UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




Form 10-Q







(Mark One)




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




For the quarterly period ended September 30, 2011




or




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




For the transition period from                                                                                      to




Commission File Number: 001-14949









Implant Sciences Corporation


(Exact name of registrant as specified in our charter)




Massachusetts

(State or other jurisdiction of

incorporation or organization)

04-2837126

(I.R.S. Employer Identification No.)600 Research Drive, Wilmington, Massachusetts

(Address of principal executive offices)

01887

(Zip Code)







(978) 752-1700


(Registrant’s telephone number, including area code)





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







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




Yes x  No q




Indicate by check mark whether the registrant has submitted electronically and posted on our corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes q  No q




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




q  Large Accelerated Filer                                                                                                           q  Accelerated Filer




q  Non-accelerated Filer                                                                                                           x  Smaller reporting company




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




As of October 31, 2011, there were 32,727,996 shares of the registrant’s Common Stock outstanding.







IMPLANT SCIENCES CORPORATION







TABLE OF CONTENTS




















PagePART I.
FINANCIAL INFORMATIONItem 1.
Condensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets as of September 30, 2011 (unaudited)

and June 30, 2011
3Condensed Consolidated Statements of Operations for the three months ended

September 30, 2011 and 2010 (unaudited)
4Condensed Consolidated Statements of Cash Flows for the three months ended

September 30, 2011 and 2010 (unaudited)
5Notes to Condensed Consolidated Financial Statements
6-22Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
23-27Item 3.
Quantitative and Qualitative Disclosures About Market Risk
27Item 4.
Controls and Procedures
28PART II.
OTHER INFORMATIONItem 1.
Legal Proceedings
29Item 1A.
Risk Factors
29Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
29Item 3.
Defaults Upon Senior Securities
29Item 4.
Removed and Reserved
29Item 5.
Other Information
29Item 6.
Exhibits
30Signatures
31
























-2-


Implant Sciences CorporationCondensed Consolidated Balance SheetsSeptember 30,


June 30,2011


2011(Unaudited)


(Audited)ASSETSCurrent assets:Cash and cash equivalents

$
425,000


$
264,000Restricted cash and investments


1,275,000



1,275,000Accounts receivable-trade, net of allowances of $21,000


1,149,000



1,066,000Inventories


2,282,000



1,867,000Prepaid expenses and other current assets


1,154,000



1,141,000Total current assets


6,285,000



5,613,000Property and equipment, net


166,000



129,000Restricted cash and investments


312,000



312,000Other non-current assets


106,000



106,000Total assets

$
6,869,000


$
6,160,000LIABILITIES AND STOCKHOLDERS' DEFICITCurrent liabilities:Senior secured convertible note

$
3,520,000


$
3,600,000Senior secured note


1,000,000



1,000,000Line of credit


18,602,000



15,785,000Current maturities of long-term debt and obligations under capital lease


21,000



20,000Payable to Med-Tec


41,000



42,000Accrued expenses


3,232,000



3,249,000Accounts payable


2,988,000



2,389,000Deferred revenue


917,000



908,000Total current liabilities


30,321,000



26,993,000Long-term liabilities:Long-term debt and obligations under capital lease, net of current maturities


57,000



58,000Total long-term liabilities


57,000



58,000Total liabilities


30,378,000



27,051,000Commitments and contingencies (Note 20)Stockholders' deficit:Common stock; $0.10 par value; 200,000,000 shares authorized; 32,405,207 and

32,394,662 at September 30, 2011 and 30,991,873 and 30,981,328 at June 30, 2011 shares

issued and outstanding, respectively


3,240,000



3,099,000Preferred stock; no stated value; 5,000,000 shares authorized

Series G Convertible Preferred Stock, no stated value; 650,000 shares authorized,

164,667 shares issued and outstanding at September 30, 2011 and June 30, 2011

(liquidation value of $1,317,000)


274,000



274,000Additional paid-in capital


81,057,000



80,695,000Accumulated deficit


(107,958,000
)


(104,886,000
)Deferred compensation


(49,000
)


-Treasury stock, 10,545 common shares, at cost


(73,000
)


(73,000
)Total stockholders' deficit


(23,509,000
)


(20,891,000
)Total liabilities and stockholders' deficit

$
6,869,000


$
6,160,000
  The accompanying notes are an integral part of these condensed consolidated financial statements.


-3-







Implant Sciences CorporationCondensed Consolidated Statements of Operations(Unaudited)For the Three Months EndedSeptember 30,2011


2010Revenues

$
1,036,000


$
1,004,000Cost of revenues


637,000



636,000Gross margin


399,000



368,000Operating expenses:Research and development


819,000



470,000Selling, general and administrative


1,813,000



1,148,000Total operating expenses


2,632,000



1,618,000Loss from operations


(2,233,000
)


(1,250,000
)Other (expense) income, net:Interest income


1,000



12,000Interest expense


(840,000
)


(516,000
)Change in fair value of warrant derivative liability


-



31,000Change in fair value of note conversion option liability


-



1,076,000Total other (expense) income, net


(839,000
)


603,000Net loss

$
(3,072,000
)

$
(647,000
)Net loss per share, basic and diluted

$
(0.10
)

$
(0.03
)Weighted average shares used in computing net loss

per common share, basic and diluted


31,950,218



25,878,335







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




-4-


Implant Sciences CorporationCondensed Consolidated Statements of Cash Flows(Unaudited)For The Three Months Ended

September 30,2011


2010Cash flows from operating activities:Net loss

$
(3,072,000
)

$
(647,000
)Adjustments to reconcile net loss to net cash flows:Depreciation and amortization


21,000



26,000Stock-based compensation expense


58,000



65,000Loss on disposal of equipment


-



2,000Fair value of warrants issued to non-employees


108,000



(6,000
)Common stock issued to consultants


197,000



8,000Change in fair value of warrant derivative liability


-



(31,000
)Change in fair value of note conversion option liability


-



(1,076,000
)Changes in assets and liabilities:Accounts receivable


(83,000
)


55,000Inventories


(415,000
)


(210,000
)Prepaid expenses and other current assets


(13,000
)


368,000Cash overdraft


-



45,000Accounts payable


325,000



(157,000
)Accrued expenses


267,000



7,000Deferred revenue


9,000



924,000Net cash used in operating activities


(2,598,000
)


(627,000
)Cash flows from investing activities:Purchases of property and equipment


(58,000
)


-Transfer from restricted funds, net


-



21,000Payments received on note receivable


-



47,000Net cash (used in) provided by investing activities


(58,000
)


68,000Cash flows from financing activities:Proceeds from common stock issued in connection with exercise of stock options


-



2,000Principal repayments of long-term debt and capital lease obligations


-



(2,000
)Net borrowings on line of credit


2,817,000



559,000Net cash provided by financing activities


2,817,000



559,000Net change in cash and cash equivalents


161,000



-Cash and cash equivalents at beginning of period


264,000



-Cash and cash equivalents at end of period

$
425,000


$
-Supplemental Disclosure of Cash Flow Information:Interest paid

$
504,000


$
356,000Non-cash Investing and Financing Activities:Conversions of senior secured convertible promissory note to common shares

$
80,000


$
-Conversion of convertible promissory note - related party


-



100,000Common stock issued to consultants


197,000



-







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









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


1.
Description of Business




Implant Sciences Corporation develops, manufactures and sells sophisticated sensors and systems for the security, safety and defense industries.  We have developed proprietary technologies used in explosives trace detection (“ETD”) applications and market and sell handheld and benchtop ETD systems that use our proprietary technologies.  Our products are marketed and sold to a growing number of locations domestically and internationally.  These systems are used by private companies and government agencies to screen baggage, cargo, other objects and people for the detection of trace amounts of explosives.




We are parties to several loan and credit agreements with DMRJ Group LLC (“DMRJ”), an accredited institutional investor (see Note 13).  As of September 30, 2011, our obligation to DMRJ under a senior secured convertible promissory note, as amended, a senior secured promissory note and under a revolving line of credit approximated $3,520,000, $1,000,000 and $18,602,000, respectively.  Further, as of September 30, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note, the senior secured promissory note and the line of credit approximated $1,705,000 and is included in current liabilities in the condensed consolidated financial statements.




As of October 31, 2011, our obligations to DMRJ under the amended and restated senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $3,520,000, $1,000,000 and $19,012,000, respectively.  Further, as of October 31, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note and the senior secured promissory note approximated $1,664,000 and is included in current liabilities.




Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  In addition, we will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; and the hiring of additional personnel, and acquiring capital equipment.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.




Any failure to comply with our debt covenants, to achieve our projections and/or obtain sufficient capital on acceptable terms would have a material adverse impact on our liquidity, financial condition and operations and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws. Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.




2.
Interim Financial Statements and Basis of Presentation




The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).  In the opinion of management, the accompanying condensed consolidated financial statements include all adjustments (consisting only of normal recurring adjustments), which we consider necessary for a fair presentation of the financial position at such date and of the operating results and cash flows for the periods presented.  All intercompany balances and transactions have been eliminated in consolidation. The results of operations and cash flows for the three months ended September 30, 2011 may not necessarily be indicative of results that may be expected for any succeeding quarter or for the entire fiscal year.  The information contained in this Form 10-Q should be read in conjunction with our audited financial statements, included in our Form 10-K, as of and for the year ended June 30, 2011.




The balance sheet at June 30, 2011 has been derived from our audited consolidated financial statements at that date, but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.




The accompanying condensed consolidated financial statements include our operations in Massachusetts and California.




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





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




The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and judgments, which are evaluated on an ongoing basis, that affect the amounts reported in our condensed consolidated financial statements and accompanying notes.  Management bases our estimates on historical experience and on various other assumptions that it believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the amounts of revenues and expenses that are not readily apparent from other sources.  Actual results could differ from those estimates and judgments.  In particular, significant estimates and judgments include those related to revenue recognition, allowance for doubtful accounts, useful lives of property and equipment, inventory reserves, valuation for goodwill and acquired intangible assets.




Significant accounting policies are described in Note 2 to the financial statements included in Item 7 of our Form 10-K for the fiscal year ended June 30, 2011.




We have evaluated subsequent events after the balance sheet date through the date of filing of these financial statements with the Securities and Exchange Commission for appropriate accounting and disclosure.




3.
Fair Value Measurement






Accounting Standards Codification (“ASC”) ASC 820, “Fair Value Measurements and Disclosures,” establishes a three-level fair value hierarchy to classify the inputs used in measuring fair value, which are as follows:




Level 1 inputs to the valuation methodology are based on quoted prices (unadjusted) in active markets for identical assets or liabilities;




Level 2 inputs to the valuation methodology are based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and




Level 3 inputs to the valuation methodology are based on unobservable inputs that reflect the company’s own assumptions about the assumptions market participants would use in pricing the asset or liability.




Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


Our financial instruments at September 30, 2011 include cash equivalents, certificates of deposit, accounts receivable, a note receivable, accounts payable, a senior secured promissory note and a senior secured convertible promissory note. The carrying amounts of cash and cash equivalents, certificates of deposit, receivables and accounts payable are representative of their respective fair values because of the short-term maturities or expected settlement dates of these instruments. The fair value of debt, as included in Note 13, is based on the fair value of similar instruments. These instruments are short-term in nature and there is no known trading market for our debt.




The following table provides the fair value measurements of assets and liabilities as of September 30, 2011:




Fair Value Measurements as of September 30, 2011Description

Carrying Value

at

Sept. 30, 2011


Quoted Prices in Active

Markets for Identical

Assets

Level 1


Significant Other

Observable

Inputs

Level 2


Significant

Unobservable

Inputs

Level 3Certificates of deposit

$
1,562,000


$
1,562,000


$
-


$
-Senior secured convertible promissory note


3,520,000



-



-



3,520,000Senior secured promissory note


1,000,000



-



-



1,000,000


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







The following table provides the fair value measurements of assets and liabilities as of September 30, 2010:




Fair Value Measurements as of September 30, 2010Description

Carrying Value

at

Sept. 30, 2010


Quoted Prices in Active

Markets for Identical

Assets

Level 1


Significant Other

Observable

Inputs

Level 2


Significant

Unobservable

Inputs

Level 3Certificates of deposit

$
1,562,000


$
1,562,000


$
-


$
-Note conversion option liability


9,610,000



-



-



9,610,000Warrant derivative liability


247,000



-



-



247,000Senior secured convertible promissory note


3,920,000



-



-



3,920,000Senior secured promissory note


1,000,000



-



-



1,000,000


The following table summarizes the changes in the fair value of our Level 3 financial liabilities that were measured at fair value for the three months ended September 30, 2010:




Three Months Ended September 30, 2010Note Conversion

Option Liability


Warrant Derivative

LiabilityBalance at July 1, 2010

$
10,686,000


$
278,000Net change in fair value of financial instrument


(1,076,000
)


(31,000
)Balance at September 30, 2010

$
9,610,000


$
247,000


In April 2011, we amended our credit facility with DMRJ. As amended, the conversion price of the senior secured convertible promissory note and warrant to purchase shares of our common stock were both fixed at $0.08 per share. As of that date, the note conversion feature and warrant were no longer subject to adjustment and were no longer required to be recorded as a separate liability under ASC 815-40-15, "Derivatives and Hedging." For the three months ended September 30, 2011, changes in fair value were no longer required to be recorded in our condensed consolidated statements of operations.  See Notes 14 and 15 for the assumptions used in calculating the fair values.




4.
Restricted Cash and Investments – Current and Long-Term




As of September 30, 2011 and June 30, 2011, we had restricted cash and investments, with maturities of less than one year, of $1,275,000, and restricted investments, with maturities of more than one year, of $312,000.  Restricted cash and investments consisted of the following:




September 30,

2011


June 30,

2011Current assetsCertificates of deposit

$
1,250,000


$
1,250,000Blocked account deposit


25,000



25,000$
1,275,000


$
1,275,000Long-term assetsCertificates of deposit

$
312,000


$
312,000$
312,000


$
312,000


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





The restricted investment of $439,000 held in a money market account collateralized our performance under an irrevocable letter of credit issued to China Civil Aviation Technology & Equipment Corporation (“AVITEC”) on June 25, 2008, in the amount of $418,000.  The letter of credit provided performance security equal to 10% of the contract amount for security products shipped in the first quarter of fiscal 2009. In September 2010, we entered into a supplementary agreement with AVITEC, effective as of February 2010, to extend the warranty period for the security products through August 2011.  To guarantee our performance under the supplementary warranty bond, and in view of the fact that we were not able to negotiate an extension to the existing letter of credit, AVITEC claimed compensation and drew against the letter of credit in July 2010, resulting in the transfer of $418,000 of funds held in the money market account to AVITEC. AVITEC agreed to transfer $418,000 to us, less nominal bank fees, upon expiration of the warranty bond in August 2011. As of September 30, 2011, AVITEC has not transferred the funds. The remaining funds held in the money market account, $21,000, were transferred to our operating account in July 2010. As of September 30, 2011 and June 30, 2011, the funds transferred to AVITEC are included in our accounts receivable and we believe these amounts to be fully collectible.




Pursuant to one of our credit agreements with DMRJ (see Note 13), we were required to maintain a balance of at least $500,000 in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement.  On December 16, 2008, we deposited $500,000 into a bank account pursuant to the blocked account agreement.  In December 2009, DMRJ waived the requirement to maintain a deposit balance of at least $500,000 in such account. As of September 30, 2011 and June 30, 2011, the balance in the blocked account was $0.




Pursuant to an additional credit agreement with DMRJ, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account are applied towards the repayment of our obligations to DMRJ under the revolving line of credit. Until the line of credit and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.   As of September 30, 2011 and June 30, 2011, the balance in the blocked collections account was $25,000.




The restricted investments of $1,562,000 held in certificates of deposit collateralize our performance under three irrevocable letters of credit issued in April 2010, aggregating to $1,488,000, in connection with our contract with the India Ministry of Defence, plus the bank required collateralization deposit of $74,000.  These letters of credit: (1) provide performance security equal to 5% of the contract amount; (2) provide warranty performance security equal to 5% of the contract amount; and (3) provide security equal to 15% of the contract amount against an advance deposit under the terms of the contract. During the year ended June 30, 2011, we amended two of the letters of credit, extending the expiration dates. As amended, the letters of credit expire between February 6, 2012 and October 5, 2012.




5.
Stock Based Compensation




Our condensed consolidated statements of operations for the three months ended September 30, 2011 and 2010 include $58,000 and $65,000, respectively, of compensation costs and no income tax benefit related to our stock-based compensation arrangements for employee and non-employee director awards.  As of September 30, 2011, the total amount of unrecognized stock-based compensation expense was approximately $357,000, which will be recognized over a weighted average period of 2.2 years.




As of September 30, 2011, there were options outstanding to purchase 4,275,850 shares of our common stock at exercise prices ranging from $0.08 to $10.00.




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





6.
Related Party Transactions




We have entered into a fixed asset lease agreement with Ferran Scientific, Inc., a firm owned by the father of the former chairman of Ion Metrics, Inc.  The lease, assumed as part of the Ion Metrics, Inc. acquisition in April 2008, expires on December 31, 2013, under the terms of which we are leasing certain property and equipment, with annual lease payments of approximately $31,000 per year.




Robert Liscouski ("Mr. Liscouski"), a member of our Board of Directors, serves as a partner at Secure Strategy Group, a homeland security-focused banking and strategic advisory firm that has been retained by us to assist with our efforts to acquire additional capital.  During the three months ended September 30, 2011 and 2010, this advisory firm was paid $8,000 and $29,000, respectively.  We also issued 500,000 shares of common stock to this advisory firm in fiscal 2010.  As of September 30, 2011, our obligation to the advisory firm was $35,000.   In April 2011, we entered into an advisory and consulting agreement with Mr. Liscouski to assist our U.S. government sales and marketing team with our efforts to advance our interests with the U.S. government.  During the three months ended September 30, 2011, Mr. Liscouski was paid $45,000.  As of September 30, 2011, our obligation to Mr. Liscouski was $15,000.




7.
Note Payable – Related Party




In June 2009, Michael Turmelle (“Mr. Turmelle”), a member of our Board of Directors, loaned $100,000 to us.  The loan bore interest at 10% and was unsecured.  In November 2009, we issued a convertible promissory note to Mr. Turmelle in consideration of that loan. The principal amount of the loan was convertible in whole or in part at the option of Mr. Turmelle into shares of our common stock at a conversion price of $0.08 per share.In July 2010, Mr. Turmelle converted the entire principal amount of the loan into 1,250,000 shares of our common stock.




As of September 30, 2011 and 2010, our obligation under the note for borrowed funds amounted to $0. As of September 30, 2011 and June 30, 2011, our obligation to Mr. Turmelle for accrued interest approximated $11,000.




8.
Prepaid expenses and other current assets




Prepaid expenses and other current assets consist of the following:




September 30,

2011


June 30,

2011Inventory

$
851,000


$
793,000Insurance


95,000



101,000Bank fees


44,000



63,000Property and equipment


-



23,000Other prepaid expenses


164,000



161,000$
1,154,000


$
1,141,000


9.
Inventories, net




We value our inventories at lower of cost or market.  Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead.The components of inventories, net of reserves, consist of the following:




September 30,

2011


June 30,

2011Raw materials

$
720,000


$
705,000Work in progress


119,000



122,000Finished goods


1,443,000



1,040,000Total inventories, net

$
2,282,000


$
1,867,000


As of September 30, 2011 and June 30, 2011, our reserves for excess and slow-moving inventories were $46,000 and $56,000, respectively.




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





10.
Property and Equipment, net




Property and equipment consist of the following:




September 30,

2011


June 30,

2011Machinery and equipment

$
438,000


$
386,000Computers and software


392,000



389,000Furniture and fixtures


9,000



9,000Leasehold improvements


80,000



77,000Equipment under capital lease


62,000



62,000981,000



923,000Less:  accumulated depreciation and amortization


815,000



794,000$
166,000


$
129,000


For the three months ended September 30, 2011 and 2010, depreciation expense was approximately $21,000 and $26,000, respectively.




11.
Accrued Expenses




Accrued expenses consist of the following:




September 30,

2011


June 30,

2011Accrued compensation and benefits

$
821,000


$
855,000Accrued taxes


1,000



376,000Accrued legal and accounting


159,000



181,000Accrued interest


1,726,000



1,393,000Accrued warranty costs


148,000



226,000Other accrued liabilities


377,000



218,000$
3,232,000


$
3,249,000


Accrued taxes as of June 30, 2011, includes our accrual of $270,000 in sales and use tax, penalties and interest incurred as a result of an audit, by California’s Board of Equalization, on the sale of substantially all of the assets of AccurelSystems International Corporation in May 2007.  We appealed the Board of Equalization’s determination and in July 2011, the Board’s Appeals Division reduced the assessment of sales and use tax and interest to approximately $270,000, which has been reclassified to accounts payable in the three months ended September 30, 2011.




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





12.
Earnings Per Share




Basic earnings per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.  Diluted earnings per share are based upon the weighted average number of common shares outstanding during the period plus additional weighted average common equivalent shares outstanding during the period.  Common equivalent shares result from the assumed exercise of outstanding stock options and warrants, the proceeds of which are then assumed to have been used to repurchase outstanding common stock using the treasury stock method and assumed conversion of certain convertible promissory notes and convertible preferred stock.  In addition, the numerator is adjusted for any changes in income or loss that would result from the assumed conversion of potential shares. As of September 30, 2011 and 2010, potentially dilutive shares would have been excluded from the earnings per share calculation, because their effect would be antidilutive.  Shares deemed to be antidilutive include stock options, warrants, convertible debt and convertible preferred stock.




Three Months Ended September 30,2011


2010Basic income (loss) per share:Numerator:Net loss

$
(3,072,000
)

$
(647,000
)Denominator:Weighted average shares


31,950,218



25,878,335Basic loss per share

$
(0.10
)

$
(0.03
)Diluted income (loss) per share:Numerator:Net loss

$
(3,072,000
)

$
(647,000
)Denominator:Weighted average shares


31,950,218



25,878,335Effect of dilutive securities:Stock options


-



-Warrants


-



-Convertible debt


-



-Convertible preferred stock


-



--



-Weighted average shares and equivalents


31,950,218



25,878,335Diluted loss per share

$
(0.10
)

$
(0.03
)


Common stock equivalents excluded from the earnings per share calculation for the three months ended September 30, 2011 and 2010, were as follows:




Three Months Ended September 30,2011


2010Common stock equivalents excludedStock options


2,392,223



1,708,534Warrants


1,063,540



897,675Convertible debt


44,489,130



49,955,882Convertible preferred stock


16,466,700



16,466,63064,411,593



69,028,721


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





13.
Long-Term Debt and Credit Arrangements




Med-Tec Payment Obligation




In July 2003, we entered into an asset purchase agreement with Med-Tec Iowa, Inc., our former exclusive distributor of prostate seeds, to purchase Med-Tec’s customer lists and further to release each other from further obligations under an earlier distribution agreement.  The purchase price of $1,250,000, which was payable in varying amounts over 28 months, with the final payment payable on December 1, 2005, was recorded at the present value of the future payment stream, using a rate of 10.24%, which equaled $1,007,000.  This amount was recorded as an intangible asset and was amortized over our estimated useful life of 29 months.  The outstanding and past due principal balance as of September 30, 2011 and June 30, 2011 was approximately $41,000 and $42,000, respectively.




Senior Secured Convertible Promissory Note, Senior Secured Promissory Note and Revolving Credit Facility




In December 2008, we entered into a note and warrant purchase agreement with DMRJ, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  The note, which is collateralized by all of our assets, originally bore interest at 11.0% per annum.  The effective interest rate on the note, at the time of issuance, was approximately 23.4%.  We prepaid interest in the amount of $616,000 upon the issuance of the note.  In lieu of paying any commitment fees, closing fees or other fees in connection with the purchase agreement, we transferred our entire interest in 1,500,000 shares of the common stock of CorNova, Inc., a privately-held development stage medical device company, to DMRJ.  The note, which has been amended and restated, as described below, was originally convertible in whole or in part at the option of DMRJ into shares of our common stock at a conversion price of $0.26 per share. The warrant, which has been amended and restated, as described below, was originally exercisable in whole or in part at the option of DMRJ into shares of our common stock at an exercise price of $0.26 per share.




The note and warrant contained reset terms providing that, in the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the note conversion price or warrant exercise price then in effect, the conversion price and exercise price will be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued. As a result of the adoption of ASC 815-40-15, the note conversion option liability and warrant derivative liability should initially and subsequently be measured at fair value with changes in fair value recorded in earnings in each reporting period.




We valued the note upon issuance at its residual value of $4,341,000 based on the fair values of the financial instruments issued in connection with this convertible debt financing, including the warrant, the fair value of the note conversion option liability and the fair value of the CorNova common stock transferred to DMRJ.  The amounts recorded in the financial statements represents the amounts attributed to the senior secured convertible debt of $5,600,000, net of the fair value $153,000 allocated to the warrant, $638,000 allocated to the note conversion liability fair value and $468,000 representing the estimated fair value of the CorNova common stock transferred to DMRJ in the financing transaction.  The note discount was calculated based upon the residual method.  The discount on the note is being amortized to interest expense over the term of the note.  The fair value of the warrant and note conversion liabilities were determined using a binomial option pricing model.  See Notes 14 and 15 for the assumptions used in calculating the fair values.




For the three months ended September 30, 2011 and 2010, we recorded non-cash benefits of $0 and $1,076,000, respectively, in our condensed consolidated statement of operations to record the change in fair value of the note conversion option liability. Fair value is estimated using a binomial option pricing model, which includes variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables are projected based on our historical data, experience, and other factors (see Notes 14 and 15).




As required under the terms of the note, we made a principal payment of $1,000,000 on December 24, 2008.  The note required us to make a principal payment in an amount equal to any funds released from the escrow created in connection with the May 2007 sales of the assets of Accurel Systems International to Evans Analytical, upon the release of such funds. DMRJ waived that requirement in connection with the settlement of the subsequent litigation with Evans.




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







The note contains restrictions and financial covenants including: (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring  any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, provided, however, that a merger or consolidation is permitted if we are the surviving entity; against the sale, assignment, transfer or lease of our assets, other than in the ordinary course of business and excluding inventory and certain asset sales expressly permitted by the note purchase agreement; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we have authorized or reserved for the purpose of issuance, 150% of the aggregate number of shares of our common stock issuable upon exercise of  the warrant; that we maintain a minimum cash balance of at least $500,000; that the aggregate dollar amount of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00.




In March 2009, we entered into a letter agreement with DMRJ pursuant to which we were granted access to $250,000 of previously restricted cash out of funds held in a blocked account.  The effect of the letter agreement made $250,000 available to us until the close of business on April 14, 2009. In consideration of the letter agreement, in March 2009, we issued an amended and restated senior secured convertible promissory note and amended and restated warrant to DMRJ to purchase shares of common stock, which replaced the note and warrant issued in December  2008.  The terms of the amended and restated note and the amended and restated warrant are identical to the terms of the original note and warrant, except that the amended instruments reduced the initial conversion price of the original note from $0.26 to $0.18 and reduced the initial exercise price of the original warrant from $0.26 to $0.18.




In July 2009, we entered into an amendment to the December 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000. We valued the note at its residual value of $726,000 based on the relative fair value of the Series F Convertible Preferred Stock issued in conjunction with the note (see Note 16).




The senior secured promissory note, which has been amended, as described below, originally bore interest at the rate of 2.5% per month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable on the earlier of (i) December 10, 2009 and (ii) the receipt by us of net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities in one or more transactions. In addition, DMRJ may require us to prepay such amounts upon (i) certain consolidations, mergers and business combinations involving us; (ii) the sale or transfer of more than 50% of our assets, other than inventory sold in the ordinary course of business, in one or more related or unrelated transactions; or (iii) the issuance by us, in one or more related or unrelated transactions, of any equity securities or securities convertible into equity securities (other than options granted to employees and consultants pursuant to employee benefit plans approved by our Board of Directors), which results in net cash proceeds to us of more than $500,000; provided, however, that DMRJ could not require us to prepay more than the net cash proceeds of any transaction described in the preceding clause (iii) of this sentence. The note permitted us to prepay all or any portion of the principal amount, without penalty or premium, after prior notice to DMRJ.




In connection with the additional note issued in July 2009, we also issued 1,646,663 shares of our Series F Convertible Preferred Stock to DMRJ. The Series F Preferred Stock was originally convertible into that number of shares of common stock which equaled the original issue price of the Series F Preferred Stock ($0.08 per share) divided by the “Series F Conversion Price.” All of the 1,646,663 shares of Series F Preferred Stock held by DMRJ were convertible into 16,466,630 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis. The Series F Preferred Stock contained reset terms providing that, in the event that we issued additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the Series F Conversion Price then in effect, the Series F Conversion Price would be automatically adjusted to equal the price per share at which such shares are issued. The reset provision did not apply, however, to issuances of stock and options to our employees, directors, consultants and advisors pursuant to any equity compensation plan approved by our stockholders. In April 2011, as further described below, DMRJ exchanged all of the shares of Series F Preferred Stock held by it for shares of a new Series G Convertible Preferred Stock. The terms of the Series G Preferred Stock are identical to the terms of the Series F Preferred Stock, except that the Series G Preferred Stock terms do not include reset provisions for dilutive issuances of our common stock.




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





We adopted ASC 815-40-15, “Derivatives and Hedging”, on July 1, 2009 and recorded a fair value note conversion option liability of $1,183,000.




In August 2009, we entered into a second amendment to the December 2008 note and warrant purchase agreement, pursuant to which we issued DMRJ a bridge note in the principal amount of $700,000.  The note bore interest at the rate of 25% per annum. The outstanding principal balance and all interest due under this bridge note were paid in September 2009.




In September 2009, we entered into an additional credit agreement with DMRJ, pursuant to which DMRJ provided us with a revolving line of credit in the maximum principal amount of $3,000,000. In connection with the credit agreement, we issued a promissory note to DMRJ evidencing our obligations under the credit facility. Each of our subsidiaries guaranteed our obligations under the credit facility. Our obligations and our subsidiaries’ obligations are secured by grants of first priority security interests in all of our respective assets. In addition, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account are applied towards the repayment of our obligations to DMRJ under the note. Until the note and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.




The revolving line of credit, which has been amended, as described below, originally bore interest at the rate of 25% per annum. Interest under the note is due on the first day of each calendar month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable in December 2009. We may prepay all or any portion of the principal amount of the note, without penalty or premium, after prior notice to DMRJ. Subject to applicable cure periods, amounts due under the note are subject to acceleration upon certain events of default, including: (i) any failure to pay when due any amount owed under the note; (ii) any failure to observe or perform any other condition, covenant or agreement contained in the note or certain conditions, covenants or agreements contained in the credit agreement; (iii) certain suspensions of the listing or trading of our common stock; (iv) a determination that any misrepresentation made by us to DMRJ in the credit agreement or in any of the agreements delivered to DMRJ in connection with the credit agreement were false or incorrect in any material respect when made; (v) certain defaults under agreements related to any of our other indebtedness; (vi) the institution of certain bankruptcy and insolvency proceedings by or against us; (vii) the entry of certain monetary judgments against us that are not dismissed or discharged within a period of 20 days; (viii) certain cessations of our business in the ordinary course; (ix) the seizure of any material portion of our assets by any governmental authority; and (x) our indictment for any criminal activity.




In lieu of paying DMRJ any commitment fees, closing fees or other fees in connection with the credit agreement, we agreed to pay DMRJ an additional amount equal to 50% of our aggregate net profits, as defined, generated between the closing date through the termination of the credit facility. For the period September 4, 2009 through January 12, 2010, the date as of which this arrangement was cancelled, we experienced a net loss and no such payments were due or payable to DMRJ.




Upon the closing of the credit facility, we requested and were granted an initial advance of approximately $1,633,000, of which we used approximately $715,000 to repay all of our outstanding indebtedness to DMRJ pursuant to the bridge note issued to DMRJ in August 2009, and approximately $548,000 to retire certain obligations owed to other parties. We used the balance of the initial advance for working capital and ordinary course general corporate purposes.




We failed to pay an aggregate of $7,505,678 in principal, together with approximately $149,292 of interest, due to DMRJ in December 2009, the maturity of each of the promissory notes described above.  On December 20, 2009, we received written notice form DMRJ, stating that we were in default of our obligations under each of the notes.




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





As a result of these defaults, effective December 11, 2009, (i) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in March 2009 automatically increased from 11% per annum to 2.5% per month (or the maximum applicable legal interest rate, if less); (ii) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in July 2009 automatically increased from 2.5% per month to 3.0% per month (or the maximum applicable legal interest rate, if less); and (iii) the interest rate that we were obligated to pay to DMRJ under the promissory note issued in September 2009 increased from 25% per annum to 30% per annum (or the maximum applicable legal interest rate, if less). All such default interest is payable upon demand by DMRJ.




On December 31, 2009, we received further written notice from DMRJ, withdrawing its default notice. Also, on December 31, 2009, DMRJ elected to convert $120,000 of the principal amount owed by us under the senior secured convertible promissory note into 1,500,000 shares of our common stock, at an adjusted conversion price of $.08 per share. DMRJ has subsequently converted additional portions of our indebtedness on similar terms. Under the promissory notes and related agreements, however, DMRJ may not convert any portion of the notes if the number of shares of common stock to be issued pursuant to such conversion, when aggregated with all other shares of common stock owned by DMRJ at such time, would result in DMRJ beneficially owning in excess of 4.99% of the then issued and outstanding shares of common stock. DMRJ may waive such limitation by providing us with 61 days’ prior written notice.




On January 12, 2010, we amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) our line of credit under the September 2009 credit agreement was increased from $3,000,000 to $5,000,000; (ii) the maturity of all of our indebtedness to DMRJ under each of the notes described above was extended from December 10, 2009 to June 10, 2010; (iii) DMRJ waived all existing defaults under all of these promissory notes and all related credit agreements through the new maturity date of June 10, 2010; (iv) the interest rate payable on our obligations under each of the promissory notes was reduced to 15% per annum; (v) all arrangements pursuant to which we were to share with DMRJ any profits resulting from certain transactions were removed from the credit documents; (vi) we agreed to certain limitations on equity financings without DMRJ’s prior consent; and (vii) we agreed that we will not prepay more than $3,600,000 of the $5,600,000 of indebtedness owed to DMRJ under the March 2009 amended and restated promissory note without DMRJ’s prior consent.




On April 23, 2010, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) our line of credit under the September 2009 credit agreement was increased from $5,000,000 to $10,000,000; and (ii) the maturity of all of our indebtedness to DMRJ, including indebtedness under each of the promissory notes described in the preceding paragraphs, was extended from June 10, 2010 to September 30, 2010.




On September 30, 2010, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments, the maturity of all of the our indebtedness to DMRJ, including indebtedness in the preceding paragraphs, was extended from September 30, 2010 to March 31, 2011.




On March 30, 2011, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments, the maturity of all of our indebtedness to DMRJ was extended to April 7, 2011 and our line of credit under the September 2009 credit agreement was increased from $10,000,000 to $15,000,000.




On April 7, 2011, we further amended each of our credit instruments with DMRJ. Those amendments: (i) extended the maturity our all our indebtedness to DMRJ from April 7, 2011 to September 30, 2011; (ii) waived our compliance with certain financial covenants in the notes and all related credit agreements through maturity; (iii) removed the reset provisions from both the senior secured convertible promissory note and the amended and restated warrant; (iv) fixed the conversion and exercise price of the senior secured convertible promissory note and the amended and restated warrant at $0.08 per share; (v) established the order in which our prepayments of the notes would be applied; (vi) required that we authorize a new series of Series G Convertible Preferred Stock, with terms identical  to the Series F Preferred Stock except that the Series G Preferred Stock would not contain the reset antidilution provision; (vii) required that we issue DMRJ 0.1 share of Series G Preferred Stock in exchange for each share of Series F Preferred Stock held by it; and (viii) provided DMRJ with the right of first refusal on any new securities we may issue to any third party.




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







The Series G Preferred Stock is convertible into that number of shares of common stock which equals the original issue price of the Series G Preferred Stock ($0.08 per share) divided by the “Series G Conversion Price” (originally $0.08 per share), multiplied by 100. All of the 164,667 shares of Series G Preferred Stock held by DMRJ were originally convertible into 16,466,700 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis. The Series G Preferred Stock is entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our common stock. In the event of any liquidation, dissolution or winding up of our company, the holders of the Series G Preferred Stock will be entitled to be paid an amount equal to $.08 per share of Series G Preferred Stock, multiplied by 100, plus any declared but unpaid dividends, prior to the payment of any amounts to the holders of our common stock by reason of their ownership of such stock.




The holders of the Series G Preferred Stock have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the Series G Preferred Stock, we may not (i) amend, alter or repeal any provision of our Restated Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series G Preferred Stock; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series G Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of our equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series G Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.




In addition, for as long as the July 2009 note or the amended and restated senior secured convertible promissory note issued to DMRJ in March 2009 remain outstanding, we may not issue additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issue to DMRJ that number of additional shares of Series G Preferred Stock which is necessary to result in the number of shares of common stock into which all Series G Preferred Stock held by DMRJ may be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto.




We considered the guidance in ASC 470-50-40-15, “Debt-Modifications and Extinguishments,” and have concluded that the April 2011 amendment to the DMRJ credit facility was a debt modification, not an extinguishment, and have not recognized a gain or loss on this transaction in our statements of operations.  Further, we did not recognize a beneficial conversion feature or reassess an existing beneficial conversion feature as a result of this amendment.




On September 29, 2011, we further amended each of our credit instruments with DMRJ. Pursuant to those amendments: (i) the maturity of our indebtedness to DMRJ was extended from September 30, 2011 to March 31, 2012; (ii) DMRJ waived our compliance with certain financial covenants in the notes and all related credit agreements through maturity; (iii) our line of credit under the September 2009 credit agreement was increased from $15,000,000 to $23,000,000; and (iv) we were required to repay sufficient amounts of our outstanding indebtedness under the notes and related credit agreements and other amounts owing to DMR such that as of December 31, 2011, the outstanding obligations to DMRJ shall not exceed $15,000,000.




On October 13, 2011, we further amended each of our credit instruments with DMRJ, to eliminate the obligation to repay any portion of our outstanding indebtedness to DMRJ by December 31, 2011.




The failure to refinance this indebtedness or otherwise negotiate extensions of our obligations to DMRJ would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirelyand/orfile for protection under bankruptcy laws.




Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.




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







As of September 30, 2011, our obligation to DMRJ under the senior secured convertible promissory note, as amended, the senior secured promissory note and under the credit facility approximated $3,520,000, $1,000,000 and $18,602,000, respectively. Further, as of September 30, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note, the senior secured promissory note and line of credit approximated $1,705,000 and is included in current liabilities in the condensed consolidated balance sheet.




As of October 31, 2011, our obligations to DMRJ under the amended and restated senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $3,520,000, $1,000,000 and $19,012,000, respectively.  Further, as of October 31, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note and the senior secured promissory note approximated $1,664,000 and is included in current liabilities.




14.
Note Conversion Option Liability




ASC 815-40-15 “Derivatives and Hedging”, requires issuers to record, as liabilities, financial instruments that provide for reset provisions as an adjustment mechanism to the relevant exercise or conversion price, since they are not deemed to be indexed to our common stock. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. In our December 2008 financing transaction with DMRJ, we issued a senior secured promissory note in the principal amount of $5,600,000. The promissory note contained reset terms, providing that, in the event that we issued additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the note conversion price, the conversion price would be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued. The conversion option liability was initially and subsequently measured at fair value with changes in fair value recorded in earnings in each reporting period. For the three months ended September 30, 2011 and 2010, we recorded non-cash benefits of $0 and $1,076,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the note conversion option liability. Fair value was estimated using a binomial option pricing model, which included variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables were projected based on our historical data, experience, and other factors.  The note conversion option liability was valued using a binomial option pricing model, with the following assumptions on the following dates:




Note Conversion Option Liability

Fair Value CalculationJune 30,

2010


September 30,

2010Convertible debt amount

$
3,920,000


$
3,920,000Potential number of convertible shares


49,000,000



49,000,000Conversion price

$
0.08


$
0.08Stock price on date of measurement

$
0.30


$
0.26Expected volatility


157.1
%


161.0
%Expected dividend yield


0.00
%


0.00
%Risk free interest rate


0.17
%


0.19
%Expected term (years)


0.25



0.50Fair value

$
10,686,000


$
9,610,000





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





The fair value of the note conversion option liability was measured at the end of each reporting period and the change in fair value was reported in our condensed consolidated statement of operations.  Upon adoption of ASC 815-40-15 at July 1, 2009, we recorded a fair value note conversion option liability of $1,183,000. On April 7, 2011, we amended the note and warrant purchase agreement. As amended on April 7, 2011, the conversion price of the senior secured convertible promissory note was fixed at $0.08 per share and subsequent changes in fair value were no longer required to be recorded in our statements of operations. As of that date, the note conversion feature was no longer subject to adjustment and was no longer required to be recorded as a separate liability under ASC 815-40-15. On April 7, 2011, we reclassified the note conversion liability of $17,845,000 to stockholders’ deficit. As of September 30, 2011 and June 30, 2011, the note conversion liability was $0.




15.
Warrant Derivative Liability




ASC 815-40-15 “Derivatives and Hedging”, requires freestanding contracts that are settled in our own stock, including common stock warrants, to be designated as an equity instrument, asset or liability. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. In our December 2008 financing transaction with DMRJ, we issued a warrant to purchase 1,000,000 shares of our common stock. The warrant contained reset terms, providing that, in the event that we issued additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the exercise price, the warrant would be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued. The warrant derivative liability was initially and subsequently measured at fair value with changes in fair value recorded in earnings in each reporting period. For the three months ended September 30, 2011 and 2010, we recorded non-cash benefits of $0 and $31,000, respectively, in our condensed consolidated statements of operations to record the change in fair value of the warrant derivative liability. Fair value was estimated using a binomial option pricing model, which included variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables were projected based on our historical data, experience, and other factors. The warrant derivative liability was valued using a binomial option pricing model, with the following assumptions on the following dates:




Warrant Derivative Liability

Fair Value CalculationJune 30,

2010


September 30,

2010Shares eligible to be purchased


1,000,000



1,000,000Exercise price

$
0.08


$
0.08Stock price on date of measurement

$
0.30


$
0.26Expected volatility


157.1
%


161.0
%Expected dividend yield


0.0
%


0.0
%Risk free interest rate


1.17
%


0.74
%Expected life (years)


3.44



3.19Fair value

$
278,000


$
247,000


We originally recorded the fair value of this warrant of approximately $160,000 as an increase to additional paid in capital.  Upon adoption of ASC 815-40-15 at July 1, 2009, we reclassified $160,000 from additional paid in capital to the warrant derivative liability. On April 7, 2011, we amended the note and warrant purchase agreement. As amended on April 7, 2011, the conversion price of the warrant was fixed at $0.08 per share and subsequent changes in fair value were no longer required to be recorded in our statements of operations. As of that date, warrant was no longer subject to adjustment and was no longer required to be recorded as a separate liability under ASC 815-40-15. On April 7, 2011, we reclassified the warrant derivative liability of $438,000 to stockholders’ deficit. As of September 30, 2011 and June 30, 2011, the warrant derivative liability was $0.




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





16.
Series F Convertible Preferred Stock




In connection with the July 2009 amendment to the December 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000, we issued 1,646,663 shares of our Series F Convertible Preferred Stock to DMRJ.  The Series F Preferred Stock was originally convertible into that number of shares of common stock which equaled the original issue price of the Series F Preferred Stock ($0.08 per share) divided by the “Series F Conversion Price.” All of the 1,646,663 shares of Series F Preferred Stock held by DMRJ were convertible into 16,466,630 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis.  In addition, for as long as the promissory note issued in July 2009 or the amended and restated promissory note issued in March 2009 remain outstanding, we were prohibited from issuing additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issued to DMRJ that number of additional shares of Series F Preferred Stock which is necessary to result in the number of shares of common stock into which all Series F Preferred Stock held by DMRJ would be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto.




On April 7, 2011, in connection with the amendments to our credit instruments with DMRJ, we issued shares of a new series of Series G Convertible Preferred Stock to DMRJ in exchange for the Series F Preferred Stock (see Note 13).




17.
Series G Convertible Preferred Stock




On April 7, 2011, in connection with theamendment to the December 2008 note and warrant purchase agreement with DMRJ, we issued 164,667 shares of our Series G Convertible Preferred Stock to DMRJ in exchange for 1,646,663 shares of our Series F Preferred Stock (see Notes 13 and 16).




The Series G Preferred Stock is convertible into that number of shares of common stock which equals the original issue price of the Series G Preferred Stock ($0.08 per share) divided by the “Series G Conversion Price.” All of the 164,667 shares of Series G Preferred Stock held by DMRJ were convertible into 16,466,700 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis.  We have concluded that the April 7, 2011 amendment to the DMRJ credit facility was a debt modification, not an extinguishment, and have not recognized a gain or loss on this transaction in our statements of operations.  Further, we did not recognize a beneficial conversion feature on the Series G Preferred Stock or reassess an existing beneficial conversion feature as a result of this amendment.




18.
Stockholders’ Deficit




Common Stock Options and Warrants




In connection with various financing agreements and services provided by consultants, we have issued warrants to purchase shares of our common stock.  The fair value of warrants issued is determined using a binomial option pricing model.  In December 2008, in conjunction with the issuance of the senior secured convertible note to DMRJ, we issued a five-year warrant to purchase 1,000,000 shares of common stock at an initial exercise price of $0.26 per share.  The warrant is exercisable between December 10, 2008 and December 10, 2013.  We recorded the fair value of this warrant of approximately $160,000 against the senior secured convertible promissory note, which was accreted to the note and interest expense was recorded over the life of the note. In March 2009, we issued DMRJ an amended and restated warrant to purchase shares of common stock, to reduce the initial exercise price of the warrant from $0.26 to $0.18. As a result of the issuance of the Series F Preferred Stock, in July 2009, the exercise price of the warrant was automatically reduced under its reset provisions to $0.08.  We adopted ASC 815-40-15 on July 1, 2009 and reclassified $160,000 from additional paid in capital to the “Warrant Derivative Liability.” The warrant derivative liability was initially and subsequently measured at fair value with changes in fair value recorded in earnings in each reporting period. On April 7, 2011, we amended our credit instruments with DMRJ. As amended on April 7, 2011, the conversion price of the warrant was fixed at $0.08 per share.  As of that date, the warrant was deemed to be indexed to our common stock and subsequent changes in fair value were no longer required to be recorded in our results of operations. For the three months ended September 30, 2011 and 2010, we recorded non-cash benefits of $0 and $31,000, respectively, in our condensed consolidated statements of operations (see Note 15).




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 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





In May 2011, we entered into two advisory and consulting services agreements, pursuant to which we agreed to issue up to an aggregate of 4,000,000 shares of our common stock.  In August 2011, we issued 333,334 shares of common stock, having a value of approximately $197,000, under these agreements. We have agreed to issue the balance of the 4,000,000 shares in monthly installments of 166,667 shares to each of the two advisors, beginning in August 2011 and ending upon the earlier of the ninth such installment or the termination of each advisor’s respective agreement.




As of September 30, 2011, there were warrants outstanding to purchase 3,024,791 shares of our common stock at exercise prices ranging from $0.08 to $12.45 expiring at various dates between December 30, 2011 and June 27, 2015.




We issued 80,000 and 12,420 shares of common stock during the three months ended September 30, 2011 and 2010, respectively, as a result of the exercise of options by employees.




19.
Income Taxes




We adopted the accounting standards related to accounting for uncertainty in income taxes recognized in an enterprise’s financial statements. The accounting standard clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The standard also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.




We are required to file federal and state income tax returns in the United States.  The preparation of these tax returns requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions, which could affect the amount of tax paid by us. In consultation with our tax advisors, we base our tax returns on interpretations that are believed to be reasonable under the circumstances. The tax returns, however, are subject to routine reviews by the various federal and state taxing authorities in the jurisdictions in which the we file tax returns. As part of these reviews, a taxing authority may disagree with respect to the income tax positions taken by us (“uncertain tax positions”) and, therefore, may require us to pay additional taxes. As required under applicable accounting rules, we accrue an amount for our estimate of additional income tax liability, including interest and penalties, which we could incur as a result of the ultimate or effective resolution of the uncertain tax positions. We  review and update the accrual for uncertain tax positions as more definitive information becomes available from taxing authorities, upon completion of tax audits, upon expiration of statutes of limitation, or upon occurrence of other events. Tax positions must meet a “more likely than not” recognition threshold at the effective date to be recognized upon adoption and in subsequent periods.




We account for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. 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 and carry-forwards 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.  A valuation allowance is established when necessary to reduce deferred tax assets to amounts expected to be realized.




We account for uncertain income tax positions by accruing for the estimated additional amount of taxes for the uncertain tax positions when the uncertain tax position does not meet the more likely than not standard for sustaining the position.  This requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits of uncertain tax positions are recorded in our condensed consolidated financial statements only after determining a more-likely-than-not probability that the uncertain tax positions will withstand challenge, if any, from tax authorities. When facts and circumstances change, we reassess these probabilities and records any changes in the consolidated financial statements as appropriate.




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 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





From time to time we may be assessed interest or penalties by major tax jurisdictions, namely the states of Massachusetts and California.  At the adoption date and as of September 30, 2011, we had no material unrecognized tax benefits and no adjustments to liabilities or operations were required. No interest and penalties have been recognized by the Company to date.




For the three months ended September 30, 2011 and 2010, we provided for no taxes in our condensed consolidated statement of operations as we have significant net loss carryforwards.




20.
Commitments and Contingencies




We lease manufacturing, research and office space in Wilmington, MA, the lease of which expires on January 31, 2015.  Under the terms of the lease, we are responsible for our proportionate share of real estate taxes and operating expenses relating to this facility.  As a result of the Ion Metrics acquisition, we assumed a lease for research and office space in San Diego, CA, which lease was renewed and expires on January 31, 2012.  Total rent expense, including assessments for maintenance and real estate taxes for the three months ended September 30, 2011 and 2010, for both continuing and discontinued operations was $83,000 and $70,000, respectively.




In April 2007, in conjunction with our plans to conduct research, development and minor manufacturing work in New Mexico, we executed an operating lease which was initially to expire on May 1, 2010.  The lease allowed for early termination, which we elected in February 2008.  As a result of the early termination, we are responsible for reimbursing the landlord for certain leasehold improvements over a 24-month period.  As of September 30, 2011 and June 30, 2011, the balance due is approximately $27,000 and is included in current liabilities in the condensed consolidated balance sheets.




21.
Financial Information By Segment




Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the chief operating decision maker or decision making group, in determining how to allocate resources and in accessing performance.  Our chief operating decision making group is composed of the chief executive officer and members of senior management.  Based on qualitative and quantitative criteria, we have determined that we operate within one reportable segment, which is the Security Products Segment.




22.
Legal Proceedings




In January 2011, Fulong Integrated Technique, Ltd. (“Fulong”) filed a complaint against us in the Middlesex Superior Court of the Commonwealth of Massachusetts, alleging non-payment of amounts owed for services provided to us in connection with the sale of handheld explosives detection equipment to a customer in China in the first quarter of fiscal 2009. Fulong seeks general monetary damages, other statutory damages, attorneys’ fees and costs. We believe the case is without merit and that we have substantial defenses against the plaintiff’s claims. We have filed counterclaims against Fulong, and are contesting the matter vigorously. If, however, Fulong is ultimately successful, it could have a material adverse effect on our business and financial condition.




We are not currently a party to any other legal proceedings, other than routine litigation incidental to our business that which we believe will not have a material effect on our business, assets or results of operations.  From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities.  Each of these matters may be subject to various uncertainties.





23.
Subsequent Events




On October 13, 2011, we amended our credit instruments with DMRJ (see Note 13).




We have evaluated subsequent events after the balance sheet date through the date these financial statements were issued, for appropriate accounting and disclosure and concluded that there were no other subsequent events requiring adjustment or disclosure in these financial statements.




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




Cautionary Note Regarding Forward-Looking Statements




This Quarterly Report on Form 10-Q contains certain statements that are “forward-looking” within the meaning of the federal securities laws. These forward looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.




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




We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Report. Important factors that could cause actual results to differ from our predictions include those discussed under this “Management’s Discussion and Analysis” and under “Risk Factors,” as well as those discussed under “Risk Factors,” “Management’s Discussion and Analysis” and “Business” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2011. Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face.  In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations.  For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof.  We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law.  We urge readers to review carefully the risk factors described in this Quarterly Report, in our Annual Report on Form 10-K for the fiscal year ended June 30, 2011 and in the other documents that we file with the Securities and Exchange Commission.  You can read these documents atwww.sec.gov.




Overview




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




We have developed proprietary technologies used in explosives trace detection (ETD) applications and market and sell handheld and benchtop ETD systems that use our proprietary technologies.  Our products are marketed and sold to a growing number of locations domestically and internationally.  These systems are used by private companies and government agencies to screen baggage, cargo, other objects and people for the detection of trace amounts of explosives. Please see our Annual Report on Form 10-K for the fiscal year ended June 30, 2011 for a complete description of our business.




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Critical Accounting Policies




Our significant accounting policies are summarized in Note 2 to our consolidated financial statements included in Item 7 of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2011.  However, certain of our accounting policies require the application of significant judgment by our management, and such judgments are reflected in the amounts reported in our condensed consolidated financial statements.  In applying these policies, our management uses our judgment to determine the appropriate assumptions to be used in the determination of estimates.  Those estimates are based on our historical experience, terms of existing contracts, our observance of market trends, information provided by our strategic partners and information available from other outside sources, as appropriate.  Actual results may differ significantly from the estimates contained in our condensed consolidated financial statements.




Results of Operations




Three Months Ended September 30, 2011 vs. September 30, 2010




Revenues




Security product revenues for the three months ended September 30, 2011 were $1,036,000 as compared with $1,004,000 for the comparable prior year period, an increase of $32,000, or 3.2%.  The increase in security revenue is primarily a result of higher average unit sell prices on sales our explosives detection products and increased sales of accessories, partially offset by a 9% decrease in the number of units sold during the three months ended September 30, 2011 as compared to the comparable prior year period.




Cost of Revenues




Cost of revenues for the three months ended September 30, 2011 were $637,000 as compared with $636,000 for the comparable prior year period, an increase of $1,000 or 0.2%.  The increase in cost of revenues is primarily due to the costs incurred to remediate certain defective component parts, partially offset by decreased unit sales of security product in the three months ended September 30, 2011, the reduction in the costs we pay to manufacture our security products and a decrease in our warranty costs.




Gross Margin




Gross margin for the three months ended September 30, 2011 was $399,000 or 38.5% of security revenues as compared with gross margin of $368,000 or 36.7% of security revenues for the comparable prior year period.  The increase in gross margin is a result of reductions in the costs we pay to manufacture our security products due to cost efficiencies realized in the production process, including efficiencies realized by our outsourced contract manufacturer and a decrease in our warranty costs, partially offset by costs incurred to remediate certain defective component parts.




Research and Development Expense




Research and development expense for the three months ended September 30, 2011 was $819,000 as compared with $470,000 for the comparable prior year period, an increase of $349,000 or 74.3%.The increase in research and development expense is due primarily to increased payroll and related fringe benefit costs, increased contracted engineering and direct material costs incurred in the development of the QS-B220 benchtop explosives and narcotics detector. We continue to expend funds to further the development of new products in the areas of explosives detection, as well as to prepare for certain government laboratory acceptance testing. Spending on research and development will increase in the next six to twelve months due to the ongoing development of the QS-B220 benchtop explosives and narcotics detector and the QS-Hx portable explosives detector.




Selling, General and Administrative Expenses




Selling, general and administrative expenses for the three months ended September 30, 2011 were $1,813,000 as compared with $1,148,000 for the comparable prior year period, an increase of $665,000, or 57.9%.  The increase in selling, general and administrative expenses is due primarily to increased consulting expense, due to the issuance of our common stock to certain consultants and the retention of consultants to assist with our efforts to advance our interests with the U.S. government, increased payroll, related fringe benefits costs and travel expense resulting from the addition of sales, marketing and administrative personnel, increased stock-based expense on warrants, increased insurance expense, partially offset by decreased vendor late payment fees.




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Other Income and Expense, Net




For the three months ended September 30, 2011, other expense, net was $839,000 as compared with other income, net of $603,000, for the comparable prior year period, a decrease of $1,442,000. The decrease was primarily due to decreases in the fair value of the note conversion option liability of $1,076,000 and warrant derivative liability of $31,000, in the three months ended September 30, 2010, both of which are related to our financing with DMRJ Group LLC. On April 7, 2011, we entered into an amendment to our credit facility with DMRJ. As amended, the conversion price of the senior secured convertible promissory note and warrant to purchase shares of our common stock were both fixed at $0.08 per share. As of that date, the note conversion feature and warrant were no longer subject to adjustment and were no longer required to be recorded as a separate liability under ASC 815-40. Interest expense increased to $840,000, compared to $516,000, for the comparable prior period, an increase of $324,000, due to higher borrowings under our credit facility with DMRJ. Interest income decreased $11,000 to $1,000, in the three months ended September 30, 2011 from $12,000, for the comparable prior year period, due to decreased interest income associated with the note receivable issued to us as part of the Core asset sale. In December 2010, we entered into a payoff agreement with Core Systems Incorporated, pursuant to which we agreed to reduce the amount due under the note by $201,000, from $688,000 to $487,000 in exchange for accelerated payment of the note.




Net Loss




Our net loss for the three months ended September 30, 2011 was $3,072,000 as compared with a net loss of $647,000 for the comparable prior year period, an increase of $2,425,000, or 374.8%.  The increase in the net loss is primarily due to the fair value adjustments recorded in the three months ended September 30, 2010 on the note conversion option liability and warrant derivative liability, both of which are related to our financing with DMRJ, a $1,014,000 increase in operating expenses and increased interest expense due to higher borrowings under our credit facility with DMRJ.




Liquidity and Capital Resources




As of September 30, 2011 and June 30, 2011, we had cash and cash equivalents of $425,000 and $264,000, respectively. On March 31, 2012, we must repay in full our obligations to DMRJ under the amended and restated senior secured promissory note issued to DMRJ in March 2009, under a second secured promissory note issued in July 2009 and under a revolving credit facility established in September 2009.  As of September 30, 2011, our obligations under the two promissory notes and under the revolving credit facility were $3,520,000, $1,000,000 and $18,602,000, respectively. Each of these notes and the credit facility are described in Note 13 of the Notes to Condensed Consolidated Financial Statements, accompanying this Quarterly Report. Further, as of September 30, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note and the senior secured promissory note approximated $1,705,000. As of October 31, 2011, our obligation to DMRJ under the two senior notes and under the revolving credit facility were $3,520,000, $1,000,000 and $19,012,000, respectively, reflecting increased borrowing under the revolving credit facility to fund working capital. Further, as of October 31, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $1,664,000.




During the three months ended September 30, 2011, we had net cash outflows of $2,598,000 from operating activities as compared to net cash outflows from operating activities of $627,000 for the comparable prior year period.  The $1,971,000 increase in net cash used in operating activities during the three months ended September 30, 2011, as compared to the comparable prior year period, was primarily a result of (i) the increased net loss of $3,072,000, compared to the net loss of $647,000, in the prior period due to increased operating expenses; (ii) an increase in accounts payable of $325,000, compared to a decrease in accounts payable of $157,000 in the prior period due to increased operating expense; (iii) an increase of $9,000 in deferred revenue, compared to a $924,000 increase in deferred revenue in the prior period due primarily to the receipt in July 2010 of the $893,000 advance deposit under our contract with the India Ministry of Defence; (iv) a $13,000 increase in prepaid expenses, compared to a $368,000 increase in prepaid expenses in the prior period, due to the receipt of inventory which had been prepaid in the comparable prior period; (v) a $267,000 decrease in accrued expenses compared to a $7,000 decrease in accrued expenses in the prior period, due to the payment of property taxes and reduced warranty costs; (vi) a $83,000 increase in accounts receivable, compared to a $55,000 increase in accounts receivable in the prior period, due to higher revenues and shipment timing; and (vii), a $415,000 increase in inventories, compared to a $210,000 increase in the prior period, due to the receipt of inventory purchased to fulfill our contract  with the India Ministry of Defence.






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During the three months ended September 30, 2011, we had net cash outflows of $58,000 from investing activities as compared to net cash inflows of $68,000 from investing activities for the comparable prior year period.  The $126,000 decrease in net cash provided by investing activities during the three months ended September 30, 2011, as compared to the comparable prior year period, was primarily due to a $58,000 increase in cash used to  purchase property and equipment, a $47,000 decrease in payments received on the Core note receivable due to the payoff agreement entered into with Core Systems Incorporated and a $21,000 decrease in cash transferred from restricted funds.




During the three months ended September 30, 2011 we had net cash inflows of $2,817,000 from financing activities as compared to net cash inflows of $559,000 from financing activities for the comparable prior year period.  The $2,258,000 increase in net cash from financing activities during the three months ended September 30, 2011, as compared to the comparable prior year period, was primarily a result of increased borrowings under our  credit facility with DMRJ. During the three months ended September 30, 2010, we received proceeds of $2,000 due to the exercise of employee stock options.




In December 2008, we entered into a note and warrant purchase agreement with DMRJ, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  Thereafter, we entered into a series of amendments, waivers and modifications of our facility with DMRJ.  As of the most recent amendments and modifications, entered into on October 13, 2011, we have a $23,000,000 line of credit with DMRJ and the maturity of all our indebtedness to DMRJ has been extended until March 31, 2012. See Note 13 of Notes to Condensed Consolidated Financial Statements, accompanying this Quarterly Report.




There can be no assurance that we will be successful in refinancing or extending our obligations to DMRJ, which mature on March 31, 2012.




Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  In addition, we will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; and the hiring of additional personnel, and acquiring capital equipment.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.




Any failure to comply with our debt covenants, to achieve our projections and/or obtain sufficient capital on acceptable terms would have a material adverse impact on our liquidity, financial condition and operations and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding.




Based on current sales, operating expense and cash flow projections, and the cash available from our line of credit, management believes there are plans in place to sustain operations for the next several months. Because there can be no assurances that sales will materialize as forecasted, and/or that management will be successful in refinancing or extending our obligations with DMRJ, management will continue to closely monitor and attempt to control our costs and will continue to actively seek the needed capital through government grants and awards, strategic alliances, private financing sources, and through its lending institutions.  Future expenditures for research and product development are discretionary and can be adjusted as can certain selling, general and administrative expenses, based on the availability of cash.  The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.




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Off-Balance Sheet Arrangements




As of September 30, 2011, we had three irrevocable standby letters of credit outstanding in the approximate amount of $1,488,000.  These letters of credit (1) provide performance security equal to 5% of the amount of our contract with the India Ministry of Defence; (2) provide warranty performance security equal to 5% of the contract amount; and (3) provide security equal to 15% of the contract amount against an advance deposit under the terms of the contract.  During fiscal 2011, we amended two of the letters of credit, extending the expiration dates. As amended, the letters of credit expire between February 6, 2012 and October 5, 2012.




As of September 30, 2011, we did not have any other off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.




New Accounting Pronouncements




In June 2011, the FASB issued Accounting Standards Update 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”(“ASU 2011-05”), which amends FASB ASC Topic 220, Comprehensive Income, to facilitate the continued alignment of U.S. GAAP with International Accounting Standards. The ASU prohibits the presentation of the components of comprehensive income in the statement of stockholder’s equity. Reporting entities are allowed to present either: a statement of comprehensive income, which reports both net income and other comprehensive income; or separate, but consecutive, statements of net income and other comprehensive income. Under previous GAAP, all 3 presentations were acceptable. Regardless of the presentation selected, the Reporting Entity is required to present all reclassifications between other comprehensive and net income on the face of the new statement or statements. The provisions of this ASU are effective for fiscal years and interim periods beginning after December 31, 2011. Early adoption is permitted. We do not currently believe that the adoption of this update will have a material effect on our consolidated financial position and results of operations.




In May 2011, the FASB issued Accounting Standards Update 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS”(“ASU 2011-04”). The adoption of ASU 2011-04 gives fair value the same meaning between U.S. generally accepted accounting principles (“U.S. GAAP”) and International Financial Reporting Standards (“IFRS”), and improves consistency of disclosures relating to fair value. The provisions of ASU 2011-04 will be effective for fiscal years and interim periods beginning after December 15, 2011 and can be applied prospectively. However, changes in valuation techniques shall be treated as changes in accounting estimates. We do not currently believe that the adoption of this update will have a material effect on our consolidated financial position and results of operations.




Item 3.
Quantitative and Qualitative Disclosures About Market Risk




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




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Item 4.
Controls and Procedures




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




Disclosure Controls and Procedures




Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2011.  The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions to be made regarding required disclosure.  It should be noted that any system of controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met and that management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our Chief Executive Officer and Chief Financial Officer, concluded that we did maintain effective internal control over financial reporting as of September 30, 2011 and further concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.




Changes in Internal Control Over Financial Reporting




Except as described above, there were no changes to our internal control over financial reporting during the quarter ended September 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.




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PART II.
OTHER INFORMATION




Item 1.
Legal Proceedings




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




Except as disclosed under Item 3 of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2011, we are not a party to any other legal proceedings, other than ordinary routine litigation incidental to our business, which we believe will not have a material affect on our business, assets or results of operations.




Item 1A.
Risk Factors




Other than as set forth below, there have not been any material changes from the risk factors previously disclosed under Item 1A of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2011.




We will be required to repay our borrowings from DMRJ Group LLC on March 31, 2012.




We will be required to repay all of our borrowings from DMRJ on March 31, 2012.  Our obligations to DMRJ are secured by a security interest in substantially all of our assets.  As of September 30, 2011, the outstanding balances due to DMRJ under a senior secured convertible promissory note, a second secured promissory note and a revolving credit facility was $3,520,000, $1,000,000 and $18,602,000, respectively.  As of October 31, 2011, the outstanding balances due to DMRJ under these instruments were $3,520,000, $1,000,000 and $19,012,000, respectively.  If we are unable to repay these amounts as required, refinance our obligations to DMRJ, or negotiate extensions of these obligations, DMRJ may seize our assets and we may be forced to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.




We will require additional capital to fund operations and continue the development, commercialization and marketing of our product.  Our failure to raise capital could have a material adverse effect on the business.




Management continually evaluates plans to reduce our operating expenses, increase sales and increase our cash flow from operations.  Despite our current sales, expense and cash flow projections, we will require additional capital in the third quarter of fiscal 2012 to fund operations and continue the development, commercialization and marketing of our products. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.




Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds




In August 2011, DMRJ converted $80,000 of the principal amount owed by us under a promissory note into 1,000,000 shares of our common stock, at an adjusted conversion price of $0.08 per share. The issuance of these securities to DMRJ is exempt from registration under the Securities Act of 1933, as amended, pursuant to an exemption provided by Section 3(a)(9) and/or Section 4(2) of the Securities Act.




In August 2011, we issued 333,334 shares of common stock, having a value of approximately $197,000, to two advisors, in consideration of services rendered to us under two advisory and consulting services agreements. The issuance of these shares was exempt from registration under the Securities Act pursuant to an exemption provided by Section 4(2) of the Securities Act.




Item 3.
Defaults Upon Senior Securities




None.




Item 4.
Submission of Matters to a Vote of Security Holders




None.




Item 5.
Other Information




None.




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Item 6.
Exhibits




Exhibit No.




10.1 (1)
Omnibus Sixth Amendment to Credit Agreement and Eighth Amendment to Note and Warrant Purchase Agreement, dated as of September 29, 2011 between Implant Sciences Corporation and DMRJ Group LLC.




10.2 (1)
Amended and Restated Promissory Note, dated as of September 29, 2011, issued by Implant Sciences Corporation.




10.3 (2)
Omnibus Seventh Amendment to Credit Agreement and Ninth Amendment to Note and Warrant Purchase Agreement, dated as of October 13, 2011, between Implant Sciences Corporation and DMRJ Group LLC.




31.1  *
Certification of Principal Executive Officer pursuant to Section 3.02 of the Sarbanes-Oxley Act of 2002.




31.2  *
Certification of Principal Financial Officer pursuant to Section 3.02 of the Sarbanes-Oxley Act of 2002.




32.1  *
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




32.2  *
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




______________________




(1)
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated September 29, 2011 and filed September 30, 2011.




(2)
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated October 13, 2011 and filed October 19, 2011.




*
Filed herewith




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SIGNATURES




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




Implant Sciences Corporation






Dated: November 14, 2011                                                                                     By:  /s/ Glenn D. Bolduc


Glenn D. Bolduc


President, Chief Executive Officer


(Principal Executive Officer)







Dated: November 14, 2011                                                                                     By:  /s/ Roger P. Deschenes


Roger P. Deschenes


Vice President, Finance and Chief Financial Officer


(Principal Financial Officer and Chief Accounting Officer)

















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