** **

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

----

 

**FORM 10-KSB**

** **
| ý | **ANNUAL REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |
|--------|-------------------------------------------------------------------------------------------|

** **

**For the fiscal year ended December 31, 2002.**

** **
| o | **TRANSITION REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |
|---|-----------------------------------------------------------------------------------------------|

** **

**For the transitionperiod                    to                     .**

 

**Commission FileNumber                    **

** **

----

 

**IMAGEWARE SYSTEMS, INC.**

(Name of Small Business Issuer in Its Charter)

 

| **California**                                                                |   | **33-0224167**                                 |
|-------------------------------------------------------------------------------|--------|------------------------------------------------|
| (State or Other Jurisdiction ofIncorporation or Organization)                 |   | (I.R.S. EmployerIdentification  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 ExchangeAmerican 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  ̈

 

Check if no disclosure of delinquent filers in response to Item 405of Regulation S-B is contained in this form, and no disclosure will becontained, to the best of the registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-KSB or any amendment to this Form 10-KSB. ý

 

The issuer’s revenues for the fiscal year ended December 31, 2002were $18,255,693.

 

The aggregate market value of the voting stock and non-voting commonequity held by non-affiliates of the issuer, based on the closing sales priceof the issuer’s Common Stock on April 11, 2003 as reported on the AmericanStock Exchange was approximately $10,452,368. Excluded from this computation were 263,206 shares of Common Stock heldby all current executive officers and directors and by each person who is knownby the registrant to own 5% or more of the outstanding Common Stock.  Share ownership information of certainpersons known by the issuer to own greater than 5% of the outstanding CommonStock for purposes of the preceding calculation is based solely on informationon Schedule 13G filed with the Commission and is as of April 11, 2003.Exclusion of shares held by any person or entity should not be construed toindicate that such person possesses the power, directly or indirectly, todirect or cause the direction of the management or the policies of the Registrant.

 

The number of shares of Common Stock outstanding as of April 11,2003 was 5,489,390.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Certain information required by Part III (Items 9, 10, 11 and12) is incorporated by reference to portions of the registrant’s definitiveproxy statement for the 2003 Annual Meeting of Shareholders which will be filedwith the Securities and Exchange Commission (“SEC”) within 120 days afterthe fiscal year ended December 31, 2002. Certain Exhibits filed with theRegistrant’s Registration Statement on Form SB-2 (333-93131), RegistrationStatement on Form S-3 (333-64192), Form 10-KSB for the Years EndedDecember 31, 2000 and December 31, 2001, Form 10-QSB for each of thequarters ended March 31, 2001, June 30, 2001, September 30, 2001,March 31, 2002, and June 30, 2002, and Forms 8-K as filed with theCommission on August 13, 2001 and on May 24, 2002 are incorporated byreference into Part III of this Form 10-KSB.

TransitionalSmall Business Disclosure Format (check one):

Yes  ̈  No ý

 

 

----

 

**IMAGEWARE SYSTEMS, INC.**

 

**2002 ANNUAL REPORT ON FORM 10-KSB**

 

**TABLE OF CONTENTS**

 
| PART I   |      |                                                                                                                   |
|----------|-----------|------------------------------------------------------------------------------------------------------------------------|
|     |      |                                                                                                                   |
|     | ITEM 1.   | Description of Business                                                                                                |
|     |      |                                                                                                                   |
|     | ITEM 2.   | Description of Property                                                                                                |
|     |      |                                                                                                                   |
|     | ITEM 3.   | Legal Proceedings                                                                                                      |
|     |      |                                                                                                                   |
|     | ITEM 4.   | Submission Of Matters To A Vote Of  Security Holders                                                                   |
|     |      |                                                                                                                   |
| PART II  |      |                                                                                                                   |
|     |      |                                                                                                                   |
|     | ITEM 5.   | Market for Common Equity and  Related Stockholder Matters                                                              |
|     |      |                                                                                                                   |
|     | ITEM 6.   | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                            |
|     |      |                                                                                                                   |
|     | ITEM 7.   | Financial Statements                                                                                                   |
|     |      |                                                                                                                   |
|     | ITEM 8.   | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosures                                 |
|     |      |                                                                                                                   |
| PART III |      |                                                                                                                   |
|     |      |                                                                                                                   |
|     | ITEM 9.   | Directors, Executive Officers,  Promoters and Control Persons; Compliance with Section 16(a) of the  Exchange Act |
|     |      |                                                                                                                   |
|     | ITEM 10.  | Executive Compensation                                                                                                 |
|     |      |                                                                                                                   |
|     | ITEM 11.  | Security Ownership of Certain  Beneficial Owners and Management and Related Stockholder Matters                        |
|     |      |                                                                                                                   |
|     | ITEM 12.  | Certain Relationships and  Related Transactions                                                                        |
|     |      |                                                                                                                   |
|     | ITEM 13.  | Exhibits, Lists and Reports on  Form 8-K                                                                          |
|     |      |                                                                                                                   |
|     | ITEM  14. | Controls  and Procedures                                                                                               |

 

ii

----

 

C.R.I.M.E.S.®, Crime Capture Systems ®, Face ID®, Suspect ID®, CrimeLab®, Vehicle ID®, Epibuilder®, Episuite®, EdiGuardTM, Castleworks®, ImageWare®,IDentifier® (for Windows), and WinBadge® are registered trademarks of theCompany. Crime WebTM, Pocket CCSTM, CCS CaptureTM, CCS RetrievalTM, EpiwebTM,WinBadge AviationTM, WinBadge NTTM, PC ProTM, PC EventTM, PDI School Days+TM,PDI ProLabTM, PDI StudioTM, PDI Green ScreenTM, and PicturemoreTM are trademarks ofthe Company.

 

All other trademarks, service marks and/or trade names appearing in thisdocument are the property of their respective holders.

 

**PART I**

 

The statements contained in this Annual Report of Form 10-KSB thatare not historical are forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended (the “SecuritiesAct”), and Section 21E of the Securities Exchange Act of 1934, as amended(the “Exchange Act”), including statements regarding our expectations, beliefs,intentions or strategies regarding the future. Forward-looking statementsinclude, without limitation, statements regarding the extent and timing offuture revenues and expenses and customer demand, statements regardingdeployment of our products, and statements regarding reliance on third parties.All forward-looking statements included in this report are based on informationavailable to us as of the date hereof and we assume no obligation to update anyforward-looking statements. Forward-looking statements involve known orunknown risks, uncertainties and other factors, which may cause our actualresults, performance or achievements, or industry results to be materiallydifferent from any future results, performance or achievements expressed orimplied by such forward-looking statements. Factors that could cause orcontribute to such differences include but are not limited to: our need foradditional capital, fluctuations in our operating results, continued newproduct introductions, market acceptance of our new product introductions, newproduct introductions by competitors, technological changes in the digital imagingindustry, uncertainties regarding intellectual property rights and the otherfactors referred to herein including, but not limited to, those items discussedunder “Risk Factors” below.

 

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

 

**Overview**

 

ImageWare Systems, Inc. utilizesits digital imaging technology to provide stand alone, networked and web-based softwaresolutions for secure credentials, biometrics, law enforcement and professionalphotography.   Our secure credentialsolutions enable the development of secure IDs & credentials, driver’slicenses, passports, national IDs, access control products, and custom,  biometric-based solutions for the aviation,transportation, government, education and private sectors.   Our law enforcement / public safety solutions provide comprehensivedigital mugshot, booking, facial recognition, data sharing composite sketchingand investigative technologies for federal, state and local government/lawenforcement agencies.   Our professionalphotography solutions provide stand alone and Web-based technology to capture,enhance, manage and print digital images for professional photographers, photographystudios and photo labs.

 

ImageWare’s law enforcement solutions group  provides solutions which enable agencies to quickly capture, archive,search, retrieve, and share digital photographs and criminal history records ona stand alone, networked, wireless or web-based platform. ImageWare develops,sells and supports a suite of modular software products used by law enforcementand public safety agencies to create and manage criminal history records and toinvestigate crime. Our C.R.I.M.E.S. system consists of seven software modules:Crime Capture System (consisting of the Capture Module and the RetrievalModule), which provides a criminal booking system and related database; FaceID, which uses biometric facial recognition to identify suspects; Suspect ID,which facilitates the creation of full-color, photo-realistic suspectcomposites; Crime Lab, which allows officers to enhance and edit digitalimages; and Vehicle ID, which helps officers identify motor vehicles stolen orinvolved in a crime. In addition, we offer Crime Web, which provides access tocentrally stored records over the Internet in a connected or wireless fashion,Pocket CCS which enables access to centrally stored records while in the fieldon a handheld Pocket PC compatible device, and central repositoryservices which allows for inter-agency data sharing on a local, regional,and/or national level.

 

ImageWare’s ID solutions group provides solutions  which empower customers to create secure andsmart digital identification documents with complete ID systems. We develop,sell and support software and design systems which

 

1

----

 

utilizedigital imaging in the production of photo identification cards, documents andidentification badging systems. Our sales in the digital identification marketwere developed through our acquisitions of ITC, Goddard and G & A(discussed below). Our products in this market consist of EpiSuite, EpiWeb,EpiWeb Enterprise, Identifier for Windows, ID Card Maker, Winbadge NT andWinbadge Aviation. These products allow for the production of digitalidentification cards and related databases and records and can be used by,among others, schools, airports, hospitals, corporations or governments.

 

ImageWare’s Digital Photography group produces a suite of software forthe professional photography market. The software allows professionalphotographers to digitally capture images, manipulate them to create a custompackage or layout, then store the images with an associated database. They canthen print the digital images themselves or send them via the Internet or CD toa professional lab for processing. Our products include PC Pro, PC Event, PDISchool Days+, PDI Studio, PDI Pro Lab and PDI Green Screen. Our customers usethe software products in a wide variety of ways including retail studioenvironments, on-location event photography and “picture day” at schools andday care centers. Our software products are sold through a dealer network anddirectly to major accounts. The PDI group also operates an e-commerce service,Picturemore.com, used by professional photographers to allow their customers toorder re-prints and various service items. Our sales in the digital photographymarket were developed as a result of our acquisition of Castleworks and E-FocusWest in August, 2001.

 

The Company, formerly known as ImageWare Software, Inc., wasincorporated in the State of California on February 6, 1987.  From its inception to 1995, the Companydesigned and sold software products for the photo entertainment industry.  In late 1994, the Company sold its photoentertainment line of products, and utilized its core technologies to developand sell products to law enforcement agencies. From 1995 to early 2000 the Company’s business consisted of only its lawenforcement product line.  The Companycompleted its initial public offering in April 2000.  At that time we recognized that our core imaging technology andknow-how could be extended into other markets and we targeted the digitalidentification market for diversification. It was a fragmented market which offered us the opportunity to establishmarket share through an acquisition program. On August 22, 2000, the Company acquired Imaging TechnologyCorporation (“ITC”), a privately held developer of software and softwaresystems for digital identification documents. On September 29, 2000, the Company purchased Goddard TechnologyCorporation (“Goddard”), a privately held developer of software identificationbadging systems. On March 30, 2001, the Company purchased substantiallyall the assets of G & A Imaging Ltd. (“G & A”), aprivately held developer of software and software systems for digitalidentification documents.  These threeacquisitions, along with the internal development of digital ID solutions forsome of our law enforcement customers, firmly placed the company in the marketfor digital ID software.  In 2001, IDsoftware and systems became the company’s largest product segment.  In 2001 the Company began a program toconsolidate its digital ID businesses and rationalize its costs with respect tothat segment.

 

Thecompany identified digital imaging systems for professional photographers asanother market into which our core technology and capabilities could beextended.   This too was a fragmentedindustry which offered the opportunity to establish a significant marketposition through acquisition. On August 10, 2001, the Company acquiredCastleworks LLC, a Nevada limited liability company (“Castleworks”), andE-Focus West LLC, a Nevada limited liability company (“E-Focus”), privatelyheld providers of digital imaging software and systems for professionalphotographers.

 

Theterrorist attacks on September 11, 2001 impacted all three of our businesssegments.  The law enforcement anddigital identification markets, although seen as markets which would ultimatelybenefit from increased spending on security, were negatively impacted in 2002by the tendency for the delay in purchasing decisions, awaiting guidance andfunding from the government.  Theattacks slowed the economy in general which had a negative impact on ourprofessional photography segment.  As werecognized the impact September 11 was having on our markets we continued ourefforts to reduce costs through continued consolidation of our businesses andcost reduction.  In early 2002 we closedour Massachusetts offices and moved the digital ID operations that were housedin that facility into our South Carolina offices.  In late 2002 we closed our Costa Mesa, California facility whichhoused our professional photography systems business and moved those operationsinto our facility in San Diego, California.

 

**Industry Background**

 

***Law Enforcement and Public SafetyMarkets***

 

The United States law enforcement and public safety markets are composedof federal, state and local law enforcement agencies.  Our target customers include local police departments, sheriffs’departments and offices, primary state law enforcement agencies, special policeagencies, county constable offices, and federal agencies such as the FBI andthe DEA.

 

The federal government has promoted the development and use ofnationwide criminal history record databases called the InterstateIdentification Index 2000, or NCIC 2000, each consisting of on line nationaland regional databases dedicated to serving criminal justice agencies. TheInterstate Identification Index is maintained by the FBI and includes personsarrested for felonies or serious misdemeanors. The FBI has indicated that thisindex will accept photographs in the future. We anticipate that the inclusionof digital images in these databases will increase the value of digital bookingsystems and the demand for facial recognition applications. Since theSeptember 11, 2001 terrorist attack on the US there has been significantdiscussion at the federal and state levels of government regarding the need forfederal, state and local agencies to share information. We anticipate that themovement toward sharing of information will 

 

2

----

 

acceleratethe adoption of systems such as Imageware’s by law enforcement agencies at alllevels.

 

We anticipate significant state and federal funding to be made availableto law enforcement in the aftermath of the September 11, 2001 terroristattacks and with the creation of the Homeland Defense Department.

 

***Identification Markets***

 

We believe our technology also has emerging applications in marketsrelated to access control and identification. Organizations concerned withsecurity issues can use our technology to create picture identification cardsthat can be instantly checked against a database of facial images to prevent unauthorizedaccess to secure areas. We believe potential customers in these markets includelarge corporations, airports, hospitals, universities and government agencies.

 

Digital ID systems have historically been sold based upon thecost-savings digital systems offer over traditional photo-based systems.Furthermore, we believe that the ability to easily capture images and data in adigital database and to enable immediate and widespread access to that databasefor remote identification will be a functionality that customers will requirein the future and that such functionality will be the primary driver for futuregrowth within this market. With the acquisitions of ITC, Goddard andG & A, we are able to provide field-proven digital ID products withhigh quality reference accounts across the board in terms of size andcomplexity of systems and users. When combined with the proven facialrecognition and web capabilities we currently offer with our law enforcementproducts, we believe we can provide a leading product offering into the IDmarket.

 

As with our law enforcement product offering, we believe that theSeptember 11, 2001 terrorist attacks and subsequent creation of theHomeland Defense Department will accelerate the adoption of digitalidentification systems that can provide secure credentials and instant accessto centrally maintained records for real time verification of identity andprivileges.

 

***Digital Photography Market***

 

We believe our technology also has potential applications in marketsrelated to professional photography. Professional photographers can use oursoftware to capture digital photos of subjects, allow re-touching of photos,manipulate the photos to change light, color, etc. and combine them with otherphotos, templates and text to create custom collages.

 

We believe the use of digital photography software and systems byprofessional photographers is growing because it allows them to capture qualityimages and either output them immediately or create a database with associatedtextual information that then can be efficiently printed by themselves orprofessional labs.

 

With the acquisition of Castleworks and E-Focus West we believe we areable to provide proven software and systems that allow professionalphotographers, labs and studios the ability to more efficiently manage theirbusiness through the use of digital images and associated databases. As camera,computer hardware and memory capabilities grow and their associated costs comedown we anticipate the adoption of digital technology by the professionalphotography community to accelerate.

 

**Products and Services**

 

***Law Enforcement and Public Safety***

 

We believe our integrated suite of software products significantlyreduces the inefficiencies and expands the capabilities of traditional bookingsystems. Using our products, an agency can create a digital database ofthousands of criminal history records, each including one or more full-colorfacial images, text information and images of other distinctive physicalfeatures. This database can be quickly searched using text queries or by usingour facial recognition technology which can compare the facial

 

3

----

 

characteristicsof an unknown suspect with facial images in the database. Our investigativesoftware products can also be used to create, edit and enhance digital imagesand to search databases of other agencies to which our customers have access.

 

Our C.R.I.M.E.S. system consists of software modules, which may also bepurchased individually. The Crime Capture System (including both the CaptureModule and the Investigative Module) is our booking system and database. Ourinvestigative modules are Face ID, Suspect ID, Crime Lab, Vehicle ID, CrimeWeb,and Pocket CCS.

 

CRIME CAPTURE SYSTEM. The Crime Capture System is a Windows-baseddigital booking system made up of two distinct software modules and associatedhardware such as cameras and computer hardware as needed. The Crime CaptureSystem allows customers to capture and store images and other information in adatabase and to search and retrieve records from the database. The CrimeCapture System uses off-the-shelf hardware and is designed to comply with openindustry standards so that it can operate on an array of systems ranging from astand-alone personal computer to a wide area network. To avoid duplication ofentries, the system can be integrated easily with several other informationstorage and retrieval systems, such as a live scan fingerprint system, arecords management system or an automated fingerprint identification system.

 

CCS CAPTURE. This software module allows users to capture and storefacial images as well as images of distinguishing features such as scars,tattoos and other marks. Each entry contains both images and text informationin an easy-to-view format made up of distinct fields. Current customers of thismodule range from agencies that capture a few thousand mugshots per year tothose that capture hundreds of thousands of mugshots each year.

 

CCS INVESTIGATIVE. This software module allows users to search thedatabase created with CCS Capture. Officers can conduct text searches in manyfields, including file number, name, alias, distinctive features, and otherinformation such as gang membership and criminal history. CCS Retrieval createsa catalogue of possible matches, allowing officers or witnesses to save time bylooking only at mugshots that closely resemble the description of the suspect.This module can also be used to create a line-up of similar facial images fromwhich a witness may identify the suspect. CCS Retrieval can be used by a lawenforcement agency’s satellite offices that need to access a database createdand maintained at a central location using CCS Capture.

 

FACE ID. This software module uses biometric facial recognition andretrieval technology to help authorities identify possible suspects. Imagestaken from surveillance videos, digital sketches or photographs can be searchedagainst a digital database of facial images to retrieve any desired number of faceswith similar characteristics. This investigative module can also be used at thetime of booking to identify persons using multiple aliases. Usingbiometrics-based technology, Face ID can search through thousands of facialimages in a matter of seconds, reducing the time it would otherwise take awitness to flip through a paper book of facial images that may or may not besimilar to the description of the suspect. Face ID then creates a selection ofpossible matches ranked in order of similarity to the suspect, and a percentageconfidence level is attributed to each possible match. Face ID incorporatessearch engine technology which we license from Identix, Inc.

 

SUSPECT ID. This software module allows officers and witnesses toquickly create full-color, photo-realistic suspect composites. Thedigital composites are constructed from libraries of facial features based uponactual color photographs of such features. Suspect ID allows officers withminimal computer training and artistic talent to create a suspect composite bypointing and clicking with a mouse. This module can be installed on a laptopcomputer and taken into the field, allowing officers to conduct interviews andcreate composites before witnesses’ memories fade. For rapid identification,officers can distribute completed composites within minutes via fax or e-mail.

 

4

----

 

CRIME LAB. This software module allows officers to enhance and editdigital images. Using Crime Lab, an officer can update old images, createnon-prejudicial line-ups, remove distracting backgrounds and enhance thequality of surveillance videos.

 

VEHICLE ID. This software module helps officers identify motor vehicleswhich may have been stolen or involved in a crime. Vehicle ID’s comprehensivedatabase includes images and text information for over 1,000 vehicle makes andmodels and can be searched using many fields, including physical features andVehicle Identification Number. Images of vehicles similar to the suspectvehicle can be viewed from front, rear, side or three quarter angles and can bedepicted in any color. A color copy of the suspect vehicle can then be producedand immediately broadcast, printed or faxed to officers in the field.  Vehicle ID also incorporates Vehicle IdentificationNumber software provided by the National Insurance Crime Bureau.

 

CRIME WEB. This Web-based investigative software tool enables authorizedpersonnel to access and search a county’s booking records stored on ImageWare’sCrime Capture System through a standard web browser from within the county’sintranet. Crime Web allows remote access to the Crime Capture System databasewithout requiring the user to be physically connected to the customer’snetwork. Crime Web requires only that the user have access to the Internet andauthorization to access the county’s intranet.

 

POCKET CCS. Pocket CCS is a powerful investigative tool that allowsofficers to access Crime Capture System (CCS) booking photos and related datain the field on a handheld Pocket PC compatible device.

 

***Identification***

 

Our Digital Identification Products consist of the following products:

 

EPISUITE. This is a software application for creating and managingpersonal identification cards. It is designed to integrate with our customers’ existingsecurity and computing infrastructure. We believe that this compatibility maybe an appealing feature to corporations, government agencies, transportationdepartments, school boards, and other public institutions.

 

EPIBUILDER. EPIBUILDER is a software development toolkit containingcomponents which developers can use to add electronic identificationfunctionality for numerous applications, including access control, tracking oftime and attendance, point of sale transactions, human resource systems, schoolphotography systems, asset management, inventory control, warehouse management,facilities management and card production systems.

 

EPIWEB. This product was created for ID service bureau organizations toprovide their customers with the ability to design and create personalidentification cards, including personnel information, using an Internetbrowser. Users can create their own badge designs or choose from an inventoryof existing designs. EPIWEB software is designed to help streamline service bureauadministration by managing the recruitment of customers and the printing,billing and shipping of orders.

 

EPIWEB ENTERPRISE. This product is a highly-secure web-based corporateidentification management system. We believe it is the only software on themarket today that provides complete employee credential lifecycle managementenabling companies to control badge issuance, validate badge holder, controlbadge production, and track badge issuance. With ImageWare customizationservices, EPIWEB Enterprise can be tailored for unique card approval processes,to transfer personnel information automatically from Human Resources Systems toeliminate re-keying of data, and even activate cards in a branch office accesscontrol system. This Internet browser-based application is easily deployedcompared to traditional client-server systems that

 

5

----

 

requiresoftware and hardware installation. EPIWEB’s central database empowers securitypersonnel to ensure that the right ID cards get issued to the right peopleacross the entire enterprise.

 

WINBADGE NT. This Microsoft Windows-based technology photo ID system isfor the production and tracking of identification cards. The system encompassesa suite of applications and tools to easily enter data and images into adatabase and customize the entry screens for each operator or create new badgedesigns. The system is capable of producing various documents, including cards,badges, dossiers, and FaceBook files containing images, text, and logos.WinBadge NT is designed to operate in many different modes: as a stand-alone,turnkey personnel imaging and data management system; as part of a network ofimage capture stations with image retrieval and verification stations; and as interfacedwith access control security systems or a human resource mainframe computer.

 

WINBADGE AVIATION. This product, designed for the airport industry hasnumerous features, from tracking badges to ensuring proper security training.It also tracks driver training, driver violations and information required bycompanies authorized to request the issuance of ID cards. Accelerator keysminimize the need for moving a computer mouse in a high badge productionenvironment. Keyboard control of camera pan, tilt, and zoom also minimizeoperator movement.

 

IDENTIFIER FOR WINDOWS. This family of products combines the ability tocapture photographic images digitally with the ability to create a database andto print identification cards. Identifier for Windows offers a powerful,versatile, and user-friendly application which can be used by schools,hospitals, corporations or governments.

 

ID CARD MAKER. The ID Card Maker family of products providessubstantially the same capabilities as Identifier for Windows and is sold andsupported by Polaroid Corporation’s authorized dealers within the UnitedStates.

 

In addition to thesoftware systems listed above, we may provide our customers with hardware(printers, laminators, cameras) and/or cardware (cards, security features,printer ribbons) purchased from third parties. Internationally we sell these products under the EdiGuard tradename.

 

***Digital Photography***

 

Our professional photographer products consist of the followingproducts:

 

PC PRO.  This software allowsprofessional photographers to reduce, enlarge, crop, retouch, density-correct,color balance, manipulate, adjust and change digital photos. Users can alsocreate multi-image compositions and design layouts. This software allows aphotographer to create collages and layouts, along with personalized text orgraphics. Photos can be rendered for output to printers or for posting to aphotographer’s website. This software is used by photographers for a variety ofuses including for taking pictures in the studio of individuals and families.

 

PC EVENT.  This software allowsfor on location event photography such as sporting events, team photos anddances. Images can be outputted at the remote site, a photographer’s studio ora centralized lab facility.

 

PDI SCHOOL DAYS+.  Thissoftware allows professional photographers who market their services to schoolsto efficiently capture students’ images and associated text. Then the imagescan be printed or sent to a lab for processing via CD or the Internet. Also theimages can be used for ID badges, class rosters and other associated uses. Aphotographer can also use the capture module to photograph dances and otherevents.

 

PDI STUDIO – The software allows for a seamless workflow of digitalimages in a studio environment.  Aprofessional photographer or their staff captures an image using a digitalcamera, transfers the image into the presentation software where it is reviewedwith the customer and added to a package or order, then printed on-site oroutput to a lab for touch-up and printing. The product includes a database for order tracking and customerinformation.  That database can be usedin a stand-alone mode or integrated with point-of-sale, accounting or othermanagement software.

 

PDI GREEN SCREEN.  This softwareis a plug-in option to both PC PRO and PC EVENT that allows for the digitalcapture of images against a blank “green screen” background so that the imagecan be digitally transposed onto a fantasy layout.

 

PICTUREMORE.  Picturemore.com isa web hosting service that allows professional photographers the ability topost photos so that their customers can order additional prints and serviceitems.

 

6

----

 

***Maintenance and Customer Support***

 

As part of our installation of a system, we offer to train ourcustomers’ employees as to the effective use of our products. We offer trainingboth on-site and at our facilities. We offer on-site hardware support to ourcustomers, generally within 24 hours of the customer request. Customers cancontract with us for technical support that enables them to use a toll freenumber to speak with our technical support center for software support andgeneral assistance 24 hours a day, seven days a week. As many of ourcustomers operate around the clock and perceive our systems as critical totheir day to day operations, a very high percentage contract for technicalsupport. Providing customer support services typically provides us with annualrevenue of 15% to 20% of the initial sales price of the hardware and softwarepurchased by our customers.

 

***Software Customization andFulfillment***

 

We directly employ computer programmers and also retain independentprogrammers to develop our software and perform quality control. We providecustomers with software that we specifically customize to operate on theirexisting computer system. We work directly with purchasers of our system toensure that the system they purchase will meet their unique needs. We configureand test the system either at our facilities or on-site and conduct anycustomized programming necessary to connect the system with any legacy systemsalready in place.  We can also providecustomers with a complete computer hardware system with our software alreadyinstalled and configured. In either case, the customer is provided with acomplete turnkey solution which can be used immediately. When we provide ourcustomers with a complete solution including hardware, we use off-the-shelfcomputers, cameras and other components purchased from other companies such asIBM or Compaq. Systems are assembled and configured either at our facilities orat the customer’s location.

 

**Our Strategy**

 

Key elements of our strategy for growth include the following:

 

***Penetrate the Access Control andIdentification Markets***

 

We believe security issues are becoming increasingly important amongpublic agencies, corporations, hospitals, universities and similarorganizations. We believe that the September 11, 2001 terrorist attacksand the subsequent establishment of the Homeland Defence Department willaccelerate the adoption of digital identification systems that can providesecure credentials and instant access to centrally maintained records for realtime verification of identity and privileges. Using our products, an organizationcan create picture IDs that correspond to images in a digital database. Asecurity guard can stop an individual and quickly and accurately check hisidentity against a database of authorized persons, and either allow or denyaccess as required. Our technology can also be applied in other markets tofacilitate activities such as voter registration, immigration control andwelfare fraud identification.

 

We believe that biometric identifiers are becoming recognized andaccepted as integral components to the identification process.  As biometric technologies (facialrecognition, fingerprint, iris, etc) are adopted, identification systems mustbe updated to enable their use in the field. We have built our solutions to enable the incorporation of one or multiplebiometrics, which can be associated with a record and stored both in a databaseand on a card for later retrieval and verification.  We believe the increasing demand for biometric technology willdrive demand for our solutions which enable their use by end users.

 

***Fully Exploit the Expanding LawEnforcement and Public Safety Markets***

 

We intend to use our successful installations with customers such as theArizona Department of Public Safety as reference accounts and to aggressivelymarket C.R.I.M.E.S. as a superior technological solution. The majority of ourrecent sales have been and will be from sales of the Crime Capture System. Wewill focus our sales effort in the near term to establish the Crime CaptureSystem as the mug shot system adopted in as many countries, states and largecounties and municipalities as

 

7

----

 

possible.Once we have a system installed in a region, we intend to then sell additionalsystems or retrieval seats to other agencies within the primary customer’sregion and in neighboring regions. In addition, we plan to market ourcomplementary investigative modules to the customer, including Face ID, SuspectID, Crime Lab, Vehicle ID, CrimeWeb, and Pocket CCS. As customer databases ofdigital mug shots grow, we expect that the perceived value of our investigativemodules, and corresponding revenues from sales of those modules, will alsogrow.

 

***Acquire Businesses That Enhance OurStrategic Position***

 

We may acquire additional businesses that will complement our growthstrategy and enhance our competitive position in our current markets and othermarkets that utilize our core imaging technology.

 

***Expand into Related Applicationswithin the Law Enforcement and Public Safety Markets***

 

Our products can provide solutions to law enforcement and public safetyagencies beyond our core application of police booking systems and relatedinvestigative products with minimal adaptation. The technology behind ourC.R.I.M.E.S. product line can be used to create databases of missing childrenand to compare the facial image of a lost child to the images in the database.Our system can be used to help correctional facilities track and controlinmates. Gun sellers could use our products to access available criminal databasesand help prevent the sale of guns to ineligible persons. Our technology can beused to monitor persons on parole or probation without requiring them to travelto their parole or probation officer. We anticipate that a parolee orprobationer will be able to have his photograph taken in a specially-designedkiosk which uses biometrics-based technology to identify the person andinform his parole or probation officer of his location.

 

***Develop the Internet and WirelessCapabilities Of Our Products***

 

One of our latest software modules, Crime Web, allows users to use theInternet or secure intranets to conduct investigative searches of digitalbooking systems. Crime Web includes the most frequently used investigativefeatures of the Crime Capture System to allow users to retrieve single images,conduct searches based on one or more parameters, create digital line-ups andprint retrieved records. We are also currently developing an Internet-basedversion of Face ID that will allow investigators to use the Internet to comparethe digital image of an unknown suspect with a database of images usingbiometrics-based technology. Our Internet products will allow users to quicklyaccess and share images via the Internet while maintaining the security andintegrity of databases, thereby encouraging the widespread dissemination andsharing of criminal information among law enforcement agencies. Since theSeptember 11, 2001 terrorist attacks there has been significant discussionat the federal and state levels of government regarding the need for federal,state and local agencies to share information. We anticipate that the movementtoward sharing of information will accelerate the adoption of digital bookingtechnology with Internet and wireless capabilities by law enforcement agenciesat all levels.

 

We are also developing Internet modules for our identification softwarewhich will provide the same remote access capabilities for our ID customers.

 

For the digital identification market, we created the products EPIWEBand EPIWEB ENTERPRISE. EPIWEB was created for ID service bureau organizationsto provide their customers with the ability to design and create personalidentification cards, including personnel information, using an Internetbrowser. EPIWEB can help streamline service bureau administration by managingthe recruitment of customers and the printing, billing and shipment of orders.EPIWEB ENTERPRISE was created to provide a highly-secure web-based corporateidentification management system. It enables companies to control badgeissuance, validate badge holder, control badge production, and track badgeissuance.  This Internet browser-based

 

8

----

 

applicationis easily deployed, compared to traditional client-server systems that requiresoftware and hardware installation. EPIWEB ENTERPRISE’S central databaseempowers security personnel to ensure that the right ID cards get issued to theright people across the entire enterprise.

 

We are also developing wireless capabilities into our products. Publicagencies as well as private sector customers require information to beavailable from remote locations. Pocket CCS is our first handheld applicationwhich can operate in the field on Pocket PC compatible devices and accompany userswherever they are located. In order to facilitate the transfer of records andinformation retrieval tools to employees in the field, we plan to developtechnology in cooperation with wireless communications companies that willallow our products in the field to operate over wireless systems.

 

As part of the acquisition of Castleworks, we acquired PictureMore.com.This web service allows professional photographers to use the Internet toincrease their revenues by posting photos of their customers for re-orders,additional copies or orders from friends and relatives. PictureMore collectsthe payments, uses a professional lab to fulfill the orders and ships theproducts to the consumer. In return we receive a fee per sheet of productpurchased.

 

***Enhance Our Position In TheProfessional Digital Photography Market***

 

We believe that the movement from film to digital photo captures andprocessing by professional photographers, labs, studios and other relatedenterprises is growing. This growth generates a demand for software solutionsto manage the customer information and create the output layout and images.Further, we believe that we have established a solid base of customers for oursoftware and we intend to exploit the market growth and demand for software.Our software and systems allow professional photographers to quickly and easilytake photos and create a database of information that can be sent to labs forprocessing. The labs can also use our software for helping to manage the ordersfrom the photographers. In this process, it is possible for both labs andphotographers to save money.

 

**Sales And Marketing**

 

We market and sell our products through our direct sales force andthrough indirect distribution channels, including systems integrators. We havesales and account representatives based in Canada, Germany, and Singapore anddomestically in Massachusetts, Pennsylvania, Georgia, South Carolina, Florida,and California.  Geographically, oursales and marketing force consists of 24 persons in the United States, 3persons in Canada, 5 persons in Germany and 1 person in Singapore.

 

Each of our product groups has a direct sales organization all of whichare supported by a common marketing organization.  Our sales professionals are supported by our technical expertswho are available by telephone and conduct on-site customer presentations.

 

The typical sales cycle for our Crime Capture System includes a pre-saleprocess to define the potential customer’s needs and budget, an on-sitedemonstration and conversations between the potential customer and existingcustomers. Government agencies are typically required to purchase large systemsby including a list of requirements in a Request For Proposal, known as an“RFP,” and by allowing several companies to openly bid for the project byresponding to the RFP. If our response is selected, we enter into negotiationsfor the contract and, if successful, ultimately receive a purchase order fromthe customer. This process can take anywhere from a few months to over a year.

 

Our ID products are sold to large integrators, direct via our salesforce and to end users through distributors. Depending on the customer’srequirements, there may be instances that require an RFP. The sales cycle canvary from a few weeks to a year.

 

In addition to our direct sales force, we have developed relationshipswith a number of systems integrators who contract with government agencies forthe installation and integration of large computer and communication systems.By acting as a subcontractor to these systems integrators, we are

 

9

----

 

ableto avoid the time consuming and often-expensive task of submitting proposals togovernment agencies, and we also gain access to large clients.

 

We also work with companies that offer complementary products, wherevalue is created through product integration. Through teaming arrangements weare able to enhance our products and to expand our customer base through therelationships and contracts of our strategic partners.

 

We promote our products through trade journal advertisements, directmail and attendance at industry trade shows, including those sponsored by theInternational Association for Law Enforcement, the International Associationfor Identification, CARDTECH/SECURETECH, the American Society of IndustrialSecurity and the International Association of Chiefs of Police. In theprofessional photography market, we also attend the Professional Photographers’Association and the Photography Marketing Association trade shows. We also target other media through publicrelations efforts, including non-industry publications, daily newspapers, localand national news programs, and television programs related to law enforcement.Articles regarding our products have appeared in Business Week, Los AngelesTimes, Chicago Tribune, The Wall Street Journal and a number of otherpublications.

 

We plan to continue to market and sell our products internationally.Some of the challenges and risks associated with international sales includethe difficulty in protecting our intellectual property rights, difficulty inenforcing agreements through foreign legal systems and volatility andunpredictability in the political and economic conditions of foreign countries.We believe we can work to successfully overcome these challenges.

 

**Customers**

 

We have a wide variety of domestic and international customers. Most ofour C.R.I.M.E.S. customers are government agencies at the federal, state andlocal levels in the United States. Our products are also being used inAustralia, Canada, the United Arab Emirates, Kuwait, Mexico, Colombia, CostaRica, Venezuela, Singapore, Indonesia and the Philippines. The customer basefor our digital identification systems includes domestic and foreign governmentagencies, universities, airports, and private sector companies, many of whichare Fortune 500 or Fortune 1000 companies. Customers for our C.R.I.M.E.S.products may be customers for our identification systems as well. Our currentcustomer base for digital photography systems includes professionalphotographers, labs and studios in the US and Canada.  In 2002, one customer, PT Nuansa Anagorindo Sejahtera, accountedfor 18% of our revenues.

 

**Competition**

 

***The Law Enforcement And Public SafetyMarkets***

 

Due to the fragmented nature of the law enforcement and public safetymarket and the modular nature of our product suite, we face different degreesof competition with respect to each C.R.I.M.E.S. module. We believe theprincipal basis on which we compete with respect to all of our products are:

 

•               the ability tointegrate our modular products into a complete imaging and investigativesystem;

 

•               our reputation as areliable systems supplier;

 

•               the usability andfunctionality of our products; and

 

•               the responsiveness,availability and reliability of our customer support.

 

Our law enforcement product line faces competition from other companiessuch as Printrak International, Inc., DataWorks Plus, and DigitalDescriptor Systems, Inc. Internationally, there are often a number oflocal companies offering solutions in most countries. Many of our competitors’products in this niche offer basic image capture and storage, but lack thefunctionality of integrated investigative products, including facialrecognition and image editing and enhancement.

 

10

----

 

***Identification Markets***

 

Due to the breadth of our software offering in the secure ID marketspace, we face differing degrees of competition in certain market segments. Thestrength of our competitive position is based upon:

 

•               ourstrong brand reputation with a customer base which includes small and mediumsized businesses, Fortune 500 corporations and large government projects;

 

•               theease of integrating our technology into other complex applications; and

 

•               theleveraged strength that comes from offering customers software tools, packagedsolutions and web-based service applications that support a wide range ofhardware peripherals.

 

Our software faces competition from Datacard Corporation, a privatelyheld manufacturer of hardware, software and consumables for the ID market.There are also a considerable number of smaller software competitors such asNumber Five Software Ltd., Loronix Information Systems, Inc. and FoxTechnology Pty Ltd. who compete in differing geographies, primarily in thepackaged product segment.

 

***Digital Photography Market***

 

The market to provide digital systems to the professional photographymarket is evolving and we face competition from a number of sources. We believethat the strength of our competitive position is based on:

 

•                                            our Development and Licensing Agreement withEastman Kodak Company (“Kodak”) as a supplier of software that is bundled withtheir cameras and/or  printers;

 

•                                            ourDevelopment and Licensing Agreement with Mitsubishi Digital Electronics America (Mitsubishi) as a supplierof software that is bundled with their printers;

 

•                                            our Licensing Agreement with Herff Jones who is amajor supplier of services to the school photography market

 

•                                            a strong product mix comprised of applications forphotographers, labs and studios;

 

•                                            our dealer and qualified lab network;

 

•                                            our support and training infrastructure;

 

•                                            our ability to offer a package including softwareand our web hosting service; and

 

•                                            the usability and functionality of our products.

 

Our software faces competition from Express Digital Inc.,Photolynx, Pixel Photographies and Tri-Prism, Inc.  Kodak and Fuji Photo Film Co., Ltd.also offer professional photographers a solution that facilitates the flow ofimages from the studio to professional lab that offers some of thefunctionality of our PDI Studio software solution.

 

**Intellectual Property**

 

We rely on  trademark, tradesecret, and copyright laws and confidentiality and license agreements toprotect our intellectual property. We have several unregistered and federallyregistered trademarks including the trademark ImageWare, as well as trademarksfor which there are pending trademark registrations with the United StatesPatent & Trademark Office.  Welicense and depend on intellectual property from third parties for our facialrecognition product. We license search engine technology from Identix. Ourlicense from Identix is on a nonexclusive, worldwide basis and expires inOctober 2003.

 

11

----

 

**Research And Development**

 

Our research and development team is made up of 35 programmers,engineers and other employees. We spent approximately $2.1 million onresearch and development in each of 2002 and 2001. We continually work toincrease the speed, accuracy, and functionality of our existing products. Weanticipate that our research and development efforts will continue to focus onnew technology and products for the law enforcement, identification and digitalphotography markets.

 

**Employees**

 

As of March 13, 2003, we had a total of 118 full-time employees.Our employees are not covered by any collective bargaining agreement, and wehave never experienced a work stoppage. We believe that our relations with ouremployees are good.

 

12

----

 

**RISK FACTORS**

 

**WE CURRENTLY HAVE LIMITED CASH RESOURCES AND NEED ADDITIONALFUNDING TO FINANCE OUR WORKING CAPITAL REQUIREMENTS DURING THE NEXT TWELVEMONTHS.**

 

We currently require financing to fund our anticipated working capitalrequirements during the next twelve months. We anticipate that our existingresources will not be sufficient to enable us to maintain our current andplanned operations for the next twelve months and the report of our independentaccountants included with this annual report. The report includes an explanatory paragraph regarding our ability tocontinue as a going concern. We are seeking additional funding through publicor private equity or debt financing. There can be no assurance that additionalfinancing will be available on acceptable terms, or at all. If we are requiredto sell equity to raise additional funds, our existing shareholders may incursubstantial dilution and any shares so issued may have rights, preferences andprivileges superior to the rights, preferences and privileges of ouroutstanding Common Stock. Also, we may be required to obtain funds througharrangements with third parties that require us to relinquish rights to certainof our technologies or products that we would seek to develop or commercializeourselves. In addition, our ability to raise additional capital may bedependent upon the Company’s Common Stock being listed on the American StockExchange. We cannot guarantee that the Company will be able to satisfy thecriteria for continued listing on the American Stock Exchange.

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALLINGAPPROXIMATELY $35.3 MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

 

As of December 31 2002, we had an accumulated deficit of$35.3 million, and these losses may continue in the future. We may need toraise capital to cover these losses, and financing may not be available to uson favorable terms. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and may never achieve profitability.

 

**THE HOLDERS OF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS ANDPRIVILEGES THAT ARE SENIOR TO THE COMMON STOCK AND WE MAY ISSUE ADDITIONALSHARES OF PREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THAT COULD HAVE AMATERIAL ADVERSE EFFECT ON THE MARKET VALUE OF THE COMMON STOCK.**

 

Our Board of Directors has the authority to issue a total of up to4,000,000 shares of preferred stock and to fix the rights, preferences,privileges, and restrictions, including voting rights, of the preferred stock,which typically are senior to the rights of the common shareholders, withoutany further vote or action by you and the other common shareholders. Yourrights will be subject to, and may be adversely affected by, the rights of theholders of the preferred stock that have been issued, or might be issued in thefuture. Preferred stock also could have the effect of making it more difficultfor a third party to acquire a majority of the outstanding voting stock ofImageWare. This could delay, defer, or prevent a change in control.Furthermore, holders of preferred stock may have other rights, includingeconomic rights, senior to the common stock. As a result, their existence andissuance could have a material adverse effect on the market value of the commonstock. We have in the past issued, and, may from time to time in the futureissue, preferred stock for financing or other purposes with rights,preferences, or privileges senior to the common stock.

 

The provisions of our outstanding Series B Preferred Stock prohibitthe payment of dividends on the common stock unless the dividends on thosepreferred shares are first paid. In addition, upon a liquidation, dissolutionor sale of ImageWare’s business, the holders of the Series B PreferredStock will be entitled to receive, in preference to any distribution to the holdersof common stock, initial distributions of $2.50 per share, plus all accrued butunpaid dividends.

 

Pursuant to the terms of our Series B Preferred Stock we are obligatedto pay cumulative cash dividends on shares of Series B Preferred Stock fromlegally available funds at the annual rate of $0.2125 per share, payable in twosemi-annual installments of $0.10625 each, which cumulative dividends must bepaid prior to payment of any dividend on our Common Stock.  As of December 31, 2002, the Company hadcumulative undeclared dividends of $146,337.

 

13

----

 

**WE DEPEND UPON A SMALL NUMBER OF LARGE SYSTEM SALES COSTINGFROM $300,000 TO $600,000, AND WE MAY FAIL TO ACHIEVE ONE OR MORE LARGE SYSTEMSALES IN THE FUTURE.**

 

In the past three years we have derived a substantial portion of ourrevenues from a small number of sales of large, relatively expensive systems,typically ranging in price from $300,000 to $600,000. As a result, if we failto receive orders for these large systems in a given sales cycle on aconsistent basis, our business could be significantly harmed. Further, ourquarterly results are difficult to predict because we cannot predict in whichquarter, if any, large system sales will occur in a given year. As a result, webelieve that quarter-to-quarter comparisons of our results of operations arenot a good indication of our future performance. In some future quarters ouroperating results may be below the expectations of securities analysts andinvestors, in which case the market price of our common stock may decreasesignificantly.

 

**WE HAVESIGNIFICANT SALES AND RECEIVABLE BALANCES FROM ONE CUSTOMER.**

 

A substantial portion ofour revenues and accounts receivable balances are dependent upon onecustomer.  If we fail to continue tosell to this customer and collect these accounts receivable we may experienceinsufficient funds which may affect our ability to effectively implement ourbusiness plan causing our business to be significantly harmed.  Insufficient funds may require us to delay,scale back or eliminate some or all of our activities.

 

**OUR LENGTHY SALES CYCLE MAY CAUSE US TO EXPEND SIGNIFICANTRESOURCES FOR AS LONG AS ONE YEAR IN ANTICIPATION OF A SALE, YET WE STILL MAYFAIL TO COMPLETE THE SALE.**

 

When considering the purchase of a large computerized booking oridentification system, a government agency may take as long as a year toevaluate different systems and obtain approval for the purchase. If we fail tocomplete a sale, we will have expended significant resources and received norevenue in return. Generally, agencies consider a wide range of issues beforecommitting to purchase our products, including product benefits, ability tooperate with their current systems, product reliability and their own budgetaryconstraints. While potential customers are evaluating our products and beforethey place an order with us, we may incur substantial selling costs and expendsignificant management effort to accomplish a sale.

 

**A SIGNIFICANT NUMBER OF OUR CUSTOMERS ARE GOVERNMENT AGENCIESTHAT ARE SUBJECT TO UNIQUE POLITICAL AND BUDGETARY CONSTRAINTS AND HAVE SPECIALCONTRACTING REQUIREMENTS WHICH MAY AFFECT OUR ABILITY TO OBTAIN NEW GOVERNMENTCUSTOMERS.**

 

A significant number of our customers are government agencies. Theseagencies often do not set their own budgets and therefore have little controlover the amount of money they can spend. In addition, these agencies experiencepolitical pressure that may dictate the manner in which they spend money. Dueto political and budgetary processes and other scheduling delays that mayfrequently occur relating to the contract or bidding process, some governmentagency orders may be canceled or substantially delayed, and the receipt ofrevenues or payments may be substantially delayed. In addition, future sales togovernment agencies will depend on our ability to meet government contractingrequirements, certain of which may be onerous or impossible to meet, resultingin our inability to obtain a particular contract. Common requirements ingovernment contracts include bonding requirements, provisions permitting thepurchasing agency to modify or terminate at will the contract without penalty,and provisions permitting the agency to perform investigations or audits of ourbusiness practices.

 

**WE MAY FAIL TO CREATE NEW APPLICATIONS FOR OUR PRODUCTS ANDENTER NEW MARKETS, WHICH MAY AFFECT OUR FUTURE SUCCESS.**

 

We believe our future success depends in part on our ability to developand market our technology for applications other than booking systems for thelaw enforcement market. If we fail in these goals, our business strategy andability to generate revenues and cash flow would be significantly impaired. Weintend to expend significant resources to develop new technology, but the successfuldevelopment of new technology cannot be predicted and we cannot guarantee wewill succeed in these goals.

 

14

----

 

**WE OCCASIONALLY RELY ON SYSTEMS INTEGRATORS TO MANAGE OURLARGE PROJECTS, AND IF THESE COMPANIES DO NOT PERFORM ADEQUATELY, WE MAY LOSEBUSINESS.**

 

We are occasionally a subcontractor to systems integrators who managelarge projects that incorporate our systems, particularly in foreign countries.We cannot control these companies, and they may decide not to promote ourproducts, or they may price their services in such a way as to make itunprofitable for us to continue our relationship with them. Further, they mayfail to perform under agreements with their customers, in which case we mightlose sales to these customers. If we lose our relationships with thesecompanies, our business may suffer.

 

**WE RELY ON A LICENSE OF TECHNOLOGY FROM IDENTIX, INC.,AND THIS LICENSE MAY BE TERMINATED IN THE FUTURE.**

 

We depend on a licensing arrangement with Identix for technology relatedto the search engine used in our systems. Our current licensing arrangementwith Identix terminates October 1, 2003. If Identix becomes unable orunwilling to continue to license us this technology or to renew the terms of thislicense, we will have to identify or develop acceptable alternative sources ofthis technology, which could take up to three months or longer. Any significantinterruption in our ability to identify and contract with alternative providersof similar technology or to develop our own search engine would result indelivery delays, which could harm our customer relationships and our businessand reputation.

 

**WE DO NOT HAVE U.S. OR FOREIGN PATENT PROTECTION FOR OURPRODUCTS, AND A COMPETITOR MAY BE ABLE TO REPLICATE OUR TECHNOLOGY.**

 

Our business is based in large part on our technology, and our successdepends in part on our ability and efforts to protect our intellectual propertyrights. If we do not adequately protect our intellectual property through copyrightsand various trade secret protections afforded to us by law, our business willbe seriously harmed. We do not have patent protection for our products.

 

We license certain elements of our trademarks, trade dress, copyrightand other intellectual property to third parties. We attempt to ensure that ourrights in our trade names and the quality of third party uses of our names aremaintained by these third parties. However, these third parties may takeactions that could significantly impair the value of our intellectual propertyand our reputation and goodwill.

 

In addition, international intellectual property laws differ fromcountry to country. Any foreign rights we have in our technology are limited bywhat has been afforded to us under the applicable foreign intellectual propertylaws. Also, under the laws of certain foreign jurisdictions, in order to haverecognizable intellectual property rights, we may be required to fileapplications with various foreign agencies or officials to register our intellectualproperty. Accordingly, our ability to operate and exploit our technologyoverseas could be significantly hindered.

 

**WE HAVE ACQUIRED SEVERAL BUSINESSES AND FACE RISKS ASSOCIATEDWITH INTEGRATING THESE BUSINESSES AND POTENTIAL FUTURE BUSINESSES THAT WE MAYACQUIRE.**

 

We completed the acquisitions of Imaging Technology Corporation (“ITC”),Goddard Technology Corporation (“Goddard”), G & A Imaging, Ltd.(“G & A”), Castleworks LLC (“Castleworks”) and E-Focus West LLC(“E-Focus”). We plan to continue to review potential acquisition candidates,and our business and our

 

15

----

 

strategyincludes building our business through acquisitions. However, acceptableacquisition candidates may not be available in the future or may not beavailable on terms and conditions acceptable to us.

 

Acquisitions involve numerous risks, including among others,difficulties and expenses incurred in the consummation of acquisitions andassimilation of the operations, personnel and services and products of theacquired companies. Additional risks associated with acquisitions include thedifficulties of operating new businesses, the diversion of management’sattention from other business concerns and the potential loss of key employeesof the acquired company. If we do not successfully integrate the businesses wemay acquire in the future, our business will suffer.

 

**WE OPERATE IN FOREIGN COUNTRIES AND ARE EXPOSED TO RISKSASSOCIATED WITH FOREIGN POLITICAL, ECONOMIC AND LEGAL ENVIRONMENTS AND WITHFOREIGN CURRENCY EXCHANGE RATES.**

 

With our acquisition of G & A, we have significant foreignoperations and are accordingly exposed to risks, including among others, risksassociated with foreign political, economic and legal environments and with foreigncurrency exchange rates. Our results may be adversely affected by, among otherthings, changes in government policies with respect to laws and regulations,anti-inflation measures, currency conversions, remittance abroad and rates andmethods of taxation.

 

**ITEM 2****. Description of Property.**

 

Our corporate headquarters are located in San Diego, California where weoccupy approximately 16,000 square feet of office space. Our lease for thisfacility continues through July 2003 at a cost of approximately $24,600per month. We are evaluating other properties in the vicinity as well asworking with our existing landlord to determine how best to meet our facilityneeds after July 2003.  Vacancy rates inour vicinity are relatively high and we do not foresee any difficulties meetingour space requirements.  We occupyapproximately 26,685 square feet of office space in Stuttgart, Germany untilSeptember 2006 at a cost of approximately $14,200 per month. We occupy10,000 square feet in Gatineau, Province of Quebec. These premises are leaseduntil May 2006 at a cost of approximately $10,000 per month. We occupyapproximately 5,500 square feet in Greenville, South Carolina. These premisesare leased until December 2006 at a cost of approximately $5,400 permonth.  We have under leaseapproximately 4,489 of office space in Costa Mesa, California at a cost ofapproximately $10,500 per month. These premises are leased until July 2005. Inthe fourth quarter of 2002, we moved this operation to our San Diego,California office and are working to sublease this facility. We occupyapproximately 1,700 square feet in Singapore. These premises are leased until August 2005 at a cost of approximately$1,300 per month.

 

**ITEM 3****. Legal Proceedings.**

 

We are involved in certain legal proceedings generally incidental to ournormal business activities. While the outcome of such proceedings cannot beaccurately predicted, we do not believe the ultimate resolution of any suchexisting matters should have a material effect on our financial position,results of operations or cash flows.

 

As disclosed in our Quarterly Report, Form 10-QSB as filed with theCommission on May 15, 2002, The Massachusetts Institute of Technology andElectronics for Imaging filed a lawsuit against several defendants, includingus.  As of January 30, 2003, we enteredinto a settlement agreement in which the plaintiffs agreed to dismiss thelawsuit, with prejudice, in exchange for the payment of a settlement fee.  The amount of the settlement was notsignificant and is recorded in the Company's financial statements atDecember 31, 2002.

 

**ITEM 4****. Submission Of Matters To A VoteOf Security Holders.**

 

No matters were submitted to a vote of our security holders during thefourth quarter of the fiscal year ended December 31, 2002.

 

**PART II**

 

**ITEM 5****. Market for Common Equity andRelated Stockholder Matters.**

 

*Market Information.*

 

Our Common Stock is quoted under the symbol “IW” on the American StockExchange.

 

16

----

 

The following table sets forth the high and low sales prices for ourCommon Stock as reported by the American Stock Exchange for each quarter in2001 and 2002:

 
| **2001 Fiscal Quarters** |   | **High** |   | **Low** |   |
|--------------------------|--------|----------|--------|---------|--------|
| First Quarter            |   | $        | 6.850  |    | $      | 4.000 |   |
| Second Quarter           |   | $        | 6.444  |    | $      | 4.000 |   |
| Third Quarter            |   | $        | 8.140  |    | $      | 2.450 |   |
| Fourth Quarter           |   | $        | 9.350  |    | $      | 4.500 |   |

 
| **2002 Fiscal Quarters** |   | **High** |   | **Low** | ** ** |
|--------------------------|--------|----------|--------|---------|------------|
| First Quarter            |   | $        | 6.890  |    | $          | 4.420 |   |
| Second Quarter           |   | $        | 6.490  |    | $          | 3.270 |   |
| Third Quarter            |   | $        | 3.700  |    | $          | 1.400 |   |
| Fourth Quarter           |   | $        | 4.340  |    | $          | 1.660 |   |

 

There is no public trading market for our preferred stock.

 

*Holders.*

 

As of April 11, 2003 there were approximately 134 holders of recordof our Common Stock.

 

*Dividends.*

 

We have never declared or paid dividends on our Common Stock and do notanticipate paying any cash dividends on our shares of Common Stock in theforeseeable future. Pursuant to the terms of our Series B Preferred Stockwe are obligated to pay cumulative cash dividends on shares of Series BPreferred Stock from legally available funds at the annual rate of $0.2125 pershare, payable in two semi-annual installments of $0.10625 each, whichcumulative dividends must be paid prior to payment of any dividend on ourCommon Stock. As of December 31, 2002, the Company had cumulativeundeclared dividends of $146,337.

 

17

----

 

*Securities Authorized for Issuance Under Equity CompensationPlans.*

 

# EquityCompensation Plan Information

# As of December 31, 2002

 
|                                                        |   | **Number of  securities to be issued upon exercise of outstanding options, warrants and  rights** |   | **Weighted-average  exercise price of outstanding options, warrants and rights** |       | **Number of  securities remaining available for future issuance under equity compensation  plans (excluding securities reflected in column (a))** |    |
|-------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|---------|
|                                                        |   | **(a)**                                                                                           |   | **(b)**                                                                          |       | **(c)**                                                                                                                                           |    |
| Equity compensation  plans approved by security holders     |   |                                                                                              |   |                                                                             |       |                                                                                                                                              |    |
| 1994 Employee Stock  Option Plan                            |   | 121,708                                                                                           |   | $                                                                                | 5.28       |                                                                                                                                              | 28,245  |   |
| 1994 Nonqualified Stock  Option Plan                        |   | 18,957                                                                                            |   | $                                                                                | 8.39       |                                                                                                                                              | -0-     |   |
| 1999 Stock Option Plan                                      |   | 347,400                                                                                           |   | $                                                                                | 6.65       |                                                                                                                                              | 1,660   |   |
| Equity compensation  plans not approved by security holders |   |                                                                                              |   |                                                                             |       |                                                                                                                                              |    |
| 2001 Equity Incentive  Plan                                 |   | 909,613                                                                                           |   | $                                                                                |  3.64 |                                                                                                                                              | 89,655  |   |
| Total                                                       |   | 1,397,678                                                                                         |   | $                                                                                |  4.59 |                                                                                                                                              | 119,560 |   |

 

*Plan Descriptions:*

 

*2001Equity Incentive Plan:* For a summary of the material terms of the 2001 Equity Incentive Plan,please see Note 11 to the financial statements included in this annual reporton Form 10-KSB.

 

**ITEM 6****. Management’s Discussion andAnalysis of Financial Condition and Results of Operations.**

 

**FORWARD-LOOKING STATEMENTS**

 

The following discussion should be read in conjunction with theConsolidated Financial Statements and Notes thereto included elsewhere withinthis report. Fluctuations in annual and quarterly results may occur as a resultof factors affecting demand for our products such as the timing of new productintroductions by us and by our competitors and our customers’ political andbudgetary constraints. Due to such fluctuations, historical results andpercentage relationships are not necessarily indicative of the operatingresults for any future period.

 

**OVERVIEW**

 

We utilize our imaging technology to develop software used to createbooking and investigative software solutions, smart and secure identificationsystems and documents, and software for professional

 

18

----

 

photographers.Our software systems and associated hardware enable our customers to quicklycapture, archive, search, retrieve and share digital photographs and associatedtext records.

 

**Critical Accounting Policies and Estimates**

 

Management’s Discussion and Analysis of Financial Condition and Resultsof Operations discusses ImageWare’s consolidated financial statements, whichhave been prepared in accordance with accounting principles generally acceptedin the United States. The preparation of these financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.

 

We have identified the policies below as critical to our businessoperations and the understanding of our results of operations. For a detaileddiscussion on the application of these and other accounting policies, seeNote 1 in the Notes to the Consolidated Financial Statements in Item 7 ofthis Annual Report on Form 10-KSB, beginning on page F-7.

 

*Revenue recognition*

 

Our revenue recognition policy is significant because our revenue is akey component of our results of operations. ImageWare Systems, Inc.recognizes revenue and profit as work progresses on long-term, fixed-pricecontracts involving significant amount of hardware and software customizationusing the percentage of completion method based on costs incurred to datecompared to total estimated costs at completion. Revenue from contracts forwhich we cannot reliably estimate total costs or there are not significantamounts of customization are recognized upon completion. Determining when acontract should be accounted for using the percentage of completion methodinvolves judgment. Critical items that are considered in this process are thedegree of customization and related labor hours necessary to complete therequired work as well as ongoing estimates of the future labor hours needed tocomplete the contract. Our revenue from periodic maintenance agreements isgenerally recognized ratably over the respective maintenance periods providedno significant obligations remain and collectibility of the related receivableis probable. The Company also generates non-recurring revenue from thelicensing of its software. Software license revenue is recognized upon theexecution of a license agreement, upon deliverance, fees are fixed anddeterminable, collectibility is probable and when all other significantobligations have been fulfilled. The Company also generates revenue from thesale of identification card media and other software. Revenue for these itemsis recognized upon delivery of these products to the customer. The Company alsogenerates revenue from the sale of professional digital photography software.Revenue for these items is recognized upon delivery of these products to thecustomer.

 

*Allowance for doubtful accounts*

 

ImageWare Systems, Inc. must make estimates of the uncollectibilityof our accounts receivables. Management specifically analyzes accountsreceivable and analyzes historical bad debts, customer concentrations, customercredit-worthiness, current economic trends and changes in our customer paymentterms when evaluating the adequacy of the allowance for doubtful accounts. Ouraccounts receivables balance was $3,295,000, net of allowance for doubtfulaccounts of $410,000 as of December 31, 2002.  As of December 31, 2002, one customer accounted for 26% oftotal accounts receivable.

 

*Valuation of goodwill and other intangible assets*

 

We assess impairment of goodwill and identifiable intangible assetswhenever events or changes in circumstances indicate that the carrying valuemay not be recoverable. Factors we consider important which could trigger animpairment review include the following:

 

•               Significantunderperformance relative to historical or expected future operating results;

 

•               Significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business;

 

•               Significantnegative industry or economic trends;

 

19

----

 

When we determine that the carrying value of goodwill and other intangibleassets may not be recoverable based upon the existence of one or more of theabove indicators of impairment, we measure any impairment based upon fair valuemethodologies. Goodwill and other net intangible assets amounted to $6,859,000as of December 31, 2002. The Company has recorded goodwill and other netintangibles of $6,402,000 at December 31, 2002 resulting from its acquisitionsof G & A and Castleworks and E-Focus on March 30, 2001 andAugust 10, 2001, respectively.

 

In 2002, Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets” became effective and as aresult, we ceased to amortize goodwill. In lieu of amortization, we performedan initial impairment review of our goodwill in 2002 and will perform an annualimpairment review thereafter in the fourth quarter of our fiscal year.  Completion of our initial impairment testindicated there was no goodwill impairment. We also performed our annual impairment review as of December 31, 2002based upon our 2003 operating plan. This annual impairment review indicated there was no goodwillimpairment.  Both of these tests wereconducted by determining and comparing the fair value of our reporting units,as defined in SFAS 142, to the reporting unit's carrying value as of that date.Our reporting units are Law Enforcement, Identification and DigitalPhotography. There are many management assumptions and estimates underlying thedetermination of an impairment loss, and estimates using different, butreasonable, assumptions could produce significantly different results.Significant assumptions include estimates of future levels of revenues andoperating expenses. Therefore, the timing and recognition of impairment lossesby us in the future, if any, may be highly dependent upon our estimates andassumptions.  There can be no assurancethat goodwill impairment will not occur in the future.

 

The selected statement of operations data and balance sheet datapresented below set forth a summary of data relating to our results ofoperations. This data has been derived from our audited consolidated financialstatements and should be read in conjunction with the financial statements andnotes included elsewhere in this report.

 

20

----

 

**STATEMENT OF OPERATIONS DATA:**

 
|                                             |   | **Year Ended December 31,** |       |
|--------------------------------------------------|--------|-----------------------------|------------|
|                                             |   | **2002**                    |       | **2001** |   |
| Revenues                                         |   | $                           | 18,255,693 |   | $ | 16,253,005 |   |
| Cost of revenues                                 |   | $                           | 8,296,447  |   | $ | 7,199,274 |   |
| Gross profit                                     |   | $                           | 9,959,246  |   | $ | 9,053,731 |   |
| Operating expenses                               |   | $                           | 14,089,018 |   | $ | 15,287,679 |   |
| Loss from operations                             |   | $                           | (4,129,772 | ) | $ | (6,233,948 | ) |
| Interest expense (income), net                   |   | $                           | 652,392    |   | $ | (127,405) |   |
| Other (income) expense, net                      |   | $                           | (53,575    | ) | $ | 11,194 |   |
| Loss before income taxes and extraordinary items |   | $                           | (4,728,589 | ) | $ | (6,117,737 | ) |
| Income tax benefit                               |   | $                           | 120,341    |   | $ | (184,828 | ) |
| Net loss                                         |   | $                           | (4,848,930 | ) | $ | (5,932,909 | ) |
| Basic loss per share                             |   | $                           | (0.90      | ) | $ | (1.22 | ) |
| Weighted average shares (basic and diluted)      |   | 5,483,973                   |       | 4,937,588 |   |

 
|                            |   | **Year Ended December 31,** |       |
|---------------------------------|--------|-----------------------------|------------|
|                            |   | **2002**                    |       | **2001** |   |
| **BALANCE SHEET DATA**          |   |                        |       |   |   |
| Cash                            |   | $                           | 214,937    |   | $ | 387,773 |   |
| Accounts receivable, net        |   | $                           | 3,294,932  |   | $ | 4,475,787 |   |
| Inventories                     |   | $                           | 1,882,082  |   | $ | 950,203 |   |
| Other current assets            |   | $                           | 422,382    |   | $ | 990,786 |   |
| Property and equipment, net     |   | $                           | 1,040,915  |   | $ | 1,188,899 |   |
| Intangibles, net                |   | $                           | 1,561,545  |   | $ | 2,478,298 |   |
| Goodwill                        |   | $                           | 5,297,627  |   | $ | 4,838,317 |   |
| Total assets                    |   | $                           | 14,518,246 |   | $ | 15,843,630 |   |
| Total current liabilities       |   | $                           | 6,958,314  |   | $ | 6,108,313 |   |
| Long-term liabilities           |   | $                           | 1,658,432  |   | $ | 209,569 |   |
| Total liabilities               |   | $                           | 8,616,746  |   | $ | 6,317,882 |   |
| Total shareholders’ equity |   | $                           | 5,901,500  |   | $ | 9,525,748 |   |

 

21

----

 

**YEARS ENDED DECEMBER 31, 2002 AND 2001**

 

The following management’s discussion and analysis of financialcondition and results of operations is based upon our law enforcement,identification and digital photography segments.

 
| **Net  Product Revenues**               |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |       |     |   |            |   |
|-----------------------------------------|--------|-----------------------------------------|------------|----------|--------|-----------------|--------|
|                                    |   | **2002**                                |       | **2001** |   | **$****Change** |   | **%****Change** |   |
| **Product revenues:**                   |   |                                    |       |     |   |            |   |   |   |
| Law Enforcement                         |   | $                                       | 2,065,121  |     | $      | 3,887,648       |   | $ | (1,822,527 | ) | -47% |   |
| Percentage of total net product revenue |   | 13                                      | %          | 28       | %      |            |   |   |   |
| Identification Group                    |   | $                                       | 12,160,050 |     | $      | 9,286,713       |   | $ | 2,873,337 |   | 31% |   |
| Percentage of total net product revenue |   | 80                                      | %          | 67       | %      |            |   |   |   |
| Digital Photography                     |   | $                                       | 890,595    |     | $      | 722,833         |   | $ | 167,762 |   | 23% |   |
| Percentage of total net product revenue |   | 6                                       | %          | 5        | %      |            |   |   |   |
| Total net product revenues              |   | $                                       | 15,115,766 |     | $      | 13,897,194      |   | $ | 1,218,572 |   | 9% |   |

 

Product revenues increased 9% from $13,897,000 for the year endedDecember 31, 2001 to $15,116,000 for the corresponding period in 2002.Product revenues related to our law enforcement products decreased 47% from$3,888,000 for the year ended December 31, 2001 to $2,065,000 for thecorresponding period in 2002. We believe that the decrease in law enforcementproduct revenues is reflective of a decrease in government procurement.  We believe that the increase in terrorismduring the past year has created heightened interest in the ability of lawenforcement and other government agencies to be able to efficiently retrieve,analyze and share information from their respective criminal databases. We alsobelieve that government agencies and private entities will react to theincreased terrorism by reevaluating and upgrading their ability to positivelyidentify and track their employees, consultants and visitors. We anticipatethat these factors will increase overall demand for the Company’s products,however, we cannot predict the timing of the shift in demand.

 

Product revenues from identification card systems, software and relatedconsumables increased 31% from $9,287,000 for the year ended December 31,2001 to $12,160,000 for the corresponding period in 2002 due primarily to theeffect of our acquisitions of G & A on March 30, 2001. Revenuesalso increased due to higher sales of hardware and print media consumablesdriven primarily by increased demand for out next generation card printer andrelated print media consumables.  Webelieve that government agencies and private entities will react to increased terrorismby reevaluating and upgrading their ability to positively identify and tracktheir employees, consultants and visitors.

 

Revenues related to our digital photography products increased 23% or$168,000 for the twelve months ended December 31, 2002 as compared to thecorresponding period in 2001.  Thisrevenue increase is due primarily to our acquisition of this businessAugust 10, 2001.  On anannualized basis, revenues related to our Digital Photography productsdecreased due primarily to our selling of software only solutions in 2002 ascompared to 2001 which included significant sales of hardware.

 

Our backlog ofproduct orders as of December 31, 2002 was approximately $602,000.

 
| **Maintenance  Revenues**                     |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |                   |   |
|-----------------------------------------------|--------|-----------------------------------------|-----------|----------|--------|------------------------|--------|
|                                          |   | **2002**                                |      | **2001** |   | **$****  Change** |   | **%****Change** |   |
| **Maintenance revenues :**                    |   |                                    |      |     |   |                   |   |   |   |
| Law Enforcement                               |   | $                                       | 2,182,524 |     | $      | 1,734,202              |   | $ | 448,322 |   | 26% |   |
| Percentage of total net maintenenance revenue |   | 69                                      | %         | 74       | %      |                   |   |   |   |
| Identification Group                          |   | $                                       | 928,403   |     | $      | 613,089                |   | $ | 315,314 |   | 51% |   |
| Percentage of total net maintenenance revenue |   | 30                                      | %         | 26       | %      |                   |   |   |   |
| Digital Photography                           |   | $                                       | 29,000    |     | $      | 8,520                  |   | $ | 20,480 |   | 240% |   |
| Percentage of total net maintenenance revenue |   | 1                                       | %         | 0        | %      |                   |   |   |   |
| Total net maintenance revenues                |   | $                                       | 3,139,927 |     | $      | 2,355,811              |   | $ | 784,116 |   | 33% |   |

 

22

----

 

Maintenance revenues increased 33% from $2,356,000 for the year endedDecember 31, 2001 to $3,140,000 for the corresponding period in 2002.Maintenance revenues related to law enforcement products increased 26% from$1,734,000 for the year ended December 31, 2001 to $2,183,000 for thecorresponding period in 2002. This increase is due primarily to the expansionof our installed base in the law enforcement market. Maintenance revenuesrelated to identification products increased $315,000 during the year endedDecember 31, 2002 due primarily to our acquisition of G & A onMarch 30, 2001.

 
| **Cost of product revenues**                       |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |       |     |       |                   |       |
|----------------------------------------------------|--------|-----------------------------------------|------------|----------|------------|------------------------|------------|
|                                               |   | **2002**                                |       | **2001** |       | **$****  Change** |       | **%****Change** |   |
| **Cost  of Product Revenues:**                     |   |                                    | ** ** |     | ** ** |                   | ** ** |   | ** ** |
| Law Enforcement                                    |   | $                                       | 787,819    |     | $          | 1,348,305              |       | $ | (560,486 | ) | -42 | % |
| Percentage of Law Enforcement product revenue      |   | 38                                      | %          | 35       | %          |                   |       |   |   |
| Identification Group                               |   | $                                       | 6,073,574  |     | $          | 4,132,441              |       | $ | 1,941,133 |   | 47 | % |
| Percentage of Identification Group product revenue |   | 50                                      | %          | 44       | %          |                   |       |   |   |
| Digital Photography                                |   | $                                       | 198,738    |     | $          | 402,872                |       | $ | (204,134 | ) | -51 | % |
| Percentage of Digital Photography product revenue  |   | 22                                      | %          | 56       | %          |                   |       |   |   |
| Total product cost of revenues                     |   | $                                       | 7,060,131  |     | $          | 5,883,618              |       | $ | 1,176,513 |   | 20 | % |
| Percentage of total product revenues               |   | 47                                      | %          | 42       | %          |                   |       |   |   |
|                                                    |        |                                         |            |          |            |                        |            |  |  |  |  |  |  |

 

 

Cost of law enforcement product revenue as a percentage of lawenforcement product revenue increased 3% from 35% for the year endedDecember 31, 2001 to 38% for the corresponding period in 2002.  This percentage change is due to the productmix of law enforcement product sales. Costs of products can vary as a percentage of product revenue fromperiod to period depending upon product mix and the hardware content includedin systems installed during a given period. The dollar decrease of $560,000 or 42% for the twelve months endedDecember 31, 2002 as compared to the corresponding period in 2001 reflects thedecrease in law enforcement revenues in 2002.

 

Costs of identification products increased 47% from $4,132,000, or 44%of revenue, for the year ended December 31, 2001 to $6,074,000, or 50% ofrevenue, for the corresponding period in 2002. Cost of identification productsas a percentage of identification product revenue can vary depending uponfactors such as product mix, hardware and software content and amount ofidentification card media sold. The dollar increase of $1,941,000 reflects theacquisition of G & A, completed on March 30, 2001, and theinclusion of G & A’s cost of product revenues for twelve months in2002 versus nine months in 2001 based on the date of acquisition.

 

Costs of Digital Photography product revenues as a percentage of DigitalPhotography product revenues decreased from 56% for the twelve months endedDecember 31, 2001 to 22% for the corresponding period in 2002.  Both the percentage decrease and dollardecrease reflects 2002 product sales of software only solutions as compared tohardware and software solutions sold in 2001.

 
| **Maintenance  cost of revenues**                     |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |       |     |       |            |       |
|-------------------------------------------------------|--------|-----------------------------------------|------------|----------|------------|-----------------|------------|
|                                                  |   | **2002**                                |       | **2001** |       | **$****Change** |       | **%****Change** |   |
| **Maintenance cost of revenues:**                     |   |                                    | ** ** |     | ** ** |            | ** ** |   | ** ** |
| Law Enforcement                                       |   | $                                       | 786,348    |     | $          | 968,734         |       | $ | (182,386 | ) | -19 | % |
| Percentage of Law Enforcement maintenance revenue     |   | 36                                      | %          | 56       | %          |            |       |   |   |
| Identification Group                                  |   | $                                       | 449,968    |     | $          | 171,328         |       | $ | 278,640 |   | 163 | % |
| Percentage of Identification maintenance revenue      |   | 48                                      | %          | 28       | %          |            |       |   |   |
| Digital Photography                                   |   | $                                       | -          |     | $          | 594             |       | $ | (594 | ) | N/A |   |
| Percentage of Digital Photography maintenance revenue |   | -                                       | %          | 7        | %          |            |       |   |   |
| Total maintenance cost of revenues                    |   | $                                       | 1,236,316  |     | $          | 1,140,656       |       | $ | 95,660 |   | 8 | % |
| Percentage of total maintenance revenues              |   | 39                                      | %          | 48       | %          |            |       |   |   |
|                                                       |        |                                         |            |          |            |                 |            |  |  |  |  |  |  |

 

23

----

 

Cost of law enforcement maintenance revenue decreased 19% from $969,000,or 56% of law enforcement maintenance revenue for the year endedDecember 31, 2001 to $786,000, or 36% of law enforcement maintenancerevenues for the corresponding period in 2002. The percentage decrease of lawenforcement cost of sales to law enforcement maintenance revenues is due to alarger revenue base over which to absorb fixed maintenance costs. Alsocontributing to the reduction in cost of law enforcement maintenance revenueswas the movement of certain help desk functions to our Canadian officeresulting in lower personnel costs.

 

Costs of identification maintenance revenues increased 163% from$171,000 or 28% of identification maintenance revenue for the year endedDecember 31, 2001 to $450,000 or 48% of identification maintenance revenues forthe corresponding period in 2002.  Thedollar increase of $279,000 is reflective of our timing of our acquisition of G& A and the inclusion of maintenance cost of revenues for an entire twelvemonth period in 2002 as compared to only nine months in 2001 along with highercosts of maintenance revenues internationally.

 
| **Product  gross profit**                         |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|---------------------------------------------------|--------|-----------------------------------------|-----------|----------|--------|-----------------|--------|
|                                              |   | **2002**                                |      | **2001** |   | **$****Change** |   | **%****Change** |   |
| Law Enforcement                                   |   | $                                       | 1,277,302 |     | $      | 2,539,343       |   | $ | (1,262,041 | ) | -50 | % |
| Percentage of Law Enforcement product revenue     |   | 62                                      | %         | 65       | %      |            |   |   |   |
| Identification Group                              |   | $                                       | 6,086,476 |     | $      | 5,154,272       |   | $ | 932,204 |   | 18 | % |
| Percentage of Identification product revenue      |   | 50                                      | %         | 56       | %      |            |   |   |   |
| Digital Photography                               |   | $                                       | 691,857   |     | $      | 319,961         |   | $ | 371,896 |   | 116 | % |
| Percentage of Digital Photography product revenue |   | 78                                      | %         | 44       | %      |            |   |   |   |
| Total product gross profit                        |   | $                                       | 8,055,635 |     | $      | 8,013,576       |   | $ | 42,059 |   | 1 | % |
| Percentage of total product revenues              |   | 53                                      | %         | 58       | %      |            |   |   |   |
|                                                   |        |                                         |           |          |        |                 |        |  |  |  |  |  |  |

 

Law enforcement product gross margins as a percentage of law enforcementproduct revenues decrease from 65% for the twelve months endedDecember 31, 2001 to 62% for the corresponding period in 2002. Thispercentage change is due to the product mix of law enforcement productsales.  Gross profit of law enforcementproducts can vary as a percentage of product revenue from period to perioddepending upon product mix and the hardware content included in systemsinstalled during a given period.  Thedollar decrease of $1,262,000 or 50% for the twelve months ended December 31,2002 as compared to the corresponding period in 2001 reflects the decrease inlaw enforcement revenues in 2002.

 

Gross margins related to identification products as a percentage ofidentification product revenue decreased from 56% of revenues for the yearended December 31, 2001 to 50% of revenues for the corresponding period in2002. Gross profit of identification products as a percentage of identificationproduct revenue can vary depending upon factors such as product mix, hardwareand software content and amount of identification card media.  The dollar increase of $932,000 reflects theacquisition of G & A, completed on March 30, 2001, and theinclusion of G & A’s product gross margins for twelve months in 2002versus nine months in 2001 based on the date of acquisition.

 
| **Maintenance  gross profit**                         |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|-------------------------------------------------------|--------|-----------------------------------------|-----------|----------|--------|-----------------|--------|
|                                                  |   | **2002**                                |      | **2001** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance gross profit**                          |   |                                    |      |     |   |            |   |   |   |
| Law Enforcement                                       |   | $                                       | 1,396,177 |     | $      | 765,468         |   | $ | 630,709 |   | 82 | % |
| Percentage of Law Enforcement product revenue         |   | 64                                      | %         | 44       | %      |            |   |   |   |
| Identification Group                                  |   | $                                       | 478,434   |     | $      | 441,761         |   | $ | 36,673 |   | 8 | % |
| Percentage of Identification product revenue          |   | 52                                      | %         | 72       | %      |            |   |   |   |
| Digital Photography                                   |   | $                                       | 29,000    |     | $      | 7,926           |   | $ | 21,074 |   |   |   |
| Percentage of Digital Photography maintenance revenue |   | 100                                     | %         | 93       | %      |            |   |   |   |
| Total maintenance gross profit                        |   | $                                       | 1,903,611 |     | $      | 1,215,155       |   | $ | 688,456 |   | 57 | % |
| Percentage of total maintenance revenues              |   | 60                                      | %         | 52       | %      |            |   |   |   |
|                                                       |        |                                         |           |          |        |                 |        |  |  |  |  |  |  |

 

Gross profit related to law enforcement maintenance revenues increased82% from $765,000 or 44% of law enforcement maintenance revenue for the twelvemonths ended December 31, 2001 to $1,396,000 or 64% of law enforcement revenuesfor the corresponding period in 2002. This increase is reflective of a largermaintenance

 

24

----

 

revenuebase over which to absorb fixed maintenance costs in conjunction with lowerpersonnel costs resulting from the movement of certain help desk function toour Canadian office resulting in lower personnel costs.

 

Gross profit related to identification maintenance revenues increased 8%from $442,000 or 72% of identification maintenance revenues for the year endedDecember 31, 2001 to $478,000 or 52% for the corresponding period in 2002.

 
| **Operating expenses**          |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |       |     |       |                   |       |
|---------------------------------|--------|-----------------------------------------|------------|----------|------------|------------------------|------------|
|                            |   | **2002**                                |       | **2001** |       | **$****  Change** |       | **%****Change** |   |
|                            |   |                                    | ** ** |     | ** ** |                   | ** ** |   | ** ** |
| General & administrative    |   | $                                       | 6,911,228  |     | $          | 6,631,995              |       | $ | 279,233 |   | 4 | % |
| Percentage of total net revenue |   | 38                                      | %          | 41       | %          |                   |       |   |   |
| Sales and marketing             |   | $                                       | 4,204,613  |     | $          | 4,120,881              |       | $ | 83,732 |   | 2 | % |
| Percentage of total net revenue |   | 23                                      | %          | 25       | %          |                   |       |   |   |
| Research & development      |   | $                                       | 2,078,777  |     | $          | 2,090,054              |       | $ | (11,277 | ) | -1 | % |
| Percentage of total net revenue |   | 11                                      | %          | 13       | %          |                   |       |   |   |
| Depreciation and amortization   |   | $                                       | 894,400    |     | $          | 2,444,749              |       | $ | (1,550,349 | ) | -63 | % |
| Percentage of total net revenue |   | 5                                       | %          | 15       | %          |                   |       |   |   |
|                                 |        |                                         |            |          |            |                        |            |  |  |  |  |  |  |

 

*General and administrative expenses*

 

General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses, as a percentage of total revenues,decreased from 41% for the year ended December 31, 2001 to 38% for thecorresponding period in 2002. This decrease is reflective of our efforts in2002 to consolidate certain functions and existing infrastructures whilemaintaining operational efficiencies. The dollar increase is also reflective ofthese efforts as the year ending December 31, 2002 contains a full twelvemonths of the acquired infrastructure of G & A and Digital Photography ascompared to the 2001 year which contains the expenses from the date ofacquisition through the end of the year. We are continuing to focus our efforts on achieving additional futureoperating efficiencies by reviewing and improving upon existing businessprocesses and evaluating our cost structure. We believe these efforts willallow us to continue to gradually decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

 

*Sales and marketing expenses*

 

Sales and marketing expenses consist primarily of the salaries,commissions, other incentive compensation, employee benefits and travelexpenses of our sales force. Such expenses, as a percentage of total revenues,decreased from 25% for the year ended December 31, 2001 to 23% for thecorresponding period in 2001. The dollar increase of $84,000 or 2% is dueprimarily to the acquired sales and marketing force of G & A, Castleworks,and E-Focus being included in the results of operations for twelve months in2002 as compared nine months for G &A and five months for Castleworks andE-Focus based on the date of acquisition of these businesses in 2001.

 

*Research and development expenses*

 

Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses, as a percentage oftotal net revenues, decreased from 13%, or $2,090,000 for the year endedDecember 31, 2001 to 11%, or $2,079,000 for the corresponding period in2002. This level of research and development expenditures reflects our beliefthat to maintain our competitive position in markets characterized by rapidrates of  technological advancement, wemust continue to invest significant resources in new systems and software aswell as continue to enhance existing products.

 

*Depreciation and amortization*

 

Depreciation and amortization decreased $1,550,000 from $2,445,000 forthe year ended December 31, 2001 to $894,000 for the corresponding periodin 2002. This decrease is due primarily from our adoption of the provisions ofFinancial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”(“FAS 142”). Under FAS 142, goodwill and intangible assets with indefinitelives are no 

 

25

----

 

longeramortized but are reviewed annually (or more frequently if impairmentindicators arise) for impairment. Seperable intangible assets that are notdeemed to have indefinite lives will continue to be amortized over their usefullives.  The amortization provisions ofFAS 142 applied immediately to and intangible assets acquired after June 30,2001.  For the twelve months ended December31, 2001, we recorded amortization expense of approximately $1,609,000 relatedto goodwill and acquired workforce that is no longer being amortized in fiscalyear 2002 under the provisions of FAS 142.

 

*Stock-based compensation*

 

For the years ended December 31, 2002 and 2001, we recognizednon-employee stock-based compensation expense of $0 and $35,000respectively, related to the issuance of stock purchase warrants ascompensation for services rendered. During the year ended December 31,2002, no warrants were provided as compensation for services rendered.  Such expenses are classified as part ofgeneral and administrative expense.

 

*Interest expense, net*

 

For the year ended December 31, 2002, we recognized interest incomeof $49,000 and interest expense of $701,000. For the year endedDecember 31, 2001, we recognized interest income of $185,000 and interestexpense of $58,000. Interest income decreased due to lower levels of cash andcash equivalents held in interest bearing accounts, resulting primarily fromour use of cash to fund our net loss. Interest expense increased due to increases in notes payable and line ofcredit facilities the proceeds of which were used to fund operations.

 

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 is convertible into common sharesof the Company at $4.31 per share.  Inconjunction with the note, the Company issued a warrant to purchase 150,000shares of common stock at $4.74 per share. The Company has recorded the note net of a discount equal to the fairvalue allocated to the warrants issued of approximately $537,000.

 

The convertible note also contained a beneficial conversion feature,which resulted in additional debt discount of $537,000.  The beneficial conversion amount wasmeasured using the accounting intrinsic value, i.e. the excess of the aggregatefair value of the common stock into which the debt is convertible over theproceeds allocated to the security.  TheCompany is accreting the beneficial conversion feature as interest expense overthe life of the note.  For the twelvemonths ended December 31, 2002, the Company recorded $326,212 as interestexpense from the amortization of the discount related to the fair value of thewarrants and from the accretion of the beneficial conversion feature.  

 

*Liquidity and capital resources*

 

As of December 31, 2002, we had total current assets of $5,874,000and total current liabilities of $6,958,000, or negative working capital of $1,084,000.At December 31, 2002 and 2001, we had available cash of $215,000 and$388,000, respectively. As of December 31, 2002, we also had $60,000 inrestricted cash securing our San Diego, California facility lease.

 

Net cash used in operating activities was $2,068,000 for the year endedDecember 31, 2002 as compared to $2,186,000 for the corresponding periodin 2001. We used cash to fund net losses of $3,512,000, excluding non-cashexpenses (depreciation and amortization) of $1,337,000 for the year endedDecember 31, 2002.  We used cash tofund net losses of $3,430,000 excluding non-cash expenses (depreciation andamortization) of $2,502,000 for the corresponding period in 2001. For the yearended December 31, 2002, we generated cash of $880,000 through reductionsin current assets and by increases in current and long-term liabilities of$564,000 (excluding debt).  In 2001, wegenerated cash of $310,000 through reductions in current assets and generatedcash by increases in current liabilities of $934,000 (excluding debt).

 

Net cash used by investing activities was $516,000 for the year endedDecember 31, 2002 as compared to $3,812,000 for the corresponding periodin 2001. For the year ended December 31, 2002, we used cash to fundcapital expenditures of computer equipment and software, furniture and fixturesand leasehold improvements of approximately $355,000. The level of equipmentpurchases resulted primarily from continued growth of the business andreplacement of older equipment. In 2002, we also used cash of $161,000 to repayadvances from related stockholders.  In2001, we used cash of $427,000 to fund capital expenditures of computerequipment and software, furniture and fixtures and leasehold improvements.  In 2001, we also used cash of approximately$3,280,000 to fund our acquisitions of G & A and Castleworks andE-Focus which includes cash to the selling shareholders and direct dealtransaction costs. In 2001, we used cash to repay advances from relatedstockholders of $105,000.

 

Net cash provided by financing activities was $2,262,000 for the yearended December 31, 2002.  Wegenerated cash of $2,000,000 from the proceeds of our issuance of a seniorsecured convertible promissory note payable offset by $384,000 in debt issuancecosts and generated cash of $500,000 from our issuance of a demand promissorynote.  We generated cash of $166,000from short-term borrowings under a bank line of credit agreement.  We also generated cash of $1,000 from theexercise of stock options.  In 2002, weused cash of $21,000 for the repayment of notes payable. For the year endedDecember 31, 2001, cash used by financing activities was $477,000.  We used cash of $583,000 for the repaymentof notes payable offset by $106,000 in proceeds received from the exercise of 

 

26

----

 

stockoptions.

 

We conduct operations in leased facilities under operating leasesexpiring at various dates through 2006. Additionally, we have acquired certainequipment under capital leases which expire at various dates through 2006. Inconjunction with our San Diego, California leased facility; we are contingentlyliable under an irrevocable letter of credit in the amount of $30,000. Theletter of credit expires July 31, 2003. We also have various short-termnotes payable and capital lease obligations due at various times during 2003.The following table sets forth a summary of our obligations under operatingleases, capital leases, notes payable and irrevocable letters of credit for thenext five years:

 
|                                                                       |   | **2003** |      | **2004** |   | **2005**  |   | **2006** |    | **2007** |   | **Total** |   |
|----------------------------------------------------------------------------|--------|----------|-----------|----------|--------|-----------|--------|----------|---------|----------|--------|-----------|--------|
|                                                                       |   |     |      |     |   |      |   |     |    |     |   |      |   |
| Minimum annual  lease payments under operating leases                      |   | $        | 657,000   |     | $      | 497,000   |   | $        | 477,000 |     | $      | 255,000   |   | $ | 0 |   | $ | 1,886,000 |   |
|                                                                       |   |     |      |     |   |      |   |     |    |     |   |      |   |
| Minimum annual  payments under notes payable and capital lease obligations |   | $        | 1,004,000 |     | $      | 2,002,000 |   | $        | 2,000   |     | $      | 1,000     |   | $ | 0 |   | $ | 3,009,000 |   |
|                                                                       |   |     |      |     |   |      |   |     |    |     |   |      |   |
| Other commercial  commitments:                                             |   |     |      |     |   |      |   |     |    |     |   |      |   |
|                                                                       |   |     |      |     |   |      |   |     |    |     |   |      |   |
| Standby letters  of credit                                                 |   | $        | 30,000    |     | $      | 0         |   | $        | 0       |     | $      | 0         |   | $ | 0 |   | $ | 30,000 |   |
|                                                                       |   |     |      |     |   |      |   |     |    |     |   |      |   |
| Total  contractual cash obligations and other commercial commitments       |   | $        | 1,691,000 |     | $      | 2,499,000 |   | $        | 479,000 |     | $      | 256,000   |   | $ | 0 |   | $ | 4,925,000 |   |

 

The report of the Company’s independent accountants included with thisAnnual Report contains an explanatory paragraph regarding our ability tocontinue as a going concern. The Company is seeking additional financing thatwe believe is necessary to fund our working capital requirements for at leastthe next twelve months in conjunction with the successful implementation of ourbusiness plan. Our business plan includes, among other things, the monitoringand controlling of operating expenses, collection of significant trade andother accounts receivables, and controlling of capital expenditures. If we areunable to secure additional financing or successfully implement our businessplan, we will be required to seek funding from alternate sources and/orinstitute significant cost reduction measures. We

 

27

----

 

mayseek to sell equity or debt securities, secure a bank line of credit, orconsider strategic alliances. The sale of equity or equity related securitiescould result in additional dilution to our shareholders. There can be noassurance that additional financing, in any form, will be available at all or,if available, will be on terms acceptable to the Company. In addition, ourability to raise additional capital may be dependent upon the Company’s CommonStock being quoted on the American Stock Exchange. There can be no assurancethat the Company will be able to satisfy the criteria for continued listing onthe American Stock Exchange. Insufficient funds may require us to delay, scaleback or eliminate some or all of our activities, and if we are unable to obtainadditional funding there is substantial doubt about our ability to continue asa going concern.

 

*New Accounting Pronouncements*

 

In December 2002, the FASB issued SFAS 148 — *Accounting for Stock-Based Compensation — Transitionand Disclosure — an amendment of FAS 123.*Accounting for Stock-BasedCompensation was issued to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. In addition, this Statement amends the disclosurerequirements of Statement 123 to require prominent disclosures in both annualand interim financial statements about the method of accounting for stock-basedemployee compensation and the effect of the method used on reported results.The adoption of this statement did not have a material effect on the Company’sresults of operations or financial condition. The disclosure provisions of FAS 148 are effective for, and arereflected in, the Company’s 2002 financial statements.

 

In November 2002,the FASB issued FASB Interpretation No. 45 (“FIN 45”), *— “Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others.”*FIN45 requires that a liability be recorded in the guarantor’s balance sheet uponissuance of a guarantee. In addition, FIN 45 requires disclosures about theguarantees that an entity has issued, including a rollforward of the entity’sproduct warranty liabilities. The Company will apply the recognition provisionsof FIN 45 prospectively to guarantees issued after December 31, 2002. Thedisclosure provisions of FIN 45 are effective for the 2002 financialstatements; however no new disclosures were deemed necessary. The adoption ofFIN 45 is not expected to have a material effect on the Company’s results ofoperations or financial condition.

 

In November 2002,the Emerging Issues Task Force (EITF) issued Issue No. 00-21,“Accounting for Revenue Arrangements with Multiple Deliverables.” This issueaddresses determination of whether an arrangement involving more than onedeliverable contains more than one unit of accounting and how arrangementconsideration should be measured and allocated to the separate units ofaccounting. EITF Issue No. 00-21 will be effective for revenue arrangementsentered into in fiscal periods beginning after June 15, 2003 or theCompany may elect to report the change in accounting as a cumulative-effectadjustment. The Company is reviewing EITF Issue No. 00-21 and has not yetdetermined the impact this issue will have on its results of operations andfinancial condition.

 

28

----

 

**ITEM 7****. Financial Statements.**

 

The financial statements for fiscal years ended December 31, 2002and 2001 are included herein following Part III, Item 13, and are filed aspart of this report.

 

**ITEM 8****. Changes in and Disagreementswith Accountants on Accounting and Financial Disclosures.**

 

None.

 

**PART III**

 

**ITEM 9****. Directors, Executive Officers,Promoters and Control Persons; Compliance with Section 16(a) of theExchange Act.**

 

The information concerning the identification and business experience ofour directors is set forth in the definitive proxy statement for the 2003Annual Meeting of Shareholders under the heading “Proposal 1—Election of Directors,”which information is incorporated herein by reference.

 

The information concerning the identification and business experience ofour executive officers is set forth in the definitive proxy statement for the2003 Annual Meeting of Shareholders under the heading “Executive Officers,”which information is incorporated herein by reference.

 

The information concerning compliance with Section 16(a) of theExchange Act is set forth in ImageWare’s definitive proxy statement for the2003 Annual Meeting of Shareholders under the heading “Security Ownership ofCertain Beneficial Owners and Management—Section 16(a) BeneficialOwnership Reporting Compliance,” which information is incorporated herein byreference.

 

**ITEM 10****. Executive Compensation.**

 

The information concerning executive compensation is set forth in thedefinitive proxy statement for the 2003 Annual Meeting of Shareholders underthe heading “Executive Compensation,” which information is incorporated hereinby reference.

 

**ITEM 11****. Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters.**

 

The informationconcerning securities authorized for issuance under quity compenstation plansis set forth in Item 5 above.

 

The information concerning security ownership of certain beneficialowners and management is set forth in the definitive proxy statement for the2003 Annual Meeting of Shareholders under the heading “Security Ownership ofCertain Beneficial Owners and Management,” which information is incorporatedherein by reference.

 

**ITEM 12****. Certain Relationships andRelated Transactions.**

 

The information concerning certain relationships and relatedtransactions is set forth in the definitive proxy statement for the 2003 AnnualMeeting of Shareholders under the heading “Certain Transactions,” whichinformation is incorporated herein by reference.

 

**ITEM 13. Exhibits, Lists and Reportson Form 8-K.**

 

(a)           Exhibits.

 

 
| **Exhibit****Number** |   | **Description**                                    |
|-----------------------|--------|----------------------------------------------------|
|                  |   |                                               |
| 3.1                   |   | Amended  and Restated Articles of Incorporation(1) |
|                  |   |                                               |
| 3.2                   |   | Bylaws(1)                                          |
|                  |   |                                               |
| 4.1                   |   | Form  of Common Stock Certificate(1)               |
|                  |   |                                               |
| 4.2                   |   | Form  of Public Warrant(1)                         |
|                  |   |                                               |
| 4.3                   |   | Form  of Representatives’ Warrant(1)          |

 

29

----

 
| **Exhibit****Number** |   | **Description**                                                                                                                                                |
|-----------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                  |   |                                                                                                                                                           |
| 4.4                   |   | Form  of Warrant and Unit Agreement(1)                                                                                                                         |
|                  |   |                                                                                                                                                           |
| 4.5                   |   | Stock  Purchase Warrant in favor of Naoya Harano dated November 10, 1999(1)                                                                                    |
|                  |   |                                                                                                                                                           |
| 4.6                   |   | Form  of Warrant (Former XImage Shareholders)(1)                                                                                                               |
|                  |   |                                                                                                                                                           |
| 4.7                   |   | Form  of Warrant (Former XImage Officers, Noteholders and Other Investors)(1)                                                                                  |
|                  |   |                                                                                                                                                           |
| 4.8                   |   | Form  of Warrant (officers and directors)(1)                                                                                                                   |
|                  |   |                                                                                                                                                           |
| 4.9                   |   | Warrant  to Purchase Common Stock in favor of Imperial Bank(1)                                                                                                 |
|                  |   |                                                                                                                                                           |
| 10.1                  |   | Employment  Agreement with S. James Miller dated January 1, 1996, as amended September  2000(2)                                                                |
|                  |   |                                                                                                                                                           |
| 10.2                  |   | Employment  Agreement with Wayne G. Wetherell dated April 1, 1997, as amended March 1,  1999(1)                                                                |
|                  |   |                                                                                                                                                           |
| 10.3                  |   | Amendment,  dated April 27, 2002, to the Employment Agreement between Registrant and  Wayne G. Wetherell dated April 1, 1997, as amended on March 1, 1999(3)   |
|                  |   |                                                                                                                                                           |
| 10.4                  |   | Employment  Agreement with Paul J. Devermann dated July 20, 1997, as amended March 1,  1999(1)                                                                 |
|                  |   |                                                                                                                                                           |
| 10.5                  |   | Amendment,  dated February 28, 2002, to the Employment Agreement between Registrant and  Paul J. Devermann dated July 20, 1997, as amended on March 1, 1999(4) |
|                  |   |                                                                                                                                                           |
| 10.6                  |   | Employment  Agreement with William Ibbetson dated November 15, 2000(5)                                                                                         |
|                  |   |                                                                                                                                                           |
| 10.7                  |   | Employment  Agreement with Lori Rodriguez dated April 15, 2001(6)                                                                                              |
|                  |   |                                                                                                                                                           |
| 10.8                  |   | Form  of Indemnity Agreement entered into by the registrant with its directors and  executive officers(1)                                                      |
|                  |   |                                                                                                                                                           |
| 10.9                  |   | Membership  Interest Purchase Agreement between the Registrant and Castle Holdings(7)                                                                          |
|                  |   |                                                                                                                                                           |
| 10.10                 |   | 1994  Employee Stock Option Plan(1)                                                                                                                            |
|                  |   |                                                                                                                                                           |
| 10.11                 |   | 1994  Nonqualified Stock Option Plan(1)                                                                                                                        |

 

30

----

 
| **Exhibit****Number** |   | **Description**                                                                                                          |
|-----------------------|--------|--------------------------------------------------------------------------------------------------------------------------|
|                  |   |                                                                                                                     |
| 10.12                 |   | 1999  Stock Option Plan(1)                                                                                               |
|                  |   |                                                                                                                     |
| 10.13                 |   | 2001  Equity Incentive Plan(8)                                                                                           |
|                  |   |                                                                                                                     |
| 10.14                 |   | Lease  between Thormint I and the Company dated June 9, 1998(1)                                                          |
|                  |   |                                                                                                                     |
| 10.15                 |   | Sublease  between Castleworks LLC and Paine and Associates dated September 28, 1998(9)                                   |
|                  |   |                                                                                                                     |
| 10.16                 |   | Commercial  Lease between I.W. Systems Canada Company and 3840743 Canada, Inc. dated  April 12, 2001(2)                  |
|                  |   |                                                                                                                     |
| 10.17                 |   | Commercial  Lease between BOS GmbH & Co. KG and Digital Imaging International GmbH  dated June 20, 2001(9)           |
|                  |   |                                                                                                                     |
| 10.18                 |   | Value  Added Reseller Agreement with Visionics Corporation dated October 1,  2001†(10)                              |
|                  |   |                                                                                                                     |
| 10.19                 |   | Note  and Warrant Purchase Agreement dated May 22, 2002 (Perseus)(11)                                                    |
|                  |   |                                                                                                                     |
| 10.20                 |   | Pledge  and Security Agrement for ImageWare Systems, Inc. dated May 22, 2002 (Perseus)(11)                               |
|                  |   |                                                                                                                     |
| 10.21                 |   | Registration  Rights Agreement dated May 22, 2002 (Perseus)(11)                                                          |
|                  |   |                                                                                                                     |
| 10.22                 |   | Senior  Secured Convertible Promissory Note dated May 22, 2002(Perseus)(11)                                              |
|                  |   |                                                                                                                     |
| 10.23                 |   | Warrant  to Purchase Common Stock dated May 22, 2002 (Perseus)(11)                                                       |
|                  |   |                                                                                                                     |
| 21.1                  |   | Subsidiaries  of the Small Business Issuer                                                                               |
|                  |   |                                                                                                                     |
| 23.1                  |   | Consent  of PricewaterhouseCoopers LLP, independent accountants                                                          |
|                  |   |                                                                                                                     |
| 99.1                  |   | Certification  by Chief Executive Officer and Chief Financial Officer pursuant to Section  906 of the Sarbanes-Oxley Act |

 

----

(1)                                  Incorporatedby reference to the Registration Statement on Form SB-2, as filed with theCommission on December 20, 1999 (No. 333-93131), as amended.

 

(2)                                  Incorporatedby reference to the Registration Statement on Form S-3, as filed with theCommission on June 29, 2001 (No. 333-64192).

 

(3)                                  Incorporatedby reference to the Quarterly Report, Form 10-QSB as filed with the Commissionon August 14, 2002.

 

(4)                                  Incorporatedby reference to the Quarterly Report, Form 10-QSB as filed with the Commissionon May 15, 2002.

 

(5)                                  Incorporated by reference to the Annual Report,Form 10-KSB as filed with the Commission on April 2, 2001.

 

(6)                                  Incorporated by reference to the Quarterly Report,Form 10-QSB as filed with the Commission on May 15, 2001.

 

(7)                                  Incorporated by reference to the Current Report,Form 8-K as filed with the Commission on August 13, 2001.

 

(8)                                  Incorporated by reference to the Quarterly Report,Form 10-QSB as filed with the Commission on November 14, 2001.

 

(9)                                  Incorporated by reference to the Quarterly Report,Form 10-QSB as filed with the Commission on August 14, 2001.

 

(10)         Incorporated byreference to the Annual Report, Form 10-KSB as filed with the Commission onApril 1, 2002.

 

(11)         Incorporated byreference to the Current Report, Form 8-K as filed with the Commission on May24, 2002.

 

31

----

 

†Certain confidential portions of this Exhibit have been omitted pursuant to arequest for confidential treatment. Omitted portions have been filed separatelywith the Securities and Exchange Commission.

 

(b)           Reports onForm 8-K.

 

During the last quarter of the year ended December 31, 2002, noreports on Form 8-K were filed.

 

**ITEM 14.Controls and procedures.**

 

*Evaluationof discloser controls and procedures.*  ImageWare's chief executive officer and itschief financial officer, after evaluating the effectiveness of ImageWare'sdisclosure controls and procedures (as defined in Exchange Act Rule 13a-14) asof a date within 90 days of the filling date of this annual report on Form10-KSB (the "Evaluation Date"), have concluded that as of such date,ImageWare's disclosure controls and procedures were adequate and sufficient toensure that information required to be disclosed by ImageWare in the reportsthat it files under the Securities and Exchange Act of 1934 is recorded,processed, summarized and reported within the time period specified in theCommission's rules and forms.

 

*Changesin internal controls.* There have been no significant changes in ImageWare's internal controlssince the Evaluation Date.  ImageWare'sChief Executive Officer and Chief Financial Officer are not aware of anysignificant change in any other factor that could significantly affect itsinternal controls subsequent to the Evaluation Date.

32

----

 

**SIGNATURES**

 

Inaccordance with Section 13 or 15(d) of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|           | **.**  | **IMAGEWARE  SYSTEMS, INC.**                                |
|----------------|--------|------------------------------------------------------------------|
|           |   |                                                             |
|           |   |                                                             |
| April 14, 2003 |   | By:                                                              | /s/ **S. James  Miller, Jr.** |
|           |   | **S. James Miller, Jr.**                                         |
|           |   | Chief  Executive Officer and  Chairman of the Board of Directors |

 

Inaccordance with the Exchange Act, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 

 
| **Signature**            |   | **Title**                                                                                                            |   | **Date**        |
|--------------------------|--------|----------------------------------------------------------------------------------------------------------------------|--------|-----------------|
|                     |   |                                                                                                                 |   |            |
| /s/ S. James Miller, Jr. |   | Chief Executive Officer and  Chairman of the Board of  Directors * (Principal Executive Officer)*          |   | April  14, 2003 |
| S.James  Miller, Jr.     |   |                                                                                                                 |   |
|                     |   |                                                                                                                 |   |            |
| /s/ Wayne G. Wetherell   |   | Senior Vice President of  Administration and Chief Financial Officer *(Principal  Financial and Accounting Officer)* |   | April  14, 2003 |
| Wayne  G. Wetherell      |   |                                                                                                                 |   |
|                     |   |                                                                                                                 |   |            |
| /s/ John Callan          |   | Director                                                                                                             |   | April  14, 2003 |
| John  Callan             |   |                                                                                                                 |   |            |
|                     |   |                                                                                                                 |   |            |
| /s/ Patrick J. Downs     |   | Director                                                                                                             |   | April  14, 2003 |
| Patrick  J. Downs        |   |                                                                                                                 |   |            |
|                     |   |                                                                                                                 |   |            |
| /s/ John L. Holleran     |   | Director                                                                                                             |   | April  14, 2003 |
| John  L. Holleran        |   |                                                                                                                 |   |            |
|                     |   |                                                                                                                 |   |            |
| /s/ David Loesch         |   | Director                                                                                                             |   | April  14, 2003 |
| David  Loesch            |   |                                                                                                                 |   |            |
|                     |   |                                                                                                                 |   |            |
| /s/ Yukuo Takenaka       |   | Director                                                                                                             |   | April  14, 2003 |
| Yukuo  Takenaka          |   |                                                                                                                 |   |            |

 

33

----

 

**CERTIFICATION**

 

I, S. James Miller, the Chief Executive Officer of ImageWare Systems,Inc., certify that:

 

1.             I have reviewedthis annual report on Form 10-KSB of ImageWare Systems, Inc.;

 

2.             Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.             Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this annual report;

 

4.             The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and have: 

 

(a)           designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report is being prepared;

 

(b)           evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

(c)           presented in thisannual report, our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.             The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)           all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)           any fraud, whetheror not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.             The registrant’sother certifying officer and I have indicated in this annual report whetherthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Dated: | April 14, 2003          |   | /s/ S. James Miller |   |
|--------|-------------------------|--------|---------------------|--------|
|   | S. James Miller         |
|   | Chief Executive Officer |

 

34

----

 

**CERTIFICATION**

 

I, Wayne G. Wetherell,the Chief Financial Officer of ImageWare Systems, Inc., certify that:

 

1.             I have reviewed this annual report on Form 10-KSB ofImageWare Systems, Inc.;

 

2.             Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

4.             The registrant’s other certifying officer and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant andhave:

 

(a)           designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)           evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)           presented in this annual report, ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5)             The registrant’s other certifying officer and I havedisclosed, based on our most recent evaluation, to the registrant’s auditorsand the audit committee of registrant’s board of directors (or personsperforming the equivalent functions):

 

(a)           all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

(b)           any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.             The registrant’s other certifying officer and I haveindicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 
| Dated: | April 14, 2003          |   | /s/ Wayne G. Wetherell |   |
|--------|-------------------------|--------|------------------------|--------|
|   | Wayne G. Wetherell      |
|   | Chief Financial Officer |

 

35

----

 

**IMAGEWARE SYSTEMS, INC.**

 

**INDEX TO FINANCIAL STATEMENTS**

** **
| REPORT OF INDEPENDENT  ACCOUNTANTS          |
|---------------------------------------------|
|                                        |
| CONSOLIDATED FINANCIAL  STATEMENTS:         |
|                                        |
| BALANCE  SHEETS                             |
|                                        |
| STATEMENTS OF OPERATIONS                    |
|                                        |
| STATEMENTS OF CASH FLOW                     |
|                                        |
| STATEMENTS  OF SHAREHOLDERS’ EQUITY    |
|                                        |
| STATEMENTS  OF COMPREHENSIVE LOSS           |
|                                        |
| NOTES TO  CONSOLIDATED FINANCIAL STATEMENTS |

 

----

** **

**REPORT OF INDEPENDENT ACCOUNTANTS**

 

To Board of Directors andShareholders of

ImageWare Systems, Inc.

 

In our opinion, the accompanying consolidatedbalance sheets and the related consolidated statements of operations, ofshareholders equity and of cash flows present fairly, in all material respects,the financial position of ImageWare Systems, Inc. and its subsidiaries(the “Company”) at December 31, 2002 and 2001, and the results of theiroperations and their cash flows for the years then ended in conformity withaccounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management; ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements in accordance withauditing standards generally accepted in the United States of America, whichrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of 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. We believe that our audits provide areasonable basis for our opinion.

 

The accompanying financial statements have beenprepared assuming that the Company will continue as a going concern. Asdiscussed in Note 1 to the financial statements, the Company has sufferedlosses from operations and has a net capital deficiency that raise substantialdoubt about its ability to continue as a going concern. Management’s plans inregard to these matters are also described in Note 1. The financial statementsdo not include any adjustments that might result from the outcome of thisuncertainty.

 

PricewaterhouseCoopers LLP

San Diego, CA

April 11, 2003

 

F-1

----

 

**IMAGEWARESYSTEMS, INC.**

 

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                                                                                                                                                                                                                          |   | **December  31,  2002** |           | **December  31,  2001** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                                    |   |                    |           |                    |       |
| Current Assets:                                                                                                                                                                                                                                                                                                                                                               |   |                    |           |                    |       |
| Cash                                                                                                                                                                                                                                                                                                                                                                          |   | $                       | 214,937        |                    | $          | 387,773 |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                                                                                                                          |   | 60,000                  |           | 60,000                  |       |
| Accounts receivable, net of allowance for doubtful accounts of  $410,000 and $548,000 at December 31, 2002 and 2001, respectively                                                                                                                                                                                                                                             |   | 3,294,932               |           | 4,475,787               |       |
| Inventory                                                                                                                                                                                                                                                                                                                                                                     |   | 1,882,082               |           | 950,203                 |       |
| Other current assets                                                                                                                                                                                                                                                                                                                                                          |   | 422,382                 |           | 990,786                 |       |
| Total Current Assets                                                                                                                                                                                                                                                                                                                                                          |   | 5,874,333               |           | 6,864,549               |       |
|                                                                                                                                                                                                                                                                                                                                                                          |   |                    |           |                    |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                                                                                   |   | 1,040,915               |           | 1,188,899               |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                  |   | 743,826                 |           | 473,567                 |       |
| Intangible assets, net of accumulated amortization                                                                                                                                                                                                                                                                                                                            |   | 1,561,545               |           | 2,478,298               |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                                      |   | 5,297,627               |           | 4,838,317               |       |
| **Total Assets**                                                                                                                                                                                                                                                                                                                                                              |   | **$**                   | **14,518,246** | ** **              | **$**      | **15,843,630** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                          |   |                    |           |                    |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                                 |   |                    | ** **     |                    | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                          |   |                    |           |                    |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                                                                          |   |                    |           |                    |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                              |   | $                       | 3,232,735      |                    | $          | 2,918,963 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                                              |   | 976,046                 |           | 993,180                 |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                                              |   | 1,501,046               |           | 1,586,338               |       |
| Accrued expenses - related parties                                                                                                                                                                                                                                                                                                                                            |   | 46,597                  |           | 46,597                  |       |
| Accrued interest                                                                                                                                                                                                                                                                                                                                                              |   | 197,780                 |           | 42,457                  |       |
| Notes & advances payable to bank and third parties                                                                                                                                                                                                                                                                                                                        |   | 785,741                 |           | 141,048                 |       |
| Notes payable to related parties                                                                                                                                                                                                                                                                                                                                              |   | 218,369                 |           | 379,730                 |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                                                                                                     |   | 6,958,314               |           | 6,108,313               |       |
|                                                                                                                                                                                                                                                                                                                                                                          |   |                    |           |                    |       |
| Convertible note payable, net of discount                                                                                                                                                                                                                                                                                                                                     |   | 1,252,311               |           | —                  |       |
| Pension  obligation                                                                                                                                                                                                                                                                                                                                                           |   | 406,121                 |           | 209,569                 |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                                                             |   | 8,616,746               |           | 6,317,882               |       |
|                                                                                                                                                                                                                                                                                                                                                                          |   |                    |           |                    |       |
| 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 269,400 and 304,400 shares outstanding at December 31,  2002 and December 31, 2001 respectively, liquidation preference $673,500 and  $761,000 at December 31, 2002 and December 31, 2001, respectively |   | 2,694                   |           | 3,044                   |       |
| Common stock, $.01 par value, 50,000,000 shares authorized, 5,489,390  and 5,481,311 shares issued and outstanding at December 31, 2002 and December  31, 2001, respectively                                                                                                                                                                                                  |   | 53,712                  |           | 53,631                  |       |
| Additional paid in capital                                                                                                                                                                                                                                                                                                                                                    |   | 41,272,370              |           | 40,196,952              |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                                                                        |   | (63,688                 | )              | (63,688                 | )          |
| Shareholder note receivable                                                                                                                                                                                                                                                                                                                                                   |   | (150,000                | )              | (150,000                | )          |
| Accumulated other comprehensive income (loss)                                                                                                                                                                                                                                                                                                                                 |   | 112,881                 |           | (36,652                 | )          |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                                           |   | (35,326,469             | )              | (30,477,539             | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                                                                                                               |   | 5,901,500               |           | 9,525,748               |       |
|                                                                                                                                                                                                                                                                                                                                                                          |   |                    |           |                    |       |
| **Total Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                                                                                           |   | **$**                   | **14,518,246** | ** **              | **$**      | **15,843,630** | ** ** |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F-2

----

 

**IMAGEWARE SYSTEMS, INC.**

** **

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
|                                                   |   | **TWELVE  MONTHS ENDED  December 31,** |       |
|--------------------------------------------------------|--------|----------------------------------------|------------|
|                                                   |   | **2002**                               |       | **2001** |   |
|                                                   |   |                                   |       |   |   |
| **Revenues:**                                          |   |                                   |       |   |   |
| Product                                                |   | $                                      | 15,115,766 |   | $ | 13,897,194 |   |
| Maintenance                                            |   | 3,139,927                              |       | 2,355,811 |   |
|                                                   |   |                                   |       |   |   |
|                                                   |   | 18,255,693                             |       | 16,253,005 |   |
| **Cost of revenues:**                                  |   |                                   |       |   |   |
| Product                                                |   | 7,060,131                              |       | 6,058,618 |   |
| Maintenance                                            |   | 1,236,316                              |       | 1,140,656 |   |
| Gross profit                                           |   | 9,959,246                              |       | 9,053,731 |   |
|                                                   |   |                                   |       |   |   |
| **Operating expenses:**                                |   |                                   |       |   |   |
| General & administrative                           |   | 6,911,228                              |       | 6,631,995 |   |
| Sales and marketing                                    |   | 4,204,613                              |       | 4,120,881 |   |
| Research & development                             |   | 2,078,777                              |       | 2,090,054 |   |
| Depreciation and amortization                          |   | 894,400                                |       | 2,444,749 |   |
|                                                   |   | 14,089,018                             |       | 15,287,679 |   |
|                                                   |   |                                   |       |   |   |
| Loss from operations                                   |   | (4,129,772                             | )          | (6,233,948 | ) |
|                                                   |   |                                   |       |   |   |
| Interest (income) expense, net                         |   | 652,392                                |       | (127,405 | ) |
|                                                   |   |                                   |       |   |   |
| Other (income) expense, net                            |   | (53,575                                | )          | 11,194 |   |
|                                                   |   |                                   |       |   |   |
| Loss before income taxes                               |   | (4,728,589                             | )          | (6,117,737 | ) |
|                                                   |   |                                   |       |   |   |
| Income tax expense (benefit)                           |   | 120,341                                |       | (184,828 | ) |
|                                                   |   |                                   |       |   |   |
| Net loss                                               |   | $                                      | (4,848,930 | ) | $ | (5,932,909 | ) |
|                                                   |   |                                   |       |   |   |
| Basic and diluted (loss) per common share - see Note 2 |   | $                                      | (0.90      | ) | $ | (1.22 | ) |
| Weighted-average shares (basic and diluted)            |   | 5,483,973                              |       | 4,937,588 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F-3

----

 

**ImageWare Systems, Inc.**

** **

**Consolidated Statements of CashFlows**

** **

**For the Years Ended December 31, 2002and 2001**

 
|                                                                        |   | **2002**   |       | **2001**   | ** ** |
|-----------------------------------------------------------------------------|--------|------------|------------|------------|------------|
| **Cash flows from operating activities**                                    |   |       |       |       |       |
| Net loss                                                                    |   | $          | (4,848,930 | )          | $          | (5,932,909 | ) |
| Adjustments to reconcile net loss to net cash used by operating  activities |   |       |       |       |       |
| Depreciation and amortization                                               |   | 894,400    |       | 2,444,749  |       |
| Amortization of debt discount and debt issuance costs                       |   | 442,822    |       | —     |       |
| Stock-based compensation                                                    |   | —     |       | 57,722     |       |
| Change in assets and liabilities, net of businesses acquired                |   |       |       |       |       |
| Restricted cash and cash equivalents                                        |   | —     |       | 469,663    |       |
| Accounts receivable, net                                                    |   | 1,246,549  |       | (574,909   | )          |
| Inventory                                                                   |   | (931,879   | )          | 314,383    |       |
| Other current assets                                                        |   | 568,401    |       | 158,212    |       |
| Intangible and other assets                                                 |   | (2,986     | )          | (57,097    | )          |
| Accounts payable                                                            |   | 313,772    |       | 1,042,485  |       |
| Accrued expenses                                                            |   | (85,291    | )          | (272,717   | )          |
| Accrued interest                                                            |   | 155,323    |       | (156,775   | )          |
| Deferred revenue                                                            |   | (17,134    | )          | 320,784    |       |
| Pension obligation                                                          |   | 196,552    |       | —     |       |
|                                                                        |   |       |       |       |       |
| Total adjustments                                                           |   | 2,780,529  |       | 3,746,500  |       |
|                                                                        |   |       |       |       |       |
| Net cash used by operating activities                                       |   | (2,068,401 | )          | (2,186,409 | )          |
|                                                                        |   |       |       |       |       |
| **Cash flows from investing activities**                                    |   |       |       |       |       |
| Purchase of property and equipment                                          |   | (354,661   | )          | (427,282   | )          |
| Acquisition of businesses, net of cash acquired                             |   | —     |       | (3,280,273 | )          |
| Payment on advances from related stockholders                               |   | (161,360   | )          | (104,500   | )          |
|                                                                        |   |       |       |       |       |
| Net cash used by investing activities                                       |   | (516,021   | )          | (3,812,055 | )          |
|                                                                        |   |       |       |       |       |
| **Cash flows from financing activities**                                    |   |       |       |       |       |
| Proceeds from issuance of notes payable                                     |   | 2,500,000  |       |       |       |
| Repayment of notes payable                                                  |   | (20,934    | )          | (582,526   | )          |
| Debt issuance costs                                                         |   | (383,885   | )          | —     |       |
| Proceeds from bank line of credit                                           |   | 165,625    |       | —     |       |
| Proceeds from exercise of options and warrants                              |   | 1,247      |       | 105,856    |       |
|                                                                        |   |       |       |       |       |
| Net cash provided by financing activities                                   |   | 2,262,053  |       | (476,670   | )          |
| Effect of exchange rate changes on cash                                     |   | 149,533    |       | (36,652    | )          |
| Net decrease in cash                                                        |   | (172,836   | )          | (6,511,786 | )          |
|                                                                        |   |       |       |       |       |
| Cash at beginning of period                                                 |   | 387,773    |       | 6,899,559  |       |
|                                                                        |   |       |       |       |       |
| Cash at end of period                                                       |   | $          | 214,937    |       | $          | 387,773 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F-4

----

 

**ImageWareSystems, Inc.**

 

**ConsolidatedStatements of Shareholders’ Equity**

 

for the Years Ended December 31, 2001 and 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, 2000                                               |   | 334,400                                           |       | $                | 3,344      |               | 4,197,366  |                             | $          | 40,724                                   |       | (6,704                               | )          | $                                                    | (63,688    | )                        | $           | 34,667,147 |   | $ | (63,126 | ) | $ | (150,000 | ) | $ | — |   | $ | (24,544,630 | ) | $ | 9,889,771 |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Preferred Stock conversion to common stock                                 |   | (30,000                                           | )          | (300             | )          | 5,685              |       | 57                               |       | —                                   |       | —                               |       | 243                                                  |       | —                   |        | —     |   | — |   | — |   | (0 | ) |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Issuance of common stock for asset purchase                                |   | —                                            |       | —           |       | 1,265,000          |       | 12,650                           |       | —                                   |       | —                               |       | 5,429,310                                            |       | —                   |        | —     |   | — |   | — |   | 5,441,960 |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Issuance of common stock pursuant to option and warrant exercise for  cash |   | —                                            |       | —           |       | 20,023             |       | 200                              |       | —                                   |       | —                               |       | 105,656                                              |       | —                   |        | —     |   | — |   | — |   | 105,856 |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Warrants issued to non- employees for services                             |   | —                                            |       | —           |       | —             |       | —                           |       | —                                   |       | —                               |       | 34,892                                               |       | —                   |        | —     |   | — |   | — |   | 34,892 |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Reversal of deferred compensation for stock options granted to  employees  |   | —                                            |       | —           |       | —             |       | —                           |       | —                                   |       | —                               |       | (40,297                                              | )          | 40,297                   |        | —     |   | — |   | — |   | — |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Amortization of stock-based compensation                                   |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       | 22,829                   |        |       |   |   |   |   |   | 22,829 |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Share adjustment due to fractional share conversion                        |   | —                                            |       | —           |       | (59                | )          | —                           |       | —                                   |       | —                               |       | —                                               |       | —                   |        | —     |   | — |   | — |   | — |   |
| Other comprehensive loss                                                   |   | —                                            |       | —           |       | —             |       | —                           |       | —                                   |       | —                               |       | —                                               |       | —                   |        | —     |   | (36,652 | ) | — |   | (36,652 | ) |
| Net loss                                                                   |   | —                                            |       | —           |       | —             |       | —                           |       | —                                   |       | —                               |       | —                                               |       | —                   |        | —     |   | — |   | (5,932,909 | ) | (5,932,909 | ) |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| 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 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 |   |
|                                                                       |   |                                              |       |             |       |               |       |                             |       |                                     |       |                                 |       |                                                 |       |                     |        |       |   |   |   |   |   |   |   |
| Other comprehensive income                                                 |   | —                                            |       | —           |       | —             |       | —                           |       | —                                   |       | —                               |       | —                                               |       | —                   |        | —     |   | 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 |   |
|                                                                            |        |                                                   |            |                  |            |                    |            |                                  |            |                                          |            |                                      |            |                                                      |            |                          |             |            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

F-5

----

 

**IMAGEWARESYSTEMS, INC.**

**CONSOLIDATED STATEMENTSOF COMPREHENSIVE INCOME (LOSS)**

 
|                                     |   | **TWELVE  MONTHS ENDED  DECEMBER 31,** |       |
|------------------------------------------|--------|----------------------------------------|------------|
|                                     |   | **2002**                               | ** ** | **2001** |   |
|                                     |   |                                   | * *   |   | * * |
| Net income (loss)                        |   | $                                      | (4,848,930 | ) | $ | (5,932,909 | ) |
| Other comprehensive income (loss):       |   |                                   |       |   |   |
| Foreign currency  translation adjustment |   | 149,533                                |       | (36,652 | ) |
| Comprehensive income (loss)              |   | $                                      | (4,699,397 | ) | $ | (5,969,561 | ) |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

F-6

----

 

**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**DECEMBER 31, 2002 AND 2001**

 

**1.             DESCRIPTIONOF BUSINESS AND OPERATIONS**

 

ImageWare Systems, Inc. (the “Company”),formerly known as ImageWare Software, Inc., was incorporated in the Stateof California on February 6, 1987. The Company develops, sells andsupports a suite of modular software products used by law enforcement andpublic safety agencies to manage criminal history records and to investigatecrime and designs systems which utilize digital imaging in the production ofphoto identification cards, documents and identification badging systems.

 

*Going Concern*

 

The consolidated financial statements have beenprepared assuming that the Company will continue as a going concern. TheCompany has used approximately $2,068,000 in operations during the year endedDecember 31, 2002 and has suffered recurring losses from operations andhas an accumulated deficit of approximately $35,326,000 that raises substantialdoubt about its ability to continue as a going concern.

 

The Company operates in markets that are emergingand highly competitive. There is no assurance that the Company will operate ata profit in the future.

 

New financing will be required to fund workingcapital and operations. The Company is exploring the possible sale of equitysecurities or debt financing, and believes that additional financing will beavailable under terms and conditions that are acceptable to the Company.However, there can be no assurance that additional financing will be available.In the event financing is not available in the time frame required, the Companywill be forced to reduce its rate of growth, if any, reduce operating expenses,curtail sales and marketing activities and reschedule research and developmentprojects. In addition, the Company might be required to sell certain of itsassets or license its technologies to others. These actions, while necessaryfor the continuance of operations during a time of cash constraints and ashortage of working capital, could adversely affect the Company’s business.

 

The financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

**2.             SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

*Principles of consolidation*

 

The consolidated financial statements include theaccounts of the Company and its wholly-owned subsidiaries. Allsignificant intercompany transactions and balances have been eliminated.

 

*Use of estimates*

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements, and thereported amounts of revenue and expense during the reporting period.Significant estimates include allowance for doubtful accounts receivable,deferred tax asset valuation allowances, accounting for loss contingencies, andrecoverability of goodwill and acquired intangible assets. Actual results coulddiffer from estimates.

 

F-7

----

 

*Property and equipment*

 

Property and equipment, consisting of furnitureand equipment, are stated at cost and are being depreciated on a straight-linebasis over the estimated useful lives of the assets, which range from three tofive years. Maintenance and repairs are charged to expense as incurred. Majorrenewals or improvements are capitalized. When assets are sold or abandoned,the cost and related accumulated depreciation are removed from the accounts andthe resulting gain or loss is recognized.

 

*Long-lived assets*

 

Long-lived assets and identifiable intangibles arereviewed for impairment using fair value methodologies whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. At December 31, 2002 and 2001, there was no impairment ofthe Company’s long-lived assets.

 

*Intangible assets*

 

Intangible assets consist of patents, technology,trademarks and tradenames, customer relationship, goodwill and non-competitionagreements which are stated at cost. Amortization is calculated using thestraight-line method ranging from 5 to 15 years.

 

*Concentration of credit risk*

 

Financial instruments which potentially subjectthe Company to concentrations of credit risk consist principally of tradeaccounts receivable. Sales are typically made on credit and the Companygenerally does not require collateral. The Company performs ongoing creditevaluations of its customers’ financial condition and maintains an allowancefor doubtful accounts. Accounts receivable are presented net of an allowancefor doubtful accounts of $410,147 and $548,300 and at December 31, 2002and 2001, respectively.

 

In 2002, one customer accounted for 18% of theCompany’s revenues.  In 2001, there wereno customers who accounted for more than 10% of the Company’s revenues.

 

As of December 31, 2002, one customeraccounted for 25% of total accounts receivable. At December 31, 2001, onecustomer accounted for 19% of total accounts receivable.

 

*Stock-based compensation*

 

Stock-based compensation to employees hasbeen recognized as the difference between the per share fair value of theunderlying stock and the stock option exercise at the initial grant date. Thecost of stock options granted for services, other than those issued toemployees, are recorded at the fair value of the stock option.

 

Had compensation cost for the Company’s stockoption plan been determined based on the fair value at the grant date forawards consistent with the provisions of Statement of Financial AccountingStandards, ("SFAS") No. 123, Accounting for Stock-BasedCompensation, the Company’s net losses would have been increased to the proforma amount indicated below for the years ended December 31, 2002 and2001:

 
|                                                             |   | **2002** |       | **2001** |   |
|------------------------------------------------------------------|--------|----------|------------|----------|--------|
| NET LOSS:                                                        |   |     |       |     |   |
| As reported                                                      |   | $        | (4,848,930 | )        | $      | (5,932,909 | ) |
| Stock based  compensation included in net loss                   |   | —   |       | 57,722   |   |
| Stock based  employee compensation under fair value based method |   | (918,555 | )          | (693,473 | )      |
| Pro forma net  loss                                              |   | $        | (5,767,485 | )        | $      | (6,568,660 | ) |
| Basic loss per  common share:                                    |   |     |       |     |   |
| As reported                                                      |   | $        | (0.90      | )        | $      | (1.22 | ) |
| Pro forma                                                        |   | (1.06    | )          | (1.34    | )      |

 

The fair value of each option grant is estimatedon the date of grant using the Black-Scholes method with the following weighted-averageassumptions: dividend yield of 0%, risk-free interest rate ranging from 4.00%to 6.32%, expected stock volatility of 65%, and expected lives of five years.The volatility of the Company’s common stock underlying the options was notconsidered for options granted up to March 31, 2000 because the Company’sstock was not publicly traded. For purposes of pro forma disclosures, theestimated fair value of options is amortized to expense over the options’vesting periods using an accelerated graded method in accordance with FinancialAccounting Standards Board Interpretation 28.

 

*Income taxes*

 

Current income tax expense or benefit is theamount of income taxes expected to be payable or refundable for the currentyear. A deferred income tax asset or liability is computed for the expectedfuture impact of differences between the financial reporting and tax

 

F-8

----

 

bases of assets and liabilities and for the expected future tax benefitto be derived from tax credits and loss carryforwards. Deferred tax assets arereduced by a valuation allowance when, in the opinion of management, it is morelikely than not that some portion or all of the deferred tax assets will not berealized.

 

F-9

----

 

*Foreign currency translation*

 

The financial position and results of operationsof the Company’s foreign subsidiaries are measured using the foreignsubsidiary’s local currency as the functional currency. Revenues and expensesof such subsidiaries have been translated into U.S. dollars at average exchangerates prevailing during the period. Assets and liabilities have been translatedat the rates of exchange on the balance sheet date. The resulting translationgain and loss adjustments are recorded directly as a separate component ofshareholders’ equity, unless there is a sale or complete liquidation of theunderlying foreign investments. The Company translates foreign currencies ofits German, Canadian and Singapore subsidiaries. Foreign currency translationadjustments resulted in gains of $150,000 for the twelve months ended 2002 andlosses of $37,000 in 2001.

 

*Comprehensive Income*

 

Comprehensive income consists of net loss andother gains and losses affecting shareholders’ equity that, under generallyaccepted accounting principles, are excluded from net income (loss). For theCompany, such items consist of foreign currency translation gains and losses.The Company had comprehensive gains of $150,000 in 2002 and comprehensivelosses of $37,000 in 2001 resulting from foreign currency translations.

 

*Revenue recognition*

 

The Company recognizes revenue and profit as workprogresses on long-term, fixed-price contracts involving significant amount ofhardware and software customization using the percentage of completion methodbased on costs incurred to date compared to total estimated costs atcompletion. Revenue from contracts for which we cannot reliably estimate totalcosts or there are not significant amounts of customization are recognized uponcompletion. Our revenue from periodic maintenance agreements is generallyrecognized ratably over the respective maintenance periods provided nosignificant obligations remain and collectibility of the related receivable isprobable. The Company also generates non-recurring revenue from the licensingof its software. Software license revenue is recognized upon the execution of alicense agreement, upon deliverance, fees are fixed and determinable,collectibility is probable and when all other significant obligations have beenfulfilled. The Company also generates revenue from the sale of identificationcard media and other software. Revenue for these items is recognized upondelivery of these products to the customer. The Company also generates revenue fromthe sale of professional digital photography software. Revenue for these itemsis recognized upon delivery of these products to the customer.

 

*Capitalized software developmentcosts*

 

Software development costs incurred prior to theestablishment of technological feasibility are charged to research anddevelopment expense as incurred. Technological feasibility is established uponcompletion of a working model. Software development costs incurred subsequentto the time a product’s technological feasibility has been established, throughthe time the product is available for general release to customers, arecapitalized, if material. To date, the Company has not capitalized any softwarecosts as the period between achieving technological feasibility and the generalavailability of the related products has been short and software developmentcosts qualifying for capitalization have been insignificant.

 

*Earnings (loss) per share*

 

Basic earnings (loss) per common share iscalculated by dividing net income (loss) available to common shareholders forthe period by the weighted-average number of common shares outstandingduring the period. Diluted earnings per common share is calculated by dividingnet income (loss) available to common shareholders for the period by theweighted-average number of common shares outstanding during the period,increased to include, if dilutive, the number of additional common shares thatwould have been outstanding if the potential common shares, if dilutive, hadbeen issued. The dilutive effect of outstanding stock options is included inthe calculation of diluted earnings per common share, if dilutive, using thetreasury stock method. During the years ended December 31, 2002 and 2001,the Company has excluded all convertible preferred stock and convertible notespayable and outstanding stock options from the calculation of diluted loss pershare, as their effect would have been antidilutive.

 

F-10

----

 

The following table sets forth the computation ofbasic and diluted loss per share for the years ended December 31, 2002 and2001:

 
|                                      |   | **TWELVE  MONTHS ENDED  DECEMBER 31,** |       |
|-------------------------------------------|--------|----------------------------------------|------------|
|                                      |   | **2002**                               |       | **2001** |   |
| Numerator                                 |   |                                   |       |   |   |
| Net loss                                  |   | $                                      | (4,848,930 | ) | $ | (5,932,909 | ) |
| Less Series B preferred dividends         |   | (63,764                                | )          | (70,482 | ) |
| Net loss available to common shareholders |   | $                                      | (4,912,694 | ) | $ | (6,003,391 | ) |
|                                      |   |                                   |       |   |   |
| Denominator                               |   |                                   |       |   |   |
| Weighted-average shares outstanding       |   | 5,483,973                              |       | 4,937,588 |   |
|                                      |   |                                   |       |   |   |
| Basic and diluted loss per share          |   | $                                      | (0.90      | ) | $ | (1.22 | ) |

 

*Segment information*

 

Prior to its acquisition of G & A,Castleworks and E-Focus, the Company operated in one business segment. With itsacquisition of G & A, Castleworks and E-Focus, the Company is nowcomprised of three reportable segments: Law Enforcement, Identification and DigitalPhotography. The Law Enforcement segment develops, sells and supports a suiteof modular software products and designs systems used by law enforcement andpublic safety agencies to manage criminal history records and investigatecrime. The Identification segment develops, sells and supports software anddesigns systems which utilize digital imaging in the production of photoidentification cards, documents and identification badging systems. The DigitalPhotography segment develops digital imaging software for photographicpurposes.

 

Corporate assets are comprised primarily of cashand cash equivalents and other assets providing benefits to all businesssegments.

 

There are no intersegment transactions.

 

F-11

----

 

The table below summarizes information aboutreportable segments for the years ended December 31, 2002 and 2001:

 
|                                 |   | **Year Ended December 31,** |       |
|--------------------------------------|--------|-----------------------------|------------|
|                                 |   | **2002**                    |       | **2001** |   |
| Net Revenue:                         |   |                        |       |   |   |
| Law Enforcement                      |   | $                           | 4,247,645  |   | $ | 5,621,851 |   |
| Identification                       |   | 13,088,453                  |       | 9,899,802 |   |
| Digital Photography                  |   | 919,595                     |       | 731,352 |   |
| Total consolidated net sales         |   | $                           | 18,255,693 |   | $ | 16,253,005 |   |
| Operating profit (loss):             |   |                        |       |   |   |
| Law Enforcement                      |   | $                           | 183,103    |   | $ | (2,128,765 | ) |
| Identification                       |   | (3,205,486                  | )          | (3,679,392 | ) |
| Digital Photography                  |   | (1,107,389                  | )          | (425,791 | ) |
| Other unallocated amounts:           |   |                        |       |   |   |
| Interest expense (income)            |   | 652,392                     |       | (127,405 | ) |
| Other expense (income)               |   | (53,575                     | )          | 11,194 |   |
| Income (loss) before taxes           |   | $                           | (4,728,589 | ) | $ | (6,117,737 | ) |
| Total Assets by Segment:             |   |                        |       |   |   |
| Law Enforcement                      |   | $                           | 1,167,292  |   | $ | 2,937,345 |   |
| Identification                       |   | 10,754,234                  |       | 4,711,657 |   |
| Digital Photography                  |   | 1,712,032                   |       | 0 |   |
| Total assets for reportable segments |   | 13,633,558                  |       | 7,649,002 |   |
| Corporate                            |   | 884,688                     |       | 8,194,628 |   |
| Total consolidated assets            |   | $                           | 14,518,246 |   | $ | 15,843,630 |   |

 

The Company has total assets in foreign locationsas follows: $3,868,000 in Germany, $305,000 in Canada and $414,000 inSingapore. Revenues generated from the Company’s foreign locations were$7,398,000 and $3,362,000 for years ended December 31, 2002 and 2001,respectively.

 

*New Accounting Pronouncements*

 

In December 2002, the FASB issued SFAS 148 — *Accounting for Stock-Based Compensation — Transitionand Disclosure — an amendment of FAS 123.*Accounting for Stock-BasedCompensation was issued to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. In addition, this Statement amends the disclosurerequirements of Statement 123 to require prominent disclosures in both annualand interim financial statements about the method of accounting for stock-basedemployee compensation and the effect of the method used on reported results.The adoption of this statement did not have a material effect on the Company’sresults of operations or financial condition. The disclosure provisions of FAS 148 are effective for, and arereflected in, the Company’s 2002 financial statements.

 

In November 2002,the FASB issued FASB Interpretation No. 45 (“FIN 45”), *— “Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others.”*FIN45 requires that a liability be recorded in the guarantor’s balance sheet uponissuance of a guarantee. In addition, FIN 45 requires disclosures about theguarantees that an entity has issued, including a rollforward of the entity’sproduct warranty liabilities. The Company will apply the recognition provisionsof FIN 45 prospectively to guarantees issued after December 31, 2002. Thedisclosure provisions of FIN 45 are effective for the 2002 financialstatements; however no new disclosures were deemed necessary as a result ofadoption. The adoption of FIN 45 is not expected to have a material effect onthe Company’s results of operations or financial condition.

 

In November 2002,the Emerging Issues Task Force (EITF) issued Issue No. 00-21,“Accounting for Revenue Arrangements with Multiple Deliverables.” This issueaddresses determination of whether an arrangement involving more than onedeliverable contains more than one unit of accounting and how arrangementconsideration should be measured and allocated to the separate units ofaccounting. EITF Issue No. 00-21 will be effective for revenuearrangements entered into in fiscal periods beginning after June 15, 2003or the Company may elect to report the change in accounting as acumulative-effect adjustment. The Company is reviewing EITF IssueNo. 00-21 and has not yet determined the impact this issue will have onits operating results and financial position.

 

F-12

----

 

 

*Reclassifications*

 

Certain reclassifications were made to prioryears’ consolidated financial statements to conform to the current yearpresentation.

 

**3.             Acquisitionsand Goodwill**

 

On March 30, 2001, the Company completed thepurchase of substantially all the assets of G & A Imaging Ltd.(G & A), a privately held developer of software and software systemsfor digital identification documents for a total purchase price of $3,046,000in cash ($2,500,000 to selling shareholders and approximately $546,000 indirect transaction costs) and the issuance of 665,000 shares of the Company’scommon stock valued at approximately $3,634,000 based on the fair value of theCompany’s common stock a few days before and after the agreement of terms andannouncement.. The acquisition was accounted for using the purchase method ofaccounting and, accordingly, G & A’s results of operations havebeen included in the consolidated financial statements since the date ofacquisition.

 

On August 10, 2001, the Company completed itsacquisition of Castleworks LLC, a Nevada limited liability company(“Castleworks”), and E-Focus West LLC, a Nevada limited liability company(“E-Focus”), from Castle Holdings LLC, a Nevada limited liability company(“Castle Holdings”) for a total purchase price of $234,000 in cash ($100,000 toselling shareholders and $134,000 in direct transaction costs) and the issuanceof 600,000 shares of the Company’s common stock valued at approximately$1,808,400 based on the fair value of the Company's common stock a few daysbefore and after the agreement of terms and announcement. As a result of thistransaction, Castleworks and E-Focus became wholly owned subsidiaries ofImageWare. The acquisition was accounted for using the purchase method ofaccounting and, accordingly, Castleworks and E-Focus' results of operationshave been included in the consolidated financial statements since the date ofacquisition. Castleworks and E-Focus develop digital imaging software forprofessional photographic purposes.

 

The following (unaudited) pro forma consolidatedresults of operations for the years ended December 31, 2001 has beenprepared as if the acquisition of Goddard, G & A, and Castleworks andE-Focus had occurred at January 1, 2001:

 
|                 |   | **Year ended December 31, 2001** |       |
|----------------------|--------|----------------------------------|------------|
|                 |   |                             | ** ** |
| Sales                |   | $                                | 18,848,000 |   |
| Net (loss)           |   | $                                | (6,337,000 | ) |
| Net (loss) per share |   | $                                | (1.34      | ) |

 

F-13

----

 

The following table presents the allocation of theacquisition cost for the G & A, Castleworks, and E-Focus acquisitions,including professional fees and other related acquisition costs, to the assetsacquired and liabilities assumed:

 
|                                                             |   | **G & A  Imaging** |      | **Castlworks  &E-Focus** |   |
|------------------------------------------------------------------|--------|------------------------|-----------|------------------------------|--------|
| Cash                                                             |   | $                      | —    |                         | $      | 25,000 |   |
| Accounts  receivable                                             |   | 778,000                |      | 224,000                      |   |
| Inventories                                                      |   | 789,000                |      | 189,000                      |   |
| Other current  assets                                            |   | 1,075,000              |      | 21,000                       |   |
| Property, plant  and equipment, net                              |   | 325,000                |      | 248,000                      |   |
| Other  intangibles                                               |   | 2,500,000              |      | 395,000                      |   |
| Goodwill                                                         |   | 3,654,000              |      | 1,245,000                    |   |
| Total assets                                                     |   | 9,121,000              |      | 2,347,000                    |   |
|                                                             |   |                   |      |                         |   |
| Amounts payable  to banks and long-term debt due within one year |   | (789,000               | )         | —                       |   |
| Other current  liabilites                                        |   | (1,581,000             | )         | (304,000                     | )      |
| Long-term  obligations, net of current portion                   |   | (71,000                | )         | —                       |   |
| Total liabilites                                                 |   | (2,441,000             | )         | (304,000                     | )      |
| Total  acquisition cost                                          |   | $                      | 6,680,000 |                         | $      | 2,043,000 |   |

 

Management determined the allocation of thepurchase price based upon third-party appraisals using fair valuemethodologies.

 

The following disclosure presents certaininformation the Company’s acquired intangible assets as of December 31, 2002and 2001.  All intangible assets arebeing amortized 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,  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           |       |
| Acquired  Workforce                    |   | 3 years                  |       | —                      |       | —                        |       | —           |       |
|                                   |   |                     |       | $                           | 2,175,000  |                          | $          | (671,717         | )          | $ | 1,503,283 |   |
|                                   |   |                     |       |                        |       |                          |       |             |       |
| At December 31,  2001                  |   |                     |       |                        |       |                          |       |             |       |
| Amortized  acquired intangible assets: |   |                     |       |                        |       |                          |       |             |       |
| Technology                             |   | 5 years                  |       | $                           | 1,160,000  |                          | $          | (291,875         | )          | $ | 868,125 |   |
| Trademarks and  tradenames             |   | 14.5 years               |       | 630,000                     |       | (33,125                       | )          | 596,875          |       |
| Customer  relationship                 |   | 5 years                  |       | 200,000                     |       | (30,000                       | )          | 170,000          |       |
| Non-compete  Agreements                |   | 3 years                  |       | 125,000                     |       | (18,750                       | )          | 106,250          |       |
| Patents                                |   | 4 years                  |       | 60,000                      |       | (6,250                        | )          | 53,750           |       |
| Acquired  Workforce                    |   | 3 years                  |       | 700,000                     |       | (175,000                      | )          | 525,000          |       |
|                                   |   |                     |       | $                           | 2,875,000  |                          | $          | (555,000         | )          | $ | 2,320,000 |   |

 

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

 

Amortization expense for the twelve months endedDecember 31, 2002 was approximately $292,000.

 

F-14

----

 

The estimated acquired intangible amortizationexpense for the next five fiscal years is as follows:

 

 
| **Fical Year  Ended December 31,** |   | **Estimated  Amortization Expense** |   |
|------------------------------------|--------|-------------------------------------|--------|
| 2003                               |   | 383,000                             |   |
| 2004                               |   | 354,000                             |   |
| 2005                               |   | 253,000                             |   |
| 2006                               |   | 50,000                              |   |
| 2007                               |   | 40,000                              |   |

 

The following table presents details of theCompany’s goodwill:

 
| Balance of  Goodwill at December 31, 2001                                   |   | $       | 4,838,317 |   |
|-----------------------------------------------------------------------------|--------|---------|-----------|--------|
| Reclassification of acquired workforce intangible to goodwill               |   | 525,000 |      |
| Changes in fair value estimates of assets acquired and liabilities  assumed |   | (65,690 | )         |
| Balance of Goodwill at December 31, 2002                                    |   | $       | 5,297,627 |   |
|                                                                             |        |         |           |        |  |

 

In June 2002, we completed our transitionalgoodwill and purchased intangibles impairment tests outlined under SFAS 142which required the assessment of goodwill and purchased intangibles forimpairment as of January 1, 2002 and in December 2002, we completed our annualimpairment tests.  These tests wereconducted by determining and comparing the fair value of our reporting units,as defined in SFAS 142, to the reporting unit’s carrying value as of thatdate.  Our reporting units are LawEnforcement, Identification and Digital Photography.  Based on the results of these impairment tests, we determinedthat our goodwill assets and purchased intangible assets were not impaired asof January 1, 2002 or during December 2002. We plan to conduct our annual impairment tests in the fourth quarter ofevery year, unless impairment indicators exist sooner.

 

In accordance with the transitional disclosuresoutlined in SFAS 142, the following table reconciles and summarizes reportedresults for the years ended December 31, 2002 and 2001, adjusted to excludeamortization of goodwill and assembled workforce intangible assets, as if thenon-amortization requirements of SFAS 142 had been applied at the beginning ofeach period presented.

 
|                                                    |   | **Twelve Months Ended  December 31,** |       |
|---------------------------------------------------------|--------|---------------------------------------|------------|
|                                                    |   | **2002**                              |       | **2001** | ** ** |
|                                                    |   |                                  | ** ** |   | ** ** |
| Net loss:                                               |   |                                  |       |   |   |
|                                                    |   |                                  |       |   |   |
| Reported net loss                                       |   | $                                     | (4,848,930 | ) | $ | (5,932,909 | ) |
|                                                    |   |                                  |       |   |   |
| Add back: Goodwill and acquired workforce  amortization |   | –                                |       | 1,608,523 |   |
|                                                    |   |                                  |       |   |   |
| Adjusted net loss                                       |   | $                                     | (4,848,930 | ) | $ | (4,324,386 | ) |
|                                                    |   |                                  |       |   |   |
| Basic and diluted net loss per share:                   |   |                                  |       |   |   |
| Reported basic and diluted net loss per share           |   | $                                     | (0.90      | ) | $ | (1.22 | ) |
|                                                    |   |                                  |       |   |   |
| Amortization of goodwill and acquired workforce         |   | $                                     | –     |   | $ | 0.33 |   |
|                                                    |   |                                  |       |   |   |
| Basic and diluted net loss per share                    |   | $                                     | (0.90      | ) | $ | (0.89 | ) |

 

F-15

----

 

**4.             RestrictedCash**

 

At December 31, 2002 and 2001, the Companyhad $60,000 of restricted cash and cash equivalents which serves as collateralfor irrevocable standby letter of credits that provide financial assurance thatthe Company will fulfill its obligations under certain commitments discussed inNote 9. The cash is held in custody by the issuing bank, is restricted asto withdrawal or use, and is currently invested in time certificates ofdeposits. Income from these investments is paid to the Company.

** **

**5.             Inventory**

 

Inventories at December 31, 2002 and 2001were comprised of finished goods of $1,882,000 and $950,000, respectively.

 

F-16

----

 

**6.             Propertyand Equipment**

 

Property and equipment at December 31, 2002and 2001 consists of:

 
|                          |   | **2002**   |       | **2001**   |       |
|-------------------------------|--------|------------|------------|------------|------------|
|                          |   |       | ** ** |       | ** ** |
| Equipment                     |   | $          | 2,141,722  |       | $          | 1,959,504 |   |
| Leasehold improvements        |   | 100,630    |       | 99,634     |       |
| Furniture                     |   | 281,490    |       | 252,692    |       |
|                          |   | 2,523,842  |       | 2,311,830  |       |
| Less accumulated depreciation |   | (1,482,927 | )          | (1,122,931 | )          |
|                          |   | $          | 1,040,915  |       | $          | 1,188,899 |   |

 

Total depreciation expense for the years endedDecember 31, 2002 and 2001 was $503,000 and $346,000, respectively.

 

**7.             NotesPayable and Line of Credit**

 

Notes payable consist of the following:

 
|                                                                                                                                                                                     |   | **2002**   |      | **2001** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|-----------|----------|--------|
|                                                                                                                                                                                     |   |       |      |     |   |
| 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    |      | —   |   |
| Short-term note  payable to ITC shareholder.  Such note  accrues interest at 10% and is due upon demand                                                                             |   | 210,125    |      | 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      |      | 169,605  |   |
| Line of credit  payable to bank to accrue interest at 8.4%                                                                                                                               |   | 165,625    |      | —   |   |
| Short-term notes  payable to certain vendors                                                                                                                                             |   | 20,116     |      | 41,048   |   |
| 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  |      | —   |   |
|                                                                                                                                                                                     |   | $          | 2,256,421 |     | $      | 520,778 |   |
| Less current  portion                                                                                                                                                                    |   | (1,004,110 | )         | (520,778 | )      |
| Long-term notes  payable                                                                                                                                                                 |   | $          | 1,252,311 |     | $      | — |   |

 

In May 2002, the Company issued a senior securedpromissory note for $2,000,000 at an interest rate of 12.5%, due May 22,2004.  The note is 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 has recorded the note net of adiscount equal to the fair value allocated to the warrants issued ofapproximately $537,000.

 

The convertible note also contained a beneficialconversion feature, which resulted in additional debt discount of$537,000.  The beneficial conversionamount was measured using the accounting intrinsic value, i.e. the excess ofthe aggregate fair value of the common stock into which the debt is convertibleover the proceeds allocated to the security. The Company is accreting the beneficial conversion feature as interestexpense over the life of the note.  Forthe twelve months ended December 31, 2002, the Company recorded $326,212 asinterest expense from the amortization of the discount related to the fair valueof the warrants and from the accretion of the beneficial conversion feature.

 

The Company also granted the holder of the note anoption to acquire an additional senior secured convertible promissory note withan aggregate principal amount of up to $3,000,000, together with an additionalwarrant to acquire a proportionate number of shares of the common stock of theCompany based upon the actual amount of money invested in the additionalnote.  The terms of the additional

 

F-17

----

 

note and additional warrant would be substantially identical to theinitial note and warrant.

 

In September 2002, the Company issued a secureddemand promissory note for $500,000 at an interest rate of 12.5% to the holderof the convertible promissory note.  Thenote is due and payable upon demand given by the holder.

 

A foreign subsidiary of the Company has a line ofcredit with a commercial bank totaling $269,000.  As of December 31, 2002, the Company had utilized approximately$165,625 of this facility.  Borrowingsunder this facility bear interest at 8.4% per annum and are collateralized by the subsidiary’s accountsreceivable.

 

On June 30, 2001, the Company convertedaccrued liabilities due to an employee into a promissory note in the amount of$269,605. The note bears interest at 10% per annum. Under the terms of thenote, the Company is required to make monthly payments of $15,000 until thenote is paid in full on January 14, 2003. At December 31, 2002, thebalance of this note payable was $8,244.

 

Future maturities of notes payable and lines of credit are as follows asof December 31, 2002:

 
| 2003   |   | $         | 1,004,110 |   |
|--------|--------|-----------|-----------|--------|
| 2004   |   | 2,000,000 |      |
| 2005   |   | -         |      |
| 2006   |   | -         |      |
| 2007   |   | -         |      |
|   |   | $         | 3,004,110 |   |

 

The Company is accreting the discount on theSenior Secured Convertible note through May 22, 2004, the maturity date.

 

F-18

----

 

**8.             IncomeTaxes**

 

The significant components of the income tax provision (benefit) are asfollows:
|         |   | **December  31,** |    |
|--------------|--------|-------------------|---------|
|         |   | **2002**          |    | **2001** |   |
| **Current**  |   |              |    |   |   |
| Federal      |   | $                 | —  |   | $ | — |   |
| State        |   | —            |    | — |   |
| Foreign      |   | —            |    | — |   |
|         |   |              |    |   |   |
|         |   | —            |    | — |   |
| **Deferred** |   |              |    |   |   |
| Federal      |   | —            |    | — |   |
| State        |   | —            |    | — |   |
| Foreign      |   | 120,341           |    | (184,828 | ) |
|         |   |              |    |   |   |
|         |   | $                 | 120,341 |   | $ | (184,828 | ) |

 

The principal components of the Company’s deferred tax assets(liabilities) at December 31, 2002 and 2001 are as follows:
|                              |   | **2002**   |      | **2001**   |   |
|-----------------------------------|--------|------------|-----------|------------|--------|
|                              |   |       |      |       |   |
| Net operating  loss carryforwards |   | $          | 6,961,249 |       | $      | 5,196,932 |   |
| Research and  development credits |   | 561,033    |      | 503,797    |   |
| Intangible  Assets                |   | 209,937    |      | 407,953    |   |
| Reserves and  accrued expenses    |   | 281,310    |      | 275,339    |   |
| Deferred revenue                  |   |       |      |       |   |
| Other                             |   | (20,000    | )         | (48,548    | )      |
|                              |   |       |      |       |   |
|                              |   | 7,993,529  |      | 6,335,473  |   |
| Less valuation  allowance         |   | (7,929,042 | )         | (6,150,645 | )      |
|                              |   |       |      |       |   |
| Net deferred tax  assets          |   | $          | 64,487    |       | $      | 184,828 |   |

 

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:
|                                      |   | **2002**  |       | **2001**  |   |
|-------------------------------------------|--------|-----------|------------|-----------|--------|
|                                      |   |      |       |      |   |
| Amounts computed  at statutory rates      |   | $         | (1,548,005 | )         | $      | (2,080,031 | ) |
| State income  tax, net of federal benefit |   | (270,445  | )          | (213,779  | )      |
| Foreign tax                               |   | 120,341   |       | (184,828  | )      |
| Goodwill  amortization                    |   | —    |       | 299,737   |   |
| Other                                     |   | 40,053    |       | (23,949   | )      |
| Net change in  valuation allowance        |   | 1,778,397 |       | 2,018,022 |   |
|                                      |   |      |       |      |   |
|                                      |   | $         | 120,341    |      | $      | 184,828 |   |

** **

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, 2002 and 2001, the Company had federal net operatingloss carryforwards of approximately $18,534,000 and $13,500,000, respectively,state net operating loss carryforwards of approximately $10,022,000 and$7,500,000, respectively, which may be available to offset future taxableincome for tax purposes.  The federalnet operating loss carryforwards expire at various dates from 2003 through2022.  The state net operating losscarryforwards expire at various dates from 2003 through 2007.  In addition, the Company had foreignoperating losses carryforwards of approximately $386,000 at December 31, 2001,which were used during 2002 to offset taxable income of its foreign operations.

 

F-19

----

 

The Company also had federal research credit carryforwards ofapproximately $361,000 and $335,000 and state research credit carryforwards ofapproximately $200,000 and $169,000 for tax purposes at December 31, 2002 and2001, respectively.  The federalcarryforwards will begin to expiring, if unused, in 2007.

 

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 ownershipresulting in a change of control of the Company.  The Company’s use of its net operating loss carryforwards and taxcredit carryforwards will be significantly limited because the Companyunderwent “ownership changes” in 1991, 1995, and 2000.  The effect of the existing limitation hasbeen reflected in the above summary of the deferred tax assets.

 

**9.             Commitmentsand Contingencies**

 

*Employment Agreements*

 

The Company has employment agreements with itsChief Executive Officer, Senior Vice President of Administration and ChiefFinancial Officer,  Vice President ofResearch and Development, President of ImageWare Systems Law Enforcement Group,and President of ImageWare Systems Digital Photography. The Company mayterminate the agreements with or without cause. Should the Company terminatethe agreements without cause, the officers are entitled to compensation rangingfrom 12 to 36 months of salary.

 

*License Agreements*

 

During 2001, the Company renewed a licenseagreement related to technology used in its products. Under the terms of theagreement, the Company is required to pay royalties at fixed fees orpercentages based upon product sales. The agreement expires inOctober 2003. Minimum payments under the terms of the agreement are$100,000 per year.

 

*Letter of Credit*

 

As collateral for performance on the Company’soperating lease for its office and research and development facilities, theCompany is contingently liable under an irrevocable standby letter of credit inthe amount of $30,000. The letter of credit expires July 31, 2003.  As a condition, the bank requires theCompany to invest an equal amount in the form of a one year certificate ofdeposit which matures in March 2003. As of December 31, 2002, there were no drawings against theoutstanding balance.

 

*Litigation*

 

The Company is involved in certain legalproceedings generally incidental to its normal business activities. While theoutcome of such proceedings cannot be accurately predicted, the Company doesnot believe the ultimate resolution of any such existing matters should have amaterial effect on its financial position, results of operations or cash flows.

 

F-20

----

 

*Leases*

 

The Company currently leases office and researchand development space under operating leases which expire at various datesthrough December 2006.

 

At December 31,2002, future minimum lease payments are as follows:

 
|   |   | **Operating  Leases** |    | **Capital  Leases** |   | **Total** |   |
|--------|--------|-----------------------|---------|---------------------|--------|-----------|--------|
| 2003   |   | $                     | 657,077 |                | $      | 2,052     |   | $ | 659,129 |   |
| 2004   |   | $                     | 496,725 |                | $      | 2,052     |   | $ | 498,777 |   |
| 2005   |   | $                     | 477,413 |                | $      | 2,052     |   | $ | 479,465 |   |
| 2006   |   | $                     | 254,871 |                | $      | 684       |   | $ | 255,555 |   |
| 2007   |   | $                     | –  |                | $      | –    |   | $ | – |   |
|   |   |                  | $       | 1,886,086           |   | $         | 6,840  |   | $ | 1,892,926 |   |
|        |        |                       |         |                     |        |           |        |  |  |  |  |

 

The Company is committedto a three year lease for office space housing its Digital Photographyoperations in Costa Mesa, California which is for 4,275 square feet. During the fourth quarter of 2002, the Company consolidated these operationsinto its corporate headquarters in San Diego, California and vacated thepremises.  The Company does not intendto occupy this space and is actively seeking a tenant to sub-lease thisspace.  As of December 31, 2002, the Company has been unable to secure atenant to sub-lease this space.  During the quarter ended December 31,2002, the Company recorded an estimated loss on its lease commitment totaling$132,416, which is included in current accrued liabilities on the balancesheet. In determining this estimated loss for its lease commitment, the Companyhas been required to make various assumptions, including occupancy dates fornew tenants, sub-lease rental rates, tenant improvement allowances, abandonedleasehold improvements and commission payments, that involve estimates andjudgments.  In formulating its assumptions, the Company took into accountcurrent and projected real estate market conditions.  If the Company’sestimates and related assumptions change in the future, the Company may berequired to revise this estimated loss on its lease commitment.  If any revisionsto its estimated loss are necessary, then an additional loss or a benefit willbe recorded.

 

Rental expense under operating leases for theyears ended December 31, 2002 and 2001 was approximately $1,006,000 and$819,892 respectively.

 

**10.          Equity**

 

The Company’s Articles of Incorporation wereamended effective August 31, 1994 and authorize the issuance of twoclasses of stock to be designated “Common Stock” and “Preferred Stock,” providethat both Common and Preferred Stock shall have a par value of $.01 per shareand authorize the Company to issue 50,000,000 shares of Common Stock and4,000,000 shares of Preferred Stock. The Preferred Stock may be divided intosuch number of series and with the rights, preferences, privileges andrestrictions as the Board of Directors may determine.

 

*Series B Convertible,Redeemable Preferred Stock*

 

In April 1995, the Company’s Articles ofIncorporation were amended to authorize 750,000 shares of Series BConvertible Redeemable Preferred Stock (“Series B”). Each 5.275 shares ofSeries B are convertible into one share of the Company’s common stock. Asof December 31, 2002, the Company had 269,400 shares of Series Boutstanding.

 

The holders of Series B are entitled tocumulative preferred dividends payable at the rate of $.2125 per share perannum commencing April 30, 1996, subject to legally available funds. TheSeries B plus accrued but unpaid dividends are convertible at the optionof the holder into shares of common stock at a conversion price equal to theoriginal Series B issue price as adjusted to prevent dilution. TheSeries B will automatically be converted into shares of common stock uponthe closing of an underwritten public offering at a price per common share ofnot less than $31.65. If the public offering price is less than $31.65 but atleast $21.10 per share, the conversion shall still be automatic upon writtenconsent of a majority of the then outstanding shareholders of Series B.

 

The Series B, on an as-converted basis, havethe same voting rights per share as the Company’s common shares; provided, thatthe Series B has a special right to elect one director if the Companydefaults in the payment of any dividend to the holders of Series B. TheSeries B are entitled to initial

 

F-21

----

 

distributions of $2.50 per shareof Series B outstanding, upon liquidation and in preference to commonshares and any other series of preferred stock plus all accrued but unpaiddividends.

 

Any time after December 31, 2000, the Companyhas the right to redeem all or some of the outstanding shares of Series Bat a price equal to the original issue price, plus all accrued but unpaiddividends.

 

As of December 31, 2001, the Company had304,400 shares of Series B outstanding. During 2002, 35,000 shares ofSeries B preferred stock were converted into 7,663 shares of common stock.At December 31, 2002 and 2001, the Company had cumulative undeclareddividends of $146,337 and $81,750, respectively.

 

*Warrants*

 

As of December 31, 2002, warrants to purchase2,865,227 shares of common stock at prices ranging from $4.74 to $16.46 wereoutstanding. All warrants are exercisable as of December 31, 2001 andexpire at various dates through September 2005.

 

**11.          StockOption Plans**

 

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

 

The 1994 Plan originally provided for officers andother key employees to receive nontransferable incentive stock options topurchase up to 170,616 shares of the Company’s common stock.  The number of stock options issued andoutstanding and the number of stock options remaining available for futureissuance are shown in the table below. The option price per share must be at least equal to 100% of the marketvalue of the Company’s common stock on the date of grant and the term may notexceed ten years.

 

The Nonqualified Plan originally provided fordirectors and consultants to receive nontransferable options to purchase up to18,957 shares of the Company’s common stock. The number of options issued and outstanding and the number of optionsremaining available for future issuance are shown in the table below.  The option price per share must be at leastequal to 85% of the market value of the Company’s common stock on the date ofgrant and the term may not exceed five years.

 

Both the 1994 Plan and the Nonqualified Plan areadministered by the Board of Directors or a Committee of the Board whichdetermines the employees, directors or consultants which will be grantedoptions and the terms of the options, including vesting provisions which to datehas been over a three year period. Both the 1994 Plan and the Nonqualified Planexpire on August 31, 2004.

 

Due to a significant decline in the estimated fairvalue of the Company’s common stock, in February 1999, the exercise priceof previously granted stock options was repriced to $5.28 per share, which wasbased upon the fair value of the Company’s common stock as of that date, asdetermined by the Company’s Board of Directors. The Company was required torecord compensation expense equal to the difference between the estimated fairvalue of the common stock and the exercise price of the repriced options. Forthe years ended December 31, 2002 and 2001, the Company recorded nocompensation expense as the exercise price was equal or above the estimated fairvalue.

 

On December 17, 1999, the Company’s Board ofDirectors adopted the ImageWare Systems, Inc. Amended and Restated 1999Stock Option Plan (the “1999 Plan”). Under the terms of the 1999 Plan, theCompany could, originally, issue up to 350,000 non-qualified or incentive stockoptions to purchase common stock of the Company.  The number of options issued and outstanding and the number ofoptions remaining 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 ofDirectors approved adoption of the 2001 Equity Incentive Plan (the “2001Plan”). Under the terms of the 2001 Plan, the Company may issue stock

 

F-22

----

 

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 ofDirectors or a Committee of the Board as provided in the 2001 Plan. Optionsgranted under the 2001 Plan shall not be less than 85% of the market value ofthe Company’s common stock on the date of the grant, and, in some cases, maynot be less than 110% of such fair market value. The term of options grantedunder the 2001 Plan as well as their vesting are determined by the Board and todate, options have been granted with a ten year term and vesting over a threeyear period. While the Board may suspend or terminate the 2001 Plan at anytime, if not terminated earlier, it will terminate on the day before its tenthanniversary of the date of adoption.

 

# Stock Option Plans

# As of December 31, 2002

 

|               |   | **Number of  securities to be issued upon exercise of outstanding options, warrants and rights** |   | **Number of  securities remaining available for future issuance under equity compensation plans   (excluding securities reflected in column (a))** |   |
|--------------------|--------|-----------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|               |   | (a)                                                                                                             |   | (b)                                                                                                                                                                    |   |
| 1994 Plan          |   | 121,708                                                                                                         |   | 28,245                                                                                                                                                                 |   |
| Nonqualified  Plan |   | 18,957                                                                                                          |   | -0-                                                                                                                                                                    |   |
| 1999 Plan          |   | 347,400                                                                                                         |   | 1,660                                                                                                                                                                  |   |
| 2001 Plan          |   | 909,613                                                                                                         |   | 89,655                                                                                                                                                                 |   |
| Total              |   | 1,397,678                                                                                                       |   | 119,560                                                                                                                                                                |   |

 

 

F-23

----

 

The following table summarizes employee stockoption activity since December 31, 2000:

 

F-24

----

 
|                         |   | **Options** |   | **Weighted-Average  Exercise Price** |   |
|------------------------------|--------|-------------|--------|--------------------------------------|--------|
|                         |   |        |   |                                 |   |
| Balance at December 31, 2000 |   | 592,703     |   | $                                    | 6.36   |   |
| Granted                      |   | 853,833     |   | $                                    | 3.47   |   |
| Expired/canceled             |   | (116,096    | )      | $                                    | 5.53   |   |
| Exercised                    |   | (20,023     | )      | $                                    | 5.29   |   |
|                         |   |        |   |                                 |   |
| 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   |   |

 

F-25

----

 

At December 31, 2002, a total of 745,068options were exercisable at a weighted average price of $5.22 per share. AtDecember 31, 2001, a total of 327,471 options were exercisable at aweighted average price of $6.31 per share.

 

The following table summarizes information aboutemployee stock options outstanding and exercisable at December 31, 2002:

 
|                                 |   | **Options Outstanding** |       |                                          |   | **Options Exercisable**               |   |
|--------------------------------------|--------|-------------------------|------------|-----------------------------------------------|--------|---------------------------------------|--------|
| **Exercise Price**                   |   | **Number  Outstanding** |       | **Weighted-Average   Remaining Life (Years)** |   | **Weighted-Average   Exercise Price** |   | **Number  Exercisable** |   | **Weighted-  Average   Exercise Price** | ** ** |
|                                 |   |                    |       |                                          |   |                                  |   |   |   |   |   |
| $ 1.99 -  2.15                  |   | 125,000                 |       | 9.76                                          |   | $                                     | 2.05   |   | 0 |   | $ | 0.00 |   |
| $ 3.00 -  4.90                  |   | 557,146                 |       | 8.73                                          |   | $                                     | 3.05   |   | 255,677 |   | $ | 3.00 |   |
| $      5.28 |   | 121,708                 |       | 1.12                                          |   | $                                     | 5.28   |   | 121,708 |   | $ | 5.28 |   |
| $ 5.29 -  6.51                  |   | 494,867                 |       | 8.06                                          |   | $                                     | 6.11   |   | 268,725 |   | $ | 6.26 |   |
| $ 8.00 -11.00                        |   | 98,957                  |       | 5.95                                          |   | $                                     | 8.07   |   | 98,958 |   | $ | 8.07 |   |
|                                 |   |                    |       |                                          |   |                                  |   |   |   |   |   |
| **Total**                            |   | **1,397,678**           | ** ** |                                          |   |                                  |   | **745,068** |   |   |   |

 

The weighted-average grant-date fair value pershare of options granted to employees during the years ended December 31,2002 and 2001 was $2.59 and $2.65, respectively.

 

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

 

During 1995, the Company adopted a definedcontribution 401(k) retirement plan (the “Plan”). All employees aged21 years and older become participants after completion of three months ofemployment. The Plan provides for annual contributions by the Companydetermined at the discretion of the Board of Directors. Participants maycontribute up to 20% of their compensation.

 

Employees are fully vested in their share of theCompany’s contributions after the completion of five years of service. TheCompany made a contribution in 2001 for the 2000 plan year of $42,031. Thecompany has accrued a contribution of $50,000 for the 2002 plan year.

 

**13.****                               PensionPlan**

 

One of the Company’s foreign subsidiaries maintains a defined benefitpension plan that provide benefits based on length of service and final averageearnings. Periodic benefit costs for 2001 are from the date of the Company'sacquisition of the pension plan, March 30, 2001, through December 31,2001.

 

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:

 
|                                                    |   | **2002** |     | **2001** |   |
|---------------------------------------------------------|--------|----------|----------|----------|--------|
| Change in projected benefit obligation:                 |   |     |     |     |   |
| Benefit obligation at beginning of year                 |   | $        | 588,573  |     | $      | 304,611 |   |
| Service cost                                            |   | 115,186  |     | 33,123   |   |
| Interest cost                                           |   | 59,047   |     | 35,619   |   |
| Actuarial gain (loss)                                   |   | (4,323   | )        | 215,220  |   |
| Effect of exchange rate changes                         |   | 125,000  |     | —   |   |
| Benefits paid                                           |   | —   |     | —   |   |
| Benefit obligation at end of year                       |   | 883,483  |     | 588,573  |   |
|                                                    |   |     |     |     |   |
| Change in plan assets                                   |   |     |     |     |   |
| Fair value of plan assets at beginning of year          |   | 163,784  |     | 124,079  |   |
| Actual return of plan assets                            |   | (11,104  | )        | (7,576   | )      |
| Company contributions                                   |   | 82,531   |     | 47,281   |   |
| Benefits paid                                           |   | —   |     | —   |   |
| Fair value of plan assets at end of year                |   | 235,211  |     | 163,784  |   |
|                                                    |   |     |     |     |   |
| Unfunded status                                         |   | (648,272 | )        | (424,789 | )      |
| Unrecognized acturial loss                              |   | 242,151  |     | 215,220  |   |
| Unrecognized prior service (benefit) cost               |   | —   |     | —   |   |
| Unrecognized transition (asset) liability               |   | —   |     | —   |   |
| Prepaid (accrued) benefit cost                          |   | $        | (406,121 | )        | $      | (209,569 | ) |
|                                                    |   |     |     |     |   |
| Weighted-average assumptions as of December 31:         |   |     |     |     |   |
| Discount rate                                           |   | 6.0      | %        | 6.0      | %      |
| Expected return on plan assets                          |   | 7.0      | %        | 7.0      | %      |
| Rate of compensation increase                           |   | 2.5      | %        | 2.5      | %      |
|                                                    |   |     |     |     |   |
| Components of net periodic benefit cost are as follows: |   |     |     |     |   |
| Service cost                                            |   | 115,186  |     | 33,123   |   |
| Interest cost on projected benefit obligations          |   | 59,047   |     | 35,619   |   |
| Expected return on plan assets                          |   | (13,837  | )        | (11,057  | )      |
| Amortization of prior service costs                     |   | —   |     | —   |   |
| Amortization of acturial loss                           |   | 5,845    |     | —   |   |
| Net periodic benefit costs                              |   | 166,241  |     | 57,685   |   |

 

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

 

The Company adopted the provisions of Statement ofFinancial Accounting Standard (“SFAS”) No. 146 — Accounting for CostsAssociated with Exit or Disposal Activities in the fourth fiscal quarter of theyear ended December 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.

 

**15.          RelatedParty Transactions**

 

RDL Holdings LTD ("RDL") isconsidered to be an affiliated entity because a major shareholder of thisentity is also a major shareholder of the Company.

 

ITC entered into a five-year operating lease forits office and research and development facilities from RDL. The Companyrecorded rent expense of $26,000 and $270,000 for the years endedDecember 31, 2002 and 2001, respectively. At December 31, 2002,  $76,000 in accrued rent remained unpaid.

 

Prior to the consummation of the ITC merger,certain ITC shareholders advanced funds to ITC on a regular basis for generalcorporate and working capital purposes. Amounts owed to the shareholders forthese advances at December 31, 2002 and 2001 were $208,000 and $208,000,respectively.

 

The Company has a development contract with anon-employee shareholder. There were no costs incurred under the developmentcontract for the years ended December 31, 2002 and 2001.   In June 2001, the Company converted theamounts due the shareholder into a note payable of 

 

F-26

----

 

$270,000 which includes a principal balance of $170,000 and accrued butunpaid interest of $100,000. The note bears interest at 10% per annum and callsfor monthly payments of $15,000 until January, 2003. In conjunction with theITC transaction, the shareholder became an employee of the Company.  At December 31, 2002, $8,244 of this notewas unpaid and classified as part of notes payable to related parties. Thisnote was paid in full in January 2003.

 

A shareholder of the Company received an annualfee for management services provided to the Company. There were no costsincurred for these management services for the years ended December 31,2002 and 2001, respectively. Amounts owed to the shareholder atDecember 31, 2002 and 2001 were $47,000 and $47,000, respectively. Inconjunction with the ITC transaction, the shareholder became an employee of theCompany. Amounts due to this shareholder for management services accrueinterest at a rate of 10% per annum.

 

During the year ended December 31, 2001, thecompany entered into a consulting agreement for business development consultingservices with a member of the Board of Directors. The agreement, whichcommenced in August 2001, was for a period of five months and may beterminated by either party after October 31, 2001 for any reason. Theagreement called for a fee of $10,000 per month, plus reimbursable expenses. Duringthe year ended December 31, 2001, the Company recorded expenses of $99,000of which approximately $8,000 was unpaid at December 31, 2001andsubsequently paid in 2002. As of December 31, 2001, the agreement hadexpired and was not renewed.

 

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

 

The Massachusetts Institute of Technology andElectronics for Imaging filed a lawsuit against several defendants, includingthe Company. As of January 30, 2003, the Company entered into a settlementagreement in which the plaintiffs agreed to dismiss the lawsuit, withprejudice, in exchange for the payment of a settlement fee. The settlementamount is included in current accrued liabilities on the Company's balancesheet at December 31, 2002.

 

F-27

----