UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-Q




(Mark One)




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




For the quarterly period ended
September 30, 2010




or




[  ] 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 000-25075


ARTIFICIAL LIFE, INC.

(Exact name of registrant as specified in its charter)






|Delaware                 |  |  |  | 04-3253298                          
|------------------------ |  |  |  | ------------------------------------
|(State
of incorporation) |  |  |  | (I.R.S.
Employer Identification No.)



26/F., 88 Hing Fat Street Causeway Bay, Hong Kong(Address of principal executive offices)




(+852) 3102-2800(Issuers telephone number,
including area code)




Not Applicable(Former name, former address and
former fiscal year, if changed since last report)




Indicate by check mark whether the registrant: (1) has
filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes
x No o




Indicate by check mark whether the registrant has submitted
electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of
Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit
and post such files). Yes o No o




Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated
filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.


|Large accelerated filer o |  | Accelerated filer o |  | Non-accelerated filer o (Do not check if smaller
reporting company) |  | Smaller reporting company x
|------------------------- |  | ------------------- |  | ------------------------------------------------------------------- |  | ---------------------------



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




Indicate the number of shares outstanding of each of the
issuers classes of common stock, as of the latest practicable date:




As of November 5, 2010, the Registrant had 63,807,282
shares of common stock, $.01 par value per share, outstanding.




1


---





ARTIFICIAL LIFE, INC.




INDEX OF INFORMATION CONTAINED IN FORM 10-Q FOR THE
QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010


|                               |  |  |  |                                                                                                                                               |  | Page No.
|------------------------------ |  |  |  | --------------------------------------------------------------------------------------------------------------------------------------------- |  | --------
|PART I  FINANCIAL INFORMATION |  |  | 
|Item
1.                        |  |  |  | Unaudited
Condensed Consolidated Financial Statements                                                                                         |  |         
|                               |  |  |  | Condensed
Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009 (unaudited)                                              |  |         
|                               |  |  |  | Condensed
Consolidated Statements of Income and Comprehensive Income for the Nine-Month Periods Ended September 30, 2010 and 2009 (unaudited) |  |         
|                               |  |  |  | Condensed
Consolidated Statement of Changes in Stockholders Equity for the Nine-Month Period Ended September 30, 2010 (unaudited)            |  |         
|                               |  |  |  | Condensed
Consolidated Statements of Cash Flows for the Nine-Month Periods Ended September 30, 2010 and 2009 (unaudited)                      |  |         
|                               |  |  |  | Notes to
Condensed Consolidated Financial Statements (unaudited)                                                                              |  |         
|Item
2.                        |  |  |  | Managements
Discussion and Analysis of Financial Condition and Results of Operations                                                         |  |         
|Item
3.                        |  |  |  | Quantitative and
Qualitative Disclosures About Market Risk                                                                                    |  |         
|Item
4.                        |  |  |  | Controls and
Procedures                                                                                                                       |  |         
|PART II  OTHER INFORMATION    |  |  | 
|Item
1.                        |  |  |  | Legal
Proceedings                                                                                                                             |  |         
|Item
1A.                       |  |  |  | Risk
Factors                                                                                                                                  |  |         
|Item
2.                        |  |  |  | Unregistered
Sales of Equity Securities and Use of Proceeds                                                                                   |  |         
|Item
3.                        |  |  |  | Defaults Upon
Senior Securities                                                                                                               |  |         
|Item
4.                        |  |  |  | [Removed and
Reserved]                                                                                                                        |  |         
|Item
5.                        |  |  |  | Other
Information                                                                                                                             |  |         
|Item
6.                        |  |  |  | Exhibits                                                                                                                                      |  |         
|Signatures                     |  |  |  |                                                                                                                                               |  |         



2


---



PART I  FINANCIAL INFORMATION




ITEM 1. UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




ARTIFICIAL LIFE, INC. AND SUBSIDIARIES CONDENSED
CONSOLIDATED BALANCE SHEETS (UNAUDITED)







|                                                                                                                                                                                                    |  |  |  | September 30, 2010 |            | December 31, 2009
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  | ------------------ | ---------- | -----------------
|                                                                                                                                                                                                    |  |  |  | USD                |            | USD              
|ASSETS                                                                                                                                                                                             
|Current
assets:                                                                                                                                                                                     |  |  |  |                    |            |                  
|Cash                                                                                                                                                                                                |  |  |  | $                  | 599,535    |                  
|Pledged
deposit                                                                                                                                                                                     |  |  |  |                    | 25,641     |                  
|Trade
accounts receivables, net of discount interest of $183,242 and $208,218, respectively                                                                                                         |  |  |  |                    | 27,845,151 |                  
|Trade
installment receivables, net of discount interest of $16,580 and $139,743, respectively                                                                                                       |  |  |  |                    | 3,395,625  |                  
|Prepaid
expenses and other                                                                                                                                                                          |  |  |  |                    | 775,214    |                  
|Deferred
income taxes, net                                                                                                                                                                          |  |  |  |                    | 497,714    |                  
|Total
current assets                                                                                                                                                                                |  |  |  |                    | 33,138,880 |                  
|                                                                                                                                                                                                   
|Fixed assets,
net of accumulated depreciation of $561,532 and $1,932,684, respectively                                                                                                              |  |  |  |                    | 96,465     |                  
|                                                                                                                                                                                                   
|License
rights, net of accumulated amortization of $11,321,987 and $6,317,060, respectively                                                                                                         |  |  |  |                    | 32,970,385 |                  
|Prepaid
expenses, deposits and other assets                                                                                                                                                         |  |  |  |                    | 1,269,941  |                  
|Deferred
income taxes                                                                                                                                                                               |  |  |  |                    | 1,510,331  |                  
|                                                                                                                                                                                                    |  |  |  |                    | 35,750,657 |                  
|                                                                                                                                                                                                   
|TOTAL
ASSETS                                                                                                                                                                                        |  |  |  | $                  | 68,986,002 |                  
|                                                                                                                                                                                                    |  |  |  |                    |            |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                               
|Current
liabilities:                                                                                                                                                                                |  |  |  |                    |            |                  
|Accounts
payable                                                                                                                                                                                    |  |  |  | $                  | 1,737,796  |                  
|Accrued
expenses and other                                                                                                                                                                          |  |  |  |                    | 510,316    |                  
|Income taxes
payable                                                                                                                                                                                |  |  |  |                    | 2,257,562  |                  
|Note payable
 officer/stockholder                                                                                                                                                                  |  |  |  |                    | 1,127,566  |                  
|Note payable
 stockholder                                                                                                                                                                          |  |  |  |                    |           |                  
|Total
liabilities (all current)                                                                                                                                                                     |  |  |  |                    | 5,633,240  |                  
|                                                                                                                                                                                                    |  |  |  |                    |            |                  
|Stockholders Equity                                                                                                                                                                                |  |  |  |                    |            |                  
|Preferred
stock, $.01 par value; 5,000,000 shares authorized, no shares issued and outstanding                                                                                                      |  |  |  |                    |           |                  
|Common stock,
$.01 par value; 130,000,000 shares authorized, 61,670,489 shares issued and outstanding as of September 30, 2010 and 57,411,203 shares issued and
outstanding as of December 31, 2009 |  |  |  |                    | 616,704    |                  
|Additional
paid-in capital                                                                                                                                                                          |  |  |  |                    | 67,665,625 |                  
|Notes
receivable from stockholders                                                                                                                                                                  |  |  |  |                    | (19,577    | )                
|Accumulated
deficit                                                                                                                                                                                 |  |  |  |                    | (4,823,764 | )                
|Accumulated
other comprehensive (loss) income                                                                                                                                                       |  |  |  |                    | (86,226    | )                
|Total
stockholders equity                                                                                                                                                                          |  |  |  |                    | 63,352,762 |                  
|                                                                                                                                                                                                    |  |  |  |                    |            |                  
|TOTAL
LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                          |  |  |  | $                  | 68,986,002 |                  



See accompanying notes to unaudited condensed consolidated
financial statements.




3


---



ARTIFICIAL LIFE, INC. AND SUBSIDIARIES CONDENSED
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)







|                                             |  |  |  | Three-Month Periods Ended September 30, |            | Nine-Month Periods Ended September 30, | 
|-------------------------------------------- |  |  |  | --------------------------------------- | ---------- | -------------------------------------- | 
|                                             |  |  |  | 2010                                    |            | 2009                                   | 
|                                             |  |  |  | USD                                     |            | USD                                    | 
|Revenues:                                    |  |  |  |                                         |            |                                        | 
|Software
license agreements                  |  |  |  | $                                       | 10,560,747 |                                        | 
|Application
services and other               |  |  |  |                                         |           |                                        | 
|                                             |  |  |  |                                         | 10,560,747 |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Cost of
revenues:                            |  |  |  |                                         |            |                                        | 
|Cost of
software license agreements          |  |  |  |                                         | 3,456,832  |                                        | 
|Others                                       |  |  |  |                                         | 6,358      |                                        | 
|                                             |  |  |  |                                         | 3,463,190  |                                        | 
|Gross
profit                                 |  |  |  |                                         | 7,097,557  |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Operating
expenses:                          |  |  |  |                                         |            |                                        | 
|General and
administrative                   |  |  |  |                                         | 627,137    |                                        | 
|Research and
development                     |  |  |  |                                         | 651,886    |                                        | 
|Sales and
marketing                          |  |  |  |                                         | 442,475    |                                        | 
|Depreciation
and write-off of fixed assets * |  |  |  |                                         | 1,095,313  |                                        | 
|Total
operating expenses                     |  |  |  |                                         | 2,816,811  |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Income from
operations                       |  |  |  |                                         | 4,280,746  |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Other income
(expenses):                     |  |  |  |                                         |            |                                        | 
|Interest
income and other income             |  |  |  |                                         | (118       | )                                      | 
|Interest
expense                             |  |  |  |                                         | (11,412    | )                                      | 
|Foreign
currency transaction gain (loss)     |  |  |  |                                         | 1,623,919  |                                        | 
|                                             |  |  |  |                                         | 1,612,389  |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Income before
income taxes                   |  |  |  |                                         | 5,893,135  |                                        | 
|Income tax
(expense) benefit                 |  |  |  |                                         | (837,484   | )                                      | 
|                                             |  |  |  |                                         |            |                                        | 
|Net
income                                   |  |  |  |                                         | 5,055,651  |                                        | 
|Foreign
currency translation adjustment      |  |  |  |                                         | 2,016      |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Comprehensive
income                         |  |  |  | $                                       | 5,057,667  |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Net income
per share:                        |  |  |  |                                         |            |                                        | 
|Basic                                        |  |  |  | $                                       | 0.08       |                                        | 
|Diluted                                      |  |  |  | $                                       | 0.08       |                                        | 
|                                             |  |  |  |                                         |            |                                        | 
|Weighted
average shares outstanding:         |  |  |  |                                         |            |                                        | 
|Basic                                        |  |  |  |                                         | 61,575,272 |                                        | 
|Diluted                                      |  |  |  |                                         | 61,927,535 |                                        | 



See accompanying notes to unaudited condensed consolidated
financial statements.


|* |  | Depreciation and write-off of fixed assets charges included in operating
expenses is shown as a separate line item for reading convenience.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------



4


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ARTIFICIAL LIFE, INC. AND SUBSIDIARIES CONDENSED
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS EQUITY (UNAUDITED)







|                                                                                   |  |  |  | Common Stock |           
|---------------------------------------------------------------------------------- |  |  |  | ------------ | ----------
|                                                                                   |  |  |  | Shares       |           
|                                                                                   |  |  |  |              |           
|Balances at
January 1,2010                                                         |  |  |  |              | 57,411,203
|Issuance of
commonstock and warrants                                               |  |  |  |              | 4,219,286 
|Issuance of
commonstock and warrants inconnection withprivate placementscommission |  |  |  |              | 40,000    
|Stock-based
compensation expense                                                   |  |  |  |              |          
|Net
income                                                                         |  |  |  |              |          
|Other
comprehensive loss  foreign currencytranslation adjustment                  |  |  |  |              |          
|Balances at
September 30, 2010                                                     |  |  |  |              | 61,670,489



5


---



ARTIFICIAL LIFE, INC. AND SUBSIDIARIES CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)







|                                                                                            |  |  |  | Nine-Month Periods Ended September 30, |            
|------------------------------------------------------------------------------------------- |  |  |  | -------------------------------------- | -----------
|                                                                                            |  |  |  | 2010                                   |            
|                                                                                            |  |  |  | USD                                    |            
|Cash flows
from operating activities:                                                       |  |  |  |                                        |            
|Net
income                                                                                  |  |  |  | $                                      | 12,293,661 
|Adjustments
to reconcile net income to net cash provided by (used in) operating activities: |  |  |  |                                        |            
|Depreciation
and amortization                                                               |  |  |  |                                        | 6,014,379  
|Write-off of
fixed assets and license rights                                                |  |  |  |                                        | 2,226,621  
|Loss on
disposal of fixed assets                                                            |  |  |  |                                        | 697        
|Deferred
income tax (benefit) expense                                                       |  |  |  |                                        | (298,045   
|Bad and
doubtful debt expense                                                               |  |  |  |                                        | 7,588      
|Realized gain
on settlement of short-term investment                                        |  |  |  |                                        | (12,847    
|Foreign
currency exchange (gain) loss                                                       |  |  |  |                                        | (101,731   
|Interest
expense accrued on advances from officer / stockholder                             |  |  |  |                                        | 32,411     
|Stock-based
compensation expense                                                            |  |  |  |                                        | 79,257     
|Amortization
of prepaid consulting expense through stock issuance                           |  |  |  |                                        | 14,882     
|Salary /
bonus accrued to officer / stockholder                                             |  |  |  |                                        | 110,515    
|Changes in
operating assets and liabilities:                                                |  |  |  |                                        |            
|Increase in
trade accounts and installment receivables                                      |  |  |  |                                        | (17,430,863
|Decrease
(increase) in prepaid expenses, deposits and other assets                          |  |  |  |                                        | 497,026    
|Increase in
accounts payable                                                                |  |  |  |                                        | 43,754     
|(Decrease)
increase in accrued expenses and other                                           |  |  |  |                                        | (221,273   
|Increase in
income taxes payable                                                            |  |  |  |                                        | 2,240,168  
|Increase in
pledged deposit                                                                 |  |  |  |                                        | (25,641    
|Net cash
provided by (used in) operating activities                                         |  |  |  |                                        | 5,470,559  
|                                                                                            |  |  |  |                                        |            
|Cash flows
from investing activities:                                                       |  |  |  |                                        |            
|Purchase of
fixed assets                                                                    |  |  |  |                                        | (51,279    
|Purchase of
license rights                                                                  |  |  |  |                                        | (10,324,736
|Purchase of
short-term investment                                                           |  |  |  |                                        | (603,750   
|Proceeds from
sale of short-term investment                                                 |  |  |  |                                        | 616,597    
|Net cash used
in investing activities                                                       |  |  |  |                                        | (10,363,168
|                                                                                            |  |  |  |                                        |            
|Cash flows
from financing activities:                                                       |  |  |  |                                        |            
|Net proceeds
from issuance of common stock and warrants                                     |  |  |  |                                        | 3,784,579  
|Advances
under note payable to officer/stockholder                                          |  |  |  |                                        | 356,051    
|Repayment of
note payable to officer/stockholder                                            |  |  |  |                                        | (217,739   
|Repayment of
note payable to stockholder                                                    |  |  |  |                                        | (666,667   
|Net cash
provided by financing activities                                                   |  |  |  |                                        | 3,256,224  
|                                                                                            |  |  |  |                                        |            
|Net
decrease in cash                                                                        |  |  |  |                                        | (1,636,385 
|Cash at
beginning of period                                                                 |  |  |  |                                        | 2,356,336  
|Effect of
exchange rate changes on cash                                                     |  |  |  |                                        | (120,416   
|Cash at end
of period                                                                       |  |  |  | $                                      | 599,535    
|                                                                                            |  |  |  |                                        |            
|Supplemental
cash flow disclosure:                                                          |  |  |  |                                        |            
|Cash paid for
interest                                                                      |  |  |  | $                                      | 90,371     
|Cash paid for
income taxes                                                                  |  |  |  | $                                      | 23,557     
|                                                                                           
|Supplemental
disclosure of non-cash investing and financing activities:                     |  |  |  |                                        |            
|Purchase of
software hosting service in satisfaction for trade accounts receivable          |  |  |  | $                                      | 690,000    
|Purchase of
license rights through offsetting arrangement                                   |  |  |  | $                                      | 3,360,000  
|Issuance of
common stock and warrants in satisfaction of accounts payable                   |  |  |  | $                                      |           
|Issuance of
common stock and warrants in satisfaction of commissions                        |  |  |  | $                                      | 50,000     
|Issuance of
common stock and warrants for repayment of note payable to officer              |  |  |  | $                                      | 760,000    
|Issuance of
common stock for prepaid consulting services                                    |  |  |  | $                                      | 77,600     



See accompanying notes to unaudited condensed consolidated
financial statements.




6


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ARTIFICIAL LIFE, INC. NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED)




1. BASIS OF PRESENTATION




The accompanying unaudited
condensed consolidated financial statements of Artificial Life, Inc. (the Company) and its subsidiaries (the Group) have been
prepared in accordance with generally accepted accounting principles in the United States of America for interim financial information and in
accordance with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all information and footnotes required by generally
accepted accounting principles for a complete financial statement presentation. The unaudited condensed consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries, as follows:


| |  | Artificial Life Asia Limited, located in Hong Kong;
develops products and supports Artificial Life in its customer service and game development.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Artificial Life Europe GmbH, located in Berlin, Germany;
formed in January 2007 to concentrate on customer service and support activities of sales and marketing expansion in European, Middle Eastern and
African (EMEA) markets.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Artificial Life Japan Ltd., located in Tokyo, Japan;
acquired by the Company in July 2007 for support activities of sales and marketing expansion in Japanese markets.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Artificial Life America, Inc., Artificial Life
Ventures, Inc., Artificial Life USA, Inc., and Artificial Life Mobile Computing, Inc.; all non-operating, inactive subsidiaries in 2010, 2009 and
2008.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Green Cortex, Inc., located in Hong Kong; formed in May
2010 to develop mobile business applications and sustainability products and to venture into the green IT business.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | All significant intercompany accounts and transactions have been
eliminated in consolidation.
| |  | ---------------------------------------------------------------------------------------------



The preparation of financial
statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates
and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those
estimates.




Operating results for the
three-month and nine-month periods ended September 30, 2010 are not necessarily indicative of results that may be expected for the year ending December
31, 2010. Amounts at December 31, 2009 are derived from the Companys audited consolidated financial statements. For further information, refer to
the audited consolidated financial statements and notes thereto included in the Companys Annual Report on Form 10-K for the year ended December
31, 2009.




The
accompanying unaudited condensed consolidated financial statements include all adjustments, comprised of normal recurring adjustments and accruals,
considered necessary by management to fairly state the Companys results of operations, financial position and cash flows. These unaudited
condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2009, which has been filed with the Securities and Exchange
Commission.




Reclassifications




Certain reclassifications of
prior period amounts have been made to conform to the current period presentation. Beginning from the second quarter of 2010, the Company reports bad
debt expense as a component of general and administrative expenses in the unaudited condensed consolidated statements of income and comprehensive
income. Prior to the second quarter of 2010, the bad debt expense was partially included as a component of sales and marketing
expenses.




7


---



Recently issued and adopted accounting
standards




In April 2010, the Financial
Accounting Standards Board (FASB) issued Accounting Standards Updates (ASU) 2010-17, which amends ASC 605, Revenue
Recognition. ASU 2010-17 provides guidance on applying the milestone method to milestone payments for achieving specified performance measure
when those payments are related to uncertain future events limited to transactions involving research and development. Entities can make an accounting
policy election to recognize arrangement consideration received for achieving specified performance measure during the period in which the milestones
are achieved, provided certain criteria are met. The Company does not expect the adoption of ASU 2010-17 to have a material impact on its consolidated
financial statements.




In October 2009, the FASB issued
ASU 2009-14, which amends ASC 985-605, Software-Revenue Recognition, to exclude from its requirements (a) non-software components of
tangible products and (b) software components of tangible products that are sold, licensed, or leased with tangible products when the software
components and non-software components of the tangible product function together to deliver the tangible products essential functionality. The
Company does not expect the adoption of this statement to have a material impact on its consolidated financial statements.




2. PLEDGED DEPOSIT




At September 30, 2010, the
Company maintained an interest-bearing pledged deposit of $25,641 (2009: nil), which is required under an agreement with a bank to assure future corporate card
credit availability. The deposit is restricted for use and the agreement is renewed automatically on a month-to-month basis.




3. EMPLOYEE STOCK BASED
COMPENSATION




At January 1, 2010, all
outstanding options and warrants issued to employees were fully vested and exercisable. During the three-month and nine-month periods ended September
30, 2010, the Company granted options to one director to purchase 200,000 shares of common stock at an exercise price of $0.95 per share, and to one
employee to purchase 300,000 shares of common stock at an exercise price of $0.90 per share. These options have a three-year term and vest annually in
equal installments over the term. During the three-month and nine-month periods ended September 30, 2010, the Company granted warrants to one employee
to purchase 300,000 shares of common stock at an exercise price of $1 per share. These warrants have a three-year term and vest
immediately.




At September 30, 2010, the
Company had outstanding options to purchase 4,265,000 (2009: 4,165,000) shares of common stock under its stock option plan, issued to directors and
employees as follows:







|Weighted average
exercise price             |  |  |  | $0.91     
|------------------------------------------- |  |  |  | ----------
|Aggregate
intrinsic value                   |  |  |  | $233,900  
|Weighted average
remaining contractual term |  |  |  | 2.35
years



At September 30, 2010, the
Company had outstanding warrants to purchase 1,700,000 (2009: 1,400,000) shares of common stock issued to employees as follows:







|Weighted average
exercise price             |  |  |  | $0.91     
|------------------------------------------- |  |  |  | ----------
|Aggregate
intrinsic value                   |  |  |  | $105,000  
|Weighted average
remaining contractual term |  |  |  | 2.28
years



Total stock-based compensation
expense recognized during the three-month and nine-month periods ended September 30, 2010 was approximately $79,000. No options or warrants were
granted during the nine-month period ended September 30, 2009.




4. CUSTOMER CONCENTRATION




Financial instruments that
potentially subject the Company to concentrations of credit risk consist primarily of trade accounts and installment receivables. The Company extends
credit to its customers in the normal course of business and generally does not require collateral. Due to the global financial crisis and general
market conditions, in 2009 and 2010, the Company granted or extended payment terms (up to 180 days) to certain customers. The Company assesses the
probability of collection from each customer at the outset of the arrangement based on a number of factors, including the customers payment
history and its current creditworthiness. If in managements judgment collection is not reasonably assured, the Company does not record revenue
until the uncertainty is removed.




8


---



Management performs ongoing
credit evaluations, and the Company maintains an allowance for potential credit losses based upon its loss history and its aging analysis. Management
reviews the allowance for doubtful accounts each reporting period based on a detailed analysis of trade receivables and makes the best estimate of the
amount of credit losses in existing trade receivables. In the analysis, management primarily considers the age of the customers receivable and
also considers the creditworthiness of the customer, the economic conditions of the customers industry, general economic conditions and trends,
and the Companys business relationship and history with its customers, among other factors. If any of these factors change, the Company may also
change its original estimates, which could impact the level of the Companys future allowance for doubtful accounts. If judgments regarding the
collectability of receivables were incorrect, adjustments to the allowance may be required, which would reduce profitability. The Companys trade
receivable are often concentrated in a relatively few number of customers, and a significant change in the liquidity or financial position of any one
of these customers could have a material adverse effect on the Companys financial statements. At September 30, 2010 and December 31, 2009, there
was no allowance for doubtful accounts.




Due to the extended payment terms
granted to certain customers, payments from customers may be collected over an extended period of time. The related receivables have been discounted
using a 3.25% discount rate to reflect the present value of the future collection of payments, which is to be amortized using the effective interest
method over the period in which payments are made and the balance is outstanding. The unamortized discount on these receivables was approximately
$183,000 at September 30, 2010 and $208,000 at December 31, 2009.




In addition to the extended
payment terms granted to certain customers mentioned above, the Company has one customer with whom it has a long-standing business relationship and to
whom it has been selling software since 2007. At December 31, 2009, the Company entered into an installment receivable agreement with this customer,
which is due in various installments through December 31, 2010. This receivable has been discounted using a 3.25% discount rate to reflect the interest
component of the transaction, which is to be amortized using the effective interest method over the period in which payments are made and the balance
is outstanding. The discount rate is reset periodically, if necessary, considering prevailing interest rates. The unamortized discount on this
receivable is approximately $17,000 at September 30, 2010 and $140,000 at December 31, 2009.




At September 30, 2010, the
Company had 83 telecom carriers, resellers, distributors and general corporate customers, compared to 90 at September 30, 2009. For the three-month
period ended September 30, 2010, the Company had three customers that represented approximately 49%, 37% and 12% of the Companys revenues,
respectively. For the three-month period ended September 30, 2009, the Company had three customers that represented approximately 48%, 30% and 19% of
the Companys revenues, respectively. For the nine-month period ended September 30, 2010, the Company had five customers that represented
approximately 24%, 19%, 19%, 14%, 10% of the Companys revenues, respectively. For the nine-month period ended September 30, 2009, the Company had
four customers that represented approximately 56%, 12%, 11% and 11% of the Companys revenues, respectively.




5. UNCOLLECTED DEFERRED REVENUE




Because of the Companys
revenue recognition policies, there are circumstances where the Company is unable to recognize revenue relating to certain sales transactions that
have been billed, but the related receivable has not been collected. While the receivable represents a legally enforceable obligation of the customer,
for balance sheet presentation purposes, deferred revenue has been offset with the related receivable, and no amounts appear in the consolidated
balance sheets for such transactions. The aggregate amount of unrecognized accounts receivable and deferred revenue was approximately $4,843,000 and
$4,843,000 at September 30, 2010 and December 31, 2009, respectively.




6. FIXED ASSETS




Fixed assets are stated at cost
less depreciation and if applicable, impairment. During the three-month and nine-month periods ended September 30, 2010, the Company recorded a
write-off of approximately $957,000 (2009: $1,274,000). The charges reflect the abandonment of a software application, and
 are included in depreciation and write-off of fixed assets as part of operating expenses in the Companys statement of income and comprehensive income.




9


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7. LICENSE RIGHTS




License rights consist of the
following at September 30, 2010 and December 31, 2009:







|                               |  |  |  | September 30, 2010 |             | December 31, 2009
|------------------------------ |  |  |  | ------------------ | ----------- | -----------------
|                               |  |  |  | USD                |             | USD              
|License
rights                 |  |  |  | $                  | 44,292,372  |                  
|Less:
accumulated amortization |  |  |  |                    | (11,321,987 | )                
|                               |  |  |  | $                  | 32,970,385  |                  



Amortization expenses for the
nine-month periods ended September 30, 2010 and 2009 were approximately $5,449,000 and $2,973,000, respectively. Amortization expense for the
three-month periods ended September 30, 2010 and 2009 were approximately $2,187,000 and $1,156,000, respectively.




During the three-month and
nine-month periods ended September 30, 2010, the Company wrote off the carrying value of certain license rights of approximately $1,269,000 (2009:
$521,000). The charges were based on managements analysis of the reduction in licenses expected future cash flows due to the expected reduced life
cycle of certain games channel and the charges are included in cost of revenues in the Companys statement of income and comprehensive income.




8. NET INCOME PER SHARE




Basic net income per share is
calculated based on the weighted average number of common shares outstanding for the three-month and nine-month periods ended September 30, 2010 and
2009. Diluted net income per share is computed using the weighted average number of common shares outstanding during the period and the weighted
average dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of the incremental common shares issuable
upon the exercise of stock options and warrants; common equivalent shares are excluded from the calculation if their effect is
anti-dilutive.




The following table sets forth
the computation of fully diluted shares for the three-month and nine-month periods ended September 30, 2010 and 2009.







|                                                         |  |  |  | Three-month period ended September 30, |            | Nine-month period ended September 30, | 
|-------------------------------------------------------- |  |  |  | -------------------------------------- | ---------- | ------------------------------------- | 
|                                                         |  |  |  | 2010                                   |            | 2009                                  | 
|Weighted
average shares outstanding - basic              |  |  |  |                                        | 61,575,272 |                                       | 
|Dilutive
securities:                                     |  |  |  |                                        |            |                                       | 
|Stock
options                                            |  |  |  |                                        | 187,925    |                                       | 
|Warrants                                                 |  |  |  |                                        | 164,338    |                                       | 
|Shares used
in dilutive net income per share calculation |  |  |  |                                        | 61,927,535 |                                       | 



9. INCOME TAXES




For the three-month period ended
September 30, 2010, the Company recorded an income tax expense of $837,484 (2009: tax benefit of $31,000), which was determined based on the estimated
annual effective income tax rate for the year ending December 31, 2010.




For the nine-month period ended
September 30, 2010, the income tax expense includes a current income tax expense of $2,262,774 (2009: $627,000) and a deferred tax credit of $298,045
(2009: nil). The Companys effective income tax rates are 14.2% and 13.8% for the three-month and nine-month periods ended September 30, 2010,
respectively.




10


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10. CONTINGENCIES




From time to time, legal
proceedings or disputes arise in the normal course of business. The Company monitors and reviews these matters and maintains accruals where
appropriate.




In September 2008, an action was
brought against Artificial Life Europe GmbH in Germany in a contractual dispute in which a claim of approximately $375,000 was made against the
Company. A court hearing was held in September 2009 before the State Court in Berlin. In February 2010, the Court ordered the Company to pay the
plaintiff a settlement of approximately $350,000 and all court and attorney fees incurred by the plaintiff. The settlement amount and the estimated
court and attorney fees have been accrued as of September 30, 2010 and December 31, 2009. The Company filed an appeal with the State Court in Berlin in
March 2010, and no payment will be made until a final judgment is issued by the Court. Management believes the Company has adequately reserved for
litigation and that the ultimate outcome of the pending appeal will not have a material adverse impact on the Companys consolidated financial
position or results of operations taken as a whole.




11. NOTES PAYABLE




Related Party Note Payable:




The Company has a revolving note
payable to its chief executive officer for advances made by him to the Company, as well as for accrued salary and bonus. The note bears interest at 5%,
secured by the assets of the Company and repayable on demand.




Activity on the note payable
during the nine-month periods ended September 30, 2010 and 2009 is as follows:


|                             |  |  |  | 2010 |           | 2009
|---------------------------- |  |  |  | ---- | --------- | ----
|
|Beginning
balance, January 1 |  |  |  | $    | 1,606,328 |     
|Advances                     |  |  |  |      | 356,051   |     
|Repayments,
cash             |  |  |  |      | (217,739  | )   
|Repayments,
non cash         |  |  |  |      | (760,000  | )   
|Accrued
salary/bonus         |  |  |  |      | 110,515   |     
|Accrued
interest             |  |  |  |      | 32,411    |     
|Ending
balance, September 30 |  |  |  | $    | 1,127,566 |     



On July 8, 2010, the Company
repaid $760,000 of the outstanding loan balance of $1,694,329 owed to its chief executive officer through the issuance of 1,000,000 shares of common
stock at a purchase price of $0.76 per share (the closing price at July 7, 2010). On the same date, the Company issued warrants to purchase an
additional 300,000 shares of common stock to its chief executive officer (details on note 12), and a substitute loan agreement was entered into
between the Company and its chief executive officer on the remaining balance of $934,329, which bears interest at 5%, secured by the assets of the
Company and is repayable on demand.




12. STOCKHOLDERS EQUITY




During the nine-month period
ended September 30, 2010, the Company closed private placement offerings with three institutional investors and two accredited investors for 3,139,286
shares of common stock and warrants to purchase an additional 1,063,668 shares of common stock. The warrants have a two-year term with exercise prices
ranging from $0.80 to $2 and are immediately exercisable. The shares of common stock and warrants were sold for an aggregate purchase price of
$3,784,579, net of placement commissions of $125,000, of which $50,000 was paid through issuance of 40,000 shares of commons stock and warrants to
purchase 20,000 shares of common stock. The warrants have a two-year term with an exercise price of $2 and are immediately
exercisable.




The Company also repaid $760,000
of the outstanding loan balance owed to its chief executive officer through the issuance of 1,000,000 shares of common stock valued at $760,000 based on the closing price of the
Company's common stock on the date of the agreement. On the same date, the Company issued warrants to purchase
an additional 300,000 shares of common stock to the chief executive officer. The warrants have a three-year term with an exercise price of $1 and are immediately exercisable. The fair
value of the warrants is $67,500 and is recorded as a stock-based compensation in operating expenses in the Companys statement of income and comprehensive income.




The Company also granted options
to an employee and a director to purchase 300,000 shares and 200,000 shares of common stock under the Companys Amended and Restated 1998 Equity
Incentive Plan at an exercise price




11


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of $0.90 and $0.95 per share,
respectively. These options have a three-year term and vest annually in equal installments over the term.




The Company also issued 80,000
shares of common stock to a consultant at $0.97 per share (the closing price at the date of transaction) for prepaid consulting services. These
services are to be provided through the respective term which will expire in July 2011. The Company recognizes the fair value of these shares, which is
remeasured at the end of each reporting period, as expense on a straight-line basis, as services are provided, over the respective term of the
agreement. The Company recognized approximately $15,000 of expense as of September 30, 2010.




The above described private
placement transactions were exempt from the registration requirements of the Securities Act of 1933, as amended (the Securities Act) in
accordance with Section 4(2) and Regulation S of the Securities Act.




13. FAIR VALUE MEASUREMENTS




Accounting standards define fair
value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants
at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value,
the Company considers the principal or the most advantageous market in which the Company would transact and considers assumptions that market participants
would use when pricing the asset or liability, such as inherent risk, transfer restrictions, and risk of nonperformance.




The fair value of trade accounts
receivables, trade installment receivables, accounts payable and accrued expenses approximate the respective carrying amounts because of the short-term
maturity of these instruments. The non-financial instruments, which include fixed assets and license rights, are not required to be carried at fair
value on a recurring basis.




14. FINANCIAL INSTRUMENTS




Concerns that certain highly
leveraged European governments could default on their debt obligations have resulted in significant price declines and price volatility in sovereign
debt securities, currency exchange rates and securities issued by the financial institutions that lend to these governments in Europe. The Company
transacts business globally and is exposed to currency exchange rate risk for monetary assets and liabilities held or denominated in foreign
currencies, primarily the Euro. The Company may enter into derivative instruments to reduce the volatility of earnings associated with changes in
foreign currency. During the nine-month period ended September 30, 2009, no such derivative instrument was used. Derivative instruments may expose the
Company to credit risk to the extent the counterparty may be unable to meet the terms of the derivative instrument. The Company seeks to mitigate such
risk by limiting its counterparty to major financial institution.




15. SUBSEQUENT EVENTS




In November 2010, the Company
closed a private placement offering with one institutional investor for 1,886,793 shares of common stock for a purchase price of $1.06 per share and
five-year term warrants to purchase an additional 943,397 shares of common stock. The warrants have an exercise price of $1.35 and are immediately exercisable. The
shares of common stock and warrants were issued for an aggregate purchase price of $2,000,000.




Also in November 2010, the Company
closed a private placement offering with one individual accredited investor for 250,000 shares of common stock for a purchase price of $1.09 per share
and five-year term warrants to purchase an additional 87,500 shares of common stock. The warrants have an exercise price of $1.47 and are immediately exercisable.
The shares of common stock and warrants were issued for an aggregate purchase price of $272,500.




The above described private
placement transactions were exempt from the registration requirements of the Securities Act in accordance with Section 4(2) and Regulation S of the
Securities Act.




12


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




GENERAL




The following Managements
Discussion and Analysis is intended to help the reader understand our results of operations and financial condition and is provided as a supplement to,
and should be read in conjunction with, our financial statements and the accompanying notes included in this Quarterly Report on Form 10-Q. This
discussion contains, in addition to historical statements, forward-looking statements that involve risks and uncertainties. Our actual future results
could differ significantly from the results discussed in the forward-looking statements. Factors that could cause or contribute to such differences
include, but are not limited to, the factors discussed in the section titled Risk Factors in our Annual Report on Form 10-K for the year
ended December 31, 2009. Any forward-looking statement speaks only as of the date on which such statement is made and we do not intend to update any
such forward-looking statements.




OVERVIEW




During 2010, the Company further
strengthened its position as a global provider of full-serivce mobile software by offering a wide variety of mobile products such as mobile games
and entertainment, mobile TV, mobile distribution and aggregation, mobile business applications, and its cutting-edge mobile commerce platform
OPUS-M.




We are a registered developer for
Apples iPhone, iPod Touch and iPad platforms and develop games and applications for these platforms and we are a leading publisher of iPhone and iPod
games. Our iPhone games have been downloaded an aggregate of more than 19 million times since the launch of our first iPhone game at the end of 2008.
As of September 30, 2010, we have produced and released 35 games for the iPhone, iPod touch and iPad. The topmost title was downloaded over 4.7 million
times, the second most close to 2.8 million times and the third most over 2.1 million times. The average number of downloads per game was about 530,000.
 During the third quarter of 2010, our iPhone games were downloaded approximately 3.6 million times.




During the nine-month period
ended September 30, 2010, we continued to market and expand the distribution of our products in Europe, Asia and the United States by entering into
various strategic relationships. Our products are now sold in over 100 countries through resellers and telecom partners and in over 80 countries
through Apples App Store/iTunes distribution platform.




In the third quarter of 2010, we
continued to intensify marketing of our new m-commerce platform, OPUS-MTM,
and were very successful with our efforts as the majority of our new revenues were related to or derived from this product since its commercial launch
in the first quarter of 2010. OPUS-MTM, with its broad appeal, flexible module selection
concept, competitive pricing, hosting support and comprehensive feature set is our current key product and the basis for our future
expansion.




Significant events during the
third quarter of 2010 include the following:


| |  | In July 2010, we relocated our global headquarters from Los
Angeles back to Hong Kong to minimize overhead and reduce production cost.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------

| |  | In July 2010, we appointed our former global controller, Frank
Namyslik, as the new chief financial officer. Mr. Namyslik took over the position from our current CEO.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | In August 2010, we announced the launch of the OPUS-M Affiliate
Program (OAP) enabling technology solution providers to sell and offer services for OPUS-MTM, our modular, carrier grade, m-commerce platform. Affiliates will be able to sell, customize and support OPUS-MTM enabled solutions, creating new revenue opportunities.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | In September 2010, we appointed our former independent
consultant in Japan, Kazutoshi Miyake, as the new member of the Board of Directors and Audit Committee.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | In September 2010, we announced the launch of GluCoMoTM (short for: Glucose Monitor) on Apples App Store. GluCoMoTM is the first in a series of planned mobile healthcare products.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



13


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Recently, we became one of the first
mobile game publishers selected by Microsoft to develop games and applications for the Windows Phone 7 platform.




As of September 30, 2010, we had
total assets of $68,986,002 and total liabilities of $5,633,240. As of September 30, 2010, current assets were $33,138,880 as compared to $21,801,668
at December 31, 2009, and current liabilities were $5,633,240 as compared to $5,325,371 at December 31, 2009.




As of September 30, 2010, we had
50 full-time employed staff. We also hired and assigned temporary staff, external consultants and interns to support our operations.




RESULTS OF OPERATIONS




THREE-MONTH PERIOD ENDED
SEPTEMBER 30, 2010 COMPARED TO THREE-MONTH PERIOD ENDED SEPTEMBER 30, 2009




REVENUES: Revenues for the
quarter ended September 30, 2010 were $10,560,747 as compared to $8,723,481 for the quarter ended September 30, 2009. The increase of revenues of
$1,837,266 or 21% was mainly due to revenue recognized from global license deals for our m-commerce platform, OPUS-M, as well as license income from the
sales of our Mobile Diab® product.




COST OF REVENUES: Cost of
revenues mainly consist of amortization of intangible assets. Cost of revenues for the quarter ended September 30, 2010 was $3,463,190 as compared to
$1,732,798 for the quarter ended September 30, 2009. The increase of $1,730,392 or 100% was primarily due to the increased amortization of additional
license rights acquired and write-off of certain license rights.




GROSS MARGIN: Gross margin for
the quarter ended September 30, 2010 was $7,097,557 as compared to $6,990,683 for the quarter ended September 30, 2009. The increase of $106,874 or 2%
was mainly due to revenue recognized from global license deals for our m-commerce platform, OPUS-M, and Mobile-Diab®, offset
by amortization of license rights acquired.




GENERAL AND ADMINISTRATIVE:
General and administrative expenses consisted of salary for administrative personnel, rent, professional fees, and costs associated with employee
benefits, supplies, communications, travel, and allowance for doubtful accounts. General and administrative expenses for the quarter ended September
30, 2010 were $627,137 as compared to $464,360 for the quarter ended September 30, 2009. The increase of $162,777 or 35% was mainly due to increase in
professional fees.




SALES AND MARKETING: Sales and
marketing expenses consisted of salary expenses of sales and marketing personnel, costs relating to marketing materials, advertising, trade show
related expenses, traveling and public relations activities. Sales and marketing expenses for the quarter ended September 30, 2010 were $442,475 as
compared to $527,476 for the quarter ended September 30, 2009. The decrease of $85,001 or 16% was mostly due to decrease in consulting
expenses.




RESEARCH & DEVELOPMENT:
Research and development expenses consisted of salary, training, consulting, subcontracting and other expenses incurred to develop and fulfill the
design specifications and productions of the products and services from which we derive our revenues. Research and development expenses for the quarter
ended September 30, 2010 were $651,886 as compared to $927,212 for the quarter ended September 30, 2009. The decrease of $275,326 or 30% was primarily
due to decrease in consulting and data hosting expenses.




DEPRECIATION AND WRITE-OFF OF FIXED ASSETS:
Depreciation and write-off of fixed assets




 for the quarter ended
September 30, 2010 was $1,095,313 as compared to $1,320,867 for the quarter ended September 30, 2009. The decrease of $225,554 or 17% was primarily due
to decrease in write-off of certain fixed assets.




OTHER INCOME (EXPENSES): Other
income for the quarter ended September 30, 2010 was $1,612,389 as compared to $124,656 for the quarter ended September 30, 2009. Net other income of
$1,612,389 was primarily due to foreign currency transaction gain of approximately $1,624,000 in this quarter compared to loss of approximately $56,000
in the third quarter of 2009. The increase in foreign currency transaction gain was mostly due to the significant effect of the strengthening of the
Euro relative to the United States Dollar on the trade receivables denominated in Euro.




14


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INCOME FROM OPERATIONS AND NET
INCOME: Income from operations for the quarter ended September 30, 2010 was $4,280,746, an increase of 14%, as compared to income from operations of
$3,750,768 for the quarter ended September 30, 2009. The income from operations is primarily due to revenue of $10,560,747 generated from global
license deals for our m-commerce platform, OPUS-M and Mobile-Diab®, offset by the cost of revenue of $3,463,190 and the
operational cost of $2,816,811. Net income for the quarter ended September 30, 2010 was $5,055,651, an increase of 29%, as compared to net income of
$3,906,424 for the quarter ended September 30, 2009. The basic and diluted net income per share for the third quarter of 2010 was $0.08, as compared to
$0.08 for the quarter ended September 30, 2009.




For the three-month period ended
September 30, 2010, we recorded an income tax expense of $837,484 (2009: tax benefit of $31,000). Such income tax expense is calculated based on the
estimated annual effective income tax rate for the year ending December 31, 2010.




NINE-MONTH PERIOD ENDED
SEPTEMBER 30, 2010 COMPARED TO NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2009




REVENUES: Revenues for the
nine-month period ended September 30, 2010 were $27,788,385 as compared to $23,364,650 for the nine-month period ended September 30, 2009. The increase
of revenues of $4,423,735 or 19% was mainly due to revenue recognized from global license deals for our m-commerce platform, OPUS-M, as well as license
income from the sales of our Mobile Diab® product.




COST OF REVENUES: Cost of
revenues mainly consist of amortization of intangible assets. Cost of revenues for the nine-month period ended September 30, 2010 was $6,876,510 as
compared to $3,571,817 for the nine-month period ended September 30, 2009. The increase of $3,304,693 or 93% was primarily due to the increased
amortization of additional license rights acquired and write-off of certain license rights.




GROSS MARGIN: Gross margin for
the nine-month period ended September 30, 2010 was $20,911,875 as compared to $19,792,833 for the nine-month period ended September 30, 2009. The
increase of $1,119,042 or 6% was mainly due to revenue recognized from global license deals for our m-commerce platform, OPUS-M,
and Mobile-Diab®, offset by the decreased product license revenue generated from mobile games and amortization of license rights
acquired.




GENERAL AND ADMINISTRATIVE:
General and administrative expenses consisted of salary for administrative personnel, rent, professional fees, and costs associated with employee
benefits, supplies, communications, travel, and allowance for doubtful accounts. General and administrative expenses for the nine-month period ended
September 30, 2010 were $1,952,404 as compared to $4,104,356 for the nine-month period ended September 30, 2009. The decrease of $2,151,952 or 52% was
mainly due to significant decrease in bad debt expense of approximately $2,623,000, offset by the increase in professional fees. The significant
decrease in bad debt expense was due to a one-time write-off of trade receivables in 2009 which were determined to be irrecoverable after
managements detailed analysis.




SALES AND MARKETING: Sales and
marketing expenses consisted of salary expenses of sales and marketing personnel, costs relating to marketing materials, advertising, trade show
related expenses, traveling and public relations activities. Sales and marketing expenses for the nine-month period ended September 30, 2010 were
$1,337,812 as compared to $1,447,501 for the nine-month period ended September 30, 2009. The decrease of $109,689 or 8% was primarily due to decrease
in consulting expenses.




RESEARCH & DEVELOPMENT:
Research and development expenses consisted of salary, training, consulting, subcontracting and other expenses incurred to develop and fulfill the
design specifications and productions of the products and services from which we derive our revenues. Research and development expenses for the
nine-month period ended September 30, 2010 were $1,894,147 as compared to $2,547,455 for the nine-month period ended September 30, 2009. The decrease
of $653,308 or 26% was primarily due to decrease in staff and consulting expenses and data hosting and web service expenses.




DEPRECIATION AND WRITE-OFF OF FIXED ASSETS:
Depreciation and write-off of fixed assets for the nine-month period ended September 30, 2010 was $1,522,814 as compared to $1,431,981 for the nine-month period
ended September 30, 2009. The increase of $90,833 or
6% was primarily due to increase in depreciation, offset by decrease in write-off of certain fixed assets.




OTHER INCOME (EXPENSES): Other
income (expenses) for the nine-month period ended September 30, 2010 was $53,692 as compared to ($244,681) for the nine-month period ended September 30,
2009. Net other income of




15


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$53,692 was primarily due to foreign currency transaction gain of $101,561 for the
nine-month period ended September 30, 2010 compared to loss of $468,109 for the nine-month period ended September 30, 2009. The increase in foreign
currency transaction gain was mostly due to the effect of the strengthening of the Euro relative to the United States Dollar on the trade receivables
denominated in Euro.



INCOME FROM OPERATIONS AND NET
INCOME: Income from operations for the nine-month period ended September 30, 2010 was $14,204,698, an increase of 38%, as compared to income from
operations of $10,261,540 for the nine-month period ended September 30, 2009. The income from operations is primarily due to revenue of $27,788,385
generated from global license deals for our m-commerce platform, OPUS-M, Mobile-Diab® and games offset by the cost of
revenue of $6,876,510 and the operational cost of $6,707,177. Net income for the nine-month period ended September 30, 2010 was $12,293,661, an
increase of 31%, as compared to net income of $9,389,859 for the nine-month period ended September 30, 2009. The basic and diluted net income per share
for the nine-month period ended September 30, 2010 was $0.21 and $0.20, as compared to $0.19 and $0.19 for the nine-month period ended September 30,
2009, respectively.




The Groups operating
profits are mainly derived from Hong Kong for which the income tax rate is 16.5%. For the nine-month period ended September 30, 2010, the income tax
expense includes a current income tax expense of $2,262,774 (2009: $627,000) and deferred tax credit of $298,045 (2009: nil). The Companys
effective income tax rate for the nine-month period ended September 30, 2010 is 13.8%. The difference between the effective tax rate and the statutory
tax rate is primarily as a result of a change in judgment about the realizability of the deferred tax assets of certain subsidiaries of the Company in
future years. The change in judgment was mainly due to the successful development and launching of new products.




LIQUIDITY AND CAPITAL RESOURCES




Cash Flow Summary




Our cash flows from operating,
investing and financing activities, as reflected in the consolidated statements of cash flows for the nine-month periods ended September 30, 2010 and
2009, are summarized as follows:







|                                                                          |  |  |  | 2010 |             | 2009
|------------------------------------------------------------------------- |  |  |  | ---- | ----------- | ----
|                                                                          |  |  |  | USD  |             | USD 
|Cash (used
in) provided by:                                               |  |  |  |      |             |     
|Operating
activities                                                      |  |  |  | $    | 5,470,559   |     
|Investing
activities                                                      |  |  |  |      | (10,363,168 | )   
|Financing
activities                                                      |  |  |  |      | 3,256,224   |     
|Effect of
exchange rate changes on cash                                   |  |  |  |      | (120,416    | )   
|Net
decrease in cash, considering effect of exchange rate changes on cash |  |  |  | $    | (1,756,801  | )   



Net cash provided by operating
activities was $5,470,559 for the nine-month period ended September 30, 2010, which was an increase of $8,539,341 compared to the nine-month period
ended September 30, 2009. This increase in cash provided was due primarily to the increase in net income and collections from
customers.




Net cash used in investing
activities was $10,363,168 for the nine-month period ended September 30, 2010, which was an increase of $9,991,446 compared to the nine-month period
ended September 30, 2009. This increase was primarily due to increased cash expenditures for purchase of license rights.




Net cash provided by financing
activities was $3,256,224 for the nine-month period ended September 30, 2010, which was an increase of $1,187,709 compared to the nine-month period
ended September 30, 2009. This increase was primarily due to private placements that raised net cash proceeds of $3,784,579, as compared to $2,072,950
raised in the nine-month period ended September 30, 2009, net advances of $138,312 from our chief executive officer, offset by the repayment of note
payable of $666,667 during the nine-month period ended September 30, 2010.




As of September 30, 2010, we had
a working capital surplus of $27,505,640 and stockholders equity of $63,352,762.




We have borrowed funds from time
to time in the past from our chief executive officer, Eberhard Schoneburg. As of September 30, 2010, we owed our chief executive officer an aggregate
amount of $1,127,566, as compared to $1,606,328 at December 31, 2009. During the nine-month period ended September 30, 2010, our chief




16


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executive
officer advanced an additional $356,051 to the Company, while the Company issued 1,000,000 shares of common stock to settle $760,000 of the notes
payable to our chief executive officer. In connection with this stock issuance, the Company also issued warrants to the chief executive officer to
acquire 300,000 shares of common stock with a total fair value of $67,500, and which has been accounted for as compensation expense in our statement of
income and comprehensive income during the period. The advanced funds bear interest at a rate of 5% per year, secured by the assets of the Company and
repayable on demand.




The Company continued to generate
income in the third quarter of 2010, and we expect that cash flows generated from 2010 operations and additional financing through various sources will
be sufficient to fund the Companys operations, working capital, and commitment needs for the next 12 months.




Economic conditions in the United
States and in foreign markets in which we operate could substantially affect our sales and profitability and our cash position and collection of
accounts receivable. Economic activity in the United States and throughout much of the world has undergone a sudden, sharp economic downturn since
2008, following the housing downturn and subprime lending collapse in the United States in 2009 and the sovereign debt crisis in Europe in 2010. Global
credit and capital markets have experienced unprecedented volatility and disruption. Business credit and liquidity have tightened in much of the world.
Some of our suppliers and customers may face credit issues and could experience cash flow problems and other financial hardships. These factors have
had an impact on the timeliness of receivable collections from our customers. The Company cannot predict how this situation will
develop and whether trade receivables may need to be allowed for or written off in the coming quarters.




Changes in governmental currency,
banking, monetary, and fiscal policies to restore liquidity and increase credit availability may not be effective in alleviating the global economic
declines. It is difficult to determine the breadth and duration of the economic and financial market problems and the many ways in which they may
affect our suppliers, customers and our business in general. Continuation or further worsening of these difficult financial and macroeconomic
conditions could have a significant adverse effect on our sales, collectability of our trade receivables, profitability and results of
operations.




Because the Companys trade
receivables are often concentrated in a relatively few number of customers, a significant change in the liquidity or financial position of any one of
these customers could have a material adverse effect on the Companys financial statements. Since 2009, the Company has entered into offsetting
agreements with customers whereby consideration for the sale of license rights offset against amount payable by the Company related to the acquisition
of license rights from the same party. Management of the Company considered it appropriate and advantageous for the Company to minimize cash
expenditures and credit risk exposure and thereby entered into such offsetting arrangements. During the quarter ended September 30, 2010, no such
offsetting agreement has been entered into. At September 30, 2010, the average age of trade receivables from all customers was 116 days as compared to
128 days at December 31, 2009. The average age of receivables from the Companys eight largest customers (that represented approximately 25%, 21%,
13%, 11%, 9%, 7%, 6% and 4% of the Companys total trade receivables) was 176 days at September 30, 2010 as compared to 108 days at December 31,
2009. The average age of trade
receivables was calculated based on the aggregate number of days that individual invoices have been outstanding from the invoice date to the balance
sheet date divided by the number of outstanding invoices as of the balance sheet date. From January 1, 2010 to November 10, 2010, cash receipt of
approximately $10.8 million has been collected from our customers in settlement of the trade accounts and installment receivables, as compared to the
cash receipt of approximately $4.6 million collected during the full year of 2009.




Recently Issued and Adopted Accounting
Pronouncements




We describe recent accounting
pronouncements in Item 1-Condensed Consolidated Financial Statements - Notes to Condensed Consolidated Financial Statements Note 1.
Basis of Presentation.




OFF-BALANCE SHEET ARRANGEMENTS




At September 30, 2010, we did not
have any off-balance sheet arrangements.




ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK




Not applicable




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ITEM 4. CONTROLS AND
PROCEDURES




Evaluation of Disclosure Controls and
Procedures




(a)  Evaluation of
Disclosure Controls. Our chief executive officer and chief financial officer evaluated the effectiveness of our disclosure controls and procedures
as of the end of the period covered by this report. Disclosure controls and procedures are controls and other procedures that are designed to ensure
that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and
reported within the time periods specified in the SECs rules and forms. Disclosure controls and procedures include, without limitation, controls
and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and
communicated to our management, as appropriate to allow timely decisions regarding required disclosure. Based on their evaluation, our chief executive
officer and chief financial officer concluded that our disclosure controls and procedures were effective as of September 30, 2010.




It should be noted that any
system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are
met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these
and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all
potential future conditions.




(b)  Changes in
internal control over financial reporting. There have been no changes in our internal control over financial reporting that occurred during the
last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Our
management team will continue to evaluate our internal control over financial reporting throughout 2010.




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PART IIOTHER INFORMATION




ITEM 1  LEGAL PROCEEDINGS




From time to time, legal
proceedings or disputes arise in the normal course of business. The Company monitors and reviews these matters and maintains accruals where
appropriate.




ITEM 1A  RISK FACTORS




Not applicable.




ITEM 2  UNREGISTERED SALES OF EQUITY SECURITIES
AND USE OF PROCEEDS




See Part I, Note 12.
Stockholders Equity.




ITEM 3  DEFAULTS UPON SENIOR
SECURITIES




Not applicable.




ITEM 4  [REMOVED AND
RESERVED]




ITEM 5  OTHER INFORMATION




On July 16, 2010, we held our
annual stockholders meeting, at which our stockholders (i) elected four directors to hold office until the next annual meeting of stockholders,
and (ii) ratified the selection of KPMG, Certified Public Accountants, Hong Kong as the Companys independent registered public accounting firm
for the fiscal year ending December 31, 2011. Proxies representing 37,174,651 shares of the common stock eligible to vote at the meeting, or 61.35% of
the outstanding common shares, were voted. The vote on each matter was as follows:


|I. |  | Election of Directors
|-- |  | ---------------------






|Nominee             |  |  |  | Total Vote for Each Nominee |            | Total Vote Withheld from each Nominee |  | Broker Non-Votes |         | % Votes For*
|------------------- |  |  |  | --------------------------- | ---------- | ------------------------------------- |  | ---------------- | ------- | ------------
|Eberhard
Schoneburg |  |  |  |                             | 22,175,362 |                                       |  |                  | 217,032 |             
|Claudia
Alsdorf     |  |  |  |                             | 22,266,341 |                                       |  |                  | 126,053 |             
|Dr. Gert
Hensel     |  |  |  |                             | 22,266,291 |                                       |  |                  | 126,103 |             
|Rene
Jaeggi         |  |  |  |                             | 21,786,734 |                                       |  |                  | 605,660 |             

|* |  | Excludes broker non-votes.
|- |  | --------------------------

|II. |  | Ratification of Appointment of Independent Registered Public
Accounting Firm
|--- |  | ----------------------------------------------------------------------------






|For        |  |  |  | Against |         | Abstain |  | Broker Non-Votes |         | % Votes For
|---------- |  |  |  | ------- | ------- | ------- |  | ---------------- | ------- | -----------
|36,739,776 |  |  |  |         | 115,538 |         |  |                  | 319,337 |            



A current report for Form 8-K was
filed for such instance on July 20, 2010.




On September 2, 2010, we
appointed Mr. Kazutoshi Miyake as a new member of the Board of Directors and Audit Committee. Mr. Miyake replaces Claudia Alsdorf, who resigned as a
member of the Board of Directors and Audit Committee effective September 1, 2010.




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ITEM 6  EXHIBITS







|10.5  |  |  |  | Amendment to Employment Agreement, dated July 1, 2010 between the Registrant and Eberhard Schoneburg (Incorporated by reference to Exhibit
10.5 to the Registrants Current Report on Form 8-K/A filed on July 7, 2010)
|----- |  |  |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|     
|14.1  |  |  |  | Amended and Restated Code of Ethics (Incorporated by reference to Exhibit 14.1 to the Registrants Quarterly Report on Form 10-Q filed on
August 5, 2010)                                                              
|     
|31.1* |  |  |  | Certification of Principal Executive Officer pursuant to Exchange Act Rule 13a-1(a) or Rule 15d-14(a) (authorized by Section 302 of the
Sarbanes-Oxley Act of 2002)                                                    
|     
|31.2* |  |  |  | Certification of Principal Financial Officer pursuant to Exchange Act Rule 13a-1(a) or Rule 15d-14(a) (authorized by Section 302 of the
Sarbanes-Oxley Act of 2002)                                                    
|     
|32.1* |  |  |  | Certification of Principal 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 Principal Financial Officer Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002                                                                         

|* |  | Filed herewith.
|- |  | ---------------



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SIGNATURES




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







|                        |  |  |  | ARTIFICIAL LIFE, INC.                                                               
|----------------------- |  |  |  | ------------------------------------------------------------------------------------
|Date: November
11, 2010 |  |  |  |                                                                                     
|                        |  |  |  | By:  /s/ Eberhard SchoneburgName: Eberhard Schoneburg Title: Chief Executive
Officer
|                        |  |  |  |                                                                                     
|                        |  |  |  | By:  /s/ Frank NamyslikName: Frank Namyslik Title: Chief Financial
Officer          



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