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 December 31,
2008




or




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




For the
transition period
from                                                                                                
to




Commission
File Number: 000-25839









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)


107
Audubon Road, Wakefield, Massachusetts 01880




(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
February 12, 2009, there were 14,135,155 shares of the registrant’s Common Stock
were outstanding.









Part
I.  Financial Information
 Item
1.  Financial Statements


IMPLANT SCIENCES
CORPORATION





TABLE
OF CONTENTS














PagePART
      I.
            FINANCIAL
      INFORMATIONItem
      1.
            Condensed
      Consolidated Financial Statements (unaudited)Condensed
      Consolidated Balance Sheets at December 31, 2008 and June 30,
      2008
            3Condensed
      Consolidated Statements of Operations for the three and six months
      ended
              December
      31, 2008 and 2007
            4Condensed
      Consolidated Statements of Cash Flows for the three and six months
      ended
              December
      31, 2008 and 2007
            5Notes
      to Condensed Consolidated Financial Statements
            6-23Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            24-34Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            34Item
      4.
            Controls
      and Procedures
            34PART
      II.
            OTHER
      INFORMATIONItem
      1.
            Legal
      Proceedings
            35Item
      1A.
            Risk
      Factors
            35-37Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            37Item
      3.
            Defaults
      Upon Senior Securities
            37Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            37Item
      5.
            Other
      Information
            37Item
      6.
            Exhibits
            38-39Signatures
            40















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


Implant
      Sciences CorporationCondensed
      Consolidated Balance SheetsDecember
      31,
              
              
              June
      30,2008
              
              
              2008ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              724,000
              
              
              $
              412,000Restricted
      cash
              
              
              1,014,000
              
              
              
              514,000Accounts
      receivable-trade, net of allowance of $14,000 and
      $9,000,  respectively
              
              
              860,000
              
              
              
              667,000Accounts
      receivable, unbilled
              
              
              90,000
              
              
              
              152,000Notes
      receivable, current
              
              
              413,000
              
              
              
              -Inventories
              
              
              618,000
              
              
              
              725,000Prepaid
      expenses and other current assets
              
              
              700,000
              
              
              
              369,000Current
      assets held for sale
              
              
              290,000
              
              
              
              1,883,000Total
      current assets
              
              
              4,709,000
              
              
              
              4,722,000Property
      and equipment, net
              
              
              349,000
              
              
              
              443,000Amortizable
      intangible assets, net
              
              
              19,000
              
              
              
              54,000Notes
      receivable, net of current
              
              
              843,000
              
              
              
              -Other
      non-current assets
              
              
              1,110,000
              
              
              
              1,096,000Goodwill
              
              
              3,136,000
              
              
              
              3,136,000Non-current
      assets held for sale
              
              
              143,000
              
              
              
              2,645,000Total
      assets
              
              $
              10,309,000
              
              
              $
              12,096,000LIABILITIES
      AND STOCKHOLDERS' (DEFICIT) EQUITYCurrent
      liabilities:Senior
      secured convertible note
              
              $
              3,436,000
              
              
              $
              -Current
      maturities of long-term debt and obligations under capital
      lease
              
              
              44,000
              
              
              
              417,000Line
      of credit
              
              
              -
              
              
              
              477,000Notes
      payable
              
              
              20,000
              
              
              
              181,000Payable
      to Med-Tec
              
              
              59,000
              
              
              
              80,000Payable
      to Ion Metrics shareholders
              
              
              12,000
              
              
              
              2,514,000Accrued
      expenses
              
              
              1,953,000
              
              
              
              2,062,000Accounts
      payable
              
              
              3,254,000
              
              
              
              2,439,000Current
      portion of long-term lease liability
              
              
              326,000
              
              
              
              317,000Deferred
      revenue
              
              
              105,000
              
              
              
              66,000Current
      liabilities held for sale
              
              
              133,000
              
              
              
              1,079,000Total
      current liabilities
              
              
              9,342,000
              
              
              
              9,632,000Long-term
      liabilities:Long-term
      debt and obligations under capital lease, net of current
      maturities
              
              
              91,000
              
              
              
              113,000Long-term
      lease liability
              
              
              253,000
              
              
              
              446,000Long-term
      liabilities held for sale
              
              
              -
              
              
              
              1,000Total
      long-term liabilities
              
              
              344,000
              
              
              
              560,000Total
      liabilities
              
              
              9,686,000
              
              
              
              10,192,000Commitments
      and contingencies (Note 9)Series
      D Cumulative Redeemable Convertible Preferred Stock, $10 stated value;
      500,000 shares
                authorized,
      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; 14,145,700
      and
                14,135,155
      and 12,114,553 and 12,104,008 shares issued and outstanding,
      respectively
              
              
              1,415,000
              
              
              
              1,211,000Additional
      paid-in capital
              
              
              60,889,000
              
              
              
              58,317,000Accumulated
      deficit
              
              
              (61,632,000
              )
              
              
              (59,720,000
              )Deferred
      compensation
              
              
              (1,000
              )
              
              
              (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
              
              
              623,000
              
              
              
              (365,000
              )Total
      liabilities and stockholders' (deficit) equity
              
              $
              10,309,000
              
              
              $
              12,096,000The
      accompanying notes are an integral part of these financial
      statements.
    -3-


Implant
      Sciences CorporationCondensed
      Consolidated Statements of OperationsFor
      The Three Months Ended
              
              
              For
      The Six Months EndedDecember
      31,
              
              
              December
      31,2008
              
              
              2007
              
              
              2008
              
              
              2007RevenuesSecurity
      products
              
              $
              1,207,000
              
              
              $
              244,000
              
              
              $
              6,509,000
              
              
              $
              1,444,000Government
      contracts and services
              
              
              312,000
              
              
              
              125,000
              
              
              
              958,000
              
              
              
              272,0001,519,000
              
              
              
              369,000
              
              
              
              7,467,000
              
              
              
              1,716,000Cost
      of revenues
              
              
              881,000
              
              
              
              408,000
              
              
              
              4,053,000
              
              
              
              1,229,000Gross
      margin
              
              
              638,000
              
              
              
              (39,000
              )
              
              
              3,414,000
              
              
              
              487,000Operating
      expenses:Research
      and development
              
              
              751,000
              
              
              
              663,000
              
              
              
              1,771,000
              
              
              
              1,314,000Selling,
      general and administrative
              
              
              1,561,000
              
              
              
              1,488,000
              
              
              
              3,927,000
              
              
              
              2,845,0002,312,000
              
              
              
              2,151,000
              
              
              
              5,698,000
              
              
              
              4,159,000Loss
      from operations
              
              
              (1,674,000
              )
              
              
              (2,190,000
              )
              
              
              (2,284,000
              )
              
              
              (3,672,000
              )Other
      income (expense), net:Interest
      income
              
              
              12,000
              
              
              
              64,000
              
              
              
              20,000
              
              
              
              165,000Interest
      expense
              
              
              (773,000
              )
              
              
              (27,000
              )
              
              
              (805,000
              )
              
              
              (61,000
              )Equity
      losses in unconsolidated subsidiary
              
              
              (123,000
              )
              
              
              -
              
              
              
              (123,000
              )
              
              
              -Gain
      on transfer of investment
              
              
              468,000
              
              
              
              -
              
              
              
              468,000
              
              
              
              -Change
      in fair value of embedded derivatives related to
                preferred
      stock features
              
              
              -
              
              
              
              283,000
              
              
              
              -
              
              
              
              133,000Total
      other (expense) income, net
              
              
              (416,000
              )
              
              
              320,000
              
              
              
              (440,000
              )
              
              
              237,000Loss
      from continuing operations
              
              
              (2,090,000
              )
              
              
              (1,870,000
              )
              
              
              (2,724,000
              )
              
              
              (3,435,000
              )Preferred
      distribution, dividends and accretion
              
              
              (18,000
              )
              
              
              (289,000
              )
              
              
              (207,000
              )
              
              
              (596,000
              )Loss
      from continuing operations applicable to common
                shareholders
              
              
              (2,108,000
              )
              
              
              (2,159,000
              )
              
              
              (2,931,000
              )
              
              
              (4,031,000
              )Income
      (loss) from discontinued operations, before
                sale
      of discontinued operations
              
              
              7,000
              
              
              
              (2,945,000
              )
              
              
              997,000
              
              
              
              (3,582,000
              )Income
      on sale of discontinued operations
              
              
              22,000
              
              
              
              -
              
              
              
              22,000
              
              
              
              -Income
      (loss) from discontinued operations
              
              
              29,000
              
              
              
              (2,945,000
              )
              
              
              1,019,000
              
              
              
              (3,582,000
              )Net
      loss applicable to common shareholders
              
              $
              (2,079,000
              )
              
              $
              (5,104,000
              )
              
              $
              (1,912,000
              )
              
              $
              (7,613,000
              )Net
      loss
              
              $
              (2,061,000
              )
              
              $
              (4,815,000
              )
              
              $
              (1,705,000
              )
              
              $
              (7,017,000
              )Loss
      per share from continuing operations, basic and diluted
              
              $
              (0.15
              )
              
              $
              (0.16
              )
              
              $
              (0.20
              )
              
              $
              (0.29
              )Loss
      per share from continuing operations applicable to
                common
      shareholders, basic and diluted
              
              $
              (0.15
              )
              
              $
              (0.18
              )
              
              $
              (0.21
              )
              
              $
              (0.34
              )Income
      (loss) per share from discontinued operations, basic
                and
      diluted
              
              $
              0.00
              
              
              $
              (0.25
              )
              
              $
              0.07
              
              
              $
              (0.30
              )Net loss
      per share applicable to common shareholders,
                basic
      and diluted
              
              $
              (0.15
              )
              
              $
              (0.43
              )
              
              $
              (0.14
              )
              
              $
              (0.64
              )Net loss
      per share
              
              $
              (0.15
              )
              
              $
              (0.41
              )
              
              $
              (0.12
              )
              
              $
              (0.59
              )Weighted
      average shares used in computing net income (loss)
                per
      common share, basic and diluted
              
              
              14,135,155
              
              
              
              11,844,093
              
              
              
              13,801,822
              
              
              
              11,840,931












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









-4-


Implant
      Sciences CorporationCondensed
      Consolidated Statements of Cash FlowsFor
      the Six Months EndedDecember
      31,2008
              
              
              2007Cash
      flows from operating activities:Net
      loss
              
              $
              (1,705,000
              )
              
              $
              (7,017,000
              )Less:  Net
      income (loss) from discontinued operations
              
              
              1,019,000
              
              
              
              (3,582,000
              )Loss
      from continuing operations
              
              
              (2,724,000
              )
              
              
              (3,435,000
              )Adjustments
      to reconcile net loss from continuing operationsto
      net cash flows from operating activities:Depreciation
      and amortization
              
              
              145,000
              
              
              
              83,000Bad
      debt expense (recoveries)
              
              
              4,000
              
              
              
              (16,000
              )Share-based
      compensation expense
              
              
              147,000
              
              
              
              349,000Loss
      on disposal of fixed asset
              
              
              10,000
              
              
              
              -Change
      in fair value of embedded derivatives
              
              
              -
              
              
              
              (133,000
              )Non-cash
      interest expense
              
              
              639,000
              
              
              
              -Fair
      value of warrants issued to non-employees
              
              
              (21,000
              )
              
              
              -Warrant
      accretion on debt
              
              
              17,000
              
              
              
              6,000Equity
      in loss of unconsolidated subsidiary
              
              
              123,000
              
              
              
              -Gain
      on transfer of investment
              
              
              (468,000
              )
              
              
              -Interest
      income on note receivable
              
              
              (6,000
              )
              
              
              -Changes
      in assets and liabilities, net of effect of acquisitions and
      dispositions:Accounts
      receivable
              
              
              (135,000
              )
              
              
              250,000Inventories
              
              
              107,000
              
              
              
              (6,000
              )Prepaid
      expenses and other current assets
              
              
              (331,000
              )
              
              
              (29,000
              )Accounts
      payable
              
              
              778,000
              
              
              
              376,000Accrued
      expenses
              
              
              (375,000
              )
              
              
              (337,000
              )Deferred
      revenue
              
              
              39,000
              
              
              
              (47,000
              )Lease
      liability
              
              
              (185,000
              )
              
              
              (120,000
              )Net
      cash used in operating activities of continuing operations
              
              
              (2,236,000
              )
              
              
              (3,059,000
              )Net
      cash provided by (used in) operating activities of discontinued
      operations
              
              
              36,000
              
              
              
              (374,000
              )Net
      cash used in operating activities
              
              
              (2,200,000
              )
              
              
              (3,433,000
              )Cash
      flows from investing activities:Purchases
      of property and equipment
              
              
              (26,000
              )
              
              
              (92,000
              )Payments
      received on note receivable
              
              
              375,000
              
              
              
              -Proceeds
      from sale of property and equipment, net of transaction
    costs
              
              
              1,457,000
              
              
              
              -Proceeds
      from the sale of Core Systems, net of transaction costs
              
              
              1,080,000
              
              
              
              -(Decrease)
      increase in other non-current assets
              
              
              (14,000
              )
              
              
              53,000Net
      cash provided by (used in) investing activities of continuing
      operations
              
              
              2,872,000
              
              
              
              (39,000
              )Net
      cash used in investing activities of discontinued
    operations
              
              
              (28,000
              )
              
              
              (166,000
              )Net
      cash provided by (used in) investing activities
              
              
              2,844,000
              
              
              
              (205,000
              )Cash
      flows from financing activities:Proceeds
      from common stock issued in connection with exercise of stock options
      and
                employee
      stock purchase plan
              
              
              24,000
              
              
              
              26,000Proceeds
      from the issuance of Senior Secured Convertible Promissory
      Note
              
              
              4,484,000
              
              
              
              -Principal
      payment on Senior Secured Convertible Promissory Note
              
              
              (1,000,000
              )
              
              
              -Dividends
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
              
              
              (52,000
              )
              
              
              (166,000
              )Payments
      on Series D Cumulative Redeemable Convertible Preferred
    Stock
              
              
              (2,724,000
              )
              
              
              (606,000
              )Principal
      repayments of long-term debt and capital lease obligations
              
              
              (299,000
              )
              
              
              (431,000
              )Net
      repayments on line of credit
              
              
              (764,000
              )
              
              
              -Net
      cash used in financing activities of continuing operations
              
              
              (331,000
              )
              
              
              (1,177,000
              )Net
      cash used in discontinued operations
              
              
              (1,000
              )
              
              
              (2,000
              )Net
      cash provided by (used in) financing activities
              
              
              (332,000
              )
              
              
              (1,179,000
              )Net
      change in cash and cash equivalents
              
              
              312,000
              
              
              
              (4,817,000
              )Cash
      and cash equivalents at beginning of period
              
              
              412,000
              
              
              
              9,621,000Cash
      and cash equivalents at end of period
              
              $
              724,000
              
              
              $
              4,804,000
   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 17 for further information
relative to the acquisition of Ion Metrics.




Sale
of Accurel




In May 2007, the Company
sold substantially all of the assets of our Accurel Systems subsidiary to Evans
Analytical Group, LLC for approximately $12,705,000, including $1,000,000 held
by an escrow agent as security for certain representations and
warranties.  In February 2008, Evans filed suit in the Superior Court
of the State of California, Santa Clara County, requesting rescission of the
asset purchase agreement, plus damages, based on claims of misrepresentation and
fraud.  In March 2008, Evans filed a notice with the escrow agent
prohibiting release of any portion of the escrow to us pending resolution of the
lawsuit.  More recently, Evans filed motions to attach substantial
portions of the Company’s assets prior to any final judgment on the merits of
Evans’ claims.  On November 7, 2008, theCourtdeniedEvans’
motions.The Company is vigorously defending itself against
Evans’ claims.  During late 2008 and early 2009, the Company and
Evans each prepared comprehensive summary judgment motions against the other,
arguing that the case should be resolved by the Court as a legal matter, without
the need for jury trial.  The Company and Evans have
each opposed one another’s motions.  The motions were heard
by the Court on February 10, 2009, and the Court has not yet issued a ruling on
either motion.  A trial date of April 6, 2009 is presently
scheduled.  No assurance can be given, however, that the Company will
be successful in its defense against Evans’ claims, and any substantial final
judgment in favor of Evans would have a material adverse effect on the Company’s
business, assets and results of operations and could require the Company to file
for protection under bankruptcy laws.  Moreover, the Company believes
that its litigation with Evans has made it extremely difficult to raise capital
needed to operate its business.




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 has paid
$250,000 of the amount due in December and is in default on the balance of such
payment.  The $250,000 unpaid balance due on the December payment is
recorded as a current asset in the Company’s consolidated balance sheet as of
December 31, 2008.  As of February 17, 2009, the Buyer remained in
default in respect of that payment.




-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 six months ended December 31, 2008,
under three separate asset purchase agreements, the Company sold certain assets
of its medical coatings business, with gross proceeds aggregating approximately
$1,590,000.  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 $3,436,000 as of December 31, 2008
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 six months
ended December 31, 2008, the Company reported net loss applicable to common
shareholders of $1,912,000, loss from continuing operations of $2,724,000 and
used $2,236,000 in cash from operating activities of continuing operations.
 As of December 31, 2008, the Company had an accumulated deficit of
approximately $61,632,000 and a working capital deficit of $4,633,000.
 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, 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 December 31, 2008 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, we 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 sales of the assets of our
Accurel Systems subsidiary, upon the release of such funds.




-7-
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS
  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.  As of December 31, 2008, the outstanding
balance on the convertible debt was $3,436,000.  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.  As of December 31, 2008,
the Company’s current ratio was 0.50 to 1.00, and the Company is not in
compliance with the required current ratio.  The Company has requested a
waiver of this default.




If the
Company is unable to obtain a waiver of the current ratio default, DMRJ Group
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 Group 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 and to file for
protection under bankruptcy laws.  The Company’s ability to comply
with the debt covenants in the future depends on its ability to generate
sufficient sales, 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 and to file for protection
under bankruptcy laws.  Further, upon the occurrence of an event of
default under certain provisions of the senior secured promissory note, the
Company 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.




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, the sale of other assets, and the ability of the
Company to raise additional capital.  To further sustain the Company,
improve its cash position, and enable it to grow while reducing debt, management
will need to seek additional capital through private financing sources during
the third 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 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 December 31, 2008 and
June 30, 2008, the Company’s obligation to redeem the Series D Preferred Stock
amounted to $0 and $2,424,000, respectively.  At December 31, 2008,
$268,000, representing the fair value of the unissued shares of the Company’s
common stock is included in current liabilities.




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.




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


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 six months ended December 31, 2008
may not necessarily be indicative of results that may be expected for any
succeeding quarter or for the entire fiscal year.  The information
contained in this Form 10-Q should be read in conjunction with the Company’s
audited financial statements, included in 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 Core, the assets and liabilities
of Core are presented in the accompanying condensed consolidated balance sheet
as assets and liabilities held for sale as of 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 six months
ended December 31, 2008 and 2007.




As a
result of the Company’s decision to dispose of the medical business unit, the
assets and liabilities of the medical business unit are presented in the
accompanying condensed consolidated balance sheet as assets and liabilities held
for sale as of December 31, 2008 and June 30, 2008, and the operating results of
the medical business unit are presented in the accompanying condensed
consolidated statements of operations as discontinued operations for the three
and six months ended December 31, 2008 and 2007.




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




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




Certain
reclassifications were made to the financial statements for the three and six
months ended December 31, 2007 to conform to the presentation for the three and
six  months ended December 31, 2008.




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


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 $724,000, was required to be
measured at fair value at December 31, 2008 and the balance was included in
Level 1 inputs.




4.
            Restricted
      Cash




As of
both December 31, 2008 and June 30, 2008, the Company had restricted cash of
$1,014,000 and $514,000, respectively.  Restricted cash consisted of
the following:


December
      31,
              
              
              June
      30,2008
              
              
              2008Money
      market account
              
              $
              439,000
              
              
              $
              439,000Certificates
      of deposit
              
              
              75,000
              
              
              
              75,000Blocked
      account deposit
              
              
              500,000
              
              
              
              -$
              1,014,000
              
              
              $
              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 $75,000 deposited in certificates of deposit, collateralizes two (2)
credit cards issued by the Company’s primary lender.  Pursuant to its
agreements with DMRJ Group LLC (See Note 11), the Company is required to
maintain a balance of at least $500,000 in a bank deposit account pledged to
DMRJ Group LLC 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




5.
            Stock
      Based Compensation




The
Company’s condensed consolidated statements of operations for the three months
ended December 31, 2008 and 2007 include $33,000 and $215,000, 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 six months ended December 31, 2008 and 2007, the
condensed consolidated statements of operations include $147,000 and $347,000,
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 December 31, 2008, the total amount of
unrecognized stock-based compensation expense was approximately $488,000, which
will be recognized over a weighted average period of 2.9 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 subsidiary, Core
Systems.  During the three months ended December 31, 2008 and 2007,
this advisory company was paid $139,000 and $0, respectively.  During
the six months ended December 31, 2008 and 2007, the advisory company was paid
$169,000 and $0, respectively.  As of December 31, 2008, the Company
recorded payables to the advisory company of $7,000.




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






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 17.  Further, the Company has
entered into a fixed asset lease agreement with Ferran Scientific, Inc., a firm
owned by the father of the former Ion Metrics chairman.




7.
            Inventories




Inventories
consist of the following:


December
      31,
                
                
                June
      30,2008
                
                
                2008Raw
      materials
                
                $
                203,000
                
                
                $
                400,000Work
      in progress
                
                
                28,000
                
                
                
                23,000Finished
      goods
                
                
                387,000
                
                
                
                302,000$
                618,000
                
                
                $
                725,000


8.
            Property
      and Equipment




Property
and equipment consist of the following:


December
      31,
              
              
              June
      30,2008
              
              
              2008Machinery
      and equipment
              
              $
              512,000
              
              
              $
              517,000Computers
      and software
              
              
              876,000
              
              
              
              871,000Furniture
      and fixtures
              
              
              168,000
              
              
              
              164,000Leasehold
      improvements
              
              
              4,000
              
              
              
              369,000Equipment
      under capital lease
              
              
              93,000
              
              
              
              93,0001,653,000
              
              
              
              2,014,000Less:  accumulated
      depreciation and amortization
              
              
              1,304,000
              
              
              
              1,571,000$
              349,000
              
              
              $
              443,000




For the
three months ended December 31, 2008 and 2007, depreciation expense was $56,000
and $42,000, respectively.  For the six months ended December 31, 2008
and 2007, depreciation expense was $110,000 and $83,000,
respectively.




9.
            Accrued
      Expenses




Accrued
expenses consist of the following:


December
      31,
              
              
              June
      30,2008
              
              
              2008Accrued
      compensation and benefits
              
              $
              560,000
              
              
              $
              807,000Accrued
      taxes
              
              
              404,000
              
              
              
              289,000Accrued
      legal and accounting
              
              
              97,000
              
              
              
              259,000Accrued
      interest
              
              
              24,000
              
              
              
              46,000Accrued
      warranty costs
              
              
              224,000
              
              
              
              104,000Other
      accrued liabilities
              
              
              644,000
              
              
              
              557,000$
              1,953,000
              
              
              $
              2,062,000


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


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 December 31, 2008 and 2007, 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 further to release each other from further
obligations under an earlier distribution agreement.  The purchase
price of $1,250,000, which was payable in varying amounts over 28 months, with
the final payment payable on December 1, 2005, was recorded at the present value
of the future payment stream, using a rate of 10.24%, which equaled
$1,007,000.  This amount was recorded as an intangible asset and was
amortized over its estimated useful life of 29 months.  The
outstanding and past due principal balance as of December 31, 2008 and June 30,
2008 was approximately $59,000, and $80,000 respectively.




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 December
31, 2008 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 ABP No 14 “Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants,” the warrant was recorded at
its relative fair value of $28,000 and accreted to the term note over the
life of the note.  As of December 31, 2008, 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 ABP No 14, the warrant was recorded at its
relative fair value of $29,000 and was charged to interest expense during the
year ended June 30, 2008.




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


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
Group.  The note is convertible in whole or in part at the option of
DMRJ Group 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
Group.  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 seven (7) 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 sales of the assets of our Accurel Systems subsidiary, upon the
release of such funds.  The remaining principal balance, together with
outstanding interest, is due and payable on December 10, 2009.




Approximately
$9,000 of the warrant value was accounted for as interest expense in the three
and six months ended December 31, 2008.  The Company is accreting the
warrants 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 $71,000 of the
original issue discount and fair value of the CorNova common stock in the three
and six months ended December 31, 2008, which was recorded as interest expense
in the statement of operations.  As of December 31, 2008, the
outstanding balance on the Note was $3,436,000 (liquidation value of
$4,600,000).




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 has 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 six months ended December 31,
2008.




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


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 is accreting these discounts on the carrying value of the Series D
Preferred Stock to its redemption value at September 29, 2008, or the actual
conversion date, whichever is earlier.  The accretion of these amounts
is being recorded as a preferred dividend in the period of
accretion.  For the three and six months ended December 31, 2008 and
2007, $18,000 and $289,000, respectively, and $207,000 and $596,000,
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.  As of December 31,
2008 and June 30, 2008, the outstanding balance on the Series D Preferred Stock
was $0 and $2,424,000, respectively.




13.
            Stockholders’
      Equity




Common
Stock Options and Warrants




In
connection with various financing agreements and services provided by
consultants, the Company has issued warrants to purchase common stock of the
Company.  The fair value of warrants issued is determined using the
Black-Scholes option pricing model.  In December 2008, in conjunction
with the issuance of the senior secured convertible note to DMRJ Group, the
Company issued a five-year warrant to purchase 1,000,000 shares of common
stock at an initial exercise price of $0.26 per share.  The warrant is
exercisable between December 10, 2008 and December 10, 2013. Pursuant to ABP 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 and will be accreted to the note over
the life of the note.




As of
December 31, 2008, there were warrants outstanding to purchase 3,197,627 shares
of the Company’s common stock at exercise prices ranging from $0.26 to $12.45
expiring at various dates between January 6, 2009 and June 27,
2015.




The
Company issued no shares of common stock during the six months ended December
31, 2008 and 2007, as a result of the exercise of options by employees and
consultants.




Employee
Stock Purchase Plan




During
the six months ended December 31, 2008 and 2007, the Company issued 31,147
shares and 18,977 shares, respectively, of its common stock to its employees
pursuant to the terms of the 2006 Employee Stock Purchase Plan.  There
were no shares issued pursuant to the terms of this plan during the
three months ended December 31, 2008 and 2007.




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


Treasury
Stock and Other Transactions




In June
2004, the Board authorized the Company to repurchase up to 300,000 shares of the
Company’s common stock, from time to time in the open market, privately
negotiated transactions, block transactions or at time and prices deemed
appropriate by management.  As of December 31, 2008 and June 30, 2008,
10,545 shares were held in treasury at cost.  During each of the three
and six months ended December 31, 2008 and 2007, the Company repurchased no
shares of the Company’s common stock.  As of December 31, 2008, the
maximum number of shares authorized to be repurchased is
289,455.




14.
            Income
      Taxes




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




For the
three and six months ended December 31, 2008 and 2007, the Company provided for
no taxes as the Company has significant net loss carryforwards.




15.
            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 six months ended December 31, 2008.  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 six months ended December 31, 2008.  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.




16.
            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 six months ended December 31, 2008 and
2007, for both continuing and discontinued operations was $718,000 and $717,000,
respectively.




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


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 December 31, 2008 is
$578,000 of which $326,000 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 December 31, 2008, the balance due is approximately
$22,000 and is included in Accrued Expenses.




The
Company is obligated under two license agreements, assumed in connection with
the acquisition of Ion Metrics, whereby the Company has been granted rights to
use certain intellectual property for safety, security and drug applications,
which the Company intends to incorporate into future security product
offerings.  Minimum royalty payments due in fiscal 2009 are $50,000
and no payments have been made in the six months ended December 31,
2008.




17.
            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, par value $0.10 per share.  The fair
value of the Company's common stock was determined based on the average market
price of the Company's common stock over a period of time before April 10, 2008,
the date fair value is to be determined, pursuant to Emerging Issues Task Force
("EITF") Issue No. 99-12, “Determination of the Measurement
Date for the Market Price of Acquirer Securities Issued in a Purchase Business
Combination.”  The Company issued the 2,000,000 shares of the
Company’s common stock to 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 December 31, 2008 and June 30, 2008, the balance
due was approximately $12,000 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.




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


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


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
six months ended December 31, 2008 was $17,000 and $35,000,
respectively.  There was no amortization expense for the three and six
months ended December 31, 2007.




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




18.
            Financial
      Information By Segment




SFAS No.
131, “Disclosures about
Segments of an Enterprise and Related Financial Information,” 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.




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


19.
            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 six months ended December 31, 2008 and 2007 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 has paid $250,000 of the amount due in
December, and is in default on the balance of such payment.  The
$250,000 balance due on the December payment was recorded as a current asset in
the Company’s consolidated balance sheet as of December 31, 2008.  As
of February 17, 2009, the Buyer remained in default in respect of that
payment.




Condensed
results of operations relating to Core Systems for the three and six months
ended December 31, 2008 and 2007 are as follows:


Three
      Months Ended
              
              
              Six
      Months EndedDecember
      31,
              
              
              December
      31,2008
              
              
              2007
              
              
              2008
              
              
              2007Revenues
              
              $
              782,000
              
              
              $
              1,353,000
              
              
              $
              2,288,000
              
              
              $
              3,090,000Gross
      profit
              
              
              176,000
              
              
              
              (165,000
              )
              
              
              471,000
              
              
              
              (203,000
              )Impairment
      of long-lived assets and goodwill
              
              
              -
              
              
              
              2,224,000
              
              
              
              -
              
              
              
              2,224,000Operating
      income (loss)
              
              
              8,000
              
              
              
              (2,707,000
              )
              
              
              25,000
              
              
              
              (3,116,000
              )Gain
      on sale of discontinued operations
              
              
              22,000
              
              
              
              -
              
              
              
              22,000
              
              
              
              -Income
      (loss) from discontinued operations
              
              
              30,000
              
              
              
              (2,707,000
              )
              
              
              46,000
              
              
              
              (3,117,000
              )


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




The
assets and liabilities of Core Systems as of June 30, 2008 are as
follows:


June
      30,2008Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
              
              $
              1,178,000Inventories
              
              
              251,000Total
      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




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
six months ended December 31, 2008 and 2007 are as follows:


Three
      Months Ended
              
              
              Six
      Months EndedDecember
      31,
              
              
              December
      31,2008
              
              
              2007
              
              
              2008
              
              
              2007Revenues
              
              $
              200,000
              
              
              $
              162,000
              
              
              $
              557,000
              
              
              $
              296,000Gross
      profit
              
              
              (94,000
              )
              
              
              (205,000
              )
              
              
              (51,000
              )
              
              
              (383,000
              )Operating
      loss
              
              
              (94,000
              )
              
              
              (238,000
              )
              
              
              (51,000
              )
              
              
              (465,000
              )Gain
      on sale of assets
              
              
              93,000
              
              
              
              -
              
              
              
              1,024,000
              
              
              
              -Income
      (loss) from discontinued operations
              
              
              (1,000
              )
              
              
              (238,000
              )
              
              
              973,000
              
              
              
              (465,000
              )


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




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


December
      31,
              
              
              June
      30,2008
              
              
              2008Assets
      of Discontinued OperationsCurrent
      assets of discontinued operations:Accounts
      receivable-trade, net
              
              $
              112,000
              
              
              $
              149,000Inventories
              
              
              178,000
              
              
              
              305,000Total
      current assets of discontinued operations
              
              
              290,000
              
              
              
              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
              
              $
              433,000
              
              
              $
              1,014,000Liabilities
      of Discontinued OperationsCurrent
      liabilities of discontinued operations:Accounts
      payable
              
              $
              119,000
              
              
              $
              100,000Accrued
      expenses
              
              
              14,000
              
              
              
              131,000Total
      liabilities of discontinued operations
              
              $
              133,000
              
              
              $
              231,000


20.
            Legal
      Proceedings




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




Evans
Analytical Group LLC




In May 1,
2007, the Company sold substantially all of the assets of our Accurel Systems
subsidiary to Evans Analytical Group, LLC 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.  The escrow agreement provided, subject
to any claims of indemnifications, for a release of $500,000 on approximately
each of March 31, 2008 and March 31, 2009.




Also in
connection with the transaction, the Company entered into a Non-competition and
Nondisclosure Agreement with Evans whereby the Company agreed not to engage in
any business that directly competes with the business of Accurel.  In
addition, this agreement prohibits the Company from disclosing any confidential
information concerning the business of Accurel.  This agreement will
remain in effect for five years from the date of its execution.




-20-
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS


On
February 22, 2008, Evans filed suit requesting rescission of the asset purchase
agreement, plus damages, based on claims of misrepresentation and
fraud.  On March 28, 2008, Evans filed a formal claims notice with the
escrow agent prohibiting release of any portion of the escrow to the Company as
a result of the litigation.  As a result, the Company has classified
the $1,000,000 escrow amount as a long term asset.  More recently, Evans filed
motions to attach substantial portions of the Company’s assets prior to any
final judgment on the merits of Evans’ claims.  On November 7, 2008,
theSuperior
Court of the State of California, Santa Clara County, deniedEvans’
motion.  Management believes the Evans’ claims are without
merit and, in addition, management does not believe that potential liabilities,
if any, are currently probable or estimable.  The Company is
vigorously defending itself against Evans’ claims.  During late 2008
and early 2009, the Company and Evans each prepared comprehensive summary
judgment motions against the other, arguing that the case should be resolved by
the Court as a legal matter, without the need for jury trial.  The
Company and Evans have each opposed one another’s
motions.  The motions were heard by the Court on February 10, 2009,
and the Court has not yet issued a ruling on either motion.  A trial
date of April 6, 2009 is presently scheduled.  No assurance can be
given, however, that the Company will be successful in its defense against
Evans’ claims, and any substantial final judgment in favor of Evans would have a
material adverse effect on the Company’s business, assets and results of
operations, and could require the Company to file for protection under
bankruptcy laws.  Moreover, the Company believes that our litigation
with Evans has made it extremely difficult to raise capital needed to operate
the Company’s business.




Rapiscan
Systems, Inc.




In March
2005, the Company entered into a Development, Distribution and Manufacturing
Agreement with Rapiscan Systems, Inc., in which the Company granted Rapiscan the
exclusive worldwide rights to market its Quantum SnifferTM
portable and benchtop trace detection devices under Rapiscan’s private
label.  The Company also agreed to grant Rapiscan the exclusive
worldwide rights to distribute certain other new security products which the
Company may develop in the future with Rapiscan’s funding, as well as rights, in
some circumstances, to manufacture certain components of the private-labeled
Quantum SnifferTM
portable and benchtop trace detection devices.




In March
2006, Rapiscan filed a complaint against the Company and its contract assembler,
Columbia Tech, alleging claims against the Company of breach of contract and
breach of warranty and requested specific performance, declaratory relief and
injunctive relief.  Rapiscan’s complaint against Columbia Tech alleged
tortuous interference with contractual relations and requested injunctive relief
and declaratory relief.  In April 2006, Rapiscan dismissed all claims
against Columbia Tech.




On
January 4, 2008, the Company settled this litigation.  In addition to
the immediate dismissal of the litigation, other terms of the settlement
agreement include (i) the rescission of the original agreement with Rapiscan,
(ii) the payment by the Company of $200,000, in the form of 221,729 shares of
the Company’s common stock,  (iii) the granting of non-exclusive
distribution rights to Rapiscan, (iv) the payment by the Company of up to
$1,000,000 in technology transfer fees, payable over time at a rate of 2% of the
gross sales price received by the Company when and if a passenger portal is
sold, and (v) the opportunity for Rapiscan to supply certain components to the
Company.




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.




-21-
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS


21.
            Subsequent
      Events




NYSE
Alternext US Listing Determination




On
February 2, 2009, the Company received a notice from the NYSE Alternext US LLC
(the “Exchange”) stating that the Exchange intends to initiate proceedings to
delist the Company’s common stock for failure to comply with Sections
1003(a)(i), 1003(a)(ii), 1003(a)(iii) and 1003(a)(iv) of the Exchange’s Company
Guide.




As
previously reported, the Exchange notified the Company in April 2008, June 2008
and November 2008 that it was not in compliance with Section 1003(a)(i) of the
Company Guide, in that the Company had stockholders’ equity of less than
$2,000,000 and losses from continuing operations and net losses in two out of
its three most recent fiscal years; Section 1003(a)(ii) of the Company Guide, in
that it had stockholders’ equity of less than $4,000,000 and losses from
continuing operations and net losses in three out of its four most recent fiscal
years; Section 1003(a)(iii) of the Company Guide, in that it had stockholders’
equity of less than $6,000,000 and losses from continuing operations and net
losses in its five most recent fiscal years; and Section 1003(a)(iv) of the
Company Guide, in that it had sustained losses which were so substantial in
relation to its overall operations or its existing financial resources, or its
financial condition had become so impaired that it appeared questionable, in the
opinion of the Exchange, as to whether the Company would be able to continue
operations and/or meet its obligations as they mature.




Also, as
previously reported, the Company submitted a plan of compliance to the Exchange
in May 2008, in response to the April 2008 notification, which addressed the
actions the Company had taken and will take that were intended to bring it into
compliance with Sections 1003(a)(ii) and 1003(a)(iii) of the Company Guide by
October 2009.  The Company submitted a revised plan of compliance to
the Exchange in November 2008, in response to the November 2008 notification,
which addressed additional actions the Company had taken and will take that were
intended to bring it into compliance with Section 1003(a)(iv) of the Company
Guide by February 2009.




The
Exchange’s February 2 notice states that the Staff of the Exchange does not
believe that the steps outlined in the Company’s revised compliance plan make a
reasonable demonstration of the Company’s ability to regain compliance with all
of the Exchange’s listing standards by October 9, 2009, and that, accordingly,
the Company’s common stock is subject to immediate delisting
proceedings.




In
addition, the Exchange’s February 2 notice states that the Company’s common
stock has closed at between $0.15 and $0.28 per share over the last 30 trading
days, and that the Staff is concerned that, as a result of the low selling
price, the Company’s common stock may not be suitable for auction market trading
should the Company’s securities continue to be listed on the
Exchange.  The Staff has determined that this constitutes an
additional deficiency and that, pursuant to Section 1003(f)(v) of the Company
Guide, any continued listing of the Company’s common stock will be predicated on
the Company effecting a reverse split of its common stock within a reasonable
amount of time.




The
Company is entitled to appeal the Staff’s determination to initiate delisting
proceedings on or before February 9, 2009.  The Company filed an
appeal on February 6, 2009 and requested a hearing before a committee of the
Exchange.  The Exchange responded to the Company’s hearing request and
has scheduled a hearing on March 18, 2009.




Pursuant
to the Company Guide, the Company expects that its common stock will remain
listed for trading pending the outcome of the appeal, subject to the Exchange’s
ongoing review of the matter.  The Company can provide no assurance,
however, that its appeal will be successful or that the Exchange will not
suspend trading in the Company’s common stock prior to the hearing.




-22-
 IMPLANT
SCIENCES CORPORATION
  NOTES
TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




Employment
Agreement




On
February 6, 2009, the Company entered into a new three-year employment agreement
with Mr. Glenn D. Bolduc, President, Chief Executive Officer and Chief Financial
Officer, pursuant to which Mr. Bolduc receives a base salary of $275,000 per
year, commencing as of January 1, 2009.  After the third year, the
agreement will automatically renew for additional one-year periods unless notice
of non-renewal is given by either party.  The agreement also provides
for Mr. Bolduc to be eligible to receive incentive compensation in an amount of
up to $137,000 for the fiscal year ending June 30, 2009, upon the achievement of
certain performance milestones established by the Board of Directors and a car
allowance.  Incentive compensation, if any, for subsequent fiscal
years will be based on performance milestones to be established by mutual
agreement between the Company and Mr. Bolduc within 60 days after the
commencement of each such fiscal year.




In
connection with his new employment agreement, Mr. Bolduc has been granted an
incentive option under the Company’s 2004 Stock Option Plan to purchase 680,000
shares of the Company’s common stock, par value $.10 per share, with an exercise
price of $.17 per share.  The option vests in equal annual
installments over a three-year period commencing on January 1,
2010.  These options were valued using the Black-Scholes method, using
the following assumptions;  volatility 99.0%, risk-free interest rate
1.52%, expected life of six years and expected dividend yield of
0.0%.




In
addition, Mr. Bolduc may participate in the Company’s employee fringe benefit
programs or programs readily available to employees of comparable status and
position.  The Company may terminate his employment for any material
breach of this employment agreement at any time.  In the event Mr.
Bolduc’s employment is terminated by the Company without “cause” or Mr. Bolduc
resigns for “good reason” (as those terms are defined in the agreement), the
Company will pay him twelve months salary on a regular payroll basis and a pro
rata portion of any bonus compensation earned during the year of termination, as
well as the continuation of certain benefits as separation
payments.  Under his employment agreement, Mr. Bolduc is subject to
restrictive covenants, including confidentiality provisions and a one year
non-compete and non-solicitation provision.
























-23-


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.




-24-


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 and our 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 six months ended December
31, 2008 and 2007, the operations of Core have been recorded in our statements
of operations as discontinued operations.




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




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 the
Subsidiary's 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 December 31, 2008 we sold
additional assets associated with our coatings business.  As of
December 31, 2008 and June 30, 2008, the assets and liabilities of the Medical
Business Unit have been recorded on our balance sheet as
held-for-sale.  For the three months ended December 31, 2008 and 2007,
the operations of the Medical Business Unit have been recorded in our statements
of operations as discontinued operations.




Security Business
Unit




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




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




-25-


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.




-26-




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




Products Under
Development




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




We
believe that as market demand grows for greater precision of substance
identification and the list of substances to be detected increases, more
advanced detectors based on ion mobility spectrometry technology will be
required.  Our acquisition of Ion Metrics enabled us to obtain
miniaturized quadrupole mass spectrometry (“QMS”) 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 December
31, 2008.




-27-


Results
of Operations




Three Months Ended December
31, 2008 vs. December 31, 2007




Revenues




Security
revenues for the three months ended December 31, 2008 were $1,519,000 as
compared with $369,000 for the comparable prior year period, an increase of
$1,150,000 or 311.7%.  Revenue from security products for the three
months ended December 31, 2008 was $1,207,000 as compared with $244,000 for the
comparable prior year period, an increase of $963,000 or
394.7%.  Revenue from government funded contracts for the three months
ended December 31, 2008 was $312,000 as compared with $125,000 for the
comparable prior year period, an increase of $187,000 or 149.6%.  The
increase in security revenue is primarily a result of an increase in the number
of units sold of our explosives detection products during the three months ended
December 31, 2008 as compared to comparable prior year period.  In
addition, we recorded increased revenue from government contracts resulting
primarily to an award from the Department of Homeland Security.




Cost
of Revenues




Cost of
revenues for the three months ended December 31, 2008 were $881,000 as compared
with $408,000 for the comparable prior year period, an increase of $473,000 or
115.9%.  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 three months ended December 31, 2008 was $638,000 or 42.0% of
security revenues as compared with negative gross margin of $39,000 or (10.6%)
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 three months ended December 31, 2008 was
$751,000 as compared with $663,000 for the comparable prior year period, an
increase of $88,000 or 13.3%.  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.  We focused additional resources on our
internally funded research and development programs during the three month
period ended December 31, 2008 as compared with the comparable prior year
period.  We charge our research and development personnel to cost of
revenues for work performed on these contracts and grants.  Research and
development expenses incurred prior to starting government contracts are charged
to operating expenses.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the three months ended December 31, 2008
was $1,561,000 as compared with $1,488,000 for the comparable prior year period,
an increase of $73,000, or 4.9%.  During the three months ended
December 31, 2008, we initiated cost containment measures, including reduction
in force and reduction in work hours.  During the three months ended
September 30, 2008, we reported selling, general and administrative expenses of
$2,366,000 which compares to $1,561,000 for the three months ended December 31,
2008, a net cost reduction of $805,000.  We also relocated to a new
facility upon the expiration of our facility lease on December 31,
2008.  We expect to realize future savings on facility and facility
related costs during the remainder of fiscal 2009 as a result of the facility
relocation.




-28-


Other
Income and Expense, Net




For the
three months ended December 31, 2008, we recorded other expense, net of $416,000
as compared with other income, net of $320,000, for the comparable prior year
period, an increase in other expense, net of $736,000.  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  $746,000 resulting, in part, from a penalty of
$568,000 assessed on the Series D Redeemable Convertible 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 issued to DMRJ Group; (iii)
decrease in income related to the embedded derivative associated with the Series
D Preferred Stock, which was extinguished on December 10, 2008, and (iv)
realized 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 three months ended December 31, 2008 was
$2,090,000 as compared with $1,870,000 for the comparable prior year period,
an increase of $220,000, or 11.8%.  The increase in loss from
continuing operations is primarily the result of the increase in interest
expense and realization of unrealized loss of our share of CardioTech’s stock
owned by CorNova; offset by increased sales of our handheld explosives detection
product and improved gross margins resulting from these sales.




Preferred
Distribution, Dividends and Accretion




Preferred
distribution, dividends and accretion on the Series D Redeemable Convertible
Preferred Stock for the three months ended December 31, 2008 was $18,000 as
compared with $289,000 for the comparable prior year period, a decrease of
$271,000 or 93.8%.




Income
(Loss) from Discontinued Operations




Income
from discontinued operations for the three months ended December 31, 2008 was
$29,000 as compared with net loss from discontinued operations of $2,945,000 for
the comparable prior year period, a decrease in loss from discontinued
operations of $2,974,000.  Income from discontinued operations for the
three months ended December 31, 2008 is composed of (i) operating income of
$8,000 from our Core Systems subsidiary, which was sold during the second
quarter of fiscal 2009, (ii) operating loss of $94,000 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
$93,000.  Loss from discontinued operations for the three months ended
December 31, 2007 includes:  (i) losses of $2,707,000 from operations
of our Core Systems subsidiary; and (ii) losses of $238,000 from operations of
our medical reporting unit.




Six Months Ended December
31, 2008 vs. December 31, 2007




Revenues




Security
revenues for the six months ended December 31, 2008 were $7,467,000 as compared
with $1,716,000 for the comparable prior year period, an increase of $5,751,000
or 335.1%.  Revenue from security products for the six months ended
December 31, 2008 was $6,509,000 as compared with $1,444,000 for the comparable
prior year period, an increase of $5,065,000 or 350.8%.  Revenue from
government funded contracts for the six months ended December 31, 2008 was
$958,000 as compared with $272,000 for the comparable prior year period, an
increase of $686,000 or 252.2%.  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 six months ended December 31, 2008 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 six months ended December 31, 2008 were $4,053,000 as compared
with $1,229,000 for the comparable prior year period, an increase of $2,824,000
or 229.8%.  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.




-29-


Gross
Margin




Gross
margin for the six months ended December 31, 2008 was $3,414,000 or 45.7% of
security revenues as compared with $487,000 or 28.4% 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 six months ended December 31, 2008 was
$1,771,000 as compared with $1,314,000 for the comparable prior year period, an
increase of $457,000 or 34.8%.  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.  We focused additional resources on our
internally funded research and development programs during the six months ended
December 31, 2008 as compared with the comparable prior year
period.  We charge our research and development personnel to cost of
revenues for work performed on these contracts and grants.  Research and
development expenses incurred prior to starting government contracts are charged
to operating expenses.




Selling,
General and Administrative Expenses




Selling,
general and administrative expenses for the six months ended December 31, 2008
was $3,927,000 as compared with $2,845,000 for the comparable prior year period,
an increase of $1,082,000, or 38.0%.  The increase is primarily a
result of costs associated with the additions to our senior management team;
increased expenditures in our sales and marketing efforts, including increased
selling expenses related to our China sales; and increased legal
expenses.  During the three months ended December 31, 2008, we
initiated cost containment measures, including reduction in force and reduction
in work hours.  We also relocated to a new facility upon the
expiration of our facility lease on December 31, 2008.  We expect to
realize future savings on facility and facility related costs during the
remainder of fiscal 2009 as a result of the facility relocation.




Other
Income and Expense, Net




For the
six months ended December 31, 2008, we recorded other expense, net of $440,000
as compared with other income, net of $237,000, for the comparable prior year
period, an increase in other expense, net of $677,000.  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 $744,000 resulting, in part, from a penalty of $568,000
assessed on the Series D Redeemable Convertible 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 $145,000 as a result of lower available cash balances for investment;
(iv) decrease in income related to the embedded derivative associated with the
Series D 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 six months ended December 31, 2008 was $2,724,000
as compared with $3,435,000 for the comparable prior year period, a decrease of
$711,000, or 20.7%.  The decrease in loss from continuing operations
is primarily the result of increased sales of our handheld explosives detection
product and improved gross margins resulting from these sales; offset by the
increase in interest expense and realization of unrealized loss of our share of
CardioTech’s stock owned by CorNova.




Preferred
Distribution, Dividends and Accretion




Preferred
distribution, dividends and accretion on the Series D Redeemable Convertible
Preferred Stock for the six months ended December 31, 2008 was $207,000 as
compared with $596,000 for the comparable prior year period, a decrease of
$389,000 or 65.3%.




-30-


Income
(Loss) from Discontinued Operations




Income
from discontinued operations for the six months ended December 31, 2008 was
$1,019,000 as compared with net loss from discontinued operations of $3,582,000
for the comparable prior year period, a decrease in loss from discontinued
operations of $4,601,000.  Income from discontinued operations for the
six months ended December 31, 2008 is composed of (i) operating income of
$25,000 from our Core Systems subsidiary, which was sold during the second
quarter of fiscal 2009, (ii) operating loss of $51,000 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
$1,024,000.  Loss from discontinued operations for the six months
ended December 31, 2007 includes:  (i) losses of $3,117,000 from
operations of our Core Systems subsidiary; and (ii) losses of $465,000 from
operations of our medical reporting unit.




Liquidity
and Capital Resources




As of
December 31, 2008, we had approximately $724,000 of cash and cash equivalents,
an increase of $312,000 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 on December 10, 2008, by December 10,
2009.  The balance due on that Note as of December 31, 2008 was
$3,436,000 (liquidation value of $4,600,000).




On
December 10, 2008, we used approximately $477,000 of the proceeds from the
issuance of the note to DMRJ Group 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 December 31, 2008 and June 30, 2008, the outstanding
balance on the Series D Preferred Stock was $0 and $2,424,000,
respectively.




During
the six months ended December 31, 2008 we had net cash outflows of $2,236,000
from operating activities of continuing operations as compared to net cash
outflows from operating activities of continuing operations of $3,059,000 for
the comparable prior year period.  The approximate $823,000 decrease
in net cash used in operating activities of continuing operations during the six
months ended December 31, 2008, as compared to the comparable prior year period,
was primarily a result of (i) cash provided by a decrease in the loss from
continuing operations, and (ii) increase in cash provided by changes in accounts
payable.  These cash inflows were offset by increased cash outflows
for accrued expenses, prepaid expenses and accounts receivable.  For
the six months ended December 31, 2008, we had net cash inflows of $36,000 from
operating activities of discontinued operations, compared with net cash outflows
of $374,000 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 six months ended December 31, 2008 we had net cash inflows of $2,872,000
from investing activities of continuing operations as compared to net cash
outflows of $39,000 from investing activities of continuing operations for the
comparable prior year period.  The approximate $2,911,000 increase in
net cash provided by investing activities of continuing operations during the
six months ended December 31, 2008, 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 six months ended December 31, 2008, we had net
cash outflows of $28,000 from investing activities of discontinued operations,
compared to net cash outflows of $166,000 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 six months ended December 31, 2008 we had net cash outflows of $331,000 from
financing activities of continuing operations as compared to net cash outflows
of $1,177,000 from financing activities of continuing operations for the
comparable prior year period.  The approximate $846,000 decrease in
net cash used in financing activities of continuing operations during the six
months ended December 31, 2008, 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 six
months ended December 31, 2008, 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.




-31-




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 Group.  The note is convertible in whole or in part at the option
of DMRJ Group into shares of our common stock at an initial conversion
price of $0.26 per share.




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 Group.  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 warrants were
valued using the Black-Scholes model with the following
assumptions:  volatility 93.7%, risk-free interest rate of 2.82%,
expected life of 7 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 our Accurel Systems
subsidiary, upon the release of such funds.  The remaining principal
balance, together with outstanding interest, is due and payable on December 10,
2009.  As of December 31, 2008, the outstanding balance on the Note
was $3,436,000.




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, one 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 one hundred
(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
December 31, 2008, our current ratio was 0.50 to 1.00, and we are not in
compliance with the required current ratio.  We have requested a
waiver of this default.  If we are unable to obtain a waiver of
the current ratio default, DMRJ Group may declare the entire unpaid principal
balance of the note, together with all interest accrued hereon, plus fees and
expenses, due and payable.




-32-




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




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




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




Off-Balance
Sheet Arrangements




As of
December 31, 2008 we had an irrevocable standby letter of credit outstanding in
the approximate amount of $418,000.  The letter of credit provides
performance security equal to 10% of the contract amount for product shipped in
the first quarter of fiscal 2009.  The letter of credit expires on
July 31, 2010.




As of
December 31, 2008, we did not have any other off-balance sheet arrangements that
have, or are reasonably likely to have, a current or future material effect on
our condensed consolidated financial condition, results of operations,
liquidity, capital expenditures or capital resources.




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.




-33-




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.




Item
      3.
            Quantitative
      and Qualitative Disclosures About Market
Risk.




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




Item 4.
            Controls
      and Procedures




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




Disclosure
Controls and Procedures




The
Company’s management, with the participation of the Company’s chief executive
officer and chief financial officer, evaluated the effectiveness of the
Company’s disclosure controls and procedures as of December 31,
2008.  The term “disclosure controls and procedures,” as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended, means controls and other procedures of a company that are designed to
ensure that information required to be disclosed by the Company in the reports
that it files or submits under the Exchange Act is recorded, processed,
summarized, and reported, within the time periods specified in the Securities
and Exchange Commission’s rules and forms.  Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports
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
December 31, 2008, the Company’s chief executive officer and chief financial
officer concluded that, as of such date, the Company’s disclosure controls and
procedures were effective at the reasonable assurance level.




Changes
in Internal Control Over Financial Reporting




There
were no changes to the Company’s internal control over financial reporting
during the quarter ended December 31, 2008 that have materially affected, or are
reasonably likely to materially affect, the Company’s internal control over
financial reporting.




-34-


PART
II.                      OTHER
INFORMATION




Item
      1.
            Legal
      Proceedings




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




In May
2007, we entered into an asset purchase agreement to sell substantially all of
the assets of our Accurel Systems subsidiary to Evans Analytical Group LLC for
approximately $12,705,000, including $1,000,000 held by an escrow agent as
security for certain representations and warranties.  On February 22,
2008, Evans filed suit in the Superior Court of the State of California, Santa
Clara County, requesting rescission of the asset purchase agreement, plus
damages, based on claims of misrepresentation and fraud.  In March
2008, Evans filed a claims notice with the escrow agent prohibiting release of
any portion of the escrow to us pending resolution of the
lawsuit.  More recently, Evans filed motions to attach substantial
portions of our assets prior to any final judgment on the merits of Evans’
claims.  On November 7, 2008, the Court denied Evans’
motions.  We are vigorously defending ourselves against Evans’
claims.   No assurance can be given, however, that we will be
successful in our defense against Evans’ claims.  Any substantial
final judgment in favor of Evans would have a material adverse effect on our
business, assets and results of operations, and could require us to file for
protection under bankruptcy laws.  Moreover, we believe that our
litigation with Evans has made it extremely difficult to raise capital we need
to operate our business.




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




Item
      1A.
            Risk
      Factors




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




We
have relied on a third-party credit facility to provide working
capital.  Our credit facility was terminated on December 10, 2008 and
we have currently do not have access to a new credit facility.  If our
access to a third-party credit facility continues to be unavailable, our
business could be adversely affected.




We have
relied on third-party credit, private equity financing and cash generated from
our operations for working capital purposes.  Our credit facility with
Bridge Bank, N.A. was terminated on December 10, 2008 and the unpaid balance of
$477,000 on that date was repaid in full.




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




We
are in default of certain financial covenants of the Senior
Secured Convertible Promissory Note issued to DMRJ Group.  If we are
unable to obtain a waiver from DMRJ Group, then DMRJ Group 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
December 31, 2008, we were not in compliance with certain financial covenants of
the  senior secured convertible promissory note issued on December 10, 2008
to DMRJ Group, LLC.  We have requested a waiver of this
default.  If we are unable to obtain a waiver, DMRJ Group 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 Group would have a material adverse effect on our liquidity
and financial condition and could require us to curtail or discontinue
all of our operations and to file for protection under bankruptcy
laws.  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 require us
to curtail or discontinue operations entirely and to file for protection under
bankruptcy laws.  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.




-35-


We
are engaged in litigation with Evans Analytical Group LLC, the buyer of our
Accurel Systems subsidiary.  If we are unsuccessful in defending the
claims made by Evans, our business, assets and results of operations could be
materially adversely affected.




In May
2007, we entered into an asset purchase agreement to sell substantially all of
the assets of our Accurel Systems subsidiary to Evans for approximately
$12,705,000, including $1,000,000 held by an escrow agent as security for
certain representations and warranties.  In February 2008, Evans filed
suit requesting rescission of the asset purchase agreement, plus damages, based
on claims of misrepresentation and fraud.  In March 2008, Evans filed
a claims notice with the escrow agent prohibiting release of any portion of the
escrow to us pending resolution of the lawsuit.  More recently, Evans filed
motions to attach substantial portions of our assets prior to any final judgment
on the merits of Evans’ claims.  On November 7, 2008, theSuperior Court of the
State of California, Santa Clara County, deniedEvans’
motions.  We are vigorously defending ourselves against Evans’
claims.  During late 2008 and early 2009, we and Evans each
prepared comprehensive summary judgment motions against the other, arguing that
the case should be resolved by the Court as a legal matter, without the need for
jury trial.  We and Evans have each opposed each other’s
motions.  The motions were heard by the Court on February 10, 2009,
and the Court has not yet issued a ruling on either motion.  A trial
date of April 6, 2009 is presently scheduled.  No assurance can be
given, however, that we will be successful in our defense against Evans’
claims.  Any substantial final judgment in favor of Evans would have a
material adverse effect on our business, assets and results of operations, and
could require us to file for protection under bankruptcy
laws.  Moreover, we believe that our litigation with Evans has made it
extremely difficult to raise capital we need to operate our
business.




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




Management
continually evaluates plans to reduce its operating expenses, increase sales and
increase its cash flow from operations.  Despite the current sales,
expense and cash flow projections, the cash available from our line of credit,
the projected cash from the sale of Core Systems and certain other assets, we
will require additional capital in the third 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 require us to file for protection under bankruptcy laws.




We
have received notification that the New York Stock Exchange Alternext US
intends to initiate proceedings to delist our common stock from trading on the
Exchange.  Our inability to appeal the Exchange’s decision to delist
our common stock could adversely affect our business and ability to raise
capital.




On
February 2, 2009, we received a notice from the NYSE Alternext US LLC stating
that the Exchange intends to initiate proceedings to delist our common stock for
failure to comply with Sections 1003(a)(i), 1003(a)(ii), 1003(a)(iii) and
1003(a)(iv) of the Exchange’s Company Guide.




As
previously reported, the Exchange notified us in April 2008, June 2008 and
November 2008 that we were not in compliance with Section 1003(a)(i) of the
Company Guide, in that we had stockholders’ equity of less than $2,000,000 and
losses from continuing operations and net losses in two out of our three most
recent fiscal years; Section 1003(a)(ii) of the Company Guide, in that we had
stockholders’ equity of less than $4,000,000 and losses from continuing
operations and net losses in three out of our four most recent fiscal years;
Section 1003(a)(iii) of the Company Guide, in that we had stockholders’ equity
of less than $6,000,000 and losses from continuing operations and net losses in
our five most recent fiscal years; and Section 1003(a)(iv) of the Company Guide,
in that we had sustained losses which were so substantial in relation to our
overall operations or our existing financial resources, or our financial
condition had become so impaired that it appeared questionable, in the opinion
of the Exchange, as to whether we would be able to continue operations and/or
meet our obligations as they mature.




Also as
previously reported, we submitted a plan of compliance to the Exchange in May
2008, in response to the April 2008 notification, which addressed the actions we
had taken and will take that were intended to bring us into compliance with
Sections 1003(a)(ii) and 1003(a)(iii) of the Company Guide by October
2009.  We submitted a revised plan of compliance to the Exchange in
November 2008, in response to the November 2008 notification, which addressed
additional actions we had taken and will take that were intended to bring us
into compliance with Section 1003(a)(iv) of the Company Guide by February
2009.




-36-




The
Exchange’s February 2 notice states that the Staff of the Exchange does not
believe that the steps outlined in our revised compliance plan make a reasonable
demonstration of our ability to regain compliance with all of the Exchange’s
listing standards by October 9, 2009, and that, accordingly, our common stock is
subject to immediate delisting proceedings.




In
addition, the Exchange’s February 2 notice states that our common stock has
closed at between $0.15 and $0.28 per share over the last 30 trading days, and
that the Staff is concerned that, as a result of the low selling price, our
common stock may not be suitable for auction market trading should our
securities continue to be listed on the Exchange.  The Staff has
determined that this constitutes an additional deficiency and that, pursuant to
Section 1003(f)(v) of the Company Guide, any continued listing of our common
stock will be predicated on our effecting a reverse split of our common stock
within a reasonable amount of time.




We are
entitled to appeal the Staff’s determination to initiate delisting proceedings
on or before February 9, 2009.  We filed an appeal on February 6, 2009
and requested a hearing before a committee of the Exchange.  The
Exchange responded to our hearing request and has scheduled a hearing on March
18, 2009.




Pursuant
to the Company Guide, we expect our common stock will remain listed for trading
pending the outcome of the appeal, subject to the Exchange’s ongoing review of
the matter.  We can provide no assurance, however, that our appeal
will be successful or that the Exchange will not suspend trading in our common
stock prior to the hearing.




If our
common stock is delisted from the NYSE Alternext US, the liquidity of our stock
could be substantially limited and our ability to raise capital would be
impaired.




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




On 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.





On December 10, 2008, 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 common
stock, to DMRJ Group, LLC. The note has an initial conversion price of $.26 per
share and the warrant has an initial exercise price of $.26 per
share.




On
December 30, 2008, we agreed to issue 300,000 shares of common stock, having a
value of $70,000, to JFS Investments, Inc., in consideration of services
rendered in connection with the financing by DMRJ Group LLC.




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.




-37-


Item
      6.
            Exhibits




Exhibit
No.




2.1
      (1)
            Asset
      Purchase Agreement by and among Core Systems Incorporated, C Acquisition
      Corp. and Implant Sciences Corporation, dated November 14,
      2008




2.2
      (2)
            Amendment
      dated November 24, 2008, to Asset Purchase Agreement dated November 14,
      2008, by and among Implant Sciences Corporation, C Acquisition Corp. and
      Core Systems Incorporated




10.1
      (2)
            $1,625,000
      promissory note dated November 24, 2008, executed by Core Systems
      Incorporated and delivered to C Acquisition
  Corp.




10.2
      (2)
            Security
      Agreement dated November 24, 2008, between Core Systems Incorporated and C
      Acquisition Corp.




10.3
      (3)
            Omnibus
      Amendment, dated as of September 30, 2008, among Implant Sciences
      Corporation and LV Administrative Services, Inc., as administrative and
      collateral agent for each of Laurus Master Fund, Ltd. and Valens Offshore
      SPV I, Ltd., to (i) that certain Securities Purchase Agreement, dated as
      of September 29, 2005, by and between the Company and Laurus Master Fund,
      Ltd. and (ii) certain the other related agreements referred to in the
      Purchase Agreement




10.4
      (4)
            Omnibus
      Amendment, dated as of October 31, 2008, among Implant Sciences
      Corporation and LV Administrative Services, Inc., as administrative and
      collateral agent for each of Laurus Master Fund, Ltd. and Valens Offshore
      SPV I, Ltd., to (i) that certain Securities Purchase Agreement, dated as
      of September 29, 2005, by and between the Company and Laurus Master Fund,
      Ltd. and (ii) certain the other related agreements referred to in the
      Purchase Agreement




10.5
      (4)
            Amendment,
      dated November 4, 2008, to the Transition Agreement dated as of September
      27, 2007, between Implant Sciences Corporation and Dr. Anthony
      Armini




10.6
      (5)
            Note
      and Warrant Purchase Agreement, dated as of December 10, 2008, between
      Implant Sciences Corporation and DMRJ Group
  LLC




10.7
      (5)
            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




10.8
      (5)
            Warrant
      to Purchase Shares of Common Stock, dated December 10, 2008, issued by
      Implant Sciences Corporation to DMRJ Group
LLC




10.9
      (5)
            Security
      Agreement, dated as of December 10, 2008, among Implant Sciences
      Corporation, C Acquisition Corp., Accurel Systems International
      Corporation and IMX Acquisition Corp., as grantors, and DMRJ Group LLC, as
      secured party




10.10
      (5)
            Patent
      Security Agreement, dated as of December 10, 2008, among Implant Sciences
      Corporation, C Acquisition Corp., Accurel Systems International
      Corporation and IMX Acquisition Corp., as grantors, and DMRJ Group LLC, as
      secured party




10.11
      (5)
            Guaranty,
      dated as of December 10, 2008, of the obligations of Implant Sciences
      Corporation by C Acquisition Corp., Accurel Systems International
      Corporation and IMX Acquisition Corp. in favor of DMRJ Group
      LLC




10.12
      (6)
            Lease
      dated December 11, 2008 between Implant Sciences Corporation and Wakefield
      Investments, Inc.




10.13
      (7)
              Employment
      Agreement dated February 6, 2009 between Implant Sciences Corporation and
      Glenn D. Bolduc.




31.1
      (8)
            Certification
      of Principal Executive Officer pursuant to Section 3.02 of the
      Sarbanes-Oxley Act of 2002.




31.2
      (8)
            Certification
      of Principal Financial Officer pursuant to Section 3.02 of the
      Sarbanes-Oxley Act of 2002.




-38-


32.1
      (8)
            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
      (8)
            Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.




________________________




(1)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K dated November
      14, 2008 and filed November 19, 2008, and incorporated herein by
      reference.




(2)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K dated November
      24, 2008 and filed December 1, 2008, and incorporated herein by
      reference.




(3)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K dated September
      30, 2008 and filed October 6, 2008, and incorporated herein by
      reference.




(4)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K dated November 4,
      2008 and filed November 6, 2008, and incorporated herein by
      reference.




(5)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K dated December
      10, 2008 and filed December 16, 2008, and incorporated herein by
      reference.




(6)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K dated December
      11, 2008 and filed December 17, 2008, and incorporated herein by
      reference.




(7)
            Filed
      as an Exhibit to Implant Sciences Corporation’s Form 8-K
      dated February 6, 2009 and filed February 11, 2009, and
      incorporated herein by reference.




(8)
            Filed
      herewith.




-39-


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:  February
17, 2009




















-40-