UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

              [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                     THE SECURITIES EXCHANGE ACT OF 1934 For
                     the fiscal year ended DECEMBER 31, 2006
                                       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 0-29798

                              CompuDyne Corporation
             (Exact name of registrant as specified in its charter)

            Nevada                                               23-1408659
(State or other jurisdiction of                               (I.R.S. Employer
 incorporation or organization)                              Identification No.)

2530 Riva Road, Suite 201, Annapolis, Maryland, 21401          (410) 224-4415
      (Address of principal executive offices                 (Telephone number,
               including zip code)                          including area code)

        Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: Common Stock $.75
par value

     Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes NO Indicate by check mark if
the registrant is not required to file reports pursuant to Section 13 or Section
15(d) of the Act. Yes |_|  NO |X|

     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 |_|  NO |X|

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein,
and will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [ ]

   Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
     filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
                                  (Check one):
Large accelerated filer |_|   Accelerated filer |_|   Non-accelerated filer |X|

     Indicate by checkmark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act) Yes |_|  NO |X|

    The aggregate market value of common equity held by non-affiliates of the
 Registrant, based upon the price the common equity was last sold on the Nasdaq
 National Market on June 30, 2006 was approximately $42.0 million. (see ITEM 5)
   As of April 4, 2007, a total of 8,437,915 shares of Common Stock, $.75 par
                            value, were outstanding.

   Documents incorporated by reference: Portions of the Proxy Statement relating
to the 2007 Annual Meeting of Shareholders are incorporated in Part III.

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                                     PART I

ITEM 1. BUSINESS

CompuDyne  Corporation (the "Company") was  reincorporated in Nevada in 1996. We
were originally  incorporated in 1952. We believe that we are a leading provider
of products  and  services to the public  security  markets.  We operate in four
distinct  segments:  Institutional  Security Systems ("ISS");  Attack Protection
("AP");  Integrated  Electronic  Systems ("IES");  and Public Safety and Justice
("PS&J").

Revenues from external  clients,  gross profit,  pre-tax income and total assets
for each  segment for the last three years are  discussed  in footnote 20 to the
consolidated financial statements.

Four Business Segments
----------------------

Institutional Security Systems

The  Institutional  Security  Systems  segment is  headquartered  in Montgomery,
Alabama and operates under the trade name Norment  Security  Group  ("Norment").
The  clients  this  segment  serves   consist   primarily  of  state  and  local
governmental  units.  This segment  provides  physical and  electronic  security
products and services to the corrections industry (prisons and jails) and to the
courthouse, municipal and commercial markets. ISS, through a network of regional
offices,  provides  field level design,  installation  and  maintenance  of both
physical and electronic security products.

Key products and services of the Institutional Security Systems segment include:

o    MaxWall: a modular steel, concrete-filled, prefabricated jail cell.

o    Airteq: a complete line of pneumatic and electro-mechanical operating
     devices, locks and hardware.

o    Integrated Security Systems: integrated central control and monitoring
     products for locking, paging, audio, closed circuit television cameras,
     nurse call and duress signals.

o    Hardline products and construction services.

Attack Protection

The Attack Protection  segment is one of the country's largest  manufacturers of
bullet,  blast and attack resistant windows and doors. The ultimate clients this
segment  serves  consist  primarily  of units of the Federal  Government.  These
products  are  designed  for  high  security  applications  such  as  embassies,
courthouses and Federal buildings.  We also provide our products and services to
corporate  headquarters  and other  facilities  requiring  the highest  level of
protection  currently  available.  We believe that we are a premier  provider of
Underwriters  Laboratory  ballistic standard UL-752 Level 8 security windows and
doors,  the highest rating level of commercial  ballistic  security  windows and
doors.  Additionally,  this segment  designs and installs  both fixed and pop-up
bollards and barrier security systems.

Key products of the Attack Protection segment include:

o    Bullet and Blast Protection: integrated and structurally secure bullet,
     blast and attack resistant windows and doors.

o    Vehicle Intrusion Barriers: fixed, removable, semi-automatic and automatic
     vehicle bollards and wedge barrier security systems.

o    Fiber SenSys: a sophisticated fiber optic monitoring system used to detect
     physical intrusion.

o    SecurLAN: integrated security management system designed to detect
     intrusion attempts aimed at secure and classified communications networks.

Integrated Electronic Systems

The  Integrated   Electronic  Systems  segment  consists  of  our  subsidiaries,
CompuDyne-Integrated  Electronics  Division,  LLC and Signami DCS,  LLC. Our IES
segment provides turnkey design,  production,  installation,  and integration of
public  security and safety  systems.  The ultimate  clients this segment serves
consist primarily of units of the Federal Government. This segment is a security
systems  integrator,  specializing  in  a  wide  range  of  customized  systems,
including:

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<PAGE>


o    Access Control and Biometric Applications
o    Asset Tracking
o    Badging and Identification
o    Barriers and Turnstiles
o    Command, Control, and Communications
o    Computer Aided Dispatch (CAD)/ Records Management
o    Electronic Article Surveillance
o    Fencing, Lighting, Uninterrupted Power
o    Fire/Life Safety
o    Information Technology
o    Intrusion Detection (Exterior, Interior, and Duress)
o    Fiber Optic Network
o    Perimeter Security
o    Smart Card
o    Surveillance and Assessment
o    Signals Intelligence Gathering Technology


Our IES segment provides  central station  oversight and control of multiple and
separate  facilities  as well as security  and public  life  safety  systems and
equipment.

Key products and services of the IES segment include:

o    Regionalization Systems: Command and control centers that consolidate the
     operation and management of 911 emergency services (fire, rescue, and
     police), radio frequency communications, intrusion detection systems,
     access control systems, and video surveillance systems for multitudes of
     buildings at diverse geographical locations. This system centralizes
     monitoring and dispatch functions, maximizing utility and efficiency of all
     resources.

o    Waterside Sentry Systems: Multi-functional security systems designed to
     detect, alert, monitor, track, and record water-based and shoreline attack
     threats.

o    Flightline Sentry Systems: An integration of surveillance, intrusion
     detection, access control, and other electro/mechanical systems in a
     comprehensive, "layered" approach to security, which begins inside
     operations centers and extends beyond base perimeters, providing protection
     against both overt and covert acts of aggression.

o    Signals Intelligence+ (SigInt) Systems: Signal gathering and analysis
     products and systems used for field-based collecting and monitoring,
     providing the U.S. intelligence community and U.S. allies with real time
     intelligence for strategic and tactical decision making.

o    Modular, One-Box, Signals Intercept and Analysis Hardware/Software

     o  Intelligence Gathering Solutions
     o  Monitoring/Recording/First Alerts

o    Worldwide Deployable: Mobile or Fixed-Station Configurations

o    Installation/Integration/Training

Public Safety and Justice

The Public Safety and Justice  segment  consists of Tiburon,  Inc.  ("Tiburon"),
CorrLogic, LLC, its subsidiary Xanalys Corporation and the acquired assets of 90
Degrees,   Inc.  ("90  Degrees")  and  Copperfire   Software   Solutions,   Inc.
("Copperfire").  The clients this segment serves consist  primarily of state and
local  governmental  units.  This segment  provides a fully  integrated suite of
products including  computer-assisted dispatch, records management and court and
probation software systems for the law enforcement, fire and rescue, corrections
and justice  environments.  We believe that we are a worldwide  market leader in
the  development,  implementation  and  support  of public  safety  and  justice
automation systems.  Tiburon, acquired by us in 2002, has been in business since
1980.

                                       3
<PAGE>


Key products and services of the Public Safety and Justice segment include:

o    Dispatch Systems: computer-assisted dispatch systems designed for first
     responders such as police, fire and emergency medical personnel that
     feature peer-to-peer technology that is less vulnerable to server and
     database failures.

o    Records Management Systems: integrated software modules to automate today's
     law enforcement and fire protection agencies, from initial incident entry
     to final disposition and related state reporting.

o    Mobile Computing Systems: solutions that provide instant access to computer
     assisted dispatch and records management systems by law enforcement and
     emergency personnel in the field.

o    Inmate Management Systems: development, implementation and support of
     complex, integrated inmate management software systems.

o    Court Administrative Software

o    Investigative analysis software systems.

Substantially all of the Company's  research and development  expenditures occur
in the PS&J segment.  The PS&J segment  incurred $6.5 million,  $7.8 million and
$7.1 million of research and  development  expenses in the years ended  December
31, 2006, 2005 and 2004, respectively.

The Market
----------

The market  opportunity for jail and prison  security  systems is related to new
facility  construction,  existing  facility  renovations,  and the trend towards
outsourcing government services. We believe approximately $4.0-$4.5 billion will
be spent in 2007 on correctional facility construction, of which between 10% and
15% typically relates to security equipment and security electronics,  which are
the  markets  that we  currently  serve.  Our  modular  cell  product,  Maxwall,
generally  addresses an additional 10% to 15% potential of the overall  facility
construction  budget.  Other larger security  markets we serve include state and
local government facilities,  federal government facilities and large commercial
installations.

In all four  segments of our business,  we face  considerable  competition  from
large and small  companies.  We  compete  primarily  on a price  basis  with our
competitors.  We are one of the largest  suppliers  of physical  and  electronic
security to the corrections industry however, we have many smaller competitors.

Most of our business occurs on a bid or request for proposal  basis.  Because of
the bid and request for proposal process, we do not generally have access to the
underlying  assumptions  that resulted in our  competitors'  bids and therefore,
other than price, we cannot determine why our bid was successful or unsuccessful
for particular contracts.

The Public Safety and Justice segment  competes in a market where the annual new
solution spending is approximately  $2.0 billion.  Solution spending  represents
resources dedicated to implement predefined  information systems through the mix
of  hardware,   software  and  services  and  excludes   existing  warranty  and
maintenance agreements.  Most of the competitors in this market are smaller than
us,  providing  best  of  breed  solutions  as  opposed  to our  broad  solution
capability. Our large competitors include divisions of Motorola,  Intergraph and
Northrop Grumman.

Business Strategy
-----------------

We continually strive to position the Company to meet the expanding requirements
of the public security market. We believe that we have market-leading  positions
in key areas of high-end  security systems  integration,  security  electronics,
advanced security technology  products and first responder support software.  We
consider  ourselves  to be a  one-stop  shop  and  therefore  serve  as a single
supplier  resource for the most difficult and complex public  security and first
responder requirements. Few of our competitors have this capability. In order to
enhance our position in the public security market, our current strategy is to:

     Pursue our existing  business through  internal growth.  We believe that we
     have market-leading positions in many product and service categories, which
     provide us a leverageable and ready-made growth platform.

     Expand  our client  base to  encompass  high-end  commercial  clients.  Our
     products are now being marketed to banks, corporate  headquarters,  private
     estates and other facilities.

                                       4
<PAGE>


     Utilize our Institutional  Security  capabilities in other markets. Many of
     our products and  technologies,  and the applications of those products and
     technologies, were designed to keep offenders confined to certain areas and
     to keep inmates from "breaking  out." These same products and  technologies
     can be adapted to keep people from "breaking in." We are currently  working
     towards adapting our products to this new market.

     Develop  strategic  alliances  with large defense  contractors  and teaming
     agreements  with  other  integrators,  which  may put us in a  position  to
     participate  in large blanket  procurement  projects from the Department of
     Homeland Security and other Federal Agencies.

     Improve our cost structure,  quality, and client and employee satisfaction,
     and  re-engineer  our  business  model to  generate  a  greater  degree  of
     recurring revenue.

     In addition,  we are  continually  evaluating our structure to determine if
     another organizational  structure would be more advantageous to the Company
     in light of the current operating environment.

Corporate Information
---------------------

We were  reincorporated  in Nevada in 1996 and our  predecessor  corporation was
incorporated  in  Pennsylvania  in 1952.  Our  principal  executive  offices are
located at 2530 Riva Road, Suite 201,  Annapolis,  Maryland 21401. Our telephone
number is (410) 224-4415. Our Company Code of Ethics can be found on our website
at www.CompuDyne.com.

General Information
-------------------

The Company  purchases  most of the parts and raw materials used in its products
from various  suppliers.  The primary raw materials used in the manufacturing of
its products are electronic  components and steel or aluminum sheets,  stampings
and castings. These materials are generally available from a number of different
suppliers.  While the bulk of such raw material is purchased from relatively few
sources of supply,  the Company  believes that  alternative  sources are readily
available.

There is no  significant  seasonality  in  CompuDyne's  business.  The Company's
construction  related  business,  ISS,  however,  has  historically  been a very
cyclical  business in line with the cycle of prison  construction  in the United
States.

See Management Outlook located in Item 7 for a discussion of backlogs.

At December 31, 2006, the Company had approximately 707 permanent employees.  Of
the permanent employees,  approximately 62 are subject to collective  bargaining
agreements.  The  Institutional  Security Systems Segment  regularly hires union
personnel on a temporary basis for field  projects.  These personnel are subject
to  various  collective  bargaining  agreements  depending  on their  skills and
locale.  At December 31, 2006, there were no temporary  employees  covered under
collective bargaining agreements.

The ultimate clients through which substantially all of the sales of the Company
are  generated  are the  Federal  government  or  state  and  local  governments
primarily in the United States of America.

Risks Related to Our Businesses
-------------------------------

Budget  constraints of state and local  governments  could adversely  affect our
business.
Contracts  for  which  state  or local  governments  are the  ultimate  customer
accounted  for  approximately  60% of our  business  in the  fiscal  year  ended
December 31, 2006.  Our  Institutional  Security  Systems  segment,  our largest
business segment,  outfits correctional  facilities and courthouses.  Similarly,
our Public Safety and Justice segment almost  exclusively serves state and local
governments.  Many state and local  governments  operate under very tight budget
constraints.  Budget  constraints on these governments could cause them to delay
or  cancel  pending  projects,  which  could  materially  adversely  affect  our
financial results.

The loss or reduction of U.S.  Government  contracts could adversely  affect our
business.
Contracts  where the U.S.  Government  is the ultimate  customer  accounted  for
approximately  30% of our  revenues in the fiscal year ended  December 31, 2006.
The  U.S.  Government  funds  these  contracts  in  annual  increments,  and the
contracts  require  subsequent  authorization and  appropriation,  which may not
occur or which may provide  less than the total amount of the  contract.  We may
not receive  future  contracts and the size of any contracts that we receive may
vary. Fluctuations in spending by the U.S. Government for national defense could
also adversely affect our ability to receive future contracts. Additionally, the
U.S. Government may cancel its contracts unilaterally,  at its convenience.  The
loss of, or a  significant  reduction  in, this  business  could have an adverse
effect on our business.

                                       5
<PAGE>


We operate  under fixed price  contracts and our inability to estimate our costs
may adversely affect our financial results.
Much  of our  business  is  pursuant  to  fixed  price  contracts.  If we do not
accurately  estimate  our  costs,  we could  suffer  losses on these  contracts.
Increases  in the cost of raw  materials  could  have an  adverse  impact on our
financial performance if we are not able to effectively forecast such increases.
In  addition,  our  revenues  under these  contracts  are  recognized  under the
percentage of completion method of accounting. This method requires considerable
judgment  and,  as a result,  the  estimates  derived at any point in time could
differ significantly from the final results attained.

Our  ability to obtain  payment  and/or  performance  bonds is  critical  to our
ability to conduct business.
In the conduct of our business we are often  required by our customers to obtain
payment and/or  performance  bonds. The majority of these bonds have been needed
in the ISS and PS&J segments.  Recently,  approximately  60% of ISS' revenue has
come from jobs where  payment and  performance  bonds are required and for PS&J,
19% of its revenue has required  payment and  performance  bonds.  The Company's
recent  losses  have made it more  challenging  for the  Company  to obtain  the
bonding needed to secure  certain of its projects.  As of December 31, 2006, the
Company was required to provide  collateral to its primary bonding company which
it did by placing cash, invested in a money market mutual fund, as collateral in
the  amount of $7.5  million.  If we are  unable to  obtain  such  bonds for any
reason, or if the terms, particularly collateral requirements,  of the bonds are
not within our financial means, it would  significantly  diminish our ability to
secure new contracts,  and consequently our financial performance and results of
operations may be materially adversely affected.

If we are unable to design,  manufacture and market our products  offerings in a
timely and efficient manner, we may not remain competitive.
We offer a wide variety of products.  If the design,  manufacturing or marketing
of a product or products is not  successful  and we must allocate more resources
to ensure the products' success, it could lower the profitability of the product
or products  and affect  customer  perceptions  as to the quality of products we
produce.

In addition,  all four  segments of our business face  considerable  competition
from large and small companies.  We compete  primarily on a price basis with our
competitors and because of the bid and request for proposal process, we often do
not have access to the underlying  assumptions that resulted in our competitor's
bids,  and  therefore,  other than price,  we cannot  determine  why our bid was
successful or unsuccessful for particular  projects.  This creates difficulty in
accurately  projecting  the success of future  bids. A decrease in the amount of
successful  bids and  subsequent  projects  could have an adverse  effect on our
business.

If we are unable to develop and market new products in a timely  manner,  we may
not remain competitive.
Some of our markets are characterized by continuing  technological  advancement,
changes in customer requirements, and evolving product standards. In particular,
our PS&J segment  specializes in the development,  implementation and support of
complex,   integrated  software  systems,   and  accordingly,   PS&J  devotes  a
substantial amount of resources to product development. To compete successfully,
PS&J must  develop and market new  products  that  provide  increasingly  higher
levels of performance and reliability.  Product  development is highly uncertain
and there can be no assurance  that we will  successfully  develop new products.
Our  inability  to develop  and market  these  products  or to achieve  customer
acceptance of these products could have an adverse effect on our business.

The  failure  to  obtain  U.S.  Government  contracts  in  connection  with  the
Department of Homeland  Security's  Homeland Defense  initiative could adversely
affect our business.
We  currently  do not  have  any  U.S.  Government  contracts  derived  from the
Department  of  Homeland  Security's  Homeland  Defense  initiative.  We may not
receive  any  contracts  as a  result  of this  initiative  and the  size of any
contracts  that we receive  may vary.  Our  failure to secure  Homeland  Defense
contracts could give other companies in the public security market a competitive
advantage and could have an adverse effect on our business.

We are subject to substantial  government  regulation that could cause delays in
the  delivery of our products and services and may subject us to audits or other
similar review processes.
As a  contractor  with  agencies  of  the  U.S.  Government  and  various  state
governments,  we are obligated to comply with a variety of regulations governing
our operations and the workplace.  These  regulations  include those promulgated
by,  among  others,  the  various  states  with  which  we  contract,  the  U.S.
Departments  of  Commerce,  State,  Transportation  and the  U.S.  Environmental
Protection Agency, the Occupational  Safety and Health  Administration,  and the
U.S. Bureau of Alcohol, Tobacco and Firearms.  Certain of our contracts give the
contracting agency the right to conduct audits of our facilities and operations,
including a review of our compliance with the prescribed procedures  established
in connection with the government contract.  We may be subject to investigations
as a result of an audit or for other causes.  The Company also conducts internal
investigations from time to time regarding  potential  violations of regulations
or Company Policies,  and a recent  investigation found violations  resulting in
disciplinary actions being taken by the Company. Government contractors that are
found to have  violated the False  Claims Act, or are indicted or convicted  for
violations  of other  federal  laws,  or are  considered  not to be  responsible
contractors,  may be suspended or debarred from government  contracting for some
period of time.  Such  convictions  could also  result in fines.  Suspension  or
debarment would have a material adverse effect on the Company.  U.S.  Government
contracts  may also contain  specific  delivery  requirements,  which if not met
satisfactorily by us could result in penalties assessed against us and a loss of
profits.  In addition,  changes in federal,  state and local laws may impact our
ability to secure new  contracts  and  otherwise  affect the  operations  of our
business.

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<PAGE>


Our inability to effectively  integrate  acquisitions could adversely affect our
business.
We have made a number of  acquisitions  in recent  years,  which require that we
integrate  operations and systems and personnel from those  businesses  into our
Company.  This process  requires,  among other things,  that we must continually
evaluate our  operational  and financial  systems and controls and enhance those
systems and controls as necessary.  If we are unable to  successfully  integrate
these  acquisitions  it could  adversely  affect our  operating  results and our
ability to comply fully with laws and regulations.

Our inability to or  successfully  complete our  restructuring  and simplify our
structure could adversely affect our business.
Our  Institutional  Security  Systems,  Attack  Protection and Public Safety and
Justice  business  segments are undergoing  significant  organizational  expense
restructuring.  In addition,  we are  evaluating  our  structure and strategy to
determine  if a less  decentralized,  or other  organizational  structure  would
result in lower selling,  general and administrative costs and we are evaluating
our strategy to determine if we would benefit from  focusing on fewer  segments.
If we are unable to  successfully  complete our current  organizational  expense
restructuring,  or if we are unable to effectively  further change our structure
in order to achieve lower selling,  general and  administrative  costs, it could
adversely   affect  our  operating   results  and  detract  from  future  growth
opportunities.

If we are unable to comply with  Sarbanes-Oxley  Act Section 404 ("Section 404")
and the requirement to maintain adequate disclosure controls and procedures,  we
may be adversely impacted.
Section 404 requires that certain  companies  establish and maintain an adequate
internal control structure and procedures for financial  reporting and assess on
an on-going  basis,  the design and operating  effectiveness  of their  internal
control structure and procedures for financial  reporting.  Although we were not
required  to comply  with  Section  404 for 2005 and 2006,  we were  required to
comply  in 2004 and we  previously  disclosed  that our  internal  control  over
financial  reporting as of December  2004 had material  weaknesses.  Although we
have  remediated  the material  weaknesses,  and  currently  are not required to
comply with  Section 404, we will be required to comply with Section 404 in 2007
and any future inability to maintain an adequate  internal control structure and
disclosure  controls and procedures  could result in our independent  registered
public  accounting  firm issuing an adverse  opinion on our  internal  controls,
increased   regulatory  scrutiny  and  possible  restatement  of  our  financial
statements  and delisting of our common stock on the Nasdaq  market.  Compliance
with Section 404 will also result in substantial additional expenses.

We may need additional financing for bonding  requirements,  working capital and
capital  expenditures  and  additional  financing  may not be available on terms
acceptable to us.
In order to operate our business, we may need to obtain additional surety bonds,
maintain working capital and make significant capital  expenditures and may need
additional  capital to do so. Our ability to operate and grow is dependent upon,
and may be limited  by,  among  other  things,  the  availability  of  financing
arrangements.  Additional  funding sources may be needed, and we may not be able
to obtain the  additional  capital  necessary to pursue new projects or maintain
our  operations,  and if we can  obtain  additional  financing,  the  additional
financing may not be on terms which are satisfactory to us.

Our failure to remain in compliance  with the terms of our credit facility could
adversely affect our business.
As of  September  30, 2004 we were not in  compliance  with the  "minimum  fixed
charge  coverage  ratio" and as of December  31, 2004 we were not in  compliance
with the "minimum  EBITDA"  covenant in our credit  facility.  The bank who is a
party to our credit facility agreed to waive  compliance with these covenants in
connection  with an amendment to our credit  facility dated October 29, 2004 and
March 4, 2005, respectively.  On May 3, 2005, our bank confirmed in writing that
there will not be any event of default under the various credit  agreements,  by
virtue of our failure to timely file an Amendment  to our Annual  Report on Form
10-K for the year ended December 31, 2004. In the event that we were to breach a
covenant under our credit facility in the future, there can be no guarantee that
we could  secure a waiver for such  breach and we would be in default  under the
credit  facility.  Our  failure  to remain in  compliance  with the terms of our
credit  facility could have a material  adverse effect on our ability to conduct
our business and to fulfill our obligations  under our Convertible  Subordinated
Notes due 2011 ("2011 Notes").

Legal proceedings may adversely affect our business.
We are a party to certain  legal actions and  inquiries  for  environmental  and
other  matters  resulting  from  the  normal  course  of  business.  Some of our
businesses,  especially  Institutional  Security  Systems,  involve working as a
subcontractor  to a prime  contractor.  From time to time we make claims against
the prime  contractor,  or the prime  contractor makes claims against us. At any
point  in  time  we are  engaged  in a  number  of  claim  disputes  with  prime
contractors, some of which may have a significant negative outcome. Although the
total amount of liability  with respect to these matters  cannot be  ascertained
given the nature of the  related  allegations,  we  presently  believe  that any
resulting  liability would not have a material effect on our financial position,
results of future  operations  or cash  flows.  In addition to claims with prime
contractors,  we may also make claims  against  customers and customers may make
claims against us.

                                       7
<PAGE>


We have been named in lawsuits  involving  asbestos  related personal injury and
death  claims in which  CompuDyne  Corporation,  individually  and as an alleged
successor, is a defendant. We have been named as a defendant in cases related to
claims for asbestos exposure  allegedly due to asbestos  contained in certain of
its predecessor's products. We have advised our insurers of each of these cases,
and the insurers are providing a defense  pursuant to agreement with us, subject
to reservation of rights by the insurers.  The insurers have advised that claims
in such  litigation  for punitive  damages,  exemplary  damages,  malicious  and
willful and wanton behavior and intentional conduct are not covered.  One of the
carriers has given notice that asbestos related claims are excluded from certain
of these  policies.  The insurers have  additional  coverage  defenses which are
reserved,  including that claims may fall outside of a particular  policy period
of coverage.  Litigation costs to date have not been significant and we have not
paid any settlements from our own funds.

The Company  cannot  ascertain  the total  amount of  potential  liability  with
respect to these legal  matters,  but does not believe  that any such  potential
liability  should  have a  material  effect on its  financial  position,  future
operations or future cash flows.  However,  litigation  is inherently  risky and
unexpected results could have a material adverse effect on us.

We are exposed to potential liability to clients and others.
Our  involvement  in the public  security  and  justice  business  exposes us to
potential  liability  claims  from  our  clients.   Our  products  are  used  in
applications  where their failure could result in serious personal  injuries and
death. We have sought ways to minimize loss to our clients by obtaining  product
liability and professional  liability insurance policies;  however, a successful
claim could result in liability in excess of coverage limits or the cancellation
of insurance coverage and have an adverse effect on our business and operations.

We are subject to various environmental laws that could subject us to unforeseen
expenditures.
Our operations are subject to various  environmental  statutes and  regulations,
including laws and regulations  addressing  materials used in the manufacture of
our products.  In addition,  certain of our  operations  are subject to federal,
state and local  environmental  laws and regulations that impose  limitations on
the discharge of pollutants  into the air and water and establish  standards for
the treatment,  storage and disposal of solid and hazardous wastes.  Although we
believe that we have made sufficient capital expenditures to maintain compliance
with  existing laws and  regulations,  future  expenditures  may be necessary as
compliance standards and technology change.  Unforeseen significant expenditures
required to maintain such compliance,  including unforeseen  liabilities,  could
have an adverse effect on our business and financial condition.

Our ability to generate  sufficient cash to make principal and interest payments
on the 2011 Notes depends on many factors beyond our control.
Our ability to make  payments on and to retire the 2011 Notes upon maturity will
depend on our  ability to  generate  cash in the future.  Our  business  may not
generate sufficient cash flow from operations, cost savings may not be realized,
and future borrowings may not be available to us under credit arrangements in an
amount  sufficient to enable us to make the  principal and interest  payments on
the 2011 Notes.  We may need to refinance  all or a portion of our  indebtedness
under the 2011 Notes on or before maturity.  We may not be able to refinance the
2011 Notes, if necessary, on commercially reasonable terms or at all.

Cautionary Statement Regarding Forward-Looking Information
----------------------------------------------------------

Certain  statements  made  in  this  Form  10-K  with  regard  to the  Company's
expectations as to future revenues,  expenses,  financial  position and industry
conditions, the Company's ability to secure new contracts, the ability to secure
payment and performance bonds, its goals for future  operations,  implementation
of  business  strategy  and  other  future  events  constitute  "forward-looking
statements" within the meaning of the federal securities laws. When used in this
Form 10-K, words such as "anticipate," "believe," "estimate," "expect," "intend"
and  similar  expressions  identify  forward-looking  statements.  Although  the
Company makes such  statements  based on current  information and assumptions it
believes to be  reasonable,  there can be no assurance  that actual results will
not differ  materially from those  expressed or implied by such  forward-looking
statements.  Actual results could differ  materially from those  contemplated by
the  forward-looking  statements  as a  result  of  certain  important  factors,
including but not limited to, capital  spending  patterns of the security market
and the demand for the  Company's  products,  competitive  factors  and  pricing
pressures, changes in legislation and regulatory requirements, government budget
problems,  the Company's ability to secure new contracts,  the ability to remain
in  compliance  with  its  bank  covenants,  delays  in  government  procurement
processes,  inability to obtain bid, payment and performance bonds on various of
the Company's  projects,  technological  change or difficulties,  the ability to
refinance debt when it becomes due, product development risks, commercialization
difficulties,  adverse results in litigation,  the level of product returns, the
amount  of  remedial  work  needed to be  performed,  costs of  compliance  with
Sarbanes-Oxley  requirements  and the impact of the  failure to comply with such
requirements,  risks associated with internal control  weaknesses  identified in
complying with Section 404 of Sarbanes-Oxley  ("SOX"),  the Company's ability to
realize  anticipated  cost  savings,  the  Company's  ability  to  simplify  its
structure and modify its strategic objectives,  and general economic conditions.
Risks   inherent  in  the   Company's   business  and  with  respect  to  future
uncertainties are further described in our other filings with the Securities and
Exchange Commission.

                                       8
<PAGE>


Available Information
---------------------

Our website is located at www.CompuDyne.com. The Company makes available free of
charge  all of its SEC  filings  (including  its  annual  report  on Form  10-K,
quarterly  reports on Form 10-Q,  current reports on Form 8-K and all amendments
to these  reports)  on the  Company  website  and posts the  filings  as soon as
reasonably  practicable after electronically filing or otherwise furnishing such
material to the SEC.

ITEM 2. PROPERTIES

The Company's principal  executive offices are in Annapolis,  Maryland where the
Company leases approximately 4,358 square feet of office space.

At December 31, 2006 the  Institutional  Security Systems segment leased primary
facilities for engineering,  assembly and  administration  including:  Alabama -
40,250  square feet,  California - 15,795  square feet,  Maryland - 9,500 square
feet, North Carolina - 5,775 square feet and Arizona - 5,570 square feet.

At December 31, 2006 the Attack Protection  segment owned primary facilities for
engineering,  manufacturing and administration in Alabama - 165,883 square feet.
A portion of this space is used by the ISS segment for administrative  purposes.
These  facilities  are  encumbered  by  Industrial  Revenue  Bonds.  The  Attack
Protection segment also leases 31,372 square feet of  office/warehouse  space in
Oregon.

At December 31, 2006 the Integrated  Electronic  Systems  segment leased primary
facilities for  engineering,  assembly and  administration  in Maryland - 16,001
square feet.

At  December  31,  2006 the Public  Safety and Justice  segment  leased  primary
facilities for  engineering  and  administration  including  California - 33,249
square feet,  Texas - 10,247  square feet,  United  Kingdom - 6,663 square feet,
Oregon - 5,669  square feet,  Utah - 5,422 square feet,  Colorado - 4,474 square
feet, Washington - 4,000 square feet, and Wisconsin - 1,902 square feet.

The Company leases only those  properties  necessary to conduct its business and
does not invest in real  estate or  interests  in real  estate on a  speculative
basis.  The  Company  believes  that the current  properties  are  suitable  and
adequate for its current operations. Additional space may be required to service
contracts in other areas.

ITEM 3. LEGAL PROCEEDINGS

The Company is party to certain legal  actions and  inquiries for  environmental
and other  matters  resulting  from the normal  course of business.  Some of the
businesses,  especially  Institutional  Security  Systems,  involve working as a
subcontractor to a prime contractor.  From time to time the Company makes claims
against the prime  contractor,  or the prime contractor makes claims against the
Company.  At any  point in time the  Company  is  engaged  in a number  of claim
disputes with prime contractors,  some of which may have a significant  negative
outcome.  Although the total amount of potential liability with respect to these
matters can not be ascertained given the nature of the related allegations,  the
Company presently believes that any resulting liability will not have a material
effect on its financial position, results of future operations or cash flows.

In addition to claims with prime  contractors,  the Company may also make claims
against customers and customers may make claims against the Company.

During 2006 we received a letter from a client of our Public  Safety and Justice
segment  indicating  their intent to terminate their contract with us for cause.
The letter alleges that we failed to complete the project under the terms of the
agreement  and the  applications  implemented  failed to meet the  functionality
requirements of the agreement. The customer is seeking a refund of approximately
$400  thousand  previously  paid  by  them.  Costs  in  excess  of  billings  of
approximately  $600 thousand  related to this project  remain as an asset on our
books and records as of  December  31,  2006.  The  segment  disagrees  with the
client's  views.  While the ultimate  outcome  cannot be predicted,  the Company
intends to vigorously pursue this matter. The Company has established an accrual
for this matter which is included in accounts payable and accrued liabilities on
the balance sheet.

                                       9
<PAGE>


On November 21, 2006,  CompuDyne  Corporation  ("CompuDyne")  and William  Blair
Mezzanine Capital Fund II, L.P.  ("Blair") entered into a Release and Settlement
Agreement with Friedman,  Billings,  Ramsey Group,  Inc.  ("FBR"),  by which FBR
agreed to pay $4.5 million to CompuDyne and Blair, CompuDyne and Blair agreed to
release FBR, and FBR has agreed to release CompuDyne and Blair, from any and all
causes of action arising out of or relating to, among other things,  an offering
of CompuDyne  common stock in 2001 for which FBR acted as lead  underwriter  and
financial  advisor.  Blair is former  shareholder  of CompuDyne  which also sold
shares in the 2001  offering.  After  legal and other  expenses  and  payment of
Blair's  share of the  settlement,  the net amount  recorded  by  CompuDyne  was
approximately $2.7 million which is recorded in additional paid-in capital.

The Company has learned  that the National  Association  of  Securities  Dealers
("NASD")  and other  regulatory  bodies are seeking  sanctions  against  certain
purchasers  of the  Company's  common  stock in its 2001 PIPE  transaction.  The
Company is investigating  these matters,  and has filed lawsuits against certain
purchasers. The Company is currently attempting to resolve these matters.

The Company  has been named in  lawsuits  involving  asbestos  related  personal
injury and death claims in which CompuDyne  Corporation,  individually and as an
alleged successor, is a defendant.  The Company has been named as a defendant in
cases  related  to  claims  for  asbestos  exposure  allegedly  due to  asbestos
contained in certain of its predecessor's  products. The Company has advised its
insurers  of each of these  cases,  and the  insurers  are  providing  a defense
pursuant to agreement with the Company,  subject to reservation of rights by the
insurers.  The insurers have advised that claims in such litigation for punitive
damages,  exemplary  damages,  malicious  and  willful and wanton  behavior  and
intentional  conduct are not covered.  One of the carriers has given notice that
asbestos  related  claims  are  excluded  from  certain of these  policies.  The
insurers have additional coverage defenses,  which are reserved,  including that
claims may fall outside of a particular  policy  period of coverage.  Litigation
costs  to date  have  not  been  significant  and the  Company  has not paid any
settlements from its own funds.

The Company  cannot  ascertain  the total  amount of  potential  liability  with
respect to these legal  matters,  but does not believe  that any such  potential
liability  should  have a  material  effect on its  financial  position,  future
operations or future cash flows.

The Company,  as a government  contractor,  is from time to time subject to U.S.
Government investigations relating to its operations.  The Company also conducts
internal  investigations  from time to time  regarding  potential  violations of
regulations  or  Company  Policies;  a  recent  investigation  found  violations
resulting  in  disciplinary  actions  being  taken  by the  Company.  Government
contractors  that are  found to have  violated  the  False  Claims  Act,  or are
indicted or convicted for  violations  of other federal laws, or are  considered
not to be responsible contractors,  may be suspended or debarred from government
contracting  for some  period of time.  Such  convictions  could also  result in
fines.  Suspension,  debarment or fines could have a material  adverse effect on
the Company.

In connection  with the  acquisition  of the assets of Signami,  LLC made by the
Company in July 2006,  the Company issued 93,334 shares to the sellers for which
it  guaranteed  for a 2 year  period  that  upon sale of these  securities,  the
Company would guarantee a price of $7.50 per share for these shares. This period
is extended for members  precluded  from  selling  their shares due to statutory
reasons.  Included  in other  long term  liabilities  at  December  31,  2006 is
approximately $86 thousand representing the fair value of this liability.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

                                       10
<PAGE>


                                     PART II

ITEM 5. MARKET FOR THE REGISTRANT'S  COMMON EQUITY RELATED  STOCKHOLDER  MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES

CompuDyne Common Stock is quoted on the Nasdaq National Market, under the symbol
"CDCY." There were 1,367 common shareholders of record as of April 4, 2007.

The following table sets forth the high and low sales for CompuDyne Common Stock
as quoted on the Nasdaq National Market.

                               2006                           2005
                               ----                           ----
Quarter Ended            High         Low               High         Low
-------------          --------------------            -------------------
March 31                $ 7.60      $ 6.00             $ 7.80      $ 4.65
June 30                 $ 7.44      $ 6.06             $ 8.00      $ 5.03
September 30            $ 6.78      $ 4.94             $ 9.40      $ 5.27
December 31             $ 6.98      $ 5.56             $ 6.75      $ 4.74

The Company did not pay any dividends on its common stock during the years ended
December 31, 2006 and 2005, and its bank covenants forbid paying dividends until
satisfaction in full of the obligations and termination of the banking
agreements. In addition, the Company's 2011 Notes restrict the Company's ability
to declare or pay cash dividends.

Securities Authorized For Issuance Under Equity Compensation Plans

See Item 12 of Part III.

Comparative Stock Performance

                 COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN*
       AMONG COMPUDYNE CORPORATION, THE NASDAQ STOCK MARKET (U.S.) INDEX,
                     AND BOTH CURRENT AND PRIOR PEER GROUPS
<TABLE>
<CAPTION>
<S>                             <C>             <C>             <C>             <C>             <C>             <C>
                                12/01           12/02           12/03           12/04           12/05           12/06

CompuDyne Corporation           100.00          35.94           58.24           42.63           35.54           37.60
NASDAQ Composite                100.00          69.66           99.71          113.79          114.47          124.20
New Peer Group                  100.00          71.00           76.77           79.59           76.28           74.36
Old Peer Group                  100.00          49.66           84.18          146.82          128.78          155.79

* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends
                        Fiscal year ending December 31.
</TABLE>

The above graph compares the cumulative total  stockholder  return on our common
stock for the last five fiscal  years with the  cumulative  total  return on the
Nasdaq  Composite  Index.  This graph assumes the investment of $100 on December
31, 2001 in our common stock and the index listed above,  and assumes  dividends
are  reinvested.  We have not paid any  dividends  on our  common  stock  and no
dividends are included in the representation of our performance. The stock price
performance  shown in the below graph is not  necessarily  indicative  of future
price  performance.  Measurement  points are the last  trading day of the fiscal
years ended December 31, 2002, 2003, 2004, 2005 and 2006.

                                       11
<PAGE>


The graph and table above are not  "soliciting  material,"  are not deemed filed
with the SEC and are not to be  incorporated  by reference in any filing of ours
under the Securities Act of 1933, as amended,  or the Exchange Act, whether made
before or after the date hereof and  irrespective  of any general  incorporation
language in any such filing.

The  Company  is  using  a new  peer  group  that  is  more  similar  in  market
capitalization to CompuDyne than the previous peer group.

         Previous Peer Group                          New Peer Group
         -------------------                          --------------

    Armor Holdings (AH)                     OSI Systems Inc. (OSIS)
    Magal Security Systems(MAGS)            Lasercard Corporation (LCRD)
                                            Henry Bros. Electronics, Inc. (HBE)

ITEM 6. SELECTED FINANCIAL DATA

The  following is a  consolidated  summary of  operations  of CompuDyne  and its
subsidiaries  for the years ended December 31, 2006, 2005, 2004, 2003, and 2002.
The  information  in the  table  below is based  upon the  audited  consolidated
financial  statements of CompuDyne and its  subsidiaries for the years indicated
appearing  elsewhere in this annual  report or in prior  annual  reports on Form
10-K  filed by the  Company  with the SEC,  and  should  be read in  conjunction
therewith and the notes thereto.
<TABLE>
<CAPTION>
<S>     <C>                                   <C>           <C>           <C>           <C>           <C>
(In thousands except per share data)                            For the years ended December 31
                                              ------------------------------------------------------------------
                                                2006(a)       2005(b)        2004          2003         2002(c)
                                              ----------    ----------    ----------    ----------    ----------
Total revenues                                $ 147,462     $ 141,650     $ 142,782     $ 193,263     $ 155,556
                                              ==========    ==========    ==========    ==========    ==========
Gross profit                                  $  47,867     $  42,539     $  37,678     $  46,396     $  34,816
Selling, general and administrative expenses     38,261        40,567        36,219        32,305        25,785
Research and development                          7,294         8,685         7,755         7,374         4,916
Impairment of goodwill and other intangibles     16,141             -         1,826             -             -
                                              ----------    ----------    ----------    ----------    ----------
Operating (loss) income                       $ (13,829)    $  (6,713)    $  (8,122)    $   6,717     $   4,115
                                              ==========    ==========    ==========    ==========    ==========
Interest expense, net of interest income      $   2,105     $   2,233     $   2,289     $   1,051     $   1,394
                                              ==========    ==========    ==========    ==========    ==========
Net (loss) income                             $ (14,993)    $  (8,691)    $  (8,198)    $   3,408     $   1,814
                                              ==========    ==========    ==========    ==========    ==========
(Loss) earnings per share (d):
Basic
-----
  (Loss) earnings per common share            $   (1.82)    $   (1.07)    $   (1.01)    $     .43     $     .24
                                              ==========    ==========    ==========    ==========    ==========
Weighted average number of common
 shares outstanding                               8,256         8,129         8,136         7,895         7,456
                                              ==========    ==========    ==========    ==========    ==========
Diluted
-------
  (Loss) earnings per common share            $   (1.82)    $   (1.07)    $   (1.01)    $     .42     $     .23
                                              ==========    ==========    ==========    ==========    ==========
Weighted average number of common
 shares and equivalents                           8,256         8,129         8,136         8,158         7,940
                                              ==========    ==========    ==========    ==========    ==========

Total assets                                  $ 103,950     $ 126,692     $ 132,891     $ 115,732     $ 120,804
                                              ==========    ==========    ==========    ==========    ==========
Long-term debt                                $  42,617     $  42,870     $  43,123     $  17,658     $  27,510
                                              ==========    ==========    ==========    ==========    ==========
Total shareholders' equity                    $  26,839     $  36,422     $  45,831     $  52,927     $  49,204
                                              ==========    ==========    ==========    ==========    ==========
</TABLE>
Reclassifications - Certain prior year amounts have been reclassified to conform
with the current year's presentation.

Notes:
(a)  Includes operations from the acquired assets of Signami LLC, from July 20,
     2006, the date of acquisition.
(b)  Includes operations of Xanalys Corporation from August 24, 2005, the date
     of acquisition.
(c)  Includes operations of Tiburon, Inc. from May 2, 2002, the date of
     acquisition.
(d)  No dividends have been paid on the Company's Common Stock during the above
     periods.

                                       12
<PAGE>


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Introduction

Overview of CompuDyne Corporation

CompuDyne  Corporation was  reincorporated in Nevada in 1996. We were originally
incorporated in 1952. We believe that we are a leading  provider of products and
services to the public security markets.  We operate in four distinct  segments:
Institutional  Security Systems ("ISS");  Attack Protection  ("AP");  Integrated
Electronic Systems ("IES"); and Public Safety and Justice ("PS&J").

The  Institutional  Security  Systems  segment is  headquartered  in Montgomery,
Alabama and operates under the trade name Norment  Security  Group  ("Norment").
This segment provides physical and electronic  security products and services to
the corrections  industry  (prisons and jails) and to the courthouse,  municipal
and commercial markets. ISS typically serves as a subcontractor, responsible for
their portion of the installation work on larger projects. Installations involve
hard-line   (steel  security  doors,   frames,   locking   devices,   etc.)  and
sophisticated  electronic  security systems,  including  software,  electronics,
touch-screens,  closed  circuit  television,  perimeter  alarm devices and other
security  monitoring  controls.  ISS also  developed a product  called  MaxWall.
MaxWall is a modular steel,  concrete filled  prefabricated jail cell. It allows
for  construction  projects  to use  considerably  less  space  and can save the
project owner  significant  amounts of money.  ISS provides  field level design,
installation and maintenance of both physical and electronic security products.

Included in the  Institutional  Security  Systems  segment is the TrenTech  line
which  manufactures  and  integrates   electronic  security  systems.   TrenTech
integrates  generally  available products and software as well as developing its
own  proprietary  systems.  TrenTech has developed a  sophisticated  proprietary
video badging system,  with  approximately 250 systems installed at more than 70
facilities, most of which are military installations.

The Institutional  Security Systems segment also manufactures a complete line of
locks and locking  devices  under the brand name  Airteq.  Airteq is an industry
leader  in  pneumatic  and  electro-mechanical   locking  devices  used  in  the
corrections industry.

The Attack Protection  segment is one of the country's largest  manufacturers of
bullet,  blast and attack resistant windows and doors designed for high security
applications such as embassies, courthouses, Federal buildings, banks, corporate
headquarters  and other  facilities  that insist on having the highest  level of
protection  currently  available.  We believe that we are a premier  provider of
Underwriters  Laboratory  ballistic standard UL-752 Level 8 security windows and
doors,  the highest rating level of commercial  ballistic  security  windows and
doors.  Our attack  resistant  windows and doors are integrated and structurally
secure  products with  specifically  designed  frames and  encasements  that are
integral  parts of the structure in which they are installed.  Existing  product
installations  number in the  thousands  and range from the  Middle  East to the
White House. AP is a significant  supplier of bullet and blast resistant windows
and doors to United  States  embassies  throughout  the world.  AP usually works
under contracts from prime contractors who have direct contracts with the United
States  Department of State,  the segment's  largest  client.  Other  commercial
applications  include guard booths,  tollbooths,  cash drawers and other similar
items.  Additionally,  this segment  designs and installs  both fixed and pop-up
bollards and wedge barrier security systems.

The Attack  Protection  segment also  manufactures a  sophisticated  fiber optic
sensor system,  known as Fiber SenSys, used to detect physical  intrusion.  This
application is designed to protect large perimeters  including such applications
as Federal  facilities,  military  deployments  and bases,  oil fields,  airport
tarmacs,  public utilities,  nuclear reactors and water systems. In addition, it
has been  installed  to protect  the  perimeters  of private  estates  and other
similar properties.

The  Integrated  Electronic  Systems  segment  consists of  CompuDyne-Integrated
Electronics  Division,  LLC and the newly-formed  Signami DCS, LLC. Its customer
base  includes  the  military,   governmental  agencies,  and  state  and  local
governmental  units. IES provides turnkey system  integration of public security
and safety  systems.  This  segment  specializes  in a wide range of  customized
access control and badging,  intrusion  detection,  surveillance and assessment,
communications,  command and control,  fire and life safety,  and asset tracking
systems.  IES provides  central  station  oversight  and control of multiple and
separate  facilities  as well as security  and public  life  safety  systems and
equipment.  This segment also designs and  manufactures  advanced digital signal
processing products used in reconnaissance of foreign telecommunications signals
designed for the United States  Government and its foreign allies. In July 2006,
the Company  acquired  the assets and  certain  liabilities  of Signami,  LLC, a
producer of software and hardware  systems for signals  intelligence  gathering.
Together with the Data Control Systems  ("DCS")  division of IES, a new business
was established and is going to market under the name Signami DCS.

                                       13
<PAGE>


The Public Safety and Justice segment consists of Tiburon, Inc., CorrLogic, LLC,
Xanalys  Corporation  ("Xanalys"),  and the acquired assets of 90 Degrees,  Inc.
("90 Degrees") and Copperfire Software Solutions,  Inc.  ("Copperfire").  PS&J's
software  systems  are used in a wide  range of  applications  within the public
safety and criminal  justice sectors of governmental  units,  including  police,
fire and emergency medical services computer-aided dispatch systems, and police,
fire, jail,  prosecution,  probation,  court records and  institutional  medical
software   management   systems.   We  also   specialize  in  the   development,
implementation  and support of complex,  integrated inmate  management  software
systems  that  improve the  efficiency  and  accuracy of  correctional  facility
operations.

Management Outlook

We continue to find  ourselves in very  challenging  times.  We have three major
areas of focus:

     o    The first is increasing the amount of our backlog.
     o    The second is migrating to a business model with a more predictable
          revenue stream.
     o    The third is to improve our cost structure (including evaluating our
          strategy to determine if we would benefit from focusing on fewer
          segments), quality, and customer and employee satisfaction.

Our backlog is a key indicator of what our future  revenues will look like.  Our
backlog  peaked at December 31, 2002,  at which time it exceeded  $204  million.
Backlog was  approximately  $117.3 million at December 31, 2006, as shown in the
following table:

                                                              Public
                      Institutional              Integrated   Safety
                        Security       Attack    Electronic    and      Backlog
    (in thousands)       Systems     Protection    Systems   Justice     Total
                      ----------------------------------------------------------
  December 31, 2002      $ 99,527     $ 18,478   $  11,440  $ 74,867  $ 204,312
  December 31, 2003      $ 57,258     $ 10,043   $   8,326  $ 63,727  $ 139,354
  December 31, 2004      $ 49,324     $ 20,803   $   8,299  $ 48,434  $ 126,860
  December 31, 2005      $ 58,128     $ 28,802   $   7,503  $ 53,705  $ 148,138
  March 31, 2006         $ 57,030     $ 20,961   $   6,590  $ 43,874  $ 128,455
  June 30, 2006          $ 51,173     $ 13,593   $   7,393  $ 39,351  $ 111,510
  September 30, 2006     $ 65,489     $  7,991   $   8,137  $ 40,088  $ 121,705
  December 31, 2006      $ 64,687     $  5,686   $   7,902  $ 39,067  $ 117,342

During the fourth  quarter of 2005 the Attack  Protection  segment was awarded a
significant  contract to provide its products to a large  embassy  project.  The
execution of this contract is complete as of December 31, 2006.  Since the award
of this contract,  the Norshield  component of the Attack Protection segment has
had limited  success in winning new contracts due to  competitive  factors which
has resulted in a  significant  decline in the backlog of this  segment.  We are
actively pursuing  non-embassy work in an effort to generate awards  incremental
to our  embassy  work.  The  overall  decline in backlog in 2006 could lead to a
potential decline in future quarterly revenues.

Historically,  approximately  90% of our revenues  were  generated  from sources
where the ultimate client is a federal,  state or local government unit.  During
the last few  years,  state and local  budgets,  which we are  dependent  on for
approximately 60% of our revenue sources, have come under intense pressure. Most
states were running in a deficit situation, as were many local governments. This
caused  many of them to delay and in some cases  cancel  certain  infrastructure
projects until such time as their economic fortunes  rebound.  In recent months,
tax revenues have been improving resulting in increased activity  preparatory to
the issuance of bids and ultimately  the awarding of new projects.  In addition,
we have increased our sales and marketing  efforts with a specific  objective of
marketing  to the  commercial  sector which  inherently  offers  faster  project
implementation schedules.

Our second area of focus is the  reengineering  of our business model so that it
contains  a  greater  percentage  of  recurring  revenue.  As  indicated  in the
following  table,  approximately  18% of our revenue in 2006 was generated  from
recurring revenue sources (primarily maintenance revenues),  and the majority of
these  revenues  occurred in our Public  Safety and Justice  segment.  We define
one-time revenue as revenue derived from discrete projects, from which we do not
expect to generate  incremental  revenue upon the completion of the project.  We
define  recurring  revenue  as  sources  of  revenue  from  which we  anticipate
receiving revenue in the current, as well as future periods,  for example annual
renewable maintenance contracts.

                                       14
<PAGE>


                                          Year Ended December 31, 2006
                                -----------------------------------------------
     (in thousands)              One-time          Recurring
                                  Revenue     %     Revenue     %       Total
                                ---------- ------  --------- ------  ----------
Institutional Security Systems  $  43,488   29.5   $  4,777    3.2   $  48,265
Attack Protection                  40,241   27.3          -      -      40,241
Integrated Electronic Systems       9,993    6.8      3,901    2.7      13,894
Public Safety and Justice          27,066   18.3     17,996   12.2      45,062
                                ---------- ------  --------- ------  ----------
    Total                       $ 120,788   81.9   $ 26,674   18.1   $ 147,462
                                ========== ======  ========= ======  ==========

Since the majority of our revenues are one-time revenues and are  non-recurring,
we must reinvent our book of business on a continual  basis.  This makes it very
difficult  for us to project  our future  revenue  stream and thus makes it very
difficult for us to project our earnings as well as our business  outlook.  Over
the next five  years,  we hope to modify  our  business  model to rely less upon
one-time sources of revenue and more on recurring sources of revenue.

Our third focus area is to improve our cost structure,  quality,  and client and
employee satisfaction.  Our Institutional Security Systems and Attack Protection
business  segments  are  undergoing   significant   organizational  and  expense
restructuring,  including a partial consolidation of regional office efforts and
an increased focus on centralized  performance of the most complicated  security
projects. This initiative began by ensuring our organization is properly aligned
with our  clients'  needs.  Many  changes  have  been made and  initial  results
indicate  that  our  cost,  our  quality,  our  clients  and our  employees  are
responding  favorably to the changes implemented thus far. We have much room for
improvement as we move toward a more client-oriented  organization. In addition,
our Public Safety and Justice  segment has and is continuing to undergo  expense
restructuring including right sizing its organization in light of its relatively
low level of backlog.  The Attack Protection segment also has a very low backlog
level which will necessitate us to reevaluate and reduce our expense  structure.
In addition,  in light of the  escalating  selling,  general and  administrative
costs  associated with the current  heightened  regulatory  environment,  we are
evaluating our structure and strategy to determine if a less  decentralized,  or
other  organizational  structure  would  result in lower  selling,  general  and
administrative costs and we are evaluating our strategy to determine if we would
benefit from focusing on fewer segments.

We believe that if we address and implement  successfully  the above three areas
of focus, we will significantly enhance our future growth opportunities and will
provide for more predictable financial results.

On May 2, 2005, we filed a Form 8-K disclosing  that we failed to timely file an
amendment to our Annual Report on Form 10-K for the year ended December 31, 2004
to provide  management's  report on internal control over financial reporting as
of December 31, 2004 and the related report of our independent registered public
accounting  firm on  management's  assessment of the  effectiveness  of internal
control  over  financial  reporting  (together,  the "404  Report")  required by
Section 404 of the Sarbanes-Oxley Act of 2002.

On May 4, 2005, we received a notice from the Listing Qualifications  Department
of The Nasdaq  Stock  Market  stating that due to our failure to timely file the
404 Report, we were no longer in compliance with the requirements of Marketplace
Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports
required to be filed with the  Securities  and Exchange  Commission on or before
the date they are required to be filed with the SEC.

On June 27, 2005,  the Company filed its Form 10-K/A with the SEC containing the
404 Report.  On June 30, 2005, the Nasdaq Listing  Qualifications  Panel advised
CompuDyne  that  CompuDyne had remedied its filing  delinquency  and was in full
compliance with Nasdaq Market Place Rules.

On December 21, 2005 the Securities and Exchange  Commission  issued Release No.
33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For
Filing Periodic Reports" (the "Release").  The Release revised the definition of
"accelerated filer" to make it simpler for accelerated filers whose public float
falls below the $50 million threshold on the measurement date of June 30 to exit
accelerated  filer status.  Under the new rules,  an accelerated  filer that has
voting and non-voting  equity held by non-affiliates of less than $50 million at
the end of its second  fiscal  quarter is  permitted to exit  accelerated  filer
status at the end of that year and to file its  annual  report for that year and
subsequent periodic reports on a non-accelerated basis. Accelerated filer status
affects an issuer's  deadlines for filing its periodic  reports with the SEC and
complying  with the  requirements  of Section 404 of the  Sarbanes-Oxley  Act of
2002. A  non-accelerated  filer must begin to comply with the  internal  control
over  financial  reporting  requirements  for its first fiscal year ending on or
after December 15, 2007.

The aggregate worldwide market value of CompuDyne  Corporation's  equity held by
non-affiliates as of June 30, 2005, the last business day of CompuDyne's  second
fiscal quarter, was less than $50 million. As a result, as of December 31, 2005,
CompuDyne  exited  accelerated  filer status.  CompuDyne's  aggregate  worldwide
market  value as June 30, 2006,  the last  business  day of  CompuDyne's  second
fiscal quarter,  was also less than $50 million;  as such CompuDyne continued to
be classified as a non-accelerated filer for the year ended December 31, 2006.

                                       15
<PAGE>


Prior  to  the  issuance  of  the  Release,   CompuDyne  was  classified  as  an
"accelerated  filer" and was required to comply with the requirements of Section
404 of the Sarbanes-Oxley Act of 2002. In light of the Release,  CompuDyne, as a
non-accelerated  filer as of December 31, 2005,  was not required to comply with
Section 404 for the years ended December 31, 2005 and 2006.

Results of Operations

YEARS ENDED DECEMBER 31, 2006 and 2005

Revenues.  The Company had revenues of $147.5 million and $141.7 million for the
years ended December 31, 2006 and December 31, 2005, respectively,  representing
an increase of $5.8 million or 4.1%. As discussed below,  the increase  occurred
primarily  due to higher  revenues in our AP, IES and PS&J  segments,  offset in
part by a decrease in revenues from our ISS segment.

Revenues from the Institutional  Security Systems segment were $48.3 million for
the year ended  December 31, 2006,  a decrease  from $60.7  million for the year
ended December 31, 2005,  representing a decrease of $12.4 million or 20.4%. The
Institutional   Security  Systems  segment  is  largely  a  construction  driven
business.  Much of its  revenue  is  obtained  by  working  on new and  retrofit
construction  projects  in the  corrections  industry,  as opposed to sources of
recurring revenue.  As such, the decrease in revenue experienced by this segment
is largely  attributable  to our  working on fewer  projects  than we did in the
previous  year and the delay in the  start of some  projects.  Although  backlog
increased  significantly  during  the  second  half  of  2006,  it was  not at a
significantly  high enough level prior  thereto to maintain its revenue  levels.
Backlog was $64.7  million and $58.1  million at December  31, 2006 and December
31, 2005, respectively.  Several of ISS' recently won awards were delayed and/or
not yet  available  to be  worked on by us.  The  years  2003 and 2004 were slow
bidding  periods for the  Company.  Although  the gross  amount of  construction
spending in the corrections area remained relatively flat between 2003 and 2004,
the types of projects that the Company solicits,  namely  large-scale  medium to
maximum security  installations,  declined  significantly in 2003 and 2004. This
situation was further  compounded  by the general  state and local  governmental
budget deficits which caused these  governmental units to rethink and delay many
of their  pending  corrections  projects.  Since 2005,  ISS has seen  heightened
bidding activity, particularly in the market space it serves, namely large-scale
medium to maximum security prisons.

Revenues  from the Attack  Protection  segment  were $40.2  million for the year
ended  December 31, 2006,  an increase from $27.0 million for the same period of
2005,  representing an increase of $13.2 million or 48.9%.  During 2005 and 2006
factory  utilization  increased  significantly.  This segment is composed of two
chief product  offerings,  namely Norshield,  which encompasses bullet and blast
resistant  windows and doors and ancillary  products,  and Fiber  SenSys,  which
encompasses fiber optic intrusion detection systems. For the year ended December
31, 2006 the Norshield line experienced a 53.0% increase in revenues as compared
to the year ended December 31, 2005, whereas the Fiber SenSys line experienced a
35.9% increase in revenues for the comparable period. The increase in revenue of
$10.9 million in the Norshield  line is a direct result of execution on an award
of a major  contract  won in the  fourth  quarter  of  2005.  Execution  on this
contract  began  immediately  upon award.  Fiber SenSys'  revenue  increase is a
result of the rollout of its next  generation  product,  which until its testing
was completed and accepted, at the end of the second quarter of 2006, negatively
impacted revenues.  During 2004,  Norshield bid on fifteen new embassy projects.
We were awarded seven of these embassy  projects for a total  contract  value of
$9.9 million,  and lost eight embassy project bids to  competitors.  In 2005, we
bid on  seventeen  embassy  projects.  The  Company  was  awarded  five of these
projects,  for a total contract  value of $20.4 million,  and lost four projects
and one bulk bid embassy project  comprising eight embassies to competitors.  In
2006, eleven embassy projects were planned, seven of which have not been awarded
yet. The Company was awarded two of these projects for a total contract value of
$3.3 million and lost two of these 2006 projects.  We believe that the increased
level of new embassy construction will continue for the next several years.

Revenues  from  Integrated  Electronic  Systems were $13.9  million for the year
ended  December 31, 2006,  an increase from $10.1 million for the same period of
2005,  representing an increase of $3.8 million or 37.4%. The first half of 2005
was a difficult  time for IES,  with a downturn in  revenues  and gross  profit,
ensuing from:  (i) a delay in a large-scale  installation  contract  pending the
government's  completion of a building to house the system's Command and Control
Center;  (ii)  a  reduction  in an  ongoing  governmental  integration  program,
resulting from the  Department of Defense's  base  relocation and closure (BRAC)
program;  (iii) delays in several significant  awards,  because funding had been
redirected to the war efforts in Iraq and  Afghanistan;  and (iv) a delay in the
start-up of a 5-year, $25 million security contract with the Bureau of Engraving
& Printing ("BEP"), due to an award protest by the predecessor  contractor.  IES
is currently  performing work under the BEP contract although due to the protest
the BEP has  decided  to put the  contract  out for  re-bid  later in  2007.  In
addition,  revenue  from  Signami  since  its  acquisition  in July 2006 of $1.4
million is included in IES's 2006 revenues.

                                       16
<PAGE>


Revenues from the Public  Safety and Justice  segment were $45.1 million for the
year ended December 31, 2006, an increase from $43.9 million for the same period
of 2005,  representing  an  increase  of $1.2  million  or  2.7%.  PS&J has been
experiencing  lower  backlogs and has increased its focus on developing its next
generation  products.  Beginning  in the fourth  quarter of 2005 and  continuing
through  2006,  PS&J  redeployed  a portion of its  technical  staff,  typically
deployed in the  research  and  development  area,  to work on projects and thus
increase  quarterly  revenues.  It should be noted that  although  we made three
acquisitions in this segment, two in 2004 (90 Degrees and Copperfire) and one in
August  2005  (Xanalys),  these  acquisitions  have had little  impact on Public
Safety and Justice's revenues due to their relatively small size.

Expenses.  Cost of goods sold of $99.6  million for the year ended  December 31,
2006 were up $0.5 million or 0.5% from $99.1  million  during the same period of
2005.  The larger  percentage  increase in sales as  compared to the  percentage
increase in cost of goods sold resulted in an increased gross profit  percentage
of 32.5% for the year ended December 31, 2006, as compared to 30.0% for the year
ended December 31, 2005.

Cost of  goods  sold in the  Institutional  Security  Systems  segment  of $40.9
million for the year ended  December  31, 2006 were down $9.8  million or 19.4%,
from $50.8 million  during the same period of 2005.  This decrease  coupled with
the related sales decrease of this segment of 20.4%, resulted in a 1.1% decrease
in the gross profit  percentage to 15.2% from 16.3% for the year ended  December
31, 2005.  The decrease in the gross  profit  percentage  is largely a result of
ISS' fixed costs now being absorbed by a smaller revenue base during the year of
2006.  In  addition,  during the first  quarter of 2005,  one of this  segment's
customers terminated its contract for convenience,  resulting in the recognition
of $1.3 million in gross margin.

Cost of goods sold in the Attack  Protection  segment of $27.2  million  for the
year ended  December 31, 2006 increased $6.2 million or 29.9% from $20.9 million
during the same period of 2005.  This  increase was less than the related  sales
increase of 48.9%,  resulting in an 9.9% increase in the gross profit percentage
to 32.5% from 22.6%  during the year ended  December  31,  2005.  The  principal
reason for the  increase in the gross  profit  percentage  during the year ended
December 31, 2006, as compared to the year ended  December 31, 2005, was a shift
in product mix and a significant increase in facility utilization as a result of
the significant increase in sales of this segment.

Cost of goods sold in the Integrated Electronic Systems segment of $10.9 million
for the year ended  December 31, 2006  increased $2.4 million or 28.6% from $8.5
million during the same period of 2005.  This increase was largely the result of
the  acquisition of Signami in July 2006,  whose gross margins tend to be higher
than those of what this segment's historical margins had been. This increase was
less than the related  sales  increase of this segment of 37.4%,  resulting in a
5.4%  increase in the gross  profit  percentage  to 21.5% from 16.1% in the year
ended  December 31,  2005.  Substantially  all of the  projects  awarded in this
segment are discrete projects.

Cost of goods sold in the Public Safety and Justice segment of $20.6 million for
the year ended  December 31, 2006 was up $1.6 million or 8.7% from $19.0 million
during 2005.  This increase was greater than the related sales  increase of this
segment of 2.7%,  resulting in a 2.5% decrease in the gross profit percentage to
54.3% from 56.8% in the year ended December 31, 2005.

Selling,  general and  administrative  expenses  were $38.3 million for the year
ended  December 31, 2006, a decrease of $2.3 million or 5.7% from $40.6  million
for the same period of 2005.  Much of this decrease is related to costs incurred
by the Company  during 2005 related to  compliance  with Section 404 of SOX. The
Company exited  accelerated  filer status as of December 31, 2005 and remained a
non-accelerated filer in 2006.

In conjunction  with the  acquisition  of the assets of Signami,  90 Degrees and
Copperfire  and the  stock  of  Xanalys  and in  compliance  with  Statement  of
Financial  Accounting  Standards No. 141 (SFAS 141) Business  Combinations,  the
Company  determined  the fair  value of the  following  identifiable  assets and
assigned the indicated lives for the purposes of amortization and depreciation.

                               December 31,      December 31,
                                   2006              2005             Life
                              (in thousands)    (in thousands)     (in years)
                              --------------    --------------     ----------
    Software                     $ 3,064           $ 2,434              5
    Non Compete Agreements           590               130             3-5
    Customer Relationships           780                 -              7
    Other                             60                60             15
                                 --------          --------
                                 $ 4,494           $ 2,624
                                 ========          ========

The  amortization  of  the  above  assets  resulted  in  the  Company  recording
amortization  expense related to these assets of $673 thousand and $525 thousand
for the years ended December 31, 2006 and 2005, respectively,  which is included
in operating expenses.

                                       17
<PAGE>


Research and development  expenses were $7.3 million for the year ended December
31,  2006,  a decrease of $1.4  million or 16.0% from $8.7  million for the year
ended December 31, 2005.  Being a  technology-driven  enterprise,  the Company's
Public Safety and Justice segment  continually updates and enhances its software
offerings,  thus incurring  significant  research and development costs.  During
September of each year, Tiburon hosts its annual users group conference which is
attended by approximately 400 client personnel. During 2005, to be in a position
to  adequately  demonstrate  the  segment's  new Nextgen  products,  the Company
diverted significant resources to its research and development effort to advance
the  demonstrability of its updated product offerings.  As the Company's Nextgen
product  development effort advances towards  completion,  the need for research
and  development  on its core  products  diminishes,  which  has  resulted  in a
decrease in research and development expenditures during the year ended December
31, 2006 as compared to the year ended December 31, 2005.

The impairment of goodwill and  intangible  assets totaled $16.1 million for the
year ended December 31, 2006. The Company reviews the carrying value of goodwill
annually  during the fourth quarter of the year or whenever events or changes in
circumstances  indicate that the carrying value may not be recoverable.  Changes
in estimates of future cash flows caused by items such as  unforeseen  events or
changes in market  conditions could negatively  affect the reporting unit's fair
value and result in an impairment charge.  During the fourth quarter of 2006 the
Company  concluded that an impairment  occurred in its Public Safety and Justice
segment. The Company performed its interim impairment test of the reporting unit
as of October 1, 2006 and based on its  valuation  concluded it was necessary to
write down the value of the segment's  goodwill in the amount of $14.4  million.
The Company reviews the carrying value of intangible  assets when  circumstances
indicate  that the  carrying  value may not be  recoverable.  During  the fourth
quarter of 2006 the Company  concluded  that an  impairment  had occurred in its
Public Safety and Justice segment.  The Company performed its impairment test of
intangible assets as of October 1, 2006 and based on its valuation  concluded it
was necessary to write down the value of the intangible  assets in the amount of
$1.7 million.  These valuations are performed by the Company with the assistance
of an independent  national  valuation firm which considers  market  valuations,
discounted cash flows and other factors when preparing the valuations.

Pre-Tax  Income.  The Company had a pre-tax  loss of $15.7  million for the year
ended  December 31, 2006 compared to a pre-tax loss of $8.9 million for the year
ended December 31, 2005. As discussed below, the increased pre-tax loss occurred
primarily due to the impairment of goodwill and other  intangible  asset charges
at our Public Safety and Justice segment.  This was partially offset by improved
results in our Attack Protection segment.

Pre-tax loss from the  Institutional  Security  Systems segment was $1.3 million
for the year ended  December 31, 2006, a decrease from a pre-tax  income of $629
thousand  for the year ended  December  31,  2005.  This  decrease was largely a
result of this segment's sales decline.

Pre-tax income from the Attack Protection  segment was $4.7 million for the year
ended December 31, 2006, an improvement  from the $2.3 million  pre-tax loss for
the year ended  December  31,  2005.  This  increase in pre-tax  income for this
segment is attributable to the significant  increase in this segment's revenues,
amplified by the fact that products with higher margins were sold during 2006 as
compared to 2005.

Pre-tax income from the Integrated  Electronic Systems segment was $985 thousand
for the year ended  December 31, 2006, an increase from a $431 thousand  pre-tax
income for the year ended December 31, 2005.  This increase in pre-tax income is
a result of the increased  revenue generated by this segment in 2006 as compared
to 2005,  which  includes  revenues  from  the new  signals  intercept  business
acquired by  Integrated  Electronic  Systems  during the third  quarter of 2006,
which contributed revenues with higher margins to this segment.

Pre-tax loss from the Public  Safety and Justice  segment was $18.0  million for
the year ended December 31, 2006 which included a goodwill  impairment charge of
$14.4 million and an intangible  asset impairment  charge of $1.7 million.  This
segment is making a significant  investment  in advancing  its products  using a
Microsoft.net  platform.  As a  result  of  this  undertaking,  which  has  been
previously  expensed,  reported  earnings  have been  adversely  affected.  This
compares to a $2.9 million  pre-tax  loss for the year ended  December 31, 2005.
This net improvement  prior to the impairment  charges in this segment's pre-tax
loss,  is  largely  a result  of a  significant  reduction  in  costs  including
headcount by this segment in its effort to return to profitability.

Pre-tax loss at the Corporate level was $2.1 million for the year ended December
31,  2006 as  compared  to a pre-tax  loss of $4.7  million  for the year  ended
December 31, 2005. During 2005, the Company incurred significant costs to comply
with Section 404 of the Sarbanes  Oxley Act,  which the Company was not required
to incur in 2006 having exited accelerated filing status in 2005.

Interest  expense was $3.3 million and $3.1 million for the years ended December
31, 2006 and December 31, 2005,  respectively.  The following table compares the
weighted average of the Company's year ended December 31, 2006 and 2005 interest
bearing  borrowings,  which  includes  bank  letters  of  credit  fees  for  the
industrial revenue bonds, and the related rates charged thereon:

                                       18
<PAGE>


                                 Monthly Weighted         Monthly Weighted
                                  Average - 2006           Average - 2005
                                  Amount                   Amount
                              (in thousands)   Rate    (in thousands)   Rate
                              --------------   ----    --------------   ----
    Industrial revenue bonds     $  3,319      6.3%       $  3,722      3.7%
    Subordinated borrowings      $ 40,250      6.3%       $ 40,250      6.3%
    Swap hedge agreement         $      -        -        $  1,015      1.4%

The Company also incurred letter of credit fees, in addition to those related to
the industrial revenue bonds, of $141 thousand and $26 thousand for the years
ended December 31, 2006 and 2005, respectively.

In addition the Company recorded the following non-cash interest expense, in
thousands:
                                             2006          2005
      Amortization and write-off            ------        ------
     of deferred financing charges          $ 329         $ 283

Other  income  benefited  during  2006 by  receipt of $161  thousand  in a legal
settlement by the Attack Protection segment.

Taxes on Income. The effective tax rate was a benefit of 4.7% for the year ended
December 31, 2006 and the  effective tax rate was a benefit of 2.4% for the year
ended  December  31,  2005.  The  Company  has  decided to  provide a  valuation
allowance  against its deferred tax assets, as it has determined that due to the
Company's  accumulated  deficit resulting from recent prior year losses there is
uncertainty  as to  whether  it is  more  likely  than  not the  assets  will be
realized.  The  Company  had  Federal  net  operating  loss carry  forwards  for
financial accounting purposes of $6.5 million at December 31, 2006.

Net Income (Loss). The Company reported a net loss of $15.0 million for the year
ended  December  31,  2006 and a net  loss of $8.7  million  for the year  ended
December 31, 2005.  Diluted loss per share was $1.82 for the year ended December
31, 2006 and a loss of $1.07 for the year ended  December 31, 2005. The weighted
average number of common shares  outstanding and  equivalents  used in computing
earnings per share was 8.3 million and 8.1 million for the years ended  December
31, 2006 and 2005, respectively.

YEARS ENDED DECEMBER 31, 2005 AND 2004

Revenues.  The Company had revenues of $141.6 million and $142.8 million for the
years ended December 31, 2005 and December 31, 2004, respectively,  representing
a decrease of $1.13 million or 0.8%. As discussed below,  the decrease  occurred
primarily from our IES and PS&J segments offset by increases from our ISS and AP
segments.

Revenues from the Institutional  Security Systems segment were $60.7 million for
the year ended  December 31, 2005,  an increase  from $54.0 million for the year
2004  representing  an  increase  of $6.7  million or 12.4%.  The  Institutional
Security Systems segment is largely a construction driven business.  Much of its
revenue is obtained by working on new and retrofit  construction projects in the
corrections  industry,  as opposed to sources of recurring revenue. As such, the
increase in revenue  experienced by this segment is largely  attributable to our
working on more projects than we did in the previous  year.  Backlog for ISS had
decreased  from $99.5  million at December 31, 2002 to $57.3 million at December
31, 2003.  Backlog was $49.3  million and $58.1 million at December 31, 2004 and
December  31,  2005,  respectively.  The years  2003 and 2004 were slow  bidding
periods for the Company.  Although the gross amount of construction  spending in
the corrections  area remained  relatively flat between 2003 and 2004, the types
of projects  that the Company  solicits,  namely  large-scale  medium to maximum
security installations,  declined significantly in 2003 and 2004. This situation
was  further  compounded  by the  general  state and local  governmental  budget
deficits  which  caused  these  governmental  units to rethink and delay many of
their  pending  corrections  projects.  Beginning  in  early  2005,  ISS  sought
significant,  heightened  bidding activity,  particularly in the market space it
serves,  namely large-scale  medium to maximum security prisons.  This increased
bidding activity was expected to result in securing more projects,  which should
result in  increased  revenue.  During the last  three  quarters  of 2005,  ISS'
backlog increased significantly providing the segment with a greater opportunity
to generate revenue during the second half of 2005.

Revenues  from the Attack  Protection  segment  were $27.0  million for the year
ended  December 31, 2005,  an increase from $25.2 million for the same period of
2004  representing  an increase of $1.9  million or 7.4%.  In 2002,  the Company
purchased  an  existing  75,000  square foot  factory for the Attack  Protection
segment  on 20 acres of land in  close  proximity  to its  existing  factory  in
Montgomery,  Alabama. This capacity increase was largely driven by the Company's
expectation that the demands for its products,  principally its bullet and blast
resistant windows and doors would accelerate significantly in the post September
11, 2001 world.  Throughout 2002,  2003, and 2004 this  anticipated  increase in
demand did not materialize leaving the segment with significant excess capacity.
This segment is composed of two chief product offerings, namely Norshield, which
encompasses bullet and blast resistant windows and doors and ancillary products,

                                       19
<PAGE>

and Fiber SenSys, which encompasses fiber optic intrusion detection systems. For
the year ended December 31, 2005 the Norshield line experienced a 14.6% increase
in revenues as compared to the year ended  December 31, 2004,  whereas the Fiber
SenSys line experienced a 10.8% decrease in revenues for the comparable  period.
The  increase  in revenue of $2.6  million  in the  Norshield  line was a direct
result of the  award of a major  contract  won in the  fourth  quarter  of 2005.
Execution on this contract began  immediately upon award.  Fiber SenSys' revenue
decline was a result of the rollout of its next generation product,  which until
its testing is completed,  expected in the first  quarter of 2006,  has and will
continue to negatively impact revenues. The slow-down in the government building
process  experienced  during 2002 and 2003 has reversed.  Projects are now being
released  for  construction,   and  thus  the  Attack   Protection   segment  is
experiencing  increased  bidding  activity for its  products.  During 2003,  the
Company furnished bids to supply its products for eight new embassy projects. At
the time,  this was the  largest  number  of  embassy  projects  bid in a single
calendar  year for this  segment.  The Company was awarded four of these embassy
projects,  for a total  CompuDyne  contract value of $7.0 million,  and lost the
remaining  four embassy  project  bids to  competitors.  During 2004,  we bid on
fifteen new embassy projects.  Through December 31, 2005 the Company was awarded
seven of these embassy projects for a total contract value of $9.6 million,  and
lost seven embassy project bids to competitors,  with one project still awaiting
award. In 2005, twenty-eight embassy projects were planned. We believe that this
increased level of new embassy  construction  will continue for the next several
years.  Through  December 31, 2005 the Company had been  awarded  three of these
projects,  one of which was for a total of $14.3  million,  and lost one project
and one bulk bid embassy project comprising eight embassies to competitors, with
sixteen projects still awaiting award.

Revenues  from  Integrated  Electronic  Systems were $10.1  million for the year
ended  December 31, 2005, a decrease  from $14.3  million for the same period of
2004 representing a decrease of $4.2 million or 29.3%. A significant  portion of
this segment's revenue is backlog driven.  Backlog at both December 31, 2003 and
December  31, 2004 was $8.3  million.  IES'  revenue  decline was largely due to
certain  government  clients,  for which the segment  receives repeat  business,
having had their  budgets  significantly  reduced.  This  decrease was partially
offset by a new $2.0  million  project.  The first half of 2005 was a  difficult
time for IES,  with a downturn in revenues  and gross  profit,  ensuing  from: a
delay  in  a  large-scale   installation  contract,   pending  the  government's
completion of the building to house the system's  Command and Control Center;  a
reduction in an ongoing  governmental  integration  program,  resulting from the
Department of Defense's base  relocation and closure (BRAC)  program;  delays in
several  significant  awards,  because  funding had been  redirected  to the war
efforts in Iraq and  Afghanistan;  and a delay in the start-up of a 5-year,  $25
million  security  contract,   due  to  an  award  protest  by  the  predecessor
contractor.

Revenues from the Public  Safety and Justice  segment were $43.9 million for the
year ended  December 31, 2005, a decrease from $49.4 million for the same period
of 2004  representing  a decrease  of $5.5  million or 11.2%.  The  decline  was
primarily the result of lower backlogs and an increased  focus on developing our
next  generation  product  which  resulted in more hours  worked on research and
development and less hours worked on revenue-generating  projects. Revenues were
also  impacted by  relatively  low  contract  signing  rates in early 2005,  low
billing rates and difficult  performance  requirements  on some  contracts.  The
lower levels of backlog did, however,  start to improve late in the year. During
the fourth quarter of 2005,  PS&J  redeployed a portion of its technical  staff,
typically  deployed in the research and  development  area, to work on projects,
resulting in increased  revenue.  It should be noted that although we made three
acquisitions in this segment, two in 2004 (90 Degrees and Copperfire) and one in
August 2005 (Xanalys), these acquisitions had little impact on Public Safety and
Justice's revenues due to their relatively small size.

Expenses.  Cost of sales of $99.1  million for the year ended  December 31, 2005
were down $6.0  million or 5.7% from  $105.1  million  during the same period of
2004.  The smaller  percentage  decrease in sales as compared to the  percentage
decrease in cost of goods sold resulted in an increased gross profit  percentage
of 30.0% for the year ended  December 31, 2005 as compared to 26.4% in 2004.  In
2004,  the  windows  and  door  component  of  the  Attack  Protection   segment
experienced  significant  operating   inefficiencies  and  difficulties.   These
inefficiencies  and difficulties,  which did not recur in 2005, reduced the 2004
gross profit percentage.

Cost of  goods  sold in the  Institutional  Security  Systems  segment  of $50.8
million for the year ended  December  31, 2005 were up $3.2 million or 6.8% from
$47.5  million  during the same period of 2004.  This increase was less than the
related sales increase of this segment of 12.4%, resulting in a 4.4% increase in
the gross profit  percentage to 16.3% from 11.9% for the year ended December 31,
2004. This increase in gross profit percentage  resulted mainly from one of this
segment's customers  terminating its contract for convenience,  resulting in the
recognition  of $1.3 million in gross  margin.  Starting in 2002 and  continuing
through 2004,  Institutional  Security  Systems'  senior  management  identified
managerial  problems at its West Coast  operations and determined  that numerous
problems  existed there,  including that the costs to complete its projects were
going to be significantly higher than was previously projected. This resulted in
significant cost overruns on many of these projects. As the work on the projects
progressed,  the Institutional  Security Systems segment  identified  additional
cost  overruns  which caused the costs to complete  these  projects to increase.
Although the problem projects identified in 2002 are substantially all complete,
the  problems in the ISS West Coast  operations  continued  into 2003,  2004 and
2005. The West Coast office continues to be affected by one final contract which
requires ISS to install a  proprietary  duress  system which has been  validated
through an independent consultant and the manufacturer of the equipment but will


                                       20
<PAGE>

not  function as  required  by the  contract  specifications.  ISS has  incurred
significant costs trying to make the equipment function as desired. The customer
is  working  with ISS to  develop  a level of  acceptance,  and both ISS and the
customer  are  cooperating  to close out the project in an amicable  manner.  We
believe that all future costs on these projects have been  adequately  accounted
for through  December 31, 2005.  Senior  management at the West Coast operations
has been replaced as well as certain project  management and engineering  staff.
It should be noted that the West Coast office has been  downsized to a sales and
support  office,  consolidating  the  estimating,  electronics  engineering  and
electronics  fabrication  functions into the Montgomery home office. The project
management  and hard line  engineering  staff has been  upgraded to  experienced
professional  personnel,  and this office  only  manages  projects  specifically
suited to their  expertise  or as  required by the local  marketplace.  The West
Coast office  realized  eleven  consecutive  months of positive gross margins on
such projects in 2005.  Despite these  positive  gross  margins,  the West Coast
office  experienced  high legal and overhead  costs  closing out many of the old
projects.  While this  resulted in an overall loss at the West Coast  operation,
the office was also able to  significantly  reduce  aged  receivables  and filed
multiple  claims  for  possible  future  upside  recovery.  The office is in the
process of moving its  facilities to a smaller,  more cost  effective  facility,
which will further reduce overhead costs in the future.

The West Coast problems,  including project overruns, resulted in pre-tax losses
recorded in the following periods, in thousands:

         Second Half of 2002                                 $  2,698
         Full Year 2003                                         4,087
         Full Year 2004                                         6,092
         First Quarter of 2005                                    740
         Second Quarter of 2005                                   472
         Third Quarter of 2005                                    399
         Fourth Quarter of 2005                                   417
                                                             ---------
             Total West Coast Losses                         $ 14,905
                                                             =========

To  address  this  situation,  the  Company  has  implemented  more  centralized
controls,  replaced  certain  personnel  at its West  Coast  operations  and its
Alabama headquarters, and has reorganized the function of the West Coast office.

Cost of goods sold in the Attack  Protection  segment of $20.9  million  for the
year ended  December 31, 2005 decreased $2.7 million or 11.4% from $23.6 million
during the same period of 2004. This decrease was not proportional when compared
to the  relative  sales  increase,  resulting  in a 16.4%  increase in the gross
profit  percentage  to 22.6% from 6.2% during the year ended  December 31, 2004.
Significant  factors  contributing to this increase in gross profit included the
fact that in 2004,  significant  operating  inefficiencies and difficulties were
experienced  by the  windows  and  doors  components  of the  Attack  Protection
segment.  These  inefficiencies and difficulties  amounted to approximately $1.9
million, which contributed to the reduction of the 2004 gross profit percentage.
They did not recur in 2005 due to new senior  management  hired in January  2005
that has reduced  manufacturing  and overhead  costs.  In addition,  one of this
segment's  customers  terminated its contracts for convenience  during the first
quarter of 2005 resulting in the recognition of $0.2 million in gross margin due
to contract closeout activities.

Cost of goods sold in the Integrated  Electronic Systems segment of $8.5 million
for the year ended  December 31, 2005 decreased $3.8 million or 30.9% from $12.3
million during the same period of 2004.  This decrease was  consistent  with the
related sales decrease of this segment of 29.3%, resulting in a 2.0% increase in
the gross profit  percentage to 16.1% from 14.1% in the year ended  December 31,
2004.  Substantially  all of the  projects  awarded in this segment are discrete
projects.

Cost of goods sold in the Public Safety and Justice segment of $19.0 million for
the year ended December 31, 2005 was down $2.7 million or 12.7% from $21.7
million during 2004. This decrease was more than the related sales decrease of
this segment of 11.2%, resulting in a 0.8% increase in the gross profit
percentage to 56.8% from 56.0% in the year ended December 31, 2004.
Substantially all of the projects awarded in this segment are discrete projects.

Selling,  general and  administrative  expenses  were $40.6 million for the year
ended December 31, 2005, an increase of $4.3 million or 12.0% from $36.2 million
for the same  period of 2004.  Much of this  increase  is related to  additional
costs  incurred  by the  Company  related to  compliance  with new  requirements
mandated  by  the   Sarbanes-Oxley   Act  and  the  SEC.  The  Company  expended
approximately  $0.4  million to perform its 2003 audit,  which did not require a
SOX 404 report.  This was paid to our independent  registered  public accounting
firm for audit and audit  related  services.  For the 2004  audit,  the  Company
expended $3.2 million for external  third party costs to complete its 2004 audit
and its SOX 404 report. Of this amount,  approximately  $2.5 million was paid to
our independent  registered  public  accounting firm for audit and audit related
services  with the  balance  paid to  various  consultants  and  others who have
assisted the Company in the 404 process.  Expenses  related to audit and SOX 404
of $2.1 million and $1.9 million were recorded  during the years ended  December
31, 2005 and 2004,  respectively,  for  services  provided or accrued for during
these periods. In addition,  AP's selling,  general and administrative  expenses
increased by $1.2  million or 24.8%  during the year ended  December 31, 2005 as
compared to the year ended  December  31,  2004.  This  increase was largely the
result of increased legal costs  associated  with ongoing claims  resolutions in
actions both as plaintiff and  defendant and for increased  selling and training
costs as the  segment is trying to expand its  presence  into new  marketplaces.
PS&J's selling, general and administrative expenses increased by $1.8 million or
10.3%  during the year ended  December  31,  2005 as  compared to the year ended
December 31, 2004.  This increase was largely the result of increased  headcount
and related costs from the three  acquisitions made by PS&J in 2004 and 2005. In
addition,  the Xanalys  acquisition  contributed  approximately $600 thousand to
this increase.

                                       21
<PAGE>


In conjunction  with the  acquisition of the assets of 90 Degrees and Copperfire
and  the  stock  of  Xanalys  and in  compliance  with  Statement  of  Financial
Accounting  Standards  No. 141 (SFAS 141)  Business  Combinations,  the  Company
determined the fair value of the following  identifiable assets and assigned the
indicated lives for the purposes of amortization and depreciation.

                                       Amount
                                   (in thousands)    Life (in years)
                                   --------------    ---------------
Software                               $ 2,434              5
Non Compete Agreements                     130              3
Tradename                                  60              15
                                       --------
                                       $ 2,624
                                       ========

The  amortization  of  the  above  assets  resulted  in  the  Company  recording
amortization  expense related to these assets of $582 thousand and $178 thousand
for the years ended December 31, 2005 and 2004, respectively,  which is included
in operating expenses.

In an effort to further  reduce costs,  during 2005 the Company  eliminated  the
position of Chief  Operating  Officer  and had its  division  Presidents  report
directly to the Company's CEO.

Research and development  expenses were $8.7 million for the year ended December
31,  2005,  an increase of $0.9  million or 12.0% from $7.8 million for the same
period of 2004.  Being a  technology-driven  enterprise,  the  Company's  Public
Safety and  Justice  segment  continually  updates  and  enhances  its  software
offerings,  thus incurring  significant  research and development costs.  During
2005 Public  Safety and Justice  started  investing  in its next  generation  of
products and expended $884  thousand for this project,  and is expected to spend
$2.5 million and $1.0 million in 2006 and 2007, respectively.

Interest  expense  was $3.1  million for the year ended  December  31,  2005,  a
decrease of $0.2  million or 7.1% from $3.3 million for the same period of 2004.
The following table compares the weighted average of the Company's twelve months
ended December 31, 2005 and 2004 interest bearing borrowings,  in thousands, and
the related rates charged thereon:

                                 Monthly Weighted        Monthly Weighted
                                  Average - 2005          Average - 2004
                                   Amount    Rate          Amount    Rate
                                 ---------  ------       ---------  ------
Bank borrowings                  $      -      -%        $    617    4.2%
Industrial revenue bonds         $  3,722    3.7%        $  4,162    3.1%
Subordinated borrowings          $ 40,250    6.2%        $ 40,250    6.2%
Swap hedge agreement             $  1,015    1.4%        $  3,721    3.6%

In addition the Company recorded the following non-cash interest expense, in
thousands:

Amortization and write-off
 of deferred financing charges   $    283                $    600

Taxes on Income. The effective tax rate was a benefit of 2.4% for the year ended
December 31, 2005 and the effective tax benefit rate was approximately 21.4% for
the year ended  December 31, 2004. The Company's tax benefit of $2.2 million for
the year ended December 31, 2004 was primarily a result of the Company's ability
to carryback the loss incurred in 2004 to prior years,  resulting in Federal and
State tax receivables.  Since all available tax loss prior year receivables were
used via the 2004  carrybacks,  no such receivables were available to offset the
December 31, 2005 losses generated by the Company.  The tax benefit for the year
ended  December  31,  2005 is  primarily  a result of $500  thousand  previously
recorded as a reserve for  uncertain tax  positions  which is no longer  needed,
partially  offset by state tax  expenses.  The  Company has decided to provide a
valuation  allowance  against its deferred tax assets, as it has determined that
due to the Company's  recent operating losses there is uncertainty as to whether
more likely than not the assets will be realized.  The Company had net operating
loss carryforwards for financial accounting purposes of $8.9 million at December
31, 2005.

                                       22
<PAGE>


Net Loss.  The  Company  reported a net loss of $8.7  million for the year ended
December 31, 2005 and a net loss of $8.2 million for the year ended December 31,
2004. Diluted loss per share was a loss of $1.07 for the year ended December 31,
2005 and a loss of $1.01 for the year ended  December  31,  2004.  The  weighted
average number of common shares  outstanding and  equivalents  used in computing
EPS was 8.1 million in both 2005 and 2004.

Liquidity and Capital Resources

The  Company  funds  its  operations  through  cash  flows  generated  from  its
operations,  bank and public  financings,  and the sale of its common stock. The
Company's  liquidity  requirements  arise  from  cash  necessary  to  carry  its
inventories and billed and unbilled receivables,  for capital  expenditures,  to
repurchase  shares of its common stock under its share repurchase  program,  for
payments of principal and interest on  outstanding  indebtedness,  and to retire
its 2011 Notes. The ultimate clients of the Company are primarily federal, state
and local  governmental  units.  In the event the funding of these  governmental
units is reduced for any reason,  including budgetary reductions due to economic
conditions, there is a risk that the demand for the Company's goods and services
would decrease which would reduce the availability of funds to the Company.

As of December  31,  2006,  the Company  had  working  capital of $31.0  million
compared with $35.3 million as of December 31, 2005.

Net cash provided by operating activities was $6.3 million during the year ended
December 31, 2006 versus $3.6 million  used in operating  activities  during the
year ended  December  31,  2005.  The  largest  component  of cash  provided  by
operating  activities  was a decrease in accounts  receivable of $14.2  million,
which was  partially  offset by a  decrease  in  accounts  payable  and  accrued
liabilities of $8.9 million.

Net cash  used in  investing  activities  was $0.3  million  for the year  ended
December  31,  2006  compared to net cash  provided of $6.5  million in the year
ended  December  31,  2005.  In the year ended  December  31,  2006,  the net of
marketable  securities  bought  and  redeemed  was an  increase  of cash of $2.5
million.  In the year ended  December 31, 2005 the net  redemption of marketable
securities was $8.0 million.

Net cash used in financing activities amounted to $5.2 million for the year
ended December 31, 2006 compared with net cash used in financing activities of
$1.1 million in the year ended December 31, 2005.

The following table summarizes contractual obligations consisting of total notes
payable,  related  interest,  non-cancelable  operating  lease  obligations  and
purchase obligations of the Company as of December 31, 2006 and the payments due
by period, in thousands.

                             Interest on  Non-Cancelable
                    Notes    Contractual     Operating     Purchase
                   Payable   Obligations      Leases      Obligations
                  ---------  -----------  --------------  -----------
 December 31:
     2007         $    440    $  2,632       $  3,203       $ 8,363
     2008              440       2,614          2,670             -
     2009              440       2,596          2,179             -
     2010              440       2,578          1,747             -
     2011           40,690         147          1,356             -
 Thereafter            925         376            381             -
                  ---------   ---------      ---------      --------
 Totals           $ 43,375    $ 10,943       $ 11,536       $ 8,363
                  =========   =========      =========      ========

The Company enters into purchase  obligations to procure equipment and services,
including  subcontractor   contracts,  in  the  performance  of  the  day-to-day
operations of its business.  Substantially  all of these obligations are covered
by our  existing  backlog  and the  revenues  generated  by these  backlogs  are
expected to be sufficient to meet any payment  obligations  resulting from these
purchase commitments.

On January 22, 2004, the Company  completed the offering of the 2011 Notes.  The
offering was for $40.25 million principal  amount.  The 2011 Notes bear interest
at the rate of 6.25% per annum, payable semi-annually,  and are convertible into
shares of common stock at a conversion  price of $13.89 per share.  The proceeds
from the  2011  Notes  were  used to repay  substantially  all of the  Company's
outstanding bank borrowings.

On November 21, 2006,  CompuDyne  Corporation  ("CompuDyne")  and William  Blair
Mezzanine Capital Fund II, L.P.  ("Blair") entered into a Release and Settlement
Agreement with Friedman,  Billings,  Ramsey Group,  Inc.  ("FBR"),  by which FBR
agreed to pay $4.5 million to CompuDyne and Blair, CompuDyne and Blair agreed to
release FBR,  and FBR agreed to release  CompuDyne  and Blair,  from any and all
causes of action arising out of or relating to, among other things,  an offering
of CompuDyne  common stock in 2001 for which FBR acted as lead  underwriter  and
financial  advisor.  Blair is former  shareholder  of CompuDyne  which also sold
shares in the 2001  offering.  After  legal and other  expenses  and  payment of
Blair's  share of the  settlement,  the net amount  recorded  by  CompuDyne  was
approximately $2.7 million which is recorded in additional paid-in capital.

                                       23
<PAGE>


On December 19, 2005, the Company and its bank entered into a Second Amended and
Restated Revolving Credit and Security Agreement (the "Credit  Agreement").  The
Credit Agreement  amended and restated the Company's Amended and Restated Credit
Agreement dated March 31, 2004.

In connection with the execution of the Credit  Agreement,  the Company provided
the bank with  collateral  that  includes all  receivables,  equipment,  general
intangibles,  inventories,  investment  property,  real  property and a security
interest in subsidiary  stock. The Credit Agreement allows the Company to obtain
revolving  advances  in a  principle  amount  of up to  $20  million.  Revolving
advances  are limited by a borrowing  base  formula  based upon the value of the
Company's receivables,  inventories, fixed assets, real property, and issued and
outstanding  letters of credit.  The maximum aggregate face amount of letters of
credit that may be drawn under the Credit  Agreement  is limited to $18 million.
The Credit Agreement matures on December 18, 2008.

Revolving advances under the Credit Agreement bear interest,  at the election of
the  Company,  at a variable  rate  equal to the  alternate  base rate,  a prime
interest  based rate, or the  Eurodollar  rate plus two percent.  For letters of
credit,  the Company  pays an amount  equal to the average  daily face amount of
each  outstanding  letter of credit  multiplied by two percent per annum,  and a
fronting  fee of one  quarter  of one  percent  per annum,  together  with other
administrative fees and charges.  The Company paid its bank a closing fee of $50
thousand  in  connection  with  the  execution  of the  Second  Restated  Credit
Agreement.  The Company is also  required to pay the bank an unused fee equal to
three-eighths  of one  percent  per annum of the  amount  by which  $20  million
exceeds the average daily unpaid  balance of the revolving  advances and undrawn
amount of any  outstanding  letters  of  credit.  In  addition,  the  Company is
required to pay a collateral monitoring fee equal to $1 thousand per month and a
collateral evaluation fee as required.

The  Credit  Agreement  contains  various  affirmative  and  negative  covenants
including  financial   covenants.   The  Company  is  required  to  maintain  an
unrestricted  undrawn  borrowing  base  availability  of at  least  $5  million.
Commencing  with the fiscal quarter ended June 30, 2006, the Company is required
to maintain a fixed  charge  coverage  ratio of at least 1.1 to 1.0. The Company
was in compliance with this ratio during the applicable period in 2006.

On July 14, 2006,  the Company and its banks  entered into a First  Amendment to
Second Amended and Restated  Revolving Credit and Security Agreement (the "First
Amendment").  The First Amendment amended the Credit Agreement to (i) modify the
borrowing base, (ii) permit any Borrower to guaranty certain indebtedness of any
other  Borrower,  (iii)  increase  the  maximum  limit of  rental  payments  for
non-capitalized  leases  from $3  million to $4 million  per fiscal  year,  (iv)
permit the Company, subject to certain conditions, to repurchase or redeem up to
$2.0 million of the Company's 6.25% Convertible  Subordinated  Notes due January
15, 2011 and (v) consent to an acquisition by a newly formed indirect subsidiary
of the Company pursuant to an asset purchase transaction.

On December 5, 2006,  the Company and its banks entered into a Second  Amendment
to Second Amended and Restated  Revolving Credit Security Agreement (the "Second
Amendment").  The Second  Amendment  amended the Credit  Agreement to reduce the
interest rate being charged on Eurodollar  loans and the letter of credit fee by
0.5%.

On March 28, 2007,  the Company and its banks entered into a Third  Amendment to
Second Amended and Restated  Revolving Credit and Security Agreement (the "Third
Amendment").  The Third Amendment  amended the Credit  Agreement by (i) amending
the definition of EBITDA to exclude from the  calculation of EBITDA any non-cash
impairment  charges against goodwill and other intangible assets incurred by the
Company's  subsidiary,  Tiburon,  Inc., during the fiscal quarter ended December
31, 2006, (ii) increasing the aggregate  maximum  permissible  amount of capital
expenditures in any fiscal year to $2.5 million;  (iii)  permitting the Company,
subject to certain  conditions,  to  purchase  or redeem up to $8 million of the
Company's  6.25%  Convertible  Subordinated  Notes due  January 15,  2011,  (iv)
permitting  the Company to deliver its  audited  financials  for the fiscal year
ended  December 31, 2006 by no later than April 30, 2007 and (v)  permitting the
Company's annual projected  operating budget and cash flow projections be broken
down on a quarterly basis versus a monthly basis.

The  Company's  total  outstanding  borrowings  at December 31, 2006 amounted to
approximately  $43.4  million,  less  broker's  discounts  in the amount of $0.8
million.  The 2011 Notes accounted for $39.5 million, net of broker's discounts,
of  these  borrowings.  The  remaining  amount  of $3.1  million  resulted  from
borrowings  at variable  rates and  consisted of two  industrial  revenue  bonds
outstanding  in the  amounts  of $1.1  million  and $2.0  million.  The  average
interest  rate  charged to the Company at December  31, 2006 for its  industrial
revenue  bonds  was  4.1%.  The  variable  interest  rate for  these  borrowings
fluctuated  between 3.1% and 4.2% during the year ended  December 31, 2006 based
on weekly  market  conditions.  These  bonds are  fully  collateralized  by bank
letters  of credit  issued  under  the  Credit  Agreement.  The  Company's  bank
considers  letters of credit as  outstanding  borrowings  when  considering  the
amount of availability the Company has remaining under its line of credit.

                                       24
<PAGE>


At December 31, 2006 the Company had $16.8 million of unused  availability under
the Second Restated Credit Agreement,  subject to the availability of collateral
under its line of credit.

The Company  anticipates  that cash generated from  operations and its currently
available  cash will enable the Company to meet its liquidity,  working  capital
and capital  expenditure  requirements  during the next 12 months.  The Company,
however,  may require  additional  financing  to meet its  long-term  liquidity,
working  capital and capital  expenditure  requirements.  If such  financing  is
required,  there are no assurances  that it will be available,  or if available,
that it can be obtained on terms  favorable to the  Company.  From time to time,
the Company may be party to one or more non-binding  letters of intent regarding
material  acquisitions,  which,  if  consummated,  may be paid for with  cash or
through the issuance of a significant  number of shares of the Company's  common
stock.

The Company  recorded  significant  losses in fiscal 2004,  2005,  and 2006.  We
recognize  that  sustaining  profitability  is a  critical  objective  which the
Company must attain.  The Company continued to have a significant amount of cash
and  marketable  securities on its balance sheet at December 31, 2006,  however,
the Company must sustain its  profitability  prior to depleting its current cash
and marketable securities.

On May 2, 2005, we filed a Form 8-K disclosing  that we failed to timely file an
amendment to our Annual Report on Form 10-K for the year ended December 31, 2004
to provide  management's  report on internal control over financial reporting as
of December 31, 2004 and the related report of our independent registered public
accounting  firm on  management's  assessment of the  effectiveness  of internal
control  over  financial  reporting  (together,  the "404  Report")  required by
Section 404 of the  Sarbanes-Oxley  Act of 2002.  On May 3, 2005,  the Company's
bank  confirmed in writing that there will not be any event of default under the
various credit agreements, by virtue of the Company's failure to file its report
required by Section 404 of Sarbanes-Oxley in a timely manner.

On May 4, 2005, we received a notice from the Listing Qualifications  Department
of The Nasdaq  Stock  Market  stating that due to our failure to timely file the
404 Report, we were no longer in compliance with the requirements of Marketplace
Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports
required to be filed with the  Securities  and Exchange  Commission on or before
the date they are required to be filed with the SEC.

On June 27, 2005,  the Company filed its Form 10-K/A with the SEC containing the
404 Report.  On June 30, 2005, the Nasdaq Listing  Qualifications  Panel advised
CompuDyne  that  CompuDyne had remedied its filing  delinquency  and was in full
compliance with Nasdaq Market Place Rules.

Another  consequence of not filing the 404 Report timely as noted above includes
our  inability to use a shorter form  registration  document for one year in the
event we were to engage in an offering of our securities. This could have had an
adverse impact on our ability to raise capital and the cost of raising  capital.
This consequence lapsed on June 27, 2006.

Off-Balance Sheet Arrangements

Other than the Company's  letters of credit,  which  amounted to $3.2 million at
December  31,  2006,  the  Company  has no  other  material  off  balance  sheet
liabilities.

Additional Considerations

Bid Bonds and Payment and Performance Bonds
In the conduct of our business we are often  required by our customers to obtain
payment and/or  performance  bonds. The majority of these bonds have been needed
in the ISS and PS&J segments.  Recently,  approximately  60% of ISS' revenue has
come from jobs where  payment and  performance  bonds are required and for PS&J,
19% of its revenue has required  payment and  performance  bonds.  The Company's
recent  losses  have made it more  challenging  for the  Company  to obtain  the
bonding needed to secure  certain of its projects.  As of December 31, 2006, the
Company was required to provide  collateral to its primary bonding company which
it did by placing cash, invested in a money market mutual fund, as collateral in
the  amount of $7.5  million.  If we are  unable to  obtain  such  bonds for any
reason, or if the terms, particularly collateral requirements,  of the bonds are
not within our financial means, it would  significantly  diminish our ability to
secure new contracts,  and consequently our financial performance and results of
operations may be materially adversely affected.

                                       25
<PAGE>


Cost Containment
Due to current economic conditions, the Company's losses in 2004, 2005 and 2006,
and in light of a very strong  competitive  environment,  the Company recognizes
that its  ability to increase  the prices it charges its clients is limited.  In
addition,  in light of significant  selling,  general and  administrative  costs
associated with the current heightened regulatory environment, we are evaluating
our strategy to determine if a revised  strategy  would result in lower selling,
general  and  administrative  costs.  As a  result,  in  order  to  enhance  our
profitability, the Company will continue to seek ways to reduce its costs.

Total Backlog
CompuDyne's  backlog amounted to $117.3 million at December 31, 2006. This was a
decrease  of 20.8%  from the  Company's  December  31,  2005  backlog  of $148.1
million.  The break down of the Company's  backlog by segment is as follows,  in
thousands:

                                      December 31,      December 31,
                                          2006              2005
                                      ------------      ------------
    Institutional Security Systems    $    64,687       $    58,128
    Attack Protection                       5,686            28,802
    Integrated Electronic Systems           7,902             7,503
    Public Safety and Justice              39,067            53,705
                                      ------------      ------------
        Total                         $   117,342       $   148,138
                                      ============      ============

The  decline in backlog  could lead to a potential  decline in future  quarterly
revenues.

Included in the backlog of the ISS, AP and PS&J segments at December 31, 2006 is
$19.6 million, $2.1 million and $3.7 million, respectively,  representing awards
received by the segment for which the clients  have not yet entered  into signed
contracts. These awards are expected to result in signed contracts over the next
twelve months.

Corporate Reorganization
As part of the Company's  efforts to better  manage its costs,  during the first
quarter of 2005 the Company  implemented a corporate  reorganization  whereby it
converted several corporate entities into LLCs (Limited Liability Corporations).
This activity was designed to improve the Company's tax reporting  structure and
should  help  better  manage the  Company's  state  income tax  obligations.  In
conjunction  with this  reorganization,  our  Federal  Security  Systems  group,
formerly   known   as   Quanta   Systems    Corporation,    was   re-formed   as
CompuDyne-Integrated Electronics Division, LLC. In addition, CorrLogic, Inc. was
converted  to  CorrLogic,  LLC and Fiber  SenSys,  Inc.  was  converted to Fiber
SenSys,  LLC.  The  impact  of this  reorganization  is not  expected  to have a
material  effect on  operations.  In addition,  in light of escalating  selling,
general  and  administrative   costs  associated  with  the  current  heightened
regulatory environment,  we are evaluating our structure to determine if another
organizational   structure   would   result  in  lower   selling,   general  and
administrative costs.

Critical Accounting Policies and Estimates

Percentage of Completion  Accounting and Revenue Recognition.  A majority of the
Company's  revenues  are  derived  from  long-term  contracts  where  revenue is
recognized  under  the  percentage  of  completion  method  of  accounting.  The
Company's  software related  contracts utilize labor hours incurred to date on a
project, divided by the total expected project hours to determine the completion
percentage.  The Company's construction contracts utilize costs incurred to date
on a project,  divided by the total  expected  project  costs to  determine  the
completion percentage.  Both of these methods require considerable judgment and,
as such, the estimates  derived at any point in time could differ  significantly
from actual  results.  These  estimates  affect  many of the  balance  sheet and
statement of operations  accounts  including total revenue,  cost of goods sold,
accounts receivable, contract costs in excess of billings and billings in excess
of contract  costs  incurred.  Revenues from these  contracts are  classified as
contract revenues earned on the statement of operations.

Change orders are modifications of an original contract that effectively  change
the  provisions  of the  contract  without  adding new  provisions.  They may be
initiated by either us as the contactor, or by the customer, and include changes
in  specifications  or  design,  method or manner  of  performance,  facilities,
equipment, materials, site, and period for completion of the work.

Change orders approved by the customer and us regarding both scope and price are
reflected  as an  adjustment  to the  revenue and costs of the  contract.  Costs
attributable  to  unpriced  change  orders  are  treated  as costs  of  contract
performance  in the period in which the costs are incurred if it is not probable
that the costs will be recovered through a change in the contract price. When it
is probable  that the costs will be  recovered  through a change in the contract
price,  the costs are  deferred  until the parties  have agreed on the change in
contract price. Change orders that are in dispute or are unapproved in regard to
both scope and price, are evaluated as claims. Customer termination of contracts
result in the  Company's  ceasing of any  further  revenue  recognition  and any
existing  assets  at that  date  are  evaluated  for  collectibility  under  the
contractual terms.

                                       26
<PAGE>


Revenues for support and  maintenance  contracts  are  deferred  and  recognized
ratably over the life of the contract.  Revenues for these items are  classified
as maintenance revenues on the statement of operations.

Sales of products  unrelated to contract  revenue are recognized as revenue when
all of the following  criteria are met:  persuasive  evidence of an  arrangement
exists; delivery has occurred or services have been rendered; the seller's price
to the buyer is fixed or determinable; and collectibility is reasonably assured.
Revenues for these items are  classified  as other  revenues on the statement of
operations.

Provisions for estimated  losses on uncompleted  contracts are recognized in the
period such losses are determined.

Inventories  are  stated at the  lower of cost or  market,  using the  First-in,
First-out  (FIFO) method.  Costs  included in inventories  consist of materials,
labor,  and  manufacturing  overhead,  which are  related  to the  purchase  and
production of inventories.

Warranty  reserves are  estimated  and recorded at the time products are sold or
services are rendered.  They are established using historical information on the
nature,  frequency  and average cost of warranty  claims.  The Company  warrants
numerous  products,  the terms of which vary  widely.  In  general,  the Company
warrants its products against defect and specific non-performance.

Accounts  receivable are expected to be substantially  collected within one year
except  for a  portion  of the  receivables  recorded  as  retainage.  Retainage
expected to be collected in over one year is reflected as a current  asset as it
will be collected within the operating cycle under the related contract.

Tax valuation  allowances are  established  when the Company  believes it is not
"more  likely than not" that the Company will be able to receive tax benefits in
the future. The federal income tax benefit recorded in the first quarter of 2006
is primarily the result of the reduction of a liability maintained for uncertain
tax positions which was no longer required.

Goodwill and Intangible Assets.
The  Company  reviews  the  carrying  value of goodwill  and  intangible  assets
annually  during  the fourth  quarter  of the year or when  events or changes in
circumstances indicate that the carrying value may not be recoverable, utilizing
a discounted  cash flow model.  Changes in estimates of future cash flows caused
by items  such as  unforeseen  events  or  changes  in market  conditions  could
negatively  affect the  Company's  reporting  units' fair value and result in an
impairment  charge.  The carrying  value of goodwill and  intangible  assets not
subject to amortization  totaled  approximately  $13.3 million and $4.0 million,
respectively,   and   intangible   assets   subject  to   amortization   totaled
approximately  $3.5  million,  net, at December  31,  2006.  The Company  cannot
predict the occurrence of events that might adversely affect these values.

Stock Compensation Policy.
Effective  January 1, 2006, we adopted SFAS No. 123(R),  "Share-Based  Payment."
This  statement  requires  us to  expense  the fair  value of grants of  various
stock-based  compensation  programs  over the vesting  period of the awards.  We
elected to adopt the "Modified Prospective  Application" transition method which
does not require the  restatement  of previously  issued  financial  statements.
Compensation expense is measured and recognized beginning in 2006 as follows:

Awards granted after December 31, 2005 - Awards are measured at their fair value
at date of grant.  The  resulting  compensation  expense  is  recognized  in the
consolidated  statement of  operations  ratably  over the vesting  period of the
award.

Awards  granted  prior to December 31, 2005 - Awards were measured at their fair
value at the date of original grant.  Compensation  expense  associated with the
unvested  portion  of these  options at  January  1, 2006 is  recognized  in the
consolidated statement of operations ratably over the remaining vesting period.

For all  grants  issued  after  December  31,  2005  the  amount  of  recognized
compensation  expense is adjusted based upon an estimated  forfeiture rate which
is derived from historical data.

Economic  Conditions  and the After Effect of the September  11, 2001  Terrorist
Attacks
Much of the work CompuDyne performs is for state and local  governmental  units.
These  entities were severely  impacted by recent  economic  conditions  and the
resulting  contraction of the tax bases of these governmental units. This caused
these  governmental units to carefully evaluate their budgets and defer expenses
and projects where possible. Much of the work of the Company's Public Safety and
Justice and  Institutional  Security  Systems  segments is contracted with these
state and local governmental units. As a result, these segments have seen delays
in new work  available to be bid and worked on. In addition,  even work that had
been contracted for was sometimes  deferred by the customer into the future.  In
recent  months,  it appears the state and local  government  revenues  have been
improving,  resulting  in  increased  activity  preparatory  to the  issuance of
requests for new bids and  ultimately,  the Company  expects the awarding of new
projects.  It  appears  to us that we are in the  early  stages  of an  economic
recovery as it relates to the segments of the marketplace we serve.

                                       27
<PAGE>


After the  occurrence of the tragic  events of the September 11, 2001  terrorist
attacks,  there was a general perception that our Integrated  Electronic Systems
and Attack Protection  segments would see a significant  increase in order flow.
To the  contrary,  in the  months  subsequent  to the  terrorist  attacks  these
segments saw a slowing in new work opportunities as the various federal agencies
and other  customers  that are the usual source of their  business  slowed their
procurement  processes waiting for definitive  direction as to how to proceed in
the post September 11 world.  Now further  complicated by the military action in
Afghanistan  and Iraq,  the Company's  clients are  reevaluating  priorities and
budgets and are funding only their most  pressing  demands while also making key
decisions as to which projects can be deferred.

As a result of the above  factors,  during  the last few years the  Company  has
experienced a more  challenging  marketplace  than it  experienced  in the years
prior to September 11, 2001.

Market Risk
On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million
principal  amount of the 2011 Notes. The 2011 Notes bear interest at the rate of
6.25% per annum,  payable  semi-annually,  and are  convertible  into  shares of
common  stock at a  conversion  price of $13.89 per share.  The  Company  used a
portion of the proceeds of this note offering to pay down outstanding borrowings
under its variable rate bank notes. Subsequent to the pay-down of its bank notes
the only variable rate borrowing  remaining  outstanding at December 31, 2006 is
approximately  $3.1 million of industrial  revenue  bonds.  Since this borrowing
bears  interest  at  variable  rates,  in  the  event  interest  rates  increase
dramatically  the increase in interest  expense to the Company could be material
to the results of operations of the Company.

Recent Accounting Pronouncements
In February  2007, the Financial  Accounting  Standards  Board  ("FASB")  issued
Statement of Financial  Accounting  Standard  ("SFAS") No. 159,  "The Fair Value
Option for Financial  Assets and Financial  Liabilities - Including an amendment
of FASB Statement No. 115" ("SFAS 159").  SFAS 159 permits  entities to elect to
measure  many  financial  instruments  and  certain  other  items at fair value.
Unrealized  gains and losses on items for which the fair  value  option has been
elected will be recognized in earnings at each  subsequent  reporting date. SFAS
159 is effective for fiscal years beginning after November 15, 2007. The Company
is  currently  assessing  the impact of SFAS 159 on its  consolidated  financial
statements.

In September  2006,  the FASB issued SFAS No. 158,  "Employers'  Accounting  for
Defined Benefit Pension and Other  Postretirement  Plans -- an amendment of FASB
Statements No. 87, 88, 106 and 132(R)." This  statement  would require a company
to (a)  recognize in its  statement of financial  position an asset for a plan's
overfunded status or a liability for a plan's  underfunded  status (b) measure a
plan's assets and its obligations that determine its funded status as of the end
of the employer's fiscal year, and (c) recognize changes in the funded status of
a defined  postretirement  plan in the year in which the changes occur (reported
in comprehensive income). The adoption of this new accounting  pronouncement has
not had an impact on our financial position or results of operation. The Company
does not have any such plans.

In September 2006, the FASB issued SFAS No 157 "Fair Value  Measurements".  This
Statement  defines fair value,  establishes a framework for measuring fair value
in generally accepted  accounting  principles  (GAAP),  and expands  disclosures
about fair value measurements. The adoption of this new accounting pronouncement
has not had an impact on our financial position or results of operation.

In June 2006,  the FASB  issued  Interpretation  48 ("FIN 48"),  Accounting  for
Uncertainty  in Income  Taxes,  an  interpretation  of FASB  Statement  No. 109,
Accounting for Income Taxes.  FIN 48 clarifies the accounting for uncertainty in
income taxes  recognized in an enterprise's  financial  statements in accordance
with FASB  Statement  No. 109.  FIN 48  describes a  recognition  threshold  and
measurement  attribute for financial statement  recognition and measurement of a
tax  position  taken or expected  to be taken in a tax return and also  provides
guidance on de-recognition,  classification,  interest and penalties, accounting
in interim  periods,  disclosure and  transition.  The guidance is effective for
fiscal years beginning after December 15, 2006,  which we intend to adopt during
our fiscal year ending  December 31, 2007. We have not yet determined the impact
from adoption of this new accounting  pronouncement on our financial position or
results of operation.

In  May  2005,  the  FASB  issued  SFAS  154,   "Accounting  Changes  and  Error
Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting  Changes"
and SFAS 3, "Reporting  Accounting  Changes in Interim  Financial  Statements-An
Amendment of APB Opinion No. 28." SFAS 154 provides  guidance on the  accounting
for and reporting of accounting  changes and error  corrections.  It establishes
retrospective  application,  or the latest  practicable  date,  as the  required
method for  reporting a change in  accounting  principle  and the reporting of a
correction  of an  error.  SFAS 154 is  effective  for  accounting  changes  and
corrections  of errors made in fiscal years  beginning  after December 15, 2005.
The  adoption  of SFAS  154 did not  have a  material  impact  on our  financial
position, results of operations or cash flows.

                                       28
<PAGE>


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk
CompuDyne  has fixed and variable rate notes  payable.  These  on-balance  sheet
financial instruments expose the Company to interest rate risk, with the primary
interest  rate  exposure  resulting  from  changes  in the bond  market  used to
determine the interest rate  applicable  to the  borrowings  under the Company's
industrial revenue bond borrowings.

The following information  summarizes our sensitivity to market risks associated
with  fluctuations in interest rates as of December 31, 2006. To the extent that
the Company's  financial  instruments  expose the Company to interest rate risk,
they are presented in the table below.  The table presents  principal cash flows
and related  interest  rates by year of maturity of the Company's  notes payable
with variable rates of interest in effect at December 31, 2006.

On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million
principal  amount of 6.25%  Convertible  Subordinated  Notes due on January  15,
2011.  The 2011  Notes  bear  interest  at a rate of 6.25%  per  annum,  payable
semi-annually,  and are convertible  into shares of common stock at a conversion
price of $13.89 per share.  The  Company  used a portion of the  proceeds of the
2011  Notes to pay down its  variable  bank notes  payable.  The pay down of its
variable borrowings reduced the Company's interest rate risk.

                 Financial Instruments by Expected Maturity Date

Notes Payable      Variable                           Fixed
 Year Ending       Rate ($)    Average Variable      Rate ($)      Average Fixed
 December 31   (in thousands)   Interest Rate     (in thousands)   Interest Rate
-------------  --------------   -------------     --------------   -------------
 2007              $   440           4.05%          $      -              -
 2008                  440           4.05%                 -              -
 2009                  440           4.05%                 -              -
 2010                  440           4.05%                                -
 2011                  440           4.05%            40,250            6.25%
 Thereafter            925           4.05%                 -              -
                   --------                         ---------
 Total             $ 3,125           4.05%          $ 40,250            6.25%
 Fair Value        $ 3,125                          $ 36,024            9.89%


                                       29
<PAGE>


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following consolidated financial statements of the Corporation and its
subsidiaries are included herein as indicated below:
     Report of Independent Registered Public Accounting Firm - Aronson & Company
     Report of Independent Registered Public Accounting Firm -
     PricewaterhouseCoopers LLP
     Consolidated Balance Sheets at December 31, 2006 and 2005
     Consolidated Statements of Operations for the years ended December 31,
     2006, 2005 and 2004
     Consolidated Statement of Changes in Shareholders' Equity for the years
     ended December 31, 2006, 2005 and 2004
     Consolidated Statements of Cash Flows for the years ended December 31,
     2006, 2005 and 2004
     Notes to Consolidated Financial Statements


                                       30
<PAGE>


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders
CompuDyne Corporation
Annapolis, Maryland


We have  audited  the  accompanying  Consolidated  Balance  Sheets of  CompuDyne
Corporation  and  Subsidiaries  as of December 31, 2006 and 2005 and the related
Consolidated  Statements of Operations,  Stockholders' Equity and Cash Flows for
the years then ended. Our audit also included the financial  statement schedules
for the years  ended  December  31,  2006 and 2005,  listed in the index at Item
15a(2).  These financial  statements and financial  statement  schedules are the
responsibility of the Corporation's management. Our responsibility is to express
an opinion on these financial statements and financial statement schedules based
on our audits.

We conducted our audits in accordance  with the standards of the Public  Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes consideration of
internal  control  over  financial  reporting  as a basis  for  designing  audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the  effectiveness  of the Company's  internal  control
over financial reporting. Accordingly, we express no such opinion. An audit also
includes  examining,  on a test  basis,  evidence  supporting  the  amounts  and
disclosures in the financial  statements.  An audit also includes  assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation.  We believe that our
audits provide a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all  material  respects,   the  consolidated  financial  position  of  CompuDyne
Corporation  and  Subsidiaries as of December 31, 2006 and 2005, and the results
of their  operations and their cash flows for the years then ended in conformity
with accounting  principles  generally accepted in the United States of America.
Also, in our opinion,  the related financial  statement  schedules for the years
ended  December  31,  2006 and 2005,  when  considered  in relation to the basic
financial  statements taken as a whole,  present fairly in all material respects
the information set forth therein.

As  discussed in Note 1 to the  financial  statements,  on January 1, 2006,  the
Company  adopted  Statement of Financial  Accounting  Standards No. 123(R) Share
Based Payment.

Aronson & Company
Rockville, Maryland
April 6, 2007

                                       31
<PAGE>


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of
CompuDyne Corporation
Annapolis, Maryland


In our  opinion,  the  consolidated  statements  of  operations,  of  changes in
shareholders'  equity  and of cash flows for the year ended  December  31,  2004
present  fairly,  in all material  respects,  the results of operations and cash
flows of CompuDyne  Corporation and its subsidiaries for the year ended December
31, 2004 in conformity  with  accounting  principles  generally  accepted in the
United States of America. In addition,  in our opinion,  the financial statement
schedule  for the year ended  December  31, 2004  listed in the index  appearing
under Item 15(a)(2) presents fairly, in all material  respects,  the information
set  forth  therein  when  read in  conjunction  with the  related  consolidated
financial  statements.   These  financial  statements  and  financial  statement
schedule are the responsibility of the Company's management.  Our responsibility
is to express an opinion on these financial  statements and financial  statement
schedule  based on our audit.  We  conducted  our audit of these  statements  in
accordance with the standards of the Public Company  Accounting  Oversight Board
(United States).  Those standards  require that we plan and perform the audit to
obtain reasonable  assurance about whether the financial  statements are free of
material  misstatement.  An audit includes examining,  on a test basis, evidence
supporting the amounts and  disclosures in the financial  statements,  assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall  financial  statement  presentation.  We believe that our
audit provides a reasonable basis for our opinion.



PricewaterhouseCoopers LLP

Baltimore, Maryland
March 31, 2005

                                       32
<PAGE>


                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS


                                                     December 31,   December 31,
                                                         2006           2005
                                     ASSETS          ------------   ------------
                                                        (dollars in thousands)
Current Assets
  Cash and cash equivalents                          $     7,740    $     6,938
  Marketable securities                                    8,687         11,429
  Accounts receivable, net                                25,534         39,625
  Contract costs in excess of billings                    12,031         13,764
  Inventories                                              5,577          6,195
  Prepaid expenses and other                               4,595          2,809
                                                     ------------   ------------
     Total Current Assets                                 64,164         80,760

Cash equivalents pledged                                   7,500              -
Property, plant and equipment, net                         9,630          9,962
Goodwill                                                  13,274         26,846
Other intangible assets, net                               7,428          8,221
Other                                                      1,954            903
                                                     ------------   ------------
     Total Assets                                    $   103,950    $   126,692
                                                     ============   ============

                      LIABILITIES AND SHAREHOLDERS' EQUITY

Current Liabilities
  Accounts payable and accrued liabilities           $    14,155    $    23,030
  Billings in excess of contract costs incurred            9,221         13,847
  Deferred revenue                                         9,305          8,094
  Current portion of notes payable                           440            440
                                                     ------------   ------------
     Total Current Liabilities                            33,121         45,411

Notes payable                                              2,685          3,125
Convertible subordinated notes payable, net               39,492         39,305
Deferred tax liabilities                                   1,425          2,060
Other                                                        388            369
                                                     ------------   ------------
     Total Liabilities                                    77,111         90,270
                                                     ------------   ------------

Commitments and Contingencies

Shareholders' Equity
  Preferred stock, 2,000,000 shares authorized and
   unissued                                                    -              -
  Common stock, par value $.75 per share:
   50,000,000 shares authorized at December 31,
   2006 and December 31, 2005; 9,293,637 and
   8,950,356 shares issued at December 31, 2006
   and December 31, 2005, respectively                     6,970          6,712
  Additional paid-in-capital                              50,034         44,388
  Accumulated deficit                                    (23,956)        (8,963)
  Accumulated other comprehensive loss                      (331)           (39)
  Treasury stock, at cost; 862,922 and 831,777
   shares at December 31, 2006 and December 31,
   2005, respectively.                                    (5,878)        (5,676)
                                                     ------------   ------------
     Total Shareholders' Equity                           26,839         36,422
                                                     ------------   ------------
     Total Liabilities and Shareholders' Equity      $   103,950    $   126,692
                                                     ============   ============


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


                                       33
<PAGE>


                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS


                                                     Year Ended December 31,
                                                  2006       2005         2004
                                                ---------  ---------   ---------
                                                   (in thousands, except per
                                                           share data)
Revenues:
  Contract revenues earned                      $ 76,366   $ 89,454    $ 95,343
  Maintenance revenues                            26,674     21,826      19,556
  Other revenues                                  44,422     30,370      27,883
                                                ---------  ---------   ---------
    Total revenues                               147,462    141,650     142,782

Cost of  Sales                                    99,595     99,111     105,104
                                                ---------  ---------   ---------


Gross profit                                      47,867     42,539      37,678

Selling, general and administrative expenses      38,261     40,567      36,219
Research and development                           7,294      8,685       7,755
Impairment of goodwill and other intangibles      16,141          -       1,826
                                                ---------  ---------   ---------
Loss from operations                             (13,829)    (6,713)     (8,122)
                                                ---------  ---------   ---------

Other expense (income)
  Interest expense                                 3,268      3,065       3,298
  Interest income                                 (1,163)      (832)     (1,009)
  Other (income) expense                            (209)       (40)         19
                                                ---------  ---------   ---------
    Total other expense                            1,896      2,193       2,308
                                                ---------  ---------   ---------

Loss before income taxes                         (15,725)    (8,906)    (10,430)
Income taxes benefit                                (732)      (215)     (2,232)
                                                ---------  ---------   ---------
Net loss                                        $(14,993)  $ (8,691)   $ (8,198)
                                                =========  =========   =========

Earnings (loss) per share:
-------------------------
Basic loss per common share                     $ (1.82)   $  (1.07)   $  (1.01)
                                                =========  =========   =========

Weighted average number of common
 shares outstanding                                8,256      8,129       8,136
                                                =========  =========   =========

Diluted loss per common share                   $  (1.82)  $  (1.07)   $  (1.01)
                                                =========  =========   =========

Weighted average number of common
 shares and equivalents                            8,256      8,129       8,136
                                                =========  =========   =========


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

                                       34
<PAGE>


<TABLE>
<CAPTION>
                                                        COMPUDYNE CORPORATION AND SUBSIDIARIES
                                                CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
                                                                        (in thousands)

                                                                              Accumulated
                                                      Additional   Retained      Other
                                     Common Stock      Paid-in     Earnings  Comprehensive  Treasury Stock
                                   Shares    Amount    Capital    (Deficit)   Income(Loss) Shares   Amount      Total
                                   -----------------  ----------  ----------  ----------- -------- ---------  ----------
<S>     <C>                        <C>      <C>       <C>         <C>         <C>         <C>      <C>        <C>
Balance at December 31, 2003        8,568   $ 6,426   $  42,755   $   7,926   $      (93)     595  $ (4,087)  $  52,927

Common stock issued in
 connection with acquisition           72        54         585                                                     639
Stock options exercised               304       227       1,028                                                   1,255
Purchase of treasury shares                                                                   126      (899)       (899)
                                   -------------------------------------------------------------------------------------
  Subtotal                          8,944     6,707      44,368       7,926          (93)     721    (4,986)     53,922
Comprehensive income:
  Net loss                                                           (8,198)                                     (8,198)
Other comprehensive
 income, net of tax:
  Gain on interest rate swap
   agreement                                                                          93                             93
  Unrealized gain on available for
   sale marketable securities                                                         14                             14
                                                                                                              ----------
Comprehensive loss                                                                                               (8,091)
                                   -------------------------------------------------------------------------------------
Balance at December 31, 2004        8,944     6,707      44,368        (272)          14      721    (4,986)     45,831

Stock options exercised                 6         5          20                                                      25
Purchase of treasury shares                                                                   111      (690)       (690)
                                   -------------------------------------------------------------------------------------
  Subtotal                          8,950     6,712      44,388        (272)          14      832    (5,676)     45,166
Comprehensive income:
  Net loss                                                           (8,691)                                     (8,691)
Other comprehensive
 loss, net of tax:
  Unrealized loss on available for
   sale marketable securities                                                        (53)                           (53)
                                                                                                              ----------
Comprehensive loss                                                                                               (8,744)
                                   -------------------------------------------------------------------------------------
Balance at December 31, 2005        8,950     6,712      44,388      (8,963)         (39)     832    (5,676)     36,422

Common stock issued in
 connection with acquisition          308       231       1,630                                                   1,861
Settlement of prior year
 equity transaction                                       2,723                                                   2,723
Warrants exercised in cashless
 exercise                              35        26         176                                31      (202)          -
Stock options exercised                 1         1           4                                                       5
Stock-based compensation                                  1,113                                                   1,113
                                   -------------------------------------------------------------------------------------
Subtotal                            9,294     6,970      50,034      (8,963)         (39)     863    (5,878)     42,124
Comprehensive income:
  Net loss                                                          (14,993)                                    (14,993)
Other comprehensive loss, net of
 tax:
  Unrealized loss on available for
   sale marketable securities                                                       (292)                          (292)
                                                                                                              ----------
Comprehensive loss                                                                                              (15,285)
                                   -------------------------------------------------------------------------------------
Balance at December 31, 2006        9,294   $ 6,970   $  50,034   $ (23,956)  $     (331)     863  $ (5,878)  $  26,839
                                   =======  ========  ==========  ==========  =========== ======== =========  ==========
</TABLE>


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

                                       35
<PAGE>


                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>

                                                                              Year Ended December 31,
                                                                          2006         2005         2004
                                                                        ---------   ---------   ---------
                                                                                  (in thousands)
Cash flows from operating activities:
<S>                                                                     <C>         <C>         <C>
Net (loss)                                                              $(14,993)   $ (8,691)   $ (8,198)

Adjustments to reconcile net income (loss) to
net cash provided by (used in) operations:
        Depreciation and amortization                                      3,167       3,393       2,921
        Stock-based compensation expense                                   1,113          --          --
        Deferred income tax benefit                                         (635)        (12)       (219)
        (Gain) loss from disposition of property, plant and equipment         --          (5)          2
        Impairment of goodwill and other intangibles                      16,141          --       1,826
        Amortization of debt discount                                        187         187         176
        Amortization of discounts of marketable securities                    (3)         11         (18)
        Unrealized loss on interest rate swap                                 --          --          21

Changes in assets and liabilities:
        Accounts receivable                                               14,177      (5,244)      7,507
        Contract costs in excess of billings                               1,733       2,323       1,481
        Inventories                                                          749      (1,028)      1,539
        Prepaid expenses and other current assets                         (1,802)      3,018      (3,160)
        Other assets                                                      (1,050)       (190)        191
        Accounts payable and accrued liabilities                          (8,914)        885         616
        Billings in excess of contract costs incurred                     (4,626)        350         (54)
        Deferred revenue                                                   1,211       1,606         (38)
        Other liabilities                                                   (116)       (230)        (66)
                                                                        --------    --------    --------
Net cash flows provided by (used in) operating activities                  6,339      (3,627)      4,527
                                                                        --------    --------    --------

Cash flows from investing activities:
        Purchase of marketable securities                                 (6,938)    (14,610)    (42,361)
        Redemption of marketable securities                                9,410      22,660      22,824
        Additions to property, plant and equipment                        (1,852)     (1,252)     (1,784)
        Proceeds from sale of property, plant and equipment                   --           7           4
        Cash acquired from acquisition                                        --         363          --
        Net payment for acquisitions                                        (945)       (696)     (5,526)
                                                                        --------    --------    --------
Net cash flows (used in) provided by investing activities                   (325)      6,472     (26,843)
                                                                        --------    --------    --------

Cash flows from financing activities:
        Stock options exercised                                                5          25       1,255
        Purchase of treasury stock                                            --        (690)       (899)
        Restricted cash equivalents pledged to surety company             (7,500)         --          --
        Settlement of prior year equity transaction                        2,723          --          --
        Repayment of bank notes and lines of credit                         (440)       (440)    (13,653)
        Borrowings of convertible subordinated notes payable                  --          --      38,942
                                                                        --------    --------    --------
Net cash flows (used in) provided by financing activities                 (5,212)     (1,105)     25,645
                                                                        --------    --------    --------

Net change in cash and cash equivalents                                      802       1,740       3,329
Cash and cash equivalents at the beginning of the year                     6,938       5,198       1,869
                                                                        --------    --------    --------
Cash and cash equivalents at the end of the year                        $  7,740    $  6,938    $  5,198
                                                                        ========    ========    ========

Supplemental disclosures of cash flow information:
  Cash paid during the year for:
        Interest                                                        $  2,906    $  2,690    $  1,573
        Income taxes, net of refunds                                    $     59    $     88    $    771
  Common stock issued in connection with acquisition                    $  1,861    $     --    $    639
  Warrants exercised                                                    $    202    $     --    $     --
  Treasury stock received with cashless exercise of warrants            $   (202)   $      -    $      -

</TABLE>

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


                                       36
<PAGE>

                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations
CompuDyne  Corporation,  a Nevada  corporation,  operates in four sectors of the
security industry - Institutional  Security Systems,  Attack Protection,  Public
Safety and Justice, and Integrated Electronic Systems.

The  Institutional  Security  Systems segment  provides  physical and electronic
security products and services to the corrections  industry (jails and prisons),
and to the courthouse, municipal and commercial markets.

The Attack Protection segment  manufactures  bullet,  blast and attack resistant
windows  and  doors  designed  for  high-end  security  applications,  including
embassies,   courthouses,   Federal  Reserve   buildings  and  banks;  and  also
manufactures  fiber optic  systems used to detect  physical  intrusion,  protect
large  perimeters  and for the physical  protection of data lines;  and,  fixed,
removable, semi-automatic vehicle bollards and wedge barrier security systems.

The Integrated  Electronic  Systems segment provides the United States military,
governmental  agencies and state and local units with specialty  engineering and
security services,  often of a classified nature. Their products include Signals
Intelligence+  (SigInt)  Systems:  Signal  gathering  and analysis  products and
systems used for  field-based  collecting  and  monitoring,  providing  the U.S.
intelligence community and U.S. allies with real time intelligence for strategic
and tactical decision making.

The Public  Safety and  Justice  segment  provides a fully  integrated  suite of
products including computer assisted dispatching,  records management, court and
probation  software  systems,   and  inmate  management  software  for  the  law
enforcement, fire and rescue, corrections and justice environments.

Summary of Significant Accounting Policies
The  consolidated   financial  statements  of  CompuDyne   Corporation  and  its
subsidiaries  have  been  prepared  in  accordance  with  accounting  principles
generally accepted in the United States of America.

Principles of Consolidation
The  consolidated   financial  statements  include  the  accounts  of  CompuDyne
Corporation and its subsidiaries (collectively "CompuDyne" or the "Company").

Use of Estimates
The preparation of financial statements in conformity with accounting principles
generally  accepted in the United States of America requires  management to make
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 period. These include estimates of percentage-completion on
long-term contracts and valuation allowances for contracts, accounts receivable,
inventories  and deferred  tax assets.  Actual  results  could differ from those
estimates.

Revenue Recognition
Much of the  Company's  revenues  are derived  from  long-term  contracts  where
revenue is recognized  under the percentage of completion  method of accounting.
Revenues and the associated  costs from software  products and related  hardware
installations,  as well as computer programming and systems engineering services
delivered  as part of the  Company's  delivery  of its  software  products,  are
recognized using the percentage-of-completion  method using labor hours incurred
relative to total  estimated  contract hours as the measure of progress  towards
completion.  The Company's construction contracts utilize costs incurred to date
on a project  divided  by the total  expected  project  costs to  determine  the
completion  percentage.  Revenue under cost reimbursable contracts is recognized
to the extent of costs incurred to date plus a  proportionate  amount of the fee
earned.  Revenue under time and materials  contracts is recognized to the extent
of billable rates times hours incurred plus materials expense incurred.  Revenue
from fixed price  construction  contracts is recognized  under the percentage of
completion  method,  whereby a portion of the total contract price is recognized
based on the amount of costs incurred to date as a percentage of total estimated
costs.  Changes in revenue,  costs,  and profit  estimates  occurring during the
course of a contract are  recognized  in the period in which the  revisions  are
determined.  Revenues  for support and  maintenance  contracts  are deferred and
recognized  ratably  over the life of the  service  contract.  Sales of products
unrelated  to  contract  revenue  are  recognized  as  revenue  when  all of the
following  criteria  are met:  persuasive  evidence  of an  arrangement  exists;
delivery has occurred or services have been rendered;  the seller's price to the
buyer  is fixed or  determinable;  and  collectibility  is  reasonably  assured.
Provisions for estimated  losses on uncompleted  contracts are recognized in the
period such losses are  determined.  Costs and  estimated  earnings in excess of
billings on  uncompleted  contracts  represent  the excess of contract  revenues
recognized  to date over  billings  to date on certain  contracts.  Billings  in
excess of costs and estimated  earnings on uncompleted  contracts  represent the
excess of  billings  to date over the  amount of revenue  recognized  to date on
certain contracts.


                                       37
<PAGE>

Research and Development
Expenditures for research and development are charged to operations as incurred.

Goodwill
Goodwill represents the cost in excess of the fair value of net assets acquired.
In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial  Accounting  Standards  No. 142 ("SFAS  142"),  "Goodwill and Other
Intangible  Assets",  which was  effective  January 1, 2002.  SFAS 142 requires,
among other things,  the discontinuance of goodwill  amortization.  In addition,
the standard includes  provisions for the  reclassification  of certain existing
recognized intangibles as goodwill, reassessment of the useful lives of existing
recognized   intangibles,   reclassification   of  certain  intangibles  out  of
previously  reported  goodwill and the  identification  of  reporting  units for
purposes of assessing  potential  future  impairments  of goodwill.  The Company
elected to perform these annual  assessements as of October 1 of each year. SFAS
142  requires  the Company to conduct  impairment  assessments  annually or when
events  indicate a triggering  event has occurred.  During the fourth quarter of
2004, the Company  concluded  that the continuing  decline in the backlog in its
ISS segment  constituted a triggering  event. The Company  performed its interim
impairment  test of the reporting  unit as of December 31, 2004 and based on its
valuation  concluded it was  necessary  to write off the value of the  segment's
goodwill  in the  amount  of  $739  thousand.  This  write-off  is  included  in
impairment  of  goodwill  and  other   intangibles  in  the  2004  statement  of
operations.  During the fourth  quarter of 2006,  the Company  concluded that an
impairment  occurred  in its Public  Safety and  Justice  segment.  The  Company
performed its interim  impairment  test of the reporting unit as of December 31,
2006 and based on its  valuation  concluded  it was  necessary  to write  down a
portion of the value of the  segment's  goodwill in the amount of $14.4  million
and $1.7 million of other  intangible  assets.  This  write-down  is included in
impairment  of  goodwill  and  other   intangibles  in  the  2006  statement  of
operations.  As of  October  1 and  December  31,  2006,  there  were  no  other
impairments of goodwill or other intangibles.  These valuations are performed by
the Company with the assistance of an independent  national valuation firm which
considers  market  valuations,  discounted  cash  flows and other  factors  when
preparing the valuations.

Cash and Cash Equivalents
The  Company  considers  all  highly  liquid  investments  with an  original  or
remaining  maturity of three months or less to be cash equivalents.  The Company
deposits  cash  and  cash  equivalents   with  high  credit  quality   financial
institutions. These deposits may exceed the federally insured limits.

Marketable Securities
The  Company's  marketable  securities  are  categorized  as  available-for-sale
securities,  as defined by Statement of Financial  Accounting Standards No. 115,
"Accounting  for Certain  Investments in Debt and Equity  Securities,"  and as a
result, were reported at fair value. Unrealized gains and losses are reported as
a component of accumulated other comprehensive  income in shareholders'  equity.
The  amortized  costs of debt  securities is adjusted for accretion of discounts
from the date of purchase to  maturity.  The  accretion  is included in interest
income on the  investments.  The cost for  marketable  securities was determined
using  the  specific  identification  method.  The  fair  values  of  marketable
securities are estimated based on the quoted market price for these securities.

Allowance for Doubtful Accounts
An  allowance  for  doubtful  accounts is estimated  based on a  combination  of
write-off history, aging analysis and any specific, known troubled accounts.

Property, Plant, and Equipment
Property, plant and equipment are stated at cost less accumulated  depreciation.
Depreciation of plant and equipment is computed principally by the straight-line
method based upon the estimated  useful lives of the various  classes of assets.
Leasehold  improvements are amortized over their useful lives or the term of the
underlying lease, whichever is shorter. Maintenance and repair costs are charged
to operations as incurred;  major renewals and betterments are capitalized.  Any
gain or loss from the  retirement  or sale of an asset is credited or charged to
operations.

Inventories
Inventories  are  stated at the  lower of cost or  market,  using the  First-in,
First-out  (FIFO) method.  Costs  included in inventories  consist of materials,
labor,  and  overhead,  which are  related to the  purchase  and  production  of
inventories.

Warranty Reserves
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure  Requirements for Guarantees,  Including  Indirect  Guarantees of
Indebtedness  of  Others"  ("FIN  45").  FIN  45  requires  the  recognition  of
liabilities  for guarantees  that are issued or modified  subsequent to December
31, 2002. The liabilities  should reflect the fair value,  at inception,  of the
guarantors'  obligations  to  stand  ready to  perform,  in the  event  that the
specified  triggering  events  or  conditions  occur.  The  Interpretation  also
requires  disclosure of accounting  policies and  methodologies  with respect to
warranty  accruals,  as well as a reconciliation of the change in these accruals
for the reporting period.  Refer to Note 12, "Product  Warranties," in the Notes
to Consolidated Financial Statements for additional information.


                                       38
<PAGE>

Deferred Revenue
The Company provides  ongoing  maintenance and service for many of its completed
projects.  Much of this work is performed  pursuant to  maintenance  agreements,
which  typically  cover such  services  for a twelve month  period.  The Company
recognizes  revenue under these contracts ratably over the term of the contract.
Any revenue not yet earned under the contract is recorded as deferred revenue in
the accompanying financial statements.

Fair Value and Hedging
The  Company  hedged  the cash  flows  of some of its  long-term  debt  using an
interest rate swap. The Company entered into this derivative  contract to manage
its exposure to interest  rate  movements by achieving a desired  proportion  of
fixed rate versus  variable rate debt.  In the interest  rate swap,  the Company
agreed to exchange the difference  between a variable interest rate and either a
fixed or another  variable  interest  rate,  multiplied by a notional  principal
amount.  The Company's  hedge matured on September 30, 2005 at which time it was
no longer in force.

Income Taxes
The Company follows  Statement of Financial  Accounting  Standards  ("SFAS") No.
109,  "Accounting  for Income Taxes." Under SFAS 109,  deferred income taxes are
recognized for the future tax  consequences of differences  between tax bases of
assets and liabilities and financial  reporting amounts,  based upon enacted tax
laws and statutory tax rates  applicable to the periods in which the differences
are  expected  to affect  taxable  income.  The Company has decided to provide a
valuation  allowance  against its deferred tax assets, as it has determined that
due to the  Company's  accumulated  deficit  resulting  from recent years losses
there is  uncertainty as to whether it is more likely than not that these assets
will be realized.

Comprehensive Income (Loss)
The following table shows the components of comprehensive  (loss), net of income
taxes, for the years ended December 31, 2006 and 2005, in thousands.
                                                               For the Year
                                                             Ended December 31,
                                                            2006          2005
                                                          ---------    ---------

Net loss                                                  $(14,993)    $ (8,691)
Unrealized loss on available-for-sale securities              (292)         (53)
                                                          --------     --------
Comprehensive loss                                        $(15,285)    $ (8,744)
                                                          ========     ========

Stock-Based Compensation
In December  2004,  the FASB issued SFAS No. 123R  (revised  2004)  "Share-Based
Payment."  This statement  replaces SFAS No. 123,  "Accounting  for  Stock-Based
Compensation,"  and supersedes  Accounting  Principles Board ("APB") Opinion No.
25, "Accounting for Stock Issued to Employees." This statement requires that the
cost resulting from all  share-based  payment  transactions be recognized in the
financial  statements.  Pro forma  disclosure is no longer an alternative.  This
statement  establishes fair value as the measurement objective in accounting for
share-based   payment   arrangements  and  requires  all  entities  to  apply  a
fair-value-based  measurement  method  in  accounting  for  share-based  payment
transactions  with  employees.  This statement uses the terms  compensation  and
payment in their broadest senses to refer to the consideration paid for goods or
services, regardless of whether the supplier is an employee.

The Company  adopted SFAS No. 123R effective  January 1, 2006 and is recognizing
the cost of stock-based  compensation,  consisting of stock  options,  using the
modified  prospective  application  method  whereby  the cost of new  awards and
awards modified,  repurchased or cancelled after January 1, 2006 and the portion
of awards  for which  the  requisite  service  has not been  rendered  (unvested
awards) that are outstanding as of January 1, 2006, as the requisite  service is
rendered on or after the effective  date,  January 1, 2006.  This standard has a
material impact on our financial statements.

On December  27,  2005 the  Compensation  Committee  of the  Company's  Board of
Directors approved the acceleration of option vesting terms for 166,600 unvested
out of the  money  employee  stock  options,  including  executive  officers  in
accordance  with the provisions of the Company's  1996 and 2005 Stock  Incentive
Plans for Employees. Stock options which had been awarded under the Non-employee
directors plans were not included in such acceleration. This accelerated vesting
included all options with a grant price of $9.00 and above.  The exercise prices
of the affected  stock options were above the  Company's  closing stock price on
the  date  of  acceleration.  As a  result  of the  accelerated  vesting  terms,
approximately $954 thousand has been included in pro forma compensation  expense
for the twelve  months ended  December 31, 2005.  The  accelerated  options have
exercise  prices  ranging from $9.19 to $14.09 and a weighted  average  exercise
price of $11.45. The total number of accelerated options includes 20,200 options
held by executive  officers of the Company,  with exercise  prices  ranging from
$9.19 to $12.21 and a weighted average exercise price of $10.11.


                                       39
<PAGE>

The  primary  purpose  of  accelerating  the  vesting  of these  options  was to
eliminate the recognition of non-cash compensation expense associated with these
options  that the Company  would have been  required to  recognize in its future
consolidated  statements  of  operations  upon  its  adoption  of  Statement  of
Financial  Accounting  Standards  No. 123 (revised  2004),  Share-Based  Payment
("SFAS  123R").  SFAS  123R  generally  requires  that  the  fair  value  of all
share-based payments to employees,  including stock option awards, be recognized
as compensation expense in the Company's  statements of operations.  The Company
was required to adopt the expense recognition  provisions of SFAS 123R effective
January 1, 2006.

The fair value of the  Company's  stock-based  option  awards to  employees  was
estimated using the Black-Scholes  model assuming no expected  dividends and the
following weighted-average assumptions:

                                               For the Year Ended December 31,
                                              2006          2005          2004
                                              ----          ----          ----
        Expected life in years                6.5           4.8           5.4
        Risk-free interest rate               4.9%          4.0%          3.4%
        Expected volatility                  77.4%         81.5%         75.3%
        Annual forfeiture rate                4.4%           --            --
        Dividend yield                         --            --            --

On May 27, 2005, the Company's shareholders approved amendments to the CompuDyne
Corporation  1996  Stock  Incentive  Compensation  Plan  for  Employees  and the
CompuDyne  Corporation 1996 Stock Option Plan for  Non-Employee  Directors ("the
1996 Plans") to provide  primarily for a definition of a change in control.  The
Company  does not believe  the  amendments  have a material  impact on the stock
awards issued under the 1996 Plans.

On May 27, 2005, the Company's  shareholders  approved the CompuDyne Corporation
2005  Stock  Incentive   Compensation  Plan  for  Employees  and  the  CompuDyne
Corporation 2005 Stock Option Plan for Non-Employee Directors ("the 2005 Plans")
and authorized awards exercisable for up to 4,000,000 and 400,000 common shares,
respectively,  under the 2005 Plans.  The 2005 Plans are intended to replace the
1996 Plans, which expire in March 2006, and contain similar provisions. The 2005
Plans permit the  issuance of either  incentive  stock  awards or  non-qualified
stock awards.

For the years ended  December 31, 2005 and  December  31,  2004,  we applied the
intrinsic  value based method of accounting for stock options  prescribed by APB
No. 25.  Accordingly,  no  compensation  expense was  recognized for these stock
options  since all options  granted  had an  exercise  price equal to the market
value of the  underlying  stock on the grant date. If  compensation  expense had
been  recognized  based on the estimate of the fair value of each option granted
in  accordance  with the  provisions of SFAS No. 123 as amended by SFAS No. 148,
our results of  operations  would have been reduced to the  following  pro forma
amounts as follows, in thousands:

<TABLE>
<CAPTION>

                                                     For the Year Ended    For the Year Ended
                                                     December 31, 2005     December 31, 2004
                                                     ------------------    ------------------

<S>                                                  <C>                   <C>
         Net loss as reported                        $           (8,691)   $           (8,198)
         Deduct:  pro forma stock based employee
            compensation expense, net of tax                      2,678                 1,040
                                                     ------------------    ------------------
         Pro forma net loss                          $          (11,369)   $           (9,238)
                                                     ==================    ==================

         Earnings per common share:
             Basic - as reported                     $            (1.07)   $            (1.01)
             Basic - pro forma                       $            (1.40)   $            (1.14)

             Diluted - as reported                   $            (1.07)   $            (1.01)
             Diluted - pro forma                     $            (1.40)   $            (1.14)

</TABLE>

Pro forma  compensation  expense recognized under SFAS No. 123 does not consider
potential forfeitures.

Corporate Reorganization
As part of the Company's  efforts to better  manage its costs,  during the first
quarter of 2005 the Company  implemented a corporate  reorganization  whereby it
converted several corporate entities into LLCs (Limited Liability Corporations).
This activity was designed to improve the Company's tax reporting  structure and
to help better manage the Company's state income tax obligations. In conjunction
with this reorganization,  our Federal Security Systems group, formerly known as
Quanta Systems Corporation,  was re-formed as  CompuDyne-Integrated  Electronics
Division, LLC. In addition,  CorrLogic, Inc. was converted to CorrLogic, LLC and
Fiber  SenSys,  Inc.  was  converted  to Fiber  SenSys,  LLC. The impact of this
reorganization  is not  expected  to have a material  effect on  operations.  In
addition,  in light of the escalating selling,  general and administrative costs
associated with the current heightened regulatory environment, we are evaluating
our structure to determine if another  organizational  structure would result in
lower selling, general and administrative costs.


                                       40
<PAGE>

Other Recently Issued Accounting Pronouncements
In February  2007, the Financial  Accounting  Standards  Board  ("FASB")  issued
Statement of Financial  Accounting  Standard  ("SFAS") No. 159,  "The Fair Value
Option for Financial  Assets and Financial  Liabilities - Including an amendment
of FASB Statement No. 115" ("SFAS 159").  SFAS 159 permits  entities to elect to
measure  many  financial  instruments  and  certain  other  items at fair value.
Unrealized  gains and losses on items for which the fair  value  option has been
elected will be recognized in earnings at each  subsequent  reporting date. SFAS
159 is effective for fiscal years beginning after November 15, 2007. The Company
is  currently  assessing  the impact of SFAS 159 on its  consolidated  financial
statements.

In September  2006,  the FASB issued SFAS No. 158,  "Employers'  Accounting  for
Defined Benefit Pension and Other  Postretirement  Plans -- an amendment of FASB
Statements No. 87, 88, 106 and 132(R)." This  statement  would require a company
to (a)  recognize in its  statement of financial  position an asset for a plan's
overfunded status or a liability for a plan's underfunded  status, (b) measure a
plan's assets and its obligations that determine its funded status as of the end
of the employer's fiscal year, and (c) recognize changes in the funded status of
a defined  postretirement  plan in the year in which the changes occur (reported
in comprehensive income). The adoption of this new accounting  pronouncement has
not had an impact on our  financial  position  or  results of  operation  as the
Company does not have any such plans.

In September 2006, the FASB issued SFAS No 157 "Fair Value  Measurements".  This
Statement  defines fair value,  establishes a framework for measuring fair value
in generally accepted  accounting  principles  (GAAP),  and expands  disclosures
about fair value measurements. The adoption of this new accounting pronouncement
has not had an impact on our financial position or results of operation.

In June 2006,  the FASB  issued  Interpretation  48 ("FIN 48"),  Accounting  for
Uncertainty  in Income  Taxes,  an  interpretation  of FASB  Statement  No. 109,
Accounting for Income Taxes.  FIN 48 clarifies the accounting for uncertainty in
income taxes  recognized in an enterprise's  financial  statements in accordance
with FASB  Statement  No. 109.  FIN 48  describes a  recognition  threshold  and
measurement  attribute for financial statement  recognition and measurement of a
tax  position  taken or expected  to be taken in a tax return and also  provides
guidance on de-recognition,  classification,  interest and penalties, accounting
in interim  periods,  disclosure and  transition.  The guidance is effective for
fiscal years beginning after December 15, 2006,  which we intend to adopt during
our fiscal year ending  December 31, 2007. We have not yet determined the impact
from adoption of this new accounting  pronouncement on our financial position or
results of operation.

In  May  2005,  the  FASB  issued  SFAS  154,   "Accounting  Changes  and  Error
Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting  Changes"
and SFAS 3, "Reporting  Accounting  Changes in Interim  Financial  Statements-An
Amendment of APB Opinion No. 28." SFAS 154 provides  guidance on the  accounting
for and reporting of accounting  changes and error  corrections.  It establishes
retrospective  application,  or the latest  practicable  date,  as the  required
method for  reporting a change in  accounting  principle  and the reporting of a
correction  of an  error.  SFAS 154 is  effective  for  accounting  changes  and
corrections  of errors made in fiscal years  beginning  after December 15, 2005.
The  adoption  of SFAS  154 did not  have a  material  impact  on our  financial
position, results of operations or cash flows.

Reclassifications
 Certain prior year amounts have been  reclassified  to conform with the current
year's  presentation.  The effect of these  reclassifications is not material to
the consolidated financial statements.

2.   EARNINGS PER SHARE

Earnings per share are presented in accordance with SFAS No. 128,  "Earnings Per
Share." This Statement  requires dual presentation of basic and diluted earnings
per share on the face of the statement of  operations.  Basic earnings per share
is computed using the weighted average number of shares  outstanding  during the
period and excludes any dilutive  effects of options,  warrants,  or convertible
securities.  Diluted  earnings per share is computed using the weighted  average
number of common and  common  stock  equivalent  shares  outstanding  during the
period;  common stock  equivalent  shares are excluded from the  computation  if
their effect is antidilutive.

Stock options and warrants to purchase  1,273,600,  1,257,133 and 729,800 shares
for the years ended  December 31,  2006,  2005 and 2004  respectively,  were not
dilutive  and,  therefore,  were not  included  in the  computation  of  diluted
earnings per common  share.  Additionally,  the 2,897,768  shares  issuable upon
conversion of the 6.25% Convertible Subordinated Notes due January 15, 2011 (the
"2011 Notes") are excluded for the years ended December 31, 2006,  2005 and 2004
as the effect is antidilutive.


                                       41
<PAGE>

The  computations of the Company's  basic and diluted  earnings per common share
amounts were as follows:

<TABLE>
<CAPTION>

                                                        Year Ended December 31,
                                                   --------------------------------
                                                     2006        2005        2004
                                                   --------    --------    --------
                                                 (in thousands, except per share data)
<S>                                                <C>         <C>         <C>
Net loss                                           $(14,993)   $ (8,691)   $ (8,198)
                                                   ========    ========    ========

Weighted average common shares outstanding            8,256       8,129       8,136
Effect of dilutive stock options and warrants            --          --          --
                                                   --------    --------    --------

Diluted weighted average number of common shares
outstanding                                           8,256       8,129       8,136
                                                   ========    ========    ========

Net loss per common share
Basic                                              $  (1.82)   $  (1.07)   $  (1.01)
Diluted                                            $  (1.82)   $  (1.07)   $  (1.01)

</TABLE>

In March 2004, the Emerging Issues Task Force ("EITF") reached a final consensus
on Issue 03-6,  "Participating  Securities  and the Two-Class  Method under FASB
Statement No. 128, Earnings Per Share" ("Issue 03-6"),  effective June 30, 2004.
Issue 03-6  requires  the use of the  two-class  method to compute  earnings per
share for  companies  that have issued  securities  other than common stock that
contractually entitle the holder to participate in dividends and earnings of the
Company  ("participation  rights")  when,  and if, it declares  dividends on its
common stock.

The 2011 Notes contain contingent participation rights. The participation rights
are contingent  upon the ability,  based on the  undistributed  earnings for the
period, of the Company to declare and distribute dividends per share equal to or
in  excess  of the per share  fair  value of the  Company's  common  stock.  The
contingency  was not met for the years ended  December 31, 2006,  2005 and 2004.
Accordingly,  no  undistributed  earnings have been allocated to the 2011 Notes.
The  2011  Notes  provide  that  "if the  portion  of the  cash  so  distributed
applicable  to one share of Common Stock is equal to or greater than the Current
Market  Price on the  Record  Date [of the  dividend  declared],  in lieu of the
foregoing adjustment [to the conversion price], adequate provision shall be made
so that each  Noteholder  shall have the right to receive  upon  conversion  the
amount of cash such holder would have  received had such holder  converted  each
Note on the Record  Date." Under EITF 03-06,  the  assessment  as to whether the
contingency  criteria  have been met must be made each  reporting  period.  This
determination  is  made  without  regard  to  the  participation  rights  of the
convertible  notes.  Under the consensus  reached for Issue 3 of EITF 03-06, the
criteria could be met even if the dividend were not declared. The consensus also
permits consideration of avoiding allocation to the participating  securities in
certain  events.  At each reporting  period,  the Company  assesses  whether the
contingency  criteria have been met and consequently if  undistributed  earnings
should be allocated to participating securities.

3.   INVESTMENTS IN MARKETABLE SECURITIES

The  Company's  marketable  securities  are  categorized  as  available-for-sale
securities,  as defined by SFAS No. 115,  "Accounting for Certain Investments in
Debt and Equity  Securities."  At December 31, 2006 and December 31, 2005 all of
the  Company's   investments  in  marketable   securities   were  classified  as
available-for-sale,  and as a result,  were  reported at fair value.  Unrealized
gains and losses are reported as a component of accumulated other  comprehensive
income/(loss) in shareholders'  equity.  The cost for marketable  securities was
determined using the specific  identification  method and adjusted for accretion
of discounts or  amortization of premiums from the date of purchase to maturity.
The accretion and amortization is included in interest  income.  The fair values
of  marketable  securities  are  estimated  based on the quoted market price for
these securities.

Marketable securities are summarized, in thousands, as follows:

<TABLE>
<CAPTION>

                                                  December 31, 2006                      December 31, 2005
                                          ------------------------------------   ------------------------------------
                                                    Gross Unrealized                       Gross Unrealized
                                                    ----------------    Fair               ----------------   Fair
                                           Cost     Gains    Losses     Value     Cost     Gains    Losses    Value
                                          -------   ------   -------   -------   -------   ------   -------   -------
<S>                                       <C>       <C>      <C>       <C>       <C>       <C>      <C>       <C>
Collateralized mortgage
  obligations (CMO's) consisting
  of securities issued by
  Fannie Mae and Freddie Mac              $ 9,026   $   --   $   339   $ 8,687   $11,494   $   --   $    65   $11,429

</TABLE>

The cost and estimated fair value of current  marketable  securities at December
31, 2006, by contractual  maturity,  are shown below.  Expected  maturities will
differ from  contractual  maturities  because the issuers of the securities have
the right to repay obligations without prepayment penalties. It is the Company's
policy to classify  available-for-sale  securities that are available for use in
current operations as a current asset.


                                       42
<PAGE>

                                                                    Estimated
                                                       Cost         Fair Value
                                                   ------------    -----------
                                                          (in thousands)
        Due within one year                          $1,735           $1,732
        Due after one year and beyond                $7,291           $6,955
                                                     ------           ------
        Total debt securities                        $9,026           $8,687
                                                     ======           ======

The  following  table  shows the gross  unrealized  losses and fair value of the
Company's  investments  with  unrealized  losses  that  are  not  deemed  to  be
other-than-temporarily impaired, aggregated by investment category and length of
time that  individual  securities  have  been in a  continuous  unrealized  loss
position, at December 31, 2006, in thousands:

<TABLE>
<CAPTION>

                                   Less Than 12 Months        12 Months or Greater             Total
                                 -----------------------    -----------------------   -----------------------
                                   Fair       Unrealized      Fair       Unrealized     Fair       Unrealized
                                   Value       (Gains)        Value        Losses       Value        Losses
                                 ----------   ----------    ----------   ----------   ----------   ----------

<S>                              <C>          <C>           <C>          <C>          <C>          <C>
Federal agency mortgage-backed
 securities                      $    3,252   $       (2)   $    5,435   $      341   $    8,687   $      339
                                 ==========   ==========    ==========   ==========   ==========   ==========

</TABLE>

The   unrealized   losses  on  the  Company's   investments  in  federal  agency
mortgage-backed  securities were caused by interest rate increases.  The Company
purchased  these  investments at a discount of or at their face amount,  and the
contractual  cash flows of these  investments are guaranteed by an agency of the
U.S.  government.  Accordingly,  it is expected that the securities would not be
settled at a price less than the  amortized  cost of the  Company's  investment.
Because the decline in market value is attributable to changes in interest rates
and not credit  quality  and  because  the Company has the ability and intent to
hold these investments until their expected  redemption at full principal value,
the Company does not consider  these  investments  to be  other-than-temporarily
impaired at December 31, 2006.

4.   ACCOUNTS RECEIVABLE

Accounts receivable consist of the following, in thousands:

                                                              December 31,
                                                       ------------------------
                                                         2006            2005
                                                       --------        --------
         U.S. Government Contracts
              Billed                                   $  2,279        $  1,926
              Unbilled                                      369             424
                                                       --------        --------
                                                          2,648           2,350
                                                       --------        --------
         Commercial
              Billed                                     20,713          33,954
              Retainage                                   4,291           5,642
                                                       --------        --------
                                                         25,004          39,596
                                                       --------        --------
         Total accounts receivable                       27,652          41,946
         Less: allowance for doubtful accounts           (2,118)         (2,321)
                                                       --------        --------
         Accounts receivable, net                      $ 25,534        $ 39,625
                                                       ========        ========

The Company expects to collect  substantially  all  receivables  within one year
except  for a  portion  of the  receivables  recorded  as  retainage.  Retainage
expected to be collected in over one year amounts to $0.5  million,  or 12.5% of
the total  retainage  amount at December 31, 2006, and is reflected as a current
asset as it will be  collected  within the  operating  cycle  under the  related
contract.  Substantially all of the U.S.  Government billed  receivables  result
from cost reimbursable or time-and-material  contracts. Direct sales to the U.S.
Government  for  the  years  ended  December  31,  2006,   2005  and  2004  were
approximately  $16.4 million,  $9.4 million and $9.9 million,  respectively,  or
11.1%,  6.7%, and 7.0% of the Company's total revenue for the respective  years.
The sales to the U.S.  Government were in the  Institutional  Security  Systems,
Attack Protection and Integrated Electronic Systems segments. No single customer
accounted for greater than 10% of the Company's  net sales.  Contract  costs for
services  provided to the U.S.  Government,  including  indirect  expenses,  are
subject to audit by the Defense  Contract  Audit Agency  ("DCAA").  All contract
revenues are recorded in amounts expected to be realized upon final  settlement.
In  the  opinion  of  management,   adequate   provisions  have  been  made  for
adjustments,  if any, that may result from the  government  audits.  The Company
received final approval on its indirect costs billed to the U. S. Government for
2002 from DCAA in May 2006 and final  approval on its  indirect  costs billed to
the U.S. Government for 2003 from DCAA in June 2006. No significant  payments or
billings  were made as a result of the approval of the 2002 and 2003 rates.  The
years 2004, 2005 and 2006 are still open and subject to audit.  The Company does
not expect the audit of these years to have a material  effect on its  financial
position or results of operations.


                                       43
<PAGE>


5.   CONTRACTS IN PROCESS

Amounts included in the financial statements,  which relate to recoverable costs
and accrued  profits not yet billed on contracts in process,  are  classified as
current assets. Billings on uncompleted contracts in excess of incurred cost and
accrued  profits are classified as current  liabilities.  The Company expects to
bill and collect  substantially all costs in excess of billings within one year.
Summarized below are the components of the amounts:

<TABLE>
<CAPTION>

                                                                     December 31,
                                                                ----------------------
                                                                  2006          2005
                                                                ---------    ---------
                                                                    (in thousands)
<S>                                                             <C>          <C>
        Costs and estimated earnings on uncompleted contracts   $ 283,891    $ 277,048
        Less customer progress payments                           290,386      285,225
                                                                ---------    ---------
                                                                $  (6,495)   $  (8,177)
                                                                =========    =========
        Included in the consolidated balance sheets:
        Costs and estimated earnings in excess of billings
          on uncompleted contracts                              $  12,031    $  13,764
        Billings in excess of contract costs and estimated
          on uncompleted contracts                                 (9,221)     (13,847)
        Deferred revenue                                           (9,305)      (8,094)
                                                                ---------    ---------
                                                                $  (6,495)   $  (8,177)
                                                                =========    =========

</TABLE>


6.   INVENTORIES

Inventories consist of the following, in thousands:

<TABLE>
<CAPTION>

                                                                     December 31,
                                                                ----------------------
                                                                  2006          2005
                                                                ---------    ---------
<S>                                                             <C>          <C>
        Raw materials                                           $   3,645    $   3,984
        Work in progress                                            2,575        3,342
        Finished goods                                                274          240
                                                                ---------    ---------
        Total inventories                                           6,494        7,566
              Less: Reserve for excess and obsolete inventory        (917)      (1,371)
                                                                ---------    ---------
        Inventories, net                                        $   5,577    $   6,195
                                                                =========    =========

</TABLE>

7.   PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consist of the following, in thousands:

<TABLE>
<CAPTION>

                                                                                         Estimated
                                                                     December 31,         Useful
                                                               ----------------------      Life
                                                                 2006          2005      In Years
                                                               ---------    ---------    ---------
<S>                                                            <C>          <C>          <C>
        Land                                                   $     435    $     435
        Buildings and leasehold improvements                       4,924        4,889         7-39
        Machinery and equipment                                    7,518        7,170         3-10
        Furniture and fixtures                                     1,456        1,238         3-10
        Automobiles                                                  309          396          3-7
        Software                                                   9,408        8,734          3-7
        Construction in progress                                   1,289          966
                                                               ---------    ---------
                                                                  25,339       23,828
             Less: accumulated depreciation and amortization     (15,709)     (13,866)
                                                               ---------    ---------
                                                               $   9,630    $   9,962
                                                               =========    =========

</TABLE>

The  Company  acquired  software  as a result of its  purchase  of the assets of
Signami in 2006,  and 90 Degrees and  Copperfire in 2005 of $0.6  million,  $2.2
million and $0.2 million, respectively.

Depreciation and amortization  expense on property,  plant and equipment for the
years ended December 31, 2006, 2005, and 2004 was $2.8 million, $3.1 million and
$2.6 million, respectively.

8.   GOODWILL

The December 31, 2006  consolidated  financial  statements also include the fair
market  value of the assets  acquired  and  liabilities  assumed and the related
allocations  of the purchase  price related to the  acquisition of the assets of
Signami on July 20, 2006.  Goodwill  recorded for the Signami asset  acquisition
was approximately $0.8 million at December 31, 2006.

                                       44
<PAGE>

The Company  reviews the carrying value of goodwill  annually  during the fourth
quarter of the year or whenever events or changes in circumstances indicate that
the carrying value may not be  recoverable.  Changes in estimates of future cash
flows caused by items such as unforeseen  events or changes in market conditions
could  negatively  affect  the  reporting  unit's  fair  value and  result in an
impairment charge. During the fourth quarter of 2006, the Company concluded that
an  impairment  occurred in its Public Safety and Justice  segment.  The Company
performed its interim  impairment  test of the  reporting  unit as of October 1,
2006 and based on its  valuation  concluded  it was  necessary to write down the
value of the segment's goodwill in the amount of $14.4 million.  This write-down
is  included  in  impairment  of  goodwill  and  other  intangibles  in the 2006
statement of  operations.  The Company  cannot  predict the occurrence of events
that might  adversely  affect the reported  value of the  remaining  goodwill of
approximately  $13.3 million at December 31, 2006.  This valuation was performed
by the Company with the  assistance of an  independent  national  valuation firm
which considered market valuations, discounted cash flows and other factors when
preparing the valuations.

Goodwill, by segment, consists of the following, in thousands:

<TABLE>
<CAPTION>

                                                  Integrated    Public
                                       Attack     Electronic    Safety &
                                     Protection    Systems      Justice         Total
                                     ----------   ----------   ----------    ----------

<S>                                  <C>          <C>          <C>           <C>
December 31, 2004                    $      728   $       --   $   25,166    $   25,894
Addition from 2005 acquisitions              --           --          952           952
                                     ----------   ----------   ----------    ----------
December 31, 2005                           728           --       26,118        26,846
Addition from 2006 acquisition               --          829           --           829
Impairment charge                            --           --      (14,401)      (14,401)
                                     ----------   ----------   ----------    ----------
December 31, 2006                    $      728   $      829   $   11,717    $   13,274
                                     ==========   ==========   ==========    ==========

</TABLE>

9.    OTHER INTANGIBLE ASSETS

The December 31, 2006 consolidated  financial statements include the fair market
value of the assets acquired and liabilities assumed and the related allocations
of the purchase  price  related to the  acquisition  of the assets of Signami on
July 20, 2006.  Other  intangible  assets for the Signami asset  acquisition are
approximately $1.2 million at December 31, 2006.

The Company reviews the carrying value of intangible  assets when  circumstances
indicate that the carrying value may not be recoverable,  utilizing a discounted
cash flow model. During the fourth quarter of 2006 the Company concluded that an
impairment  had occurred in its Public Safety and Justice  segment.  The Company
performed its  impairment  test of  intangible  assets as of October 1, 2006 and
based on its valuation concluded it was necessary to write down the value of the
intangible assets in the amount of $1.7 million.  This write-down is included in
impairment  of  goodwill  and  other   intangibles  in  the  2006  statement  of
operations.  The  Company  cannot  predict the  occurrence  of events that might
adversely  affect  the  reported  value of the  remaining  intangible  assets of
approximately $7.4 million at December 31, 2006. This valuation was performed by
the Company with the assistance of an independent  national valuation firm which
considered excess earnings method, the relief from royalty method and discounted
earnings method when preparing the valuations.

The weighted average life for purposes of amortization of identified  intangible
assets acquired in 2006 amounting to $1.2 million was six years.

Other  intangible  assets  include the trade name,  customer  relationships  and
backlog from the acquisition of Tiburon, Inc. in 2002. Other intangibles include
trade names, Department of State Certifications, Underwriters Laboratories, Inc.
listings,  and patents  related to the  acquisition of Norment in 1998 and other
recent  acquisitions.  With  the  exception  of  the  trade  names,  which  have
indefinite   lives,  the  intangible   assets  are  being  amortized  using  the
straight-line  method.  Other  intangible  assets consist of the  following,  in
thousands:


                               December 31,    December 31,    Amortizable
                                   2006            2005           Lives
                               ------------    ------------    ------------
Cost                                                            (in years)
  Trade names                  $      3,952    $      5,632     Indefinite
  Customer relationships              3,280           2,500        7-14
  Other                               1,715           1,255        2-20
                               ------------    ------------
                                      8,947           9,387
                               ------------    ------------

Accumulated amortization
  Customer relationships               (883)           (655)
  Other                                (636)           (511)
                               ------------    ------------
                                     (1,519)         (1,166)
                               ------------    ------------

Other intangible assets, net   $      7,428    $      8,221
                               ============    ============


                                       45
<PAGE>

Amortization  expense for the  Company's  intangible  assets for the years ended
December  31,  2006,  2005 and 2004 was $353  thousand,  $309  thousand and $358
thousand  respectively.  The following schedule lists the expected  amortization
expense for each of the next five years ending December 31, in thousands:

                   Year
                   ----
                   2007                         $ 459
                   2008                           447
                   2009                           447
                   2010                           432
                   2011                           390
                   Thereafter                   1,300
                                                -----
                   Total                       $3,475
                                               ======

10.  ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liabilities consist of the following, in thousands:

                                                       December 31,
                                                   ---------------------
                                                    2006          2005
                                                   -------       -------

        Accounts payable                           $ 7,321       $15,461
        Accrued payroll costs                        3,011         3,558
        Income taxes payable                            32           206
        Other accrued expenses                       3,791         3,805
                                                   -------       -------
                                                   $14,155       $23,030
                                                   =======       =======

11.  NOTES PAYABLE AND LINE OF CREDIT

<TABLE>
<CAPTION>

                                                                                   December 31,      December 31,
                                                                                       2006              2005
                                                                                   ------------      ------------
                                                                                           (in thousands)
<S>                                                                                <C>               <C>
Industrial  revenue bond,  interest payable monthly at a variable rate of 3.14 %
to  4.19 %  (4.16  % at  December  31,  2006)  principal  payable  in  quarterly
installments of $35,000. The bond is fully collateralized
by a $1.1 million letter of credit and a bond guarantee agreement.                 $      1,120      $      1,260

Industrial revenue bond, interest payable monthly at a variable rate
of 3.07 % to 4.11 % (4.05 % at December 31, 2006) principal payable
in annual installments of $300,000 until 2013 when the annual
installments become $100,000.  The bond is fully collateralized by
a $2.0 million letter of credit and a bond guarantee agreement.                           2,005             2,305

6.25%  Convertible  Subordinated  Notes due  January  15,  2011.  The notes bear
interest  at  a  rate  of  6.25%  per  annum,  payable  semi-annually,  and  are
convertible  into  shares of common  stock at a  conversion  price of $13.89 per
share. These notes
are subordinated to all other liabilities of the Company.                                40,250            40,250
                                                                                   ------------      ------------


Total notes payable                                                                      43,375            43,815
Less convertible subordinated notes discount                                                758               945
                                                                                   ------------      ------------
Subtotal                                                                                 42,617            42,870
Less amount due within one year                                                             440               440
                                                                                   ------------      ------------
                                                                                   $     42,177      $     42,430
                                                                                   ============      ============

</TABLE>

                                       46
<PAGE>

Maturities of notes payable are as follows, in thousands:

               Year Ending December 31,               Amount

               2007                               $       440
               2008                                       440
               2009                                       440
               2010                                       440
               2011                                    40,690
         Thereafter                                       925
                                                  ------------
                                                  $    43,375
                                                  ============

On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million
principal  amount of the 2011 Notes.  The 2011 Notes bear  interest at a rate of
6.25% per annum,  payable  semi-annually,  and are  convertible  into  shares of
common stock at a conversion price of $13.89 per share,  subject to adjustments.
The 2011 Notes are  subordinated  to all other  liabilities of the Company.  The
December 31, 2006 carrying value is listed below, in thousands.

            Face value                          $  40,250
            Underwriters discounts, net               758
                                                ---------
                                                $  39,492
                                                =========

The 2011 Notes can be converted into the Company's common stock at the option of
the holder at any time at a  conversion  price of $13.89  per share,  subject to
adjustments for stock splits, stock dividends, the issuance of certain rights or
warrants to the existing  holders of the Company's common stock and common stock
cash dividends in excess of a stated threshold.

The 2011 Notes are  redeemable  at the option of the Company  after  January 15,
2009, at a premium of two percent of the face value plus accrued interest unless
a change in control event,  as defined in the indenture  dated as of January 15,
2004 between the Company and U.S. Bank,  relating to the 2011 Notes,  occurs. If
such an event does occur, the Company may redeem the 2011 Notes at a premium, in
whole but not in part,  to face.  If a change in  control  event  occurs and the
Company  does not elect to redeem the 2011  Notes,  the  holders can require the
Company to repurchase the 2011 Notes at face value plus accrued interest.

The debt issuance  costs for the 2011 Notes are recorded as a non-current  asset
and are amortized on a straight-line  basis to interest expense over the term of
the 2011 Notes. In addition,  underwriters'  discounts  totaled $1.3 million and
are amortized on a straight-line  basis to interest expense over the term of the
2011 Notes. There is no material difference between the straight-line  method of
amortization and the effective  interest method with respect to the amortization
of the  underwriter's  discounts  and debt  issuance  costs  on the 2011  Notes.
Interest  expense recorded for the total of the deferred debt issuance costs and
underwriters'  discounts  on the  2011  Notes  totaled  $251  thousand  and $251
thousand for the years ended December 31, 2006 and 2005, respectively.

On December 19, 2005, the Company and its bank entered into a Second Amended and
Restated  Revolving  Credit and Security  Agreement (the "Second Restated Credit
Agreement").  The Second  Restated  Credit  Agreement  amended and  restated the
Company's Amended and Restated Credit Agreement dated March 31, 2004.

In connection with the execution of the Second Restated  Credit  Agreement,  the
Company  provided  the bank  with  collateral  that  includes  all  receivables,
equipment,  general intangibles,  inventory,  investment property, real property
and a  security  interest  in  subsidiary  stock.  The  Second  Restated  Credit
Agreement allows the Company to obtain revolving  advances in a principal amount
of up to $20 million. Revolving advances are limited by a borrowing base formula
based upon the value of the Company's  receivables,  inventories,  fixed assets,
real  property  and  issued and  outstanding  letters  of  credit.  The  maximum
aggregate  face  amount of letters of credit  that may be drawn under the Second
Restated Credit  Agreement is $18 million.  The Second Restated Credit Agreement
matures on December 18, 2008.

Revolving advances under the Second Restated Credit Agreement bear interest,  at
the  election of the Company,  at a variable  rate equal to the  alternate  base
rate, a prime interest based rate, or the Eurodollar rate plus two percent.  For
letters of credit,  the Company pays an amount  equal to the average  daily face
amount of each outstanding letter of credit multiplied by two percent per annum,
and a fronting fee of one quarter of one percent per annum,  together with other
administrative fees and charges.  The Company paid its bank a closing fee of $50
thousand  in  connection  with  the  execution  of the  Second  Restated  Credit
Agreement.  The Company is also  required to pay the bank an unused fee equal to
three-eighths  of one  percent  per annum of the  amount  by which  $20  million
exceeds the average daily unpaid  balance of the revolving  advances and undrawn
amount of any  outstanding  letters  of  credit.  In  addition,  the  Company is
required to pay a collateral monitoring fee equal to $1 thousand per month and a
collateral evaluation fee as required.


                                       47
<PAGE>

The Second Restated Credit Agreement  contains various  affirmative and negative
covenants including financial covenants.  The Company is required to maintain an
unrestricted  undrawn  borrowing  base  availability  of at  least  $5  million.
Commencing  with the fiscal quarter ended June 30, 2006, the Company is required
to maintain a fixed charge  coverage  ratio of at least 1.1 to 1.0. This Company
was in compliance with this ratio during the applicable period in 2006.

On July 14, 2006,  the Company and its banks  entered into a First  Amendment to
Second  Amended and Restated  Revolving  Credit  Security  Agreement (the "First
Amendment").  The First Amendment amended the Credit Agreement to (i) modify the
borrowing base, (ii) permit any Borrower to guaranty certain indebtedness of any
other  Borrower,  (iii)  increase  the  maximum  limit of  rental  payments  for
non-capitalized  leases  from $3  million to $4 million  per fiscal  year,  (iv)
permit the  Company to  repurchase  or redeem  certain  of the  Company's  6.25%
Convertible  Subordinated  Notes due  January  15,  2011 and (v)  consent  to an
acquisition by a newly formed indirect  subsidiary of the Company pursuant to an
asset purchase transaction.

On December 5, 2006,  the Company and its banks entered into a Second  Amendment
to Second Amended and Restated  Revolving Credit Security Agreement (the "Second
Amendment").  The Second Amendement amended the Credit Agreement to supply a new
definition for the loan agreement  which reduced the interest rate being charged
by 0.5%.

On March 28, 2007,  the Company and its banks entered into a Third  Amendment to
Second Amended and Restated  Revolving Credit and Security Agreement (the "Third
Amendment").  The Third Amendment  amended the Credit  Agreement by (i) amending
the definition of EBITDA to exclude from the  calculation of EBITDA any non-cash
impairment  charges against goodwill and other intangible assets incurred by the
Company's  subsidiary,  Tiburon,  Inc., during the fiscal quarter ended December
31, 2006, (ii) increasing the aggregate  maximum  permissible  amount of capital
expenditures in any fiscal year to $2.5 million;  (iii)  permitting the Company,
subject to certain  conditions,  to  purchase  or redeem up to $8 million of the
Company's  6.25%  Convertible  Subordinated  Notes due  January 15,  2011,  (iv)
permitting  the Company to deliver its  audited  financials  for the fiscal year
ended  December 31, 2006 by no later than April 30, 2007 and (v)  permitting the
Company's annual projected  operating budget and cash flow projections be broken
down on a quarterly basis versus a monthly basis.

12.  PRODUCT WARRANTIES

Included in accounts  payable and accrued  liabilities  are  estimated  expenses
related  to  warranties  made at the  time  products  are sold or  services  are
rendered.  These accruals are established  using  historical  information on the
nature,  frequency,  and average cost of warranty  claims.  The Company warrants
numerous  products,  the terms of which vary  widely.  In  general,  the Company
warrants its products against defect and specific  non-performance.  The changes
in the product  warranty  liability  are displayed in the  following  table,  in
thousands:

                                                 2006               2005
                                                 -----              -----
  Beginning balance at January 1                 $ 388              $ 359
  Plus:  accruals for product warranties           343                375
  Less:  warranty charges/claims                  (321)              (346)
                                                 -----              -----
  Ending balance at December 31                  $ 410              $ 388
                                                 =====              =====

13.  FAIR VALUE OF FINANCIAL INSTRUMENTS

The following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments:

Cash and Cash Equivalents,  Accounts Receivable and Accounts Payable and Accrued
Expenses - The carrying  amounts  reported in the balance sheets for these items
approximate  fair value due to the  short-term  maturities  of these  assets and
liabilities.

Long-Term  Debt - The fair value of these Notes at  December  31, 2006 was $36.0
million.

Interest Rate Swap Agreements - The Company used an interest rate swap agreement
to manage  exposure to fluctuations in interest rates. At December 31, 2004, the
Company had an unleveraged swap agreement with a bank with a notional  principal
amount of $2.0 million.  This agreement was placed on June 26, 2001 with a fixed
rate of 4.9% and was settled in cash on a quarterly  basis. The termination date
was September 30, 2005.

In prior years the Company  hedged the cash flows of some of its long-term  debt
using an interest rate swap. The Company entered into this  derivative  contract
to manage its  exposure  to  interest  rate  movements  by  achieving  a desired
proportion  of fixed rate versus  variable  rate debt. In an interest rate swap,
the Company exchanges the difference between a variable interest rate and either
a fixed or another variable  interest rate,  multiplied by a notional  principal
amount.


                                       48
<PAGE>

As of December 31, 2003, the Company  recognized the cash flow hedge at its fair
value  of  $155  thousand  in  accounts  payable  and  accrued  expenses  on the
consolidated  balance  sheet.  As of December  31, 2003 the  interest  rate swap
qualified for cash flow hedge  accounting,  therefore an unrealized loss of $155
thousand ($93 thousand net of tax),  representing  the effective  portion of the
change in its fair value, was reported in other comprehensive loss. For the year
ended December 31, 2004, the interest rate swap was determined to be ineffective
and the changes in fair value were recognized in earnings.

14.  INCOME TAXES

The  components  of the  income  tax  provision  (benefit)  are as  follows,  in
thousands:

                                     For the years ended December 31,
                                    -----------------------------------
                                     2006          2005          2004
                                    -------       -------       -------
        Current                     $   (97)      $  (203)      $(2,013)
        Deferred                       (635)          (12)         (219)
                                    -------       -------       -------
                                    $  (732)      $  (215)      $(2,232)
                                    =======       =======       =======

The  tax  effects  of the  primary  temporary  differences  giving  rise  to the
Company's net deferred tax assets and  liabilities at December 31, 2006 and 2005
are summarized as follows, in thousands:

                                                                December 31,
                                                            -------------------
                                                             2006        2005
                                                            -------     -------
Deferred tax assets:
        Accrued expenses and deferred compensation          $   349     $   204
        Tax operating loss carryforward                       4,928       4,349
        Book reserves in excess of tax                        1,430       1,762
        Tax depreciation and amortization in excess
           of book depreciation and amortization              1,423         821
        Unrealized loss on marketable securities                132          25
        Other                                                   246          --
                                                            -------     -------
        Total deferred tax assets                             8,508       7,161
                                                            -------     -------
Deferred tax liabilities:
        Purchased intangibles                                (2,686)     (3,086)
        Other                                                    --          (9)
                                                            -------     -------
        Total deferred tax liabilities                       (2,686)     (3,095)
        Valuation allowance                                  (7,247)     (6,126)
                                                            -------     -------
Net deferred tax (liability) asset                          $(1,425)    $(2,060)
                                                            =======     =======

In the third  quarter of 2005 the  Company  reversed  $500  thousand  previously
recorded as a reserve for uncertain tax positions which was no longer needed. In
the first quarter of 2006 the Company reversed $200 thousand previously recorded
as a reserve for uncertain tax positions which was no longer needed.

At December 31, 2006 and 2005 the Company  established a valuation  allowance to
reserve  substantially  all of its net deferred tax assets,  because the Company
believes  that it is not "more  likely than not" that it will be able to realize
the deferred tax assets in the future.  Deferred tax assets at December 31, 2006
include  $32.4  million  of state net  operating  losses  for which a  valuation
allowance  has  been  established.   The  Company  completed  an  organizational
restructuring  during the year ended  December  31,  2005,  creating a state tax
structure  that may result in  realization  of the state net  operating  loss in
future years if the Company returns to profitability.

At  December  31,  2006,  the  Company  and its  subsidiaries  have  Federal net
operating  loss  carryforwards  available  to offset  future  taxable  income of
approximately $6.5 million, of which $1.0 million is subject to limitations. The
limited tax loss  carryforwards are limited to approximately  $235 thousand each
year as a result of an ownership change,  which occurred in 1995.  Approximately
$5.5  million is available  for use on an  unlimited  basis  through  2025.  The
balance of these carryforwards expires between 2006 and 2010.

At December 31, 2006,  the Company and its  subsidiaries  have $32.4  million of
state net operating loss carryforwards  available to offset future taxable state
income.

We  excluded   approximately   $629  thousand  of  Federal  net  operating  loss
carryforwards  from the  calculation  of the deferred tax asset above because it
represents  excess stock option  deductions  that did not reduce taxes  payable.
These unrealized excess stock option deductions, if realized in the future, will
result in an increase  to paid-in  capital.  We  recognize  the  benefits of net
operating loss  carryforwards  in the following  order: (1) net operating losses
from items other than excess stock option  deductions;  (2) net operating losses
from excess stock option deductions accounted for under SFAS 123R. We calculated
our  adoption  date pool of excess tax benefits  previously  included in paid-in
capital under the long-form method outlined in SFAS 123R.


                                       49
<PAGE>

The  difference  between the statutory tax rate and the Company's  effective tax
rate is summarized as follows:

                                                      For the years ended
                                                          December 31,
                                                     ----------------------
                                                     2006     2005     2004
                                                     ----     ----     ----
        Statutory federal income tax rate           (34.0)%  (34.0)%  (34.0)%
        State income taxes, net of
            Federal benefit                          (0.7)    (4.6)    (0.3)
        Change in valuation allowance                 0.0     38.7     14.8
        Tax effect of non-deductible goodwill        31.7     --       --
        Tax effect of other non-deductible items      1.5      0.7      0.5
        Foreign income exclusion                     (1.1)    (1.4)    (1.9)
        Other                                        (2.1)    (1.8)    (0.5)
                                                     ----     ----     ----
        Effective tax rate                           (4.7)%   (2.4)%  (21.4)%
                                                     ====     ====     ====

15.  SHAREHOLDERS' EQUITY

Warrants for Common  Stock.  In connection  with a Private  Investment in Public
Equity  ("PIPE")  transaction  the Company  entered  into in October  2001,  the
Company  granted  its  underwriter  an option to purchase  40,000  shares of the
Company's  common stock at $12.00 per share,  the price at which the shares were
sold in the PIPE. These warrants were granted on October 29, 2001 and expired on
October 29, 2006.

In connection  with the Company's  acquisition  of Tiburon in 2002,  the Company
exchanged warrants and convertible securities to purchase shares of Tiburon into
warrants to purchase  shares of the Company.  On May 2, 2002, the Company issued
90,962 warrants to purchase  shares of CompuDyne  common stock at prices ranging
from  $3.75 to $6.71  per  share.  During  2002,  11,909  of the  warrants  were
exercised,  during 2003,  44,417 of the warrants were  exercised and during 2006
the remaining 34,636 warrants were exercised.

16.  STOCK-BASED COMPENSATION

Effective  January 1, 2006, we adopted SFAS No. 123(R),  "Share-Based  Payment."
This  statement  requires  us to  expense  the fair  value of grants of  various
stock-based  compensation  programs  over the vesting  period of the awards.  We
elected to adopt the "Modified Prospective  Application" transition method which
does not require the restatement of previously issued financial statements,  and
therefore  previously issued financial statements are not directly comparable to
periods   after   adoption.   Compensation   expense  is   measured   using  the
Black-Scholers-Merton  option  pricing model which we have  determined to be the
most appropriate  fair-value  method for determining the value of our awards and
we have recognized  compensation costs on a straight-line  basis over the awards
vesting  periods  in  accordance  with  the  provisions  of FAS  123R.  We  have
recognized stock based compensation beginning in 2006 as follows:

Awards granted after December 31, 2005 - Awards are measured at their fair value
at date of grant.  The  resulting  compensation  expense  is  recognized  in the
consolidated  statement of  operations  ratably  over the vesting  period of the
award.

Awards  granted  prior to December 31, 2005 - Awards were measured at their fair
value at the date of original grant.  Compensation  expense  associated with the
unvested  portion  of these  options at  January  1, 2006 is  recognized  in the
consolidated statement of operations ratably over the remaining vesting period.

For all  grants  issued  after  December  31,  2005  the  amount  of  recognized
compensation  expense is adjusted based upon an estimated  forfeiture rate which
is derived from historical data.

The following table shows total stock-based compensation expense included in the
Consolidated Statement of Operations, in thousands:

                                                          For the Year
                                                    Ended December 31, 2006
                                                    -----------------------
       Cost of sales                                          $  60
       Selling, general and administrative                      995
       Research and development                                  58
                                                             ------
             Total                                           $1,113
                                                             ======

No similar  expense was charged  against  income in the prior  periods as we had
elected to apply the  provisions  of APB No. 25 to those periods as permitted by
SFAS No. 123.


                                       50
<PAGE>

SFAS No.  123(R) also requires that the tax benefit from the exercise of options
be  reflected  in the  statement  of cash flows as a cash inflow from  financing
activities.  Prior to the adoption of SFAS No.  123(R),  these tax benefits were
reflected as a cash inflow from operations. The tax benefit from the exercise of
options was $1,500 and $6,800 for the years ended December 31, 2006 and December
31, 2005, respectively.  Additionally,  the Company used the long-form method to
calculate the additional  paid-in capital  ("APIC") pool, the tax benefit of any
resulting  excess tax deduction should increase the APIC pool; any resulting tax
deficiency should be deducted from the APIC pool.

Stock Option Plans
------------------

2005 Stock Incentive Compensation Plan for Employees.  Stock options are granted
with an  exercise  price  equal to the market  price of the stock at the date of
grant.  Substantially  all of the options granted are exercisable  pursuant to a
five-year vesting  schedule.  The fair value of these options is estimated using
the Black-Scholes  option pricing model which incorporates the assumptions noted
in  the  table  below.   Expected  volatilities  are  based  on  the  historical
performance of our stock. We also use historical data to estimate the timing and
amount of option  exercises  and  forfeitures  within the valuation  model.  The
expected  term of the options is derived  from the output of the option  pricing
model and  represents  the period of time that  options  are  expected to remain
unexercised. The risk-free interest rate for periods within the contractual life
of the option is based on the U.S.  Treasury  bond rate in effect at the time of
grant.

2005 Stock Option Plan for  Non-Employee  Directors.  Stock  options are granted
with an  exercise  price  equal to the market  price of the stock at the date of
grant.  Substantially  all of the options granted are exercisable  pursuant to a
three-year vesting schedule.  The fair value of these options is estimated using
the Black-Scholes  option pricing model which incorporates the assumptions noted
in  the  table  below.   Expected  volatilities  are  based  on  the  historical
performance of our stock. We also use historical data to estimate the timing and
amount of option  exercises  and  forfeitures  within the valuation  model.  The
expected  term of the options is derived  from the output of the option  pricing
model and  represents  the period of time that  options  are  expected to remain
unexercised. The risk-free interest rate for periods within the contractual life
of the option is based on the U.S.  Treasury  bond rate in effect at the time of
grant.

The 1996 Stock  Incentive  Plan for Employees and the 1996 Stock Option Plan for
Non-Employee  Directors,  collectively referred to as the "Prior Plans," expired
in accordance with their terms and no further stock options may be granted under
these plans.

The fair values of grants in the stated period were computed using the following
range of assumptions for our various stock option plans:

                                                  For the Year
                                             Ended December 31, 2006
                                             -----------------------
       Risk-free interest rate                           4.9  %
       Dividend yield                                   none
       Expected volatility                              77.6  %
       Expected lives                              6.5 years
       Annual forfeiture rate                            4.4  %

 The  Company has various  stock  option  plans.  Under these  plans,  5,407,100
options to purchase  common  stock may be granted  until May 27,  2015.  Options
generally are granted at fair market value at the date of grant,  typically vest
over 1 to 5 years from the date of grant,  and expire 10 years after the date of
grant.  The plans  permit the  issuance  of either  incentive  stock  options or
non-qualified  stock options.  Under all plans,  there were 3,894,000  shares of
common stock  reserved for future  grants as of December 31, 2006.  Transactions
for stock options and warrants are summarized as follows:

<TABLE>
<CAPTION>

                                     Year Ended     Weighted         Year Ended     Weighted         Year Ended      Weighted
                                    December 31,    Average         December 31,     Average        December 31,     Average
                                        2006         Price              2005         Price              2004          Price
                                    ------------  ------------      ------------  ------------      ------------  ------------
<S>                                 <C>           <C>               <C>           <C>               <C>           <C>
Outstanding, Beginning of Year      1,453,358     $      8.755      1,671,958     $      9.418      1,414,556     $      8.587
         Granted                      494,000     $      6.752        287,000     $      6.983        675,000     $      9.145
         Forfeited                    215,200     $      7.200             --               --             --               --
         Exercised                     35,661     $      5.777          6,500     $      3.906        303,898     $      4.131
         Expired or Cancelled         183,397     $      9.948        499,100     $     10.004        113,700     $     11.590
                                    ------------                    ------------                    ------------
Outstanding, End of Year            1,513,100     $      8.248      1,453,358     $      8.755      1,671,958     $      9.418
                                    ============                    ============                    ============

Exercisable, End of Year              770,100     $      9.448        843,308     $      9.587        492,861     $      9.226
                                    ============                    ============                    ============

</TABLE>

                                       51
<PAGE>

A summary of our stock options outstanding at December 31, 2006 follows:

<TABLE>
<CAPTION>

                                           Options outstanding                          Options exercisable
                              --------------------------------------------         -----------------------------
                                             Weighted-            Weighted-                          Weighted-
                                              Average             Average                             Average
                                             Remaining            Exercise                            Exercise
 Range of Exercise Price       Shares       Life (yrs)             Price            Shares             Price
 -----------------------      --------      ----------           ---------         --------          ---------
<S>                            <C>              <C>               <C>                <C>               <C>
   $  1.690  -   6.235         163,800          6.63              $5.3315            42,800            $3.3002
   $  6.250  -   6.825         198,500          7.37              $6.5909             8,100            $6.3224
   $  6.860  -   6.950         246,800          7.70              $6.9248             6,800            $6.8750
   $  7.000  -   7.500         160,500          4.52              $7.2899            62,500            $7.3481
   $  7.719  -   8.075         164,000          4.98              $8.0511           149,600            $8.0567
   $  8.105  -   8.960         169,200          5.38              $8.5807           115,000            $8.5512
   $  9.190  -  10.420         183,800          5.27             $10.0763           158,800           $10.0371
   $ 11.165  -  13.445         223,000          5.46             $12.2925           223,000           $12.2925
   $ 13.750  -  16.330           2,500          4.90             $14.8100             2,500           $14.8100
   $ 16.630  -  16.630           1,000          4.74             $16.6300             1,000           $16.6300
------------------------------------------------------------------------------------------------------------------

   $  1.690  -  16.630       1,513,100          6.02              $8.2478           770,100            $9.4480
                             =========                                              =======

</TABLE>

In the  years  ended  December  31,  2006,  2005 and  2004 the  weighted-average
grant-date  fair  value of an  option  granted  was  $4.89,  $4.15 and $5.95 per
option,  respectively.  The total intrinsic  value,  the difference  between the
exercise  price and the market  price on the date of  exercise,  of all  options
exercised  during  the  year  ended  December  31,  2006 was  approximately  $24
thousand. Total unrecognized compensation expense from stock options outstanding
at  December  31,  2006  was  approximately  $2.6  million  excluding  estimated
forfeitures,  which is expected to be recognized over a weighted-average  period
of 2.2 years as follows, in thousands:

                                           Compensation Expense
                                           Excluding Estimated
                Year                           Forfeitures
                ----                       --------------------
                2007                             $   933
                2008                                 690
                2009                                 495
                2010                                 371
                2011                                 111
                                                 -------
                      Total                      $ 2,600
                                                 =======

Share - Based Compensation Fair Value Assumption
------------------------------------------------

The fair value of each option  award is  estimated  on the date of grant using a
Black-Scholes-Merton  option  pricing  model  that  uses  the  weighted  average
assumptions  noted in the table in  footnote  number 1. For 2006,  2005 and 2004
volatility is based on historical volatility of CompuDyne's stock. The risk-free
interest rate is based on the zero-coupon U.S.  Treasury bond. We use historical
data to estimate  stock option  exercises and  forfeitures  within the valuation
model.  The  expected  term of stock  option  awards  granted  is  derived  from
historical  exercise  experience  under the  share-based  employee  compensation
arrangements  and represents the period of time option awards are expected to be
outstanding.

17.  COMMITMENTS AND CONTINGENCIES

Operating  Leases.  The Company  leases office space,  equipment,  distribution,
manufacturing and storage facilities under non-cancelable  operating leases with
various  expiration  dates through  December 2012.  Total rental expense for the
years ended December  2006,  2005 and 2004 was $3.2 million,  $3.2 million,  and
$3.2 million, respectively.

As of December 31, 2006,  future  minimum  rental  payments  required  under all
non-cancelable operating leases are as follows, in thousands:

              Year Ending
             December 31,                      Total
             ------------                    --------
               2007                          $  3,203
               2008                             2,670
               2009                             2,179
               2010                             1,747
               2011                             1,356
               Thereafter                         381
                                             --------
                                             $ 11,536
                                             ========


                                       52
<PAGE>

Interest on Contractual Obligations.  As of December 31, 2006, the Company has a
$40.25  million note  outstanding  at a fixed rate of 6.25%.  In addition it has
industrial  revenue bonds in the amount of $3.1 million  outstanding  which have
variable interest rates and decreasing principal balances until maturity. Future
interest on contractual obligations is as follows, in thousands:

              Year Ending
             December 31,                      Total
             ------------                    --------
               2007                          $  2,632
               2008                             2,614
               2009                             2,596
               2010                             2,578
               2011                               147
               Thereafter                         376
                                             --------
                                             $ 10,943
                                             ========

Purchase  Obligations.  The Company enters into purchase  obligations to procure
equipment and services, including subcontractor contracts, in the performance of
the  day-to-day   operations  of  its  business.   Substantially  all  of  these
obligations  are covered by our existing  backlog and the revenues  generated by
these  backlogs are expected to be  sufficient  to meet any payment  obligations
resulting from these purchase  commitments.  Future purchase  obligations are as
follows, in thousands:

              Year Ending
             December 31,                      Total
             ------------                    --------
               2007                          $  8,363
               2008                                 -
               2009                                 -
               2010                                 -
               2011                                 -
               Thereafter                           -
                                             --------
                                             $  8,363
                                             ========

Legal  Matters.  The Company is party to certain legal actions and inquiries for
environmental  and other matters  resulting  from the normal course of business.
Some of the  businesses,  especially  Institutional  Security  Systems,  involve
working as a subcontractor to a prime contractor.  From time to time the Company
makes claims against the prime contractor,  or the prime contractor makes claims
against the Company.  At any point in time the Company is engaged in a number of
claim  disputes  with prime  contractors,  some of which may have a  significant
negative outcome.  Although the total amount of potential liability with respect
to  these  matters  can not be  ascertained  given  the  nature  of the  related
allegations,  the Company presently  believes that any resulting  liability will
not  have a  material  effect  on its  financial  position,  results  of  future
operations or cash flows.

In addition to claims with prime  contractors,  the Company may also make claims
against customers and customers may make claims against the Company.

During 2006 we received a letter from a client of our Public  Safety and Justice
segment  indicating  their intent to terminate their contract with us for cause.
The letter alleges that we failed to complete the project under the terms of the
agreement  and the  applications  implemented  failed to meet the  functionality
requirements of the agreement. The customer is seeking a refund of approximately
$400  thousand  previously  paid  by  them.  Costs  in  excess  of  billings  of
approximately  $600 thousand  related to this project  remain as an asset on our
books and records as of  December  31,  2006.  The  segment  disagrees  with the
client's  views.  While the ultimate  outcome  cannot be predicted,  the Company
intends to vigorously pursue this matter. The Company has established an accrual
for this matter which is included in accounts payable and accrued liabilities on
the balance sheet.

On November 21, 2006,  CompuDyne  Corporation  ("CompuDyne")  and William  Blair
Mezzanine Capital Fund II, L.P.  ("Blair") entered into a Release and Settlement
Agreement with Friedman,  Billings,  Ramsey Group,  Inc.  ("FBR"),  by which FBR
agreed to pay $4.5 million to CompuDyne and Blair, CompuDyne and Blair agreed to
release FBR, and FBR has agreed to release CompuDyne and Blair, from any and all
causes of action arising out of or relating to, among other things,  an offering
of CompuDyne  common stock in 2001 for which FBR acted as lead  underwriter  and
financial  advisor.  Blair is a former  shareholder of CompuDyne which also sold
shares in the 2001  offering.  After  legal and other  expenses  and  payment of
Blair's  share of the  settlement,  the net amount  recorded  by  CompuDyne  was
approximately $2.8 million which is recorded in additional  paid-in capital.  At
December  31,  2006,  $1.3  million in cash was received and the balance of $1.5
million was received in January, 2007.


                                       53
<PAGE>

The Company has learned  that the National  Association  of  Securities  Dealers
("NASD")  and other  regulatory  bodies are seeking  sanctions  against  certain
purchasers  of the  Company's  common  stock in its 2001 PIPE  transaction.  The
Company is investigating  these matters,  and has filed lawsuits against certain
purchasers. The Company is currently attempting to resolve these matters.

The Company  has been named in  lawsuits  involving  asbestos  related  personal
injury and death claims in which CompuDyne  Corporation,  individually and as an
alleged successor, is a defendant.  The Company has been named as a defendant in
cases  related  to  claims  for  asbestos  exposure  allegedly  due to  asbestos
contained in certain of its predecessor's  products. The Company has advised its
insurers  of each of these  cases,  and the  insurers  are  providing  a defense
pursuant to agreement with the Company,  subject to reservation of rights by the
insurers.  The insurers have advised that claims in such litigation for punitive
damages,  exemplary  damages,  malicious  and  willful and wanton  behavior  and
intentional  conduct are not covered.  One of the carriers has given notice that
asbestos  related  claims  are  excluded  from  certain of these  policies.  The
insurers have additional coverage defenses,  which are reserved,  including that
claims may fall outside of a particular  policy  period of coverage.  Litigation
costs  to date  have  not  been  significant  and the  Company  has not paid any
settlements from its own funds.

The Company  cannot  ascertain  the total  amount of  potential  liability  with
respect to these legal  matters,  but does not believe  that any such  potential
liability  should  have a  material  effect on its  financial  position,  future
operations or future cash flows.

The Company,  as a government  contractor,  is from time to time subject to U.S.
Government  investigations  relating to its operations.  Government  contractors
that are found to have  violated  the  False  Claims  Act,  or are  indicted  or
convicted for  violations of other  federal  laws, or are  considered  not to be
responsible   contractors,   may  be  suspended  or  debarred  from   government
contracting  for some  period of time.  Such  convictions  could also  result in
fines.  Suspension,  debarment or fines could have a material  adverse effect on
the Company.

In connection  with the  acquisition  of the assets of Signami,  LLC made by the
Company in July 2006,  the Company issued 93,334 shares to the sellers for which
it  guaranteed  for a 2 year  period  that  upon sale of these  securities,  the
Company would guarantee a price of $7.50 per share for these shares. This period
is extended for members  precluded  from  selling  their shares due to statutory
reasons.  Included  in other  long term  liabilities  at  December  31,  2006 is
approximately $86 thousand representing the fair value of this liability.

18.  RELATED PARTY TRANSACTION

During 2006 and 2005 the Company's  Integrated  Electronic Systems unit recorded
revenue of  approximately  $339 thousand and $255 thousand,  respectively,  from
sales to a company of which one of CompuDyne's Directors (this director resigned
from  CompuDyne's  Board of Directors  during  February  2007) was a senior vice
president  and  member of its board of  directors.  Included  in the  Integrated
Electronic  Systems unit at December 31, 2006 and 2005 related to the company at
which this  Director was employed was $9 thousand and $351  thousand of accounts
receivables,  respectively, and $9 thousand and $9 thousand of contract costs in
excess of billings, respectively.

19.  EMPLOYEE BENEFIT PLANS

The Company established a non-qualified  Employee Stock Purchase Plan in October
1999,  the  terms of  which  allow  for  qualified  employees  (as  defined)  to
participate in the purchase of shares of the Company's common stock. The Company
matches at a rate of 15% of the  employee  purchase  at the market  value of the
common stock for the monthly purchase period. The Company purchases stock on the
open  market  and  distributes  the  shares  monthly  to  employees'  individual
accounts.  Expense for matching  contributions to the plan was $27 thousand, $33
thousand, and $33 thousand for 2006, 2005, and 2004 respectively.

The Company has a 401(k)  retirement  savings plan covering all  employees.  All
employees are eligible to participate  in the plan after  completing one year of
service (as defined by the plan). Participants may make before tax contributions
subject to Internal Revenue Service limitations.  CompuDyne currently matches up
to 2.5% of  employee  contributions  up to a  maximum  of  $5,000.  Expense  for
matching  contributions  to the Plan was $789  thousand,  $783 thousand and $694
thousand for 2006, 2005, and 2004, respectively.

The Company entered into the CompuDyne  Corporation  Retention Plan for Selected
Employees  (the  "Retention  Plan")  effective June 28, 2005. The Retention Plan
provides  for cash  bonuses  and  acceleration  of  vesting  of all  unexercised
unvested stock awards upon the occurrence of a change in control,  as defined in
the Retention Plan, for eligible  employees.  A change in control, as defined in
the  Retention  Plan,  did not occur during the year ended  December 31, 2006 or
2005  and  therefore,  the  Company  did  not  record  a  liability  or  related
compensation expense for the Retention Plan.


                                       54
<PAGE>

20.  OPERATING SEGMENT INFORMATION

Segment  information has been prepared in accordance with Statement of Financial
Accounting Standards (SFAS) No. 131, "Disclosure about Segments of an Enterprise
and Related  Information"  ("SFAS No.  131").  SFAS No. 131  defines  "operating
segments" to be those  components of a business about which  separate  financial
information is available  that is regularly  evaluated by management in deciding
how to allocate  resources  and in assessing  performance.  SFAS No. 131 further
requires that the segment information presented be consistent with the basis and
manner in which management  internally  evaluates financial  information for the
purpose of assisting in making internal operating decisions.

The following segment information includes operating information for CompuDyne's
four operating  segments,  Institutional  Security Systems,  Attack  Protection,
Integrated  Electronic  Systems  and Public  Safety and  Justice in  addition to
Corporate  activities  for each of the years ended  December 31, 2006,  2005 and
2004.

<TABLE>
<CAPTION>

                                                   Revenues                               Gross Profit
                                                   --------                               ------------
(in thousands)                          2006         2005         2004           2006         2005         2004
                                     ----------   ----------   ----------     ----------   ----------   ----------

<S>                                  <C>          <C>          <C>            <C>          <C>          <C>
Institutional Security Systems       $   48,265   $   60,652   $   53,952     $    7,336   $    9,896   $    6,437
Attack Protection                        40,241       27,017       25,161         13,081        6,105        1,551
Integrated Electronic Systems            13,894       10,110       14,293          2,986        1,625        2,019
Public Safety and Justice                45,062       43,871       49,376         24,464       24,913       27,671
CompuDyne Corporate                           -            -            -              -            -            -
                                     ----------   ----------   ----------     ----------   ----------   ----------
                                     $  147,462   $  141,650   $  142,782     $   47,867   $   42,539   $   37,678
                                     ==========   ==========   ==========     ==========   ==========   ==========

                                           Total Assets, at Year End                   Pre-tax Income (Loss)
                                           -------------------------                   ---------------------
                                        2006         2005         2004           2006         2005         2004
                                     ----------   ----------   ----------     ----------   ----------   ----------
Institutional Security Systems       $   17,648   $   23,755   $   26,895     $   (1,277)  $      629   $   (5,174)
Attack Protection                        14,196       20,621       15,760          4,672       (2,333)      (5,444)
Integrated Electronic Systems             6,535        4,354        3,807            985          431          563
Public Safety and Justice                35,573       57,780       56,538        (17,983)      (2,928)       2,364
CompuDyne Corporate                      29,998       20,182       29,891         (2,122)      (4,705)      (2,739)
                                     ----------   ----------   ----------     ----------   ----------   ----------
                                     $  103,950   $  126,692   $  132,891     $  (15,725)  $   (8,906)  $  (10,430)
                                     ==========   ==========   ==========     ==========   ==========   ==========

                                             Capital Expenditures                  Depreciation and Amortization
                                             --------------------                  -----------------------------
                                        2006         2005         2004           2006         2005         2004
                                     ----------   ----------   ----------     ----------   ----------   ----------
Institutional Security Systems       $       44   $      132   $      411     $      385   $      388   $      531
Attack Protection                           183          264           64            603          767          644
Integrated Electronic Systems                42            8           16            183           35           41
Public Safety and Justice                 1,528          815        1,140          1,938        2,145        1,664
CompuDyne Corporate                          55           33          153             58           58           41
                                     ----------   ----------   ----------     ----------   ----------   ----------
                                     $    1,852   $    1,252   $    1,784     $    3,167   $    3,393   $    2,921
                                     ==========   ==========   ==========     ==========   ==========   ==========
</TABLE>

Included in the 2006 results are $14.4 million  charge related to the impairment
of the Public Safety and Justice  Segment's  goodwill and a $1.7 million  charge
related to the impairment of a tradename.  In addition Public Safety and Justice
expended $4.4 million on its NextGen products which are expected to be sold into
the market in 2008.

Included in the 2005 results are certain contract closeout activities in the ISS
segment which resulted in the  recognition  of $2.0 million of gross margin.  In
addition  $2.0  million  in  losses  recorded  in the  ISS  segment  related  to
continuing problems in its West Coast office.  Additionally,  PS&J increased its
focus on its Next Generation products, expending $884 thousand. Also included in
the 2005 results are costs  related to SOX 404  compliance in the amount of $2.4
million.

Included in the 2004  results is a $739  thousand  pre-tax  charge to record the
impairment of the Institutional  Security Systems segment's  goodwill and a $1.1
million charge to record the impairment of certain of the Institutional Security
Systems segment's other intangible assets. In addition,  the continuing problems
in the West Coast  office of ISS  resulted in the Company  recording  additional
losses of $6.1 million from the work  performed in this office and an additional
$2.0 million was added to a project's estimated cost to complete.  Also included
in 2004's results are charges of $411 thousand for terminated deal costs related
to unconsummated acquisitions,  and $2.6 million of interest expense incurred in
connection  with the 2011 Notes  issued in January  2004;  these  expenses  were
recorded in CompuDyne Corporate's accounts.


                                       55
<PAGE>

21.  SELECTED QUARTERLY FINANCIAL DATA  (Unaudited)
<TABLE>
<CAPTION>
                                                  First        Second          Third         Fourth
(In thousands, except per share data)            Quarter       Quarter        Quarter        Quarter         Total
-----------------------------------------       --------      ---------      ---------      ---------      ---------
Year Ended December 31, 2006

Revenues
--------
<S>                                             <C>            <C>            <C>            <C>            <C>
Institutional Security Systems                  $ 13,355       $ 13,220       $ 11,091       $ 10,599       $ 48,265
Attack Protection                                 11,684         11,333          8,822          8,402         40,241
Integrated Electronic Systems                      3,587          2,983          4,117          3,207         13,894
Public Safety and Justice                         11,844         10,858         10,666         11,694         45,062
                                                --------       --------       --------       --------       --------
Total revenues                                  $ 40,470       $ 38,394       $ 34,696       $ 33,902       $147,462

Gross Profit
------------
Institutional Security Systems                   $ 2,173        $ 1,853       $  1,780       $  1,530       $  7,336
Attack Protection                                  3,292          3,859          3,279          2,651         13,081
Integrated Electronic Systems                        506            494          1,009            977          2,986
Public Safety and Justice                          6,538          5,930          5,750          6,246         24,464
                                                --------       --------       --------       --------       --------
Total gross profit                              $ 12,509       $ 12,136       $ 11,818       $ 11,404       $ 47,867

Pre-tax Income (Loss)
---------------------
Institutional Security Systems                  $    136       $   (386)      $   (360)      $   (667)      $ (1,277)
Attack Protection                                  1,205          1,548          1,456            463          4,672
Integrated Electronic Systems                        184            161            377            263            985
Public Safety and Justice                              7           (529)          (644)       (16,817)       (17,983)
Unallocated corporate expense                       (909)          (482)          (494)          (237)        (2,122)
                                                --------       --------       --------       --------       --------
Pre-tax income (loss) from operations           $    623       $    312       $    335       $(16,995)      $(15,725)
                                                --------       --------       --------       --------       --------
Net income (loss)                               $    807       $    305       $    327       $(16,432)      $(14,993)
                                                --------       --------       --------       --------       --------
Basic loss per share                            $    .10       $    .04       $    .04       $  (1.95)      $  (1.82)
                                                --------       --------       --------       --------       --------
Diluted loss per share                          $    .10       $    .04       $    .04       $  (1.95)      $  (1.82)
                                                --------       --------       --------       --------       --------


                                                  First        Second          Third         Fourth
(In thousands, except per share data)            Quarter       Quarter        Quarter        Quarter         Total
-----------------------------------------       --------      ---------      ---------      ---------      ---------
Year Ended December 31, 2005

Revenues
--------
Institutional Security Systems                  $ 15,732       $ 11,728       $ 15,548       $ 17,644       $ 60,652
Attack Protection                                  6,898          6,065          5,892          8,162         27,017
Integrated Electronic Systems                      2,019          1,888          2,898          3,305         10,110
Public Safety and Justice                         11,657         11,423          9,161         11,630         43,871
                                                --------       --------       --------       --------       --------
Total revenues                                  $ 36,306       $ 31,104       $ 33,499       $ 40,741       $141,650

Gross Profit
------------
Institutional Security Systems                  $  3,567       $  1,581       $  2,343       $  2,405       $  9,896
Attack Protection                                  2,368          1,380            341          2,016          6,105
Integrated Electronic Systems                        282            340            473            530          1,625
Public Safety and Justice                          6,166          7,126          5,360          6,261         24,913
                                                --------       --------       --------       --------       --------
Total gross profit                              $ 12,383       $ 10,427       $  8,517       $ 11,212       $ 42,539

Pre-tax Income (Loss)
---------------------
Institutional Security Systems                  $  1,230       $   (532)      $   (170)      $    101       $    629
Attack Protection                                    499           (840)        (1,800)          (192)        (2,333)
Integrated Electronic Systems                         (8)            16            172            251            431
Public Safety and Justice                           (482)           400         (3,188)           342         (2,928)
Unallocated corporate expense                     (1,558)        (1,683)          (791)          (673)        (4,705)
                                                --------       --------       --------       --------       --------
Pre-tax loss from operations                    $   (319)      $ (2,639)      $ (5,777)      $   (171)      $ (8,906)
                                                --------       --------       --------       --------       --------
Net loss                                        $   (319)      $ (2,639)      $ (5,277)      $   (456)      $ (8,691)
                                                --------       --------       --------       --------       --------
Basic loss per share                            $   (.04)      $   (.33)      $   (.65)      $   (.06)      $  (1.07)
                                                --------       --------       --------       --------       --------
Diluted loss per share                          $   (.04)      $   (.33)      $   (.65)      $   (.06)      $  (1.07)
                                                --------       --------       --------       --------       --------
</TABLE>


                                       56
<PAGE>

Included in the fourth  quarter 2006  results for the Public  Safety and Justice
segment  is a $14.4  million  pre-tax  charge to record the  impairment  of this
segment's  goodwill  and  a  $1.7  million  charge  to  record  impairment  of a
tradename.

Included in the fourth  quarter 2006,  results for the Public Safety and Justice
segment  is a $400  thousand  charge  related  to a  reserve  established  for a
customer who has  indicated  their intent to terminate  their  contract with the
Company.

Included  in  the  first,  second,  third  and  fourth  quarters  of  2005  were
approximately  $0.6  million,  $0.9  million,  $0.5  million  and $0.4  million,
respectively, in costs related to SOX 404 compliance.






                                       57
<PAGE>

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Changes in Accelerated Filer Status

On December 21, 2005 the Securities and Exchange  Commission  issued Release No.
33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For
Filing  Periodic  Reports"  (the  "Release").  Included  in the  Release  was an
amendment to revise the definition of the term "accelerated  filer" to permit an
accelerated  filer that has an  aggregate  worldwide  market value of voting and
non-voting  common equity held by  non-affiliates of less than $50 million as of
the last business day of its second  fiscal  quarter to exit  accelerated  filer
status at the end of the fiscal year in which the  company's  equity falls below
$50 million as of the last business day of its second fiscal quarter and to file
its  annual  report  for  that  year  and  subsequent   periodic  reports  on  a
non-accelerated basis.

The aggregate worldwide market value of CompuDyne  Corporation's  equity held by
non-affiliates as of June 30, 2005, the last business day of CompuDyne's  second
fiscal quarter, was less than $50 million. As a result, as of December 31, 2005,
CompuDyne  exited  accelerated  filer status.  CompuDyne's  aggregate  worldwide
market  value as June 30, 2006,  the last  business  day of  CompuDyne's  second
fiscal quarter,  was also less than $50 million;  as such CompuDyne continued to
be classified as a non-accelerated filer for the year ended December 31, 2006.

Prior to the Release, CompuDyne was classified as an "accelerated filer" and was
required to comply with the  requirements  of Section 404 of the  Sarbanes-Oxley
Act of 2002.

Disclosure Controls and Procedures

As required by Rule 13a-15 under the Securities Exchange Act of 1934, as amended
(the "Exchange Act"), the Company  conducted an evaluation under the supervision
and with the  participation  of the  Company's  management,  including the Chief
Executive Officer and the Chief Financial  Officer,  of the effectiveness of the
Company's disclosure controls and procedures as of the end of the period covered
by this report.  Based on that evaluation,  the Chief Executive  Officer and the
Chief Financial  Officer  concluded that the disclosure  controls and procedures
are  effective  in ensuring  that all  information  required to be  disclosed in
reports  that the Company  files or submits  under the Exchange Act is recorded,
processed,  summarized  and reported  within the time  periods  specified in the
Securities  and Exchange  Commission  rules and forms.  There was no significant
change in the Company's internal control over financial  reporting that occurred
during the Company's most recent fiscal year that has materially affected, or is
reasonably  likely to materially  affect,  the Company's  internal  control over
financial reporting.

ITEM 9B. OTHER INFORMATION

None.




                                       58
<PAGE>


                                    PART III

Information  required  by  Items  10,  11,  12,  13 and 14  about  CompuDyne  is
incorporated  herein  by  reference  from  the  definitive  proxy  statement  of
CompuDyne  to be filed  with the SEC within  120 days  following  the end of the
fiscal year ended December 31, 2006.

                                     PART IV


ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) Financial Statements
    (1) Index to Financial Statements
          Report of Independent Registered Public Accounting Firm - Aronson
           & Company
          Report of Independent Registered Public Accounting Firm -
           PricewaterhouseCoopers LLP
          Consolidated Balance Sheets at December 31, 2006 and 2005
          Consolidated Statements of Operations for the years ended
           December 31, 2006, 2005 and 2004
          Consolidated Statement of Changes in Shareholders' Equity
           for the years ended December 31, 2006, 2005 and 2004
          Consolidated Statements of Cash Flows for the years ended
           December 31, 2006, 2005 and 2004
          Notes to Consolidated Financial Statements
    (2) Schedule II - Schedule of valuation and qualifying accounts

(b) Exhibits
    The Exhibits listed on the index below are filed as a part of this Annual
Report.






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<PAGE>


<TABLE>
<CAPTION>
                                   SCHEDULE II

                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                  SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS
                  YEARS ENDED DECEMBER 31, 2006, 2005, and 2004
                                ($ in thousands)


                                                          Balance at     Charged to     Transferred                     Balance
                                                           Beginning     Costs and    (to) from other                   At End
Description                                                Of Period      Expenses      Accounts (1)     Deduction     Of Period
-----------                                               ----------     ----------     ------------     ---------     ---------
<S>                                                       <C>               <C>             <C>            <C>         <C>
Year Ended December 31, 2006
Reserve and allowances deducted from asset accounts:
Reserve for excess and slow moving inventory              $    1,371            3              -           (457)       $     917
Reserve for accounts receivable                           $    2,321          542              -           (745)       $   2,118
Deferred tax asset valuation allowance                    $    6,126        1,262           (141)             -        $   7,247

Year Ended December 31, 2005
Reserve and allowances deducted from asset accounts:
Reserve for excess and slow moving inventory              $    1,362          315              -           (306)       $   1,371
Reserve for accounts receivable                           $    1,919          699              -           (297)       $   2,321
Deferred tax asset valuation allowance                    $    1,858        4,268              -              -        $   6,126

Year Ended December 31, 2004
Reserve and allowances deducted from asset accounts:
Reserve for excess and slow moving inventory              $      840          649              -           (127)       $   1,362
Reserve for accounts receivable                           $    1,252        1,153              -           (486)       $   1,919
Deferred tax asset valuation allowance                    $        -        1,858              -              -        $   1,858
</TABLE>



(1) Transferred  (to) from other accounts  includes  adjustments to the deferred
tax  valuation  allowance  for the effect of  unrealized  gains or losses on our
marketable   securities  which  is  recorded  in  shareholders'  equity  through
"Accumulated Other Comprehensive Income (Loss)"



                                       60
<PAGE>


                              COMPUDYNE CORPORATION
                                INDEX TO EXHIBITS
                                  (Item 15(b))

2(A).  Agreement and Plan of Merger dated May 8, 1996,  herein  incorporated  by
       reference to Exhibit 3(B) to Registrant's 10-K filed March 31, 1997.

3(A).  Articles  of  Incorporation  of  CompuDyne  Corporation  filed  with  the
       Secretary  of  State  of the  State  of  Nevada  on May 8,  1996,  herein
       incorporated by reference to  Registrant's  Proxy Statement dated May 13,
       1996 for its 1996 Annual Meeting of Shareholders.

3(B).  Amendment  to the  Articles of  Incorporation  of  CompuDyne  Corporation
       increasing  the  number  of  authorized  common  shares  filed  with  the
       Secretary  of  the  State  of  Nevada  on  February   16,  2001,   herein
       incorporated by reference to Exhibit 3(B) to the Registrant's  10-K filed
       March 27, 2001.

3(C).  By-Laws,  as amended through January 28, 1997 and as presently in effect,
       herein  incorporated  by reference to Exhibit 3(C) to  Registrant's  10-K
       filed March 31, 1997.

4(A)   CompuDyne Corporation to Wachovia Bank of Delaware,  National Association
       as Trustee Indenture dated January 15, 2004, filed as Exhibit 4.1 to Form
       10-Q filed on May 1, 2006.

4(B)   Specimen Note included as Exhibit A to Exhibit 4.1 of Form 10-Q filed  on
       May 1, 2006.

10 (A). CompuDyne  Corporation 1996 Stock Incentive  Compensation  Plan for
       Employees,   herein  incorporated  by  reference  to  Registrant's  Proxy
       Statement   dated  July  17,  2001  for  its  2001   Annual   Meeting  of
       Shareholders.

10 (B). Credit  Agreement  dated  November 16, 2001 by and among  CompuDyne
       Corporation,  its  subsidiaries,  certain  participating  lenders and PNC
       Bank,  National  Association  in its  capacity as agent for the  lenders,
       herein  incorporated by reference to Exhibit 10 (b) to  Registrant's  8-K
       filed November 21, 2001.

10 (C)(1). Amended and Restated Credit Agreement dated March 31, 2004 by and
       among CompuDyne  Corporation and its subsidiaries,  certain participating
       lenders and PNC Bank, National Association,  in its capacity as agent for
       the  lenders,   herein  incorporated  by  reference  to  Exhibit  3.1  to
       Registrant's 10-Q filed May 7, 2004.

10(C)(2).  Amendment to Amended and Restated Credit  Agreement dated October 29,
       2004 by and among CompuDyne  Corporation,  its subsidiaries,  certain
       participating  lenders  and PNC  Bank,  National  Association  in its
       capacity as agent for the lenders,  herein  incorporated by reference
       to Exhibit 10.1 to Registrant's 8-K filed on November 1, 2004.

10(C)(3).  Second  Amendment  to  Amended  and  Restated  Credit  Agreement  and
       Amendment to Securities  Pledge  Agreement dated March 4, 2005 by and
       among CompuDyne Corporation, its subsidiaries,  certain participating
       lenders and PNC Bank,  National  Association in its capacity as agent
       for the lenders,  herein incorporated by reference to Exhibit 10.1 to
       registrant's 8-K filed on March 7, 2005.

10(C)(4).  Third  Amendment  to Amended  and  Restated  Credit  Agreement  dated
       November 17, 2005 by and among  CompuDyne  Corporation  and PNC Bank,
       National  Association,  and Sixth Amended and Restated Revolving Note
       dated November 17, 2005, herein incorporated by reference to Exhibits
       10.1 and 10.2 to Registrant's 8-K filed on November 17, 2005.

10(C)(5).  Second Amended and Restated  Revolving Credit and Security  Agreement
       dated  December  19,  2005 by and among  CompuDyne  Corporation,  its
       subsidiaries and PNC Bank, National Association,  herein incorporated
       by reference to Exhibit  10.1 to  Registrant's  8-K filed on December
       19, 2005.

10(D). 1996  Stock  Non-Employee   Director  Plan,  herein  incorporated  by
       reference to  Registrant's  Proxy  Statement dated April 18, 1997 for
       its 1997 Annual Meeting of Shareholders.

10(E). Stock Option  Agreement  dated August 21, 1995 by and between Martin
       A. Roenigk and CompuDyne Corporation, herein incorporated by reference to
       Exhibit (4.5) to Registrant's Form 8-K filed September 5, 1995.

10(F).* Compensatory Arrangements.


                                       61
<PAGE>

10(G). 2005 Stock Option Plan for Non-Employee Directors, herein incorporated by
       reference to  Registrant's  Proxy  Statement dated April 29, 2005 for its
       2005 Annual Meeting of Shareholders.

10(H). 2005 Stock Incentive Compensation Plan for Employees, herein incorporated
       by reference to Registrant's Proxy Statement dated April 29, 2005 for its
       2005 Annual Meeting of Shareholders.

10(I). Amendment  to the 1996  Stock  Option  Plan for  Non-Employee  Directors,
       herein  incorporated by reference to  Registrant's  Proxy Statement dated
       April 29, 2005 for its 2005 Annual Meeting of Shareholders.

10(J). Amendment to the 1996 Stock  Incentive  Compensation  Plan for Employees,
       herein  incorporated by reference to  Registrant's  Proxy Statement dated
       April 29, 2005 for its 2005 Annual Meeting of Shareholders.

10(K). CompuDyne  Corporation  Retention  Plan for  Selected  Employees,  herein
       incorporated by reference to Exhibit 10.1 to Registrant's  8-K filed July
       1, 2005.

10(L)  The Joinder Agreement and the First Amendment to the Second Amendment and
       Restated Revolving Credit and Security Agreement both dated July 14, 2006
       by and  among  CompuDyne  Corporation,  subsidiaries  of the  Company  as
       co-borrowers and PNC Bank, National  Association,  herein incorporated by
       reference to Exhibits 10.1 and 10.2 to Registrants  8-K filed on July 20,
       2006.

10(M)* The Release and Settlement Agreement between the Company, William Blair
       Mezzanine Capital Fund II, L.P. and Friedman, Billings, Ramsey Group,
       Inc., initially filed as Exhibit 10.1 to Form 8-K filed November 21,
       2006, and refiled herein.

10(N)* The Second Amendment to the Second Amended and Restated  Revolving Credit
       and Security Agreement both dated December 5, 2006 by and among CompuDyne
       Corporation,  subsidiaries of the Company as  co-borrowers  and PNC Bank,
       National Association, filed herein.

10(O)  Employment  Agreement  between  CompuDyne  Corporation  and  Mr.  Bradley
       Wiggins herein,  incorporated by reference to Exhibit 10.1, filed on Form
       8-K on November 30, 2006.

10(P)  The Third Amendment to the Second Amended and Restated  Revolving  Credit
       and  Security  Agreement  dated  March 28,  2007 by and  among  CompuDyne
       Corporation,  subsidiaries of the Company as  co-borrowers  and PNC Bank,
       National  Association,  herein incorporated by reference to Exhibit 10.1,
       filed on Form 8-K on March 30, 2007.

21.*   Subsidiaries of the Registrant.

23.1*  Consent of Independent Registered Public Accounting Firm - Aronson &
       Company.

23.2*  Consent of Independent Registered Public Accounting Firm -
       PricewaterhouseCoopers LLP.

31.1*  Certification by Mr. Martin Roenigk, Chief Executive Officer pursuant to
       Rule 13a-14(a), filed herewith.

31.2*  Certification by Mr. Geoffrey F. Feidelberg, Chief Financial Officer
       pursuant to Rule 13a-14(a), filed herewith.

32.1*  Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002,
       18 U.S.C. Section 1350, for Mr. Martin Roenigk, Chief Executive Officer,
       filed herewith.

32.2*  Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002,
       18 U.S.C. Section 1350, for Mr. Geoffrey F. Feidelberg, Chief Financial
       Officer, filed herewith.

*      Filed herewith.


                                       62
<PAGE>


                                   SIGNATURES

      Pursuant  to the  requirements  of Section  13 or 15(d) 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.

                                              COMPUDYNE CORPORATION
                                              ---------------------
                                                 (Registrant)

                                                 By: /s/Martin Roenigk
                                                    ----------------------------
                                                 Martin Roenigk
                                                 Chief Executive Officer

                                                 By: /s/Geoffrey F. Feidelberg
                                                    ----------------------------
                                                 Geoffrey F. Feidelberg
Dated: April 10, 2007                            Chief Financial Officer


      Pursuant to the requirements of the Securities  Exchange Act of 1934, this
report  has  been  signed  below  by the  following  persons  on  behalf  of the
Registrant and in the capacities indicated on April 2, 2007.


<TABLE>
<CAPTION>
<S>                      <C>                                         <C>                       <C>

______________________   Director, Chairman, President               _______________________   Director
Martin A. Roenigk        and Chief Executive Officer                 David W. Clark, Jr.
                         (Principle Executive Officer)

______________________   Director                                    _______________________   Director
John H. Gutfreund                                                    Ronald J. Angelone


______________________   Director                                    _______________________   Director
Albert R. Dowden                                                     Wade B. Houk


______________________   Director, Chief Financial Officer
Geoffrey F. Feidelberg   and Treasurer
                         (Principle Financial and Accounting Officer)
</TABLE>




                                       63