**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-KSB/A**

 

**AmendmentNo. 1**

 
| **ý** |   | **ANNUAL  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**     |
|------------|--------|-----------------------------------------------------------------------------------------------|
|       |   |                                                                                          |
|       |   | **For the fiscal year ended December 31,  2003.**                                        |
|       |   |                                                                                          |
| **o**      |   | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |

 

**For the transitionperiod               to               .**

 

**Commission File Number**

 

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**IMAGEWARESYSTEMS, INC.**

(Name of Small Business Issuer in ItsCharter)

 
| **California**                                                                                                              |   | **33-0224167**                                   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization)                                                             |   | (I.R.S. Employer Identification No.              |
|                                                                                                                        |   |                                             |
| **10883 Thornmint Road, San Diego, California**                                                                             |   | **92127**                                        |
| (Address of Principal Executive Offices)                                                                                    |   | (Zip Code)                                       |
|                                                                                                                        |   |                                             |
| **(858) 673-8600**                                                                                                     |
| (Issuer’s Telephone Number, Including Area  Code)  Securities registered under Section 12(b) of the Exchange Act: |
|                                                                                                                        |   |                                             |
| **Title of Each Class**                                                                                                     |   | **Name of Each Exchange  on Which Registered**   |
| Common Stock, $0.01 par value  Warrants to Purchase Common Stock                                                            |   | American Stock Exchange  American Stock Exchange |
|                                                                                                                        |   |                                             |
| Securities registered pursuant to  Section 12(g) of the Act: **None**                                                  |

 

Check whether the issuer: (1) filed all reports required to befiled by Section 13 or 15(d) of the Exchange Act during the past12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.

 

Yes ý   No o

 

Check if no disclosure of delinquent filers in response toItem 405 of Regulation S-B is contained in this form, and nodisclosure will be contained, to the best of the registrant’s knowledge, indefinitive proxy or information statements incorporated by reference inPart III of this Form 10-KSB or any amendment to thisForm 10-KSB. ý

 

The issuer’s revenues for the fiscal year ended December 31, 2003were $16,267,541.

 

The aggregate market value of the voting and non-voting common equityheld by non-affiliates of the issuer, based on the closing sales price of theissuer’s Common Stock on March 19, 2004 as reported on the American StockExchange was approximately $38,678,831. Excluded from this computation were 272,002 shares of Common Stock heldby all current executive officers and directors and 1,848,637 shares held byeach person who is known by the registrant to own 5% or more of the outstandingCommon Stock.  Share ownershipinformation of certain persons known by the issuer to own greater than 5% ofthe outstanding Common Stock for purposes of the preceding calculation is basedsolely on information on Schedule 13G filed with the Commission and is asof March 19, 2004. Exclusion of shares held by any person or entity shouldnot be construed to indicate that such person possesses the power, directly orindirectly, to direct or cause the direction of the management or the policiesof the Registrant.

 

The number of shares of Common Stock outstanding as of March 19,2004 was 11,790,347.

** **

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Certain Exhibits filed with the Registrant’s Registration Statement onForm SB-2 (333-93131), Registration Statement on Form S-3 (333-64192),Form 10-KSB for the Years Ended December 31, 2000 andDecember 31, 2001, Form 10-QSB for each of the quarters endedMarch 31, 2001, June 30, 2001, September 30, 2001, March 31,2002, and June 30, 2002, and Forms 8-K as filed with the Commission onAugust 13, 2001 and on May 24, 2002 are incorporated by reference intoPart III of this Form 10-KSB.

 

Transitional Small Business Disclosure Format (check one):Yes o   No ý

 

 

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EXPLANATORY NOTE

 

This Amendment No. 1 to ImageWare Systems, Inc.’s Annual Report on Form10-KSB for the year ended December 31, 2003 is being filed to add the conformedsignature of PricewaterhouseCoopers LLP to the Independent AccountantsReport.  The conformed signature wasinadvertently omitted from the Independent Accountants Report filed with theoriginal Annual Report on Form 10-KSB filed on March 30, 2004.  There have been no changes to the balance ofthe Form 10-KSB from the original filing.

 

 

**ITEM 7. FinancialStatements.**

 

INDEPENDENT AUDITORS’ REPORT

 

TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF IMAGEWARE SYSTEMS, INC.:

 

We have audited the accompanying consolidated balance sheet of ImageWareSystems, Inc. as of December 31, 2003 and the related consolidated statementsof operations, stockholders’ equity and cash flows for the year then ended.  These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudit.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditprovides a reasonable basis for our opinion.

 

In our opinion, the consolidate financial statements referred to abovepresent fairly, in all material respects, the consolidated financial positionof the ImageWare Systems, Inc. as of December 31, 2003 and the results of theiroperations and their cash flows for the year then ended in conformity withgenerally accepted accounting principles in the United States.

 
| /s/Stonefield Josephson, Inc. |   |
|-------------------------------|--------|
| STONEFIELD JOSEPHSON, INC.    |
| Certified Public Accountants  |
| Santa Monica, California      |
| March  26, 2004               |

 

2

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**REPORT OF INDEPENDENT ACCOUNTANTS**

 

To Board of Directors and Shareholders’ of

ImageWare Systems, Inc.

 

In our opinion, the accompanying consolidated balance sheet and therelated consolidated statements of operations, of shareholders’ equity and ofcash flows present fairly, in all material respects, the financial position ofImageWare Systems, Inc. and its subsidiaries (the “Company”) at December 31,2002, and the results of their operations and their cash flows for the yearthen ended in conformity with accounting principles generally accepted in theUnited States of America.  These financialstatements are the responsibility of the Company’s management; ourresponsibility is to express an opinion on these financial statements based onour audit.  We conducted our audit ofthese statements in accordance with auditing standards generally accepted inthe United States of America, which require that we plan and perform the auditto obtain reasonable assurance about whether the financial statements are freeof material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audit provide a reasonable basis for our opinion.

 

The accompanying financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company hassuffered losses from operations and has a net capital deficiency that raisesubstantial doubt about its ability to continue as a going concern.  Management’s plans in regard to thesematters are also described in Note 1. The financial statements do not include any adjustments that mightresult from the outcome of this uncertainty.

 
| /s/PricewaterhouseCoopers LLP |   |
|-------------------------------|--------|
| PRICEWATERHOUSE COOPERS LLP   |
| San Diego, California         |
| March 30, 2004                |

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                                                                                                                                                                                                               |   | **December 31,  2003** |           | **December 31,  2002** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|----------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                         |   |                        | ** **     |                        | ** ** |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        |           |                        |       |
| Current  Assets:                                                                                                                                                                                                                                                                                                                                                   |   |                        |           |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                                                               |   | $                           | 578,093        |                        | $          | 214,937 |   |
| Restricted  cash and cash equivalents                                                                                                                                                                                                                                                                                                                              |   | 155,215                     |           | 60,000                      |       |
| Accounts  receivable, net of allowance for doubtful accounts of $483,254 and $410,000  at December 31, 2003 and 2002, respectively                                                                                                                                                                                                                            |   | 1,449,968                   |           | 3,294,932                   |       |
| Inventories,  net                                                                                                                                                                                                                                                                                                                                                  |   | 804,526                     |           | 1,882,082                   |       |
| Other  current assets                                                                                                                                                                                                                                                                                                                                              |   | 204,065                     |           | 422,382                     |       |
| Total  Current Assets                                                                                                                                                                                                                                                                                                                                              |   | 3,191,867                   |           | 5,874,333                   |       |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        |           |                        |       |
| Property  and equipment, net                                                                                                                                                                                                                                                                                                                                       |   | 634,966                     |           | 1,040,915                   |       |
| Other  assets                                                                                                                                                                                                                                                                                                                                                      |   | 571,199                     |           | 743,826                     |       |
| Intangible  assets, net                                                                                                                                                                                                                                                                                                                                            |   | 1,120,675                   |           | 1,561,545                   |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                           |   | 5,297,627                   |           | 5,297,627                   |       |
| **Total Assets**                                                                                                                                                                                                                                                                                                                                                   |   | **$**                       | **10,816,334** | ** **                  | **$**      | **14,518,246** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        | ** **     |                        | ** ** |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                      |   |                        |           |                        |       |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        |           |                        |       |
| Current  Liabilities:                                                                                                                                                                                                                                                                                                                                              |   |                        |           |                        |       |
| Accounts  payable                                                                                                                                                                                                                                                                                                                                                  |   | $                           | 1,052,862      |                        | $          | 3,232,735 |   |
| Deferred  revenue                                                                                                                                                                                                                                                                                                                                                  |   | 847,690                     |           | 976,046                     |       |
| Accrued  expenses                                                                                                                                                                                                                                                                                                                                                  |   | 1,067,379                   |           | 1,501,046                   |       |
| Accrued  expenses - related parties                                                                                                                                                                                                                                                                                                                                |   | —                      |           | 46,597                      |       |
| Accrued  interest                                                                                                                                                                                                                                                                                                                                                  |   | 103,057                     |           | 197,780                     |       |
| Notes  & advances payable to bank and third parties                                                                                                                                                                                                                                                                                                            |   | 181,976                     |           | 785,741                     |       |
| Notes  payable to related parties                                                                                                                                                                                                                                                                                                                                  |   | 59,000                      |           | 218,369                     |       |
| Total  Current Liabilities                                                                                                                                                                                                                                                                                                                                         |   | 3,311,964                   |           | 6,958,314                   |       |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        |           |                        |       |
| Convertible  notes payable, net of discount                                                                                                                                                                                                                                                                                                                        |   | —                      |           | 1,252,311                   |       |
| Warrant  liability                                                                                                                                                                                                                                                                                                                                                 |   | 3,460,120                   |           | —                      |       |
| Pension  obligation                                                                                                                                                                                                                                                                                                                                                |   | 732,485                     |           | 406,121                     |       |
| Total  Liabilities                                                                                                                                                                                                                                                                                                                                                 |   | 7,504,569                   |           | 8,616,745                   |       |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        |           |                        |       |
| Shareholders’  equity                                                                                                                                                                                                                                                                                                                                         |   |                        |           |                        |       |
| Preferred  stock, $.01 par value, authorized 4,000,000 shares Series B convertible  redeemable preferred stock, designated 750,000 shares, 389,400 shares issued,  and 249,400 and 269,400 shares outstanding at December 31, 2003 and 2002  respectively, liquidation preference $623,500 and $673,500 at  December 31, 2003 and December 31, 2002 |   | 2,494                       |           | 2,694                       |       |
| Common  stock, $.01 par value, 50,000,000 shares authorized, 9,930,037 shares issued,  9,923,333 and 5,481,311 shares outstanding at December 31, 2003 and  2002, respectively                                                                                                                                                                                |   | 98,051                      |           | 53,712                      |       |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        |           |                        |       |
| Additional  paid in capital                                                                                                                                                                                                                                                                                                                                        |   | 49,221,700                  |           | 41,272,370                  |       |
| Treasury  stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                                                            |   | (63,688                     | )              | (63,688                     | )          |
| Shareholder  note receivable                                                                                                                                                                                                                                                                                                                                       |   | (150,000                    | )              | (150,000                    | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                                                                                            |   | 265,470                     |           | 112,881                     |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                                               |   | (46,062,262                 | )              | (35,326,469                 | )          |
| Total  shareholders’ equity                                                                                                                                                                                                                                                                                                                                   |   | 3,311,765                   |           | 5,901,500                   |       |
|                                                                                                                                                                                                                                                                                                                                                               |   |                        |           |                        |       |
| **Total Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                                                                                |   | **$**                       | **10,816,334** | ** **                  | **$**      | **14,518,246** | ** ** |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
|                                                  |   | **TWELVE MONTHS ENDED  December 31,** |        |
|-------------------------------------------------------|--------|--------------------------------------------|-------------|
|                                                  |   | **2003**                                   |        | **2002** |   |
|                                                  |   |                                       | ** **  |   | ** ** |
| **Revenues:**                                         |   |                                       |        |   |   |
| Product                                               |   | $                                          | 13,470,629  |   | $ | 15,115,766 |   |
| Maintenance                                           |   | 2,762,829                                  |        | 3,139,927 |   |
|                                                  |   | 16,233,458                                 |        | 18,255,693 |   |
| **Cost of revenues:**                                 |   |                                       |        |   |   |
| Product                                               |   | 6,180,726                                  |        | 7,060,131 |   |
| Maintenance                                           |   | 1,201,710                                  |        | 1,236,316 |   |
|                                                  |   |                                       |        |   |   |
| Gross  profit                                         |   | 8,851,022                                  |        | 9,959,246 |   |
|                                                  |   |                                       |        |   |   |
| **Operating expenses:**                               |   |                                       |        |   |   |
| General  & administrative                         |   | 6,106,438                                  |        | 6,911,228 |   |
| Sales  and marketing                                  |   | 3,820,595                                  |        | 4,204,613 |   |
| Research  & development                           |   | 1,920,696                                  |        | 2,078,777 |   |
| Depreciation  and amortization                        |   | 924,257                                    |        | 894,400 |   |
|                                                  |   | 12,771,986                                 |        | 14,089,018 |   |
|                                                  |   |                                       |        |   |   |
| Loss  from operations                                 |   | (3,920,964                                 | )           | (4,129,772 | ) |
|                                                  |   |                                       |        |   |   |
| Interest  expense, net                                |   | 6,960,140                                  |        | 652,392 |   |
|                                                  |   |                                       |        |   |   |
| Other  income, net                                    |   | (207,046                                   | )           | (53,575 | ) |
|                                                  |   |                                       |        |   |   |
| Loss  before income taxes                             |   | (10,674,058                                | )           | (4,728,589 | ) |
|                                                  |   |                                       |        |   |   |
| Income  tax expense                                   |   | 61,735                                     |        | 120,341 |   |
|                                                  |   |                                       |        |   |   |
| Net  loss                                             |   | $                                          | (10,735,793 | ) | $ | (4,848,930 | ) |
|                                                  |   |                                       |        |   |   |
| Basic  and diluted loss per common share - see note 2 |   | $                                          | (1.81       | ) | $ | (0.90 | ) |
| Weighted-average  shares (basic and diluted)          |   | 5,953,801                                  |        | 5,483,973 |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**

 
|                                     |   | **TWELVE MONTHS ENDED  DECEMBER 31,** |        |
|------------------------------------------|--------|--------------------------------------------|-------------|
|                                     |   | **2003**                                   |        | **2002** |   |
|                                     |   |                                       | ** **  |   | ** ** |
| Net  loss                                |   | $                                          | (10,735,793 | ) | $ | (4,848,930 | ) |
| Other  comprehensive income:             |   |                                       |        |   |   |
| Foreign  currency translation adjustment |   | 152,589                                    |        | 149,533 |   |
| Comprehensive  loss                      |   | $                                          | (10,583,204 | ) | $ | (4,699,397 | ) |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

6

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
|                                                                         |   | **TWELVE  MONTHS ENDED  December 31,** |        |
|------------------------------------------------------------------------------|--------|----------------------------------------|-------------|
|                                                                         |   | **2003**                               |        | **2002** |   |
|                                                                         |   |                                   |        |   |   |
| **Cash flows from  operating activities**                                    |   |                                   |        |   |   |
| Net loss                                                                     |   | $                                      | (10,735,793 | ) | $ | (4,848,930 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities  |   |                                   |        |   |   |
| Depreciation and amortization                                                |   | 924,257                                |        | 894,400 |   |
| Non cash interest and amortization of debt  discount and debt issuance costs |   | 6,136,480                              |        | 442,822 |   |
| Issuance of commson stock for professional  services                         |   | 48,000                                 |        | — |   |
| Other non-cash charges                                                       |   | 268,317                                |        | — |   |
| Change in assets and liabilities                                             |   |                                   |        |   |   |
| Accounts receivable                                                          |   | 1,756,784                              |        | 1,246,549 |   |
| Inventories                                                                  |   | 897,418                                |        | (931,879 | ) |
| Other current assets                                                         |   | 218,320                                |        | 568,401 |   |
| Other assets                                                                 |   | (94,922                                | )           | (2,986 | ) |
| Accounts payable                                                             |   | (2,096,017                             | )           | 313,772 |   |
| Accrued expenses                                                             |   | (433,670                               | )           | (85,291 | ) |
| Accrued expenses - related parties                                           |   | (2,722                                 | )           | — |   |
| Accrued interest                                                             |   | (59,378                                | )           | 155,323 |   |
| Deferred revenue                                                             |   | (128,356                               | )           | (17,134 | ) |
| Pension obligation                                                           |   | 326,364                                |        | 196,552 |   |
|                                                                         |   |                                   |        |   |   |
| Total adjustments                                                            |   | 7,760,875                              |        | 2,780,529 |   |
|                                                                         |   |                                   |        |   |   |
| Net cash used by operating activities                                        |   | (2,974,918                             | )           | (2,068,401 | ) |
|                                                                         |   |                                   |        |   |   |
| **Cash flows from  investing activities**                                    |   |                                   |        |   |   |
| Purchase of property and equipment                                           |   | (135,964                               | )           | (354,661 | ) |
| Restricted cash and cash equivalents                                         |   | (95,215                                | )           | — |   |
| Payment on advances from related  stockholders                               |   | (203,243                               | )           | (161,360 | ) |
| Sale of property and equipment                                               |   | 58,526                                 |        | — |   |
|                                                                         |   |                                   |        |   |   |
| Net cash used by investing activities                                        |   | (375,896                               | )           | (516,021 | ) |
|                                                                         |   |                                   |        |   |   |
| **Cash flows from  financing activities**                                    |   |                                   |        |   |   |
| Proceeds from issuance of notes payable  with warrants                       |   | 4,856,000                              |        | 2,500,000 |   |
| Proceeds from issuance of common stock, net  of issuance costs               |   | 6,203,080                              |        | — |   |
| Repayment of convertible notes payable                                       |   | (6,777,996                             | )           | (20,934 | ) |
| Debt issuance costs                                                          |   | (554,078                               | )           | (383,885 | ) |
| Proceeds from (repayment of) bank line of  credit                            |   | (165,625                               | )           | 165,625 |   |
| Proceeds from exercise of options and  warrants                              |   | —                                 |        | 1,247 |   |
|                                                                         |   |                                   |        |   |   |
| Net cash provided by financing activities                                    |   | 3,561,381                              |        | 2,262,053 |   |
| Effect of exchange rate changes on cash                                      |   | 152,589                                |        | 149,533 |   |
| Net increase (decrease) in cash                                              |   | 363,156                                |        | (172,836 | ) |
|                                                                         |   |                                   |        |   |   |
| Cash at beginning of period                                                  |   | 214,937                                |        | 387,773 |   |
|                                                                         |   |                                   |        |   |   |
| Cash at end of period                                                        |   | $                                      | 578,093     |   | $ | 214,937 |   |
|                                                                         |   |                                   |        |   |   |
| Supplemental disclosure of cash flow  information:                           |   |                                   |        |   |   |
| Cash paid for interest                                                       |   | $                                      | 651,955     |   | $ | — |   |
| Summary of non-cash investing and financing  activities:                     |   |                                   |        |   |   |
| Conversion of trade accounts payable to  notes payable                       |   | $                                      | 98,661      |   | $ | — |   |
| Conversion of convertible notes and accrued  interest to common stock        |   | $                                      | 632,001     |   | $ | — |   |
| Conversion of preferred stock to common  stock                               |   | $                                      | 200         |   | $ | 350 |   |

 

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

 

7

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**ImageWareSystems, Inc.**

**ConsolidatedStatements of Shareholders’ Equity**

for the Years Ended December 31, 2003and 2002

 
|                                                                                   |   | **Series B  Convertible,  Redeemable  Preferred** |   | **Common Stock** |   | **Treasury Stock** |      | **Additional  Paid-In  Capital** |   | **Unearned  Stock  Based  Compensation** |   | **Share-   holder  Note  Receivable** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |    | **Accumulated  Deficit** |   | **Total**  |   |
|----------------------------------------------------------------------------------------|--------|---------------------------------------------------|--------|------------------|--------|--------------------|-----------|----------------------------------|--------|------------------------------------------|--------|---------------------------------------|--------|------------------------------------------------------|---------|--------------------------|--------|------------|--------|
|                                                                                   |   | **Shares**                                        |   | **Amount**       |   | **Shares**         |      | **Amount**                       |   | **Shares**                               |   | **Amount**                            |
| Balance at December 31, 2001                                                      |   | 304,400                                           |   | $                | 3,044  |               | 5,488,015 |                             | $      | 53,631                                   |   | (6,704                                | )      | $                                                    | (63,688 | )                        | $      | 40,196,952 |   | $ | — |   | $ | (150,000 | ) | $ | (36,652 | ) | $ | (30,477,539 | ) | $ | 9,525,748 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Preferred Stock conversion to common stock                                             |   | (35,000                                           | )      | (350             | )      | 7,663              |      | 77                               |   | —                                   |   | —                                |   | 273                                                  |    | —                   |   | —     |   | — |   | — |   | — |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Issuance of common stock pursuant to option and  warrant exercise for cash             |   | —                                            |   | —           |   | 416                |      | 4                                |   | —                                   |   | —                                |   | 1,243                                                |    | —                   |   | —     |   | — |   | — |   | 1,247 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Warrants issued in conjunction with convertible  debt                                  |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | 536,951                                              |    | —                   |   | —     |   | — |   | — |   | 536,951 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Beneficial conversion feature of convertible debt                                      |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | 536,951                                              |    | —                   |   | —     |   | — |   | — |   | 536,951 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Accumulated other comprehensive loss                                                   |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | —                                               |    | —                   |   | —     |   | 149,533 |   | — |   | 149,533 |   |
| Net loss                                                                               |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | —                                               |    | —                   |   | —     |   | — |   | (4,848,930 | ) | (4,848,930 | ) |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Balance at December 31, 2002                                                      |   | 269,400                                           |   | 2,694            |   | 5,496,094          |      | 53,712                           |   | (6,704                                   | )      | (63,688                               | )      | 41,272,370                                           |    | —                   |   | (150,000   | )      | 112,881 |   | (35,326,469 | ) | 5,901,500 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Preferred Stock conversion to common stock                                             |   | (20,000                                           | )      | (200             | )      | 4,804              |      | 48                               |   | —                                   |   | —                                |   | 152                                                  |    | —                   |   | —     |   | — |   | — |   | — |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Issuance of common stock for cash, net of issuance  costs                              |   | —                                            |   | —           |   | 4,069,484          |      | 40,695                           |   | —                                   |   | —                                |   | 6,162,385                                            |    | —                   |   | —     |   | — |   | — |   | 6,203,080 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Conversion  of convertible notes payable and accrued unpaid interest into common stock |   |                                              |   |             |   | 334,392            |      | 3,344                            |   |                                     |   |                                  |   | 632,001                                              |    |                     |   |       |   |   |   |   |   | 635,345 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Issuance  of common stock for professional services                                    |   |                                              |   |             |   | 25,263             |      | 252                              |   |                                     |   |                                  |   | 47,748                                               |    |                     |   |       |   |   |   |   |   | 48,000 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Warrants issued in conjunction with convertible  debt and common stock                 |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | (990,530                                             | )       | —                   |   | —     |   | — |   | — |   | (990,530 | ) |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Beneficial conversion feature of convertible debt                                      |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | 3,088,417                                            |    | —                   |   | —     |   | — |   | — |   | 3,088,417 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Reacquisition  value of beneficial conversion feature                                  |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   | (1,100,737                                           | )       |                     |   |       |   |   |   |   |   | (1,100,737 | ) |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Induced  conversion expense of convertible debt                                        |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   | 109,894                                              |    |                     |   |       |   |   |   |   |   | 109,894 |   |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Foreign  currency translation adjustment                                               |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | —                                               |    | —                   |   | —     |   | 152,589 |   | — |   | 152,589 |   |
| Net loss                                                                               |   | —                                            |   | —           |   | —             |      | —                           |   | —                                   |   | —                                |   | —                                               |    | —                   |   | —     |   |   |   | (10,735,793 | ) | (10,735,793 | ) |
|                                                                                   |   |                                              |   |             |   |               |      |                             |   |                                     |   |                                  |   |                                                 |    |                     |   |       |   |   |   |   |   |   |   |
| Balance at December 31, 2003                                                      |   | 249,400                                           |   | $                | 2,494  |               | 9,930,037 |                             | $      | 98,051                                   |   | (6,704                                | )      | $                                                    | (63,688 | )                        | $      | 49,221,700 |   | $ | — |   | $ | (150,000 | ) | $ | 265,470 |   | $ | (46,062,262 | ) | $ | 3,311,765 |   |
|                                                                                        |        |                                                   |        |                  |        |                    |           |                                  |        |                                          |        |                                       |        |                                                      |         |                          |        |            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

8

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**DECEMBER 31, 2003 AND 2002**

 

**1.****             DESCRIPTION OFBUSINESS AND OPERATIONS**

 

ImageWare Systems, Inc. (the “Company”), formerly known asImageWare Software, Inc., was incorporated in the State of California onFebruary 6, 1987. The Company utilizes digital imaging technology toprovide stand alone, networked and web-based software solutions for securecredentials, biometrics, law enforcement and professional photography.

 

ImageWare’s law enforcement solutions which enable agencies to quicklycapture, archive, search, retrieve, and share digital photographs and criminalhistory records on a stand alone, networked, wireless or web-based platform.ImageWare develops, sells and supports a suite of modular software productsused by law enforcement and public safety agencies to create and managecriminal history records and to investigate crime. Our C.R.I.M.E.S. systemconsists of eight software modules: Crime Capture System (consisting of theCapture Module and the Retrieval Module), which provides a criminal bookingsystem and related database; Face ID, which uses biometric facial recognitionto identify suspects; Suspect ID, which facilitates the creation of full-color,photo-realistic suspect composites; Crime Lab, which allows officers to enhanceand edit digital images; and Vehicle ID, which helps officers identify motorvehicles stolen or involved in a crime. In addition, we offer Crime Web, whichprovides access to centrally stored records over the Internet in a connected orwireless fashion, Pocket CCS which enables access to centrally stored recordswhile in the field on a handheld Pocket PC compatible device, and centralrepository services which allows for inter-agency data sharing on a local,regional, and/or national level.  Werecently added a new module to CCS which incorporates fingerprint livescancapabilities into CCS for real-time capture of single to ten prints and palm tofurther improve the booking, investigative and identification procedures.

 

ImageWare’s ID solutions empower customers to create secure and smartdigital identification documents with complete ID systems. We develop, sell andsupport software and design systems which utilize digital imaging in the productionof photo identification cards and credentials and identification systems. Oursales in the digital identification market were developed through ouracquisitions of ITC, Goddard and G & A (discussed below). Our productsin this market consist of EpiSuite, EpiWeb, EpiWeb Enterprise, EpiBuilder(SDK), Identifier for Windows, ID Card Maker, Winbadge NT and WinbadgeAviation. These products allow for the production of digital identificationcards and related databases and records and can be used by, among others,schools, airports, hospitals, corporations or governments.  We have recently added the ability toincorporate multiple biometrics into the ID systems we offer with the additionof our new Omni Biometric Engine to our product line.

 

ImageWare’s Digital Photography (“PDI”) product line consists of asuite of software for the professional photography market. The software allowsprofessional photographers to digitally capture images, manipulate them tocreate a custom package or layout, then store the images with an associateddatabase. They can then print the digital images themselves or send them viathe Internet or CD to a professional lab for processing. Our products includePC Pro, PC Event, PDI School Days+, PDI Studio, PDI Pro Lab and PDI Green Screen.Our customers use the software products in a wide variety of ways includingretail studio environments, on-location event photography and “picture day” atschools and day care centers. Our software products are sold through a dealernetwork and directly to major accounts. The PDI group also operates ane-commerce service, Picturemore.com, used by professional photographers toallow their customers to order re-prints and various service items. Our salesin the digital photography market were developed as a result of our acquisitionof Castleworks and E-Focus West in August, 2001.

 

*Going Concern*

 

As reflected in the accompanying consolidated financial statements, theCompany has losses and negative cash flows from operations and negative workingcapital. These matters raise substantial doubt about the Company’s ability tocontinue as a going concern.

 

In view of the matters described in the preceding paragraph,recoverability of a major portion of the recorded asset amounts shown in theaccompanying consolidated balance sheet is dependent upon continued operationsof the Company, which, in turn, is dependent upon the Company’s ability tocontinue to raise capital and generate positive cash flows fromoperations.  The consolidated financialstatements do not include any adjustments relating to the recoverability andclassification of recorded asset amounts or amounts and classifications ofliabilities that might be necessary should the Company be unable to continueits existence.

 

Subsequentto year end, the Company has completed a private placement in which the Companyraised gross proceeds of approximately $6.6 million.  The Company believes that its current cash balances will satisfyits projected working capital and capital requirements for at least the nexttwelve months.  See Note 16 for furtherdetails.

 

**2.****             SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

*Principles of consolidation*

 

The consolidated financial statements include the accounts of theCompany and its wholly-owned subsidiaries. All significant intercompanytransactions and balances have been eliminated.

 

9

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*Use of estimates*

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements, and the reported amounts of revenueand expense during the reporting period. Significant estimates includeallowance for doubtful accounts receivable, deferred tax asset valuationallowances, accounting for loss contingencies, and recoverability of goodwilland acquired intangible assets. Actual results could differ from estimates.

 

*Fair Value of Financial Instruments:*

 

Forcertain of the Company’s financial instruments, including accounts receivable,accounts payable, accrued expenses and deferred revenues the carrying amountsapproximate fair value due to their relatively short maturities.

 

*Property and equipment*

 

Property and equipment, consisting of furniture and equipment, arestated at cost and are being depreciated on a straight-line basis over theestimated useful lives of the assets, which range from three to five years.Maintenance and repairs are charged to expense as incurred. Major renewals orimprovements are capitalized. When assets are sold or abandoned, the cost andrelated accumulated depreciation are removed from the accounts and theresulting gain or loss is recognized.

 

*Goodwill:*

 

Goodwillarising from the acquisition of G & A Imaging and Castleworks and E-Focuswas first attributed to developed technology, trademarks and tradenames,patents, agreements not-to-compete and customer relationship based upon theirestimated fair value at the date of acquisition.  These intangible assets are being amortized over their estimateduseful lives, which range from 3-15 years. Goodwill acquired will bereviewed for impairment pursuant to SFAS No. 142.

 

TheCompany accounts for its intangible assets under the provisions of SFAS No.142, “Goodwill and Other Intangible Assets”. In accordance with SFAS No. 142, intangible assets with a definite lifeare accounted for impairment under SFAS No. 144 and intangible assets withindefinite life are accounted for impairment under SFAS No. 142.  In accordance with SFAS No. 142, goodwill,or the excess of cost over fair value of net assets acquired, is no longer amortizedbut is tested for impairment using a fair value approach at the “reportingunit” level.  A reporting unit is theoperating segment, or a business one level below that operating segment(referred to as a component) if discrete financial information is prepared andregularly reviewed by management at the component level.  The Company recognizes an impairment chargefor any amount by which the carrying amount of a reporting unit’s goodwillexceeds its fair value.  The Companyuses discounted cash flows to establish fair values.  When available and as appropriate, comparative market multiplesto corroborate discounted cash flow results is used.  When a business within a reporting unit is disposed of, goodwillis allocated to the gain or loss on disposition using the relative fair valuemethodology.

 

TheCompany did not record any goodwill impairment charges for the years endedDecember 31, 2003 and 2002.

 

*Intangible and Long-lived assets*

 

In October 2001, the FASB issued SFAS No. 144, “Accounting forImpairment of Disposal of Long-Lived Assets”, which supercedes SFAS No. 121,“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto Be Disposed Of”, and the accounting and reporting provision of APB OpinionNo. 30, “Reporting the Results of Operations-Reporting the Effects of Disposalof a Segment of a Business, and Extraordinary, Unusual and InfrequentlyOccurring Events and Transactions”, for the disposal of a segment of abusiness.  This statement also amendsARB No. 51, “Consolidated Financial Statements”, to eliminate the exception toconsolidation for a subsidiary for which control is likely to be impaired.  SFAS No. 144 requires that long-lived assetsto be disposed of by sale, including those of discontinued operations, bemeasured at the lower of carrying amount or fair value less cost to sell,whether reported in continuing operations or in discontinued operations. SFASNo. 144 broadens the reporting of discontinued operations to include allcomponents of an entity with operations that can be distinguished from the restof the entity and that will be eliminated from the ongoing operations of theentity in a disposal transaction.  SFASNo. 144 also establishes a “primary-asset” approach to determine the cash flowestimation period for a group of assets and liabilities that represents theunit of accounting for a long-lived asset to be held and used.  At December 31, 2003 and 2002, there was noimpairment of the Company’s intangible or long-lived assets.

 

10

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*Concentration of credit risk*

 

Financial instruments which potentially subject the Company toconcentrations of credit risk consist principally of cash and trade accountsreceivable.  The Company places its cashwith high quality financial institutions and at times may exceed the FDIC$100,000 insurance limit.  Sales aretypically made on credit and the Company generally does not require collateral.The Company performs ongoing credit evaluations of its customers’ financialcondition and maintains an allowance for doubtful accounts. Accounts receivableare presented net of an allowance for doubtful accounts of $483,254 and$410,147 and at December 31, 2003 and 2002, respectively.

 

In 2003, there were no customers who accounted for more than 10% of theCompany’s revenues.  In 2002, onecustomer accounted for 18% of the Company’s revenues.

 

As of December 31, 2003, there were no customers who accounted formore than 10% of total accounts receivable. At December 31, 2002, onecustomer accounted for 25% of total accounts receivable.

 

*Stock-based compensation*

 

Stock-based compensation to employees has been recognized as thedifference between the per share fair value of the underlying stock and thestock option exercise at the initial grant date. The cost of stock optionsgranted for services, other than those issued to employees, are recorded at thefair value of the stock option.

 

SFAS No. 123, “Accountingfor Stock-Based Compensation,” establishes and encourages the use of the fairvalue based method of accounting for stock-based compensation arrangementsunder which compensation cost is determined using the fair value of stock-basedcompensation determined as of the date of grant and is recognized over theperiods in which the related services are rendered. The statement also permitscompanies to elect to continue using the current intrinsic value accountingmethod specified in Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees,” to account for stock-basedcompensation. The Company has elected to use the intrinsic value based methodand has disclosed the pro forma effect of using the fair value based method toaccount for its stock-based compensation issued to employees. For optionsgranted to employees where the exercise price is less than the fair value ofthe stock at the date of grant, the Company recognizes an expense in accordancewith APB 25.  Fornon-employee stock based compensation the Company recognizes an expense inaccordance with SFAS No. 123 and values the equity securities based on the fairvalue of the security on the date of grant. For stock-based awards the value isbased on the market value for the stock on the date of grant. Stock optionawards are valued using the Black-Scholes option-pricing model.

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes method with the following assumptions:  risk free interest rate ranging from 4.00%to 6.32%; dividend yield of 0% for each of the years 2003 and 2002; volatilityfactor of the expected market price of the Company’s common stock of 65% for2003 and 2002; and an expected life of the options of 5 years for 2003 and2002.  The volatility of the Company’scommon stock underlying the options was not considered for options granted upto March 31, 2000 because the Company’s stock was not publicly traded.

 

If the Company had elected to recognize compensation expense based uponthe fair value at the grant date for awards under the Stock Option Planconsistent with the methodology prescribed by SFAS No. 123, the Company’snet loss and loss per share would have been increased to the pro forma amountsindicated below for the years ended December 31, 2003 and 2002:

 
|                                                             |   | **2003** |        | **2002** |       |
|------------------------------------------------------------------|--------|----------|-------------|----------|------------|
| NET LOSS:                                                        |   |     | ** **  |     | ** ** |
| As reported                                                      |   | $        | (10,735,793 | )        | $          | (4,848,930 | ) |
| Stock based compensation included in net  loss                   |   | —   |        | —   |       |
| Stock based employee compensation under  fair value based method |   | (527,374 | )           | (918,555 | )          |
| Pro forma net loss                                               |   | $        | (11,263,168 | )        | $          | (5,767,485 | ) |
| Basic loss per common share:                                     |   |     |        |     |       |
| As reported                                                      |   | $        | (1.81       | )        | $          | (0.90 | ) |
| Pro forma                                                        |   | (1.90    | )           | (1.06    | )          |

 

*Income taxes*

 

Current income tax expense or benefit is the amount of income taxesexpected to be payable or refundable for the current year. A deferred incometax asset or liability is computed for the expected future impact ofdifferences between the financial reporting and tax bases of assets andliabilities and for the expected future tax benefit to be derived from taxcredits and loss carryforwards. Deferred tax assets are reduced by a valuationallowance when, in the opinion of management, it is more likely than not thatsome portion or all of the deferred tax assets will not be realized.

 

*Foreign currency translation*

 

The financial position and results of operations of the Company’sforeign subsidiaries are measured using the foreign subsidiary’s local currencyas the functional currency. Revenues and expenses of such subsidiaries havebeen translated into U.S. dollars at average exchange rates prevailing duringthe period. Assets and liabilities have been translated at the rates ofexchange on the balance sheet date. The resulting translation gain and lossadjustments are recorded directly as a separate component of shareholders’equity, unless there is a sale or complete liquidation of the underlyingforeign investments. The Company translates

 

11

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foreign currencies of its German, Canadian and Singapore subsidiaries.The cumulative translation adjustment account, which is part of accumulatedother comprehensive income, increased $153,000 for the twelve months endedDecember 31, 2003 and $150,000 for the twelve months ended 2002.

 

*Comprehensive Income*

 

Comprehensive income consists of net gains and losses affectingshareholders’ equity that, under generally accepted accounting principles, areexcluded from net income (loss). For the Company, the only item is thecumulative translation adjustment.

 

*Revenue recognition*

 

The Company recognizes revenue and profit as work progresses onlong-term, fixed-price contracts involving significant amount of hardware andsoftware customization using the percentage of completion method based on costsincurred to date compared to total estimated costs at completion. Revenue fromcontracts for which we cannot reliably estimate total costs or there are notsignificant amounts of customization are recognized upon completion. Ourrevenue from periodic maintenance agreements is generally recognized ratablyover the respective maintenance periods provided no significant obligationsremain and collectibility of the related receivable is probable. The Companyalso generates non-recurring revenue from the licensing of its software.Software license revenue is recognized upon the execution of a licenseagreement, upon deliverance, fees are fixed and determinable, collectibility isprobable and when all other significant obligations have been fulfilled. TheCompany also generates revenue from the sale of identification card media andother software. Revenue for these items is recognized upon delivery of theseproducts to the customer. The Company also generates revenue from the sale ofprofessional digital photography software. Revenue for these items isrecognized upon delivery of these products to the customer.

 

*Capitalized software development costs*

 

Software development costs incurred prior to the establishment oftechnological feasibility are charged to research and development expense asincurred. Technological feasibility is established upon completion of a workingmodel. Software development costs incurred subsequent to the time a product’stechnological feasibility has been established, through the time the product isavailable for general release to customers, are capitalized, if material. Todate, the Company has not capitalized any software costs as the period betweenachieving technological feasibility and the general availability of the relatedproducts has been short and software development costs qualifying forcapitalization have been insignificant.

 

*Earnings (loss) per share*

 

Basic earnings (loss) per common share is calculated by dividing netincome (loss) available to common shareholders for the period by theweighted-average number of common shares outstanding during the period. Dilutedearnings (losses) per common share is calculated by dividing net income (loss)available to common shareholders for the period by the weighted-average numberof common shares outstanding during the period, increased to include, ifdilutive, the number of additional common shares that would have been outstandingif the potential common shares, if dilutive, had been issued at the beginningof the year.  The dilutive effect ofoutstanding stock options is included in the calculation of diluted earnings(losses) per common share, if dilutive, using the treasury stock method. Duringthe years ended December 31, 2003 and 2002, the Company has excluded thefollowing securities from the calculation of diluted loss per share, as theireffect would have been antidilutive due to the Company’s net loss:

 
| **Potential Dilutive Securities:** |   | **Number of  Common Shares  Convertible into at  December 31, 2003** |   | **Number of  Common Shares  Convertible into at  December 31, 2002** |   |
|------------------------------------|--------|---------------------------------------------------------------------------|--------|---------------------------------------------------------------------------|--------|
|                               |   |                                                                      |   |                                                                      |   |
| Convertible  preferred stock       |   | 60,017                                                                    |   | 60,489                                                                    |   |
| Stock  options                     |   | 912,895                                                                   |   | 745,068                                                                   |   |
| Convertible  notes payable         |   | —                                                                    |   | 464,037                                                                   |   |
| Warrants                           |   | 5,772,229                                                                 |   | 2,865,227                                                                 |   |

 

12

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The following table sets forth the computation of basic and dilutedloss per share for the years ended December 31, 2003 and 2002:

 
|                                       |   | **TWELVE MONTHS ENDED  DECEMBER 31,** |        |
|--------------------------------------------|--------|--------------------------------------------|-------------|
|                                       |   | **2003**                                   |        | **2002** |   |
| Numerator                                  |   |                                       |        |   |   |
| Net  loss                                  |   | $                                          | (10,735,793 | ) | $ | (4,848,930 | ) |
| Less  Series B preferred dividends         |   | (61,356                                    | )           | (63,764 | ) |
| Net  loss available to common shareholders |   | $                                          | (10,797,149 | ) | $ | (4,912,694 | ) |
|                                       |   |                                       |        |   |   |
| Denominator                                |   |                                       |        |   |   |
| Weighted-average  shares outstanding       |   | 5,953,801                                  |        | 5,483,973 |   |
|                                       |   |                                       |        |   |   |
| Basic  and diluted loss per share          |   | $                                          | (1.81       | ) | $ | (0.90 | ) |

 

*Segment information*

 

Prior to its acquisition of G & A, Castleworks and E-Focus,the Company operated in one business segment. With its acquisition ofG & A, Castleworks and E-Focus, the Company is now comprised of threereportable segments: Law Enforcement, Identification and Digital Photography.The Law Enforcement segment develops, sells and supports a suite of modularsoftware products and designs systems used by law enforcement and public safetyagencies to manage criminal history records and investigate crime. TheIdentification segment develops, sells and supports software and designssystems which utilize digital imaging in the production of photo identificationcards, documents and identification badging systems. The Digital Photographysegment develops digital imaging software for photographic purposes.

 

Corporate assets are comprised primarily of cash and other assets providingbenefits to all business segments.

 

There are no intersegment transactions.

 

The table below summarizes information about reportable segments forthe years ended December 31, 2003 and 2002:

 
|                                 |   | **Year  Ended December 31,** |        |
|--------------------------------------|--------|-----------------------------------|-------------|
|                                 |   | **2003**                          |        | **2002** |   |
| Revenues:                            |   |                              |        |   |   |
| Law Enforcement                      |   | $                                 | 3,273,001   |   | $ | 4,247,645 |   |
| Identification                       |   | 11,783,672                        |        | 13,088,453 |   |
| Digital Photography                  |   | 1,176,785                         |        | 919,595 |   |
| Total consolidated revenues          |   | $                                 | 16,233,458  |   | $ | 18,255,693 |   |
| Operating profit (loss):             |   |                              |        |   |   |
| Law Enforcement                      |   | $                                 | (459,243    | ) | $ | 183,103 |   |
| Identification                       |   | (3,170,974                        | )           | (3,205,486 | ) |
| Digital Photography                  |   | (290,747                          | )           | (1,107,389 | ) |
| Other unallocated amounts:           |   |                              |        |   |   |
| Interest expense (income)            |   | 6,960,140                         |        | 652,392 |   |
|                                 |   |                              |        |   |   |
| Other expense (income)               |   | (207,046                          | )      | (53,575 | ) |
| Loss before taxes                    |   | $                                 | (10,674,058 | ) | $ | (4,728,589 | ) |
| Total Assets by Segment:             |   |                              |        |   |   |
| Law Enforcement                      |   | $                                 | 528,175     |   | $ | 1,167,292 |   |
| Identification                       |   | 8,238,539                         |        | 10,754,234 |   |
| Digital Photography                  |   | 1,502,936                         |        | 1,712,032 |   |
| Total assets for reportable segments |   | 10,269,650                        |        | 13,633,558 |   |
| Corporate                            |   | 546,684                           |        | 884,688 |   |
| Total consolidated assets            |   | $                                 | 10,816,334  |   | $ | 14,518,246 |   |

 

13

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The Company has total assets in foreign locations as follows:$2,531,000 in Germany, $152,000 in Canada and $393,000 in Singapore. Revenuesgenerated from the Company’s foreign locations were $6,973,000 and $7,398,000for years ended December 31, 2003 and 2002, respectively.

 

*New Accounting Pronouncements*

 

In December 2003 the FASB concluded to revise certain elements of FIN46, primarily to clarify the required accounting for interests in variableinterest entities.  FIN-46R replacesFIN-46, that was issued in January 2003. FIN-46R exempts certain entities fromits requirements and provides for special effective dates for entities thathave fully or partially applied FIN-46 as of December 24, 2003. In certainsituations, entities have the option of applying or continuing to apply FIN-46for a short period of time before applying FIN-46R. In general, for allentities that were previously considered special purpose entities, FIN 46should be applied in periods ending after December 15, 2003. Otherwise, FIN 46is to be applied for registrants who file under Regulation SX in periods endingafter March 15, 2004, and for registrants who file under Regulation SB, inperiods ending after December 15, 2004. The Company does not expect theadoption to have a material impact on the Company’s financial position orresults of operations.

 

In April 2003, the FASB issued Statement of Financial AccountingStandard No. 149, (“SFAS 149”), “Amendment of Statement 133 on DerivativeInstruments and Hedging Activities,” which amends and clarifies financialaccounting and reporting for derivative instruments, including certain derivativeinstruments embedded in other contracts and for hedging activities under SFAS133.  SFAS 149 is effective forcontracts entered into or modified after June 30, 2003 and for hedgingrelationships designated after June 30, except for the provisions thatwere cleared by the FASB in prior pronouncements.  The adoption of this statement did not impact the Company’sconsolidated financial statements.

 

In May 2003, the FASB issued Statement of Financial AccountingStandard No. 150 (SFAS 150), “Accounting for Certain Financial Instrumentswith Characteristics of both Liabilities and Equity.” SFAS 150 is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003. SFAS 150 establishes standards for how an issuerclassifies and measures in its statement of financial position certainfinancial instruments with characteristics of both liabilities and equity. Itrequires that an issuer classify a financial instrument that is within itsscope as a liability because that financial instrument embodies an obligationof the issuer. The adoption of this statement did not have a significant impacton the Company’s consolidated financial statements.

 

In May 2003, the Emerging Issues Task Force (EITF) finalized IssueNo. 00-21, “Accounting for Revenue Arrangements with MultipleDeliverables.” During December 2003, the Securities and ExchangeCommission issued Staff Accounting Bulletin (SAB)  104, “Revenue Recognition,” which incorporated EITF 00-21.  This issue addresses determination ofwhether an arrangement involving more than one deliverable contains more thanone unit of accounting and how arrangement consideration should be measured andallocated to the separate units of accounting. The adoption of EITF 00-21 and SAB 104 was not material to the Company’sresults of operations or financial condition.

 

In December 2003, the FASB issued a revision to SFAS 132,Employers’ Disclosures about Pensions and Other Postretirement Benefits, whichrequires additional disclosures about the assets, obligations, cash flows, andperiodic benefit costs of defined benefit pension plans and other definedbenefit postretirement plans. Disclosure of additional information about foreign plans is not requireduntil the Company’s next fiscal year.

 

14

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*Reclassifications*

 

Certain reclassifications were made to prior years’ consolidatedfinancial statements to conform to the current year presentation.

 

**3.****             Acquisitions andGoodwill**

 

The following disclosure presents certain information about theCompany’s acquired intangible assets as of December 31, 2003 and2002.  All intangible assets are beingamortized over their estimated useful lives, as indicated below, with noestimated residual values.

 
| **Acquired Intangible Assets**        |   | **Amortization  Period** |   | **Gross  Carrying  Amount** |      | **Accumulated  Amortization** |   | **Net  Balance** |   |
|---------------------------------------|--------|--------------------------|--------|-----------------------------|-----------|-------------------------------|--------|------------------|--------|
| At December 31, 2003             |   |                     |   |                        |      |                          |   |             |   |
| Amortized acquired intangible assets: |   |                     |   |                        |      |                          |   |             |   |
| Technology                            |   | 5 years                  |   | $                           | 1,160,000 |                          | $      | (678,288         | )      | $ | 481,712 |   |
| Trademarks and tradenames             |   | 14.5 years               |   | 630,000                     |      | (128,119                      | )      | 501,881          |   |
| Customer relationship                 |   | 5 years                  |   | 200,000                     |      | (109,998                      | )      | 90,002           |   |
| Non-compete Agreements                |   | 3 years                  |   | 125,000                     |      | (101,670                      | )      | 23,330           |   |
| Patents                               |   | 4 years                  |   | 60,000                      |      | (36,250                       | )      | 23,750           |   |
|                                  |   |                     |   | $                           | 2,175,000 |                          | $      | (1,054,325       | )      | $ | 1,120,675 |   |
| At December 31, 2002             |   |                     |   |                        |      |                          |   |             |   |
| Amortized acquired intangible assets: |   |                     |   |                        |      |                          |   |             |   |
| Technology                            |   | 5 years                  |   | $                           | 1,160,000 |                          | $      | (438,180         | )      | $ | 721,820 |   |
| Trademarks and tradenames             |   | 14.5 years               |   | 630,000                     |      | (80,623                       | )      | 549,377          |   |
| Customer relationship                 |   | 5 years                  |   | 200,000                     |      | (69,998                       | )      | 130,002          |   |
| Non-compete Agreements                |   | 3 years                  |   | 125,000                     |      | (61,666                       | )      | 63,334           |   |
| Patents                               |   | 4 years                  |   | 60,000                      |      | (21,250                       | )      | 38,750           |   |
|                                  |   |                     |   | $                           | 2,175,000 |                          | $      | (671,717         | )      | $ | 1,503,283 |   |

 

As a result of adopting FAS 142 on January 1, 2002, “Acquiredworkforce” with a net book value of $525,000 was subsumed into goodwill.

 

Amortization expense for the twelve months ended December 31, 2003was approximately $383,000.

 

The estimated acquired intangible amortization expense for the nextfive fiscal years is as follows:

 
| **Fiscal Year Ended December 31,** |   | **Estimated  Amortization Expense** |   |
|-----------------------------------------|--------|-------------------------------------|--------|
| 2004                                    |   | 354,000                             |   |
| 2005                                    |   | 253,000                             |   |
| 2006                                    |   | 50,000                              |   |
| 2007                                    |   | 40,000                              |   |
| 2008                                    |   | 40,000                              |   |

 

The balance of the Company’s goodwill was $5,297,627 atDecember 31, 2003 and 2002.

 

In June 2002, we completed our transitional goodwill and purchasedintangibles impairment tests outlined under SFAS 142 which required theassessment of goodwill and purchased intangibles for impairment as ofJanuary 1, 2002 and in December 2002 and 2003, we completed ourannual impairment tests.  These testswere conducted by determining and comparing the fair value of our reportingunits, as defined in SFAS 142, to the reporting unit’s carrying value as ofthat date.  Our reporting units are LawEnforcement, Identification and Digital Photography.  Based on the results of these impairment tests, we determinedthat our goodwill

 

15

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assets and purchased intangible assets were not impaired as ofJanuary 1, 2002 or during December 2002 and December 2003.  We plan to conduct our annual impairmenttests in the fourth quarter of every year, unless impairment indicators existsooner.

 

**4.****             Restricted Cash**

 

At December 31, 2003 and 2002, the Company had $155,000 and$60,000, respectively, of restricted cash and cash equivalents which serves ascollateral for irrevocable standby letter of credits that provide financial assurancethat the Company will fulfill its obligations under certain commitmentsdiscussed in Note 9. The cash is held in custody by the issuing bank, isrestricted as to withdrawal or use, and is currently invested in timecertificates of deposits.  Income fromthese investments is paid to the Company.

 

**5.****             Inventory**

 

Inventories at December 31, 2003 and 2002 were comprised offinished goods of $805,000 and $1,882,000 net of reserves of $316,000 and$171,000, respectively.  Inventories arestated at the lower of cost or market. Market is determined based on net realizable value.  Appropriate consideration is given toobsolescence, excessive levels, deterioration, and other factors in evaluatingnet realizable value.

 

**6.****             Property andEquipment**

 

Property and equipment at December 31, 2003 and 2002 consists of:

 
|                          |   | **2003**   |       | **2002**   |       |
|-------------------------------|--------|------------|------------|------------|------------|
|                          |   |       | ** ** |       | ** ** |
| Equipment                     |   | $          | 1,649,901  |       | $          | 2,141,722 |   |
| Leasehold improvements        |   | 119,930    |       | 100,630    |       |
| Furniture                     |   | 219,685    |       | 281,490    |       |
|                          |   | 1,989,516  |       | 2,523,842  |       |
| Less accumulated depreciation |   | (1,354,550 | )          | (1,482,927 | )          |
|                          |   | $          | 634,966    |       | $          | 1,040,915 |   |

 

Total depreciation expense for the years ended December 31, 2003and 2002 was $483,000 and $503,000, respectively.

 

**7.****             Notes Payable andLine of Credit**

 

Notes payable consist of the following:

 
|                                                                                                                                                                                      |   | **2003** |    | **2002**   |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|---------|------------|--------|
| Notes payable to bank and third parties:                                                                                                                                                  |   |     |    |       |   |
| Short-term note payable to third party to  accrue interest at 10%.  Note due upon  demand                                                                                            |   | $        | 100,000 |       | $      | 100,000 |   |
| Short-term note payable to third party to  accrue interest at 12.5%.  Note due  upon demand                                                                                          |   | —   |    | 500,000    |   |
| Line of credit payable to bank to accrue  interest at 8.4%                                                                                                                                |   | —   |    | 165,625    |   |
| Short-term notes payable to certain vendors                                                                                                                                               |   | 81,976   |    | 20,116     |   |
| Total notes payable to bank and third  parties                                                                                                                                            |   | 181,976  |    | 785,741    |   |
|                                                                                                                                                                                      |   |     |    |       |   |
| Notes payable to related parties:                                                                                                                                                         |   |     |    |       |   |
| Short-term note payable to ITC  shareholder.  Such note accrues  interest at 10% and is due upon demand                                                                              |   | 59,000   |    | 210,125    |   |
| Short-term note payable to ITC  shareholder.  Such note accrues  interest at 10% and includes monthly payments through December 31, 2002                                             |   | —   |    | 8,244      |   |
| Total notes payable to related parties                                                                                                                                                    |   | 59,000   |    | 218,369    |   |
|                                                                                                                                                                                      |   |     |    |       |   |
| Convertible notes payable, net of discount:                                                                                                                                               |   |     |    |       |   |
| Senior secured convertible promissory note  to accrue interest at 12.5%.  Face  value of note $2,000,000. Discount on note at December 31, 2002 is $747,689.  Note due May 22, 2004. |   | —   |    | 1,252,311  |   |
| Total notes payable                                                                                                                                                                       |   | $        | 240,976 |       | $      | 2,256,421 |   |
| Less current portion                                                                                                                                                                      |   | (240,976 | )       | (1,004,110 | )      |
| Long-term notes payable                                                                                                                                                                   |   | $        | —  |       | $      | 1,252,311 |   |

 

In May 2002, the Company issued a senior secured promissory note for$2,000,000 at an interest rate of 12.5%, due May 22, 2004 (the “Note”).  The Note initially was convertible intocommon shares of the Company at $4.31 per share.  In conjunction with the note, the Company issued a warrant topurchase 150,000 shares of common stock at $4.74 per share.  The Company recorded the note net of adiscount equal to the fair value allocated to the warrants issued ofapproximately $537,000.

 

16

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The Note also contained a beneficial conversion feature, which resultedin additional debt discount of $537,000. The beneficial conversion amount was measured using the accountingintrinsic value, i.e. the excess of the aggregate fair value of the commonstock into which the debt is convertible over the proceeds allocated to thesecurity.  The Company accreted thebeneficial conversion feature as interest expense over the life of the note.  For the twelve months endedDecember 31, 2002, the Company recorded $326,212 as interest expense fromthe amortization of the discount related to the fair value of the warrants andfrom the accretion of the beneficial conversion feature.

 

The issuance by the Company of $600,000 in convertible subordinatedpromissory notes in March 2003 (described below) triggered certainanti-dilution provisions contained in the Note.  This resulted in the conversion price of the Note being reducedto $1.90 per share.  Similar provisionsalso reduced the warrant exercise price to $4.65 per share.  These reductions resulted in the recognitionof an additional beneficial conversion feature in the amount of $926,000 whichwas recorded as additional debt discount. The Company accreted this additional beneficial conversion feature asinterest expense through the date of extinguishment.

 

In September 2002, the Company issued a secured demand promissorynote for $500,000 at an interest rate of 12.5% to the holder of the Note.  The note was due and payable upon demandgiven by the holder.  The Company repaidthis note in full in June 2003.

 

In March 2003, the Company issued to certain accredited investorsconvertible subordinated promissory notes (“the Subordinated Notes”).  The Subordinated Notes had an aggregateprincipal amount of $600,000, bear an interest rate of 8.5% per annum, payablesemi-annually in arrears, have a maturity date of April 15, 2005 and areconvertible into shares of the Company’s common stock at a conversion price of$1.90 per share.

 

The Subordinated Notes contained an embedded beneficial conversionfeature which resulted in debt discount of $111,000.  The beneficial conversion amount was measured using theaccounting intrinsic value, i.e. the excess of the aggregate fair value of thecommon stock into which the debt is convertible over the proceeds allocated tothe security.  The Company accreted thebeneficial conversion feature as interest expense over the life of the note.

 

In November 2003, the holders of the Subordinated Notes convertedthe principal amount and accrued interest outstanding into 334,392 shares ofthe Company’s Common Stock.  To inducethe holders of the Subordinated Notes to convert their debt, the Company issuedthe holders of the Subordinated Notes warrants to purchase 66,876 shares of theCompany’s common stock at $2.58 per share. The Company has recorded $110,000 as induced conversion expense based onthe value of the warrants on the date of issuance.  The estimated value of the warrants of $110,000 was determinedusing the Black-Scholes option pricing model and the following assumptions:term of 5 years, a risk free interest rate of 2.53%, a dividend yield of 0% andvolatility of 85%.

 

In June 2003, the Company issued two senior secured convertiblepromissory notes for an aggregate of $4,150,000 and a third senior securedconvertible note for $106,000 (collectively “the New Notes”) in lieu of paymentof financing fees.  The New Notes bearinterest at 12.5% per annum and are due on May 22, 2005.  Under the terms of the New Notes, theholders retain the right, subject to certain exceptions, to convert all or anypart of the principal and accrued interest outstanding under the New Notes intoshares of our Common Stock at a conversion price equal to $2.11.  In conjunction with the issuance of the NewNotes, the Company issued warrants to acquire 1,600,000 shares of the Company’sCommon Stock at an exercise price of $2.11 per share.

 

In accordance with EITF 00-27,the Company first determined the fair value of the New Notes and the fair valueof the detachable warrants issued in connection with these notes.  The estimated value of thewarrants of $2,770,000 was determined using the Black-Scholes option pricingmodel and the following assumptions: term of 6 years, a risk free interest rateof 2.53%, a dividend yield of 0% and volatility of 82%. The face amount of the New Notes of$4,256,000 was proportionately allocated to the New Notes and the warrants inthe amount of $2,218,000 and $2,038,000, respectively.  The amount allocated to the warrantsof $2,038,000 was recorded as a discount on the New Notes and as additionalpaid-in capital.  The value of the New Notes was then allocatedbetween the New Notes and the beneficial conversion feature, which amounted to$166,000 and $2,052,000, respectively. The amount allocated to thebeneficial conversion feature of $2,052,000 was recorded as a discount on theNew Notes and as additional paid-in capital. The Company accreted the discounts on the New Notes as interest expenseover the life of the notes.

 

The Company utilized a portion of the proceeds from the issuance of theNew Notes to extinguish the $2,000,000 Senior Secured Convertible Note issuedMay 2002 and the $500,000 secured demand promissory note issued inSeptember 2002.  The Company hasrecorded additional interest expense of $766,757 representing the unamortizeddebt discount at the date of the extinguishment.  The Company has also recorded additional interest expense of$225,000 representing unamortized deferred financing fees at the date of extinguishment.  The Company allocated $516,000 of thereacquisition price to the beneficial conversion feature based on the intrinsicvalue of the conversion feature on the date of extinguishment.

 

In November 2003, the Company repaid the principal amount of theNew Notes plus accrued interest outstanding at the date of extinguishment.  The Company has recorded additional interestexpense of $2,715,000 representing the unamortized debt discount at the date ofthe extinguishment.  The Company hasalso recorded additional interest expense of $429,000 representing

 

17

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unamortized deferred financing fees at the date of extinguishment.  The Company allocated $585,000 of thereacquisition price to the beneficial conversion feature based on the intrinsicvalue of the conversion feature on the date of extinguishment.

 

A foreign subsidiary of the Company had two lines of credit withcommercial banks totaling $606,000.  Asof December 31, 2002, the Company had utilized approximately $165,625 ofthis facility.  Borrowings under thisfacility bear interest at  8.4% perannum and are collateralized by the subsidiary’s accounts receivable.  During 2003, the Company repaid alloutstanding borrowings under these credit facilities upon their termination.

 

On June 30, 2001, the Company converted accrued liabilities due toan employee into a promissory note in the amount of $269,605. The note bearsinterest at 10% per annum. Under the terms of the note, the Company is requiredto make monthly payments of $15,000 until the note is paid in full onJanuary 14, 2003. At December 31, 2002, the balance of this notepayable was $8,244.  During 2003, theCompany repaid the remainder of this note in full.

 

On February 23, 2003, pursuant to a settlement agreement, theCompany amended the $ 210,125 note due the ITC shareholder and convertedapproximately $44,000 in accrued liabilities into a new promissory note.  This new note bears interest at 7% perannum.  Under the terms of the note, theCompany is required to make monthly payments of $15,000 until the note is paidin full on April 15, 2004.  AtDecember 31, 2003, the balance of this note payable was $59,000.

 

In July 2003, the Company converted $99,000 in trade accountspayable into promissory notes.  Thenotes bear interest between 6.50% to 7.50% per annum, call for monthly paymentsbetween $1,000 to $2,000 until paid in full, with payments commencingAugust 1, 2003.

 

Future maturities of notes payable as of December 31, 2003 are$240,976 due at various dates in 2004 and $0 due thereafter.

 

**8.****             Warrant Liability**

 

In conjunction with the Company’s issuance ofthe New Notes, the Company agreed to register with the Securities and ExchangeCommission, the shares of common stock underlying the warrants issued as partof the New Notes.  In conjunction withthe Company’s issuance of common stock in a private placement, the Companyagreed to register with the Securities and Exchange Commission, the shares ofcommon stock underlying the warrants issued as part of the privateplacement.  In accordance with theFinancial Accounting Standards Board Emerging Issue Task Force 00-19, theCompany has recorded as long-term liability for the allocated value of thewarrants.  Accordingly, the Company isaccounting for the liability under fair value accounting.  The following table sets forth the changesin fair value and the resulting interest income or expense of this liability asdetermined under fair value accounting:

 

18

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|                                          |   | **Warrant Liability  in Conjunction  with warrants  issued withNew Notes** |      | **Interest  Expense  (Income)  from warrant  revaluation  of New NotesWarrants** |   | **Warrant Liability  in Conjunction  with warrants  issued withPrivate Placement** |   | **Interest  Expense  (Income)  from warrant  revaluation  of Private  PlacementWarrants** |      |
|-----------------------------------------------|--------|----------------------------------------------------------------------------|-----------|----------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------|-----------|
|                                          |   |                                                                       |      |                                                                             |   |                                                                               |   |                                                                                      |      |
| Warrant  liability at date of inception       |   | $                                                                          | 2,037,000 |                                                                             |   |                                                                               | $      | 1,035,000                                                                                 |      |   |   |
|                                          |   |                                                                       |      |                                                                             |   |                                                                               |   |                                                                                      |      |
| Change  in fair value of warrant liability    |   | $                                                                          | 321,000   |                                                                             | $      | 321,000                                                                            |   |                                                                                      |      |   |   |
|                                          |   |                                                                       |      |                                                                             |   |                                                                               |   |                                                                                      |      |
| Warrant  liability at June 30, 2003      |   | $                                                                          | 2,358,000 |                                                                             |   |                                                                               |   |                                                                                      |      |   |
|                                          |   |                                                                       |      |                                                                             |   |                                                                               |   |                                                                                      |      |
| Change  in fair value of warrant liability    |   | $                                                                          | (711,000  | )                                                                                | $      | (711,000                                                                           | )      |                                                                                      |      |   |   |
|                                          |   |                                                                       |      |                                                                             |   |                                                                               |   |                                                                                      |      |
| Warrant  liability at September 30, 2003 |   | $                                                                          | 1,647,000 |                                                                             |   |                                                                               |   |                                                                                      |      |   |
|                                          |   |                                                                       |      |                                                                             |   |                                                                               |   |                                                                                      |      |
| Change  in fair value of warrant liability    |   | $                                                                          | 399,000   |                                                                             | $      | 399,000                                                                            |   | $                                                                                         | 379,000   |   | $ | 379,000 |   |
|                                          |   |                                                                       |      |                                                                             |   |                                                                               |   |                                                                                      |      |
| Warrant  liability at December 31, 2003  |   | $                                                                          | 2,046,000 |                                                                             | $      | 9,000                                                                              |   | $                                                                                         | 1,414,000 |   | $ | 379,000 |   |

 

The estimated warrant liability and subsequent valuations were determinedusing the Black-Scholes option pricing model and the following assumptions:term of 5-6 years, a risk free interest rate of 2.53%, a dividend yield of 0%and volatility of 82% - 85%.

 

**8.****             Income Taxes**

 

The significant components of the income tax provision (benefit) are asfollows:

 
|         |   | **December 31,** |   |
|--------------|--------|-----------------------|--------|
|         |   | **2003**              |   | **2002** |   |
| **Current**  |   |                  |   |   |   |
| Federal      |   | $                     | — |   | $ | — |   |
| State        |   | —                |   | — |   |
| Foreign      |   | —                |   | — |   |
|         |   |                  |   |   |   |
| **Deferred** |   |                  |   |   |   |
| Federal      |   | —                |   | — |   |
| State        |   | —                |   | — |   |
| Foreign      |   | 61,735                |   | 120,341 |   |
|         |   |                  |   |   |   |
|         |   | $                     | 61,735 |   | $ | 120,341 |   |

 

The principal components of the Company’s deferred tax assets(liabilities) at December 31, 2003 and 2002 are as follows:

 
|                             |   | **2003**   |      | **2002**   |   |
|----------------------------------|--------|------------|-----------|------------|--------|
|                             |   |       |      |       |   |
| Net operating loss carryforwards |   | $          | 8,586,589 |       | $      | 6,961,249 |   |
| Research and development credits |   | 607,614    |      | 561,033    |   |
| Intangible Assets                |   | 534,656    |      | 209,937    |   |
| Reserves and accrued expenses    |   | 248,875    |      | 281,310    |   |
| Other                            |   | (48,550    | )         | (20,000    | )      |
|                             |   | 9,929,184  |      | 7,993,529  |   |
| Less valuation allowance         |   | (9,929,184 | )         | (7,929,042 | )      |
|                             |   |       |      |       |   |
| Net deferred tax assets          |   | $          | —    |       | $      | 64,487 |   |

 

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A reconciliation of the provision (benefit) for income taxes to theamount computed by applying the statutory income tax rates to loss beforeincome taxes is as follows:

 
|                                     |   | **2003**  |       | **2002**  |   |
|------------------------------------------|--------|-----------|------------|-----------|--------|
|                                     |   |      |       |      |   |
| Amounts computed at statutory rates      |   | $         | (3,649,626 | )         | $      | 1,548,005 | ) |
| State income tax, net of federal benefit |   | (201,348  | )          | (270,445  | )      |
| Foreign tax                              |   | 61,735    |       | 120,341   |   |
| Non-deductible interest                  |   | 1,823,746 |       | —    |   |
| Other                                    |   | (13,930   | )     | 40,053    |   |
| Net change in valuation allowance        |   | 2,039,910 |       | 1,778,397 |   |
|                                     |   |      |       |      |   |
|                                     |   | $         | 60,487     |      | $      | 120,341 |   |

 

The Company has established a valuation allowance against its deferredtax asset due to the uncertainty surrounding the realization of suchasset.  Management periodicallyevaluates the recoverability of the deferred tax asset.  At such time as it is determined that ismore likely than not that deferred tax assets are realizable, the valuationallowance will be reduced.

 

At December 31, 2003 and 2002, the Company had federal net operatingloss carryforwards of approximately $23,104,000 and $18,534,000, respectively,state net operating loss carryforwards of approximately $10,022,000 and$12,534,000, respectively, which may be available to offset future taxableincome for tax purposes.  The federalnet operating loss carryforwards expire at various dates from 2004 through2023.  The state net operating losscarryforwards expire at various dates from 2004 through 2008.  In addition, the Company had foreignoperating losses carryforwards of approximately $659,000 at December 31,2003.

 

The Company also had federal research credit carryforwards ofapproximately $396,000 and $361,000 and state research credit carryforwards ofapproximately $212,000 and $200,000 for tax purposes at December 31, 2003and 2002, respectively.  The federalcarryforwards will begin to expiring, if unused, in 2008.

 

The Internal Revenue Code (the “Code”) limits the availability of netoperating losses and certain tax credits that arose prior to certain cumulativechanges in a corporations’s ownership resulting in a change of control of theCompany.  The Company’s use of its netoperating loss carryforwards and tax credit carryforwards will be significantlylimited because the Company underwent “ownership changes” in 1991, 1995, 2000and 2003.  The effect of the existinglimitation has been reflected in the above summary of the deferred tax assets.

 

**9.****             Commitments andContingencies**

 

*Employment Agreements*

 

The Company has employment agreements with its Chief Executive Officer,Senior Vice President of Administration and Chief Financial Officer, VicePresident of Research and Development, President of ImageWare Systems LawEnforcement Group, and President of ImageWare Systems Digital Photography. TheCompany may terminate the agreements with or without cause. Should the Companyterminate the agreements without cause, the officers are entitled tocompensation ranging from 12 to 36 months of salary.

 

*Letter of Credit*

 

As collateral for performance on various software installation andimplementation contracts, the Company is contingently liable under twoirrevocable standby letters of credits in an aggregate amount of approximately$155,000. The letters of credit expire in an amount of $49,000 onApril 19, 2004.  The second letterof credit in the amount of $106,000 expires December 26, 2008.  As a

 

20

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condition, the bank requires the Company to invest an equal amount inthe form of certificate of deposit.  Asof December 31, 2003, there were no drawings against the outstandingbalance.

 

*Litigation*

 

The Company is involved in certain legal proceedings generallyincidental to its normal business activities. While the outcome of suchproceedings cannot be accurately predicted, the Company does not believe theultimate resolution of any such existing matters should have a material effecton its financial position, results of operations or cash flows.

 

*Leases*

 

The Company currently leases office and research and development spaceunder operating leases which expire at various dates throughDecember 2006.

 

At December 31, 2003, future minimum lease payments are asfollows:

 
| 2004   |   | $ | 780,000   |   |
|--------|--------|---|-----------|--------|
| 2005   |   | $ | 774,000   |   |
| 2006   |   | $ | 830,000   |   |
| 2007   |   | $ | —    |   |
| 2008   |   | $ | —    |   |
|   |   | $ | 2,384,000 |   |

 

The Company is committed to a three year lease foroffice space housing its Digital Photography operations in Costa Mesa,California which is for 4,275 square feet.  During 2002, the Companyconsolidated these operations into its corporate headquarters in San Diego,California and vacated the premises. The Company does not intend to occupy this space and is actively seekinga tenant to sub-lease this space. During 2002, the Company recorded an estimated loss on its leasecommitment totaling $132,416, which is included in current accrued liabilitieson the balance sheet. In determining this estimated loss for its leasecommitment, the Company has been required to make various assumptions,including occupancy dates for new tenants, sub-lease rental rates, tenantimprovement allowances, abandoned leasehold improvements and commissionpayments, that involve estimates and judgments.  In formulating itsassumptions, the Company took into account current and projected real estatemarket conditions.  If the Company’s estimates and related assumptionschange in the future, the Company may be required to revise this estimated losson its lease commitment.  If any revisions to its estimated loss arenecessary, then an additional loss or a benefit will be recorded.

 

----

During 2003, the Company secured a tenant to sublease this space.  As a result of subletting this property, theCompany recorded an additional $38,000 loss on its lease commitment.

 

Rental expense under operating leases for the years endedDecember 31, 2003 and 2002 was approximately $828,000 and $1,006,000respectively.

 

**10.****          Equity**

 

The Company’s Articles of Incorporation were amended effectiveAugust 31, 1994 and authorize the issuance of two classes of stock to bedesignated “Common Stock” and “Preferred Stock,” provide that both Common andPreferred Stock shall have a par value of $.01 per share and authorize theCompany to issue 50,000,000 shares of Common Stock and 4,000,000 shares ofPreferred Stock. The Preferred Stock may be divided into such number of seriesand with the rights, preferences, privileges and restrictions as the Board ofDirectors may determine.

 

*Series B Convertible, RedeemablePreferred Stock*

 

In April 1995, the Company’s Articles of Incorporation wereamended to authorize 750,000 shares of Series B Convertible RedeemablePreferred Stock (“Series B”). Each 5.275 shares of Series B areconvertible into one share of the Company’s common stock. As ofDecember 31, 2003, the Company had 249,400 shares of Series Boutstanding.

 

The holders of Series B are entitled to cumulative preferreddividends payable at the rate of $.2125 per share per annum commencingApril 30, 1996, subject to legally available funds. The Series B plusaccrued but unpaid dividends are convertible at the option of the holder intoshares of common stock at a conversion price equal to the originalSeries B issue price as adjusted to prevent

 

21

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dilution. The Series B will automatically be converted into sharesof common stock upon the closing of an underwritten public offering at a priceper common share of not less than $31.65. If the public offering price is lessthan $31.65 but at least $21.10 per share, the conversion shall still beautomatic upon written consent of a majority of the then outstandingshareholders of Series B.

 

The Series B, on an as-converted basis, have the same votingrights per share as the Company’s common shares; provided, that theSeries B has a special right to elect one director if the Company defaultsin the payment of any dividend to the holders of Series B. TheSeries B are entitled to initial distributions of $2.50 per share ofSeries B outstanding, upon liquidation and in preference to common sharesand any other series of preferred stock plus all accrued but unpaid dividends.

 

Any time after December 31, 2000, the Company has the right toredeem all or some of the outstanding shares of Series B at a price equalto the original issue price, plus all accrued but unpaid dividends.

 

As of December 31, 2002, the Company had 269,400 shares ofSeries B outstanding. During 2003, 20,000 shares of Series Bpreferred stock were converted into 4,804 shares of common stock. AtDecember 31, 2003 and 2002, the Company had cumulative undeclareddividends of approximately $174,000 and $146,000, respectively.

 

*Common Stock*

 

On November 24, 2003, the Company completed a private placement ofsecurities, which involved the sale of units consisting of one share of commonstock and a warrant to purchase 0.20 shares of common stock.  Each unit was priced at $1.72.  The warrants have a five-year term and anexercise price of $2.58 per share.  As aresult of these transactions, the company issued an aggregate of approximately4,070,000 new shares of common stock and warrants to purchase up toapproximately 814,000 shares of common stock. In connection with this transaction, the Company also issued to certainplacement agents warrants to purchase an additional approximately 407,000shares of common stock.  The Companyraised approximately $7.0 million for the private placement, approximately $4.5million of which was used to retire the Company’s outstanding 12.5% convertiblesecured debt.

 

*Warrants*

 

As of December 31, 2003, warrants to purchase 5,772,229 shares ofcommon stock at prices ranging from $2.11 to $16.46 were outstanding. Allwarrants are exercisable as of December 31, 2003 and expire at variousdates through June 2009.

 

The following table summarizes warrant activitysince 2001:

 
|                             |   | **Warrants**  |       | **Weighted-  Average  Exercise Price** |       |
|----------------------------------|--------|---------------|------------|----------------------------------------|------------|
|                             |   |          |       |                                   |       |
| **Balance at December 31, 2001** |   | **2,823,943** | ** ** | **$**                                  | **11.28**  | ** ** |
| **Granted**                      |   | **200,282**   | ** ** | **$**                                  | **3.55**   | ** ** |
| **Expired / Canceled**           |   | **(108,717**  | **)**      | **$**                                  | **7.91**   | ** ** |
| **Exercised**                    |   | **—**    | ** ** | **$**                                  | **—** | ** ** |
| **Balance at December 31, 2002** |   | **2,915,508** | ** ** | **$**                                  | **10.87**  | ** ** |
| **Granted**                      |   | **2,887,721** | ** ** | **$**                                  | **2.32**   | ** ** |
| **Expired / Canceled**           |   | **(31,000**   | **)**      | **$**                                  | **6.25**   | ** ** |
| **Exercised**                    |   | **—**    | ** ** | **$**                                  | **—** | ** ** |
| **Balance at December 31, 2003** |   | **5,772,229** | ** ** | **$**                                  | **6.62**   | ** ** |

 

22

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The following table summarized information aboutwarrants outstanding and exercisable at December 31, 2003:

 
| **Exercise Price**      |   | **Number  Outstanding** |   | **Weighted—Average  Remaining Life (Years)** |   | **Weighted—Average  Exercise Price** |    |
|-------------------------|--------|-------------------------|--------|---------------------------------------------------|--------|-------------------------------------------|---------|
|                    |   |                    |   |                                              |   |                                      |    |
| $2.1100                 |   | 1,600,000               |   | 5.45                                              |   | $                                         | 2.1100  |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $2.5800                 |   | 1,287,721               |   | 4.90                                              |   | $                                         | 2.5800  |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $3.5500                 |   | 200,282                 |   | 3.39                                              |   | $                                         | 3.5500  |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $6.0000                 |   | 125,000                 |   | 0.86                                              |   | $                                         | 6.0000  |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $7.9125                 |   | 23,065                  |   | 0.29                                              |   | $                                         | 7.9125  |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $9.6000                 |   | 181,339                 |   | 1.25                                              |   | $                                         | 9.6000  |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $10.8600                |   | 176,273                 |   | 1.83                                              |   | $                                         | 10.8600 |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $12.000                 |   | 2,162,389               |   | 1.26                                              |   | $                                         | 12.0000 |   |
|                    |   |                    |   |                                              |   |                                      |    |
| $15.000 — $16.4600 |   | 16,161                  |   | 1.42                                              |   | $                                         | 15.5566 |   |
|                    |   |                    |   |                                              |   |                                      |    |
|                    |   | 5,772,229               |   |                                              |   |                                      |    |

 

**11.****          Stock Option Plans**

 

On August 31, 1994, the directors of the Company adopted theCompany’s 1994 Employee Stock Option Plan (the “1994 Plan”) and the 1994Nonqualified Stock Option Plan (the “Nonqualified Plan”). The 1992 Stock OptionPlan and options previously granted were canceled by the Board of Directors.

 

The 1994 Plan originally provided for officers and other key employeesto receive nontransferable incentive stock options to purchase up to 170,616shares of the Company’s common stock. The number of stock options issued and outstanding and the number ofstock options remaining available for future issuance are shown in the tablebelow.  The option price per share mustbe at least equal to 100% of the market value of the Company’s common stock onthe date of grant and the term may not exceed ten years.

 

The Nonqualified Plan originally provided for directors and consultantsto receive nontransferable options to purchase up to 18,957 shares of theCompany’s common stock.  The number ofoptions issued and outstanding and the number of options remaining availablefor future issuance are shown in the table below.  The option price per share must be at least equal to 85% of themarket value of the Company’s common stock on the date of grant and the termmay not exceed five years.

 

Both the 1994 Plan and the Nonqualified Plan are administered by theBoard of Directors or a Committee of the Board which determines the employees,directors or consultants which will be granted options and the terms of theoptions, including vesting provisions which to date has been over a three yearperiod. Both the 1994 Plan and the Nonqualified Plan expire on August 31,2004.

 

Due to a significant decline in the estimated fair value of theCompany’s common stock, in February 1999, the exercise price of previouslygranted stock options was repriced to $5.28 per share, which was based upon thefair value of the Company’s common stock as of that date, as determined by theCompany’s Board of Directors. The Company was required to record compensationexpense equal to the difference between the estimated fair value of the commonstock and the exercise price of the repriced options. For the years endedDecember 31, 2003 and 2002, the Company recorded no compensation expenseas the exercise price was equal or above the estimated fair value.

 

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On December 17, 1999, the Company’s Board of Directorsadopted the ImageWare Systems, Inc. Amended and Restated 1999 Stock OptionPlan (the “1999 Plan”). Under the terms of the 1999 Plan, the Company could,originally, issue up to 350,000 non-qualified or incentive stock options topurchase common stock of the Company. The number of options issued and outstanding and the number of optionsremaining available for future issuance are shown in the table below.  The 1999 Plan has substantially the sameterms as the 1994 Employee Stock Option Plan and the 1994 Nonqualified StockOption Plan and expires on December 17, 2009.

 

On September 12, 2001, the Company’s Board of Directors approvedadoption of the 2001 Equity Incentive Plan (the “2001 Plan”). Under the termsof the 2001 Plan, the Company may issue stock awards to employees, directorsand consultants of the Company, and such stock awards may be given fornonstatutory stock options (options not intended to qualify as an “incentivestock option” within the meaning of Section 422 of the Internal RevenueCode of 1986, as amended), stock bonuses, and rights to acquire restrictedstock. The Company originally reserved 1,000,000 shares of its common stock forissuance under the 2001 Plan.  Thenumber of options issued and outstanding and the number of options remainingavailable for future issuance are shown in the table below.

 

The 2001 Plan is administered by the Board of Directors or a Committeeof the Board as provided in the 2001 Plan. Options granted under the 2001 Planshall not be less than 85% of the market value of the Company’s common stock onthe date of the grant, and, in some cases, may not be less than 110% of suchfair market value. The term of options granted under the 2001 Plan as well astheir vesting are determined by the Board and to date, options have beengranted with a ten year term and vesting over a three year period. While theBoard may suspend or terminate the 2001 Plan at any time, if not terminatedearlier, it will terminate on the day before its tenth anniversary of the dateof adoption.

 

# **Stock Option PlansAs of December 31, 2003**

 

|              |   | **Number of  securities to be  issued upon exercise of  outstanding options** |   | **Number of  securities  remaining available for  future issuance under equity  compensation plans   (excluding securities  reflected in column (a))** |   |
|-------------------|--------|-------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|              |   | **(a)**                                                                       |   | **(b)**                                                                                                                                                |   |
| 1994 Plan         |   | 112,038                                                                       |   | 37,915                                                                                                                                                 |   |
| Nonqualified Plan |   | 18,957                                                                        |   | -0-                                                                                                                                                    |   |
| 1999 Plan         |   | 312,000                                                                       |   | 37,060                                                                                                                                                 |   |
| 2001 Plan         |   | 897,011                                                                       |   | 102,257                                                                                                                                                |   |
| Total             |   | 1,340,006                                                                     |   | 177,232                                                                                                                                                |   |

 

The following table summarizes employee stock option activity since December 31,2001:

 
|                              |   | **Options** |   | **Weighted-  Average  Exercise Price** |   |
|-----------------------------------|--------|-------------|--------|----------------------------------------|--------|
|                              |   |        |   |                                   |   |
| Balance at December 31, 2001 |   | 1,310,417   |   | $                                      | 4.56   |   |
| Granted                           |   | 255,508     |   | $                                      | 3.75   |   |
| Expired/canceled                  |   | (167,831    | )      | $                                      | 3.02   |   |
| Exercised                         |   | (416        | )      | $                                      | 3.00   |   |
|                              |   |        |   |                                   |   |
| Balance at December 31, 2002 |   | 1,397,678   |   | $                                      | 4.59   |   |
| Granted                           |   | 203,750     |   | $                                      | 2.52   |   |
| Expired/canceled                  |   | (261,422    | )      | $                                      | 3.77   |   |
| Exercised                         |   | (0          | )      | $                                      | 0      |   |
|                              |   |        |   |                                   |   |
| Balance at December 31, 2003 |   | 1,340,006   |   | $                                      | 4.44   |   |

 

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At December 31, 2003, a total of 912,895 options were exercisableat a weighted average price of $5.03 per share. At December 31, 2002, atotal of 745,068 options were exercisable at a weighted average price of $5.22per share.

 

The following table summarizes information about employee stock optionsoutstanding and exercisable at December 31, 2003:

 
|               |   | **Options  Outstanding** |       |                                 |   |                                   |   |
|--------------------|--------|--------------------------|------------|--------------------------------------|--------|----------------------------------------|--------|
|               |   |                     |       | **Weighted-**                        |   |                                   |   | **Options  Exercisable** |   |
| **Exercise Price** |   | **Number  Outstanding**  |       | **Average  Remaining Life  (Years)** |   | **Weighted-  Average  Exercise Price** |   | **Number  Exercisable** |   | **Weighted-  Average  Exercise Price** | ** ** |
|               |   |                     |       |                                 |   |                                   |   |   |   |   |   |
| $ 1.97 - 2.15      |   | 178,750                  |       | 9.02                                 |   | $                                      | 2.02   |   | 37,016 |   | $ | 2.03 |   |
| $ 2.65 - 4.90      |   | 509,700                  |       | 8.20                                 |   | $                                      | 3.01   |   | 301,175 |   | $ | 3.05 |   |
| $ 5.28             |   | 112,038                  |       | 0.10                                 |   | $                                      | 5.28   |   | 112,038 |   | $ | 5.28 |   |
| $ 5.29 - 6.51      |   | 455,561                  |       | 7.06                                 |   | $                                      | 6.10   |   | 378,709 |   | $ | 6.15 |   |
| $ 8.00 -11.00      |   | 83,957                   |       | 4.78                                 |   | $                                      | 8.09   |   | 83,957 |   | $ | 8.09 |   |
|               |   |                     |       |                                 |   |                                   |   |   |   |   |   |
| **Total**          |   | **1,340,006**            | ** ** |                                 |   |                                   |   | **912,895** |   |   |   |

 

The weighted-average grant-date fair value per share of options grantedto employees during the years ended December 31, 2003 and 2002 was $1.61and $2.59, respectively.

** **

**12.****          Employee Benefit Plan**

 

During 1995, the Company adopted a defined contribution 401(k)retirement plan (the “Plan”). All employees aged 21 years and older becomeparticipants after completion of three months of employment. The Plan providesfor annual contributions by the Company determined at the discretion of theBoard of Directors. Participants may contribute up to 20% of theircompensation.

 

Employees are fully vested in their share of the Company’scontributions after the completion of five years of service. The Company didnot make contributions to the plan for the 2002 plan year. The company hasaccrued a contribution of $50,000 for the 2003 plan year.

** **

**13.****          Pension Plan**

 

One of the Company’s foreign subsidiaries maintains a defined benefitpension plan that provide benefits based on length of service and final averageearnings.

 

The following table sets forth the benefit obligation, fair value ofplan assets, and the funded status of the Company’s plan; amounts recognized inthe Company’s consolidated financial statements; and the assumptions used indetermining the actuarial present value of the benefit obligations as ofDecember 31:

 
|                                                     |   | **2003** |     | **2002** |   |
|----------------------------------------------------------|--------|----------|----------|----------|--------|
| Change in projected benefit obligation:                  |   |     |     |     |   |
| Benefit obligation at beginning of year                  |   | $        | 883,483  |     | $      | 588,573 |   |
| Service cost                                             |   | 72,200   |     | 115,186  |   |
| Interest cost                                            |   | 78,795   |     | 59,047   |   |
| Actuarial gain (loss)                                    |   | (66,520  | )        | (4,323   | )      |
| Effect of exchange rate changes                          |   | 150,277  |     | 125,000  |   |
| Effect of curtailment                                    |   | (410,130 | )        |     |   |
| Benefits paid                                            |   | —   |     | —   |   |
| Benefit obligation at end of year                        |   | 708,105  |     | 883,483  |   |
|                                                     |   |     |     |     |   |
| Change in plan assets                                    |   |     |     |     |   |
| Fair value of plan assets at beginning of year           |   | 235,211  |     | 163,784  |   |
| Actual return of plan assets                             |   | (29,357  | )        | (11,104  | )      |
| Company contributions                                    |   | 98,740   |     | 82,531   |   |
| Benefits paid                                            |   | —   |     | —   |   |
| Fair value of plan assets at end of year                 |   | 304,594  |     | 235,211  |   |
|                                                     |   |     |     |     |   |
| Unfunded status                                          |   | (406,121 | )        | (648,272 | )      |
| Unrecognized actuarial loss (gain)                       |   | (326,364 | )        | 242,151  |   |
| Unrecognized prior service (benefit) cost                |   | —   |     | —   |   |
| Unrecognized transition (asset) liability                |   | —   |     | —   |   |
| Prepaid (accrued) benefit cost                           |   | $        | (732,485 | )        | $      | (406,121 | ) |
|                                                     |   |     |     |     |   |
| Weighted-average assumptions as of  December 31:    |   |     |     |     |   |
| Discount rate                                            |   | 5.5      | %        | 6.0      | %      |
| Expected return on plan assets                           |   | 6.0      | %        | 7.0      | %      |
| Rate of compensation increase                            |   | 2.5      | %        | 2.5      | %      |
|                                                     |   |     |     |     |   |
| Components of net periodic benefit cost are as  follows: |   |     |     |     |   |
| Service cost                                             |   | 72,200   |     | 115,186  |   |
| Interest cost on projected benefit obligations           |   | 78,795   |     | 59,047   |   |
| Expected return on plan assets                           |   | (24,006  | )        | (13,837  | )      |
| Amortization of prior service costs                      |   | —   |     | —   |   |
| Amortization of actuarial loss                           |   | —   |     | 5,845    |   |
| Net periodic benefit costs                               |   | 126,989  |     | 166,241  |   |

 

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**14.****          Exit Activities**

 

The Company adopted the provisions of Statement of Financial AccountingStandard (“SFAS”) No. 146 — Accounting for Costs Associated with Exit orDisposal Activities in the fourth fiscal quarter of the year endedDecember 31, 2002.  The Companyterminated its operating lease for 4,275 square feet of office space used tohouse our Digital Photography operations and moved these operations to its SanDiego, California facility.  Inconnection with this exit activity, the Company also reduced headcount.  The Company has recorded a liability for theremaining lease payments under the operating lease net of estimated subleaserents of $132,000 and accrued $6,000 in severance as of December 31, 2002.  These expenses are classified as part ofgeneral and administrative expenses as of December 31, 2002.

 

In May 2003, the Company entered into an agreement to sublet thisoffice space.  Under the terms of thesublease, the Company will receive rents of $144,000 over the term of thesublease.

 

The following table summarizes charges recorded and changes in the exitactivities reserve during 2003:

 
| Accrued  for exit activities at December 31, 2002 |   | $       | 138,000 |   |
|--------------------------------------------------------|--------|---------|---------|--------|
|                                                   |   |    |    |
| Reductions  to exit activity reserve:                  |   |    |    |
| Payments:                                              |   |    |    |
| Severance                                              |   | (6,000  | )       |
| Lease  Obligation, net of Sublease income              |   | (97,000 | )       |
|                                                   |   |    |    |
| Addtions  to exit activity reserve:                    |   |    |    |
| Additions  to reserve based on sublease finalization   |   | 38,000  |    |
|                                                   |   |    |    |
| Accrued  for exit activities at December 31, 2003 |   | $       | 73,000  |   |

 

**15.****          Related PartyTransactions**

 

RDL Holdings LTD (“RDL”) is considered to be an affiliated entitybecause a major shareholder of this entity is also a major shareholder of theCompany.

 

ITC entered into a five-year operating lease for its office andresearch and development facilities from RDL. The Company recorded rent expenseof $0 for the years ended December 31, 2003 and 2002. At December 31,2003, $76,000 in accrued rent remained unpaid.

 

Prior to the consummation of the ITC merger, certain ITC shareholdersadvanced funds to ITC on a regular basis for general corporate and workingcapital purposes. Amounts owed to the shareholders for these advances atDecember 31, 2002 and 2001 were $208,000 and $208,000, respectively.  On February 23, 2003, pursuant to asettlement agreement, the Company amended the amount due the ITC shareholderand converted an additional approximately $44,000 in accrued liabilitiesincurred for management services into a new promissory note.  This new note bears interest at 7% per annum.  Under the terms of the note, the Company isrequired to make monthly payments of $15,000 until the note is paid in full onApril 15, 2004.  AtDecember 31, 2003, the balance of this note payable was $59,000.

 

The Company has a development contract with a non-employee shareholder.There were no costs incurred under the development contract for the years endedDecember 31, 2002 and 2001.  InJune 2001, the Company converted the amounts due the shareholder into anote payable of $270,000 which includes a principal balance of $170,000 andaccrued but unpaid interest of $100,000. The note bears interest at 10% perannum and calls for monthly payments of $15,000 until January, 2003. Inconjunction with the ITC transaction, the shareholder became an employee of theCompany.  At December 31, 2002, $8,244of this note was unpaid and classified as part of notes payable to relatedparties. This note was paid in full in January 2003.

 

**16.****          Subsequent Event**

 

On January 29, 2004, the Company completed a private placement,which involved the sale of units consisting of one share of common stock and awarrant to purchase 0.20 shares of common stock.  Each unit was priced at $3.65. The warrants, which are first exercisable six-months after the closingdate, have a five-year term and an exercise price of $5.48

 

26

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per share.  As a result of thistransaction, the Company issued an aggregate of approximately 1,818,000 newshares of common stock and warrants to purchase up to approximately 364,000shares of common stock.  In connectionwith this transaction, the Company also issued to certain placement agentswarrants to purchase an additional 199,000 shares of common stock.  The Company raised approximately $6.6million from the private placement, and expects to use the net proceeds forworking capital.

 

27

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, as amended, the Registrant has duly caused this AmendmentNo. 1 on Form 10-KSB/A to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                |   |   | CYMER, INC.             |
|---------------------|--------|--------|-------------------------|
|                |   |   |                    |
|                |   |   |                    |
| Dated: May 20, 2004 |   | By:    | /s/ Wayne G. Watherall  |
|                |   |   | Wayne G. Watherall      |
|                |   |   | Chief Financial Officer |

28

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Exhibit Index

 

23.1 Consent of Pricewaterhouse Coopers LLP, Independent Accountants

23.2 Consent of Stonefield Josephson, Inc., Independent Accountants

31.1 Certification of Chief Executive Officer pursuant to Section 302of the Sarbanes-Oxley Act

31.2 Certification of Chief Financial Officer pursuant to Section 302of the Sarbanes-Oxley Act

32.1 Certification of Chief Executive Officer pursuant to Section 906of the Sarbanes-Oxley Act

 

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