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 March 31,
2009




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 its 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 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
June 4, 2009, there were 15,424,195 shares of the registrant’s Common Stock were
outstanding.












IMPLANT SCIENCES
CORPORATION





TABLE
OF CONTENTS














PagePART
      I.
            FINANCIAL
      INFORMATIONItem
      1.
            Condensed
      Consolidated Financial Statements (unaudited)Condensed
      Consolidated Balance Sheets at March 31, 2009 and June 30,
      2008
            3Condensed
      Consolidated Statements of Operations for the three and nine months
      ended
              March
      31, 2009 and 2008
            4Condensed
      Consolidated Statements of Cash Flows for the nine months
      ended
              March
      31, 2009 and 2008
            5Notes
      to Condensed Consolidated Financial Statements
            6-21Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            22-31Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            32Item
      4T.
            Controls
      and Procedures
            32PART
      II.
            OTHER
      INFORMATIONItem
      1.
            Legal
      Proceedings
            33Item
      1A.
            Risk
      Factors
            33-34Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            34Item
      3.
            Defaults
      Upon Senior Securities
            34Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            34Item
      5.
            Other
      Information
            34Item
      6.
            Exhibits
            35Signatures
            36
























2


Implant
      Sciences CorporationCondensed
      Consolidated Balance Sheets(unaudited)March
      31,
              
              
              June
      30,2009
              
              
              2008ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              229,000
              
              
              $
              412,000Restricted
      cash
              
              
              1,739,000
              
              
              
              514,000Accounts
      receivable-trade, net of allowance of $64,000 and
      $9,000,  respectively
              
              
              130,000
              
              
              
              667,000Accounts
      receivable, unbilled
              
              
              102,000
              
              
              
              152,000Notes
      receivable, current
              
              
              164,000
              
              
              
              -Inventories
              
              
              479,000
              
              
              
              725,000Prepaid
      expenses and other current assets
              
              
              709,000
              
              
              
              369,000Current
      assets held for sale
              
              
              216,000
              
              
              
              1,883,000Total
      current assets
              
              
              3,768,000
              
              
              
              4,722,000Property
      and equipment, net
              
              
              356,000
              
              
              
              443,000Amortizable
      intangible assets, net
              
              
              2,000
              
              
              
              54,000Notes
      receivable, net of current
              
              
              813,000
              
              
              
              -Other
      non-current assets
              
              
              78,000
              
              
              
              1,096,000Goodwill
              
              
              3,136,000
              
              
              
              3,136,000Non-current
      assets held for sale
              
              
              143,000
              
              
              
              2,645,000Total
      assets
              
              $
              8,296,000
              
              
              $
              12,096,000LIABILITIES
      AND STOCKHOLDERS' (DEFICIT) EQUITYCurrent
      liabilities:Senior
      secured convertible note,  (liquidation value
      $4,600,000)
              
              $
              3,741,000
              
              
              $
              -Current
      maturities of long-term debt and obligations under capital
      lease
              
              
              30,000
              
              
              
              417,000Line
      of credit
              
              
              -
              
              
              
              477,000Notes
      payable
              
              
              -
              
              
              
              181,000Payable
      to Med-Tec
              
              
              59,000
              
              
              
              80,000Payable
      to Ion Metrics shareholders
              
              
              -
              
              
              
              2,514,000Accrued
      expenses
              
              
              2,963,000
              
              
              
              2,062,000Accounts
      payable
              
              
              3,649,000
              
              
              
              2,439,000Current
      portion of long-term lease liability
              
              
              276,000
              
              
              
              317,000Deferred
      revenue
              
              
              17,000
              
              
              
              66,000Current
      liabilities held for sale
              
              
              121,000
              
              
              
              1,079,000Total
      current liabilities
              
              
              10,856,000
              
              
              
              9,632,000Long-term
      liabilities:Long-term
      debt and obligations under capital lease, net of current
      maturities
              
              
              88,000
              
              
              
              113,000Long-term
      lease liability
              
              
              168,000
              
              
              
              446,000Long-term
      liabilities held for sale
              
              
              -
              
              
              
              1,000Long-term
      litigation settlement liability
              
              
              5,000,000
              
              
              
              -Total
      long-term liabilities
              
              
              5,256,000
              
              
              
              560,000Total
      liabilities
              
              
              16,112,000
              
              
              
              10,192,000Commitments
      and contingencies (Note 17)Series
      D Cumulative Redeemable Convertible Preferred Stock, $10 stated value;
      500,000 sharesauthorized,
      0 and  242,424 shares outstanding, respectively, (liquidation
      value $2,424,000)
              
              
              -
              
              
              
              2,269,000Stockholders'
      (deficit) equity:Common
      stock; $0.10 par value; 50,000,000 shares authorized; 14,205,205
      and
                14,194,660
      and 12,114,553 and 12,104,008 shares issued and outstanding,
      respectively
              
              
              1,421,000
              
              
              
              1,211,000Additional
      paid-in capital
              
              
              61,035,000
              
              
              
              58,317,000Accumulated
      deficit
              
              
              (70,224,000
              )
              
              
              (59,720,000
              )Deferred
      compensation
              
              
              -
              
              
              
              (2,000
              )Accumulated
      other comprehensive income (loss)
              
              
              25,000
              
              
              
              (98,000
              )Treasury
      stock, 10,545 common shares, respectively, at cost
              
              
              (73,000
              )
              
              
              (73,000
              )Total
      stockholders' (deficit) equity
              
              
              (7,816,000
              )
              
              
              (365,000
              )Total
      liabilities and stockholders' (deficit) equity
              
              $
              8,296,000
              
              
              $
              12,096,000The
      accompanying notes are an integral part of these financial
      statements.


3








Implant
      Sciences CorporationCondensed
      Consolidated Statements of Operations(unaudited)For
      The Three Months Ended
              
              
              For
      The Nine Months EndedMarch
      31,
              
              
              March
      31,2009
              
              
              2008
              
              
              2009
              
              
              2008RevenuesSecurity
      products
              
              $
              305,000
              
              
              $
              679,000
              
              
              $
              6,814,000
              
              
              $
              2,123,000Government
      contracts and services
              
              
              248,000
              
              
              
              110,000
              
              
              
              1,206,000
              
              
              
              382,000553,000
              
              
              
              789,000
              
              
              
              8,020,000
              
              
              
              2,505,000Cost
      of revenues
              
              
              333,000
              
              
              
              580,000
              
              
              
              4,386,000
              
              
              
              1,809,000Gross
      margin
              
              
              220,000
              
              
              
              209,000
              
              
              
              3,634,000
              
              
              
              696,000Operating
      expenses:Research
      and development
              
              
              809,000
              
              
              
              821,000
              
              
              
              2,580,000
              
              
              
              2,135,000Selling,
      general and administrative
              
              
              1,898,000
              
              
              
              1,331,000
              
              
              
              5,825,000
              
              
              
              4,176,000Litigation
      settlement
              
              
              5,700,000
              
              
              
              -
              
              
              
              5,700,000
              
              
              
              -8,407,000
              
              
              
              2,152,000
              
              
              
              14,105,000
              
              
              
              6,311,000Loss
      from operations
              
              
              (8,187,000
              )
              
              
              (1,943,000
              )
              
              
              (10,471,000
              )
              
              
              (5,615,000
              )Other
      income (expense), net:Interest
      income
              
              
              15,000
              
              
              
              28,000
              
              
              
              35,000
              
              
              
              193,000Interest
      expense
              
              
              (377,000
              )
              
              
              (21,000
              )
              
              
              (1,182,000
              )
              
              
              (82,000
              )Equity
      in losses in unconsolidated subsidiary
              
              
              -
              
              
              
              -
              
              
              
              (123,000
              )
              
              
              -Gain
      on transfer of investment
              
              
              -
              
              
              
              -
              
              
              
              468,000
              
              
              
              -Change
      in fair value of embedded derivatives related to
                preferred
      stock features
              
              
              -
              
              
              
              (97,000
              )
              
              
              -
              
              
              
              36,000Total
      other (expense) income, net
              
              
              (362,000
              )
              
              
              (90,000
              )
              
              
              (802,000
              )
              
              
              147,000Loss
      from continuing operations
              
              
              (8,549,000
              )
              
              
              (2,033,000
              )
              
              
              (11,273,000
              )
              
              
              (5,468,000
              )Preferred
      distribution, dividends and accretion
              
              
              -
              
              
              
              (249,000
              )
              
              
              (207,000
              )
              
              
              (845,000
              )Loss
      from continuing operations applicable to commonshareholders
              
              
              (8,549,000
              )
              
              
              (2,282,000
              )
              
              
              (11,480,000
              )
              
              
              (6,313,000
              )(Loss)
      income from discontinued operations, before sale of discontinued
      operations
              
              
              (43,000
              )
              
              
              504,000
              
              
              
              954,000
              
              
              
              (3,078,000
              )Gain on
      sale of discontinued operations
              
              
              -
              
              
              
              -
              
              
              
              22,000
              
              
              
              -(Loss)
      income from discontinued operations
              
              
              (43,000
              )
              
              
              504,000
              
              
              
              976,000
              
              
              
              (3,078,000
              )Net
      loss applicable to common shareholders
              
              $
              (8,592,000
              )
              
              $
              (1,778,000
              )
              
              $
              (10,504,000
              )
              
              $
              (9,391,000
              )Net
      loss
              
              $
              (8,592,000
              )
              
              $
              (1,529,000
              )
              
              $
              (10,297,000
              )
              
              $
              (8,546,000
              )Loss
      per share from continuing operations, basic and diluted
              
              $
              (0.60
              )
              
              $
              (0.17
              )
              
              $
              (0.81
              )
              
              $
              (0.46
              )Loss
      per share from continuing operations applicable to
                common
      shareholders, basic and diluted
              
              $
              (0.60
              )
              
              $
              (0.19
              )
              
              $
              (0.82
              )
              
              $
              (0.53
              )(Loss)
      income per share from discontinued operations, basic
                and
      diluted
              
              $
              (0.00
              )
              
              $
              0.04
              
              
              $
              0.07
              
              
              $
              (0.26
              )Net
      loss per share applicable to common shareholders,
                basic
      and diluted
              
              $
              (0.61
              )
              
              $
              (0.15
              )
              
              $
              (0.75
              )
              
              $
              (0.79
              )Net
      income (loss) per share
              
              $
              (0.61
              )
              
              $
              (0.13
              )
              
              $
              (0.74
              )
              
              $
              (0.72
              )Weighted
      average shares used in computing net loss
                per
      common share, basic and diluted
              
              
              14,154,990
              
              
              
              11,956,189
              
              
              
              13,919,545
              
              
              
              11,879,350


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




4





Implant
      Sciences CorporationCondensed
      Consolidated Statements of Cash Flows(unaudited)For
      the Nine Months EndedMarch
      312009
            
            
            2008Cash
      flows from operating activities:Net
      loss
            
            $
            (10,297,000
            )
            
            $
            (8,546,000
            )Less:  Net
      income (loss) from discontinued operations
            
            
            976,000
            
            
            
            (3,078,000
            )Loss
      from continuing operations
            
            
            (11,273,000
            )
            
            
            (5,468,000
            )Adjustments
      to reconcile net loss from continuing operationsto
      net cash flows from operating activities:Depreciation
      and amortization
            
            
            207,000
            
            
            
            127,000Bad
      debt expense
            
            
            55,000
            
            
            
            28,000Share-based
      compensation expense
            
            
            278,000
            
            
            
            515,000Loss
      on disposal of fixed asset
            
            
            10,000
            
            
            
            -Change
      in fair value of embedded derivatives
            
            
            -
            
            
            
            (36,000
            )Non-cash
      interest expense
            
            
            904,000
            
            
            
            -Fair
      value of warrants issued to non-employees
            
            
            (17,000
            )
            
            
            -Warrant
      accretion on debt
            
            
            56,000
            
            
            
            9,000Equity
      in loss of unconsolidated subsidiary
            
            
            123,000
            
            
            
            -Gain
      on transfer of investment
            
            
            (468,000
            )
            
            
            -Litigation
      settlement
            
            
            5,700,000
            
            
            
            -Interest
      income on note receivable
            
            
            (6,000
            )
            
            
            -Changes
      in assets and liabilities, net of effect of acquisitions and
      dispositions:Accounts
      receivable
            
            
            532,000
            
            
            
            147,000Inventories
            
            
            246,000
            
            
            
            117,000Prepaid
      expenses and other current assets
            
            
            (340,000
            )
            
            
            (13,000
            )Accounts
      payable
            
            
            1,173,000
            
            
            
            404,000Accrued
      expenses
            
            
            (127,000
            )
            
            
            (315,000
            )Deferred
      revenue
            
            
            (49,000
            )
            
            
            259,000Lease
      liability
            
            
            (319,000
            )
            
            
            -Net
      cash used in operating activities of continuing operations
            
            
            (3,315,000
            )
            
            
            (4,226,000
            )Net
      cash provided by (used in) operating activities of discontinued
      operations
            
            
            59,000
            
            
            
            (506,000
            )Net
      cash used in operating activities
            
            
            (3,256,000
            )
            
            
            (4,732,000
            )Cash
      flows from investing activities:Purchases
      of property and equipment
            
            
            (16,000
            )
            
            
            (74,000
            )Proceeds
      from (investment in) certificates of deposit
            
            
            25,000
            
            
            
            (50,000
            )Payments
      received on note receivable
            
            
            654,000
            
            
            
            -Proceeds
      from sale of property and equipment, net of transaction
    costs
            
            
            1,459,000
            
            
            
            -Proceeds
      from the sale of Core Systems, net of transaction costs
            
            
            1,080,000
            
            
            
            -(Decrease)
      increase in other non-current assets
            
            
            18,000
            
            
            
            -Net
      cash provided by (used in) investing activities of continuing
      operations
            
            
            3,220,000
            
            
            
            (124,000
            )Net
      cash used in investing activities of discontinued
    operations
            
            
            (28,000
            )
            
            
            (271,000
            )Net
      cash provided by (used in) investing activities
            
            
            3,192,000
            
            
            
            (395,000
            )Cash
      flows from financing activities:Proceeds
      from common stock issued in connection with exercise of stock options
      and
              employee
      stock purchase plan
            
            
            24,000
            
            
            
            52,000Proceeds
      from the issuance of Senior Secured Convertible Promissory
      Note
            
            
            4,734,000
            
            
            
            -Principal
      payment on Senior Secured Convertible Promissory Note
            
            
            (1,000,000
            )
            
            
            -Dividends
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
            
            
            (52,000
            )
            
            
            (222,000
            )Payments
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
            
            
            (2,724,000
            )
            
            
            (1,060,000
            )Principal
      repayments of long-term debt and capital lease obligations
            
            
            (336,000
            )
            
            
            (1,068,000
            )Net
      (repayments) proceeds on line of credit
            
            
            (764,000
            )
            
            
            227,000Net
      cash used in financing activities of continuing operations
            
            
            (118,000
            )
            
            
            (2,071,000
            )Net
      cash used in discontinued operations
            
            
            (1,000
            )
            
            
            (2,000
            )Net
      cash used in financing activities
            
            
            (119,000
            )
            
            
            (2,073,000
            )Net
      change in cash and cash equivalents
            
            
            (183,000
            )
            
            
            (7,200,000
            )Cash
      and cash equivalents at beginning of period
            
            
            412,000
            
            
            
            9,621,000Cash
      and cash equivalents at end of period
            
            $
            229,000
            
            
            $
            2,421,000


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








5
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS


1.
            Description
      of Business




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




Acquisition
of Ion Metrics




In April
2008, the Company acquired all of the capital stock of Ion Metrics, Inc, a
California corporation.  Ion Metrics is in the business of producing
low cost mass sensor systems for the detection and analysis of chemical
compounds such as explosives, chemical warfare agents, narcotics, and toxic
industrial chemicals for the homeland defense, forensic, environmental, and
safety/security markets. The transaction was structured as a reorganization of
Ion Metrics with and into a newly formed, wholly-owned subsidiary of the
Company.  The total purchase price, including $564,000 of assumed
liabilities, was approximately $3,309,000.  As part of the
transaction, the Company issued to the former stockholders of Ion Metrics
consideration consisting of 2,000,000 shares of the Company’s common stock, par
value $0.10 per share. The integration of the Ion Metrics technologies into the
Company’s Quantum Sniffer product line is expected to provide opportunities to
introduce smaller, lower cost, and higher performance security
solutions.  Please refer to Note 18 for further information relative
to the acquisition of Ion Metrics.




Sale
of Accurel




In May
2007, the Company sold substantially all of the assets of our Accurel Systems
subsidiary to Evans Analytical Group, LLC for approximately $12,705,000,
including $1,000,000 held by an escrow agent as security for certain
representations and warranties.  In February 2008, Evans filed suit in
the Superior Court of the State of California, Santa Clara County, requesting
rescission of the asset purchase agreement, plus damages, based on claims of
misrepresentation and fraud.  In March 2008, Evans filed a notice with
the escrow agent prohibiting release of any portion of the escrow to us pending
resolution of the lawsuit.  On March 27, 2009, the Company announced
the settlement of this litigation and the mutual release by the Company and
Evans of all claims related to the sale of Accurel.  In settling this
litigation, the Company agreed to pay Evans damages in the amount of
approximately $5,700,000 by (i) agreeing to release to Evans approximately
$700,000 that had been held in escrow since the time of the closing of the
Accurel sale and (ii) agreeing to issue to Evans 1,000,000 shares of a new
series of preferred stock having an aggregate liquidation preference of
$5,000,000.  On April 8, 2009, approximately $700,000 of the funds
held in escrow were released to Evans and $300,000, the balance of the escrow
amount was released to the Company.




Sale
of Core




On
November 14, 2008, the Company and its wholly owned semiconductor subsidiary C
Acquisition Corp., which had operated under the name Core Systems (the
“Subsidiary”), entered into a definitive agreement, with Core Systems
Incorporated, an entity newly formed by the Subsidiary’s general manager and
certain other investors (the “Buyer”), to sell substantially all of Core
Systems’ assets for a purchase price of $3,000,000 plus the assumption of
certain liabilities.  The Buyer made a cash down payment of $250,000
prior to the execution of the definitive agreement.  On November 24,
2008, the parties amended the agreement and completed the asset
sale.  On that date, the Buyer made a cash payment of $1,125,000 and
issued a promissory note in the amount of $1,625,000.  The promissory
note required the Buyer to pay the Subsidiary $125,000 on or before November 28,
2008, an additional $500,000 on or before December 24, 2008, and the remaining
principal balance, together with accrued interest, in equal monthly installments
over a period of 60 months commencing on February 1, 2009.  The Buyer and
the Subsidiary also executed a security agreement, pursuant to which the Buyer
granted the Subsidiary a security interest in all of the Buyer’s assets to
secure its obligations under the promissory note.  The Buyer paid
$250,000 of the amount due in December, paid the remaining $250,000 balance due
on the December payment on March 20, 2009 and has paid all monthly installments
due on the note.











6
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS


Sale
of Medical Reporting Unit




In June
2007, the Company sold certain of the assets related to its brachytherapy
products and divested the prostate seed and medical software
businesses.  In March 2008, the Company informed its medical coatings
customers of its intention to discontinue coating operations by the end of the
2008 calendar year.  During the nine months ended March 31, 2009,
under three separate asset purchase agreements, the Company sold certain assets
of its medical coatings business, with gross proceeds aggregating approximately
$1,591,000.  The Medical Reporting Unit is reported as discontinued
operations in the accompanying financial statements.




CorNova




The
Company had partnered with CorNova, Inc., a privately-held, development stage
company focused on the development of a next-generation drug-eluting stent, and
was issued 1,500,000 shares of CorNova’s common stock representing a 15%
ownership interest.  On December 10, 2008, the Company transferred its
CorNova shares in connection with the issuance of the Senior Secured Convertible
Promissory Note (See Note 11).




Risks
and Uncertainties




The
Company's condensed consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of
business.  The Company has suffered recurring losses from operations
and must repay in full the balance of the senior secured convertible promissory
note (see Note 11) on December 10, 2009.  The senior secured
convertible promissory note was recorded at $3,741,000 as of March 31, 2009 and
has a liquidation value of $4,600,000.  These conditions raise
substantial doubt about the Company's ability to continue as a going
concern.  The financial statements do not include any adjustments
relating to the recoverability and classification of asset amounts or the
amounts and classification of liabilities that might be necessary should the
Company be unable to continue as a going concern.




While the
Company strives to bring new products to market, it is subject to a number of
risks similar to other technology-based companies, including risks related to:
(a) its dependence on key individuals and collaborative research partners; (b)
competition from substitute products and larger companies; (c) its ability to
develop and market commercially usable products and obtain regulatory approval
for its products under development; and (d) its ability to obtain substantial
additional financing necessary to adequately fund the development,
commercialization and marketing of its products.  For the nine months
ended March 31, 2009, the Company reported net loss applicable to common
shareholders of $10,504,000, loss from continuing operations of $11,273,000 and
used $3,315,000 in cash from operating activities of continuing operations.
 As of March 31, 2009, the Company had an accumulated deficit of
approximately $70,224,000 and a working capital deficit of
$7,088,000.  Management continually evaluates plans to reduce its
operating expenses and increase its cash flow from operations.  Failure of
the Company to achieve its projections may require the Company to seek
additional financing or discontinue operations.




In June,
August, October and November 2008, the Company entered into a series of
amendments, waivers and modifications to its credit agreements with Bridge Bank,
N.A., pursuant to which, in exchange for the payment by the Company of
forbearance fees in the amount of $90,000, the bank waived certain existing and
anticipated defaults, the bank reduced the Company’s credit line to $1,500,000
from $5,000,000, and the bank extended the modified facility through December
10, 2008. On December 10, 2008, the Company used approximately $477,000 of the
proceeds of the sale of the senior secured convertible promissory note (see Note
11) to repay all of the indebtedness outstanding to the bank and the credit
facility was terminated.  As of March 31, 2009 and June 30, 2008, the
Company’s obligation for borrowed funds under the credit facility amounted to $0
and $862,000, respectively.




On
December 10, 2008, the Company entered into a Note and Warrant Purchase
Agreement with DMRJ Group LLC, an accredited institutional investor, pursuant to
which the Company 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 Company valued the note at issuance at its residual
value of $4,356,000 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 CorNova common stock and the original issue
discount.  As required under the terms of the note, the Company made a
principal payment of $1,000,000 on December 24, 2008.  The note
requires the Company to make a principal payment in an amount equal to any funds
released from the escrow created in connection with the May 2007 sale of the
assets of Accurel Systems International, upon the




7
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




release
of such funds.  DMRJ waived the requirement that the Company make a
principal payment in an amount equal to the amount of the escrow funds released
in connection with the Evans litigation settlement.  The remaining
principal balance, together with outstanding interest, is due and payable on
December 10, 2009.  The note bears interest at 11.0% per
annum.  The Company prepaid interest in the amount of $616,000 upon
the issuance of the note.  On March 12, 2009, the
Company entered into a letter agreement with DMRJ pursuant to which we were
granted access to $250,000 of previously restricted cash 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.  The
Company is required to maintain a minimum balance of not less than $500,000 in
the blocked account on or after April 15, 2009.  As of April 15, 2009, the
Company was not in compliance with the $500,000 minimum cash balance required,
which event of noncompliance was waived by DMRJ.  In consideration of
the letter agreement, on March 12, 2009, we issued to DMRJ an Amended
and Restated Senior Secured Convertible Promissory Note and an Amended and
Restated Warrant to Purchase Shares of Common Stock, which replaced the
note and warrant issued on December 10, 2008.  The terms of the amended and
restated note and warrant are identical to the terms of the original note and
warrant except that the amended document 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.  As of
March 31, 2009, the outstanding balance on the amended and restated
note was $3,741,000, and the liquidation value was
$4,600,000.  The note contains restrictions and financial
covenants including a requirement that the Company maintain a current ratio,
defined as current assets minus current liabilities, of no less than 0.60 to
1.00 and requires that the aggregate dollar amount of all accounts payable to be
no more than one hundred (100) days past due.  As of March 31, 2009,
the Company’s current ratio was 0.35 to 1.00 and the Company’s aggregate dollar
amount of all accounts payable exceeded one hundred days past due, as such the
Company is not in compliance with the required current ratio and accounts
payable financial covenants.  The Company has requested a waiver for
these events of noncompliance.




If the
Company is unable to obtain a waiver, DMRJ may declare the entire unpaid
principal balance of the note, together with all interest accrued hereon, plus
fees and expenses, due and payable.  Any such action by DMRJ would
have a material adverse effect on the Company’s liquidity and financial
condition and could require the Company to curtail or discontinue all
of its operations.  The Company’s ability to comply with its debt
covenants in the future depends on its ability to generate sufficient sales
and control its expenses, and will require the Company to seek additional
capital through private financing sources.  There can be no assurances
that the Company will achieve its forecasted financial results or that it will
be able to raise additional capital to operate its business.  Any such
failure would have a material adverse impact on the Company's liquidity and
financial condition and could require the Company to curtail or
discontinue operations entirely.  Further, upon the occurrence of an
event of default under certain provisions of the amended and
restated note, the Company could be required to pay default rate interest
equal to the lesser of two and one half percent (2.5%) per month and the maximum
applicable legal rate per annum on the outstanding principal balance of the
note.




Management
believes there are plans in place to sustain operations for the near
future.  These plans depend on current sales, expense and cash flow
projections, a substantial increase in sales of the Company’s handheld trace
explosives detector product and the ability of the Company to raise additional
capital.  To further sustain the Company, improve its cash position,
and enable it to grow while reducing debt, management will need to seek
additional capital through private financing sources during the fourth quarter
of fiscal 2009.  However, there can be no assurance that management
will be successful in executing these plans.  Management will continue
to closely monitor and attempt to control costs at the Company and actively seek
needed capital through sales of its products, equity infusions, government
grants and awards, strategic alliances, and through its lending
institutions.




Under its
agreements with Laurus Master Fund, Ltd. and its affiliates, the Company had
been required to redeem its Series D Cumulative Redeemable Convertible Preferred
Stock on a monthly basis, with the final redemption payment to be made in
September 2008.  The Company received a waiver of the monthly
redemption payments for the period December 2006 through August 2007 and, in
September 2007, the Company resumed making monthly redemptions.  In
September, 2008, Laurus agreed to extend the final redemption date to October
24, 2008 in exchange for a redemption payment of $250,000, including $22,000 of
accrued dividends.  The Company did not meet its redemption obligation
on October 24, 2008 and, on November 4, 2008, Laurus and the Company again
amended their agreements, effective as of October 31, 2008, to provide that the
amount necessary to redeem in full the Series D Preferred Stock would be
approximately $2,461,000, together with accrued and unpaid
dividends.  Under these amendments, the Company agreed to make monthly
redemption payments through a new final




8
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS






redemption
date of April 10, 2009.  The Company redeemed $268,000 of the $518,000
of Series D Preferred Stock required to be redeemed as of the October 31, 2008
redemption date by agreeing to issue 929,535 shares of its common stock, and
redeemed the balance with a cash payment of $250,000.  On December 10,
2008, the Company used approximately $1,161,000 of the proceeds of the sale of
the senior secured convertible promissory note (see Note 11) to redeem in full
all of its outstanding Series D Preferred Stock.  As of March 31, 2009
and June 30, 2008, the Company’s obligation to redeem the Series D Preferred
Stock amounted to $0 and $2,424,000, respectively.  At March 31,
2009, $268,000, representing the fair value of the unissued shares of the
Company’s common stock is included in current liabilities.  In May 2009,
the Company issued the 929,535 shares to Laurus Master Fund, Ltd.




There can
be no assurances that forecasted results will be achieved or that the Company
will be able to raise additional capital necessary to operate the
business.  These conditions raise substantial doubt about the
Company's ability to continue as a going concern.  The financial
statements do not include any adjustments relating to the recoverability and
classification of asset amounts or the amounts and classification of liabilities
that might be necessary should the Company be unable to continue as a going
concern.




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




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




2.
            Interim
      Financial Statements and Basis of
Presentation




The
accompanying condensed consolidated financial statements of the Company have
been prepared in accordance with U.S. generally accepted accounting principles
(“U.S. GAAP”).  In the opinion of management, the accompanying
condensed consolidated financials statements include all adjustments (consisting
only of normal recurring adjustments), which the Company considers necessary for
a fair presentation of the financial position at such date and of the operating
results and cash flows for the periods presented.  The results of
operations and cash flows for the three and nine months ended March 31, 2009 may
not necessarily be indicative of results that may be expected for any succeeding
quarter or for the entire fiscal year.  The information contained in
this Form 10-Q should be read in conjunction with the Company’s audited
financial statements, included in its Form 10-K, as amended, as of and for the
year ended June 30, 2008.




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




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




As a
result of the Company’s decision to dispose of its Core Systems business, the
assets and liabilities of Core are presented in the accompanying condensed
consolidated balance sheet as assets and liabilities held for sale as of June
30, 2008 and the operating results of Core are presented in the accompanying
condensed consolidated statements of operations as discontinued operations for
the three and nine months ended March 31, 2009 and 2008.




As a
result of the Company’s decision to dispose of the medical business unit, the
assets and liabilities of the medical business unit are presented in the
accompanying condensed consolidated balance sheet as assets and liabilities held
for sale as of March 31, 2009 and June 30, 2008, and the operating results of
the medical business unit are presented in the accompanying condensed
consolidated statements of operations as discontinued operations for the three
and nine months ended March 31, 2009 and 2008.




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




9
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




Significant
accounting policies are described in Note 2 to the financial statements included
in Item 7 of the Company’s Form 10-K, as amended, for the fiscal year
ended June 30, 2008.  The preparation of financial statements in
conformity with U.S. GAAP requires management to make estimates and judgments,
which are evaluated on an ongoing basis, that affect the amounts reported in the
Company's condensed consolidated financial statements and accompanying
notes.  Management bases its estimates on historical experience and on
various other assumptions that it believes are reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities and the amounts of revenues and
expenses that are not readily apparent from other








sources.  Actual
results could differ from those estimates and judgments.  In
particular, significant estimates and judgments include those related to revenue
recognition, allowance for doubtful accounts, useful lives of property and
equipment, inventory reserves, valuation for goodwill and acquired intangible
assets, and realization of amounts held in escrow.




Certain
reclassifications were made to the financial statements for the three and nine
months ended March 31, 2008 to conform to the presentation for the three and
nine months ended March 31, 2009.




3.
            Fair
      Value Measurement




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




Financial
assets and liabilities are classified in their entirety based on the lowest
level of input that is significant to the fair value
measurement.  Under SFAS No. 157, the Company’s cash and cash
equivalents, which had a balance of approximately $229,000, was required to be
measured at fair value at March 31, 2009 and the balance was included in Level 1
inputs.




4.
            Restricted
      Cash




As of
March 31, 2009 and June 30, 2008, the Company had restricted cash of $1,739,000
and $514,000, respectively.  Restricted cash consisted of the
following:


March
      31,
              
              
              June
      30,2009
              
              
              2008Money
      market account
              
              $
              439,000
              
              
              $
              439,000Funds
      held in escrow
              
              
              1,000,000
              
              
              
              -Certificates
      of deposit
              
              
              50,000
              
              
              
              75,000Blocked
      account deposit
              
              
              250,000
              
              
              
              -$
              1,739,000
              
              
              $
              514,000


The
restricted cash of $439,000 held in a money market account collateralizes the
Company’s performance under an irrevocable letter of credit issued on June 25,
2008, in the amount of $418,000.  The letter of credit provides
performance security equal to 10% of the contract amount for security product
which shipped in the first quarter of fiscal 2009.  The restricted
funds of $50,000 and $75,000 deposited in certificates of deposit,
collateralizes credit cards issued by the Company’s primary
lender.  Pursuant to its agreements with DMRJ (See Note 11), the
Company is 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,  the Company deposited $500,000 into a bank account
pursuant to the blocked account agreement.  On March 12, 2009, the
Company and DMRJ entered into a letter agreement to which DMRJ granted the
Company access to $250,000 of the funds held in the blocked account for a period
commencing on March 12, 2009 and ending April 14, 2009 at which date
the Company is required to maintain a minimum balance of not less that $500,000
in the blocked account.  As of April 15, 2009, the Company was not in
compliance with the $500,000 minimum cash balance requirement, which event of
noncompliance was waived by DMRJ.




In May 1,
2007, the Company sold substantially all of the assets of our Accurel Systems
subsidiary to Evans Analytical Group, LLC and entered into an escrow agreement
with Evans, Accurel, and Zions First National Bank.




10
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS






Pursuant
to the escrow agreement, Evans deposited $1,000,000 of the total purchase price
for the assets into an escrow account.  On March 27, 2009, the Company
announced the settlement of litigation with Evans and the mutual
release by the Company and Evans of all claims related to the sale of
Accurel.  As part of the settlelment, on April 8, 2009, approximately
$700,000 of the funds held in escrow since the closing of the Accurel sale were
released to Evans and $300,000, the balance of the escrow amount, was released
to the Company.




5.
            Stock
      Based Compensation




The
Company’s condensed consolidated statements of operations for the three months
ended March 31, 2009 and 2008 include $131,000 and $168,000, respectively, of
compensation costs and no income tax benefit related to the Company’s
stock-based compensation arrangements for employee and non-employee director
awards.  For the nine months ended March 31, 2009 and 2008, the
condensed consolidated statements of operations include $278,000 and $515,000,
respectively, of compensation costs and no income tax benefit related to the
Company’s stock-based compensation arrangements for employees and non-employee
director awards.  As of March 31, 2009, the total amount of
unrecognized stock-based compensation expense was approximately $315,000, which
will be recognized over a weighted average period of 2.5 years.




6.
            Related
      Party Transactions




SFAS No.
57, “Related Party
Disclosures,” specifies the nature of information that is required to be
disclosed in financial statements regarding related party
transactions.  The former chairman of Ion Metrics, Inc., which was
acquired by the Company on April 10, 2008, serves as a Managing Director of a
merger and acquisition and management advisory company that was engaged by the
Company to market the Company’s wholly-owned Core Systems
subsidiary.  During the three months ended March 31, 2009 and 2008,
this advisory company was paid $0 and $25,000, respectively.  During
the nine months ended March 31, 2009 and 2008, the advisory company was paid
$138,000 and $25,000, respectively.  As of March 31, 2009, the Company
recorded payables to the advisory company of $7,000.




In
connection with the April 2008 acquisition of Ion Metrics, the Company entered
into a board observer rights agreement, providing for, among other things, the
right of one representative of Ion Metrics’ former shareholders to attend
meetings of the Company’s board of directors as an observer, which role has been
represented by the former chairman of Ion Metrics.  On October 13,
2008, the Company and Ion Metrics’ former shareholders agreed to terminate the
board observer rights agreement and agreed to terminate the related escrow
agreement, as further described in Note 18.  Further, the Company has
entered into a fixed asset lease agreement with Ferran Scientific, Inc., a firm
owned by the father of the former Ion Metrics chairman.




7.
            Inventories




Inventories
consist of the following:


March
      31,
              
              
              June
      30,2009
              
              
              2008Raw
      materials
              
              $
              169,000
              
              
              $
              400,000Work
      in progress
              
              
              30,000
              
              
              
              23,000Finished
      goods
              
              
              280,000
              
              
              
              302,000$
              479,000
              
              
              $
              725,000


11
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




8.
            Property
      and Equipment




Property
and equipment consist of the following:


March
      31,
              
              
              June
      30,2009
              
              
              2008Machinery
      and equipment
              
              $
              509,000
              
              
              $
              517,000Computers
      and software
              
              
              876,000
              
              
              
              871,000Furniture
      and fixtures
              
              
              166,000
              
              
              
              164,000Leasehold
      improvements
              
              
              62,000
              
              
              
              369,000Equipment
      under capital lease
              
              
              93,000
              
              
              
              93,0001,706,000
              
              
              
              2,014,000Less:  accumulated
      depreciation and amortization
              
              
              1,350,000
              
              
              
              1,571,000$
              356,000
              
              
              $
              443,000


For the
three months ended March 31, 2009 and 2008, depreciation expense was $55,000 and
$44,000, respectively.  For the nine months ended March 31, 2009 and
2008, depreciation expense was $155,000 and $127,000, respectively.




9.
            Accrued
      Expenses




Accrued
expenses consist of the following:


March
      31,
              
              
              June
      30,2009
              
              
              2008Accrued
      compensation and benefits
              
              $
              425,000
              
              
              $
              807,000Accrued
      taxes
              
              
              472,000
              
              
              
              289,000Accrued
      legal and accounting
              
              
              337,000
              
              
              
              259,000Accrued
      interest
              
              
              5,000
              
              
              
              46,000Accrued
      warranty costs
              
              
              227,000
              
              
              
              104,000Litigation
      settlement
              
              
              700,000
              
              
              
              -Other
      accrued liabilities
              
              
              797,000
              
              
              
              557,000$
              2,963,000
              
              
              $
              2,062,000


10.
            Earnings
      Per Share




The
Company follows SFAS No. 128, “Earnings Per Share,” where
basic earnings per share is computed by dividing net income (loss) by the
weighted average number of common shares outstanding during the
period.  Diluted earnings per share are based upon the weighted
average number of common shares outstanding during the period plus additional
weighted average common equivalent shares outstanding during the
period.  Common equivalent shares result from the assumed exercise of
outstanding stock options and warrants, the proceeds of which are then assumed
to have been used to repurchase outstanding common stock using the treasury
stock method.  In addition, the numerator is adjusted for any changes
in income or loss that would result from the assumed conversion of potential
shares.  As of March 31, 2009 and 2008, there were no potentially
dilutive shares, which shares were excluded from the earnings per share
calculation because their effect would be antidilutive.  Shares deemed
to be antidilutive include stock options and warrants.




11.
            Long-Term
      Debt and Credit Arrangements




Med-Tec
Payment Obligation




In July
2003, the Company entered into an asset purchase agreement with Med-Tec Iowa,
Inc., its former exclusive distributor of prostate seeds, to purchase Med-Tec’s
customer lists and to release one another 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 its estimated useful life of 29 months.  The
outstanding and past due principal balance as of March 31, 2009 and June 30,
2008 was approximately $59,000, and $80,000 respectively.




12
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




Revolving
Credit Facility and Term Note




In June
2005, the Company executed a revolving credit facility for $1,500,000 with
Silicon Valley-based Bridge Bank, N.A.  On January 3, 2007, the
revolving credit facility was increased from $1,500,000 to
$5,000,000.  In June, August, October and November, the Company
entered into a series of further amendments, waivers and modifications to its
credit agreements with Bridge Bank, pursuant to which, in exchange for the
payment by the Company of forbearance fees in the amount of $90,000, the bank
waived certain existing and anticipated defaults, the bank reduced the Company’s
credit line to $1,500,000 from $5,000,000, and the bank extended the modified
facility through December 10, 2008.  On December 10, 2008, the Company
used approximately $477,000 of the proceeds of the sale of the senior secured
convertible promissory note to DMRJ to repay all of the indebtedness outstanding
to the bank and the credit facility was terminated.  As of March 31,
2009 and June 30, 2008, the Company’s obligation for borrowed funds under the
credit facility amounted to $0 and $862,000, respectively.





Pursuant
to the original loan agreement with Bridge Bank, the Company issued to the bank
a seven-year warrant to purchase up to 18,939 shares of the Company’s common
stock at a price equal to $2.64 per share.  The warrant was valued
using the Black-Scholes model.  Pursuant to APB No. 14, “Accounting for Convertible Debt and Debt Issued with
Stock Purchase Warrants,” the warrant was recorded at its relative fair
value of $28,000 and accreted to the term note over the life of the
note.  As of March 31, 2009, approximately $28,000 has been
amortized.  Pursuant to an amendment to the loan agreement, the
Company issued to the Bank a seven-year warrant to purchase up to 43,860
additional shares of the Company’s common stock at a price equal to $1.14 per
share.  The warrant was valued using the Black-Scholes
model.  Pursuant to APB No. 14, the warrant was recorded at its
relative fair value of $29,000 and was charged to interest expense during the
year ended June 30, 2008.




Senior
Secured Convertible Promissory Note




On
December 10, 2008, the Company entered into a Note and Warrant Purchase
Agreement  with DMRJ Group LLC, an accredited institutional investor,
pursuant to which the Company 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 the Company’s common stock.  The note bears interest at
11.0% per annum and is collateralized by all of the assets of the
Company.  The effective interest rate on the note is approximately
23.4%.  The Company 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 issuance of the note, the
Company transferred its entire interest in 1,500,000 shares of the common stock
of CorNova, 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 the Company’s common stock at an initial conversion price of $0.26 per
share.




The
Company valued the note at issuance at its residual value of $4,356,000 based on
the fair values of the financial instruments issued in connection with this
convertible debt financing, including the warrant, the original issue discount
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
$160,000 allocated to warrants, $616,000 of original issue discount and $468,000
representing the estimated fair value of the CorNova common
stock.  The fair value of the CorNova common stock was determined
based on the Company’s estimate of a market-equivalent fee, factoring in the
Company’s liquidity and financial condition on the date of the note
issuance.  The warrant was valued using the Black-Scholes model with
the following assumptions:  volatility 93.7%, risk-free interest rate
of 2.82%, expected life of five years and expected dividend yield of 0.00%.
As required under
the terms ofthe
note, the Company made a principal payment of $1,000,000 on December 24,
2008.  The note requires the Company to make a principal payment in an
amount equal to any funds released from the escrow created in connection with
the May 2007 sale of the assets of Accurel Systems International, upon the
release of such funds.  DMRJ waived the requirement that the Company
make a principal payment in an amount equal to the amount of the escrow
funds released in connection with the Evans litigation settlement.  The
remaining principal balance, together with outstanding interest, is due and
payable on December 10, 2009.




On March 12,
2009, the Company entered into a letter agreement with DMRJ, pursuant to which
the Company was granted access to $250,000 to previously restricted cash 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.  The
Company is required to maintain a minimum balance of not less than $500,000 in
the blocked account on and after April 15, 2009.  As of April 15, 2009, the
Company was not in compliance with the $500,000 minimum cash balance
requuirement, which event of noncompliance was waived by DMRJ. In
consideration of the letter agreement, on March 12, 2009, the Company issued to
DMRJ an Amended and Restated the Senior Secured Convertible Promissory Note and
an Amended and Restated Warrant to Purchase Shares of Common
Stock,  which replaced the note and warrant issued on December 10,
2008. The effect of the reduction in the exercise price of the warrants was
immaterial.  The terms of the amended and restated note and the amended and
restated warrant are identical to the terms of the original note and thewarrantexcept
that the amended documents 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.




13
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




Approximately
$40,000 and $49,000, respectively, of the warrant value was accounted for as
interest expense in the three and nine months ended March 31,
2009.  The Company is accreting the warrant on the carrying value of
the convertible debt to its redemption value at December 10, 2009, or the actual
conversion date, whichever is earlier.  Further, the Company accreted
approximately $265,000 and $336,000, respectively, of the original issue
discount and fair value of the CorNova common stock in the three and nine months
ended March 31, 2009, which was recorded as interest expense in the statement of
operations.  As of March 31, 2009, the outstanding balance on the Note
was $3,741,000, the liquidation value was $4,600,000 as of that
date.




12.
            Redeemable
      Convertible Preferred Stock




On
September 30, 2005, the Company issued 500,000 shares of Series D Cumulative
Redeemable Convertible Preferred Stock, having a stated value of $10 per share,
pursuant to a securities purchase agreement with Laurus Master Fund, Ltd. for
gross cash proceeds of $5,000,000.  The Series D Preferred Stock had a
dividend equal to the prime rate plus one percent (1%) and originally provided
for redemption over a thirty-six month period, pursuant to an amortization
schedule.




The
Company received a waiver of the monthly redemption payments for the period
December 2006 through August 2007 and, in September 2007, the Company resumed
making monthly redemptions. In September, 2008, Laurus agreed to extend the
final redemption date to October 24, 2008 in exchange for a redemption payment
of $250,000, including $22,000 of accrued dividends.  The Company did
not meet its redemption obligation on October 24, 2008 and, on November 4, 2008,
Laurus and the Company again amended their agreements, effective as of October
31, 2008, to provide that the amount necessary to redeem in full the Series D
Preferred Stock would be approximately $2,461,000, together with accrued and
unpaid dividends.  The agreed upon redemption amount for the Series D
Preferred Stock included a penalty of approximately $568,000, which amount was
charged to interest expense in the nine months ended March 31,
2009.




Under
these amendments, the Company agreed to make monthly redemption payments through
a new final redemption date of April 10, 2009.  The Company redeemed
$268,000 of the $518,000 of Series D Preferred Stock required to be redeemed as
of the October 31, 2008 redemption date by agreeing to issue 929,535 shares of
its common stock to an affiliate of Laurus, and redeemed the balance with a cash
payment of $250,000.  The shares were valued at $0.28829 per share,
which was equal to the volume-weighted average price of the Company’s common
stock as reported by Bloomberg, L.P. for the 15-day period immediately preceding
the date of the amendment.  The holder has agreed, with certain
exceptions, not to transfer any of these shares or any interest therein,
directly or indirectly, prior to April 30, 2009.  The Company has the
right to repurchase up to 50% of the issued shares prior to April 30, 2009 at a
price per share equal to 110% of volume-weighted average price of the common
stock as reported by Bloomberg, L.P. for the 15-day period immediately preceding
the date upon which the holder receives notice of the Company’s desire to
repurchase such Payment shares.




The
Company valued the Series D Preferred Stock at issuance at its residual value of
$2,700,000 based on the fair values of the financial instruments issued in
connection with this preferred stock financing, including certain warrants, the
embedded derivative instruments and offering costs.  The amounts
recorded in the financial statements represent the amounts attributed to the
sale of the Series D Preferred Stock, the amount allocated to warrants, the
value attributed to the embedded derivatives and issuance costs.  The
Company accreted these discounts as a compnent of interest expense on the
carrying value of the Series D Preferred Stock to its redemption value at
September 29, 2008, or the actual conversion date, whichever is
earlier.  The accretion of these amounts was recorded as a preferred
dividend in the period of accretion.  For the three and nine months
ended March 31, 2009 and 2008, $0 and $249,000, respectively, and $207,000 and
$845,000, respectively, was amortized




On
November 25, 2008 the Company redeemed an additional $800,000 of the Series D
Preferred Stock, using proceeds from the sale of the assets of Core
Systems.  On December 10, 2008, the Company used approximately
$1,161,000 of the proceeds from the sale of convertible note to DMRJ to repay
all of the indebtedness outstanding to the Laurus, excluding the Preferred
Series D redemption which is to be redeemed by the issuance of shares of the
Company’s common stock, which had not been issued.  In May 2009, the
Company issued 929,535 shares to Laurus Master Fund, Ltd.  As of March 31,
2009 and June 30, 2008, the outstanding balance on the Series D Preferred Stock
was $0 and $2,269,000, respectively, and the liquidation value as of June 30,
2008 was $2,424,000.




14
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




13.
            Long-term
      Litigation Settlement Liability




On March
27, 2009, the Company announced the settlement of its litigation and the mutual
release by the  Company and Evans Analytical Group, LLC of all claims
related to the sale of Accurel. In
settling this litigation, the Company agreed to issue 1,000,000 shares of Series
E Preferred Stock having an aggregate liquidation preference of
$5,000,000.  The Company issued the preferred stock as of May 15,
2009.  The preferred stock is subject to cancellation, without
consideration and without liability to the Company, under certain conditions
related to the Company’s continued cooperation in the pursuit (as controlled and
funded by Evans and its counsel) of certain claims against a former officer of
the Company and Accurel related to thesale of Accurel, including the
outcome of such litigation.  The preferred stock is convertible into
common stock at the election of Evans or the Company at any time after
the ninth anniversary of this agreement, and under certain other
circumstances.  The preferred stock is entitled to participate on
an “as converted” basis in all dividends or distributions
declared or paid on the Company’s common stock.  The holders of the
preferred stock have no voting rights except as required by applicable
law.




14.  Stockholders’
Equity




Common
Stock Options and Warrants




In
December 2008, the Company’s Board of Directors approved a plan to offer each
holder of stock options the opportunity to exchange their outstanding options
for options to purchase 50% as many shares, priced at the current market value
but with the same vesting terms as the original options.  During
the three months ended March 31, 2009, option holders exchanged
options to purchase 1,234,300 shares and received optins to purchase
617,150 shares at the current market value of $0.18 per share.  As a
consequence of the option exchange the Company recorded additional stock-based
compensation expense of approximately $29,000  representing the excess
of the fair value of the modified award based on current assumptions over the
fair value of the original option measured immediately before its terms are
modified based on current assumptions, without regard to the assumptions made on
the option grant date.




In
connection with various financing agreements and services provided by
consultants, the Company has issued warrants to purchase common stock of the
Company.  The fair value of warrants issued is determined using the
Black-Scholes option pricing model.  In December 2008, in conjunction
with the issuance of the senior secured convertible note to DMRJ Group, LLC, the
Company issued five-year warrants 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.  In
consideration of a letter agreement granting the Company access to certain
restricted cash on March 12, 2009, the Company issued DMRJ an
amended and restated warrant, which reduced the initial exercise price of
the warrant from $0.26 to $0.18.Pursuant to APB No. 14,
“Accounting for Convertible
Debt and Debt Issued with Stock Purchase Warrants,” the Company recorded
the fair value of this warrant of approximately $160,000 to the senior secured
convertible promissory note, which will be accreted to the note over the
life of the note.




As of
March 31, 2009, there were warrants outstanding to purchase 3,214,119 shares of
the Company’s common stock at exercise prices ranging from $0.18 to $12.45
expiring at various dates between May 11, 2009 and June 27, 2015.




The
Company issued 59,505 and 0 shares of common stock, respectively, during the
nine months ended March 31, 2009 and 2008, as a result of the exercise of
options by employees and consultants.




Employee
Stock Purchase Plan




During
the nine months ended March 31, 2009 and 2008, the Company issued 31,147 shares
and 57,163 shares, respectively, of its common stock to its employees pursuant
to the terms of the 2006 Employee Stock Purchase Plan.  No shares were
issued pursuant to that plan during the three months ended March 31,
2009 and 2008.




Treasury
Stock and Other Transactions




In June
2004, the Board authorized the Company to repurchase up to 300,000 shares of the
Company’s common stock, from time to time in the open market, privately
negotiated transactions, block transactions or at time and prices deemed
appropriate by management.  As of March 31, 2009 and June 30, 2008,
10,545 shares were held in treasury at cost.  During each of the three
and nine months ended March 31, 2009 and 2008, the Company repurchased no shares
of the Company’s common stock.  As of March 31, 2009, the maximum
number of shares authorized to be repurchased was 289,455.




15
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




15.
            Income
      Taxes




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




For the
three and nine months ended March 31, 2009 and 2008, the Company recorded no
provision for taxes as the Company has significant net loss
carryforwards.





16.
            Investment
      in CorNova




On December 10, 2008, the
Company transferred its entire interest in 1,500,000 shares of the common stock
of CorNova, Inc. to DMRJ Group LLC in lieu of commitment fees, closing fees and
other transaction related fees in connection with the issuance by the Company of
the senior secured convertible promissory note (See Note
11).As a result, $123,000, representing unrealized losses of
the Company’s share of CardioTech stock owned by CorNova which had been recorded
as a separate component of equity in other accumulated comprehensive loss were
realized and recorded to other expense in the statement of operations in the
three and nine months ended March 31, 2009.  In addition, the Company
recorded a $468,000 gain on the transfer of the Company’s investment in the
CorNova common stock to other expense in the statement of operations in the
three and nine months ended March 31, 2009.  Prior to the transfer of
the CorNova shares, the Company’s ownership interest in CorNova was
15%.




The
Company had historically accounted for its investment in CorNova, an
unconsolidated subsidiary, under the equity method, due in part, to the
significant influence the Company had over CorNova resulting from Dr. Anthony J.
Armini serving on CorNova’s Board of Directors.  Dr. Armini served as
the President and Chief Executive Officer of the Company, resigning both
positions on September 27, 2007.  As a result of Dr. Armini’s
resignation from CorNova’s board in September 2007, the equity method was no
longer appropriate and the cost method was used.




17.
            Commitments
      and Contingencies




The
Company leases manufacturing, research and office space in Wilmington,
Massachusetts.  The lease expires on December 31, 2009, subject to the
Company’s option to renew the lease for one three-year period.  Under
the terms of the lease, the Company is responsible for its proportionate share
of real estate taxes and operating expenses relating to this
facility.  The Company leases a facility in Sunnyvale, California,
under a lease which expires in September 2010.  The Company has an
option to extend the lease for five additional years.  Effective with
the sale of the assets of Accurel Systems on May 1, 2007, the Company executed a
sublease agreement for one of its California facilities.  As a result
of the Ion Metrics acquisition, the Company assumed the obligation of a lease
for research and office space in San Diego, California, which lease expired on
January 31, 2009.  The Company is currently in negotiations to renew
the lease and expects to renew the lease with similar terms and conditions as
the expired lease.  Total rent expense, including assessments for
maintenance and real estate taxes for the nine months ended March 31, 2009 and
2008, for both continuing and discontinued operations was $880,000 and
$1,062,000, respectively.




In
conjunction with the acquisition of Accurel, in March 2005, the Company recorded
a lease liability of $829,000.  This liability reflected management’s
estimate of the excess of payments required under the Accurel facility lease, at
the date of acquisition, versus the fair market value of lease payments that
would have been required, had the lease been negotiated under current market
conditions.  Subsequently, as a result of the sale of Accurel, the
Company has recorded an additional liability of $487,000 representing that
portion of the lease in excess of the sublease arrangement with
Evans.  The balance of the lease liability on March 31, 2009 is
$444,000 of which $276,000 is current.




In April
2007, in conjunction with the Company’s plans to conduct research, development
and minor manufacturing work in New Mexico, the Company executed an operating
lease which was initially to expire on May 1, 2010.  The lease allowed
for early termination, which the Company elected in February 2008.  As
a result of the early termination, the Company is responsible for reimbursing
the landlord for certain leasehold improvements over a 24-month
period.  As of March 31, 2009, the balance due is approximately
$15,000 and is included in Accrued Expenses.




16
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




The
Company is obligated under two license agreements, assumed in connection with
the acquisition of Ion Metrics, whereby the Company has been granted rights to
use certain intellectual property for safety, security and drug applications,
which the Company intends to incorporate into future security product
offerings.  Minimum royalty payments due in fiscal 2009 are $50,000
and no payments have been made in the nine months ended March 31,
2009.




18.
            Acquisition




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




The
aggregate purchase price of Ion Metrics, including assumed liabilities, was
$3,309,000.  As part of the Transaction, the Company issued to the
former stockholders of Ion Metrics consideration consisting of 2,000,000 shares
of the Company’s common stock.  The fair value of the Company's common
stock was determined based on the average market price of the Company's common
stock over a period of time before April 10, 2008, the date fair value is to be
determined, pursuant to Emerging Issues Task Force ("EITF") Issue No. 99-12,
“Determination of the
Measurement Date for the Market Price of Acquirer Securities Issued in a
Purchase Business Combination.”  The Company issued the
2,000,000 shares of the Company’s common stock to Ion Metrics stockholders in
August 2008.  The Company entered into an agreement with Ferran
Scientific, Inc., a firm owned by the father of the former Ion Metrics chairman,
under which the Company assumed certain Ion Metrics obligations and
rights.  In consideration for the assignment of these obligations and
rights, the Company agreed to a $50,000 fee payable to the Ion Metrics
shareholders for these assignments.  As of March 31, 2009 and June 30,
2008, the balance due was approximately $0 and $50,000,
respectively.  This agreement also included modifications to these
assumed obligations including the deferral of payment obligations for a period
up to 12 months from the closing date.




The
former Ion Metrics stockholders have agreed not to sell any of their shares of
common stock for a period of 18 months from the closing date; provided, however
that for the period from six to 18 months after the closing date, each holder
may sell, in any three month period, the greater of (a) 1% of the outstanding
shares of the same class being sold or (b) if the class is listed on a stock
exchange or quoted on the American Stock Exchange, the greater of (i) 1% of the
outstanding shares of such class or (ii) the average reported weekly trading
volume during the four weeks preceding the sale.




In
connection with this transaction, the Company entered into an escrow agreement
with Ion Metrics and ComputerShare Trust Company, as escrow
agent.  The Company deposited 400,000 shares of common stock,
representing 20% of the purchase price, into an escrow account.  The
escrow agreement initially provided, subject to any claims of indemnifications,
for a release of the escrowed shares on April 10, 2009.  On October
13, 2008, the Company agreed to the complete release of the escrowed
shares.




The
transaction also included board observer rights which permitted a designee of
the former Ion Metrics stockholders to attend meetings of the Company’s board of
directors.  On October 13, 2008, the Company and the former Ion
Metrics shareholders mutually agreed to terminate these observer
rights.




The
following table summarizes the purchase price:


Cash
              
              $
              91,000Direct
      costs
              
              
              140,000Liabilities
      assumed
              
              
              564,000Payable
      to Ion Metrics Shareholders
              
              
              2,514,000$
              3,309,000


17
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




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


Accounts
      receivable
              
              $
              7,000Other
      receivables
              
              
              3,000Prepaid
      expenses
              
              
              11,000Property,
      plant and equipment
              
              
              83,000Goodwill
              
              
              3,136,000Customer
      relationships
              
              
              69,000$
              3,309,000


The
allocation of purchase price is the responsibility of management.  The
Company considered a number of factors, including professional appraisals, for
the valuation of equipment acquired, in making its purchase price allocation
determination.  The acquisition of Ion Metrics resulted in goodwill of
$3,136,000 and the identification of $69,000 of intangible assets with finite
lives.  The intangible assets are being amortized over a period of
twelve months, the estimated useful lives of the assets, from the date of
acquisition, April 10, 2008.  Amortization expense for the three and
nine months ended March 31, 2009 was $17,000 and $52,000,
respectively.  There was no amortization expense for the three and
nine months ended March 31, 2008.




The
acquisition of Ion Metrics is accounted for as a purchase under SFAS No. 141,
“Business
Combinations.”  Accordingly, the operating results of Ion
Metrics are included in the accompanying condensed consolidated financial
statements since the acquisition date as part of the Company's Security
segment.




19.
            Financial
      Information By Segment




SFAS No.
131, “Disclosures about
Segments of an Enterprise and Related Financial Information,” defines
operating segments as components of an enterprise about which separate financial
information is available that is regularly evaluated by the chief operating
decision maker or decision making group, in determining how to allocate
resources and in accessing performance.  The Company’s chief operating
decision making group is composed of the chief executive officer and members of
senior management.  Based on qualitative and quantitative criteria
established by SFAS No. 131, the Company has determined that it operates within
one reportable segment, which is the Security Products Segment.




20.
            Discontinued
      Operations




Core
Systems




In
accordance with SFAS No. 144, “Accounting for the Impairment or
Disposal of Long-Lived Assets,” the accompanying condensed consolidated
balance sheets as of June 30, 2008 and statements of operations for the three
and nine months ended March 31, 2009 and 2008 of C Acquisition Corp., the
Company’s former wholly-owned semiconductor subsidiary, which has operated under
the name Core Systems, are presented as discontinued operations.  The
Company’s Board of Directors approved a plan to sell Core Systems in February
2008.  The Company has (i) eliminated Core Systems’ financial results
from its ongoing operations, (ii) determined that Core Systems, which operated
as a separate subsidiary, was a separate component of its aggregated business
as, historically, management reviewed separately the Core Systems financial
results and cash flows apart from its ongoing continuing operations, and (iii)
determined that it will have no further continuing involvement in the operations
of Core Systems or cash flows from Core Systems after the
sale.  Accordingly, the assets and liabilities of Core Systems were
classified as held for sale as of June 30, 2008.






On
November 14, 2008, the Company and C Acquisition Corp. (the “Subsidiary”),
entered into a definitive agreement with Core Systems Incorporated, an entity
newly formed by the Subsidiary’s general manager and certain other investors
(the “Buyer”), to sell substantially all of Core Systems’ assets for a purchase
price of $3,000,000 plus the assumption of certain liabilities.  The
Buyer made a cash down payment of $250,000 prior to the execution of the
definitive agreement.  On November 24, 2008, the parties amended the
agreement and completed the asset sale. On that date, the Buyer made a cash
payment of $1,125,000 and issued a promissory note in the amount of
$1,625,000.  The promissory note required the Buyer to pay the
Subsidiary $125,000 on or before November 28, 2008, an additional $500,000 on or
before December 24, 2008, and the remaining principal balance, together with
accrued interest, in equal monthly installments over a period of 60 months
commencing on February 1, 2009.  The Buyer and the Subsidiary also executed
a security agreement, pursuant to which the Buyer granted the Subsidiary a
security interest in all of the Buyer’s assets to secure its obligations under
the promissory note.  The Buyer paid $250,000 of the amount due in
December, paid the remaining $250,000 balance due on the December payment on
March 20, 2009 and has paid all monthly installments due on the
note.




18
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




Condensed
results of operations relating to Core Systems for the three and nine months
ended March 31, 2009 and 2008 are as follows:





Three
      Months Ended
              
              
              Nine
      Months EndedMarch
      31,
              
              
              March
      31,2009
              
              
              2008
              
              
              2009
              
              
              2008Revenues
              
              $
              -
              
              
              $
              1,599,000
              
              
              $
              2,288,000
              
              
              $
              4,689,000Gross
      profit
              
              
              -
              
              
              
              317,000
              
              
              
              471,000
              
              
              
              114,000Impairment
      of long-lived assets and goodwill
              
              
              -
              
              
              
              (737,000
              )
              
              
              -
              
              
              
              1,487,000Operating
      income (loss)
              
              
              -
              
              
              
              714,000
              
              
              
              25,000
              
              
              
              (2,403,000
              )Gain
      on sale of discontinued operations
              
              
              -
              
              
              
              -
              
              
              
              22,000
              
              
              
              -Income
      (loss) from discontinued operations
              
              $
              -
              
              
              $
              714,000
              
              
              $
              46,000
              
              
              $
              (2,403,000
              )




June
      30,2008Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
              
              $
              1,178,000Inventories
              
              
              251,000Prepaid
      expenses and other current assets
              
              
              -Total
      current assets of discontinued operations
              
              
              1,429,000Non-current
      assets of discontinued operations:Property,
      plant and equipment, net
              
              
              833,000Goodwill
              
              
              1,195,000Other
      assets
              
              
              25,000Intangible
      assets, net
              
              
              32,000Total
      non-current assets of discontinued operations
              
              
              2,085,000Total
      assets of discontinued operations
              
              $
              3,514,000Liabilities
      of Discontinued OperationsCurrent
      liabilities of discontinued operations:Current
      portion of long term debt and capital leases
              
              $
              5,000Accounts
      payable
              
              
              517,000Accrued
      expenses
              
              
              316,000Deferred
      revenue
              
              
              10,000Total
      current liabilities of discontinued operations
              
              
              848,000Non-current
      liabilities of discontinued operations:Long-term
      debt and obligations under capital lease, net of current
      maturities
              
              
              1,000Total
      liabilities of discontinued operations
              
              $
              849,000


19
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




Medical
Business Unit






In
accordance with SFAS No. 144, “Accounting for the Impairment or
Disposal of Long-Lived Assets,” the accompanying condensed consolidated
balance sheets and statements of operations present the results of the Medical
Business Unit as discontinued operations.






Condensed
results of operations relating to the Medical Business Unit for the three and
nine months ended March 31, 2009 and 2008 are as follows:





Three
      Months Ended
            
            
            Nine
      Months EndedMarch
      31,
            
            
            March
      31,2009
            
            
            2008
            
            
            2009
            
            
            2008Revenues
            
            $
            82,000
            
            
            $
            154,000
            
            
            $
            639,000
            
            
            $
            450,000Gross
      profit
            
            
            (45,000
            )
            
            
            (199,000
            )
            
            
            (96,000
            )
            
            
            (582,000
            )Operating
      loss
            
            
            (45,000
            )
            
            
            (210,000
            )
            
            
            (96,000
            )
            
            
            (675,000
            )Gain
      on sale of assets
            
            
            2,000
            
            
            
            -
            
            
            
            1,026,000
            
            
            
            -Income
      (loss) from discontinued operations
            
            $
            (43,000
            )
            
            $
            (210,000
            )
            
            $
            930,000
            
            
            $
            (675,000
            )




The
assets and liabilities of the Medical Business Unit as of March 31, 2009 and
June 30, 2008 are as follows:


March
      31,
              
              
              June
      30,2009
              
              
              2008Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
              
              $
              38,000
              
              
              $
              149,000Inventories
              
              
              178,000
              
              
              
              305,000Total
      current assets of discontinued operations
              
              
              216,000
              
              
              
              454,000Non-current
      assets of discontinued operations:Property,
      plant and equipment, net
              
              
              143,000
              
              
              
              560,000Total
      non-current assets of discontinued operations
              
              
              143,000
              
              
              
              560,000Total
      assets of discontinued operations
              
              $
              359,000
              
              
              $
              1,014,000Liabilities
      of Discontinued OperationsCurrent
      liabilities of discontinued operations:Accounts
      payable
              
              $
              107,000
              
              
              $
              100,000Accrued
      expenses
              
              
              14,000
              
              
              
              131,000Total
      liabilities of discontinued operations
              
              $
              121,000
              
              
              $
              231,000


21.
            Legal
      Proceedings




Evans
Analytical Group LLC




In May 1,
2007, the Company sold substantially all of the assets of our Accurel Systems
subsidiary to Evans Analytical Group, LLC for approximately $12,705,000. In
connection with this transaction, the Company entered into an escrow agreement
with Evans, Accurel, and Zions First National Bank.  Pursuant to the
escrow agreement, Evans deposited $1,000,000 of the total purchase price for the
assets into an escrow account.




In
February 2008, Evans filed suit in the Superior Court of the State of
California, Santa Clara County, requesting rescission of the asset purchase
agreement, plus damages, based on claims of misrepresentation and
fraud.  In March 2008, Evans filed a notice with the escrow agent
prohibiting release of any portion of the escrow to us pending resolution of the
lawsuit.




20
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




On March
27, 2009, the Company announced the settlement of this litigation and the mutual
release by the Company and Evans of all claims related to the sale of
Accurel.  In settling this litigation, the Company agreed to pay Evans
damages in the amount of approximately $5,700,000 by (i) agreeing to release to
Evans approximately $700,000 that had been held in escrow since the time of the
closing of the Accurel sale and (ii) agreeing to issue to Evans 1,000,000 shares
of a new series of preferred stock having an aggregate liquidation preference of
$5,000,000.  On April 8, 2009, approximately $700,000 of the funds
held in escrow were released to Evans and $300,000, the balance of the escrow
amount, was released to the Company.




Other




The
Company may, from time to time, be involved in other actual or potential
proceedings that it considers to be in the normal course of its
business.  The Company does not believe that any of these proceedings
will have a material adverse effect on its business.





22.
              Subsequent
      Events
  Election
of Additional Directors
 On May
22, 2009, by vote of the Board of Directors, three new members were elected to
the Company’s Board of Directors. The three new directors are:
  ·
                John
      Keating, a recognized expert in retail distribution and transportation, is
      currently Vice President of Global Customer Fulfillment for the Timberland
      Company;
  ·
                Robert
      P. Liscouski, former Assistant Secretary for Infrastructure Protection of
      the U.S. Department of Homeland Security, and a member of an advisory
      board to the Director of National Intelligence, is currently the President
      and Chief Operating Officer of Steel City Re, a firm specializing in
      intangible asset risk management;
and
  ·
                Howard
      Safir, former Police Commissioner and Fire Commissioner of New York City,
      and former Assistant Director of the U.S. Drug Enforcement Administration,
      is currently the Chief Executive Officer of the Security Consulting and
      Investigations Unit of GlobalOptions Group, Inc., a provider of risk
      mitigation and management
services.
  NYSE
Amex Listing Determination
  On May 5,
2009, the Company received a notice from NYSE Amex LLC, formerly known as NYSE
Alternext US LLC, stating that the NYSE Amex Committee on Securities had
unanimously affirmed a prior decision by a Listing Qualifications Panel to
delist the Company’s common stock. The Exchange’s decision was not subject to
further appeal by the Company. The trading of the Company’s common stock
was suspended by the Exchange on April 6, 2009 and will be delisted
effective June 22, 2009.  The Company's common stock was approved
for trading on the Over-The-Counter Bulletin Board under the symbol “IMSC”
on May 4, 2009.





21


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




Cautionary
Note Regarding Forward-Looking Statements




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




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




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




Overview




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




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




History




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




SemiconductorBusiness
Unit




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




22
 
  and common
stock.  In February 2008, our Board approved a formal plan to sell
Core Systems as part of our strategic initiative to focus on our security
business.  As of June 30, 2008, the assets and liabilities of Core
have been recorded on our balance sheet as held-for-sale.  For the
three and nine months ended March 31, 2009 and 2008, the operations of Core have
been recorded in our statements of operations as discontinued
operations.




In March
2005, we acquired Accurel Systems International Corporation, a privately-held
semiconductor wafer analytical services company located in Sunnyvale, California
for $12,176,000 in cash and common stock.  In March 2007, our Board
approved a formal plan to sell Accurel Systems as part of our strategic
initiative to focus on our security business.  In May 2007, we
completed the sale of Accurel Systems to Evans Analytical Group LLC, in
exchange for $12,705,000 in cash of which $1,000,000 was placed in
escrow. In February 2008, Evans filed suit requesting rescission of the
acquisition agreement, plus damages, based on claims of misrepresentation and
fraud.  In March 2008, Evans filed a claims notice with the escrow
agent prohibiting release of any portion of the escrowed funds pending
resolution of the lawsuit.  On March 27, 2009, the
Company announced the settlement of this litigation and the mutual release by
the Company and Evans of all claims related to the sale of
Accurel.  In settling this litigation, the Company agreed to pay Evans
damages in the amount of approximately $5,700,000 by (i) agreeing to release to
Evans approximately $700,000 that had been held in escrow since the time of the
closing of the Accurel sale and (ii) agreeing to issue to Evans 1,000,000 shares
of a new series of preferred stock having an aggregate liquidation preference of
$5,000,000.




On
November 14, 2008, we and our wholly owned subsidiary C Acquisition Corp., which
had operated under the name Core Systems (the “Subsidiary”), entered into a
definitive agreement, as amended on November 24, 2008, with Core Systems
Incorporated, an entity newly formed by the Subsidiary’s general manager and
certain other investors, to sell substantially all of Core Systems’ assets for a
purchase price of $3,000,000 plus the assumption of certain
liabilities.




Medical Business
Unit




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




In
further support of our strategic initiative to focus on our security business,
in June 2007, we sold certain assets associated with our prostate seed business
and discontinued the manufacturing of brachytherapy
products.  Management currently has plans in place to sell the
remaining medical segment assets and discontinue the surface modification
services provided to the medical device marketplace by the end of fiscal
2009.  During the three months ended March 31, 2009 we sold additional
assets associated with our coatings business.  As of March 31, 2009
and June 30, 2008, the assets and liabilities of the Medical Business Unit have
been recorded on our balance sheet as held-for-sale.  For the three
and nine months ended March 31, 2009 and 2008, the operations of the Medical
Business Unit have been recorded in our statements of operations as discontinued
operations.




Security Business
Unit




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




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




23


Technology
and Intellectual Property




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




Tiny
particles of explosives and narcotics are “sticky” and generally adhere to
surfaces.  Our competitors commonly swipe a surface to be interrogated
for explosives particles with a cloth or paper material.  We have
developed a patented method using an aerosol of fine dry ice particles mixed
into an air puff as a means of harvesting particles, which we believe could
increase collection sensitivity.  Our aerosol technology functions as
a very gentle version of “sandblasting” and is safe for almost all
surfaces.  We have two patents pending on this
methodology.




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




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




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




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




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




Products




Current
Products




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




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




24




Products Under
Development




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




We
believe that as market demand grows for greater precision of substance
identification and the list of substances to be detected increases, more
advanced detectors based on ion mobility spectrometry technology will be
required.  Our acquisition of Ion Metrics enabled us to obtain
miniaturized quadrupole mass spectrometry (“QMS”) detector
technology.  The QMS detector senses the mass of a molecular ion
resulting in an “orthogonal” detection method in which a different unique
characteristic of a substance is sensed.  We believe that, because it
is unlikely that two substances would share the same mass and the same ion
mobility in air, QMS detector technology improves the accuracy of detection and
minimizes false alarms.  We are currently developing interfaces for
using the QMS detector in our advanced equipment.




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




Manufacturing
Operations




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




Critical
Accounting Policies




Our
significant accounting policies are summarized in Note 2 to our consolidated
financial statements included in Item 7 of our Annual Report on Form 10-K, as
amended, for the fiscal year ended June 30, 2008.  However, certain of
our accounting policies require the application of significant judgment by our
management, and such judgments are reflected in the amounts reported in our
condensed consolidated financial statements.  In applying these
policies, our management uses its judgment to determine the appropriate
assumptions to be used in the determination of estimates.  Those
estimates are based on our historical experience, terms of existing contracts,
our observance of market trends, information provided by our strategic partners
and information available from other outside sources, as
appropriate.  Actual results may differ significantly from the
estimates contained in our condensed consolidated financial
statements.  There has been no change
to our critical accounting policies through the fiscal quarter ended March 31,
2009.




25


Results
of Operations




Three Months Ended March 31,
2009 vs. March 31, 2008




Revenues




Security
revenues for the three months ended March 31, 2009 were $553,000 as compared
with $789,000 for the comparable prior year period, a decrease of $236,000 or
29.9%.  Revenue from security products for the three months ended
March 31, 2009 was $305,000 as compared with $679,000 for the comparable prior
year period, a decrease of $374,000 or 55.1%.  Revenue from government
funded contracts for the three months ended March 31, 2009 was $248,000 as
compared with $110,000 for the comparable prior year period, an increase of
$138,000 or 125.4%.  The decrease in security revenue is due to a
decrease in the number of units sold of our explosives detection products during
the three months ended March 31, 2009 as compared to comparable prior year
period.  Revenue from government contracts increased primarily
due to an award from the Department of Homeland Security.




Cost
of Revenues




Cost of
revenues for the three months ended March 31, 2009 were $333,000 as compared
with $580,000 for the comparable prior year period, a decrease of $247,000 or
42.6%.  The decrease in cost of revenues is primarily a result of the
decrease in sales of security products, offset partially by an increase in
government contract revenue and the associated direct expenses of the
contracts.




Gross
Margin




Gross
margin for the three months ended March 31, 2009 was $220,000 or 40.0% of
security revenues as compared with gross margin of $209,000 or 26.5% of security
revenues for the comparable prior year period.  The increase in gross
margin is a result of design changes to our handheld explosives detectors which
improved the manufacturability; and overall cost efficiencies realized in the
production process, including efficiencies realized by our outsourced contract
manufacturer.




Research,
Development and Regulatory Expenses




Research
and development expense for the three months ended March 31, 2009 was $809,000
as compared with $821,000 for the comparable prior year period, a decrease of
$12,000 or 1.5%.  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.  In
addition, the increase in research and development expenses relates to the
volume and timing of customer funded programs, primarily through government
grants and contracts and an increase in stock-based compensation expense
incurred in the three months ended March 31, 2009. We focused additional
resources on our internally funded research and development programs during the
three month period ended March 31, 2009 as compared with the comparable prior
year period.  We charge our research and development personnel to cost
of revenues for work performed on these contracts and grants.  Research and
development expenses incurred prior to starting government contracts are charged
to operating expenses.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the three months ended March 31, 2009
was $1,898,000 as compared with $1,331,000 for the comparable prior year period,
an increase of $567,000, or 42.6%.  The increase in selling, general
and administrative expenses is due to a significant increase in legal fees in
connection with our litigation and settlement with Evans Analytical Group,
LLC, and increased loan financing fees.




Litigation
Settlement




For the
three months ended March 31, 2009, we recorded a $5,700,000 charge resulting
from the settlement of the litigation with Evans.  In settling the
litigation we agreed to release approximately $700,000 that had been held in
escrow since the time of the closing of the Accurel sale and agreed to issue
1,000,000 shares of a new series of preferred stock having an aggregate
liquidation preference of $5,000,000.




Other
Income and Expense, Net




For the
three months ended March 31, 2009, we recorded other expense, net of $362,000 as
compared with other expense, net of $90,000, for the comparable prior year
period, an increase in other expense, net of $272,000.  The increase
in other expense, net, is primarily a result of an increase in interest expense
of  $356,000 due to interest expense on the senior secured convertible
promissory note issued to DMRJ Group and a decrease in interest income of
$13,000, to $15,000 in the three months ended March 31, 2009 from $28,000, for
the comparable prior year period,  offset




26
 
  partially
by an increase in income related to the embedded derivative associated with the
Series D Redeemable Convertible Preferred Stock, which was extinguished on
December 10, 2008.




Loss
from Continuing Operations




Loss from
continuing operations for the three months ended March 31, 2009 was $8,549,000
as compared with $2,033,000 for the comparable prior year period,
an increase of $6,516,000, or 320.5%.  The increase in loss from
continuing operations is primarily the result of the $5,700,000 charge recorded
to settle the litigation with Evans Analytical Group, increased operating
expenses, primarily increased legal fees associated with the Evans
litigation and settlement, and an increase in interest
expense.




Preferred
Distribution, Dividends and Accretion




Preferred
distribution, dividends and accretion on the Series D Redeemable Convertible
Preferred Stock for the three months ended March 31, 2009 was $0 as compared
with $249,000 for the comparable prior year period due to the redemption of
the preferred stock in 2009.




Income
(Loss) from Discontinued Operations




The net
loss from discontinued operations for the three months ended March 31, 2009 was
$43,000 as compared with income from discontinued operations of $504,000 for the
comparable prior year period, a decrease in income from discontinued operations
of $547,000.  The net loss from discontinued operations for the three
months ended March 31, 2009 is composed of operating loss of $43,000 from our
medical reporting unit.  Income from discontinued operations for the
three months ended March 31, 2008 includes:  (i) income of $714,000
from operations of our Core Systems subsidiary; and (ii) losses of $210,000 from
operations of our medical reporting unit.




Nine Months Ended March 31,
2009 vs. March 31, 2008




Revenues




Security
revenues for the nine months ended March 31, 2009 were $8,020,000 as compared
with $2,505,000 for the comparable prior year period, an increase of $5,515,000
or 220.2%.  Revenue from security products for the nine months ended
March 31, 2009 was $6,814,000 as compared with $2,123,000 for the comparable
prior year period, an increase of $4,691,000 or 221.0%.  Revenue from
government funded contracts for the nine months ended March 31, 2009 was
$1,206,000 as compared with $382,000 for the comparable prior year period, an
increase of $824,000 or 215.7%.  The increase in security revenue is
primarily a result of an increase in the number of units sold of our explosives
detection products during the nine months ended March 31, 2009 as compared to
comparable prior year period.  The sales of security products included
significant shipments of our handheld explosives detection equipment to a
customer in China during the three months ended September 30, 2008 aggregating
approximately $4,169,000 in sales, which shipments coincided with security
preparations for the Beijing Olympics.  In addition, we recorded
increased revenue from government contracts resulting primarily to an award from
the Department of Homeland Security.




Cost
of Revenues




Cost of
revenues for the nine months ended March 31, 2009 were $4,386,000 as compared
with $1,809,000 for the comparable prior year period, an increase of $2,577,000
or 142.4%.  The increase in cost of revenues is primarily a result of
the increase in sales of security products and increase in government contract
revenue and the associated direct expenses of the contracts.




Gross
Margin




Gross
margin for the nine months ended March 31, 2009 was $3,634,000 or 45.3% of
security revenues as compared with $696,000 or 27.8% of security revenues for
the comparable prior year period.  The increase in gross margin is a
result of increased sales volume of our handheld explosives detection equipment;
design changes to our handheld explosives detectors which improved the
manufacturability; and overall cost efficiencies realized in the production
process, including efficiencies realized by our outsourced contract
manufacturer.




Research,
Development and Regulatory Expenses




Research
and development expense for the nine months ended March 31, 2009 was $2,580,000
as compared with $2,135,000 for the comparable prior year period, an increase of
$445,000 or 20.8%.  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.  In
addition, the increase in research and development expenses relates to the
volume and timing of customer funded programs, primarily through government
grants and contracts.




27
 
  We
focused additional resources on our internally funded research and development
programs during the nine months ended March 31, 2009 as compared with the
comparable prior year period.  We charge our research and development
personnel to cost of revenues for work performed on these contracts and
grants.  Research and development expenses incurred prior to starting
government contracts are charged to operating expenses.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the nine months ended March 31, 2009 was
$5,825,000 as compared with $4,176,000 for the comparable prior year period, an
increase of $1,649,000, or 39.5%.  The increase is primarily a result
of increased legal expenses, primarily related to our litigation and
settlement with Evans, and, to a lesser extent, costs associated with the
additions to our senior management team; increased expenditures in our sales and
marketing efforts, including increased selling expenses related to our first
quarter 2009 China shipments; and increased loan financing fees.




Litigation
Settlement




For the
nine months ended March 31, 2009, we recorded a $5,700,000 charge resulting from
the settlement of the litigation with Evans.  In settling the
litigation we agreed to release approximately $700,000 that had been held in
escrow since the time of the closing of the Accurel sale and agreed to issue
1,000,000 shares of a new series of preferred stock having an aggregate
liquidation preference of $5,000,000.




Other
Income and Expense, Net




For the
nine months ended March 31, 2009, we recorded other expense, net of $802,000 as
compared with other income, net of $147,000, for the comparable prior year
period, an increase in other expense, net of $949,000.  The increase
in other expense, net, is primarily a result of (i) realization of the $123,000
unrealized loss of our share of CardioTech stock owned by CorNova; (ii) increase
in interest expense of $1,100,000 resulting, in part, from a penalty of $568,000
assessed on the Series D Preferred Stock due to our failure to meet the amended
redemption date, $90,000 forbearance fees due to cure events of default under
our former credit facility, and interest expense on the senior secured
convertible promissory note; (iii) decrease in interest income of $158,000 as a
result of lower available cash balances for investment; (iv) decrease in income
related to the embedded derivative associated with the Series D Redeemable
Convertible Preferred Stock, which was extinguished on December 10, 2008; and
(v) realized a gain of $468,000 on the transfer of our investment in CorNova
common stock as part of the senior secured convertible promissory note
issuance.




Loss
from Continuing Operations




Loss from
continuing operations for the nine months ended March 31, 2009 was $11,273,000
as compared with $5,468,000 for the comparable prior year period,
an increase of $5,805,000, or 106.2%.  The increase in loss from
continuing operations is primarily due to the $5,700,000 charge recorded for the
Evans litigation settlement, increased operating expenses, primarily legal
fees associated with the Evans litigation and settlement, increased interest
expense and the realization of an unrealized loss of our share of CardioTech’s
stock owned by CorNova, offset partially by increased sales of our handheld
explosives detection product and improved gross margins resulting from these
sales and the gain realized on the transfer of our investment in CorNova common
stock.




Preferred
Distribution, Dividends and Accretion




Preferred
distribution, dividends and accretion on the Series D Redeemable Convertible
Preferred Stock for the nine months ended March 31, 2009 was $207,000 as
compared with $845,000 for the comparable prior year period, a decrease of
$638,000 or 75.5% due to the redemption fo the preferred stock in
2009.




Income
(Loss) from Discontinued Operations




Income
from discontinued operations for the nine months ended March 31, 2009 was
$976,000 as compared with net loss from discontinued operations of $3,078,000
for the comparable prior year period, a decrease in loss from discontinued
operations of $4,054,000.  Income from discontinued operations for the
nine months ended March 31, 2009 is composed of (i) income of $24,000 from
our Core Systems subsidiary, which was sold during the second quarter of fiscal
2009, (ii) operating loss of $96,000 from our medical reporting unit, (iii) gain
on sale of Core Systems of $22,000 and (iv) gain on sale of assets of our
medical reporting unit of approximately $1,026,000.  Loss from
discontinued operations for the nine months ended March 31, 2008
includes:  (i) losses of $2,403,000 from operations of our Core
Systems subsidiary; and (ii) losses of $675,000 from operations of our medical
reporting unit.




28


Liquidity
and Capital Resources




As of
March 31, 2009, we had approximately $229,000 of cash and cash equivalents, a
decrease of $183,000 when compared with a balance of $412,000 as of June 30,
2008.  We must repay in full the balance on the senior secured
promissory note issued to DMRJ Group LLC by December 10, 2009.  The
balance due on that note as of March 31, 2009 was $3,741,000, and the
liquidation value was $4,600,000.




On
December 10, 2008, we used approximately $477,000 of the proceeds from the
issuance of the note to DMRJ to repay all of the indebtedness outstanding to
Bridge Bank, N.A., and the credit facility with the bank terminated. On December
10, 2008, we also used approximately $1,161,000 of the proceeds from the
issuance of the note to redeem all of the Series D Preferred Stock held by
Laurus, excluding the Preferred Series D redemption which is to be redeemed by
the issuance of shares of our common stock, which had not been
issued.  As of March 31, 2009 and June 30, 2008, the outstanding
balance on the Series D Preferred Stock was $0 and $2,269,000, respectively, and
the liquidation value as of June 30, 2008 was $2,424,000.




During
the nine months ended March 31, 2009 we had net cash outflows of $3,315,000 from
operating activities of continuing operations as compared to net cash outflows
from operating activities of continuing operations of $4,226,000 for the
comparable prior year period.  The approximate $911,000 decrease in
net cash used in operating activities of continuing operations during the nine
months ended March 31, 2009, as compared to the comparable prior year period,
was primarily a result of (i) cash provided by a decrease in accounts receivable
and inventories, and (ii) increase in cash provided by changes in accounts
payable.  These cash inflows were offset by increased cash outflows
for accrued expenses and prepaid expenses.  For the nine months ended
March 31, 2009, we had net cash inflows of $59,000 from operating activities of
discontinued operations, compared with net cash outflows of $506,000 from
operating activities of discontinued operations for the comparable prior year
period, due primarily to a decrease in the loss from discontinued
operations.




During
the nine months ended March 31, 2009 we had net cash inflows of $3,220,000 from
investing activities of continuing operations as compared to net cash outflows
of $124,000 from investing activities of continuing operations for the
comparable prior year period.  The approximate $3,344,000 increase in
net cash provided by investing activities of continuing operations during the
nine months ended March 31, 2009, as compared to the comparable prior year
period, was primarily a result of cash provided from the sale of property and
equipment, sale of Core Systems and payments received on a note
receivable.  For the nine months ended March 31, 2009, we had net cash
outflows of $28,000 from investing activities of discontinued operations,
compared to net cash outflows of $271,000 from investing activities of
discontinued operations for the comparable prior year period, due primarily to a
decrease in cash used to purchase property and equipment.




During
the nine months ended March 31, 2009 we had net cash outflows of $118,000 from
financing activities of continuing operations as compared to net cash outflows
of $2,071,000 from financing activities of continuing operations for the
comparable prior year period.  The approximate $1,953,000 decrease in
net cash used in financing activities of continuing operations during the nine
months ended March 31, 2009, as compared to the comparable prior year period,
was primarily a result of cash provided by the issuance of the senior secured
convertible promissory note, net of principal repayments; offset by the
repayments of the Series D Redeemable Convertible Preferred Stock, long-term
debt, credit facility, and capital lease obligations.  For the nine
months ended March 31, 2009, we had net cash outflows of $1,000 from financing
activities of discontinued operations compared with net cash outflows of $2,000
from financing activities of discontinued operations for the comparable prior
year period, due to decreased principal payments of capital lease
obligations.  We expect that the absence of negative cash flows from
our discontinued operations will have a favorable impact on our future liquidity
and capital resources.




On
December 10, 2008, we entered into a Note and Warrant Purchase Agreement with
DMRJ Group LLC, 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 bears interest at 11.0% per annum and is
collateralized by all of our assets.  The effective interest rate on
the note is 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 share of the common
stock of CorNova, a privately-held, development stage medical device company to
DMRJ.  The note, which has been amended and restated, as described
below, was convertible in whole or in part at the option of DMRJ into shares of
our common stock at an initial conversion price of $0.26 per
share.




29




We valued
the note upon issuance at its residual value of $4,356,000 based on the fair
values of the financial instruments issued in connection with this convertible
debt financing, including the warrants, the original issue discount 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 $160,000 allocated to
the warrant, $616,000 of original issue discount and $468,000 representing
the estimated fair value of the CorNova common stock.  The warrant was
valued using the Black-Scholes model with the following
assumptions:  volatility 93.7%, risk-free interest rate of 2.82%,
expected life of 5 years and expected dividend yield of 0.00%.  As
required under the terms of the note, we made a principal payment of $1,000,000
on December 24, 2008.  The note requires 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, upon the release of such funds.  DMRJ waived the requirement
that we make a principal repayment in an amount equal to the amount of the
escrow funds released in connection with the Evans litigation
stllement.




On March 12,
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, on March 12, 2009, we issued DMRJ an
Amended and Restated the Senior Secured Convertible Promissory Note and an
Amended and Restated Warrant to Purchase Shares of Common Stock, which replaced
the note and warrant issued on December 10, 2008.  As of April 15,
2009, we were not in compliance with the $500,000 minimum cash balance
requirement, which event of noncompliance was waived by DMRJ.  The terms of
the amended and restated note and warrant are identical to the terms of the
original note and thewarrant except that the amended documents 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.




The
remaining principal balance, together with outstanding interest, is due and
payable on December 10, 2009.  As of March 31, 2009, the outstanding
balance on the Note was $3,741,000, and the liquidation value was
$4,600,000.




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 survivor of such consolidation or merger; against the
sale, assignment, transfer or lease of our assets, other than in the ordinary
course of business 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 share of our common
stock to provide for the issuance of the warrant shares; 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 minus current liabilities, of no less than 0.60
to 1.00.  As of March 31, 2009, our current ratio was 0.35 to 1.00 and
the Company’s aggregate dollar amount of all accounts payable exceeded one
hundred days past due, as such, we are not in compliance with the required
current ratio and accounts payable financial covenants.  We have
requested a waiver of these defaults.  If we are unable to obtain a
waiver, DMRJ may declare the entire unpaid principal balance of the note,
together with all interest accrued hereon, plus fees and expenses, due and
payable.  Any such action by DMRJ would have a material adverse effect
on our liquidity and financial condition and could require the Company to
curtail or discontinue all of our operations.




Our
ability to comply with the debt covenants in the future depends on our ability
to generate sufficient sales, control our 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.  Further, upon the occurrence of an event of default under
certain provisions of the senior secured promissory note, we could be required
to pay default rate interest equal to the lesser of 2.5% per month and the
maximum applicable legal rate per annum on the outstanding principal balance of
the note.




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




30


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




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




Off-Balance
Sheet Arrangements




As of
March 31, 2009 we had an irrevocable standby letter of credit outstanding in the
approximate amount of $418,000.  The letter of credit provides
performance security equal to 10% of the contract amount for product shipped in
the first quarter of fiscal 2009.  The letter of credit expires on
July 31, 2010.




As of
March 31, 2009, we did not have any other off-balance sheet arrangements that
have, or are reasonably likely to have, a current or future material effect on
our condensed consolidated financial condition, results of operations,
liquidity, capital expenditures or capital resources.




New
Accounting Pronouncements




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




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




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




31




Item
      3.
            Quantitative
      and Qualitative Disclosures About Market
Risk.




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




Item 4T.
            Controls
      and Procedures






The
certificates of the Company’s chief executive officer and chief financial
officer attached as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q
include, in paragraph 4 of such certifications, information concerning the
Company’s disclosure controls and procedures, and internal control over
financial reporting.  Such certifications should be read in
conjunction with the information contained in this Item 4T for a more complete
understanding of the matters covered by such certifications.




Disclosure
Controls and Procedures




The
Company’s management, with the participation of the Company’s chief executive
officer and chief financial officer, evaluated the effectiveness of the
Company’s disclosure controls and procedures as of March 31,
2009.  The term “disclosure controls and procedures,” as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended, means controls and other procedures of a company that are designed to
ensure that information required to be disclosed by the Company in the reports
that it files or submits under the Exchange Act is recorded, processed,
summarized, and reported, within the time periods specified in the Securities
and Exchange Commission’s rules and forms.  Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the company’s management, including its chief executive officer and chief
financial officer, as appropriate, to allow timely decisions to be made
regarding required disclosure.  It should be noted that any system of
controls and procedures, however well designed and operated, can provide only
reasonable, and not absolute, assurance that the objectives of the system are
met and that management necessarily applies its judgment in evaluating the
cost-benefit relationship of possible controls and procedures.  Based
on the evaluation of the Company’s disclosure controls and procedures as of
March 31, 2009, the Company’s chief executive officer and chief financial
officer concluded that, as of such date, the Company’s disclosure controls and
procedures were effective at the reasonable assurance level.




Changes
in Internal Control Over Financial Reporting




There
were no changes to the Company’s internal control over financial reporting
during the quarter ended March 31, 2009 that have materially affected, or are
reasonably likely to materially affect, the Company’s internal control over
financial reporting.




32


PART
II.                      OTHER
INFORMATION







Item
      1.
            Legal
      Proceedings






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




In May
2007, we entered into an asset purchase agreement to sell substantially all of
the assets of our Accurel Systems subsidiary to Evans Analytical Group LLC for
approximately $12,705,000, including $1,000,000 held by an escrow agent as
security for certain representations and warranties.  On February 22,
2008, Evans filed suit in the Superior Court of the State of California, Santa
Clara County, requesting rescission of the asset purchase agreement, plus
damages, based on claims of misrepresentation and fraud.  In March
2008, Evans filed a claims notice with the escrow agent prohibiting release of
any portion of the escrow to us pending resolution of the lawsuit.




On March
27, 2009, we announced the settlement of this litigation and the mutual release
with Evans of all claims related to the sale of Accurel.  In settling
this litigation, the we agreed to pay Evans damages in the amount of
approximately $5,700,000 by (i) agreeing to release to Evans approximately
$700,000 that had been held in escrow since the time of the closing of the
Accurel sale and (ii) agreeing to issue to Evans 1,000,000 shares of a new
series of preferred stock having an aggregate liquidation preference of
$5,000,000.




We are
not a party to any other legal proceedings, other than ordinary routine
litigation incidental to our business, which we believe will not have a material
affect on our business, assets or results of operations.




Item
      1A.
            Risk
      Factors






Other than as set forth below, there have not been any
material changes from the risk factors previously disclosed under Item 1A of our
Annual Report on Form 10-K, as amended, for the fiscal year ended June 30,
2008.


We
will be required to repay the Senior Secured Convertible Promissory
Note  issued to DMRJ Group, LLC on or before December 10,
2009.
  The
remaining principal balance, together with outstanding interest, of our Secured
Convertible Promissory Note  issued to DMRJ Group, LLC is due and
payable on December 10, 2009. Our obligations to DMRJ are secured by a security
interest in substantially all of our assets.  As of March 31, 2009,
the outstanding principal balance due to DMRJ was $3,741,000.  If we
are unable to repay the note in full, as required, refinance our obligations to
DMRJ, or negotiate an extension of the note’s maturity, DMRJ may seize our
assets and we may be forced to curtail or discontinue operations
entirely.


We
are in default of certain financial covenants of
the note issued to DMRJ Group LLC.  If we are unable to
obtain a waiver from DMRJ, then DMRJ may declare the entire unpaid principal
balance of the note, together with all interest accrued hereon, plus fees and
expenses, due and payable.




As of
March 31, 2009, we were not in compliance with certain financial covenants
of the senior secured convertible promissory note issued to
DMRJ.  We have requested a waiver of these defaults.  If we
are unable to obtain a waiver, DMRJ may declare the entire unpaid principal
balance of the note, together with all interest accrued hereon, plus fees and
expenses, due and payable.  Any such action on the part of DMRJ would
have a material adverse effect on our liquidity and financial condition
and could force us to curtail or discontinue all of our
operations.  Our ability to comply with the debt covenants in the
future depends on our ability to generate sufficient sales, control our 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.  Further, upon the
occurrence of an event of default under certain provisions of the Note, we could
be required to pay default rate interest equal to the lesser of (2.5%) per
month and the maximum applicable legal rate per annum on the outstanding
principal balance of the note.




33


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




Management
continually evaluates plans to reduce its operating expenses, increase sales and
increase its cash flow from operations.  Despite the current sales,
expense and cash flow projections, the cash available from our line of credit,
the projected cash from the sale of Core Systems and certain other assets, we
will require additional capital in the fourth quarter of fiscal 2009 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 operations and
could force us to curtail or discontinue all of our operations.


Our common stock has been
delisted by theNYSE Amex LLC, and is currently trading on the
Over-The-Counter Bulletin Board.
  On May 5,
2009, the Company received a notice from NYSE Amex LLC, formerly known as NYSE
Alternext US LLC, stating that the NYSE Amex Committee on Securities had
unanimously affirmed a prior decision by a Listing Qualifications Panel to
delist the Company’s common stock. The Exchange’s decision was not subject to
further appeal by the Company.  The trading of the Company’s common stock
was suspended by the Exchange on April 6, 2009 and will be delisted
effective June 22, 2009.  The Company's common stock was approved
for trading on the Over-The-Counter Bulletin Board under the symbol “IMSC”
on May 4, 2009.  The delisting of our common stock by the
Exchange could substantially limit the liquidity of our stock and could
substantially impair our ability to raise
capital.






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




On November 4, 2008, we
agreed to issue929,535 shares of common stock, having a value of
$268,000, to an affiliate of Laurus Master Fund, Ltd., in partial redemption of
our Series D Cumulative Redeemable Convertible Preferred Stock.  The shares
were issued in May 2009.




On March 12, 2009, we
issued an amended and restated senior secured convertible promissory
note in the principal amount of $5,600,000, and an amended and
restated warrant to purchase 1,000,000 shares of common stock, to DMRJ
Group, LLC.




On
February 3, 2009, we agreed to issue 1,000,000 shares of common stock, having a
value of $162,000, to JFS Investments, Inc. in consideration of services
rendered and to be rendered in connection the with our efforts to secure
additional funding of which 250,000 vested  immediately and the
balance of which will vest in equal monthly installments of 75,000 commencing on
May 6, 2009.




The
issuance of these securities is exempt from registration under the Securities
Act of 1933, as amended, pursuant to an exemption provided by Section 4(2) of
the Securities Act.









Item
      3.
            Defaults
      Upon Senior Securities




None.




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




None.




Item 5.
            Other
      Information




None.




34


Item
      6.
            Exhibits




Exhibit
No.








3.1 (1)
            Restated
      Articles of Organization, as amended, of Implant Sciences
      Corporation.




10.1
      (2)
            Letter
      Agreement, dated as of March 12, 2009, between Implant Sciences
      Corporation and DMRJ Group LLC.




10.2
      (2)
            Amended
      and Restated Senior Secured Convertible Promissory Note, dated December
      10, 2008, in the principal amount of $5,600,000, issued by Implant
      Sciences Corporation to DMRJ Group
LLC.




10.3
      (2)
            Amended
      and Restated Warrant to Purchase Shares of Common Stock, dated March 12,
      2009, issued by Implant Sciences Corporation to DMRJ Group
      LLC.




31.1
      (1)
            Certification
      of Principal Executive Officer pursuant to Section 3.02 of the
      Sarbanes-Oxley Act of 2002.




31.2
      (1)
            Certification
      of Principal Financial Officer pursuant to Section 3.02 of the
      Sarbanes-Oxley Act of 2002.




32.1
      (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
      (1)
            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
      herewith.




(2)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K dated March 12,
      2009 and filed March 18, 2009, and incorporated herein by
      reference.




























35


SIGNATURES




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




Implant
Sciences Corporation






By:  /s/ Glenn D.
Bolduc


Glenn D.
Bolduc


President,
Chief Executive Officer and Chief Financial Officer




Dated:  June
12, 2009









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