the Securities Purchase Agreement, the
Company is obligated to make monthly redemption payments through the mandatory
redemption date of April 10, 2009.




We are
currently expending significant resources to develop the next generation of our
current products and to develop new products.  Although we continue to
fund as much research and development as possible through government grants and
contracts in accordance with the provisions of the respective grant awards, we
will require additional funding in order to continue the advancement of the
commercial development and manufacturing of the explosives detection
system.  We will attempt to obtain such financing by: (i) government
grants, (ii) private financing, or (iii) strategic
partnerships.  However, there can be no assurance that we will be
successful in our attempts to raise such additional financing.




We will
require substantial funds for further research and development, regulatory
approvals, and the marketing of our explosives detection
products.  Our capital requirements depend on numerous factors,
including but not limited to; the progress of our research and development
programs; the cost of filing, prosecuting, defending and enforcing any
intellectual property rights; competing technological and market developments;
changes in our development of commercialization activities and arrangements; and
the hiring of additional personnel, and acquiring capital
equipment.




Based on
the current sales, expense and cash flow projections, advances on our line of
credit, proceeds from certain expected sales of assets, and the ability to raise
additional capital, management believes it has plans in place to fund operations
for the near future.  Because there can be no assurances that (i)
sales will materialize as forecasted, (ii) management will be successful in
executing these plans, and/or (iii) additional capital will be raised;
management will continue to closely monitor and attempt to control our costs and
will continue to actively seek the needed capital through government grants and
awards, strategic alliances, private financing sources, and through its lending
institutions.  We believe, however, that our litigation with Evans has
made it extremely difficult to raise capital we need to operate our
business.  Future expenditures for research and product development are
discretionary and can be adjusted as can certain selling, general and
administrative expenses, based on the availability of cash.  The
financial statements do not include any adjustments relating to the
recoverability and classification of asset amounts or the amounts and
classification of liabilities that might be necessary should we be unable to
continue as a going concern.




Off-Balance
Sheet Arrangements
  As of
September 30, 2008 we had an irrevocable standby letter of credit outstanding in
the approximate amount of $418,000.  The letter of credit provides
performance security equal to 10% of the contract amount for product which is
expected to be shipped in the first quarter of fiscal 2009.  The
letter of credit expires on July 31, 2010.
  As of
September 30, 2008, we did not have any other off-balance sheet arrangements
that have, or are reasonably likely to have, a current or future material effect
on our condensed consolidated financial condition, results of operations,
liquidity, capital expenditures or capital resources.


-27-




New
Accounting Pronouncements




In February 2007, the FASB issued SFAS No.
159, “The Fair Value Option
for Financial Assets and Financial Liabilities,” which provides companies
with an option to report selected financial assets and liabilities at fair
value.  The objective of SFAS No. 159 is to reduce both complexity in
accounting for financial instruments and the volatility in earnings caused by
measuring related assets and liabilities differently.  SFAS No. 159
establishes presentation and disclosure requirements designed to facilitate
comparisons between companies that choose different measurement attributes for
similar types of assets and liabilities and to more easily understand the effect
of the company’s choice to use fair value on its earnings.  SFAS No.
159 also requires entities to display the fair value of the selected assets and
liabilities on the face of the balance sheet.  SFAS No. 159 does not
eliminate disclosure requirements of other accounting standards, including fair
value measurement disclosures in SFAS No. 157.  This Statement is
effective as of the beginning of an entity’s first fiscal year beginning after
November 15, 2007.  The Company adopted SFAS No. 159 on July 1, 2008,
which adoption did not have a material affect on the Company’s financial
position and results of operations.




In
December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements.”  SFAS No. 160 clarifies
that a non-controlling or minority interest in a subsidiary is considered an
ownership interest and accordingly, requires all entities to report such
interests in subsidiaries as equity in the condensed consolidated financial
statements.  SFAS No. 160 is effective for fiscal years beginning
after December 15, 2008. The Company expects to adopt SFAS No. 160 on July 1,
2009, and does not expect it to have a material affect on the Company’s financial
position and results of operations.




In
December 2007, the FASB issued SFAS No. 141(R), “Business
Combinations.”  SFAS No. 141(R) replaces SFAS No. 141, “Business Combinations” and
establishes principles and requirements for how an acquirer recognizes and
measures in its financial statements the identifiable assets acquired, the
liabilities assumed, any non-controlling interests in the acquiree and the
goodwill acquired.  Some of the key changes under SFAS No. 141(R) will
change the accounting treatment for certain specific acquisition related items
including: (1) accounting for acquired in process research and development as an
indefinite-lived intangible asset until approved or discontinued rather than as
an immediate expense; (2) expensing acquisition costs rather than adding them to
the cost of an acquisition; (3) expensing restructuring costs in connection with
an acquisition rather than adding them to the cost of an acquisition; (4)
including the fair value of contingent consideration at the date of an
acquisition in the cost of an acquisition; and (5) recording at the date of an
acquisition the fair value of contingent liabilities that are more likely than
not to occur.  SFAS No. 141(R) also includes a substantial number of
new disclosure requirements.  SFAS No. 141(R) is effective
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008.  Early adoption of SFAS No. 141(R) is
prohibited.  The Company expects to adopt SFAS No. 141(R) on July 1,
2009.  The Company believes the adoption of SFAS N0. 141(R) could have
a material impact on how the Company will identify, negotiate, and value future
acquisitions and a material impact on how an acquisition will affect the
Company’s condensed consolidated financial statements.




Item
      3.
            Quantitative
      and Qualitative Disclosures About Market
Risk.




Not
required pursuant to Item 305(e) of Regulation S-K.




Item 4.
            Controls
      and Procedures




The
certificates of the Company’s chief executive officer and chief financial
officer attached as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q
include, in paragraph 4 of such certifications, information concerning the
Company’s disclosure controls and procedures, and internal control over
financial reporting.  Such certifications should be read in
conjunction with the information contained in this Item 4 for a more complete
understanding of the matters covered by such certifications.




Disclosure
Controls and Procedures
  The
Company’s management, with the participation of the Company’s chief executive
officer and chief financial officer, evaluated the effectiveness of the
Company’s disclosure controls and procedures as of September 30,
2008.  The term “disclosure controls and procedures,” as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended, means controls and other procedures of a company that are designed to
ensure that information required to be disclosed by the Company in the reports
that it files or submits under the Exchange Act is recorded, processed,
summarized, and reported, within the time periods specified in the Securities
and Exchange Commission’s rules and forms.  Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports




-28-




that it
files or submits under the Exchange Act is accumulated and communicated to the
company’s management, including its chief executive officer and chief financial
officer, as appropriate, to allow timely decisions to be made regarding required
disclosure.  It should be noted that any system of controls and
procedures, however well designed and operated, can provide only reasonable, and
not absolute, assurance that the objectives of the system are met and that
management necessarily applies its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.  Based on the
evaluation of the Company’s disclosure controls and procedures as of September
30, 2008, the Company’s chief executive officer and chief financial officer
concluded that, as of such date, the Company’s disclosure controls and
procedures were effective at the reasonable assurance level.




Changes
in Internal Control Over Financial Reporting




There
were no changes to the Company’s internal control over financial reporting
during the quarter ended September 30, 2008 that have materially affected, or
are reasonably likely to materially affect, the Company’s internal control over
financial reporting.




-29-


PART
II.                      OTHER
INFORMATION







Item
      1.
            Legal
      Proceedings




From time
to time, we are subject to various claims, legal proceedings and investigations
covering a wide range of matters that arise in the ordinary course of our
business activities. Each of these matters is subject to various
uncertainties.


In May
2007, we entered into an asset purchase agreement to sell substantially all of
the assets of our Accurel Systems subsidiary to Evans Analytical Group LLC for
approximately $12,705,000, including $1,000,000 held by an escrow agent as
security for certain representations and warranties.  On February 22,
2008, Evans filed suit in the Superior Court of the State of California, Santa
Clara County, requesting rescission of the asset purchase agreement, plus
damages, based on claims of misrepresentation and fraud.  In March
2008, Evans filed a claims notice with the escrow agent prohibiting release of
any portion of the escrow to us pending resolution of the
lawsuit.  More recently, Evans filed motions to attach substantial
portions of our assets prior to any final judgment on the merits of Evans’
claims.  On November 7, 2008, the Court denied Evans’
motions.  We are vigorously defending ourselves against Evans’
claims.   No assurance can be given, however, that we will be
successful in our defense against Evans’ claims.  Any substantial
final judgment in favor of Evans would have a material adverse effect on our
business, assets and results of operations, and could require us to file for
protection under bankruptcy laws.  Moreover, we believe that our
litigation with Evans has made it extremely difficult to raise capital we need
to operate our business.
  We are
not a party to any other legal proceedings, other than ordinary routine
litigation incidental to our business, which we believe will not have a material
affect on our business, assets or results of operations.
  Item
      1A.
                Risk
      Factors
  Other than as set forth below, there have not been
any material changes from the risk factors previously disclosed under Item 1A of
our Annual Report on Form 10-K, as amended, for the fiscal year ended June 30,
2008.
  We
will be required to redeem our Series D Preferred Stock, from time to time,
beginning on October 31, 2008, with final payment due on April 10,
2009.
 We will
be required to redeem the remaining shares of Series D Redeemable Convertible
Preferred Stock held by Laurus Master Fund, Ltd. on the following schedule:
 Repayment
      Date
                    
                    Redemption
                      Amount
                    
                    
                    Remaining
                      Stated
      ValueOctober
      31, 2008
                    
                    $
                    518,000
                    
                    
                    $
                    1,943,000November
      28, 2008
                    
                    
                    800,000
                    
                    
                    
                    1,143,000December
      19, 2008
                    
                    
                    250,000
                    
                    
                    
                    893,000January
      16, 2009
                    
                    
                    250,000
                    
                    
                    
                    643,000February
      13, 2009
                    
                    
                    250,000
                    
                    
                    
                    393,000March
      13, 2009
                    
                    
                    250,000
                    
                    
                    
                    143,000April
      10, 2009
                    
                    
                    143,000
                    
                    
                    
                    -
 Notwithstanding the
foregoing, we are required, within two business days of the consummation of the
sale of our Core Systems subsidiary) to any third party, to redeem no less than
$800,000 of the Series D Preferred Stock. Management
does not believe that we will meet the conditions necessary for us to redeem the
Series D Preferred Stock by issuing shares of our common stock and that we will
be required to redeem such preferred stock for cash.  Our obligations
to Laurus are secured by a security interest in substantially all of our
assets.  If we are unable to redeem the Series D Preferred Stock as
required, refinance our obligations to Laurus, or negotiate a further extension
of the obligation to redeem the Series D Preferred Stock, Laurus may seize our
assets and we may be forced to curtail or discontinue operations
entirely.
  We
rely on a third-party credit facility to provide working capital.  If
our access to a third-party credit facility were unavailable or restricted, our
business could be adversely affected.
  We
currently rely on third-party credit, private equity financing and cash
generated from our operations for working capital purposes. Our credit facility with
Bridge Bank, N.A.matures on the earlier of November 30, 2008 or the date
we receive the first proceeds from the sale of Core Systems.  As of
September 30, 2008, the unpaid balance due under the credit facility was
$718,000.






-30-




If we are
unable to renegotiate a new credit facility with Bridge Bank or another lender,
or if we are unable to raise additional capital through other third-party
sources, we will be required to reduce or curtail our operations and
research and development projects.  This would have a material adverse
effect on our business and results of operations.




We
are engaged in litigation with Evans Analytical Group LLC, the buyer of our
Accurel Systems subsidiary.  If we are unsuccessful in defending the
claims made by Evans, our business, assets and results of operations could be
materially adversely affected.
  In May
2007, we entered into an asset purchase agreement to sell substantially all of
the assets of our Accurel Systems subsidiary to Evans for approximately
$12,705,000, including $1,000,000 held by an escrow agent as security for
certain representations and warranties.  In February 2008, Evans filed
suit requesting rescission of the asset purchase agreement, plus damages, based
on claims of misrepresentation and fraud.  In March 2008, Evans filed
a claims notice with the escrow agent prohibiting release of any portion of the
escrow to us pending resolution of the lawsuit.  More recently, Evans filed
motions to attach substantial portions of our assets prior to any final judgment
on the merits of Evans’ claims.  On November 7, 2008, theSuperior Court of the
State of California, Santa Clara County, deniedEvans’ motions.  We are
vigorously defending ourselves against Evans’ claims.  No assurance
can be given, however, that we will be successful in our defense against Evans’
claims.  Any substantial final judgment in favor of Evans would have a
material adverse effect on our business, assets and results of operations, and
could require us to file for protection under bankruptcy
laws.  Moreover, we believe that our litigation with Evans has made it
extremely difficult to raise capital we need to operate our
business.
  We
will require additional capital to fund operations and continue the development,
commercialization and marketing of our product.  Our failure to raise
capital could have a material adverse effect on the business.
  Management
continually evaluates plans to reduce its operating expenses, increase sales and
increase its cash flow from operations.  Despite the current sales,
expense and cash flow projections, the cash available from our line of credit,
the projected cash from the sale of Core Systems and certain other assets, we
will require additional capital in the second quarter of fiscal 2009 to fund
operations and continue the development, commercialization and marketing of our
products.
  Our
failure to achieve our projections, sell Core and other assets, and/or obtain
sufficient additional capital on acceptable terms, would have a material adverse
effect on our operations and could require us to file for protection under
bankruptcy laws.
  We
have received notification from the New York Stock Exchange Alternext US (the
“Exchange”) that we are not in compliance with certain standards for the
continued listing of our common stock.  Our inability to regain
compliance with the Exchange’s continued listing standards could adversely
affect our business and ability to raise capital.
  In April
2008, the Exchange indicated we were not in compliance with certain conditions
of the continued listing standards.  Specifically, we were not in
compliance with Section 1003(a)(ii) of the NYSE Alternext US Company Guide with
stockholders’ equity of less than $4,000,000 and losses from continuing
operations and net losses in three out of its four most recent fiscal years and
Section 1003(a)(iii) of the NYSE Alternext US Company Guide with stockholders’
equity of less than $6,000,000 and losses from continuing operations and net
losses in its five most recent fiscal years. We
submitted a plan of compliance to the Exchange in May 2008, and in June 2008,
the Exchange notified us that it had accepted our plan of compliance and had
granted us an extension until October 9, 2009 to regain compliance with the
continued listing standards noted above in addition to complying with Section
1003(a)(i) of the NYSE Alternext US Company Guide requiring stockholders’ equity
of not less than $2,000,000 with losses from continuing operations and net
losses in two out of its three most recent fiscal years.
  On
November 5, 2008, we received a notice from the Exchange that the we are not in
compliance with additional continued listing standards set forth by the
Exchange.  Specifically, after reviewing our Annual  Report
on Form 10-K for the fiscal year ended June 30, 2008, the Exchange has
determined that we are not in compliance with Section 1003(a)(iv) of the NYSE
Alternext US Company Guide because we have sustained losses which are so
substantial in relation to our overall operations or our existing financial
resources, or our financial condition has become so impaired that it appears
questionable, in the opinion of the Exchange, as to whether we will be able to
continue operations and/or meet our obligations as they mature.  We
intend to submit a revised Plan to the Exchange on or before November 19, 2008,
which will address the actions we have taken and will take that would bring us
into compliance with Section 1003(a)(iv) of the NYSE Alternext US Company Guide
by February 5, 2009.  Our common stock will continue to be listed on
the Exchange pending the Exchange’s review of the revised
Plan.




-31-




We will
remain subject to the conditions set forth in the Exchange’s notification of
April 9, 2008 and be subject to periodic review by the Exchange Staff during any
extension period.  Accordingly, if our revised Plan is not accepted,
our common stock may be subject to delisting proceedings.  If the
revised Plan is accepted, but we are not in compliance with all of the
Exchange’s continued listing standards by October 9, 2009 or do not make
progress consistent with the revised Plan prior to that date, our common stock
may be subject to delisting proceedings.  If our common stock is
delisted from the NYSE Alternext US, the liquidity of our stock could be
substantially limited and our ability to raise capital would be
impaired.




Item
      2.
              Unregistered
      Sales of Equity Securities and Use of
Proceeds
  On August
11, 2008, we issued 2,000,000 shares of common stock, having a value of
$2,464,000, to the former shareholders of Ion Metrics in connection with our
April 2008 acquisition of Ion Metrics.  The issuance of these shares
was exempt from registration under the Securities Act of 1933, as amended,
pursuant to an exemption provided by Section 4(2) of the Securities
Act.
  Item 3.
              Defaults
      Upon Senior Securities
  None.
  Item
      4.
              Submission
      of Matters to a Vote of Security
Holders
  None.
  Item 5.
              Other
      Information
  None.
  Item
      6.
              Exhibits
  Exhibit
No.
  10.1
                Omnibus
      Amendment, dated as of September 30, 2008, among Implant Sciences
      Corporation and LV Administrative Services, Inc., as administrative and
      collateral agent for each of Laurus Master Fund, Ltd. and Valens Offshore
      SPV I, Ltd., to (i) that certain Securities Purchase Agreement, dated as
      of September 29, 2005, by and between the Company and Laurus Master Fund,
      Ltd. and (ii) certain the other related agreements referred to in the
      Purchase Agreement (incorporated by reference from the Registrant’s
      Current Report on Form 8-K, filed with the Securities and Exchange
      Commission on October 6, 2008.
  31.1
                Certification
      of Principal Executive Officer pursuant to Section 3.02 of the
      Sarbanes-Oxley Act of 2002.
  31.2
                Certification
      of Principal Financial Officer pursuant to Section 3.02 of the
      Sarbanes-Oxley Act of 2002.
  32.1
                Certification
      of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.
  32.2
                Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.




-32-




SIGNATURES




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




Implant
Sciences Corporation




By:  /s/ Phillip C.
Thomas


Phillip
C. Thomas


President
& Chief Executive Officer






By:  /s/ Glenn D.
Bolduc


Glenn D.
Bolduc


Chief
Financial Officer




Dated:  November
14, 2008









-33-