**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**


x
            Quarterly
                report pursuant to section 13 or 15(d) of the Securities Exchange
                Act of
                1934. For the quarterly period ending September 30,
                2006.





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**
            
            **04-2837126**(State
                or other jurisdiction of incorporation or organization)
            
            (IRS
                Employer Identification number)107
                Audubon Road, #5 Wakefield, MA
            
            01880(Address
                of Principal Executive Offices)
            
            (Zip
                Code)




**781-246-0700**


(Registrant’s
      Telephone Number, Including Area Code)





Securities
      registered pursuant to Section 12(b) of the Act:


**Title
                  of Each Class**
              
              **Name
                  of Each Exchange on Which Registered**Common
                  Stock, $.10 par value
              
              American
                  Stock Exchange








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 o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer or a non-accelerated filer.


Large
                Accelerated Filero
            
            Accelerated
                Filero
            
            Non-Accelerated
                Filerx





Indicate
      by checkmark whether the Registrant is a shell company (as defined in Rule
      12b-2
      of the Exchange Act)


YES o NO x




The
      aggregate market value of the voting stock held by non-affiliates of the
      registrant was approximately $31,508,000 as of November 9, 2006 (based on the
      closing price for such stock as of November 9, 2006).





Indicate
      the number of shares outstanding of each of the issuer's classes of common
      stock:





Class
            
            Outstanding
                at November 9, 2006Common
                Stock, $.10 par value
            
            11,800,811














**IMPLANT
      SCIENCES CORPORATION**





**INDEX**





Page
                No.PART
                I. FINANCIAL INFORMATIONEXPLANATORY
                NOTEItem
                1.
            Financial
                Statements:Condensed
                Consolidated Balance Sheets as of September 30, 2006
                (unaudited) and June 30, 2006 (audited)
            3Condensed
                Consolidated Statements of Operations for the Three
                Months Ended September 30, 2006 and 2005 (unaudited)
            4Condensed
                Consolidated Statements of Cash Flows for the Three
                Months Ended September 30, 2006 and 2005 (unaudited)
            5Notes
                to Condensed Consolidated Financial Statements
                (unaudited)
            6Item
                2.
            Management's
                Discussion and Analysis of Financial Conditionand
                Results of OperationsItem
                3.
            Quantitative
                and Qualitative Disclosure About Market
                RiskItem
                4.
            Controls
                and ProceduresPART
                II. OTHER INFORMATIONItem
                1.
            Legal
                ProceedingsItem
                1A
            Risk
                FactorsItem
                2.
            Unregistered
                Sales of Equity SecuritiesItem
                3.
            Defaults
                Upon Senior SecuritiesItem
                4.
            Submission
                of Matters to a Vote of
                Security-HoldersItem
                5.
            Other
                InformationItem
                6.
            Exhibits
                and Reports on Form 8-KSignatures





2
 *Index*





**IMPLANT
                SCIENCES CORPORATION****CONDENSED
                CONSOLIDATED BALANCE SHEETS****(Unaudited)****September
                30,**
            
            **June
                30,****ASSETS**
            
            **2006**
            
            **2006**Current
                assets:Cash
                and cash equivalents
            
            $
            1,084,000
            
            $
            2,204,000Restricted
                cash
            
            
            264,000
            
            
            -Accounts
                receivable, net of allowance of $121,000 at September 30, 2006 and
                June
                30, 2006
            
            
            3,364,000
            
            
            3,658,000Accounts
                receivable, unbilled
            
            
            192,000
            
            
            43,000Inventories
            
            
            1,696,000
            
            
            1,532,000Investments
                - available for sale securities
            
            
            155,000
            
            
            222,000Prepaid
                expenses and other current assets
            
            
            366,000
            
            
            505,000Total
                current assets
            
            
            7,121,000
            
            
            8,164,000Property
                and equipment, net
            
            
            8,517,000
            
            
            8,909,000Amortizable
                intangible assets, net
            
            
            1,492,000
            
            
            1,620,000Investment
                in unconsolidated subsidiary
            
            
            16,000
            
            
            174,000Other
                non-current assets
            
            
            253,000
            
            
            229,000Goodwill
            
            
            11,666,000
            
            
            11,666,000Total
                assets
            
            $
            29,065,000
            
            $
            30,762,000**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Current
                maturities of long-term debt and obligations under capital
                lease
            
            $
            440,000
            
            $
            420,000Line
                of credit
            
            
            1,000,000
            
            
            1,000,000Payable
                to Med-Tec
            
            
            233,000
            
            
            233,000Accrued
                expenses
            
            
            2,108,000
            
            
            1,985,000Accounts
                payable
            
            
            1,361,000
            
            
            1,699,000Current
                portion of long- term lease liability
            
            
            132,000
            
            
            126,000Deferred
                revenue
            
            
            485,000
            
            
            479,000Total
                current liabilities
            
            
            5,759,000
            
            
            5,942,000Long-term
                liabilities:Long-term
                debt and obligations under capital lease, net of current maturities
            
            
            704,000
            
            
            692,000Long-term
                lease liability
            
            
            542,000
            
            
            575,000Derivatives
                related to preferred stock features
            
            
            1,074,000
            
            
            1,094,000Total
                liabilities
            
            
            8,079,000
            
            
            8,303,000Commitments
                and contingenciesSeries
                D Cumulative Redeemable Convertible Preferred Stock; $10 stated value;
                500,000 shares authorized 409,091 outstanding as of September 30,
                and June
                30, 2006
            
            
            2,804,000
            
            
            2,568,000Stockholders'
                equity :Common
                stock, $0.10 par value; 50,000,000 shares authorized at September
                30 and
                June 30, 2006; 11,800,811 and 11,733,804 shares issued; 11,773,817
                and
                11,706,810 shares outstanding, at September 30 and June 30, 2006,
                respectively
            
            
            1,180,000
            
            
            1,173,000Additional
                paid-in capital
            
            
            55,708,000
            
            
            55,284,000Accumulated
                deficit
            
            
            (38,237,000
            )
            
            (36,290,000
            )Deferred
                compensation
            
            
            (97,000
            )
            
            (17,000
            )Notes
                receivable, employees
            
            
            (45,000
            )
            
            (37,000
            )Accumulated
                other comprehensive income (loss)
            
            
            (91,000
            )
            
            14,000Treasury
                stock, 26,994 common shares, at cost
            
            
            (236,000
            )
            
            (236,000
            )Total
                stockholders' equity
            
            
            18,182,000
            
            
            19,891,000Total
                liabilities and stockholders' equity
            
            $
            29,065,000
            
            $
            30,762,000





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





3
 *Index*





**IMPLANT
                SCIENCES CORPORATION****CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS**(unaudited)**Three
                Months Ended September 30,****2006**
            
            **2005**Revenues:Medical
            
            $
            1,160,000
            
            $
            1,149,000Semiconductor
            
            
            3,939,000
            
            
            3,122,000Security
                products
            
            
            481,000
            
            
            401,000Total
                revenues
            
            
            5,580,000
            
            
            4,672,000Cost
                of revenues:Cost
                of medical revenues
            
            
            850,000
            
            
            959,000Cost
                of semiconductor revenues
            
            
            3,049,000
            
            
            2,697,000Cost
                of security product revenues
            
            
            616,000
            
            
            1,022,000Total
                cost of revenues
            
            
            4,515,000
            
            
            4,678,000Gross
                margin
            
            
            1,065,000
            
            
            (6,000
            )Operating
                expenses:Research
                and development
            
            
            567,000
            
            
            316,000Selling,
                general and administrative
            
            
            1,963,000
            
            
            1,923,000Total
                operating expenses
            
            
            2,530,000
            
            
            2,239,000Loss
                from operations
            
            
            (1,465,000
            )
            
            (2,245,000
            )Other
                income (expense):Interest
                income
            
            
            4,000
            
            
            11,000Interest
                expense
            
            
            (49,000
            )
            
            (92,000
            )Change
                in fair value of embedded derivatives related to preferred stock
                features
            
            
            20,000
            
            
            -Equity
                losses in unconsolidated subsidiaries
            
            
            (120,000
            )
            
            (41,000
            )Total
                other expense, net
            
            
            (145,000
            )
            
            (122,000
            )Net
                loss
            
            
            (1,610,000
            )
            
            (2,367,000
            )Preferred
                distribution, dividends and accretion
            
            
            (236,000
            )
            
            -Net
                loss applicable to common shareholders
            
            $
            (1,846,000
            )
            $
            (2,367,000
            )Net
                per share applicable to common shareholders, basic and
                diluted
            
            $
            (0.16
            )
            $
            (0.22
            )Weighted
                average common shares outstanding used in computing basic and diluted
                loss
                per share
            
            
            11,763,574
            
            
            10,962,703




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




4
 *Index*
 **IMPLANT
                      SCIENCES CORPORATION**
                    **CONDENSED
                      CONSOLIDATED STATEMENTS OF CASH FLOWS**
                    **(unaudited)****Three
                      Months Ended**
                    **September
                      30,****Cash
                      flows from operating activities:**
                  
                  **2006**
                  
                  **2005**Net
                      loss
                  
                  $
                  (1,610,000
                  )
                  $
                  (2,367,000
                  )Adjustments
                      to reconcile net loss to net cash used in operating
                      activities:Depreciation
                      and amortization
                  
                  
                  617,000
                  
                  
                  579,000Amortization
                      of intangible assets
                  
                  
                  128,000
                  
                  
                  207,000Share-based
                      compensation expense
                  
                  
                  208,000
                  
                  
                  411,000Equity
                      loss in unconsolidated subsidiaries
                  
                  
                  120,000
                  
                  
                  41,000Change
                      in fair value of embedded derivatives
                  
                  
                  (20,000
                  )
                  
                  -Changes
                      in operating assets and liabilities, net of effect of
                      acquisitions:Accounts
                      receivable
                  
                  
                  182,000
                  
                  
                  296,000Inventories
                  
                  
                  (164,000
                  )
                  
                  (564,000
                  )Prepaid
                      expenses and other current assets
                  
                  
                  139,000
                  
                  
                  (80,000
                  )Accounts
                      payable
                  
                  
                  (338,000
                  )
                  
                  136,000Accrued
                      expenses
                  
                  
                  95,000
                  
                  
                  (224,000
                  )Deferred
                      revenue
                  
                  
                  7,000
                  
                  
                  606,000Net
                      cash used in operating activities
                  
                  
                  (636,000
                  )
                  
                  (959,000
                  )**Cash
                      flows from investing activities:**Purchase
                      of property and equipment
                  
                  
                  (86,000
                  )
                  
                  (170,000
                  )Acquisition
                      of Core Systems, net of cash received
                  
                  
                  -
                  
                  
                  (9,000
                  )Acquisition
                      of Accurel Systems International, net of cash received
                  
                  
                  -
                  
                  
                  (2,000
                  )Increase
                      in other non-current assets
                  
                  
                  (24,000
                  )
                  
                  (19,000
                  )Net
                      cash used in investing activities
                  
                  
                  (110,000
                  )
                  
                  (200,000
                  )**Cash
                      flows from financing activities:**Proceeds
                      from issuance of common stock including the exercise of options
                      and the
                      Employee Stock Purchase Plan
                  
                  
                  143,000
                  
                  
                  29,000Employee
                      notes receivable
                  
                  
                  (45,000
                  )
                  
                  -Proceeds
                      from warrant exercise
                  
                  
                  -
                  
                  
                  69,000Proceeds
                      from secured term note, net of fees and transaction costs
                  
                  
                  -
                  
                  
                  2,833,000Proceeds
                      from issuance of Series D Cumulative Redeemable Convertible
                      Preferred
                      Stock, net of issuance costs
                  
                  
                  -
                  
                  
                  1,896,000Dividends
                      on Series D Cumulative Redeemable Convertible Preferred
                      Stock
                  
                  
                  (101,000
                  )
                  
                  -Principal
                      payments of long-term debt and capital lease obligations
                  
                  
                  (107,000
                  )
                  
                  (1,760,000
                  )Proceeds
                      from issuance of common stock in connection with private placement,
                      net of
                      issuance costs
                  
                  
                  -
                  
                  
                  (25,000
                  )Net
                      cash flows provided by financing activities
                  
                  
                  (110,000
                  )
                  
                  3,042,000Net
                      change in cash and cash equivalents
                  
                  
                  (856,000
                  )
                  
                  1,883,000Cash
                      and cash equivalents at beginning of the period
                  
                  
                  2,204,000
                  
                  
                  1,549,000Cash
                      and cash equivalents at end of the period
                  
                  $
                  1,348,000
                  
                  $
                  3,432,000**Supplemental
                      Disclosure of Cash Flow Information:**Interest
                      paid in cash
                  
                  $
                  73,000
                  
                  $
                  109,000**Noncash
                      Investing and Financing Activity:**Capital
                      equipment acquired under capital lease
                  
                  $
                  139,000
                  
                  $
                  42,000Accretion
                      of Series D Cumulative Redeemable Convertible Preferred Stock
                      dividends,
                      derivatives and warrants
                  
                  $
                  135,000
                  
                  $
                  -


5
 *Index*





**IMPLANT
      SCIENCES CORPORATION**


**NOTES
      TO CONDENSED FINANCIAL STATEMENTS**


**September
      30, 2006**


**(Unaudited)**





**1.**
            **Description
                of Business**





Implant
      Sciences Corporation (the “Company”) develops products for the medical device
      and security products industry. Its core technology involves ion implantation
      and thin film coatings of radioactive and non-radioactive materials. The Company
      has received Food and Drug Administration 510(k) clearance to market both its
      I-Plant TM Iodine-125 radioactive seed for the treatment of prostate cancer and its
      Ytterbium-169 source for breast cancer therapy. The Company also modifies the
      surface characteristics of orthopedic joint implants to reduce polyethylene
      wear
      and thereby increasing the life of the implant. The Company markets and sells
      its existing trace explosives detector products while continuing to make
      significant investments in developing the next generation of these products.
      The
      Company provides ion implantation and analytical services to the semiconductor
      industry and also semiconductor equipment.





*Risks
      and Uncertainties*





While
      the
      Company strives to bring new products to market, it is subject to a number
      of
      risks similar to other technology-based companies, including risks related
      to:
      (a) its dependence on key individuals and collaborative research partners;
      (b)
      competition from substitute products and larger companies; (c) its ability
      to
      develop and market commercially usable products and obtain regulatory approval
      for its products under development; and (d) its ability to obtain the
      substantial additional financing necessary to adequately fund the development,
      commercialization and marketing of its products. For the three months ended
      September 30, 2006, the Company reported a net loss of $1,610,000 and used
      $636,000 in cash from operations. As of September 30, 2006, the Company had
      an
      accumulated deficit of approximately $38,237,000 and working capital of
      $1,362,000. The Company has drawn $1,000,000 on a $1,500,000 revolving credit
      facility with a bank. 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 take other measures to provide the cash needed to continue
      operations.





Management
      has prepared operating plans which would indicate the Company has sufficient
      financial resources to sustain operations for at least the next twelve months.
      These plans depend on the successful increase in the semiconductor service
      revenue and the successful launching of a new handheld trace explosives detector
      product. 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
      government grants and contracts to support its research and development efforts.
      Should projected revenues not be met, management has developed plans which
      provide for cost cutting measures. Management believes that these cost cutting
      measures will be sufficient to allow the Company to continue as a going concern
      should revenue projections not be met.





The
      Company's consolidated financial statements have been presented on the basis
      that it is a going concern, which contemplates the realization of assets and
      the
      satisfaction of liabilities in the normal course of business. The Company has
      suffered recurring losses from operations. The Series D preferred stock contains
      mandatory redemptions on a monthly basis beginning in November 2006. These
      mandatory redemptions are redeemable in cash or shares of the Company’s common
      stock, at the Company’s option so long as the price of the Company’s stock does
      not fall below 110% of the fixed conversion price. There can be no assurances
      that forecasted results will be achieved or that the Company’s stock price will
      remain at a level to allow the Company to redeem the outstanding shares of
      Series D preferred and accrued dividends with shares of its common stock. These
      conditions raise substantial doubt about the Company's ability to continue
      as a
      going concern.  The financial statements do not include any adjustments
      relating to the recoverability and classification of asset amounts or the
      amounts and classification of liabilities that might be necessary should the
      Company be unable to continue as a going concern.





In
      November 2006, the Company received notification from a significant customer
      that they will be discontinuing a product line to which the Company provides
      a
      coating service. The customer will be phasing out the need for our services
      over
      the next two quarters. Management anticipates that in addition to reporting
      a
      future decrease in medical revenue, and gross margin, it will record an expense
      relating to the impairment of certain pieces of capital equipment, for which
      there are no alternative uses. The loss of revenue and expense related to the
      equipment impairment are likely to have a material adverse effect on the
      Company’s financial condition and results of operations.





6
 *Index*





Based
      on
      the current sales, expense and cash flow projections, the Company believes
      that
      the current level of cash and cash-equivalents on hand, and the net proceeds
      from current government contracts will be sufficient to fund operations for
      the
      next twelve months. However, because there can be no assurances that sales
      will
      materialize as forecasted, management will continue to closely monitor and
      attempt to control costs at the Company and will continue to actively seek
      the
      needed capital through government grants and awards, strategic alliances,
      private financing sources, and through its lending institutions.





Our
      significant accounting policies are described in Note 2 to the financial
      statements included in Item 7 of our Form 10-K as of June 30, 2006. Our
      discussion and analysis of our financial condition and results of operations
      are
      based upon the financial statements, which have been prepared in accordance
      with
      accounting principles generally accepted in the United States of America. The
      preparation of these financial statements requires us to make estimates and
      judgments that affect the reported amounts of assets, liabilities, revenues
      and
      expenses, and related disclosure of contingent assets and liabilities. On an
      on-going basis, we evaluate our estimates, including those related to bad debts,
      product returns, inventories, investments, intangible assets, accounting for
      embedded derivatives and warranty obligations. We base our estimates on
      historical experience and on various other assumptions that are believed to
      be
      reasonable under the circumstances, the results of which form the basis for
      making judgments about the carrying values of assets and liabilities that are
      not readily apparent from other sources. In the past, actual results have not
      been materially different from our estimates. However, results may differ from
      these estimates under different assumptions or conditions.




**2.**
            **Interim
                Financial Statements**




The
      accompanying condensed consolidated financial statements of the Company have
      been prepared in accordance with the accounting principles generally accepted
      in
      the United States of America. In the opinion of management, the accompanying
      condensed consolidated financials statements includes 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 these periods. The result of operations
      and cash flows for the three months ended September 30, 2006 may not necessarily
      be indicative of results that may be expected for any succeeding quarter or
      for
      the entire fiscal year. The information contained in this Form 10-Q should
      be
      read in conjunction with the Company’s audited financial statements, included in
      our Form 10-K as of and for the year ending June 30, 2006 filed with the
      Securities and Exchange Commission on October 12, 2006.




The
      accompanying condensed consolidated financial statements include the accounts
      of
      the Company and its wholly owned subsidiaries Accurel Systems International
      (“Accurel”) and Core Systems Incorporated (“Core”) (the “Subsidiaries”). All
      intercompany balances have been eliminated in consolidation.




The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America (“U.S. GAAP”) requires
      management to make estimates and judgments, which are evaluated on an on-going
      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, business combinations, valuation for goodwill
      and
      acquired intangible assets, accounting for embedded derivatives and warranty
      reserves.




7
 *Index*





**3.**
            **Inventories**




Inventories
      consist of the following:





**September
                30,**
            
            **June
                30,****2006**
            
            **2006**Raw
                materials
            
            $
            636,000
            
            $
            965,000Work-in-progress
            
            
            406,000
            
            
            291,000Finished
                goods
            
            
            654,000
            
            
            276,000$
            1,696,000
            
            $
            1,532,000





**4.**
            **Property
                and Equipment**





Property
      and equipment consists of the following **:**


**September
                  30,**
              
              **June
                  30,****2006**
              
              **2006**Total
                  property and equipment
              
              $
              16,638,000
              
              $
              16,413,000Less:
                  accumulated depreciation
              
              
              (8,121,000
              )
              
              (7,504,000
              )Property
                  and equipment, net
              
              $
              8,517,000
              
              $
              8,909,000


The
      Company recorded depreciation expense of approximately $617,000 and $579,000
      for
      the three month period ended September 30, 2006 and 2005, respectively.
      Capitalized leases and leasehold improvements are amortized based upon the
      lesser of the term of the lease or the useful life of the asset and such expense
      is included in depreciation expense.




**5.**
            **Accrued
                Expenses**





Accrued
      expenses consist of the following:




**September
                  30**,
              
              **June
                  30,****2006**
              
              **2006**Accrued
                  costs related to acquisitions
              
              $
              268,000
              
              $
              304,000Accrued
                  compensation and benefits
              
              
              946,000
              
              
              883,000Other
                  accrued liabilities
              
              
              894,000
              
              
              798,000$
              2,108,000
              
              $
              1,985,000





The
      Company accrues warranty costs in the period the related revenue is recognized
      and adjusts the reserve balance as needed to address potential future
      liabilities. The following table details the changes in the Company’s warranty
      reserve:




Balance
                at June 30, 2006
            
            $
            66,000Accrued
                warranty expense
            
            
            47,000Charges
                against the reserve
            
            
            (53,000
            )Balance
                at September 30, 2006
            
            $
            60,000




8
 *Index*





**6.**
            **Investment
                in Unconsolidated
                Subsidiaries**





As
      of
      September 30, 2006, the Company has an 18% interest in CorNova, Inc. as a result
      of 87,031 shares that have been issued to CorNova by the Company, of which
      16,449 of which have been categorized as treasury stock (“CorNova treasury
      stock”) in the accompanying balance sheet. The Company’s Chief Executive Officer
      (“CEO”) is one of the directors of CorNova. For the periods ended September 30,
      2006 and 2005, the Company recognized approximately $120,000 and $41,000,
      respectively, of equity losses in unconsolidated subsidiaries, representing
      the
      Company’s portion of CorNova’s net loss. The Company also recorded approximately
      $38,000 and $78,000 as an unrealized loss in the period ended September 30,
      2006
      and 2005 respectively, relating to the change in value of the CorNova treasury
      stock. Gains and losses are recorded as other comprehensive income (loss) in
      the
      equity section of the Company’s financial statements. CorNova’s unaudited
      results for the three month period ended September 30, 2006 were:





**Period
                Ended**
              **September
                30,****2006**
            
            **2005**Revenue
            
            
            -
            
            $
            59,000Expenses
            
            $
            664,000
            
            
            386,000Income
                tax benefit
            
            
            -
            
            
            111,000Net
                Loss
            
            $
            664,000
            
            $
            216,000




**7.**
            **Commitments
                and Contingencies**




(a)
      Capital and Operating Leases




The
      Company has an operating lease for its manufacturing, research and office space
      in Wakefield, MA which expires on December 31, 2008. The Company has an option
      to extend the lease for five additional years. 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 also has leases for
      both of its facilities in Sunnyvale, CA. The leases expire in December 2009
      and
      September 2010 and the Company has an option to extend each lease for five
      additional years. The Company also has a small satellite facility in Austin,
      TX
      with a lease that expired in September 2006. The Company is currently
      negotiating a new lease for this location. Under the terms of the leases, the
      Company is responsible for its proportionate share of real estate taxes and
      operating expenses relating to these facilities.




In
      conjunction with the acquisition of Accurel, the Company recorded a lease
      liability of $829,000. This liability reflects managements 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, if the lease had been negotiated under current market conditions.
      The
      balance of the lease liability on September 30, 2006 is $674,000, of which
      $132,000 is current.




Future
      minimum rental payments required under capital leases and operating leases
      with
      non-cancelable terms in excess of one year at September 30, 2006, together
      with
      the present value of net minimum lease payments are as follows:




**Capital
                Lease Payments**
            
            **Operating
                Lease Payments**Year
                ending June 30:2007
                remaining 9 months
            
            $
            107,000
            
            $
            1,267,0002008
            
            
            132,000
            
            
            1,713,0002009
            
            
            117,000
            
            
            1,454,0002010
            
            
            106,000
            
            
            838,0002011
                and remaining
            
            
            91,000
            
            
            150,000Total
                future minimum lease payments
            
            $
            553,000
            
            $
            5,422,000Less:
                amounts representing interest
            
            
            (138,000
            )Present
                value of future minimum lease payments
            
            
            415,000Less:
                current portion
            
            
            (90,000
            )Capital
                lease obligation, net of current portion
            
            $
            325,000




9
 *Index*




(b)
      Pending Litigation




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.





On
      March
      24, 2006, the Company brought suit in the United States District Court in the
      District of Massachusetts against Rapiscan and its parent, OSI Systems, Inc.
      (“OSI”). The Company is requesting rescission of the Rapiscan Agreement, for
      lack of performance and other grounds. In the alternative, the Company is
      seeking termination of the Rapiscan Agreement due to material breaches of
      contract and implied covenant of good faith and fair dealing and for damages
      due
      to Rapiscan’s breach of contract and the implied covenant of good faith and fair
      dealing.





On
      March
      27, 2006, the Company received notice that Rapiscan filed a complaint against
      the Company in the United States District Court for the Central District of
      California, regarding the Rapiscan Agreement. Rapiscan’s complaint against the
      Company is based upon claims of breach of contract and breach of warranty and
      is
      requesting a decree for specific performance, declaratory relief and injunctive
      relief.





As
      of
      August 18, 2006, as a result of motions made by both parties, the two lawsuits
      have been consolidated in the United States District Court for the Central
      District of California with the Company as plaintiff. Presently, discovery
      is in
      process. Rapiscan and OSI have filed a motion to dismiss certain of the
      Company’s claims. As of October 30, 2006, the court has ruled that the Company’s
      claim of breach of fiduciary duty was dismissed but OSI’s motion to dismiss all
      other claims was denied.





**8.**
            **Redeemable
                Convertible Preferred Stock**





On
      September 30, 2005, the Company issued 500,000 shares of Series D Redeemable
      Convertible Preferred Stock (“Series D”) having a stated value of $10 per share,
      pursuant to a Securities Purchase Agreement with Laurus Master Fund, Ltd.
      (“Laurus”). The Company received $5,000,000 in gross proceeds, less a management
      and placement agent fee of approximately $90,000, and related transaction costs
      of approximately $27,000. The Company utilized the proceeds to repay the $3
      million term note with Laurus signed on July 6, 2005. The Series D has a
      dividend equal to the prime rate plus one percent (1%) (9.25% at September
      30,
      2006) and provides for redemption over a thirty-six month period pursuant to
      an
      amortization schedule. In conjunction with the Series D, the Company also issued
      to Laurus a warrant to purchase up to 50,000 shares of the Company’s common
      stock at a price equal to $10.20 per share. The warrants were valued using
      the
      Black Scholes model and the following assumptions: volatility of 80%, an
      expected life 5 years, and a risk free interest rate of 4.12%. Net cash proceeds
      from this financing were $1,883,000 (which included repayments of $3,000,000
      of
      principal related to the July 6, 2005 term note and $117,000 of issuance costs).





The
      following table reflects the required redemption of the Series D before the
      effect of the accrued dividends:





Year
                ending June 30:
            
            Preferred
                Stock Monthly Redemption Schedule2007
                remaining nine months
            
            $
            1,212,0002008
            
            
            1,818,0002009
            
            
            1,061,000Total
            
            $
            4,091,000





The
      monthly redemption of approximately $152,000 plus accrued dividends commences
      on
      October 1, 2006. At its option the Company deferred the October redemption
      to
      the end of the term. Subject to certain conditions, it is at the Company’s
      option to pay this amount in cash or in common stock at a fixed conversion
      price
      of $4.15 per common share. This fixed conversion price is subject to reset
      should the Company declare a stock dividend or split, combine the outstanding
      common stock into a smaller number of shares, or issue, by reclassification
      of
      its common stock, any shares or other securities of the Company. The fixed
      conversion price shall be adjusted proportionately so that the holder of the
      Series D shall be entitled to receive the kind and number of shares or other
      securities of the Company which such Laurus would have owned or have been
      entitled to receive after the happening of any of the events described above,
      had such shares of Series D Preferred Stock been converted immediately prior
      to
      the happening of such event.





10
 *Index*





The
      Company valued the Series D 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 the 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 of $672,000, the value attributed to the
      embedded derivatives of $1,397,000 and $271,000 of issuance costs (including
      $154,000 of unamortized costs of the July 6, 2005 term note). The Company is
      accreting these discounts on the carrying value of the preferred stock to its
      redemption value at September 1, 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. As of September 30, 2006,
      $1,015,000 was amortized. As of September 30, 2006, the fair value of this
      conversion feature approximated $1,074,000.    The value of
      the embedded derivates related to the adjustable dividend rate and the
      potential default provisions were determined to be immaterial at September
      30,
      2006.





On
      May
      31, 2006, the Company amended the Series D and the Certificate of Vote of
      Directors Establishing a Class or Series of Stock. The terms of the amendment
      permit the Company to defer approximately $455,000 of cash payments,
      representing the January 2006, February 2006 and March 2006 amortization
      payments, and to defer the October 2006 amortization payment, should such
      payment be required in cash, to the mandatory redemption date of September
      30,
      2008. In consideration, the Company has agreed to the conversion of the April
      2006, May 2006, June 2006, July 2006, August 2006 and September 2006
      amortization payments into 261,233 shares of common stock of the Company at
      a
      conversion price of $3.48 per share, representing a reduction in principal
      of
      approximately $909,000, and to reduce the Fixed Conversion Price of the
      remaining Series D stock from $6.80 per share to $4.15 per share. In addition,
      Laurus was granted a warrant to purchase 150,000 shares of the Company’s common
      stock at an exercise price of $4.26 per share. The warrants were valued at
      $375,000 using the Black Scholes model and the following assumptions: volatility
      of 79%, an expected life 5 years, and a risk free interest rate of 4.89%.





The
      amendment of the Series D, as described above, was accounted for as an
      extinguishment of debt in accordance with EITF 96-19 "Debtor's Accounting for
      a
      Modification or Exchange of Debt Instruments." The Company determined a
      substantial difference in the net present value of the cash flows under the
      terms of the amendment was more than 10 percent different from the present
      value
      of the remaining cash flows under the terms of the original Series D agreement.
      Due to the substantial difference, the Company determined an extinguishment
      of
      debt had occurred with the amendment, and as such, it was necessary to reflect
      the Series D at its fair market value. Accordingly, the following table shows
      the basis for the Series D extinguishment:




Extinguishment
                of Series D debt instrument at May 31, 2006:Redemption
                payments
                due
            
            $
            909,000Unamortized
                discount of warrants, derivative value of preferred stock conversion
                and
                issue costs
            
            
            266,000Derivatives
                related to the preferred stock features
            
            
            578,000Subtotal
            
            $
            1,753,000Record
                New Series D debt instrument at May 31, 2006:Fair
                value of redemption payments made
            
            $
            1,011,000Issuance
                of 150,000 warrants
            
            
            375,000Unamortized
                discount of warrants, derivative value of preferred stock conversion
                and
                issue costs
            
            
            266,000Derivatives
                related to the preferred stock features
            
            
            1,395,000Subtotal
            
            $
            3,047,000Loss
                on extinguishment of Series D debt instrument
            
            $
            1,294,000




The
      $1,294,000 aggregate loss is accounted for as an extinguishment of debt and
      is
      included in Other expenses in the fourth quarter of the Company’s fiscal year
      ended June 30, 2006.




11
 *Index*





**9.**
            **Share-based
                compensation plans**





*Stock
      Option Plans*





In
      September 1998, the Company adopted the 1998 Stock Option Plan (the “1998
      Plan”). A total of 280,000 shares of common stock have been reserved for
      issuance under the 1998 Plan. Upon adoption of the 1998 Plan, the 1992 Stock
      Option Plan was terminated.




In
      December 2000, the Company adopted the 2000 Incentive and Non Qualified Stock
      Option Plan (the “2000 Plan”). A total of 1,500,000 shares of common stock have
      been reserved for issuance under the 2000 Plan.





In
      December 2004, the Company adopted the 2004 Stock Option Plan. The 2004 Plan
      provides for the grant of incentive stock options and nonqualified stock options
      to employees and affiliates. A total of 1,000,000 shares of common stock have
      been reserved for issuance under the 2000 Plan.




As
      of
      September 30, 2006, a total of 129,003, 55,402, and 380,000 shares are available
      for issuance under the 1998 Plan, 2000 Plan and 2004 Plan, respectively.





The
      following table presents the activity of the 1998, 2000 and 2004 Stock Option
      Plans for the three months ended September 30, 2006:




**Shares**
              
              **Weighted-**
                **Average**
                **Exercise
                  Price**Outstanding
                  at June 30, 2006
              
              
              1,836,551
              
              $
              5.41Granted
              
              
              190,188
              
              
              2.50Exercised
              
              
              (
                  34,365
              )
              
              1.49Cancelled
              
              
              (105,436
              )
              
              2.94Outstanding
                  at September 30, 2006
              
              
              1,886,938
              
              
              5.32Options
                  exercisable at end of period
              
              
              1,210,660
              
              $
              5.44Weighted-average
                  fair value of options granted during the year
              
              
              
              
              $
              1.61


*Employee
      Stock Purchase Plan*





In
      September 1998, the Company adopted the 1998 Employee Stock Purchase Plan (the
      “Plan”). The Plan provides a method whereby employees of the Company will have
      an opportunity to acquire an ownership interest in the Company through the
      purchase of shares of common stock of the Company through payroll deductions.
      After 12 months of employment, an employee is eligible to participate and can
      defer up to 10% of their wages into this Plan, with a maximum of $25,000 in
      any
      calendar year. The purchase price of the common stock is calculated at the
      lower
      of 85% of the closing price of the stock on the first day of the plan period
      or
      the last day of the plan period. The periods are January 1 to June 30 and July
      1
      to December 31. Fractional shares are not issued. Participants may withdraw
      at
      any time by giving written notice to the Company and will be credited the
      amounts of deferrals in their account. The maximum number of shares eligible
      to
      be issued under the Plan is 141,000. As of September 30, 2006, a total of 45,519
      shares are available for issuance under the Plan. Compensation expense under
      the
      Plan for the three month periods ended September 30, 2006 and 2005 is $10,000
      and $0 respectively.





*Non-qualified
      options and warrants*





Included
      in the consolidated statement of operations for the period ended September
      30,
      2006 is $16,000 of compensation expense attributable to other non-employee
      options and warrants.





12
 *Index*





**10.**
            **Employee
                Stock-Based Compensation**




On
      December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS
      No. 123 (Revised 2004) “Share-Based Payments,” (“SFAS 123R”), which is a
      revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS 123R
      supersedes Accounting Principal Board (“APB”) Opinion No. 25, “Accounting for
      Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.”
Generally, the approach in SFAS 123R is similar to the approach described in
      SFAS 123, however, SFAS 123R requires all share-based payments to employees,
      including grants of employee stock options and stock issued from certain
      employee stock purchase plans, to be recognized in earnings based on their
      modified-grant date fair values. Pro forma disclosure is no longer an
      alternative. Effective July 1, 2005, the Company adopted SFAS 123R.




The
      Company recorded $198,000 of stock based compensation, which includes $16,000
      of
      compensation expense attributable to its Employee Stock Purchase Plan in the
      three month period ended September 30, 2006.





The
      total
      non-cash stock-based compensation expense, including $10,000 of options and
      warrants issued to non-employees, included in the consolidated statement of
      operations for the three month period ended September 30, 2006 and 2005 is
      included in the following expense categories:




**Three
                Months Ended September 30,**
            
            **2006**
            
            **2005**Cost
                of revenues
            
            $
            62,000
            
            $
            82,000Research
                and development
            
            
            17,000
            
            
            68,000Selling,
                general and administrative
            
            
            119,000
            
            
            261,000Total
            
            $
            208,000
            
            $
            411,000




As
      of
      September 30, 2006 there was $1,548,000 of total unrecognized compensation
      expense related to unvested share based compensation arrangements under the
      various share-based compensation plans. This expense is expected to be
      recognized as follows:





**Period
                Ended June 30:**Remaining
                9 months 2007
            
            $
            792,0002008
            
            
            586,0002009
            
            
            160,000Thereafter
            
            
            10,000Total
            
            $
            1,548,000





The
      fair
      value of each option award is estimated on the date of grant using the
      Black-Scholes option pricing model using the assumptions noted in the following
      table. Expected volatility is based on historical volatility of the Company’s
      common stock. The Company uses historical data to estimate option forfeitures
      within the valuation model. The expected term of options granted is calculated
      using the “Simplified Method” as outlined SFAS 123R and reflects the period of
      time that options granted are expected to be outstanding. The risk-free rate
      for
      periods within the contractual life of the option is based on the U.S Treasury
      yield curve in effect at the time of grant. The Company has revised its
      estimated forfeiture rate from 4% to 10% for the periods ended September 30,
      2005 and 2006, respectively, resulting in a cumulative catchup adjustment to
      adjust share-based compensation amounting to a credit of $147,000 for the three
      months ended September 30 , 2006.




**Period
                ended**
              **September
                30, 2006****Stock
                Option Plan**
            
            **Stock
                Purchase Plan**Risk
                free interest rate
            
            
            4.85%
                - 5.07
            %
            
            5.17
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %Expected
                lives (years)
            
            
            3.5
                - 6 years
            
            
            6
                monthsExpected
                volatility
            
            
            78%
                - 79
            %
            
            78
            %Expected
                forfeiture rate
            
            
            10
            %
            
            0
            %Contractual
                term
            
            
            5
                - 10 years
            
            
            6
                months




13
 *Index*





**11.**
            **Long-term
                Debt and Credit
                Arrangements**




*MED-TEC
      Payment Obligation*





On
      July
      31, 2003, the Company entered into an agreement with its former exclusive
      distributor of prostate seeds, to release each other from further obligations
      under the original Distributor Agreement.  The new agreement conveys to the
      Company direct marketing and sales capabilities to sell its I-Plant Seed
      brachytherapy seeds for use in the treatment of prostate cancer.  In
      connection with this, the Company’s former exclusive distributor agreed to work
      cooperatively to transition customers and marketing materials directly to the
      Company.  The distributor also agreed not to compete with the Company for a
      period of three years.  The present value of this payment obligation was
      recorded as approximately $1,007,000, using a rate of 10.24%. This amount was
      recorded as an intangible asset and has been amortized over its estimated useful
      life of 29 months.  During the three months ended September 30, 2006 and
      2005, approximately $0 and $383,000, respectively, of amortization expense
      was
      recognized, which is included in selling, general and administrative expenses
      in
      the accompanying consolidated statements of operations. As of September 30,
      2006, the outstanding principal balance is approximately $233,000.  For the
      three months ended September 30, 2006 and 2005, the Company recorded
      approximately $6,000 and $9,000, respectively, of interest expense relating
      to
      this transaction.




*Installment
      Note*





At
      the
      time of its acquisition, Accurel had a $1,400,000 fixed rate installment note
      with a bank. The note called for monthly payments of $29,000 plus interest
      at a
      rate of 6.84%, through September 1, 2008 (the “Loan Agreement”).The bank has
      consented to continue the note under the same terms after the acquisition.
      The
      note is collateralized by substantially all assets of Accurel. During the three
      month period ended September 30, 2006 and 2005, the Company recorded interest
      expense of approximately $7,000 and $13,000, respectively, in connection with
      this note. As of September 30, 2006, the Accurel note balance is approximately
      $729,000.




The
      Loan
      Agreement requires Accurel to report monthly financial results to the bank
      and
      for Accurel to comply with certain financial covenants. As of September 30,
      2006
      Accurel was in compliance with the covenants.





Future
      principal payments on this note are as follows:




**Year
                ending June 30,**2007
                remaining nine months
            
            $
            263,0002008
            
            
            350,0002009
            
            
            116,000Total
            
            $
            729,000





*Revolving
      Credit Facility*





On
      September 7, 2006, the Company extended the expiration date of its $1,500,000
      revolving credit facility with Silicon Valley based Bridge Bank, N.A. The
      revolving credit facility expiring December 31, 2007, provides for advances
      of
      up to eighty percent (80%) of the Company’s eligible accounts receivable, bears
      interest at the prime rate plus one-half percent (1/2%) (8.25% as of September
      30, 2006), and is collateralized by certain assets of the Company. The credit
      facility is also subject to various financial covenants. As of September 30,
      2006, $1,000,000 has been drawn on this credit facility. The Company was in
      violation of certain covenants associated with this facility and has received
      waivers from the bank





**12.**
            **Financial
                Information by Segment**





Under
      SFAS No. 131, “Disclosures about Segments of an Enterprise and Related
      Information,” operating segments are defined as components of an enterprise
      about which separate financial information is available that is evaluated
      regularly by the chief operating decision maker, or decision making group,
      in
      deciding how to allocate resources and in assessing performance. The Company's
      chief operating decision making group is composed of the chief executive officer
      and members of senior management. The Company's reportable segments are:
      Medical, Semiconductor and Security Products.





14
 *Index*





Gross
      margin is the measure that management uses when evaluating the Company’s
      segments, therefore, operating expenses are excluded from the financial
      information below.




The
      revenues, expenses and assets related to these segments for the three
      months ended September 30, 2006 and 2005 are:





**Medical**
            
            **Semiconductor**
            
            **Security**
            
            **Total****Three
                months ended September 30, 2006**Revenue
            
            $
            1,160,000
            
            $
            3,939,000
            
            $
            481,000
            
            $
            5,580,000Cost
                of revenues
            
            
            (850,000
            )
            
            (3,049,000
            )
            
            (616,000
            )
            
            (4,515,000
            )Gross
                margin
            
            $
            310,000
            
            $
            890,000
            
            $
            (135,000
            )
            $
            1,065,000Assets
            
            $
            3,310,000
            
            $
            24,051,000
            
            $
            1,704,000
            
            $
            29,065,000**Three
                months ended September 30, 2005**Revenue
            
            $
            1,149,000
            
            $
            3,122,000
            
            $
            401,000
            
            $
            4,672,000Cost
                of revenues
            
            
            (959,000
            )
            
            (2,697,000
            )
            
            (1,022,000
            )
            
            (4,678,000
            )Gross
                margin
            
            $
            190,000
            
            $
            425,000
            
            $
            (621,000
            )
            $
            (6,000
            )Assets
            
            $
            4,652,000
            
            $
            27,084,000
            
            $
            2,161,000
            
            $
            33,897,000





International
      sales accounted for $725,000 in the three month period ended September 30,
      2006.
      In the three month period ended September 30, 2005 international sales were
      not
      material.





**13.**
            **Goodwill
                and Other Intangible
                Assets**




At
      September **** 30,
      2006
      and June 30 2006, the Company had goodwill and intangible assets of $13,158,000
      and $13,286,000 respectively. SFAS No. 142, “Goodwill and Other Intangible
      Assets”, requires that goodwill and intangible assets with indefinite lives no
      longer be amortized but instead be measured for impairment at least annually
      or
      whenever events indicate that there may be an impairment. In order to determine
      if impairment exists, management continually estimates the reporting unit’s fair
      value based on market conditions and operational performance. The Company may
      employ the work of independent appraisers in making its determination. The
      Company makes its annual assessment as of August 31st of each year to determine
      if its goodwill is impaired. As of June 30, 2006 the Company had
      determined that its goodwill at its semiconductor implantation reporting unit
      was impaired. As a result of this impairment the Company took an impairment
      charge of $457,000. Goodwill and intangible assets with indefinite lives at
      the
      Company’s semiconductor testing unit are not impaired. Future events could cause
      management to conclude that impairment indicators exist and that goodwill and
      intangible assets with indefinite lives associated with the Company’s acquired
      businesses are impaired. Any resulting impairment loss could have a material
      adverse impact on the Company’s financial condition and results of operations.




Intangible
      assets with finite lives are valued according to the future cash flows they
      are
      estimated to produce. These assigned values are amortized over the period of
      time those cash flows are estimated to be produced. Management continually
      evaluates whether events or circumstances have occurred that indicate that
      the
      estimated remaining useful life or the carrying value of these assets has been
      impaired. As of September 30, 2006 management believes no impairment
      exists.




There
      were no changes in the carrying value of goodwill for the three months ended
      September 30, 2006. Goodwill within each reportable segment, are as
      follows:




**Semiconductor
                Services**
            
            **Semiconductor
                Testing**Balance
                as of September 30 and June 30, 2006
            
            $
            4,091,000
            
            $
            7,575,000




15
 *Index*





The
      following table summarizes the Company’s intangible assets as of September 30,
      2006:





**Gross
                carrying amount**
            
            **Accumulated
                Amortization**
            
            **Net
                Carrying Amount****June
                30, 2006**
            
            **Additions**
            
            **September
                30, 2006**
            
            **June
                30, 2006**
            
            **Additions**
            
            **September
                30, 2006**
            
            **September
                30, 2006**Non-Compete
            
            $
            1,057,000
            
            $
            -
            
            $
            1,057,000
            
            $
            1,050,000
            
            $
            7,000
            
            $
            1,057,000
            
            $
            -Name
                Recognition
            
            
            200,000
            
            
            -
            
            
            200,000
            
            
            38,000
            
            
            7,000
            
            
            45,000
            
            
            155,000Customer
                Base
            
            
            1,630,000
            
            
            -
            
            
            1,630,000
            
            
            445,000
            
            
            82,000
            
            
            527,000
            
            
            1,103,000Technology
            
            
            125,000
            
            
            -
            
            
            125,000
            
            
            43,000
            
            
            7,000
            
            
            50,000
            
            
            75,000Treatment
                Planning System
            
            
            300,000
            
            
            -
            
            
            300,000
            
            
            116,000
            
            
            25,000
            
            
            141,000
            
            
            159,000Total
            
            $
            3,312,000
            
            $
            -
            
            $
            3,312,000
            
            $
            1,692,000
            
            $
            128,000
            
            $
            1,820,000
            
            $
            1,492,000





Estimated
      amortization expense for intangible assets with finite lives on our balance
      sheet as of September 30, 2006, for the fiscal years ending June 30, is as
      follows:





2007
                remaining nine months
            
            $
            358,0002008
            
            
            462,0002009
            
            
            380,0002010
            
            
            246,0002011
            
            
            46,000$
            1,492,000




**14.**
            **Loss
                Per Share**




The
      Company had the following potential dilutive securities outstanding on September
      30, 2006: options and warrants to purchase 1,886,938 and 1,758,503 shares,
      respectively, of the Company’s common stock at weighted average exercise prices
      of $5.32 and $7.66 per share, respectively and (ii) Series D Preferred Stock
      convertible into an aggregate of 985,761 shares of the Company’s common stock.
      Such potential dilutive securities were not included in the calculation of
      diluted loss per share in the period ended September 30, 2006 because the
      inclusion thereof would be antidilutive.





**15.**
            **Subsequent
                Event**




In
      November 2006, the Company received notification from a significant customer
      that they will be discontinuing a product line to which the Company provides
      a
      coating service. The customer will be phasing out the need for our services
      over
      the next two quarters. Management anticipates that in addition to reporting
      a
      future decrease in medical revenue, and gross margin, it will record an expense
      relating to the impairment of certain pieces of capital equipment, for which
      there are no alternative uses. The loss of revenue and expense related to the
      equipment impairment are likely to have a material adverse effect on the
      Company’s financial condition and results of operations.




16
 *Index*




**ITEM
                2.**
            **MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                OPERATIONS**





**OVERVIEW**





Over
      the
      past twenty two years, Implant Sciences Corporation has both developed and
      acquired technologies using ion implantation and thin film coatings. Initially
      this technology was used in semiconductor processing but soon expanded to
      include various medical device applications including the modification of
      orthopedic joint implant surfaces to reduce polyethylene wear generation and
      the
      manufacture of products for radiation therapy treatments. Our latest application
      of this technology includes the manufacturing of trace explosives detection
      equipment.





We
      currently provide ion implantation and analytical services to numerous
      semiconductor manufacturers, research laboratories and universities. The
      application of our ion implantation technologies to modify the surfaces of
      orthopedic joint implants is being applied primarily to product manufactured
      by
      the Stryker-Orthopaedics Division of Stryker Corporation. While this orthopedic
      coating customer has provided a steady source of revenue to the Company for
      many
      years, we have been informed that they are changing their product line which
      will eliminate the coating services currently conducted by the Company. This
      phase out will begin in the second and third quarters of fiscal 2007.





In
      October 2004 and March 2005, we acquired two California semiconductor companies.
      Through these acquisitions, we have more than doubled our semiconductor capacity
      and are now able to offer diagnostic services and semiconductor equipment
      refurbishment services to semiconductor manufacturers, research laboratories
      and
      universities.





Other
      applications of our ion beam technology have been in the area of temporary
      brachytherapy products. In May 1999, we received Food and Drug Administration
      510(k) clearance to market our I-Plant TM Iodine-125 radioactive seed for the treatment of prostate cancer and in 2001
      recognized our first sale.





Since
      May
      1999, we have been performing research to develop a trace explosives detector,
      which could be used to detect hidden bombs in airports and other public places.
      This technology is yet another application of our ion source technology. At
      present, we have developed both portable and bench-top systems for use in
      airports and Department of Defense facilities and have successfully marketed
      these products both domestically and internationally. In fiscal 2006, as part
      of
      a plan to reduce manufacturing costs, we transitioned the production of these
      products to a contract manufacturer. As we continue to sell and deliver these
      products, we work both independently and in conjunction with various government
      agencies, to develop the next generation of trace explosives detectors and
      identify new applications for our proprietary technology.





The
      Company manages its business and reports results from operations for three
      business segments: Medical, which includes radioactive seeds, orthopedic
      coatings, medical related government contracts and other related activities;
      Security Products, which includes development contracts and product sales
      related to the Company’s trace explosives detection products; and Semiconductor,
      which includes ion implantation, disk refurbishment, source conditioning
      equipment and semiconductor analytical services.





**RESULTS
      OF OPERATIONS**





The
      following is a discussion and analysis of the financial condition and results
      of
      operation of the Company for the three month period ended September 30, 2006,
      and 2005. It should be read in conjunction with the financial statements and
      notes thereto appearing elsewhere herein.





*Three
      Month Period Ended September 30, 2006 vs. September 30, 2005*





*Revenues.* Revenues
      for the three months ended September 30, 2006 were $5,580,000 as compared to
      $4,672,000 in the three months ended September 30, 2005, an increase of $908,000
      or 19%. Our revenues by business segment are as follows:




17
 *Index*





**Three
                months ended****September
                30, 2006**
            
            **September
                30, 2005**Medical
            
            $
            1,160,000
            
            $
            1,149,000Semiconductor
            
            
            3,939,000
            
            
            3,122,000Security
                products
            
            
            481,000
            
            
            401,000Total
            
            $
            5,580,000
            
            $
            4,672,000




Revenues
      in all business segments increased over the comparable prior year period, with
      the Semiconductor segment accounting for the majority of the increase. Our
      Semiconductor business segment increased $817,000 or 26%, our Security Products
      business segment increased $80,000 or 20% and our Medical business segment
      increased $11,000 or 1%. The increase in our Semiconductor segment is
      attributable to continued strong performance at our Accurel subsidiary and
      sales
      of our Krytek source conditioning systems. The increased level of service began
      in December 2005. Our Krytek source conditioning systems sell in the range
      of
      $150,000 to $190,000 for a complete system. Two systems were sold in the period
      ended September 30, 2006, while none were sold in the prior year period. The
      increase in Security products revenue is primarily attributable to sales of
      our
      handheld explosives detection devices which increased $182,000 from the previous
      year while revenues from government contracts are down $102,000 from the
      previous year period. The Company has received a new government contract and
      revenues against this contract began to be recognized in September 2006.
      Revenues of our Medical business segment reflect a $45,000 increase in seeds
      revenues offset by a $47,000 decrease in orthopedics revenues. Management
      expects that orthopedic coating revenues will continue to decrease materially
      in
      Q2 and Q3 as our primary customer is changing their product line and phases
      out
      the Company’s services over the next two quarters. Revenues from medical
      contracts were up approximately $16,000 from the previous year period.





*Cost
      of Revenues* .
      Cost of
      revenues for the three months ended September 30, 2006 was $4,515,000 as
      compared to $4,678,000 the prior three months period ended September 30, 2005
      a
      decrease of $163,000 or 3%. The cost of revenues by business segment is as
      follows:





**Three
                months ended****September
                30, 2006**
            
            **September
                30, 2005**Medical
            
            $
            850,000
            
            $
            959,000Semiconductor
            
            
            3,049,000
            
            
            2,697,000Security
                products
            
            
            616,000
            
            
            1,022,000Total
            
            $
            4,515,000
            
            $
            4,678,000





Cost
      of
      revenues for our Semiconductor business segment was $3,049,000 for the three
      months ended September 30, 2006 as compared to $2,697,000 for the prior year
      three month period, an increase of $352,000 or 13%. The increase in
      Semiconductor cost of revenue reflects the increased activity levels at Accurel
      and the cost of our Krytek source conditioning systems. The Krytek systems
      are
      built by an outside contractor, therefore the cost is entirely variable with
      sales. Cost of revenues for our Security Products segment was $616,000 for
      the
      three months ended September 30, 2006 as compared to $1,022,000 for the prior
      year period representing a decrease of $406,000 or 40%. In the comparable prior
      year period the Company used its in house manufacturing capability to fulfill
      a
      large order, for its handheld explosives detection device, delivered in the
      second quarter of fiscal 2006. In February 2006, the Company transferred
      production of its handheld explosives detection device to a contract
      manufacturer and eliminated almost all of its in house manufacturing costs.
      Medical cost of revenues in the period ended September 30, 2006 decreased by
      $109,000 or 11% from the previous year period. The decrease reflects cost
      reduction efforts by the Company put in place to attempt to return the seeds
      business to profitability.





18
 *Index*





*Gross
      Margins*





**Three
                Months ended September 30, 2006**Medical
            
            Semiconductor
            
            Security
            
            TotalRevenues
            
            $
            1,160,000
            
            $
            3,939,000
            
            $
            481,000
            
            $
            5,580,000Cost
                of revenues
            
            $
            850,000
            
            $
            3,049,000
            
            $
            616,000
            
            $
            4,515,000Gross
                Margin
            
            $
            310,000
            
            $
            890,000
            
            $
            (135,000
            )
            $
            1,065,000Margin
                %
            
            
            27
            %
            
            23
            %
            
            -28
            %
            
            19
            %





**Three
                Months ended September 30, 2005**Medical
            
            Semiconductor
            
            Security
            
            TotalRevenues
            
            $
            1,149,000
            
            $
            3,122,000
            
            $
            401,000
            
            $
            4,672,000Cost
                of revenues
            
            $
            959,000
            
            $
            2,697,000
            
            $
            1,022,000
            
            $
            4,678,000$
            190,000
            
            $
            425,000
            
            $
            (621,000
            )
            $
            (6,000
            )Margin
                %
            
            
            17
            %
            
            14
            %
            
            -155
            %
            
            -
            %




Overall
      gross margins were 19% of revenues in the three months ended September June
      30,
      2006 as compared to a slight gross margin loss in the prior year period. The
      increase in gross margins comes from all of our business segments. Semiconductor
      gross margins were 27% for the three months ended September 30, 2006 as compared
      to 17% for the prior year period. This improvement is primarily due to Accurel
      and the sale of the Krytek systems. Accurel is a service business and is
      characterized by relatively low variable costs so increased revenues beyond
      the
      level needed to cover fixed costs will have an impact on gross margins. Security
      products had a gross margin loss of 28% for the three months ended September
      30,
      2006 as compared to a gross margin loss of 155% in the prior year period. The
      improvement in security products margin is due primarily to the elimination
      of
      handheld explosives detection device manufacturing costs. In the prior year
      period the Company’s handheld explosives detection device manufacturing
      capability was being built up to provide a high volume production run. Once
      the
      initial handheld explosives device production run was completed, and the
      manufacturing process was proven, manufacturing was transitioned to a contract
      manufacturer allowing the Company to reduce its manufacturing overhead. The
      medical segment gross margins were 27% for the three months ended September
      30,
      2006 compared to 17% for the prior year period. The improvement in gross margin
      came from manufacturing efficiencies gained in our seeds operations primarily
      from cost reductions and the reduction in scrap. However, management expects
      a
      decrease in the medical segment’s gross margins beginning in the second quarter
      of fiscal 2007 as our primary orthopedic coatings customer phases out a
      particular product line needing coating services. It is anticipated that the
      loss of this revenue beginning in the second quarter of fiscal 2007 will
      negatively impact our gross margin, as historically this service was a very
      profitable business.





*Research
      and Development* .
      Research and development expense for the three months ended September 30, 2006
      was $567,000 as compared to $316,000 for the comparable prior year period,
      an
      increase of $251,000, or 79%. The Company continued to expend funds to further
      the development of new products in the areas of explosives and toxic substance
      detection. 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. The Company charges its research and
      development personnel to cost of revenues for work performed on these contracts
      and grants. Research and development expenses prior to starting the government
      contracts are charged to operating expenses. In addition with the transfer
      of
      explosives detection manufacturing to a contract manufacturer, the Company
      reorganized its staff and a number of people previously charged to manufacturing
      were transferred to research and development. A total of $280,000 of research
      and development personnel costs were charged to operations in the three months
      ended September 30, 2006 as compared to $91,000 in the prior year period. In
      addition, other costs associated with unfunded research and development projects
      in the current fiscal year were expensed to research and
      development.





*Selling,
      General and Administrative* .
      Selling, general and administrative expense for the three months ended September
      30, 2006 was $1,963,000 as compared to $1,923,000 for the comparable prior
      year
      period, an increase of $40,000, or 2%. The increase in expense is due to the
      increased activity at Accurel and legal fees.





19
 *Index*




*Other
      Income and Expenses, Net* .
      For the
      three months ended September 30, 2006, we recorded other expense, net, of
      $145,000 as compared to $122,000, in the comparable prior year period an
      increase of $23,000 or 19%. Other income and expense includes a loss of $120,000
      for the period ended September 30, 2006 as compared to a loss of $41,000 in
      the
      prior year period, representing the Company’s share of losses attributable to
      its investment in CorNova, an unconsolidated subsidiary accounted for under
      the
      equity method of accounting. Interest expense in the current year period was
      $49,000 compared to $92,000 in the prior year period. In the comparable prior
      year period, the Company had a $3,000,000 note that was converted to Series
      D
      Preferred Stock on September 30, 2005.




*Net
      Loss.* Net loss
      for the three months ended September 30, 2006 was $1,610,000 as compared with
      $2,367,000 for the comparable prior year period, a decrease in net loss of
      $757,000, or 32%. The decrease in net loss is primarily due to reduced loss
      from
      operations of $780,000 offset by an increase in other expenses of $23,000.





Preferred
      distribution, dividends and accretion on Series D Redeemable Convertible
      Preferred Stock were $236,000 in the three months ended September 30, 2006
      as
      compared to $0 in the prior year period. The Company issued Series D Redeemable
      Convertible Preferred Stock on September 30, 2005.





**LIQUIDITY
      AND CAPITAL RESOURCES**





As
      of
      September 30, 2006, the Company had approximately $1,348,000 in the form of
      cash
      and cash equivalents. During the three months ended September 30, 2006,
      operating activities used cash of approximately $636,000. Net cash used by
      operating activities primarily reflects the $1,610,000 net loss, increased
      by a non-cash gain of $20,000, related to the change in fair value of
      derivatives, and reduced by non-cash charges of $745,000 in depreciation and
      amortization, $208,000 of share-based compensation expense and $120,000 in
      equity loss in unconsolidated subsidiaries. Working capital items used $79,000
      of cash. The Company has approximately $1,050,000 of raw materials and finished
      goods inventories related to its handheld explosives detection product. This
      inventory was built in anticipation of future shipments of this product to
      customers. Orders for the explosives detection product to date have typically
      been from foreign governments or agencies of foreign governments. The sales
      cycle to these entities can take a number of months to; close the order, set
      up
      letters of credit from the customer covering the payment, and obtain the
      necessary export licenses and other required documentation. Expected future
      shipments of these products, in the near term, can be accomplished with no
      further investment in inventories and current levels of inventory are expected
      to come down providing positive cash flows. Investing activities used $110,000
      of cash primarily for investment in, or deposits,on, plant and equipment.
      Financing activities consist of, $98,000 of proceeds received from participants
      in the Employee Stock Purchase Plan and the exercise of stock options, offset
      by
      $101,000 in cash dividends paid to the holders of the Series D preferred stock
      and $107,000 in principal payments against bank loans and capital leases.





On
      September 7, 2006, the Company extended the expiration date of its $1,500,000
      revolving credit facility with Silicon Valley based Bridge Bank, N.A. The
      revolving credit facility, expiring December 31, 2007, provides for advances
      of
      up to eighty percent (80%) of the Company’s eligible accounts receivable, bears
      interest at the prime rate plus one-half percent (1/2%), and is collateralized
      by certain assets of the Company. The credit facility is also subject to various
      financial covenants. As of September 30, 2006, $1,000,000 has been drawn on
      this
      credit facility. The credit facility is subject to various covenants that have
      been violated as of September 30, 2006. The Company has received a waiver of
      these violations from the bank.





Since
      May
      1999, we have been developing several explosive detection systems that could
      be
      used in airports, public and government buildings, and sporting event
      facilities. The systems use our proprietary Laser IMS technology, which includes
      the use of laser beams in combination with ion mobility spectrometry, to
      electronically detect minute quantities of explosive vapor molecules in the
      air.





We
      are
      currently expending significant resources to develop the next generation of
      our
      current product 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.





20
 *Index*





Consistent
      with our policy to protect our proprietary technologies, we have been awarded
      five patents and have submitted an additional four patent applications to the
      United States Patent and Trademark Office. These patents and applications will
      cover specific design configurations that are responsible for our improved
      vapor
      detection sensitivity.





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 capital equipment.





Based
      on
      the current sales, expense and cash flow projections, the Company believes
      that
      the current level of cash and cash-equivalents on hand, the net proceeds from
      its revolving line of credit and a $3.6M contract received from the U.S. Army
      in
      August 2006, will be sufficient to fund operations for the next twelve months.
      In addition, it is anticipated that the Company will be reducing its operating
      expenses to compensate for the projected decrease in medical sales revenue
      beginning in the second quarter of fiscal 2007. However, because there can
      be no
      assurances that sales will materialize as forecasted, management will continue
      to closely monitor and attempt to control costs at the Company and will continue
      to actively seek the needed capital through government grants and awards,
      strategic alliances, private financing sources, and through its lending
      institutions. Future expenditures for research and product development,
      especially relating to outside testing, are discretionary and, accordingly,
      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
      the Company be unable to continue as a going concern.





The
      Company’s future minimum payments under contractual obligations related to
      capital leases, operating leases and term notes as of September 30, 2006 are
      as
      follows:




**Debt
                and Capital Lease**
            
            **Operating
                Lease**
            
            **MED-TEC
                (1)**
            
            **Total**Three
                Months Ending September 30:2007
            
            $
            370,000
            
            $
            1,267,000
            
            $
            281,000
            
            $
            1,918,0002008
            
            
            482,000
            
            
            1,713,000
            
            
            -
            
            
            2,195,0002009
            
            
            233,000
            
            
            1,454,000
            
            
            -
            
            
            1,687,0002010
            
            
            106,000
            
            
            838,000
            
            
            -
            
            
            944,0002011
            
            
            91,000
            
            
            150,000
            
            
            -
            
            
            241,000Total
            
            $
            1,282,000
            
            $
            5,422,000
            
            $
            281,000
            
            $
            6,985,000




(1)
      Relates to MED-TEC payment obligation and includes $48,000 accrued
      interest.





*Critical
      Accounting Policies*




Our
      significant accounting policies are described in Note 2 to the financial
      statements included in Item 7 of our Form 10-K as of June 30, 2006. Our
      discussion and analysis of our financial condition and results of operations
      are
      based upon the financial statements, which have been prepared in accordance
      with
      accounting principles generally accepted in the United States. The preparation
      of these financial statements requires us to make estimates and judgments that
      affect the reported amounts of assets, liabilities, revenues and expenses,
      and
      related disclosure of contingent assets and liabilities. On an on-going basis,
      we evaluate our estimates, including those related to bad debts, product
      returns, inventories, investments, intangible assets and warranty obligations.
      We base our estimates on historical experience and on various other assumptions
      that are believed to be reasonable under the circumstances, the results of
      which
      form the basis for making judgments about the carrying values of assets and
      liabilities that are not readily apparent from other sources. In the past,
      actual results have not been materially different from our estimates. However,
      results may differ from these estimates under different assumptions or
      conditions. We adopted SFAS No. 142 and, accordingly, goodwill and other
      intangible assets with indefinite lives are no longer amortized, but rather
      such
      assets are subject to annual impairment reviews or more frequently, if events
      or
      circumstances indicate that they may be impaired.




21
 *Index*





**ITEM
                3.**
            **QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK**





The
      Company’s financial instruments include cash and cash equivalents. Cash and cash
      equivalents include cash on hand, demand deposits and short-term investments
      with maturities of three months or less when acquired. Cash equivalents
      represent a deposit in a money market account and a certificate of deposit.
      The
      Company does not utilize derivative financial instruments, derivative commodity
      instruments or other market risk sensitive instruments, positions or
      transactions in any material fashion. The principal objective of the Company’s
      asset management activities is to maximize net investment income, while
      maintaining acceptable levels of interest rate risk and facilitating its funding
      needs. At September 30, 2006, the carrying values of the Company’s financial
      instruments approximated fair values based upon current market prices and
      rates.





**ITEM4.**
            **CONTROLS
                AND PROCEDURES**





EVALUATION
      OF OUR DISCLOSURE CONTROLS AND INTERNAL CONTROLS




As
      of the
      end of the period covered by this quarterly report, we evaluated the
      effectiveness of the design and operation of our disclosure controls and
      procedures ("Disclosure Controls") and our internal controls and procedures
      for
      financial reporting ("Internal Controls"). This evaluation (the "Controls
      Evaluation") was done under the supervision and with the participation of our
      management, including our Chief Executive Officer ("CEO") and Chief Financial
      Officer ("CFO"). Rules adopted by the SEC require that in this section of the
      Annual Report, we present the conclusions of our CEO and the CFO about the
      effectiveness of our Disclosure Controls and Internal Controls based on and
      as
      of the date of the Controls Evaluation.





CEO
      AND
      CFO CERTIFICATIONS




Appearing
      as exhibits to this Annual Report are "Certifications" of the CEO and the CFO.
      The Certifications are required pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002 (the "Section 302 Certifications"). This section of the Annual
      Report contains information concerning the Controls Evaluation referred to
      in
      the Section 302 Certifications and this information should be read in
      conjunction with the Section 302 Certifications for a more complete
      understanding of the topics presented.





DISCLOSURE
      CONTROLS AND INTERNAL CONTROLS




Disclosure
      Controls are procedures that are designed with the objective of ensuring that
      information required to be disclosed in our reports filed under the Securities
      Exchange Act of 1934 ("Exchange Act"), such as this Annual Report, is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC's rules and forms. Disclosure Controls are also designed with the objective
      of ensuring that such information is accumulated and communicated to our
      management, including the CEO and CFO, as appropriate, to allow timely decisions
      regarding required disclosure. Internal Controls are procedures which are
      designed with the objective of providing reasonable assurance that (1) our
      transactions are properly authorized, recorded and reported; and (2) our assets
      are safeguarded against unauthorized or improper use, to permit the preparation
      of our financial statements in conformity with generally accepted accounting
      principles.





LIMITATIONS
      ON THE EFFECTIVENESS OF CONTROLS




Our
      management, including the CEO and CFO, has concluded that our disclosure
      controls and procedures are designed to provide reasonable assurance of
      achieving their objectives and have concluded that the controls and procedures
      are effective at that reasonable assurance level.





SCOPE
      OF
      THE CONTROLS EVALUATION




The
      CEO/CFO evaluation of our Disclosure Controls and Internal Controls included
      a
      review of the controls' objectives and design, the controls’ implementation by
      us and the effect of the controls on the information generated for use in this
      Annual Report. In the course of the Controls Evaluation, management sought
      to
      identify data errors, controls problems or acts of fraud and to confirm that
      appropriate corrective action, including process improvements, were being
      undertaken. This type of evaluation will be done on a quarterly basis so that
      the conclusions concerning controls effectiveness can be reported in our
      Quarterly Reports on Form 10-Q and Annual Report on Form 10-K. The overall
      goals
      of these various review and evaluation activities are to monitor our Disclosure
      Controls and Internal Controls and to make modifications as necessary; our
      intent in this regard is that the Disclosure Controls and the Internal Controls
      will be maintained as dynamic systems that change (including with improvements
      and corrections) as conditions warrant.





22
 *Index*





Among
      other matters, management sought in its evaluation to determine whether there
      were any "significant deficiencies" or "material weaknesses" in our Internal
      Controls, or whether we had identified any acts of fraud involving personnel
      who
      have a significant role in our Internal Controls. In the professional auditing
      literature, "significant deficiencies" are referred to as “reportable
      conditions;” these are control issues that could have a significant adverse
      effect on the ability to record, process, summarize and report financial data
      in
      the financial statements. A "material weakness" is defined in the auditing
      literature as a particularly serious reportable condition where the internal
      control does not reduce to a relatively low level the risk that misstatements
      caused by error or fraud may occur in amounts that would be material in relation
      to the financial statements and not be detected within a timely period by
      employees in the normal course of performing their assigned
      functions.





CONCLUSIONS




Based
      upon the Controls Evaluation, our CEO and CFO have concluded that, as of the
      end
      of the period covered by this quarterly report, our Disclosure Controls are
      effective to provide reasonable assurance that our financial statements are
      fairly presented in conformity with generally accepted accounting principles.




In
      June
      2006, our independent auditors reported to our Audit Committee certain matters
      involving internal controls that our independent auditors considered to be
      a
      significant deficiency. A significant deficiency is a control deficiency or
      combination of control deficiencies, that adversely affects the company’s
      ability to initiate, authorize, record, process, or report external financial
      data reliably in accordance with generally accepted accounting principles such
      that there is more than a remote likelihood that a misstatement of the company’s
      annual or interim financial statements that is more than inconsequential will
      not be prevented or detected.





The
      reportable condition related primarily to the closing and financial reporting
      process.  Management is confident that our financial statements for
      the period ended September 30, 2006 fairly present, in all material respects,
      our financial condition and results of operations.





The
      reportable condition has been discussed in detail among management, our Audit
      Committee and our independent auditors, and we are committed to addressing
      and
      resolving these matters fully and promptly, by putting in place the personnel,
      processes, technology and other resources appropriate to support our financial
      close processes. As part of this commitment, beginning in the second quarter
      of
      our fiscal year ended June 30, 2007, we intend to use the services of an outside
      consultant to evaluate our closing and financial reporting process and make
      recommendations to management to improve these processes.





**PART
                II**
            **OTHER
                INFORMATION**





**Item1.**
            **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.





On
      or
      about March 8, 2006, the Company commenced an arbitration under the Rules of
      the
      American Arbitration Association against Respondents Majid Ghafghaichi (“Majid”)
      and Vahe Sarkissisian (“Vahe”), seeking a total of $3,994,000 for
      indemnification of various “Losses,” as defined in, and expressly allowed
      pursuant to, a Stock Purchase Agreement dated March 9, 2005 (the “Agreement”),
      between the Company, as the purchaser, Accurel Systems International Corporation
      (“Accurel), and  Majid and Vahe, as the sellers of 100% of the issued and
      outstanding shares of Accurel stock.





23
 *Index*





More
      specifically, there are four claims asserted by the Company against Respondents:
      (1) Damages of $3.4 million resulting from misrepresentations concerning the
      loss of business from a key Accurel customer; (2) unauthorized withdrawals
      in
      the amount of approximately $276,000 from Accurel by the Respondents prior
      to
      the closing; (3) approximately $49,000 of disallowed transaction expenses that
      the Respondents improperly received; and (4) undisclosed net liabilities
      totaling approximately $269,000.





Respondents
      have asserted counterclaims seeking “an aggregate amount in excess of
      $1,750,000,” based on the allegedly “late payment” to Respondents of Company
      stock and a Secured Promissory Note as part of the consideration for their
      sale
      of Accurel stock.  The Company has filed a detailed denial of all
      counterclaims.





The
      arbitration is now in the discovery phase, and the hearing is scheduled for
      February 2007.





At
      this
      early stage of the proceedings, particularly before the commencement of
      depositions, it is difficult to assess the final outcome of this arbitration.
      However, the Company believes that the counterclaims have no merit, and will
      vigorously defend itself against such counterclaims.





On
      March
      23, 2005, we entered into a Development, Distribution and Manufacturing
      Agreement (the “Rapiscan Agreement”) with Rapiscan Systems, Inc.
      (“Rapiscan”).  Under the terms of this agreement, we gave Rapiscan the
      exclusive worldwide rights to market our Quantum Sniffer TM portable
      and benchtop trace detection devices under their private label.  We also
      agreed to give Rapiscan the exclusive worldwide rights to distribute certain
      other new security products which we may develop in the future with their
      funding, as well as rights, in some circumstances, to manufacture certain
      components of the Quantum Sniffer TM portable
      and benchtop trace detection devices that they are able to sell.





On
      March
      24, 2006, the Company brought suit in the United States District Court in the
      District of Massachusetts against Rapiscan and its parent, OSI Systems, Inc.
      (“OSI”). The Company is requesting rescission of the Rapiscan Agreement, for
      lack of performance and other grounds. In the alternative, the Company is
      seeking termination of the Rapiscan Agreement due to material breaches of
      contract and implied covenant of good faith and fair dealing and for damages
      due
      to Rapiscan’s breach of contract and the implied covenant of good faith and fair
      dealing.





On
      March
      27, 2006, the Company received notice that Rapiscan filed a complaint against
      the Company and its contract manufacturer, Columbia Tech, in the United States
      District Court for the Central District of California, regarding the Rapiscan
      Agreement. Rapiscan’s complaint against the Company is based upon claims of
      breach of contract and breach of warranty and is requesting a decree for
      specific performance, declaratory relief and injunctive relief. Rapiscan’s
      complaint against Columbia Tech is based upon injunctive relief, declaratory
      relief and tortuous interference with contractual relations. On April 12, 2006,
      Rapiscan dismissed all claims against Columbia Tech.





As
      of
      August 18, 2006, as a result of motions made by both parties, the two lawsuits
      have been consolidated in the United States District Court for the Central
      District of California with the Company as plaintiff. Presently, discovery
      is in
      process. Rapiscan and OSI have filed a motion to dismiss certain of the
      Company’s claims. As of October 30, 2006, the court has ruled that the Company’s
      claim of breach of fiduciary duty was dismissed but OSI’s motion to dismiss all
      other claims was denied.




Should
      the Company be unsuccessful in prosecuting this matter, it may have a material
      adverse effect on its business and results of operations. No revenue has been
      recorded related to the Rapiscan Agreement.




We
      may,
      from time to time, be involved in other actual or potential proceedings that
      we
      consider to be in the normal course of our business. We do not believe that
      any
      of these proceedings will have a material adverse effect on our
      business.





**Item
                1a**
            **Risk
                Factors**





An
      investment in our securities involves a high degree of risk. There have been
      no
      material changes to the risk factors previously disclosed in the Company's
      Annual Report on Form 10-K. You should consider carefully all of the material
      risks described in the Form 10-K, before making a decision to invest in our
      securities. If any of the events described therein occur, our business,
      financial conditions and results of operations may be materially adversely
      affected. In that event, the trading price of our securities could decline,
      and
      you could lose all or part of your investment.




24
 *Index*





**Item2.**
            **Sales
                of Unregistered Securities**





Not
      applicable.





**Item
                3.**
            **Defaults
                Upon Senior Securities**





Not
      applicable.




**Item4.**
            **Submission
                of Matters to a Vote of Security
                Holders**





None.





**Item
                5.**
            **Other**




None





**Item
                6.**
            **List
                of Exhibits and Reports**




(a)
            The
                following exhibits, required by Item 601 of Regulation S-K, are filed
                as
                part of this Quarterly Report on Form 10-Q. Exhibit numbers, where
                applicable, in the left hand column correspond to those of Item 601
                of
                Regulation S-K.




Exhibit
                No.
            
            Description31.1
            
            Certification
                of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002.31.2
            
            Certification
                of the Chief Financial Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002.32.1
            
            Certification
                of the Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.32.2
            
            Certification
                of the Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.





25
 *Index*





SIGNATURES





Pursuant
      to the requirements of the Securities and 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 CorporationDate:
                November 14, 2006
            
            
            /s/
                Anthony J. ArminiAnthony
                J. ArminiPresident
                and CEODate:
                November 14, 2006
            
            
            /s/
                Diane J. RyanDiane
                J. Ryan






26