**SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
 **__________________________________**
 
 **FORM
        10-KSB**
 (Mark
        One)
 [X]
        ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
        1934
 
 For
        the
        Fiscal Year Ended June
        30, 2005
  OR
  [
        ]
        TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
        OF
        1934
  For
        transition period from ____ to ____
  Commission
        File Number 001-10647
 
 **PRECISION
        OPTICS CORPORATION, INC.**
 (Name
        of
        small business issuer in its charter)
 
 **MASSACHUSETTS**
              **04-279-5294**(State
                  or other jurisdiction
              (I.R.S.
                  Employerof
                  incorporation or organization)
              Identification
                  No.)
 
 **22
        East Broadway**
 **Gardner,
        Massachusetts 01440**
 (Address
        of principal executive offices) (Zip Code)
 
 **(978)
        630-1800**
 (Issuer’s
        telephone number, including area code)
 
 Securities
        registered under Section 12(b) of the Act:
 
 **None**
 
 Securities
        registered under Section 12(g) of the Act:
 
 **Common
        Stock, $.01 par value**
 
 Check
        whether the issuer: (1) filed all reports required to be filed by Section
        13 or
        15(d) of the Exchange Act during the past 12 months (or for such shorter
        period
        that the registrant was required to file such reports), and (2) has been
        subject
        to such filing requirements for the past 90 days. Yes  x No 
        o
 
 Check
        if
        no disclosure of delinquent filers in response to Item 405 of Regulation
        S-B is
        contained in this form, and no disclosure will be contained, to the best
        of
        registrant’s knowledge, in definitive proxy or information statements
        incorporated by reference in Part III of this Form 10-KSB or any amendment
        to
        this Form 10-KSB. x
 
 The
        issuer’s revenues for its most recent fiscal year were $1,349,819.
 
 The
        aggregate market value of the voting stock, consisting solely of common stock,
        held by non-affiliates of the issuer computed by reference to the closing
        price
        of such stock was $2,498,162 as of August 31, 2005.
 
 The
        number of shares of outstanding common stock of the issuer as of August 31,
        2005
        was 7,008,212.
 
 **DOCUMENTS
        INCORPORATED BY REFERENCE**
 
 The
        issuer’s Proxy Statement for the 2005 Annual Meeting of Shareholders to be held
        on November 29, 2005 is incorporated into Part III of this Form
        10-KSB.
 
  **PART
        I**
 
 ITEM
        1. DESCRIPTION
        OF BUSINESS
 
 **BUSINESS
        DEVELOPMENT**
 
 Precision
        Optics Corporation, Inc. (the “Company”) was incorporated in Massachusetts in
        1982 and has been publicly owned since November 1990.
 
 References
        to the Company contained herein include its two wholly-owned subsidiaries,
        except where the context otherwise requires.
 
 **BUSINESS
        OF ISSUER**
 
 Precision
        Optics Corporation, a developer and manufacturer of advanced optical instruments
        since 1982, designs and produces high-quality medical instruments, optical
        thin
        film coatings, and other advanced optical systems. The Company’s medical
        instrumentation line includes laparoscopes, arthroscopes and endocouplers
        and a
        line of world-class 3-D endoscopes for use in minimally invasive surgical
        procedures. Precision Optics Corporation is certified to the ISO 9001 Quality
        Standard, and complies with the FDA Good Manufacturing Practices and the
        European Union Medical Device Directive for CE Marking of its medical products.
        The Company’s Internet Website is www.poci.com .
 
 **Principal
        Products and Services and Methods of Distribution** **.**
 
 Medical
        Products .
        The
        Company’s medical products include endoscopes, as well as image couplers,
        beamsplitters and adapters, all of which are used as accessories to endoscopes.
 
 Since
        January 1991, the Company has developed and sold endoscopes using various
        optical technologies for use in a variety of minimally invasive surgical
        and
        diagnostic procedures. The Company’s current line of specialized endoscopes
        include arthroscopes (which are used in joint surgery), laryngoscopes (which
        are
        used in the diagnosis of diseases of the larynx), laparoscopes (which are
        used
        in abdominal surgery) and stereo endoscopes and cameras (which are used in
        cardiac and general surgery, and enable surgeons to visualize the surgical
        field
        in 3-D imagery, thus facilitating greater finesse and minimizing surgical
        risk).
 
 The
        Company produces autoclavable endoscopes for various applications, which
        are CE
        Mark certified for European use, and have been designed and tested to withstand
        sterilization by flash and standard autoclave, as well as all other commonly
        used medical sterilization means. The major benefits of autoclavable instruments
        include increased patient safety, quick turnaround, and elimination of hazardous
        sterilant and by-product materials, all of which provide a much better value
        to
        the user. The Company believes its autoclavable endoscope technology will
        generate opportunities for endoscope revenue growth, particularly in Europe
        where autoclaving is the preferred method of sterilization.
 
 The
        Company developed and has manufactured and sold since 1985 a proprietary
        product
        line of instrumentation to couple endoscopes to video cameras. Included in
        this
        product line are imaging couplers, which physically connect the endoscope
        to a
        video camera system and transmit the image viewed through the scope to the
        video
        camera. Another product, the beamsplitter, performs the same function while
        preserving for the viewer an eyeport for direct, simultaneous viewing through
        the endoscope. The Company has sold these devices primarily to endoscope
        and
        video camera manufacturers and suppliers for resale under the Company’s
        customers’ names.
  2
  The
        Company’s image couplers and beamsplitters can withstand surgery-approved
        sterilization. The Company also offers autoclavable image couplers, which
        are
        able to withstand sterilization in superheated steam under pressure. The
        Company
        believes that it is one of the few companies in the world that produces
        autoclavable image couplers.
 
 Included
        in the Company’s medical products sales are sales of image couplers and
        beamsplitters for video-monitored examination of a variety of industrial
        cavities and interiors. The Company has developed, and may develop in the
        future, specialized borescopes for industrial applications.
 
 The
        Company continues to move forward with new products and technical innovations,
        in particular, the development of a new generation (patent pending) of its
        world-class product line of 3-D endoscopes, the development of a new prototype
        2.7 mm endoscope, and new instruments utilizing the Company’s new
        micro-precision TM lens
        technology (patent pending) for endoscopes under 1 mm. The Company continues
        to explore potential applications of single-molecule technology and nanotechnology.
 
 Optical
        Thin Films .
        The
        Company designs and manufactures various types of high quality thin film
        coatings for use in a wide range of optical applications. Thin film coatings
        are
        produced in-house for the Company’s medical instrumentation and other products.
        Presently, optical thin film manufacturing not associated with the Company’s
        medical instruments and other products is limited or very specialized.
 
 Optical
        System Design and Development Services .
        The
        Company provides on a contract basis advanced lens design, imaging analysis,
        optical system design, structural design and analysis, prototype production
        and
        evaluation, optics testing, and optical system assembly. Some of the Company’s
        development contracts have led to optical system production business for
        the
        Company, and the Company believes its prototype development service may lead
        to
        new product production from time to time.
 
 **Competition
        and Markets** **.**
 
 The
        areas
        in which the Company does business are highly competitive and include both
        foreign and domestic competitors. Many of the Company’s competitors are larger
        and have substantially greater resources than the Company. Furthermore, other
        domestic or foreign companies, some with greater experience in the optics
        industry and greater financial resources than the Company, may seek to produce
        products or services that compete with those of the Company. The Company
        may
        establish or use production facilities overseas to produce key components
        for
        the Company’s business, such as lenses. The Company believes that the cost
        savings from such production may be essential to the Company’s ability to
        compete on a price basis in the medical products area particularly and to
        the
        Company’s profitability generally.
  The
        Company believes that competition for sales of its medical products and
        services, which have been principally sold to medical device companies, who
        incorporate the Company’s products into their systems, is based on performance
        and other technical features, as well as other factors, such as scheduling
        and
        reliability, in addition to competitive price.
 
 The
        Company has marketed and sold its endoscopes to original equipment manufacturer
        (OEM) video camera and video endoscopy suppliers for resale under the
        purchaser’s name. A number of domestic and foreign competitors also sell
        endoscopes to such OEM suppliers, and the Company’s share of the endoscope
        market is nominal. The Company believes that, while its resources are
        substantially more limited than its competitors, the Company can compete
        successfully in this market on the basis of price and delivery.
 
 The
        Company currently sells its image couplers, beamsplitters, and adapters to
        a
        market that consists of approximately 30 to 35 potential OEM customers. These
        potential customers sell video cameras, endoscopes, or video-endoscopy systems.
        The Company has made sales in the past to approximately two thirds of these
        customers. The Company estimates that it has approximately 20% to 30% of
        the
        market share in these products. The Company’s primary competition in this area
        is the customers’ own in-house capabilities to manufacture such products. The
        Company believes that these customers typically purchase products from the
        Company, despite their in-house capabilities, because they choose to devote
        their own technical resources to their primary products, such as cameras
        or
        endoscopes. However, the Company estimates that approximately 50% of the
        market
        demand for image couplers, beamsplitters, and adapters is met by “captive” or
        in-house capabilities.
  3
 The
        Company offers advanced optical design and development services, not related
        to
        thin film coatings, to a wide range of potential customers and has numerous
        competitors. The ability to supply design and development services to such
        customers is highly dependent upon a company’s and its employees’ reputations
        and prior experience.
 
 The
        Company has had negligible direct export sales to date. However, the Company’s
        medical products have received the CE Mark Certification, which permits sales
        into the European marketplace.
 
 **Research
        and Development** **.**
 
 The
        Company believes that its future success depends to a large degree on its
        ability to continue to conceive and to develop new optical products and services
        to enhance the performance characteristics and methods of manufacture of
        existing products. Accordingly, it expects to continue to seek to obtain
        product-related design and development contracts with customers and to invest
        its own funds on its research and development. The Company spent approximately
        $1,143,000 and $1,319,000 of its own funds during fiscal years 2005 and 2004,
        respectively, on research and development.
 
 The
        Company is
        currently developing specialty instruments incorporating its patent-pending
        LENSLOCK TM technology which ensures lower cost, easier repairability and enhanced
        durability. The Company is also aggressively pursuing ultra-small instruments
        (some with lenses less than one millimeter in diameter) utilizing patent-pending
        micro-precision TM lens
        technology. The Company is also exploring new initiatives in single-molecule technology and nanotechnology for
        biomedical and other applications
 
 **Raw
        Materials and Principal Suppliers** **.**
 
 For
        all
        of the Company’s products, except for thin film coatings, the basic raw material
        is precision grade optical glass, which the Company obtains from several
        major
        suppliers. Outside vendors grind and polish most of the Company’s lenses and
        prisms. For optical thin film coatings, the basic raw materials are metals
        and
        dielectric compounds, which the Company obtains from a variety of chemical
        suppliers. Certain of the thin film coatings utilized in the Company’s products
        are currently procured from an outside supplier, but most thin film coatings
        are
        produced in-house. The Company believes that its demand for these raw materials
        and thin film coating services is small relative to the total supply, and
        that
        materials and services required for the production of its products are currently
        available in sufficient production quantities and will be available for fiscal
        year 2006. The Company believes, however, that there are relatively few
        suppliers of the high quality lenses and prisms which its endoscopes require.
        The Company has therefore established an in-house optical shop for producing
        ultra-high quality prisms, micro-optics and other specialized optics for
        a
        variety of medical and industrial applications.
 
 **Patents
        and Trademarks** **.**
 
 The
        Company relies, in part, upon patents, trade secrets, and proprietary knowledge
        as well as personnel policies and employee confidentiality agreements concerning
        inventions and other creative efforts to develop and to maintain its competitive
        position. The Company does not believe that its business is dependent upon
        any
        patent, patent pending, or license, although it believes that trade secrets
        and
        confidential know-how may be important to the Company’s scientific and
        commercial success.
 
 4
 The
        Company plans to file for patents, copyrights, and trademarks in the United
        States and in appropriate countries to protect its intellectual property
        rights
        to the extent practicable. The Company holds the rights to several United
        States
        and foreign patents and has several patent applications pending, including
        those
        for its new generation of 3-D endoscopes and its new micro-precision TM lens
        technology. The Company knows of no infringements of its patents. The Company
        plans to protect its patents from infringement in each instance where it
        determines that doing so would be economical in light of the expense involved
        and the level and availability of the Company’s financial resources. While the
        Company believes that its pending applications relate to patentable devices
        or
        concepts, there can be no assurance that patents will be issued or that any
        patents issued can be successfully defended or will effectively limit the
        development of competitive products and services.
 
 **Employees** **.**
 
 As
        of
        June 30, 2005, the Company had 28 full-time employees and 5 part-time employees.
        There were 15 employees in manufacturing, 11 in engineering, 2 in sales and
        marketing, and 5 in finance and administration.
 
 **Customers** **.**
 
 Revenues
        from the Company’s largest customers, as a percentage of total revenues, were as
        follows:
 
 **2005**
              
              **2004**Customer
                  A
              
              20 %
              
              24%Customer
                  B
              
              11
              
              6Customer
                  C
              
              -
              
              22All
                  Others
              
              69
              
              48100%
              
              100%
 
 No
        other
        customer accounted for more than 10% of the Company’s revenues in fiscal years
        2005 and 2004.
 
 **Environmental
        Protection and the Effect of Existing or Probable Government Regulations
        on the
        Business** **.**
  The
        Company’s operations are subject to a variety of federal, state, and local laws
        and regulations relating to the discharge of materials into the environment
        or
        otherwise relative to the protection of the environment. From time to time
        the
        Company uses a small amount of hazardous materials in its operations. The
        Company believes that it complies with all applicable environmental laws
        and
        regulations.
 
 **Need
        for Government Approval of Principal Products or Services and Effect of Existing
        or Probable Government Regulations on the Business** **.**
  The
        Company currently sells and markets several medical products, the marketing
        of
        which may require the permission of the United States Food and Drug
        Administration (“FDA”). Pursuant to the Company’s notification to the FDA of its
        intent to market its endoscopes, image couplers, beamsplitters, and adapters,
        the FDA has determined that the Company may market such devices, subject
        to the
        general controls provisions of the Food, Drug and Cosmetic Act. This FDA
        permission was obtained without the need to undergo a lengthy and expensive
        approval process on account of the FDA’s determination that such devices meet
        the regulatory standard of being substantially equivalent to an existing
        approved device. Furthermore, the Company plans to market additional endoscopes
        and related medical products that may require the FDA’s permission to market
        such products. The Company may also develop additional products or seek to
        sell
        some of its current or future medical products in a manner that requires
        the
        Company to obtain the permission of the FDA to market such products, as well
        as
        the regulatory approval or license of other federal, state, and local agencies
        or similar agencies in other countries. The FDA has authority to conduct
        detailed inspections of manufacturing plants in order to assure that “good
        manufacturing practices” are being followed in the manufacture of medical
        devices, to require periodic reporting of product defects to the FDA, and
        to
        prohibit the sale of devices which do not comply with law.
 
 5
 ITEM
        2. DESCRIPTION
        OF PROPERTY
 
 The
        Company conducts its domestic operations at two **** facilities
        in Gardner, Massachusetts. The main Gardner facility is leased from a
        corporation owned by an officer-shareholder-director of the Company. The
        lease
        terminated in December 1999 and the Company is currently a tenant at will.
        The
        other Gardner facility is being rented on a month-to-month basis. The Company
        rents office space in Hong Kong for sales, marketing and supplier quality
        control and liaison activities of its Hong Kong subsidiary.
 
 The
        Company believes these facilities are adequate for its current operations
        and
        adequately covered by insurance. Significant increases in production or the
        addition of significant equipment additions or manufacturing capabilities
        in
        connection with the production of the Company’s line of endoscopes, optical thin
        films, and other products may, however, require the acquisition or lease
        of
        additional facilities. The Company may establish production facilities
        domestically or overseas to produce key assemblies or components, such as
        lenses, for the Company’s products. Overseas facilities may subject the Company
        to the political and economic risks associated with overseas operations.
        The
        loss of or inability to establish or maintain such additional domestic or
        overseas facilities could materially adversely affect the Company’s competitive
        position and profitability.
 
 ITEM
        3. LEGAL
        PROCEEDINGS
 
 None.
 
 ITEM
        4. SUBMISSION
        OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
 No
        matters were submitted to a vote of the Company’s security holders during the
        fourth quarter of fiscal year 2005.
  6
  **Directors
        and Executive Officers of the Company**
 
 The
        Company’s executive officers and directors are as follows:
  Name
              Position
                  with the Company or Principal OccupationRichard
                  E. Forkey
              Chairman
                  of the Board, Chief Executive Officer, President, Treasurer and
                  DirectorR.
                  Michael Arbon
              Chief
                  Financial Officer and ClerkEdward
                  A. Benjamin
              Director
                  and Member of Audit Committee. Mr. Benjamin is a retired partner
                  in the
                  law firm of Ropes & Gray LLP, Boston,
                  Massachusetts.Donald
                  A. Major
              Director
                  and Chair of Audit Committee. Mr. Major is Vice President and Chief
                  Financial Officer of Digital Excellence, LLC.Joel
                  R. Pitlor
              Director.
                  Mr. Pitlor is president of J.R. Pitlor, a management consulting
                  firm based
                  in Cambridge, Massachusetts.Robert
                  R. Shannon
              Director
                  and Member of Audit Committee. Mr. Shannon is a professor at the
                  Optical
                  Sciences Center of the University of Arizona in Tucson,
                  Arizona.
   7
  **PART
        II**
 
 ITEM
        5. MARKET
        FOR COMMON EQUITY AND RELATED STOCK-HOLDER
        MATTERS
 
 The
        Company’s common stock is listed on the National Association of Securities
        Dealers Automated Quotation (NASDAQ) System under the symbol “POCI.” Since
        January 1992, the NASDAQ SmallCap Market has been the principal market in
        which
        the Company’s stock is publicly traded. The high and low sales prices for the
        Company’s stock for each full quarterly period within the two most recent fiscal
        years were as follows as reported by NASDAQ.
 
 2004
              2005Quarter
              High
              Low
              High
              LowFirst
              $
                  2.80
              $
                  1.90
              $
                  1.33
              $.82Second
              $
                  2.67
              $
                  1.71
              $
                  1.50
              $.61Third
              $
                  6.99
              $
                  1.96
              $
                  1.75
              $
                  .88Fourth
              $
                  5.72
              $
                  1.05
              $
                  1.36
              $
                  .52
 
 As
        of
        August 31, 2005, there were approximately 4,200 beneficial shareholders and
        approximately 200 holders of record of the Company’s common stock. Holders of
        record include nominees who may hold shares on behalf of multiple
        owners.
 
 The
        Company has not declared any dividends during the last two fiscal years.
        At
        present, the Company intends to retain its earnings, if any, to finance research
        and development and expansion of its business.
  **EQUITY
        COMPENSATION PLAN INFORMATION**
 
 The
        following table provides information about the Company’s Common Stock that may
        be issued upon the exercise of options, warrants and rights under all of
        our
        existing equity compensation plans as of June 30, 2005, including, but not
        limited to, the 1989 Stock Option Plan and the Amended and Restated 1997
        Incentive Plan:
 
 Number
                  of securities
                to
                  be issued upon
                exercise
                  of
                outstanding
                  options,
                warrants
                  and rights
              
              Weighted-average
                exercise
                  price of
                outstanding
                  options,
                warrants
                  and rights
              
              Number
                  of securities remaining
                available
                  for future issuance under
                equity
                  compensation plans (excluding
                securities
                  reflected in first column)Equity
                  compensationplans
                  approved byshareholders
              1,317,535
              
              $1.79
              
              177,153
                  (1)Equity
                  compensationplans
                  not approvedby
                  shareholders
              3,334(2)
              
              $7.78
              
              n/aTotal
              1,320,869
              
              $1.81
              
              177,153
 
 8
  (1)
        Includes 177,153 shares of Common Stock available for future grants under
        the
        Company’s Amended & Restated 1997 Incentive Plan. No shares are available
        for future grants under the Company’s 1989 Stock Option Plan.
 
 (2)
        Represents 3,334 shares of Common Stock issuable upon exercise of outstanding
        options granted to Werner Thiel in connection with his service as a consultant
        to the Company. These options were exercisable at a price of $7.78125 and
        expired on July 13, 2005.
 
 ITEM
                  6.
              MANAGEMENT’S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                  OPERATIONS
 
 **Important
        Factors Regarding Forward-Looking Statements**
 
 When
        used
        in this discussion, the words “believes”, “anticipates”, “intends to”, and
        similar expressions are intended to identify forward-looking statements.
        Such
        statements are subject to certain risks and uncertainties which could cause
        actual results to differ materially from those projected. These risks and
        uncertainties, many of which are not within the Company’s control, include, but
        are not limited to, the uncertainty and timing of the successful development
        of
        the Company’s new products, particularly in the optical thin films area, the
        risks associated with reliance on a few key customers; the Company’s ability to
        regain and maintain compliance with requirements for continued listing on
        the
        Nasdaq SmallCap Market; the Company’s ability to attract and retain personnel
        with the necessary scientific and technical skills, the timing and completion
        of
        significant orders; the timing and amount of the Company’s research and
        development expenditures; the timing and level of market acceptance of
        customers’ products for which the Company supplies components; performance of
        the Company’s vendors; the ability of the Company to control costs associated
        with performance under fixed price contracts; and the continued availability
        to
        the Company of essential supplies, materials and services; which are described
        further below under “Factors that May Affect Future Results and Market Price of
        Stock.” Readers are cautioned not to place undue reliance on these forward
        looking statements, which speak only as of the date hereof. The Company
        undertakes no obligation to publicly release the result of any revision to
        these
        forward-looking statements which may be made to reflect events or circumstances
        after the date hereof or to reflect the occurrence of unanticipated
        events.
 
 **Overview**
 
 Precision
        Optics Corporation, a developer and manufacturer of advanced optical instruments
        since 1982, designs and produces high-quality optical thin film coatings,
        medical instruments, and other advanced optical systems. The Company’s medical
        instrumentation line includes laparoscopes, arthroscopes and endocouplers
        and a
        world-class product line of 3-D endoscopes for use in minimally invasive
        surgical procedures.
 
 The
        Company is currently developing specialty instruments incorporating its
        patent-pending LENSLOCK TM technology which ensures lower cost, easier repairability and enhanced
        durability. The Company is also aggressively pursuing ultra-small instruments
        (some with lenses less than one millimeter in diameter) utilizing patent-pending
        micro-precision TM lens
        technology. The Company is also exploring new initiatives in single-molecule
        technology and nanotechnology for biomedical and other applications.
 
 Precision
        Optics Corporation is certified to the ISO 9001 Quality Standard, and complies
        with the FDA Good Manufacturing Practices and the European Union Medical
        Device
        Directive for CE Marking of its medical products. The Company’s Internet Website
        is www.poci.com.
 
 The
        areas
        in which the Company does business are highly competitive and include both
        foreign and domestic competitors. Many of the Company’s competitors are larger
        and have substantially greater resources than the Company. Furthermore, other
        domestic or foreign companies, some with greater experience in the optics
        industry and greater financial resources than the Company, may seek to produce
        products or services that compete with those of the Company. The Company
        uses
        production facilities overseas to produce key components for the Company’s
        business, such as lenses. The Company believes that the cost savings from
        such
        production is essential to the Company’s ability to compete on a price basis in
        the medical products area particularly and to the Company’s profitability
        generally.
 
 9
 The
        Company believes that competition for sales of its medical products and
        services, which have been principally sold to original equipment manufacturer
        (OEM) customers, is based on performance and other technical features, as
        well
        as other factors, such as scheduling and reliability, in addition to competitive
        price.
 
 The
        Company believes that its future success depends to a large degree on its
        ability to continue to conceive and to develop new optical products and services
        to enhance the performance characteristics and methods of manufacture of
        existing products. Accordingly, it expects to continue to seek to obtain
        product-related design and development contracts with customers and to invest
        its own funds on research and development, to the extent funds are available.
 
 The
        Company relies, in part, upon patents, trade secrets and proprietary knowledge
        as well as personnel policies and employee confidentiality agreements concerning
        inventions and other creative efforts to develop and to maintain its competitive
        position. The Company does not believe that its business is dependent upon
        any
        particular patent, patent pending, or license, although it believes that
        trade
        secrets and confidential know-how may be important to the Company’s scientific
        and commercial success.
 
 The
        Company conducts its domestic operations at two leased facilities in Gardner,
        Massachusetts. The Company rents office space in Hong Kong for sales, marketing
        and supplier quality control and liaison activities of its Hong Kong subsidiary.
        The Company believes these facilities are adequate for its current operations.
        Significant increases in production or the addition of significant equipment
        or
        manufacturing capabilities in connection with the production for the Company’s
        line of endoscopes, optical thin films, and other products may, however,
        require
        the acquisition or lease of additional facilities.
  **Critical
        Accounting Policies and Estimates**
 
 *General*
 
 Management’s
        discussion and analysis of financial condition and results of operations
        are
        based upon the Company’s consolidated financial statements, which have been
        prepared in accordance with accounting principles generally accepted in the
        United States of America (“U.S. GAAP”). The preparation of these consolidated
        financial statements requires the Company to make estimates and judgments
        that
        affect the reported amounts of assets, liabilities, revenues and expenses.
        The
        Company bases its estimates on historical experience and on various other
        assumptions that are believed to be reasonable under the circumstances, the
        results of which form the basis for making judgments about the carrying values
        of assets and liabilities that are not readily apparent from other sources.
        Actual results may differ from these estimates under different assumptions
        or
        conditions.
 
 The
        Company believes the following critical accounting policies affect its more
        significant judgments and estimates used in the preparation of its consolidated
        financial statements.
 
 *Revenue
        Recognition*
 
 The
        Company recognizes revenue in accordance with U.S. GAAP and SEC Staff Accounting
        Bulletin (“SAB”) No. 104, *Revenue
        Recognition in Financial Statements.* SAB
        No.
        104 requires that four basic criteria must be met before revenue can be
        recognized: (1) persuasive evidence of an arrangement exists; (2) delivery
        has
        occurred or services rendered; (3) the price to the buyer is fixed or
        determinable; and (4) collectibility is reasonably assured. Determination
        of
        criteria (3) and (4) are based on management’s judgments regarding the fixed
        nature of the price to the buyer charged for products delivered or services
        rendered and collectibility of the sales price. The Company assesses credit
        worthiness of customers based upon prior history with the customer and
        assessment of financial condition. The Company’s shipping terms are customarily
        FOB shipping point.
 
 10
 *Bad
        Debt*
 
 The
        Company maintains allowances for doubtful accounts for estimated losses
        resulting from the inability of its customers to make required payments.
        Allowances for doubtful accounts are established based upon review of specific
        account balances and historical experience. If the financial condition of
        the
        Company’s customers were to deteriorate, resulting in an impairment of their
        ability to make future payments, additional allowances may be
        required.
 
 *Inventories*
 
 The
        Company provides for estimated obsolescence on unmarketable inventory based
        upon
        assumptions about future demand and market conditions. If actual demand and
        market conditions are less favorable than those projected by management,
        additional inventory write downs may be required. Inventory, once written
        down,
        is not subsequently written back up, as these adjustments are considered
        permanent adjustments to the carrying value of the inventory.
 
 *Impairment
        of Long-Lived Assets and Long-Lived Assets to be Disposed of*
 
 The
        Company accounts for impairment of long-lived assets in accordance with SFAS
        No.
        144, *Accounting
        for the Impairment or Disposal of Long-Lived Assets.* This
        statement requires that long-lived assets and certain identifiable intangibles
        be reviewed for impairment whenever events or changes in circumstances indicate
        that the carrying amount of an asset may not be recoverable. Recoverability
        of
        assets to be held and used is measured by a comparison of the carrying amount
        of
        an asset to undiscounted future net cash flows expected to be generated by
        the
        asset. If such assets are considered to be impaired, the impairment to be
        recognized is measured by the amount by which the carrying amount of the
        assets
        exceeds the fair value of the assets. Assets to be disposed of through sale
        are
        reported at the lower of the carrying amount or fair value less estimated
        costs
        to sell.
 
 *Income
        Taxes*
  Income
        taxes are accounted for under the asset and liability method. Deferred tax
        assets and liabilities are recognized for the future tax consequences
        attributable to differences between the financial statement carrying amounts
        of
        existing assets and liabilities and their respective tax bases and operating
        loss and tax credit carryforwards. Deferred tax assets and liabilities are
        measured using enacted tax rates expected to apply to taxable income in the
        years in which those temporary differences are expected to be recovered or
        settled. The effect on deferred tax assets and liabilities of a change in
        tax
        rates is recognized in income in the period that includes the enactment date.
  In
        assessing the likelihood of utilization of existing deferred tax assets,
        management has considered historical results of operations and the current
        operating environment.
  *Stock-Based
        Compensation*
 The
        Company accounts for its stock-based compensation using the intrinsic value
        method provided for under Accounting Principles Board Opinion No. 25, *Accounting
        for Stock Issued to Employees* and
        related interpretations *.* Under
        APB
        No. 25 and related interpretations, compensation cost is recognized based
        on the
        difference, if any, on the date of grant between the fair value of the Company’s
        stock and the amount an employee must pay to acquire the stock. Statement
        of
        Financial Accounting Standards (“SFAS”) No. 123, *Accounting
        for Stock-Based Compensation* ,
        (as
        amended by SFAS No. 148, *Accounting
        for Stock-Based Compensation Transition and Disclosure* ),
        establishes a fair-value-based method of accounting for stock-based compensation
        plans. The Company has adopted the disclosure-only alternative under SFAS
        No.
        123, which requires the disclosure of the pro forma effects on net loss and
        net
        loss per share as if the fair value accounting prescribed by SFAS No. 123
        had
        been adopted.
  11
 **Fiscal
        Year 2005 Results of Operations**
 
 Total
        revenues for fiscal year 2005 were $1,349,819, a decrease of $122,189 or
        8.3%,
        from fiscal year 2004 revenues of $1,472,008.
 
 The
        revenue decrease from the prior year was due principally to lower unit volume
        sales of medical products (down 22.6%), partially offset by higher unit volume
        sales of non-medical products (up 82.4%). Medical sales were lower due primarily
        to one-time shipments last year to a customer of specialty endoscopes used
        for
        cardiac surgical applications, as previously reported. Non-medical sales
        were
        higher due primarily to higher sales of industrial lenses, couplers and thin
        film coatings.
 
 Revenues
        from the Company’s largest customers, as a percentage of total revenues, were as
        follows:
 
 **2005**
              
              **2004**Customer
                  A
              
              20%
              
              24%Customer
                  B
              
              11
              
              6Customer
                  C
              
              -
              
              22All
                  Others
              
              69
              
              48100%
              
              100%
 
 No
        other
        customer accounted for more than 10% of the Company’s revenues in fiscal years
        2005 and 2004.
 
 Gross
        profit (loss) for fiscal year 2005 reflected an unfavorable change of $56,873
        compared to fiscal year 2004. Gross profit as a percentage of revenues decreased
        from a negative 40.1% in fiscal year 2004 to a negative 48.9% in fiscal year
        2005. The unfavorable change in gross profit (loss) was due primarily to
        lower
        sales volume partially offset by lower provisions for slow moving and obsolete
        inventories of approximately $401,900 in fiscal year 2005 compared to
        approximately $500,000 in fiscal year 2004.
 
 Research
        and development expenses decreased by $175,933, or 13.3%, during fiscal year
        2005 compared to the previous year. The decrease was due to a lower level
        of
        resources being devoted to internal product development activities, and a
        shift
        in certain resources to more customer sponsored development efforts, resulting
        in initial product shipments to several new customers.
 
 Selling,
        general and administrative expenses increased by $118,575 or 6.8%, during
        fiscal
        year 2005 compared to the previous year. The increase was due primarily to
        higher bid and proposal expenses and professional services expenses, partially
        offset by lower insurance expense.
 
 The
        provision for restructuring in fiscal year 2005 of $89,512 consists of a
        provision for severance benefits substantially paid in the quarter ended
        June
        30, 2005 related to the June 2005 workforce reduction of 3%, or one employee.
        The provision for restructuring in fiscal year 2004 of $52,208 consists of
        a
        provision for severance benefits paid in the quarter ended March 31, 2004
        related to the January 2004 workforce reduction of 15%, or five employees.
 
 12
 The
        following table sets forth the quarterly impacts and cash payments associated
        with the asset impairment and restructuring provisions:
  **Provision
                  For****Employee****Severance**Reserve
                  Balance, June 30, 2003
              
              $
              -Total
                  Provision
              
              
              52,208Cash
                  Payments
              
              
              (52,208
              )Reserve
                  Balance, June 30, 2004
              
              $
              -Total
                  Provision
              
              
              89,512Cash
                  Payments
              
              
              (84,501
              )Reserve
                  Balance, June 30, 2005
              
              $
              5,011
  Interest
        income increased by $32,484 or 179.6% during fiscal year 2005 compared to
        the
        previous year. The increase was due to the higher base of cash and cash
        equivalents because of proceeds received from the rights offering in July
        2004.
 
 The
        income tax provisions in fiscal years 2005 and 2004 represent the minimum
        statutory state income tax liability.
  **Fiscal
        Year 2004 Results of Operations**
 
 Total
        revenues for fiscal year 2004 were $1,472,008, a decrease of $927,209, or
        38.7%,
        from fiscal year 2003 revenues of approximately $2,399,000.
 
 The
        revenue decrease from the prior year was due principally to lower unit volume
        sales of medical products (down 44%), partially offset by higher unit volume
        sales of non-medical products (up 50%). Medical sales were lower due primarily
        to lower sales of stereo endoscope products because of the loss of business
        from
        a major stereo endoscope customer, as previously reported. Non-medical sales
        were higher due primarily to higher sales of couplers for industrial
        use.
 
 Gross
        profit (loss) for fiscal year 2004 reflected an unfavorable change of $917,873
        compared to fiscal year 2003. Gross profit as a percentage of revenues decreased
        from 13.6% in fiscal year 2003 to a negative 40.8% in fiscal year 2004. The
        unfavorable change in gross profit (loss) was due primarily to lower sales
        volume and provisions for slow moving and obsolete inventories, partially
        offset
        by a lower manufacturing cost structure resulting from restructuring measures
        implemented in fiscal year 2003.
 
 Research
        and development expenses increased by $84,093, or 6.8%, during fiscal year
        2004
        compared to the previous year. The increase was due to a higher level of
        resources being devoted to product development activities.
 
 13
 Selling,
        general and administrative expenses decreased by $142,600, or 8.0%, during
        fiscal year 2004 compared to the previous year. The decrease was due primarily
        to lower outside consulting and legal expenses and the effects of the workforce
        reduction in January 2004.
 
 The
        provision for asset impairment and restructuring in fiscal year 2004 of $52,208
        consists of a provision for severance benefits paid in the quarter ended
        March
        31, 2004 related to the January 2004 workforce reduction of 15%, or five
        employees. The provision for asset impairment and restructuring of $176,642
        in
        fiscal year 2003, consists of a provision for severance benefits of $53,131
        paid
        in the quarter ended December 31, 2002 related to the October 2002 workforce
        reduction of 16%, or six employees, and a provision for asset impairment
        of
        $123,511 recorded in the quarter ended June 30, 2003, representing a further
        write down of assets held for sale which reflected the continuing deterioration
        in the market for used telecommunications equipment.
 
 Interest
        income decreased by $47,354 or 72.4% during fiscal year 2004 compared to
        the
        previous year. The decrease was due to the lower base of cash and cash
        equivalents.
 
 Interest
        expense consists of interest on capital lease obligations and decreased due
        to
        the liquidation of capital lease obligations during fiscal year
        2004.
 
 The
        income tax provisions in fiscal years 2004 and 2003 represent the minimum
        statutory state income tax liability.
 
 **Liquidity
        and Capital Resources**
 
 The
        Company has incurred significant operating losses during the last nine fiscal
        years. This trend was primarily the result of the loss of several significant
        customers, completion of several large nonrecurring government contracts,
        and
        operating losses and provision for asset impairment, restructuring, and
        inventory write-downs associated with the downturn in demand for optical
        filters
        used in telecommunications systems. In fiscal 1998, the Company began making
        significant investments in research and development and capital purchases
        for
        new products. In August 1999 and March 2000, the Company raised gross
        proceeds of approximately $16 million of additional cash through the
        issuance of common stock. In July 2004, the Company completed a rights offering
        to stockholders of record at June 7, 2004 by issuing 5,256,159 shares of
        common
        stock. Net cash proceeds to the Company (after offering costs of $222,176)
        were
        $5,033,983.
  In
        the
        past four fiscal years, the Company has implemented a number of restructuring
        and cost saving measures in an effort to align costs with revenues and
        strengthen financial performance. Full-time employee headcount has been reduced
        from 78 at June 30, 2001 to 28 at June 30, 2005. The Company has discontinued
        the development and manufacturing of telecommunications products, canceled
        the
        lease on its Optical Thin Films Technology Center, and written down and/or
        sold
        certain of the property, equipment and inventories invested in its
        telecommunications business, and has implemented other cost reduction measures.
        As a result of these actions, the Company has incurred asset impairment,
        restructuring and inventory write-down provisions of approximately $4,985,000,
        $177,000, $52,000 and $89,500 for the years ended June 30, 2002, 2003, and
        2004
        and 2005, respectively, and has received net proceeds from the sale of assets
        held for sale of approximately $553,000 during the year ended June 30, 2003.
        In
        addition, the Company will continue its review of other expense areas to
        determine where additional reductions in discretionary spending can be achieved.
  As
        of
        June 30, 2005, the Company’s cash and cash equivalents were $2,171,693. The
        Company believes, based on its operating and strategic plans that it will
        have
        sufficient funds to conduct operations through at least the next twelve months.
  14
  Contractual
        cash commitments for the fiscal years subsequent to June 30, 2005 are summarized
        as follows:
 
 **2006**
              
              **Thereafter**
              
              **Total**Operating
                  leases
              
              $
              24,118
              
              $
              1,853
              
              $
              25,971
  **Trends
        and Uncertainties That May Affect Future Results**
 
 For
        the
        quarter ended June 30, 2005, cash and cash equivalents decreased by $866,229
        compared to a decrease of $859,110 for the previous quarter ended March 31,
        2005. Cash disbursements during the quarter ended June30, 2005 included $84,501
        paid for employee severance costs.
 
 Capital
        equipment expenditures during the year ended June 30, 2005 were $32,140,
        down
        4.4% from the $33,605 for fiscal year 2004. Future capital equipment
        expenditures will be dependent upon future sales and success of on-going
        research and development efforts.
 
 For
        the
        quarter ended June 30, 2005, research and development expenses were $233,194,
        down 31.1% from the $338,651 for the quarter ended June 30, 2004. The decrease
        reflects a shift in certain resources to customer-sponsored development efforts
        in the quarter (the costs of which are included in cost of goods sold). The
        level of future quarterly R&D expenses is ultimately dependent upon the
        Company’s assessment of new product opportunities.
 
 The
        Company expects its recent pattern of quarter-to-quarter revenue fluctuations
        to
        continue, due to the uncertain timing of orders from customers and their
        size in
        relation to total revenues. The Company continues to move forward with new
        products and technical innovations, in particular, the development of a new
        generation (patent pending) of its world-class product line of 3-D endoscopes,
        the development of a new prototype 2.7 mm endoscope, and new instruments
        utilizing the Company’s new micro-precision TM lens
        technology (patent pending) for endoscopes under 1 mm. The Company continues
        to
        explore potential applications of single-molecule technology and
        nanotechnology.
 
 The
        Company believes that the recent introduction of several new products, along
        with new and on-going customer relationships, will generate additional revenues,
        which are required in order for the Company to achieve profitability. If
        these
        additional revenues are not achieved on a timely basis, the Company will
        be
        required and is prepared to implement further cost reduction measures, as
        necessary.
 
 Section
        404 of the Sarbanes-Oxley Act of 2002, requiring companies and their public
        accounting firms to report on the effectiveness of the Company’s internal
        controls over financial reporting, will first apply to the Company’s Annual
        Report on Form 10-KSB for the fiscal year ending June 30, 2007. The Company
        expects its operating expense will increase as a result of the costs associated
        with the implementation of and maintaining compliance with Section
        404.
 
 **Common
        Stock Listing on Nasdaq Small Cap Market**
 
 On
        June
        16, 2005, the Company received a letter from the Nasdaq Stock Market (the
        “Notice”) notifying the Company that for the 30 consecutive trading days
        preceding the date of the Notice, the bid price of the Company’s common stock
        had closed below the $1.00 per share minimum required for continued inclusion
        on
        the Nasdaq SmallCap Market pursuant to Nasdaq Marketplace Rule 4310(c)(4).
        The
        Notice further stated that the Company has been provided 180 calendar days,
        or
        until December 13, 2005, to regain compliance with the $1.00 per share bid
        price
        requirement in accordance with Nasdaq Marketplace Rule 4310(c)(8)(D). To
        regain
        compliance with the bid price requirement, the bid price of the Company’s common
        stock must close at or above $1.00 per share for a minimum of ten consecutive
        trading days prior to December 13, 2005. If by December 13, 2005 the Company
        has
        not regained compliance with the minimum bid price requirement, the Company
        may
        be granted an additional 180 day grace period to regain compliance under
        applicable Nasdaq rules, provided it meets The Nasdaq SmallCap Market initial
        listing criteria (other than the minimum bid price requirement) at that
        time.
  15
 The
        Company intends to monitor the bid price for its common stock during the
        period
        leading up to December 13, 2005 and to consider options available to the
        Company
        to achieve compliance.
  On
        August
        1, 2005, the Company received a letter from the Nasdaq Stock Market notifying
        the Company that it had not received the Company’s Corporate Governance
        Certification Form required by July 31, 2005, certifying compliance with
        the new
        Audit Committee composition, Audit and Nominating Committee charter, Executive
        Sessions and Code of Conduct requirements. As a result of the noncompliance,
        the
        Company’s common stock was subject to delisting from the Nasdaq Stock Market at
        the opening of business on August 10, 2005.
  Subsequently,
        on August 4, 2005 the Company’s Board
        of
        Directors elected Donald A. Major as a director of the Company and designated
        him as
        the
        Audit Committee financial expert. Mr. Major was also appointed to chair of
        the
        Audit Committee of the Company. Also on August 4, 2005 the Company submitted
        the
        Company’s Corporate Governance Certification Form to the Nasdaq Stock Market
        certifying its compliance with the new Audit Committee composition, Audit
        and
        Nominating Committee charter, Executive Sessions and Code of Conduct
        requirements.
  As
        a
        consequence of these actions, on August 4, 2005, the Company received a letter
        from the Nasdaq Stock Market notifying the Company that based on the information
        regarding the appointment of Donald A. Major to the Company’s Board of Directors
        and Audit Committee, it had determined that the Company was in compliance
        with
        the Rules and matters pertaining to their letter of August 1, 2005 were closed.
  **Factors
        That May Affect Future Results and Market Price of Stock**
 
 ***Our
        Quarterly Financial Results*** **** ***Depend
        on a Large Number of Factors and Therefore May Vary Quarter to Quarter--As
        a
        Result, We Cannot Predict with a High Degree of Certainty Our Operating Results
        in Any Particular Fiscal Quarter.***
 
 Our
        quarterly operating results may vary significantly depending upon factors
        such
        as:
 ·
                  the
                      timing of completion of significant orders·
                  the
                      timing and amount of our research and development expenditures·
                  the
                      costs of initial product production in connection with new
                      products·
                  the
                      timing of new product introductions -- both by us and by our
                      competitors·
                  the
                      timing and level of market acceptance of new products or enhanced
                      versions
                      of our existing products·
                  our
                      ability to retain existing customers and customers’ continued demand for
                      our products and services·
                  our
                      customers’ inventory levels, and levels of demand for our customers’
                      products and services
  16
  ·
                  competitive
                      pricing pressures
 
 We
        cannot
        be certain whether we will be able to grow or sustain revenues or achieve
        or
        maintain profitability on a quarterly or annual basis or that levels of revenue
        and/or profitability may not vary from one such period to another.
 
 ***We
        May Need to Raise Additional Funds in The Future - If We Cannot Obtain Adequate
        Financing on Acceptable Terms When Required, Our Business Will Be Adversely
        Affected.***
 
 We
        believe that our existing cash and cash equivalents are sufficient to support
        our working capital and investment needs through at least the next twelve
        months, however, we may need to raise additional capital in the future. We
        may
        seek funding through additional pubic or private equity offerings or debt
        financings. Our ability to raise additional capital, however, will be heavily
        influenced by the investment market. Additional financing may not be available
        when needed, or, if available, may not be available on favorable terms. If
        we
        cannot obtain adequate financing on acceptable terms when such financing
        is
        required, our business will be adversely affected.
 
 ***If
        We Cannot Maintain Compliance with the Requirements for Continued Listing
        on the
        Nasdaq SmallCap Market, Our Common Stock Could Be Delisted—As a Result, the
        Market Price and Liquidity of Our Common Stock Might Decline and Our Ability
        to
        Raise Capital Might Be Impaired.***
  On
        June
        16, 2005, Precision Optics Corporation, Inc. (the Company) received a letter
        from the Nasdaq Stock Market (“the Notice”) notifying the Company that for the
        30 consecutive trading days preceding the date of the Notice, the bid price
        of
        the Company’s common stock had closed below the $1.00 per share minimum required
        for continued inclusion on The Nasdaq SmallCap Market pursuant to Nasdaq
        Marketplace Rule 4310(c)(4). The Notice further stated that the Company has
        been
        provided 180 calendar days, or until December 13, 2005, to regain compliance
        with the $1.00 per share bid price requirement in accordance with Nasdaq
        Marketplace Rule 4310(c)(8)(D). To regain compliance with the bid price
        requirement, the bid price of the Company’s common stock must close at or above
        $1.00 per share for a minimum of ten consecutive trading days prior to December
        13, 2005. If by December 13, 2005 the Company has not regained compliance
        with
        the minimum bid price requirement, the Company may be granted an additional
        180
        day grace period to regain compliance under applicable Nasdaq rules, provided
        it
        meets the Nasdaq SmallCap Market initial listing criteria (other than the
        minimum bid price requirement) at that time.
  The
        Company intends to monitor the bid price for its common stock during the
        period
        leading up to December 13, 2005 and to consider options available to the
        Company
        to achieve compliance.
  The
        delisting of our Common Stock from the Nasdaq SmallCap Market may materially
        impair your ability to buy and sell shares of our Common Stock and could
        have an
        adverse effect on the market price of, and the efficiency of the trading
        market
        for, our Common Stock. In addition, the delisting of our Common Stock could
        significantly impair our ability to raise capital should we desire to do
        so in
        the future. There is no assurance that we will be able to regain compliance
        or
        continue to comply with the minimum bid or other continuing listing requirements
        of the Nasdaq SmallCap Market.
  ***We
        Rely on a Small Number of Customers and Cannot Be Certain They Will Consistently
        Purchase Our Products in the Future.***
 
 In
        the
        fiscal year ended June 30, 2005, our two largest customers represented
        approximately 20% and 11%, respectively, of our total revenues. In the fiscal
        year ended June 30, 2004, our two largest customers represented approximately
        24% and 22%, respectively, of our total revenues. In the fiscal year ended
        June
        30, 2003, our two largest customers represented approximately 44% and 17%,
        respectively, of our total revenues. No other customer accounted for more
        than
        10% of our revenues during those periods.
 
 17
 In
        the
        future, a small number of customers may continue to represent a significant
        portion of our total revenues in any given period. We cannot be certain that
        such customers will consistently purchase our products at any particular
        rate
        over any subsequent period.
 
 ***We
        Rely Heavily Upon the Talents***  ***of
        Our Chief Executive Officer and Chief Scientist, The Loss of Whom Could Severely
        Damage Our Business.***
 
 Our
        performance depends to a large extent on a small number of key scientific,
        technical, managerial, and marketing personnel. In particular, we believe
        our
        success is highly dependent upon the services and reputation of our Chief
        Executive Officer, Mr. Richard E. Forkey. Loss of Mr. Forkey’s services could
        severely damage our business.
 
 Additionally,
        Dr. Joseph N. Forkey was appointed our Chief Scientist in September 2003.
        Dr.
        Forkey’s appointment has
        provided us with
        significant additional capabilities in optical instrument development, in
        management of new technology and in potentially significant longer-term
        initiatives in Biophysics and Biomedical instrumentation, as well as new
        photonics-based market opportunities. Dr. Forkey, in his capacity as Chief
        Scientist, expects to continue to explore the development and application
        of
        optical-based microscopic single-molecule technologies. The loss of Dr. Forkey’s
        scientific contributions could severely damage our business.
 
 ***We
        Must Continue to be Able to Attract Employees With the Scientific and Technical*** ***Skills
        That our Business Requires--If We Are Unable to Attract and Retain Such
        Individuals, Our Business Could Be Severely Damaged.*** ****
 
 Our
        ability to attract employees with a high degree of scientific and technical
        talent is crucial to the success of our business. There is intense competition
        for the services of such persons, and we cannot guarantee that we will be
        able
        to attract and retain individuals possessing the necessary qualifications.
 
 ***We
        Have a Number of Large, Well-Financed Competitors Who Have Research and
        Marketing Capabilities That Are Superior to Ours.***
 
 The
        industries in which we compete are highly competitive. Many of our existing
        and
        potential competitors have greater financial resources and manufacturing
        capabilities, more established and larger marketing and sales organizations
        and
        larger technical staffs than we have. Other companies, some with greater
        experience in the telecommunications, optics, semiconductor or medical products
        industries, are seeking to produce products and services that compete with
        our
        products and services.
 
 ***We
        Are Subject to a High Degree of Regulatory Oversight--We Cannot Be Certain
        That
        We Will Continue to Receive the Necessary Regulatory
        Approvals.***
 
 The
        FDA
        has allowed us to market the medical products we currently sell in the United
        States. However, prior FDA approval may be required before we can market
        additional medical products that we may develop in the future. We may also
        seek
        to sell current or future medical products in a manner that requires us to
        obtain FDA permission to market such products. We may also require the
        regulatory approval or license of other federal, state or local agencies
        or
        comparable agencies in other countries.
 
 We
        cannot
        be certain that we will continue to receive the FDA’s permission to market our
        current products or obtain the necessary regulatory permission, approvals
        or
        licenses for the marketing of any of our future products. Also, we cannot
        predict the impact on our business of FDA regulations or determinations arising
        from future legislation or administrative action.
 
 18
 ***We
        Face Risks Inherent in Product Development and Production Under Fixed Price
        Contracts--We Cannot Be Sure That These Contracts Will Be Profitable over
        Time.***
 
 A
        significant portion of our business has been devoted to research, development
        and production under fixed price contracts. For our purposes, a fixed price
        contract is any contract under which we will provide products or services
        for a
        fixed price over an extended period of time (usually six months or longer).
        In
        our 2005 and 2004 fiscal years, fixed price contracts represented approximately
        15% and 29%, respectively, of our total revenues. We expect that revenues
        from
        fixed price contracts will continue to represent a significant portion of
        our
        total revenues in future fiscal years.
 
 Because
        they involve performance over time, we cannot predict with certainty the
        expenses involved in meeting our obligations under fixed price contracts.
        Therefore, we can never be sure at the time we enter into any single fixed
        price
        contract that such contract will be profitable for us.
 
 ***Third
        Parties May Infringe on Our Patents--As a Result, We Could Incur Significant
        Expense in Protecting Our Patents or Not Have Sufficient Resources to Protect
        Them.***
 
 We
        hold a
        number of patents that are important to our business. Although we are not
        currently aware of any past or present infringements of our patents, we plan
        to
        protect these patents from infringement and obtain additional patents whenever
        feasible. To this end, we have obtained confidentiality agreements from our
        employees and consultants and others who have access to the design of our
        products and other proprietary information. Protecting and obtaining patents,
        however, is both time consuming and expensive. We therefore may not have
        the
        resources necessary to assert all potential patent infringement claims or
        pursue
        all patents that might be available to us.
 
 ***Third
        Parties May Claim that We Have Infringed on Their Patents--As a Result, We
        Could
        Be Prohibited from Using All or Part of Any Technology Used in Our
        Products.***
 
 Should
        third parties claim a proprietary right to all or part of any technology
        that we
        use in our products, such a claim, regardless of its merit, could involve
        us in
        costly litigation. If successful, such a claim could also result in us being
        unable to freely to use the technology that was the subject of the claim,
        or
        sell products embodying such technology.
 
 ***We
        Depend on the Availability of Certain Key Supplies and Services That Are
        Available From Only a Few Sources--If We Experience Difficulty with a Supplier,
        We May Have Difficulty Finding Alternative Sources of
        Supply.***
 
 Certain
        key supplies used in our products, particularly precision grade optical glass,
        are available from only a few sources, each of which is located outside the
        United States. Also, outside vendors grind and polish certain of our lenses
        and
        other optical components, such as prisms and windows. Based upon our ordering
        experience to date, we believe the materials and services required for the
        production of our products are currently available in sufficient quantities.
        Our
        requirements are small relative to the total supply, and we are not currently
        encountering problems with availability. However, this does not mean that
        we
        will continue to have timely access to adequate supplies of essential materials
        and services in the future or that supplies of these materials and services
        will
        be available on satisfactory terms when the need arises. Our business could
        be
        severely damaged if we become unable to procure essential materials and services
        in adequate quantities and at acceptable prices.
 
 19
 From
        time
        to time, certain of our products may be produced for us by subcontractors,
        and
        our business is subject to the risk that these subcontractors fail to make
        timely delivery. Our products and services are also from time to time used
        as
        components of the products and services of other manufacturers. We are therefore
        subject to the risk that manufacturers that integrate our products or services
        into their own products or services are unable to acquire essential supplies
        and
        services from third parties in a timely fashion.
 
 ***Our
        Customers May Claim that the Products We Sold Them Were Defective--If Our
        Insurance Is Not Sufficient to Cover a Claim, We Would Be Liable for the
        Excess.***
 
 Like
        any
        manufacturer, we are and always have been exposed to liability claims resulting
        from the use of our products. We maintain product liability insurance to
        cover
        us in the event of liability claims, and no such claims have been asserted
        or
        threatened against us to date. However, we cannot be certain that our insurance
        will be sufficient to cover all possible future product liabilities.
 
 ***We
        Would Be Liable If Our Business Operations Harmed the Environment--Failure
        to
        Maintain Compliance with Environmental Laws Could Severely Damage Our
        Business.***
 
 Our
        operations are subject to a variety of federal, state and local laws and
        regulations relating to the protection of the environment. From time to time,
        we
        use hazardous materials in our operations. Although we believe that we are
        in
        compliance with all applicable environmental laws and regulations, our business
        could be severely damaged by any failure to maintain such compliance.
 
 ITEM
        7. CONSOLIDATED
        FINANCIAL STATEMENTS
 
 The
        Consolidated Financial Statements are filed on pages 21 through 41
        of this
        Form 10-KSB.
  20
  **PRECISION
        OPTICS CORPORATION, INC. AND SUBSIDIARIES**
 
 Consolidated
        Financial Statements
 as
        of
        June 30, 2005 and 2004
 Together
        with Independent Registered Public Accounting Firms’ Reports
 
 
 21
  **Report
        of Independent Registered Public Accounting Firm**
 
 To
        the
        Board of Directors and Shareholders of
 Precision
        Optics Corporation, Inc.:
 
 We
        have
        audited the accompanying consolidated balance sheet of Precision Optics
        Corporation, Inc. and subsidiaries as of June 30, 2005 and the related
        consolidated statements of operations, stockholders’ equity and cash flows for
        the year then ended. These consolidated financial statements are the
        responsibility of the Company’s management. Our responsibility is to express an
        opinion on these consolidated financial statements based on our
        audit.
 
 We
        conducted our audit in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. An audit includes consideration
        of
        internal control over financial reporting as a basis for designing audit
        procedures that are appropriate in the circumstances, but not for the purpose
        of
        expressing an opinion on the effectiveness of the Company’s internal control
        over financial reporting. Accordingly, we express no such opinion. An audit
        also
        includes examining, on a test basis, evidence supporting the amounts and
        disclosures in the financial statements. An audit also includes assessing
        the
        accounting principles used and significant estimates made by management,
        as well
        as evaluating the overall financial statement presentation. We believe that
        our
        audit provides a reasonable basis for our opinion.
 
 In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the consolidated financial position of Precision
        Optics Corporation, Inc. and subsidiaries as of June 30, 2005 and the results
        of
        their operations and their cash flows for the year then ended in conformity
        with
        accounting principles generally accepted in the United States of
        America.
  
 /s/
        Vitale Caturano and Company, Ltd.
  
 Boston,
        Massachusetts
 August
        12, 2005
  22
  **Report
        of Independent Registered Public Accounting Firm**
 
 The
        Board
        of Directors and Shareholders
 Precision
        Optics Corporation, Inc.:
 
 We
        have
        audited the accompanying consolidated balance sheet of Precision Optics
        Corporation, Inc. and subsidiaries as of June 30, 2004 and the related
        consolidated statements of operations, stockholders’ equity and cash flows for
        the year then ended. The consolidated financial statements are the
        responsibility of the Company’s management. Our responsibility is to express an
        opinion on the consolidated financial statements based on our audit.
 
 We
        conducted our audit in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. An audit includes examining,
        on a
        test basis, evidence supporting the amounts and disclosures in the financial
        statements. An audit also includes assessing the accounting principles used
        and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audit provides a
        reasonable basis for our opinion.
 
 In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the consolidated financial position of Precision
        Optics Corporation, Inc. and subsidiaries as of June 30, 2004 and the results
        of
        their operations and their cash flows for the year then ended in conformity
        with
        U.S. generally accepted accounting principles.
 
 /s/
        KPMG
        LLP
  
 Boston,
        Massachusetts
 August
        31, 2004
  23
  **PRECISION
        OPTICS CORPORATION, INC. AND SUBSIDIARIES**
 
 Consolidated
        Balance Sheets
 June
        30,
        2005 and 2004
  **ASSETS**
              
              **2005**
              
              **2004**Current
                  Assets:Cash
                  and cash equivalents
              
              $
              2,171,693
              
              $
              343,260Accounts
                  receivable (net of allowance for doubtfulaccounts
                  of approximately $14,550 in 2005 and $154,900 in 2004).
              
              
              177,031
              
              
              80,195Inventories
              
              
              599,619
              
              
              917,998Prepaid
                  expenses
              
              
              62,422
              
              
              80,646Deferred
                  financing costs
              
              
              -
              
              
              171,885Total
                  current assets
              
              
              3,010,765
              
              
              1,593,984Machinery
                  and equipment
              
              
              3,539,205
              
              
              3,507,065Leasehold
                  improvements
              
              
              553,596
              
              
              553,596Furniture
                  and fixtures
              
              
              96,831
              
              
              96,831Vehicles
              
              
              42,343
              
              
              42,3434,231,975
              
              
              4,199,835Less—Accumulated
                  depreciation and amortization
              
              
              4,092,202
              
              
              3,920,593139,773
              
              
              279,242Other
                  Assets:Cash
                  surrender value of life insurance policies
              
              
              16,440
              
              
              23,032Patents,
                  net
              
              
              201,627
              
              
              201,056Total
                  other assets
              
              
              218,067
              
              
              224,088$
              3,368,605
              
              $
              2,097,314**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY**Current
                  Liabilities:Accounts
                  payable
              
              $
              160,593
              
              $
              235,050Customer
                  advances
              
              
              18,000
              
              
              -Accrued
                  employee compensation
              
              
              208,851
              
              
              230,110Accrued
                  professional services
              
              
              74,000
              
              
              75,439Accrued
                  warranty expense
              
              
              50,000
              
              
              50,000Other
                  accrued liabilities
              
              
              7,566
              
              
              2,743Total
                  current liabilities
              
              
              519,010
              
              
              593,342Commitments
                  (Note 2)Stockholders’
                  Equity:Common
                  stock, $0.01 par value-Authorized—20,000,000
                  sharesIssued
                  and outstanding— 7,008,212 shares
                  at June 30, 2005 and 1,752,053shares
                  at June 30, 2004
              
              
              70,082
              
              
              17,521Additional
                  paid-in capital
              
              
              32,751,598
              
              
              27,770,175Accumulated
                  deficit
              
              
              (29,972,085
              )
              
              (
                  26,283,724
              )Total
                  stockholders’ equity
              
              
              2,849,595
              
              
              1,503,972$
              3,368,605
              
              $
              2,097,314
  *The
        accompanying notes are an integral part of these consolidated financial
        statements.*
 24
 **PRECISION
          OPTICS CORPORATION, INC. AND SUBSIDIARIES**
 
 Consolidated
          Statements of Operations
 for
          the
          Years Ended June 30, 2005 and 2004
 **2005**
              
              **2004**Revenues
              
              $
              1,349,819
              
              $
              1,472,008Cost
                  of Goods Sold
              
              
              1,997,586
              
              
              2,062,902Gross
                  profit (loss)
              
              
              (647,767
              )
              
              (590,894
              )Research
                  and Development Expenses
              
              
              1,143,412
              
              
              1,319,345Selling,
                  General and Administrative Expenses
              
              
              1,857,332
              
              
              1,738,757Provision
                  for Restructuring
              
              
              89,512
              
              
              52,208Total
                  operating expenses
              
              
              3,090,256
              
              
              3,110,310Operating
                  loss
              
              
              (3,738,023
              )
              
              (3,701,204
              )Interest
                  Income, net
              
              
              50,574
              
              
              18,040Loss
                  before provision for income taxes
              
              
              (3,687,449
              )
              
              (3,683,164
              )Provision
                  for Income Taxes
              
              
              912
              
              
              912Net
                  loss
              
              $
              3,688,361
              
              $
              3,684,076Loss
                  per Share - Basic and Diluted
              
              $
              (0.55
              )
              $
              (2.10
              )Weighted
                  Average Common Shares Outstanding - Basic and Diluted
              
              
              6,749,003
              
              
              1,752,053
 
 *The
        accompanying notes are an integral part of these consolidated financial
        statements* *.*
  25
 **PRECISION
            OPTICS CORPORATION, INC. AND SUBSIDIARIES**
 
 Consolidated
            Statements of Stockholders’ Equity
 for
            the
            Years Ended June 30, 2005 and 2004
 Number
                    of
                  Shares
                
                Common
                  Stock
                
                Additional
                  Paid-in
                  Capital
                
                Accumulated
                  Deficit
                
                TotalStockholders’
                    EquityBalance,
                    June 30, 2003
                
                
                1,752,053
                
                
                17,521
                
                
                27,770,175
                
                
                (22,599,648
                )
                
                5,188,
                    048Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (3,684,076
                )
                
                (3,684,076
                )Balance,
                    June 30, 2004
                
                
                1,752,053
                
                
                17,521
                
                
                27,770,175
                
                
                (26,283,724
                )
                
                1,503,972Proceeds
                    from rights offering, net
                
                
                5,256,159
                
                
                52,561
                
                
                4,981,423
                
                
                -
                
                
                5,033,984Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (3,688,361
                )
                
                (3,688,361
                )Balance,
                    June 30, 2005
                
                
                7,008,212
                
                $
                70,082
                
                $
                32,751,598
                
                $
                (29,972,085
                )
                $
                2,849,595
  *The
        accompanying notes are an integral part of these consolidated financial
        statements.*
 
 26
 **PRECISION
            OPTICS CORPORATION, INC. AND SUBSIDIARIES**
 
 Consolidated
        Statements of Cash Flows for the
 Years
        Ended June 30, 2005 and 2004
  **2005**
              
              **2004**Cash
                  Flows from Operating Activities:Net
                  loss
              
              $
              (3,688,361
              )
              $
              (3,684,076
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities-Depreciation
                  and amortization
              
              
              241,966
              
              
              240,846Provision
                  for inventory write-down
              
              
              401,900
              
              
              500,000Changes
                  in operating assets and liabilities-Accounts
                  receivable, net
              
              
              (96,836
              )
              
              111,474Inventories
              
              
              (83,521
              )
              
              (160,710
              )Prepaid
                  expenses
              
              
              18,224
              
              
              10,567Accounts
                  payable
              
              
              78,850
              
              
              (59,655
              )Customer
                  advances
              
              
              18,000
              
              
              -Accrued
                  expenses
              
              
              (17,875
              )
              
              (32,055
              )Net
                  cash used in operating activities
              
              
              (3,127,653
              )
              
              (3,073,609
              )Cash
                  Flows from Investing Activities:Purchases
                  of property and equipment
              
              
              (32,140
              )
              
              (33,605
              )Increase
                  in other assets
              
              
              (64,336
              )
              
              (31,536
              )Net
                  cash used in investing activities
              
              
              (96,476
              )
              
              (65,141
              )Cash
                  Flows from Financing Activities:Repayment
                  of capital lease obligation and other
              
              
              -
              
              
              (3,826
              )Gross
                  proceeds from rights offering
              
              
              5,256,159Payment
                  of rights offering costs
              
              
              (203,597
              )
              
              (18,578
              )Net
                  cash used in financing activities
              
              
              5,052,562
              
              
              (22,404
              )Net
                  Increase (Decrease) in Cash and Cash Equivalents
              
              
              1,828,433
              
              
              (3,161,154
              )Cash
                  and Cash Equivalents, beginning of year
              
              
              343,260
              
              
              3,504,414Cash
                  and Cash Equivalents, end of year
              
              $
              2,171,693
              
              $
              343,260Supplemental
                  Disclosure of Cash Flow Information:Cash
                  paid during the year for-Interest
              
              $
              -
              
              $
              49Income
                  taxes
              
              $
              912
              
              $
              -
 
 *The
        accompanying notes are an integral part of these consolidated financial
        statements.*
 
 27
  **PRECISION
        OPTICS CORPORATION, INC. AND SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  **(1)** **Summary
        of Significant Accounting Policies**
  **(a)** **Nature
        of Business and Liquidity**
  Precision
        Optics Corporation, Inc. (the “Company”) designs, develops, manufactures and
        sells specialized optical systems and components and optical thin-film coatings.
        The Company conducts business in one industry segment only and its customers
        are
        primarily domestic. The Company’s products and services fall into two principal
        areas: (i) medical products for use by hospitals and physicians and (ii)
        advanced optical system design and development services and products used
        by
        industrial customers.
  The
        Company has incurred significant operating losses during the last nine fiscal
        years. This trend was primarily the result of the loss of several significant
        customers, completion of several large nonrecurring government contracts,
        and
        operating losses and provision for asset impairment, restructuring, and
        inventory write-downs associated with the downturn in demand for optical
        filters
        used in telecommunications systems. In fiscal 1998, the Company began making
        significant investments in research and development and capital purchases
        for
        new products. In August 1999 and March 2000, the Company raised gross
        proceeds of approximately $16 million of additional cash through the
        issuance of common stock. In July 2004, the Company completed a rights offering
        to stockholders of record at June 7, 2004 by issuing 5,256,159 shares of
        common
        stock. Net cash proceeds to the Company (after offering costs of $222,175)
        were
        $5,033,984.
  In
        the
        past four fiscal years, the Company has implemented a number of restructuring
        and cost saving measures in an effort to align costs with revenues and
        strengthen financial performance. Full-time employee headcount has been reduced
        from 78 at June 30, 2001 to 28 at June 30, 2005. The Company has discontinued
        the development and manufacturing of telecommunications products, canceled
        the
        lease on its Optical Thin Films Technology Center, and written down and/or
        sold
        certain of the property, equipment and inventories invested in its
        telecommunications business. As a result of these actions, the Company has
        incurred a provision for excess and obsolete inventory of approximately $401,900
        and $500,000 and restructuring costs of approximately $89,500 and $52,000
        for
        the years ended June 30, 2005, and 2004, respectively. In addition, the Company
        will continue its review of other expense areas to determine where additional
        reductions in discretionary spending can be achieved.
 
 The
        Company’s current sources of liquidity consist of its cash and cash equivalents
        and accounts receivable. At June 30, 2005 the Company had $2,171,693 in cash
        and
        cash equivalents and $177,031 in accounts receivable.
  The
        Company expects its recent pattern of quarter-to-quarter revenue fluctuations
        to
        continue, due to the uncertain timing of individual orders and their size
        in
        relation to total revenues. The Company remains confident in the value of
        its
        technology and expertise both in medical and surgical applications and
        elsewhere. In addition, despite strict controls on R&D spending, the Company
        continues to move forward with new products and technical innovations.
  The
        Company believes that the recent introduction of several new products, along
        with new and on-going customer relationships, will generate additional revenues,
        which are required in order for the Company to achieve profitability. If
        these
        additional revenues are not achieved on a timely basis, the Company will
        be
        required and is prepared to implement further cost reduction measures, as
        necessary. The Company believes, based on its operating and strategic plans,
        that it will have sufficient funds to conduct operations through at least
        the
        next twelve months.
  28
 **PRECISION
        OPTICS CORPORATION, INC. AND SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  **(b)** **Principles
        of Consolidation**
  The
        accompanying consolidated financial statements include the accounts of the
        Company and its two wholly owned subsidiaries. All inter-company accounts
        and
        transactions have been eliminated in consolidation.
  **(c)** **Revenues**
  In
        December 2003, the Securities and Exchange Commission issued Staff Accounting
        Bulletin (“SAB”) No. 104 which establishes guidance in applying generally
        accepted accounting principles to revenue recognition in financial statements
        and was effective for the Company’s fiscal year 2004. SAB No. 104 requires that
        four basic criteria must be met before revenue can be recognized: (1) persuasive
        evidence of an arrangement exists; (2) delivery has occurred or services
        rendered; (3) the price to the buyer is fixed and determinable; and (4)
        collectibility is reasonably assured. The Company’s shipping terms are
        customarily FOB shipping point. The Company’s revenue recognition practices
        comply with the guidance in the bulletin.
  Sales
        price of products and services sold is fixed and determinable after receipt
        and
        acceptance of a customer’s purchase order or properly executed sales contract,
        typically before any work is performed. Management reviews each customer
        purchase order or sales contract to determine that the work to be performed
        is
        specified and there are no unusual terms and conditions which would raise
        questions as to whether the sales price is fixed or determinable. The Company
        assesses credit worthiness of customers based upon prior history with the
        customer and assessment of financial condition. Accounts receivable are stated
        at the amount management expects to collect from outstanding balances. An
        allowance for doubtful accounts is provided for that portion of accounts
        receivable considered to be uncollectible, based upon historical experience
        and
        management’s evaluation of outstanding accounts receivable at the end of the
        year. Bad debts are written off against the allowance when identified. The
        allowance for doubtful accounts at June 30, 2005 and 2004 was approximately
        $14,550 and $154,900, respectively.
  The
        Company’s shipping terms are customarily FOB shipping point. The Company’s
        revenue transactions typically do not contain multiple deliverable elements
        for
        future performance obligations to customers, other than a standard one-year
        warranty on materials and workmanship, the estimated costs for which are
        provided for at the time revenue is recognized.
  Revenues
        for industrial and medical products sold in the normal course of business
        are
        recognized upon shipment when delivery terms are FOB shipping point and all
        other revenue recognition criteria have been met. Services that the Company
        provides to customers consist of repairs and engineering design and development.
        Recognition of service revenue occurs (assuming all other revenue recognition
        criteria have been met) upon delivery to the customer of the repaired product.
        Service revenue represented 4.6% and 3.2% of total revenue for June 30, 2005
        and
        2004, respectively. Contract revenues, where the period of performance extends
        beyond six months, including revenues from customer-sponsored research and
        development contracts, are recognized under the percentage-of-completion
        method.
        The percentage of completion is determined by computing the percentage of
        the
        actual cost of work performed to the anticipated total contract costs, or
        on the
        basis of units shipped. When the estimate of a contract indicates a loss,
        the
        Company’s policy is to record the entire estimated loss in the current period.
        Gross shipping charges reimbursable from customers, to deliver product, is
        included in Revenues, while shipping costs are shown in Selling, General
        and
        Administrative Expenses section of the Consolidated Statement of Operations.
        Shipping charges invoiced to customers were approximately $6,000 and $7,000
        for
        June 30, 2005 and 2004, respectively.
  29
 **PRECISION
        OPTICS CORPORATION, INC. AND SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  **(d)** **Cash
        and Cash Equivalents**
  The
        Company includes in cash equivalents all highly liquid investments with original
        maturities of three months or less at the time of acquisition. Cash equivalents
        of approximately $2,091,000 and $299,000 at June 30, 2005 and 2004,
        respectively, consist primarily of overnight repurchase agreements, money
        market
        funds, and United States Treasury bills.
  **(e)** **Inventories**
  Inventories
        are stated at the lower of cost (first-in, first-out) or market and include
        material, labor and manufacturing overhead. The components of inventories
        at
        June 30, 2005 and 2004 are as follows:
  **2005**
                
                **2004**Raw
                    material
                
                $
                181,548
                
                $
                345,483Work-in-progress
                
                
                185,047
                
                
                307,522Finished
                    goods
                
                
                233,024
                
                
                264,993$
                599,619
                
                $
                917,998
 
 The
        Company provides for estimated obsolescence on unmarketable inventory based
        upon
        assumptions about future demand and market conditions. If actual demand and
        market conditions are less favorable than those projected by management,
        additional inventory write downs may be required. Inventory, once written
        down,
        is not subsequently written back up, as these adjustments are considered
        permanent adjustments to the carrying value of the inventory.
  During
        fiscal years 2005 and 2004, the Company recorded, in cost of goods sold,
        pretax
        non-cash provisions for slow-moving and obsolete inventories of approximately
        $401,900 and $500,000, respectively.
  **(f)** **Property
        and Equipment**
 
 Property
        and equipment are recorded at cost. Maintenance and repair items are expensed
        as
        incurred. The Company provides for depreciation and amortization by charges
        to
        operations, using the straight-line and declining-balance methods, which
        allocate the cost of property and equipment over the following estimated
        useful
        lives:
 
 **Asset
                  Classification**
              **Estimated
                  Useful Life**Machinery
                  and equipment
              2-7
                  yearsLeasehold
                  improvements
              Shorter
                  of lease term or estimated useful lifeFurniture
                  and fixtures
              5
                  yearsVehicles
              3
                  years
  Amortization
        of assets under capital leases are included in depreciation expense.
        Depreciation expense was $171,609 and $197,242 for the years ended June 30,
        2005
        and 2004, respectively.
  30
 
 **PRECISION
          OPTICS CORPORATION, INC. AND SUBSIDIARIES**
  Notes
          to
          Consolidated Financial Statements
  **(g)** **Significant
        Customers and Concentration of Credit Risk**
  Statement
        of Financial Accounting Standards (SFAS) No. 105, *Disclosure
        of Information about Financial Instruments with Off-Balance-Sheet Risk and
        Financial Instruments with Concentrations of Credit Risk,* requires
        disclosure of any significant off-balance sheet and credit risk
  Financial
        instruments that subject the Company to credit risk consist primarily of
        cash
        equivalents and trade accounts receivable. The Company places its investments
        in
        highly rated financial institutions. The Company has not experienced any
        losses
        on these investments to date. At June 30, 2005, receivables from the Company’s
        largest customers were 19%, 16%, and 10%, respectively, of the total accounts
        receivable. At June 30, 2004, receivables from the Company’s largest customers
        were 47%, 18%, 13%, and 12%, respectively, of the total accounts receivable.
        No
        other customer accounted for more than 10% of the Company’s receivables as of
        June 30, 2005 and 2004. The Company has not experienced any material losses
        related to accounts receivable from individual customers. The Company generally
        does not require collateral or other security as a condition of sale rather
        relying on credit approval, balance limitation and monitoring procedures
        to
        control credit risk of trade account financial instruments. Management believes
        that allowances for doubtful accounts, which are established based upon review
        of specific account balances and historical experience, are
        adequate.
  Revenues
        from the Company’s largest customers, as a percentage of total revenues, were as
        follows:
  **2005**
              
              **2004**Customer
                  A
              
              20%
              
              24%Customer
                  B
              
              11
              
              6Customer
                  C
              
              -
              
              22All
                  Others
              
              69
              
              48100%
              
              100%
  No
        other
        customer accounted for more than 10% of the Company’s revenues in fiscal years
        2005 and 2004.
  **(h)** **Loss
        per Share**
  The
        Company calculates earnings per share according to SFAS No. 128, *Earnings
        per Share* .
        Basic
        loss per share is computed by dividing net loss by the weighted average number
        of shares of common stock outstanding during the period. For each of the
        two
        years in the period ended June 30, 2005, the effect of stock options and
        warrants was antidilutive; therefore, they were not included in the computation
        of diluted loss per share. The number of shares underlying options and warrants
        that were excluded from the computation, as their effect would be antidilutive,
        was 1,320,869 and 218,765 during fiscal 2005 and 2004,
        respectively.
  **(i)** **Stock-Based
        Compensation**
  The
        Company accounts for its stock-based compensation using the intrinsic value
        method provided for under Accounting Principles Board Opinion No. 25, *Accounting
        for Stock Issued to Employees* and
        related interpretations *.* Under
        APB
        No. 25 and related interpretations, compensation cost is
  31
  **PRECISION
        OPTICS CORPORATION, INC. AND SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  recognized
        based on the difference, if any, on the date of grant between the fair value
        of
        the Company’s stock and the amount an employee must pay to acquire the stock.
        Statement of Financial Accounting Standards (“SFAS”) No. 123, *Accounting
        for Stock-Based Compensation* ,
        (as
        amended by SFAS No. 148, *Accounting
        for Stock-Based Compensation Transition and Disclosure* ),
        establishes a fair-value-based method of accounting for stock-based compensation
        plans. The Company has adopted the disclosure-only alternative under SFAS
        No.
        123, which requires the disclosure of the pro forma effects on net loss and
        net
        loss per share as if the fair value accounting prescribed by SFAS No. 123
        had
        been adopted.
  No
        stock-based employee compensation cost is reflected in net loss, as all options
        granted had an exercise price equal to the market value of the underlying
        common
        stock on the date of grant. The following table illustrates the effect on
        net
        loss and net loss per share as if the Company had applied the fair value
        recognition provisions of SFAS No. 123 to stock-based employee
        compensation:
  ***Year
                    Ended*****2005**
                
                **2004**Net
                    loss, as reported
                
                $
                (3,688,361
                )
                $
                (3,684,076
                )Add:
                    Total stock-based employee compensation expense determined under
                    fair
                    value based method for all awards
                
                
                (356,753
                )
                
                (
                    61,216
                )Pro
                    forma net loss
                
                $
                (4,045,114
                )
                $
                (3,745,292
                )Net
                    loss per share:
                  As
                    reported - basic and diluted
                
                $
                (.55
                )
                $
                (
                    2.10
                )Pro
                    forma - basic and diluted
                
                $
                (.60
                )
                $
                (2.14
                )
  **(j)** **Foreign
          Currency Translation**
  The
        Company translates certain accounts and financial statements of its foreign
        subsidiary in accordance with SFAS No. 52, *Foreign
        Currency Translation.* The
        functional currency of the Company’s foreign subsidiary is the United States
        dollar. Transaction gains or losses are reflected in the accompanying
        consolidated statements of operations and have not been
        significant.
  **(k)** **Patents**
  Patents
        are carried at cost, less accumulated amortization of approximately $394,500
        and
        $334,000 at June 30, 2005 and 2004, respectively. Such costs are amortized
        using
        the straight-line method over the shorter of their legal or estimated useful
        lives, generally five to ten years. Amortization expense was $70,357 and
        $43,604
        for the years ended June 30, 2005 and 2004, respectively. Amortization expense
        is expected to be approximately $41,000, $35,000, $25,000, $19,000 and $14,000,
        respectively for the years ending June 30, 2006 through June 30,
        2010.
  32
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  **(l)** **Financial
        Instruments**
  SFAS
        No.
        107, *Disclosure
        About Fair Value of Financial Instruments* ,
        requires disclosures about the fair value of financial instruments. Financial
        instruments consist principally of cash equivalents, accounts receivable,
        accounts payable, and accrued expenses. The estimated fair value of these
        financial instruments approximates their carrying value due to the short-term
        nature of these financial instruments.
  **(m)** **Long-Lived
        Assets**
  The
        Company accounts for long-lived assets in accordance with SFAS No. 144, *Accounting
        for the Impairment or Disposal of Long-Lived Assets.* This
        statement requires that long-lived assets and certain identifiable intangibles
        be reviewed for impairment whenever events or changes in circumstances indicate
        that the carrying amount of an asset may not be recoverable. Recoverability
        of
        assets to be held and used is measured by a comparison of the carrying amount
        of
        an asset to future net cash flows expected to be generated by the asset.
        If such
        assets are considered to be impaired, the impairment to be recognized is
        measured by the amount by which the carrying amount of the assets exceeds
        the
        fair value of the assets. Assets to be disposed of are reported at the lower
        of
        the carrying amount or fair value less costs to sell.
  **(n)** **Warranty
        Costs**
  The
        Company does not incur future performance obligations in the normal course
        of
        business other than providing a standard one-year warranty on materials and
        workmanship to its customers. The Company provides for estimated warranty
        costs
        at the time product revenue is recognized. Warranty costs for the years ended
        June 30, 2005 and 2004, have not been material to the consolidated financial
        statements. Warranty costs were $10,417 and $15,615 for the years ended June
        30,
        2005 and 2004, respectively, and have been included as a component of cost
        of
        goods sold in the accompanying consolidated statements of operations.
  **(o)** **Research
        and Development**
  Research
        and development expenses are charged to operations as incurred.
  **(p)** **Comprehensive
        Income**
  SFAS
        No. 130, *Reporting
        Comprehensive Income* ,
        requires disclosure of all components of comprehensive income on an annual
        and
        interim basis. Comprehensive income is defined as the change in equity of
        a
        business enterprise during a period from transactions and other events and
        circumstances from non-owners sources.
  The
        Company’s comprehensive loss for the years ended June 30, 2005 and 2004 was
        equal to its net loss for the same periods.
  **(q) I** **ncome
        Taxes**
  Income
        taxes are accounted for under the asset and liability method. Deferred tax
        assets and liabilities are recognized for the future tax consequences
        attributable to differences between the financial statement carrying amounts
        of
        existing assets and liabilities and their respective tax bases
  33
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  and
        operating loss and tax credit carryforwards. Deferred tax assets and liabilities
        are measured using enacted tax rates expected to apply to taxable income
        in the
        years in which those temporary differences are expected to be recovered or
        settled. The effect on deferred tax assets and liabilities of a change in
        tax
        rates is recognized in income in the period that includes the enactment date.
  In
        assessing the likelihood of utilization of existing deferred tax assets,
        management has considered historical results of operations and the current
        operating environment.
  **(r)** **Segment
        Reporting**
  SFAS
        No.
        131, *Disclosures
        About Segments of an Enterprise and Related Information,* establishes standards for reporting information regarding operating segments
        in
        annual financial statements and requires
        selected information for those segments to be presented in interim financial
        reports issued to stockholders. SFAS No. 131 also establishes standards for
        related disclosures about products and services and geographic areas. Operating
        segments are identified as components of an enterprise about which separate
        discrete financial information is available for evaluation by the chief
        operating decision maker, or decision making group, in making decisions about
        how to allocate resources and assess performance. The Company’s chief
        decision-maker, as defined under SFAS No. 131, is the Chief Executive Officer.
        To date, the Company has viewed its operations and manages its business as
        principally one segment. For all periods presented, over 90% of the Company’s
        sales have been to customers in the United States.
  **(s)** **Use
        of Estimates**
  The
        preparation of financial statements in conformity with accounting standards
        generally accepted in the United States requires management to make estimates
        and assumptions that affect the reported amounts of assets and liabilities
        and
        disclosure of contingent assets and liabilities at the date of the financial
        statements and the reported amounts of revenues and expenses during the
        reporting period. Actual results could differ from those estimates.
  **(t)** **Recent
        Accounting Pronouncements**
  In
        December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
        123R, *Share-Based
        Payment* (SFAS
        123R), an amendment of FASB Statements No. 123 and No. 95 *,
        Statement of Cash Flows,* which
        requires companies to measure and recognize compensation expense for all
        stock-based payments at fair value. Pro forma disclosure will no longer be
        an
        alternative. SFAS 123R is effective for the first annual period beginning
        after
        December 15, 2005 and thus, will be effective for the Company beginning with
        the
        first quarter of fiscal year 2007 (July 1, 2006). Under SFAS 123R, the Company
        must determine the appropriate fair value model to be used for valuing
        share-based payments, the amortization for compensation cost and the transition
        method to be used at the date of adoption. The transition alternatives include
        retrospective and prospective adoption methods. Under the retrospective method,
        prior periods may be restated based on the amounts previously recognized
        under
        SFAS 123 for purposes of pro forma disclosures either for all periods presented
        or as of the beginning for the year of adoption.
 
 The
        prospective method requires that compensation expense be recognized beginning
        with the effective date, based on the requirements of SFAS 123R, for all
        share-based payments granted after the effective date, and based on the
        requirements of SFAS 123, for all awards granted to employees prior to the
        effective date of SFAS 123R that remain unvested on the effective
        date.
 34
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
  N otes
        to
        Consolidated Financial Statements
 
 The
        Company is evaluating the requirements of SFAS 123R and has not determined
        its
        method of adoption or the impact on its financial position or the results
        of
        operations. See Note 1 (i) for information related to the pro forma effects
        on
        the Company's reported net loss and net loss per share of applying the fair
        value recognition provisions of the previous SFAS 123 to stock-based employee
        compensation.
 
 In
        November 2004, the FASB issued SFAS No. 151, “Inventory Costs” an amendment of
        ARB No. 43, Chapter 4, “Inventory Pricing.” This standard clarifies the
        accounting for abnormal amounts of idle facility expense, freight, handling
        costs, and waste material (spoilage). Such abnormal expenses must be recognized
        in the period in which they are incurred. In addition, SFAS No. 151 requires
        the
        allocation of fixed production overhead to inventory based on the normal
        capacity of the production facilities. Unallocated overheads must be recognized
        as an expense in the period in which they are incurred.
 
 SFAS
        No.
        151 is effective for inventory costs incurred during fiscal years beginning
        after June 15, 2005. The Company does not expect the adoption of this new
        accounting pronouncement to have a material impact on its financial position
        or
        results of operation.
  **(u)** **Reclassification**
  Certain
        reclassification of amounts in prior years has been made to conform with
        the
        current year presentation.
 
  **(2)**  **COMMITMENTS**
  **(a)** **Related
        Party Transactions**
  The
        Company leases one of its facilities from a corporation owned by an
        officer-director-shareholder of the Company. The lease terminated in December
        1999 and required lease payments of $9,000 per month. The Company is currently
        a
        tenant at will paying rent of $9,000 a month. Total rent expense for related
        parties included in the accompanying consolidated statements of operations
        amounted to $108,000 in each of fiscal years 2005 and 2004.
  The
        Company paid or accrued fees to a director of approximately $24,000 per year
        for
        services performed during fiscal 2005 and 2004. Another director is a former
        partner in a law firm that has performed legal services for the Company during
        fiscal 2005 and 2004 of approximately $76,400 and $170,000,
        respectively.
  **(b)** **Operating
        Lease Commitments**
  The
        Company has entered into operating leases for its office space and equipment
        that expire at various dates through fiscal year 2007. Total future minimum
        rental payments under all non-cancelable operating leases are approximately
        $26,000.
  Rent
        expense on operating leases, excluding the related party rent described above,
        was approximately $55,700 and $55,600 for the years ended June 30, 2005 and
        2004, respectively.
  35
 **PRECISION
              OPTICS CORPORATION, INC. AND SUBSIDIARIES**
  N otes
          to
          Consolidated Financial Statements
  **(3)** **STOCKHOLDERS’
        EQUITY**
  **(a)** **Stock
        Options**
 
 During
        fiscal 1989, the stockholders approved a stock option plan (the “1989 Plan”) for
        key employees. The 1989 Plan, as amended, authorizes the grant of options
        of up
        to 185,000 shares of the Company’s common stock at an exercise price of not less
        than 100% of the fair market value per share at the date of grant. Options
        granted vest and are exercisable for periods determined by the Board of
        Directors, not to exceed 10 years from the date of grant. No shares
        are
        available for future grants under the Company’s 1989 Stock Option
        Plan.
  During
        fiscal 1998, the stockholders approved an incentive plan (the “1997 Incentive
        Plan”), which provides eligible participants (certain employees, directors,
        consultants, etc.) the opportunity to receive a broad variety of equity based
        and cash awards. Options granted vest and are exercisable for periods determined
        by the Board of Directors, not to exceed 10 years from the date of grant.
        A
        total of 1,500,000 shares of common stock have been reserved for issuance
        under
        the 1997 Incentive Plan, as amended and restated in fiscal year 2005. Upon
        the
        adoption of the 1997 Incentive Plan, no new awards will be granted under
        the
        1989 Plan. At June 30, 2005, 177,153 shares of common stock were available
        for
        future grants under the 1997 Incentive Plan.
  The
        following is a summary of transactions in the plans for the two years ended
        June
        30, 2005:
  **Number
                      of**
                    **Shares**
                  
                  **Option
                      Price per**
                    **Share**
                  
                  **Weighted**
                    **Average**
                    **Exercise**
                    **Price**Options
                      outstanding, June 30, 2003
                  
                  
                  116,102
                  
                  $
                  1.74-75.00
                  
                  $
                  13.68Granted
                  
                  
                  18,336
                  
                  $
                  1.97
                  
                  $
                  1.97Canceled
                  
                  
                  (2,485
                  )
                  $
                  4.20-75.00
                  
                  $
                  27.70Options
                      outstanding, June 30, 2004
                  
                  
                  131,953
                  
                  $
                  1.74-75.00
                  
                  $
                  11.79Granted
                  
                  
                  1,206,000
                  
                  $
                  0.73
                      - 0.87
                  
                  $
                  0
                      .82Canceled
                  
                  
                  (20,418
                  )
                  $
                  8.25
                  
                  $
                  8.25Options
                      outstanding, June 30, 2005
                  
                  
                  1,317,535
                  
                  $
                  0
                      .73-75.00
                  
                  $
                  1.79Options
                      exercisable, June 30, 2005
                  
                  
                  450,635
                  
                  $
                  0
                      .73-75.00
                  
                  $
                  3.67Options
                      exercisable, June 30, 2004
                  
                  
                  114,807
                  
                  $
                  1.74-75.00
                  
                  $
                  13.11
 36
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
  N otes
        to
        Consolidated Financial Statements
  The
        following table summarizes information about stock options outstanding and
        exercisable at June 30, 2005:
 **Options
                    Outstanding**
                
                **Options
                    Exercisable**Range
                    of Exercise Prices
                
                Options
                    Outstanding
                
                Weighted
                    Average Remaining Contractual Life
                
                Weighted
                  Average
                    Exercise Price
                
                Options
                    Exercisable
                
                Weighted
                    Average Exercise Price$0.73-$0.87
                
                
                1,206,000
                
                
                9.95
                    years
                
                $
                0.81
                
                
                346,600
                
                $
                0.82$1.74-$4.56
                
                
                45,096
                
                
                7.3
                    years
                
                $
                3.13
                
                
                37,596
                
                $
                3.36$6.00
                    - $8.25
                
                
                10,588
                
                
                4.72
                    years
                
                $
                7.06
                
                
                10,588
                
                $
                7.06$9.38
                    - $13.13
                
                
                18,504
                
                
                1.85
                    years
                
                $
                10.93
                
                
                18,504
                
                $
                10.93$16.50
                
                
                1,042
                
                
                2.12
                    years
                
                $
                16.50
                
                
                1,042
                
                $
                16.50$23.064
                    - $33.00
                
                
                34,971
                
                
                2.95
                    years
                
                $
                24.35
                
                
                34,971
                
                $
                24.35$75.00
                
                
                1,334
                
                
                5.17
                    years
                
                $
                75.00
                
                
                1,334
                
                $
                75.00$0.73
                    - $75.00
                
                
                1,317,535
                
                
                9.51
                    years
                
                $
                1.79
                
                
                450,635
                
                $
                3.67
  In
        addition, the Company has granted options outside the plans, primarily to
        directors and a consultant at 100% of the fair market value per share at
        the
        date of grant. The weighted average remaining contractual life of the options
        outside the plans is .04 years as of June 30, 2005. The following is a summary
        of all transactions outside the plans:
  **Number
                  of Shares**
              
              **Option
                  Price per Share**
              
              **Weighted
                  Average Exercise Price**Options
                  outstanding and exercisable, June 30, 2003 and 2004
              9,168
              
              $7.78-8.25
              
              $8.08Canceled
              (5,834)
              
              $
                  8.25
              
              $8.25Options
                  outstanding and exercisable, June 30, 2005
              3,334
              
              $7.78
              
              $7.78
 
   37
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  The
        Company has computed the pro forma disclosures required under SFAS
        No. 123 ** for
        fiscal 2005 and 2004 using the Black-Scholes option pricing model prescribed
        by
        SFAS No. 123 (See Note 1(i)).
  The
        assumptions used for each of the two years in the period ended June 30, 2005
        are
        as follows:
  ***Year
                    Ended*****2005**
                
                **2004**Risk-free
                    interest rates
                
                
                3.84
                %
                
                3.85
                %Expected
                    dividend yield
                
                
                -
                
                
                -Expected
                    lives
                
                
                5.3
                    years
                
                
                7
                    yearsExpected
                    volatility
                
                
                107
                %
                
                120
                %Weighted
                    average fair value of grants
                
                $
                0.65
                
                $
                1.77
  On June
        13, 2005 the Company issued options to purchase 934,000
        shares of common stock at an exercise price of $0.83 per
        share.   At the date of issuance, 30%
        of the options
        vested immediately, and the vesting of the remaining options is subject
        to
        achievement of certain financial milestones by the Company.  According
        to
        Accounting Principles Board Opinion No. 25, " *Accounting
        for Stock Issued to Employees* ,"
        the options described above are subject to variable accounting until
        the
        awards are exercised, forfeited, or expire unexercised, which includes
        periodic measurement of compensation expense based on the intrinsic
        value of the options.  The compensation cost will
        be
        recognized and adjusted quarterly for vested options or ratably over
        the vesting period for unvested options.  No compensation expense
        related to these stock options is reflected in the
        net loss for the year ended June 30, 2005 as all options
        granted
        had an exercise price greater than the market value of the underlying
        common stock as of June 30, 2005.  As long as the options remain
        outstanding, the compensation adjustment remains subject to ongoing
        quarterly adjustments based on changes in the market price of the Company's
        common stock.
 
 **(4)** **INCOME
        TAXES**
  The
        provision for income taxes in the accompanying consolidated statements of
        operations consists of the minimum statutory state income tax liability of
        $912
        for each of the two years ended June 30, 2005.
  A
        reconciliation of the federal statutory rate to the Company’s effective tax rate
        for the two years ended June 30, 2005 is as follows:
  **2005**
              
              **2004**Income
                  tax benefit at federal statutory rate
              
              
              (34.0
              )%
              
              (34.0
              )%Increase
                  (decrease) in tax resulting from-State
                  taxes, net of federal benefit
              
              
              (6.0
              )
              
              (6.0
              )Change
                  in valuation allowance, net of NOL expirations
              
              
              27.9
              
              
              30.6Expiration
                  of state net operating loss carry forwards
              
              
              11.6
              
              
              -Expiration
                  of tax credits
              
              
              -
              
              
              7.3Nondeductible
                  items
              
              
              2.3
              
              
              -Tax
                  credits
              
              
              -
              
              
              (1.6
              )Other
              
              
              (1.8
              )
              
              3.7Effective
                  tax rate
              
              
              0.0
              %
              
              0.0
              %
  38
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
  The
        components of deferred tax assets and liabilities at June 30, 2005 and 2004
        are
        approximately as follows:
  **2005**
              
              **2004**Deferred
                  tax assets:Net
                  operating loss carryforwards
              
              
              9,746,000
              
              $
              8,745,000Tax
                  credit carryforwards
              
              
              567,000
              
              
              497,000Reserves
                  and accruals not yet deducted fortax
                  purposes
              
              
              3,870,000
              
              
              3,849,000Total
                  deferred tax assets
              
              
              14,183,000
              
              
              13,091,000Valuation
                  allowance
              
              
              (12,972,000
              )
              
              (11,943,000
              )Subtotal
              
              
              1,211,000
              
              
              1,148,000Deferred
                  tax liabilities:Accumulated
                  depreciation
              
              
              (1,211,000
              )
              
              (1,148,000
              )Net
                  deferred taxes
              
              $
              -
              
              $
              -
  The
        Company has provided a valuation allowance to reduce the net deferred tax
        asset
        to an amount the Company believes is “more likely than not” to be realized. The
        valuation allowance increased in fiscal 2005 by approximately $1,029,000.
        Approximately $2,241,000 of the valuation allowance at June 30, 2005
        related to the exercise of stock options will be allocated to stockholders’
        equity when recognized. As of June 30, 2005, the Company has net operating
        loss
        carryforwards for U.S. federal and state income taxes of approximately
        $25,803,000 and $16,215,000, respectively. The U.S. federal net operating
        loss
        carryforwards expire approximately as follows: $697,000 in 2013, $1,512,000
        in
        2019, $7,154,000 in 2020, $5,554,000 in 2022, $4,054,000 in 2023, $3,250,000
        in
        2024 and $3,582,000 in 2025. The state net operating loss carryforwards expire
        approximately as follows: $5,520,000 in 2007, $4,030,000 in 2008, $3,223,000
        in
        2009 and $3,442,000 in 2010. The tax credit carryforwards expire in 2006
        through
        2025. Pursuant to the Tax Reform Act of 1986, the utilization of net operating
        loss carryforwards for tax purposes may be subject to an annual limitation
        if a
        cumulative change of ownership of more than 50% occurs over a three-year
        period.
        As a result of the 2005 rights offering and subsequent trading activity of
        the
        Company's common stock, it is likely that the Company has
        triggered significant limitations on the utilization of net operating
        loss
        carryforwards. In the event that the Company has had a change in ownership,
        as
        defined, the utilization of substantially all of the Company’s net operating
        loss carryforwards will be significantly restricted or eliminated. The Company
        is currently estimating the impact of such transactions on their net operating
        loss carryforwards.
  **(5)** **PROVISION
        FOR RESTRUCTURING**
 
 In
        June
        2005, the Company reduced its full-time workforce by approximately 3%, or
        one
        employee. As a result of this action, the Company recorded a pretax charge
        to
        earnings in the quarter ended June 30, 2005 of $89,512 for employee severance
        benefits of which $84,501 was paid in the quarter ended June 30,
        2005.
  In
        January 2004, the Company reduced its full-time workforce by approximately
        15%,
        or five employees. As a result of this action, the Company recorded a pretax
        charge to earnings in the quarter ended March 31, 2004 of $52,208 for employee
        severance benefits.
 39
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
  Notes
        to
        Consolidated Financial Statements
 
 The
        following table sets forth the rollforward of provisions and cash payments
        associated with the restructuring reserve:
 
 **ReserveFor****Employee****Severance**Reserve
                  Balance, June 30, 2003
              
              $
              -Total
                  Provision
              
              
              52,208Cash
                  Payments
              
              
              (52,208
              )Reserve
                  Balance, June 30, 2004
              
              $
              -Total
                  Provision
              
              
              89,512Cash
                  Payments
              
              
              (84,501
              )Reserve
                  Balance, June 30, 2005
              
              $
              5,011
  **(6)** **PROVISION
        FOR INVENTORY WRITE-DOWN**
  The
        Company determined that certain inventories of telecommunications and medical
        products would not be sold within the Company’s business cycle or the products’
        life cycle. Consequently, the Company recorded, in cost of goods sold, a
        provision for excess and obsolete inventory of approximately $401,900 and
        $500,000 during the years ended June 30, 2005 and 2004,
        respectively.
 
 **(7)** **PROFIT
        SHARING PLAN**
 
 The
        Company has a defined contribution 401K profit sharing plan. Employer profit
        sharing and matching contributions to the plan are discretionary. No employer
        profit sharing contributions were made to the plan in fiscal years 2005 and
        2004. Employer matching contributions to the plan amounted to $35,310 and
        $29,972 for fiscal years 2005 and 2004, respectively.
 
 **(8)** **RIGHTS
        OFFERING**
 
 In
        July
        2004, the Company completed a rights offering to stockholders of record on
        June
        7, 2004 by issuing 5,256,159 shares of common stock at a price of $1.00 per
        share. Net cash proceeds to the Company (after offering costs of $222,175)
        were
        $5,033,984.
  The
        costs
        of the rights offering estimated to have been incurred through June 30, 2004
        of
        $171,885, were deferred and are included in the caption “deferred financing
        costs” in the accompanying consolidated balance sheets as of June 30, 2004. The
        actual offering costs of $222,175 have been charged against additional paid-in
        capital in the accompanying consolidated balance sheets as of June 30, 2005.
 
 40
 **PRECISION
              OPTICS CORPORATION, INC. AND
              SUBSIDIARIES**
 Notes
        to
        Consolidated Financial Statements
 
 **(9)** **SUBSEQUENT
        EVENT**
 
 In
        July
        2005, the Company sold equipment previously used in its telecommunications
        business for $180,000, recognizing a gain of approximately $166,000, which
        will
        be recorded in the quarter ending September 30, 2005.
 
 41
  ITEM
          8. CHANGES
          IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
          AND FINANCIAL DISCLOSURE
  None.
  ITEM
        8A. CONTROLS
        AND PROCEDURES
 
 As
        of the
        end of the period covered by this annual report, the Company’s Chief Executive
        Officer and Principal Financial Officer have conducted an evaluation of the
        Company’s disclosure controls and procedures. Based on their evaluation, the
        Company’s Chief Executive Officer and Principal Financial Officer have concluded
        that the Company’s disclosure controls and procedures are effective to ensure
        that information required to be disclosed by the Company in reports that
        it
        files or submits under the Securities Exchange Act of 1934 is (i) recorded,
        processed, summarized and reported within the time periods specified in the
        applicable Securities and Exchange Commission rules and forms and (ii)
        accumulated and communicated to the Company’s management, including the
        Company’s Chief Executive Officer and the Company’s Principal Financial Officer,
        as appropriate to allow timely decisions regarding required
        disclosure.
 
 There
        was
        no change in the Company’s internal control over financial reporting during the
        Company’s most recently completed fiscal quarter that has materially affected,
        or is reasonably likely to materially affect, the Company’s internal control
        over financial reporting.
  ITEM
        8B. OTHER
        INFORMATION
 
 None.
 42
  **PART
        III**
 
 I TEM
        9. DIRECTORS,
        EXECUTIVE OFFICERS, AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF
        THE
        EXCHANGE ACT :
 
 The
        Company will furnish to the Securities and Exchange Commission a definitive
        Proxy Statement (the “Proxy Statement”) not later than 120 days after the close
        of its fiscal year ended June 30, 2005. The information required by this
        item,
        other than with respect to the Company’s Corporate Code of Ethics and Conduct,
        is incorporated herein by reference to the Proxy Statement.
 
 A
        copy of
        the Company’s Corporate Code of Ethics and Conduct applicable to all employees,
        officers and directors of the Company is filed as Exhibit 14.1 to this report
        and can be obtained free of charge by contacting the Company’s Clerk, c/o
        Precision Optics Corporation, 22 East Broadway, Gardner, Massachusetts
        01440.
 
 
 I TEM
        10. EXECUTIVE
        COMPENSATION
 
 The
        information required by this item is incorporated herein by reference to
        the
        Proxy Statement.
 
  ITEM
        11. SECURITY
        OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND
        MANAGEMENT
 
 The
        information required by this item is incorporated herein by reference to
        the
        Proxy Statement.
 
 
 ITEM
        12. CERTAIN
        RELATIONSHIPS AND RELATED TRANSACTIONS
 
 The
        information required by this item is incorporated herein by reference to
        the
        Proxy Statement.
  ITEM
        13. EXHIBITS
 
 The
        exhibits listed below are filed with or incorporated by reference in this
        report.
 
 3.1
                Articles
                    of Organization of the Company, as amended and corrected13.2
                By-laws
                    of Precision Optics Corporation, Inc.24.1
                Specimen
                    common stock certificate34.2
                Registration
                    Rights Agreement dated as of March 17, 2000 by and among
                    the Company
                    and the Initial Investors as defined therein44.3
                Registration
                    Rights Agreement dated as of June 30, 1998 by and among the Company,
                    Special Situations Private Equity Fund, L.P. and Special Situations
                    Technology Fund, L.P.54.4
                Registration
                    Rights Agreement dated as of August 5, 1999 by and among the
                    Company,
                    Special Situations Cayman Funds, L.P., Special Situations Fund
                    III, L.P.,
                    Special Situations Private Equity Fund, L.P. and Special Situations
                    Technology Fund, L.P.610.1
                Precision
                    Optics Corporation, Inc. 1989 Stock Option Plan amended to
                    date710.2
                Three
                    separate life insurance policies on the life of Richard E.
                    Forkey.310.3
                Amended
                    and Restated Precision Optics Corporation, Inc. 1997 Incentive
                    Plan.9
  43
  10.4
                Securities
                    Purchase Agreement dated as of March 13, 2000 by and among
                    the
                    Company and the Purchasers as defined therein (excluding
                    exhibits)414.1
                Corporate
                    Code of Ethics and Conduct21
                Subsidiaries
                    of Precision Optics Corporation, Inc.823.1
                Consent
                    of KPMG LLP23.2
                Consent
                    of Vitale Caturano & Company Ltd.31.1
                Certification
                    of Chief Executive Officer required by Rule
                    13a-14(a)/15d-14(a)31.2
                Certification
                    of Chief Financial Officer required by Rule
                    13a-14(a)/15d-14(a)32.1
                Certification
                    of Chief Executive Officer and Chief Financial Officer required
                    by Rule
                    13a-14(b) and 18 U.S.C. 1350.
 
 1 Incorporated herein by reference to the Company’s Quarterly Report for the
        quarter ended December 31, 2002 on Form 10-QSB (No. 001-10647).
 2 Incorporated herein by reference to the Company’s 1991 Annual Report on Form
        10-KSB (No. 001-10647).
 3 Incorporated herein by reference to the Company’s Registration Statement on Form S-1 (No. 33-36710-B).
 4 Incorporated herein by reference to the Company’s Registration Statement on Form
        S-3 (No. 333-35884).
 5 Incorporated herein by reference to the Company’s 1998 Annual Report on Form
        10-KSB (No. 001-10647).
 6 Incorporated herein by reference to the Company’s 1999 Annual Report on Form
        10-KSB (No. 001-10647).
 7 Incorporated
        herein by reference to the Company’s 1994 Annual Report on Form 10-KSB (No.
        001-10647).
 8 Incorporated
        herein by reference to the Company’s 1996 Annual Report on Form 10-KSB (No.
        001-10647).
 9 Incorporated
        herein by reference to the Company’s Quarterly Report on Form 10-QSB for the
        quarter ended September 30, 2003 (No. 001-10647).
   ITEM
        14. PRINCIPAL
        ACCOUNTANT FEES AND SERVICES
  The
        information required by this item is incorporated herein by reference to
        the
        Proxy Statement.
  44
  **SIGNATURES**
 
 In
        accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused
        this report to be signed on its behalf by the undersigned, thereunto duly
        authorized.
 
 PRECISION
                OPTICS CORPORATION, INC.Date: September
                28, 2005
              By:
              /s/ Richard
                E. ForkeyRichard
                E. ForkeyChairman
                  of the Board,
                Chief Executive Officer, President
                and Treasurer
  In
        accordance with the Exchange Act, this report has been signed below by the
        following persons on behalf of the registrant and in the capacities and on
        the
        dates indicated.
  By:
                /s/ Richard
                  E. Forkey
                
                By:
                /s/ R.
                  Michael ArbonRichard E. Forkey
                  President, Treasurer and
                  executive officer)
                
                
                R. Michael Arbon
                  Chief Financial Officer
                  (principal financial and accounting
                    officer)Date: September 28,
                  2005
                
                Date: September 28,
                  2005
  By:
                /s/ Joel
                  R. Pitlor
                
                By:
                /s/ Edward
                  A. BenjaminJoel R. PitlorDirector
                
                
                Edward A. Benjamin
                  DirectorDate: September 28,
                  2005
                
                Date: September 28,
                  2005
  By:
              /s/ Robert
                R. Shannon
              
              By:
              /s/ Donald
                A. MajorRobert R. Shannon
                Director
              
              
              Donald A. Major
                DirectorDate: September 28, 2005
              
              Date: September 28,
                2005