**SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549**

 

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**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,  2003.**                                        |
|       |   |                                                                                          |
| **o**      |   | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |

 

**For the transitionperiod               to               .**

 

**Commission File Number**

 

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**IMAGEWARE SYSTEMS, INC.**

(Name of Small Business Issuer in ItsCharter)

 

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

 

Check whether the issuer: (1) filed allreports required to be filed by Section 13 or 15(d) of the Exchange Actduring the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes ý   No o

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

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

The aggregate market value of the voting andnon-voting common equity held by non-affiliates of the issuer, based on theclosing sales price of the issuer’s Common Stock on March 19, 2004 asreported on the American Stock Exchange was approximately $38,678,831.  Excluded from this computation were 272,002shares of Common Stock held by all current executive officers and directors and1,848,637 shares held by each person who is known by the registrant to own 5%or more of the outstanding Common Stock. Share ownership information of certain persons known by the issuer toown greater than 5% of the outstanding Common Stock for purposes of thepreceding calculation is based solely on information on Schedule 13G filedwith the Commission and is as of March 19, 2004. Exclusion of shares heldby any person or entity should not be construed to indicate that such personpossesses the power, directly or indirectly, to direct or cause the directionof the management or the policies of the Registrant.

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

**DOCUMENTSINCORPORATED BY REFERENCE**

Certain Exhibits filed with the Registrant’sRegistration Statement on Form SB-2 (333-93131), Registration Statement on FormS-3 (333-64192), Form 10-KSB for the Years Ended December 31, 2000and December 31, 2001, Form 10-QSB for each of the quarters endedMarch 31, 2001, June 30, 2001, September 30, 2001,March 31, 2002, and June 30, 2002, and Forms 8-K as filed with theCommission on August 13, 2001 and on May 24, 2002 are incorporated byreference into Part III of this Form 10-KSB.

Transitional Small Business Disclosure Format (check one):

Yes o   No ý

 

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**IMAGEWARE SYSTEMS, INC.**

 

**2003 ANNUAL REPORT ON FORM 10-KSB**

 

**TABLE OF CONTENTS**

 
| PART I    |   |     |   |                                                                                                                   | 1      |   |
|-----------|--------|----------|--------|------------------------------------------------------------------------------------------------------------------------|--------|--------|
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 1.  |   | Description  of Business                                                                                               | 1      |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 2.  |   | Description  of Property                                                                                               | 14     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 3.  |   | Legal  Proceedings                                                                                                     | 14     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 4.  |   | Submission Of Matters To A Vote Of Security  Holders                                                                   | 15     |   |
|      |   |     |   |                                                                                                                   |   |   |
| PART II   |   |     |   |                                                                                                                   | 15     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 5.  |   | Market for Common Equity and Related  Stockholder Matters                                                              | 15     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 6.  |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                            | 16     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 7.  |   | Financial Statements                                                                                                   | 26     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 8.  |   | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosures                                 | 26     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 8A. |   | Controls and Procedures                                                                                                |   |   |
|      |   |     |   |                                                                                                                   |   |   |
| PART  III |   |     |   |                                                                                                                   | 26     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM  9. |   | Directors,  Executive Officers, Promoters and Control Persons; Compliance with Section 16(a)  of the Exchange Act | 26     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 10. |   | Executive Compensation                                                                                                 | 26     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 11. |   | Security Ownership of Certain Beneficial Owners and Management and  Related Stockholder Matters                        | 27     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 12. |   | Certain Relationships and Related Transactions                                                                         | 27     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 13. |   | Exhibits, Lists and Reports on Form 8-K                                                                           | 27     |   |
|      |   |     |   |                                                                                                                   |   |   |
|      |   | ITEM 14. |   | Principal Accountant Fees and Services                                                                                 | 29     |   |

 

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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 inthis document are the property of their respective holders.

 

**PARTI**

 

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 or unknownrisks, uncertainties and other factors, which may cause our actual results,performance or achievements, or industry results to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements. Factors that could cause or contribute to suchdifferences include but are not limited to: our need for additional capital,fluctuations in our operating results, continued new product introductions,market acceptance of our new product introductions, new product introductionsby competitors, technological changes in the digital imaging industry,uncertainties regarding intellectual property rights and the other factorsreferred to herein including, but not limited to, those items discussed under“Risk Factors” below.

 

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

 

**Overview**

 

ImageWare Systems, Inc. utilizes its digital imaging technology toprovide stand alone, networked and web-based software solutions for securecredentials, biometrics, law enforcement and professional photography.   Our secure credential solutions enable thedevelopment of secure IDs & credentials, driver’s licenses, passports,national IDs, access control products, and custom,  biometric-based solutions for the aviation, transportation,government, education and private sectors.  Our lawenforcement / public safety solutions provide comprehensive digital mugshot,booking, facial recognition, data sharing, composite sketching andinvestigative 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 enforcementsolutions which enable agencies to quickly capture, archive, search, retrieve,and share digital photographs and criminal history records on a stand alone,networked, wireless or web-based platform. ImageWare develops, sells andsupports a suite of modular software products used by law enforcement andpublic safety agencies to create and manage criminal history records and toinvestigate crime. Our C.R.I.M.E.S. system consists of eight software modules:Crime Capture System (consisting of the Capture Module and the Retrieval Module),which provides a criminal booking system and related database; Face ID, whichuses biometric facial recognition to identify suspects; Suspect ID, whichfacilitates the creation of full-color, photo-realistic suspect composites;Crime Lab, which allows officers to enhance and edit digital images; andVehicle ID, which helps officers identify motor vehicles stolen or involved ina crime. In addition, we offer Crime Web, which provides access to centrallystored records over the Internet in a connected or wireless fashion, Pocket CCSwhich enables access to centrally stored records while in the field on ahandheld Pocket PC compatible device, and central repositoryservices which allows for inter-agency data sharing on a local, regional,and/or national level.  We recentlyadded a new module to CCS which incorporates fingerprint livescan capabilitiesinto CCS for real-time capture of single to ten prints and palm to furtherimprove the booking, investigative and identification procedures.

 

ImageWare’s ID solutions empowercustomers to create secure and smart digital identification documents withcomplete ID systems. We develop, sell and support software and design systemswhich utilize digital imaging in the production of photo identification cardsand credentials and identification systems. Our sales in the digitalidentification market were developed through our acquisitions of ITC, Goddardand G & A (discussed below). Our products in this market consist ofEpiSuite, EpiWeb, EpiWeb Enterprise, EpiBuilder (SDK), Identifier for Windows,ID Card Maker, Winbadge NT and Winbadge Aviation. These products allow for theproduction of digital identification cards and related databases and recordsand can be used by, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added theability to incorporate multiple biometrics into the ID systems we offer withthe addition of our new Omni Biometric Engine to our product line.

 

ImageWare’sDigital Photography (“PDI”) product line consists of 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.

 

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The Company, formerly known as ImageWare Software, Inc., wasincorporated in the State of California on February 6, 1987.  From its inception until 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 coreimaging technology and know-how could be extended into other markets and wetargeted the digital identification market for diversification.  It was a fragmented market which offered usthe opportunity to establish market share through an acquisition program.  On August 22, 2000, the Companyacquired Imaging Technology Corporation (“ITC”), a privately held developer ofsoftware and software systems for digital identification documents.  On September 29, 2000, the Companypurchased Goddard Technology Corporation (“Goddard”), a privately helddeveloper of software identification badging systems. On March 30, 2001,the Company purchased substantially all the assets of G & AImaging Ltd. (“G & A”), a privately held developer of softwareand software systems for digital identification documents.  These three acquisitions, along with theinternal development of digital ID solutions for some of our law enforcementcustomers, firmly placed the company in the market for digital IDsoftware.  In 2001, ID software andsystems became the company’s largest product segment.  In 2001 the Company began a program to consolidate its digital IDbusinesses and rationalize its costs with respect to that segment.

 

The Company identified digital imaging systems for professionalphotographers as another market into which our core technology and capabilitiescould be extended.   This too was afragmented industry which offered the opportunity to establish a significantmarket position through acquisition. On August 10, 2001, the Companyacquired Castleworks LLC, a Nevada limited liability company (“Castleworks”),and E-Focus West LLC, a Nevada limited liability company (“E-Focus”), privatelyheld providers of digital imaging software and systems for professionalphotographers.

 

The terrorist attacks on September 11, 2001 impacted all three ofour business segments.  The lawenforcement and digital identification markets, although seen as markets whichwould ultimately benefit from increased spending on security, were negativelyimpacted in 2002 and 2003 by the tendency for the delay in purchasing decisions,awaiting guidance and funding from the government.  The attacks slowed the economy in general which had a negativeimpact on our professional photography segment.  As we recognized the impact September 11 was having on ourmarkets we continued our efforts to reduce costs through continuedconsolidation of our businesses and cost reduction.  In early 2002 we closed our Massachusetts offices and moved thedigital ID operations that were housed in that facility into our South Carolinaoffices.  In late 2002 we closed ourCosta Mesa, California facility which housed our professional photographysystems business and moved those operations into our facility in San Diego,California.  In mid 2003, we closed ourSouth Carolina offices and moved those operations to our offices in San Diego,California and Ottawa, Canada.  Inconjunction with the closing of the South Carolina offices, local SouthCarolina management chose to leave the Company and establish themselves as a valueadded reseller of the Company’s technology. We agreed to sub-lease our South Carolina facilities and sell certainassets including furniture and fixtures, office equipment, and inventory totheir new company.

 

**Industry Background**

 

***Law Enforcement andPublic Safety Markets***

 

The United States law enforcement and public safety markets arecomposed of federal, state and local law enforcement agencies.  Our target customers include local policedepartments, sheriffs’ departments and offices, primary state law enforcement

 

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agencies, special police agencies, county constable offices, andfederal agencies such as the FBI and the DEA. We are also targeting agencies in foreign countries for our lawenforcement solutions.

 

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. The InterstateIdentification Index is maintained by the FBI and includes persons arrested forfelonies or serious misdemeanors. The FBI has indicated that this index willaccept photographs in the future. We anticipate that the inclusion of digitalimages in these databases will increase the value of digital booking systemsand 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 accelerate the adoption of systemssuch as Imagewares’ by law enforcement agencies at all levels.

 

We anticipate significant state and federal funding to be madeavailable to law enforcement with the creation of the Homeland DefenseDepartment.

 

***IdentificationMarkets***

 

We believe our technology also has emerging applications in marketsrelated to secure credentials, identification and access control. Organizationsconcerned with security issues can use our technology to create secure smartidentification cards that can be instantly checked against a database of facialimages or other biometrics to prevent unauthorized access to secure areas. Webelieve potential customers in these markets include, among others, largecorporations, 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. Webelieve that the ability to easily capture images and data in a digitaldatabase and to enable immediate and widespread access to that database forremote identification will be a functionality that customers will require inthe 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 user requirements. When combined with the provenbiometric and web capabilities we currently offer, we believe we can provide aleading product offering into the ID market.

 

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 PhotographyMarket***

 

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.  In addition our professional photography customers can gainsignificant efficiencies from the work flow capabilities built into ourproducts.

 

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 andPublic 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

 

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including one or more full-color facial images, finger and palm prints,text information and images of other distinctive physical features. Thisdatabase can be quickly searched using text queries or by using our facialrecognition or AFIS technology which can compare biometric characteristics ofan unknown suspect with those in the database. Our investigative softwareproducts can also be used to create, edit and enhance digital images and tosearch 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 the Capture Module,the LiveScan  Module and theInvestigative Module) is our booking system and database. Our investigativemodules are Face ID, Suspect ID, Crime Lab, Vehicle ID, CrimeWeb, and PocketCCS.

 

CRIME CAPTURE SYSTEM. The Crime Capture System is a Windows-baseddigital booking system made up of three distinct software modules andassociated hardware such as cameras, scanners and computer hardware as needed.The Crime Capture System allows customers to capture and store images and otherinformation in a database and to search and retrieve records from the database.The Crime Capture System uses off-the-shelf hardware and is designed to complywith open industry standards so that it can operate on an array of systemsranging from a stand-alone personal computer to a wide area network. To avoidduplication of entries, the system can be integrated easily with several otherinformation storage and retrieval systems, such as a records management systemor 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 LIVESCAN. This software module allows users to capture single toten prints and palm to further improve the booking, investigative andidentification procedures.  By addinglivescan capabilities, law enforcement organizations further enhance theinvestigative process by providing additional identifiers to identify suspectsinvolved in a crime.  In addition,officers no longer need to travel to multiple booking stations to capturefingerprints and mug shots.  All bookinginformation including images will be located at a central designation and canbe routed to the FBI’s criminal history record repository.

 

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 and retrievaltechnology to help authorities identify possible suspects. Images taken fromsurveillance videos, digital sketches or photographs can be searched against adigital database of facial images to retrieve any desired number of faces withsimilar characteristics. This investigative module can also be used at the timeof booking to identify persons using multiple aliases. Using biometrics-basedtechnology, Face ID can search through thousands of facial images in a matterof seconds, reducing the time it would otherwise take a witness to flip througha paper book of facial images that may or may not be similar to the descriptionof the suspect. Face ID then creates a selection of possible matches ranked inorder of similarity to the suspect, and a percentage confidence level isattributed to each possible match. Face ID incorporates search enginetechnology which we license from Identix, Inc.

 

SUSPECT ID. This software module allows officers and witnesses toquickly create full-color, photo-realistic suspect composites. The digitalcomposites are constructed from libraries of facial features based upon actualcolor photographs of such features. Suspect ID allows officers with minimalcomputer training and artistic talent to create a suspect composite by pointingand clicking with a mouse. This module can be installed on a laptop computerand taken into the field, allowing officers to conduct interviews and createcomposites before witnesses’ memories fade. For rapid identification, officerscan distribute completed composites within minutes via fax or e-mail.

 

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

 

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suspect vehicle can be viewed from front, rear, side or three quarterangles and can be depicted in any color. A color copy of the suspect vehiclecan then be produced and immediately broadcast, printed or faxed to officers inthe field.  Vehicle ID also incorporatesVehicle Identification Number software provided by the National Insurance CrimeBureau.

 

CRIME WEB. This Web-based investigative software tool enablesauthorized personnel to access and search a county’s booking records stored onImageWare’s Crime Capture System through a standard web browser from within thecounty’s intranet. Crime Web allows remote access to the Crime Capture Systemdatabase without requiring the user to be physically connected to thecustomer’s network. Crime Web requires only that the user have access to theInternet and authorization 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’existing security and computing infrastructure. We believe that thiscompatibility may be an appealing feature to corporations, government agencies,transportation departments, school boards, and other public institutions.

 

EPIBUILDER. This 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.

 

OMNI BIOMETRIC ENGINE.  This isa second-generation solution from ImageWare Systems that biometrically managesa group of people of unlimited size and conducts comparative biometricsearches.  These searches are flexibleand can be exhaustive, including both one to one verifications or one to manysearches.  Omni is biometricallyagnostic and is architected to support any type of biometric from anyvendor.  Omni is based on field-provenImageWare technology solutions that have been used to manage millions ofbiometric templates since 1997 and is ideal for a variety of applicationsincluding: criminal booking, background checks (civil and criminal), watchlist, visa/passport and border control (air, land and sea).

 

Omni is scalable, enabling it to manage populations of unlimited sizeand Omni manages biometric images and templates that are enrolled either liveor offline.  Because it is vendor independent,Omni can support any biometric hardware or algorithm.  And because Omni stores the enrolled images, a new algorithm canbe quickly converted to support new or alternate algorithms and capturedevices.  Omni additionally has afull-featured SDK that allows it to readily integrate with existingapplications.  Omni currently supportsthe following biometrics:

•      Finger– civil and livescan

•      Face– photos and NIST-compliant mug shots

•      Iris

•      Signature– capture only

ImageWare is planning near-term support for voice, hand and NIST palmbiometrics.

 

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 servicebureau administration by managing the recruitment of customers and theprinting, 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

 

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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 deployed comparedto traditional client-server systems that require software and hardwareinstallation. EPIWEB’s central database empowers security personnel to ensurethat the right ID cards get issued to the right people across the entireenterprise.

 

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 asinterfaced with access control security systems or a human resource mainframecomputer.

 

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 throughout the world.

 

In addition to the software systems listed above, we may provide ourcustomers with hardware (printers, laminators, cameras) and/or cardware (cards,security features, printer ribbons) purchased from third parties.  Internationally we sell these products underthe 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+. This software allows professional photographers who market theirservices to schools to efficiently capture students’ images and associatedtext. Then the images can be printed or sent to a lab for processing via CD orthe Internet. Also the images can be used for ID badges, class rosters andother associated uses. A photographer can also use the capture module tophotograph dances and other events.

 

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.

 

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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.

 

***Maintenance andCustomer 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. Customerscan contract 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 ourgovernment customers operate around the clock and perceive our systems ascritical to their day to day operations, a very high percentage contract fortechnical support. Providing customer support services typically provides uswith annual revenue of 15% to 20% of the initial sales price of the hardwareand software purchased by our customers.

 

***SoftwareCustomization and Fulfillment***

 

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 AccessControl and Identification 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, anorganization can create picture IDs that correspond to images in a digitaldatabase. A security guard can stop an individual and quickly and accuratelycheck his identity against a database of authorized persons, and either allowor deny access as required. Our technology can also be applied in other marketsto facilitate activities such as licensing, voter registration, immigrationcontrol and welfare 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 ormultiple biometrics, which can be associated with a record and stored both in adatabase and on a card for later retrieval and verification.  We believe the increasing demand forbiometric technology will drive demand for our solutions which enable their useby end users.

 

***Fully Exploit theExpanding Law Enforcement and Public Safety Markets***

 

We intend to use our successful installations with customers such asthe Arizona Department of Public Safety as reference accounts and toaggressively market C.R.I.M.E.S. as a superior technological solution. Themajority of our recent sales have been and will be from sales of the CrimeCapture System.  Our recent addition ofthe LiveScan module to the Crime Capture System will enhance its functionalityand value to the law enforcement customer as well as increase the potentialrevenue the Company can generate from a system sale.  We will focus our sales effort in the near term to establish theCrime Capture System as the mug shot and livescansystem adopted in as manycountries, states and large counties and municipalities as possible. Once wehave a system installed in a region, we intend to then sell additional systemsor retrieval seats to other agencies within the primary customer’s region andin neighboring regions. In addition, we plan to market our complementaryinvestigative modules to the customer, including Face ID,

 

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Suspect ID, Crime Lab, Vehicle ID, CrimeWeb, and Pocket CCS. Ascustomer databases of digital mug shots grow, we expect that the perceivedvalue of our investigative modules, and corresponding revenues from sales ofthose modules, will also grow.

 

***Acquire BusinessesThat Enhance Our Strategic 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 RelatedApplications within 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 criminaldatabases and help prevent the sale of guns to ineligible persons. Ourtechnology can be used to monitor persons on parole or probation withoutrequiring them to travel to their parole or probation officer. We anticipatethat a parolee or probationer will be able to have his photograph taken in aspecially-designed kiosk which uses biometrics-based technology to identify theperson and inform his parole or probation officer of his location.

 

***Develop the Internetand Wireless Capabilities 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-basedapplication is easily deployed, compared to traditional client-server systemsthat require software and hardware installation. EPIWEB ENTERPRISE’S centraldatabase empowers security personnel to ensure that the right ID cards getissued to the right 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 accompanyusers wherever they are located. In order to facilitate the transfer of recordsand information 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.

 

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***Enhance Our PositionIn The Professional 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 Texas, Pennsylvania, and California.  Geographically, our sales and marketing force consists of 17persons in the United States, 3 persons in Canada, 2 persons in Germany and 2persons in Singapore.

 

We sell through a direct sales organization which is supported by themarketing organization.  Our salesprofessionals are supported by our technical experts who are available bytelephone 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 able to avoidthe 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 the relationshipsand 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

 

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for our identification systems as well. Our current customer base fordigital photography systems includes professional photographers, labs andstudios in the US and Canada.  In 2003,there were no customers who accounted for more than 10% of our revenues.  In 2002, one customer, PT Nuansa AnagorindoSejahtera, accounted for 18% of our revenues.

 

**Competition**

 

***The Law EnforcementAnd Public Safety Markets***

 

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.

 

***IdentificationMarkets***

 

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:

 

•              our strong brandreputation with a customer base which includes small and medium sizedbusinesses, Fortune 500 corporations and large government projects;

 

•              the ease ofintegrating our technology into other complex applications; and

 

•              the leveragedstrength that comes from offering customers software tools, packaged solutionsand web-based service applications that support a wide range of hardwareperipherals.

 

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 PhotographyMarket***

 

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 andLicensing Agreement with Eastman Kodak Company (“Kodak”) as a supplier ofsoftware that is bundled with their cameras and/or  printers;

 

•              our Development and LicensingAgreement  with Mitsubishi DigitalElectronics America (Mitsubishi) as a supplier of software that is bundled withtheir printers;

 

•              our LicensingAgreement with Herff Jones who is a major supplier of services to the schoolphotography market

 

•              a strong product mixcomprised of applications for photographers, labs and studios;

 

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•              our dealer andqualified lab network;

 

•              our support andtraining infrastructure;

 

•              our ability to offera package including software and our web hosting service; and

 

•              the usability andfunctionality 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, trade secret, and copyright laws andconfidentiality and license agreements to protect our intellectual property. Wehave several unregistered and federally registered trademarks including thetrademark ImageWare, as well as trademarks for which there are pendingtrademark registrations with the United States, Canadian and otherInternational Patent & Trademark Offices.  We license and depend on intellectual property from third partiesfor our biometric products and modules which utilizes third party biometricencoding and matching technologies.

 

**Research And Development**

 

Our research and development team is made up of 21 programmers,engineers and other employees. We spent approximately $ 1.9 million and$2.1 million on research and development in 2003 and 2002, respectively.We continually work to increase the speed, accuracy, and functionality of ourexisting products. We anticipate that our research and development efforts willcontinue to focus on new technology and products for the law enforcement,identification and digital photography markets.

 

**Employees**

 

As of March 2004, we had a total of 86 full-time employees. Ouremployees are not covered by any collective bargaining agreement, and we havenever experienced a work stoppage. We believe that our relations with ouremployees are good.  At 86 employees ourheadcount is approximately 27% lower than it was at this same time lastyear.  The reductions reflect theclosure of our South Carolina offices in June of 2003 and the downsizingof our German office in the fourth quarter of 2003.

 

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**RISK FACTORS**

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRINGLOSSES TOTALLING APPROXIMATELY $46.0 MILLION, AND THESE LOSSES MAY CONTINUE INTHE FUTURE.**

 

As of December 31 2003, we had an accumulated deficit of$46.0 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 HAVECERTAIN RIGHTS AND PRIVILEGES THAT ARE SENIOR TO THE COMMON STOCK AND WE MAYISSUE ADDITIONAL SHARES OF PREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THATCOULD HAVE A MATERIAL 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 of ImageWare.This could delay, defer, or prevent a change in control. Furthermore, holdersof preferred stock may have other rights, including economic rights, senior tothe common stock. As a result, their existence and issuance could have amaterial adverse effect on the market value of the common stock. We have in thepast issued, and, may from time to time in the future issue, preferred stockfor financing or other purposes with rights, preferences, or privileges seniorto the common stock.

 

The provisions of our outstanding Series B Preferred Stockprohibit the payment of dividends on the common stock unless the dividends onthose preferred shares are first paid. In addition, upon a liquidation,dissolution or sale of ImageWare’s business, the holders of the Series BPreferred Stock will be entitled to receive, in preference to any distributionto the holders of common stock, initial distributions of $2.50 per share, plusall accrued but unpaid 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, 2003, the Companyhad cumulative undeclared dividends of approximately $168,000.

 

**WE DEPEND UPON A SMALL NUMBER OF LARGE SYSTEMSALES RANGING FROM $300,000 TO IN EXCESS OF $1,000,000, AND WE MAY FAIL TOACHIEVE ONE OR MORE LARGE SYSTEM SALES 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 in excess of  $1,000,000. As a result, if we fail toreceive orders for these large systems in a given sales cycle on a consistentbasis, our business could be significantly harmed. Further, our quarterlyresults are difficult to predict because we cannot predict in which quarter, ifany, large system sales will occur in a given year. As a result, we believethat quarter-to-quarter comparisons of our results of operations are not a goodindication of our future performance. In some future quarters our operatingresults may be below the expectations of securities analysts and investors, inwhich case the market price of our common stock may decrease significantly.

 

**OUR LENGTHY SALES CYCLE MAY CAUSE US TOEXPEND SIGNIFICANT RESOURCES FOR AS LONG AS ONE YEAR IN ANTICIPATION OF A SALE,YET WE STILL MAY FAIL 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.

 

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**A SIGNIFICANT NUMBER OF OUR CUSTOMERS AREGOVERNMENT AGENCIES THAT ARE SUBJECT TO UNIQUE POLITICAL AND BUDGETARYCONSTRAINTS AND HAVE SPECIAL CONTRACTING REQUIREMENTS WHICH MAY AFFECT OURABILITY TO OBTAIN NEW GOVERNMENT CUSTOMERS.**

 

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 FOROUR PRODUCTS AND ENTER 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 thesuccessful development of new technology cannot be predicted and we cannotguarantee we will succeed in these goals.

 

**WE OCCASIONALLY RELY ON SYSTEMS INTEGRATORSTO MANAGE OUR LARGE PROJECTS, AND IF THESE COMPANIES DO NOT PERFORM ADEQUATELY,WE MAY LOSE BUSINESS.**

 

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 DO NOT HAVE U.S. OR FOREIGN PATENTPROTECTION FOR OUR PRODUCTS, AND A COMPETITOR MAY BE ABLE TO REPLICATE OURTECHNOLOGY.**

 

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 throughcopyrights and various trade secret protections afforded to us by law, ourbusiness will be seriously harmed. We do not have patent protection for ourproducts.

 

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 ourintellectual property. Accordingly, our ability to operate and exploit ourtechnology overseas could be significantly hindered.

 

**WE HAVE ACQUIRED SEVERAL BUSINESSES AND FACERISKS ASSOCIATED WITH INTEGRATING THESE BUSINESSES AND POTENTIAL FUTUREBUSINESSES THAT WE MAY ACQUIRE.**

 

We completed the acquisitions of several companies and we plan tocontinue to review potential acquisition candidates, and our business and ourstrategy includes building our business through acquisitions. However,acceptable acquisition candidates may not be available in the future or may notbe available on terms and conditions acceptable to us.

 

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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 AREEXPOSED TO RISKS ASSOCIATED WITH FOREIGN POLITICAL, ECONOMIC AND LEGALENVIRONMENTS AND WITH FOREIGN 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 withforeign currency exchange rates. Our results may be adversely affected by,among other things, changes in government policies with respect to laws andregulations, anti-inflation measures, currency conversions, remittance abroadand rates and methods of taxation.

 

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

 

Our corporate headquarters are located in San Diego, California wherewe occupy approximately 16,000 square feet of office space and approximately1,000 square feet of warehouse space. Our lease for this facility continuesthrough September 2006 at a cost of approximately $17,500 per month. Weoccupy approximately 26,685 square feet of office space in Stuttgart, Germanyuntil September 2006 at a cost of approximately $20,000 per month. Weoccupy 10,000 square feet in Gatineau, Province of Quebec. These premises areleased until May 2006 at a cost of approximately $12,000 per month. Wepreviously occupied approximately 5,500 square feet in Greenville, SouthCarolina. These premises are leased until December 2006 at a cost ofapproximately $5,400 per month.  InJuly 2003, we sublet this property at a rate of approximately $5,400 per monththrough December 2006.  We haveunder lease approximately 4,489 of office space in Costa Mesa, California at acost of approximately $10,500 per month. These premises are leased untilJuly 2005. In the fourth quarter of 2002, we moved this operation to ourSan Diego, California office and in May 2003, we sublet this property atapproximately $7,100 per month through July 2005. We occupy approximately1,700 square feet in Singapore.  Thesepremises are leased until August 2005 at a cost of approximately $1,300per month.

 

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

 

We are involved in certain legal proceedings generally incidental toour normal 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.

 

On or about July 22, 2003 and August 18, 2003, the Companyreceived correspondence from counsel representing Ray St. Maurice (“St.Maurice”).  In the correspondence, St.Maurice demanded that the Company pay him the sum of $710,000 based on a claimthat he and the Company had entered into an oral agreement to pay that amountfor unspecified services he was to render after the Company’s acquisition ofG&A Imaging, Ltd.  On or aboutSeptember 17, 2003, the Company’s outside counsel wrote on behalf of theCompany to St. Maurice’s counsel denying his demand.  On January 8, 2004, St. Maurice’s counsel responded to thisletter by demanding $500,000 in settlement of his purported claims and statingthat, absent such a settlement, St. Maurice intended to initiate litigationagainst the Company and James Miller, individually, to collect the $710,000 heclaims to be owed based on purported causes of action for breach of writtencontract, breach of oral contract, fraud in the inducement, quantum meruit, andpromissory estoppel.  The Company andMr. Miller strenuously deny St. Maurice’s claims.  On February 4, 2004, the Company and Miller commenced anaction against St. Maurice in the United States District Court for the SouthernDistrict of California, case no. ‘04 CV 00225 K (BLM), seeking a judicialdeclaration that no enforceable agreement existed between St. Maurice and theCompany which obligates the Company to pay St. Maurice $710,000, or any sum atall.  On or about February 23,2004, St. Maurice filed a Motion to Institute Proceedings against ImageWare andMiller in the Superior Court, Civil Division, of the Province of Quebec,District of Hull.

 

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**ITEM 4. Submission Of Matters To A Vote OfSecurity Holders.**

 

The followingmatters were submitted to a vote of the shareholders of ImageWareSystems, Inc. at the Annual Meeting of Shareholders heldon December 31, 2003.

 

a)             The following members wereelected to and as the Board of Directors to serve for the ensuing year anduntil their successors are elected:

 
| **Nominee**          |   | **Shares  Voted For** |   | **Shares  Withheld** |   |
|----------------------|--------|-----------------------|--------|----------------------|--------|
| S. James Miller, Jr. |   | 5,841,081             |   | 32,375               |   |
| John Callan          |   | 5,843,882             |   | 29,574               |   |
| Patrick Downs        |   | 5,844,582             |   | 28,874               |   |
| John Holleran        |   | 5,733,723             |   | 139,733              |   |
| Yukuo Takenaka       |   | 5,757,544             |   | 115,912              |   |
| David Loesch         |   | 5,868,586             |   | 4,870                |   |

 

b)            A proposal to ratify theappointment of Stonefield Josephson, Inc. as our independent auditors forour fiscal year ending December 31, 2003 was approved by the followingvote: 5,846,872 in favor, 20,111 against,and 6,473 abstentions.

 

**PART II**

 

**ITEM 5. Market for Common Equity and RelatedStockholder Matters.**

 

*Market Information.*

 

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

 

The following table sets forth the high and low sales prices for ourCommon Stock as reported by the American Stock Exchange for each quarter in2002 and 2003:

 
| **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 |   |

 
| **2003 Fiscal Quarters** |   | **High** |   | **Low** |   |
|--------------------------|--------|----------|--------|---------|--------|
| First Quarter            |   | $        | 3.250  |    | $      | 1.800 |   |
| Second Quarter           |   | $        | 2.990  |    | $      | 1.750 |   |
| Third Quarter            |   | $        | 2.830  |    | $      | 1.750 |   |
| Fourth Quarter           |   | $        | 3.600  |    | $      | 1.800 |   |

 

There is no public trading market for our preferred stock.

 

*Holders.*

 

As of March 15, 2004 there were approximately 265 holders ofrecord of our Common Stock.

 

15

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*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, 2003, the Company had cumulativeundeclared dividends of approximately $168,000.

 

*SecuritiesAuthorized for Issuance Under Equity Compensation Plans.*

 

# Equity Compensation PlanInformationAs of December 31, 2003

 
|                                                                                    |   | **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 |   | 112,038                                                                                             |   | $                                                                                  | 5.28   |                                                                                                                                                | 37,915  |   |
| 1994 Nonqualified Stock Option Plan                                                     |   | 18,957                                                                                              |   | $                                                                                  | 8.39   |                                                                                                                                                | 0       |   |
| 1999 Stock Option Plan                                                                  |   | 312,000                                                                                             |   | $                                                                                  | 6.62   |                                                                                                                                                | 37,060  |   |
| Equity compensation plans not approved by  security holders 2001 Equity Incentive Plan  |   | 897,011                                                                                             |   | $                                                                                  | 3.49   |                                                                                                                                                | 102,257 |   |
| Total                                                                                   |   | 1,340,006                                                                                           |   | $                                                                                  | 5.22   |                                                                                                                                                | 177,232 |   |

 

*Plan Descriptions:*

 

*2001 Equity 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.

 

*Recent Sales of Unregistered Securities:*

 

In November 2003, we completed a private placement consisting ofseparate private transactions pursuant to separate purchase agreements, inwhich we sold shares of common stock and warrants to purchase common stock toinstitutional investors comprised of existing and new shareholders.  We raised approximately $7 million from theprivate placement, which involved the sale of units consisting of one share ofcommon stock and a warrant to purchase 0.20 shares of common stock.  Each unit was priced at $1.72.  The warrants to have a five-year term and anexercise price of $2.58 per share.  As aresult of these transactions, we issued an aggregate of approximately 4,070,000new shares of common stock and warrants to purchase up to approximately 814,000shares of common stock.

 

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

 

**FORWARD-LOOKINGSTATEMENTS**

 

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

 

16

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

 

**Critical AccountingPolicies 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 amounts ofassets and liabilities and the disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand 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 theuncollectibility of our accounts receivables. Management specifically analyzesaccounts receivable and analyzes historical bad debts, customer concentrations,customer credit-worthiness, current economic trends and changes in our customerpayment terms when evaluating the adequacy of the allowance for doubtfulaccounts. Our accounts receivables balance was $1,538,000, net of allowance fordoubtful accounts of $483,254 as of December 31, 2003.

 

*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;

 

•              Significant changesin the manner of our use of the acquired assets or the strategy of our overallbusiness;

 

•              Significant negativeindustry or economic trends;

 

17

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When we determine that the carrying value of goodwill and otherintangible assets may not be recoverable based upon the existence of one ormore of the above indicators of impairment, we measure any impairment basedupon fair value methodologies. Goodwill and other net intangible assets amountedto $6,418,000 as of December 31, 2003. The Company has recorded goodwilland other net intangibles of $6,097,000 at December 31, 2003 resultingfrom its acquisitions of G & A and Castleworks and E-Focus onMarch 30, 2001 and August 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 June, 2002 and will perform anannual impairment review thereafter in the fourth quarter of our fiscalyear.  Completion of our initialimpairment test indicated there was no goodwill impairment.  We also performed our annual impairment reviewas of December 31, 2002 and 2003 based upon our 2003 and 2004 operatingplans, respectively.  This annualimpairment review indicated there was no goodwill impairment.  Both of these tests were conducted bydetermining and comparing the fair value of our reporting units, as defined inSFAS 142, to the reporting unit’s carrying value as of that date. Our reportingunits are Law Enforcement, Identification and Digital Photography. There aremany management assumptions and estimates underlying the determination of animpairment loss, and estimates using different, but reasonable, assumptionscould produce significantly different results. Significant assumptions includeestimates of future levels of revenues and operating expenses. Therefore, thetiming and recognition of impairment losses by us in the future, if any, may behighly dependent upon our estimates and assumptions.  There can be no assurance that goodwill impairment will not occurin the future.

 

The Company accounts for long-lived assets inaccordance with the provisions of SFAS no. 144, Accounting for the Impairmentor Disposal of Long-Lived Assets.  Thisstatement requires that long-lived assets and certain identifiable intangibleassets be reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.  Recoverability of assets to be held and usedis measured by a comparison of the carrying amount of an asset to future netundiscounted cash flows expected to be generated by the asset.  If such assets are considered to beimpaired, the impairment to be recognized is measured by the amount which thecarrying amount of the assets exceeds the fair value of the assets.  Fair value is determined based on discountedcash flows or appraised values, depending upon the nature of the asset.  Assets to be disposed of are reported at thelower of the carrying amount of fair value less costs to sell.  We recorded no impairment losses forlong-lived or intangible assets during the twelve months ended December 31,2003 or 2002.

 

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.

 

**STATEMENT OFOPERATIONS DATA:**

 
|                                        |   | **Year Ended  December 31,** |        |
|---------------------------------------------|--------|------------------------------|-------------|
|                                        |   | **2003**                     |        | **2002** |   |
| Revenues                                    |   | $                            | 16,233,458  |   | $ | 18,255,693 |   |
| Cost of revenues                            |   | $                            | 7,382,436   |   | $ | 8,296,447 |   |
| Gross profit                                |   | $                            | 8,851,022   |   | $ | 9,959,246 |   |
| Operating expenses                          |   | $                            | 12,771,986  |   | $ | 14,089,018 |   |
| Loss from operations                        |   | $                            | (3,920,964  | ) | $ | (4,129,772 | ) |
| Interest expense (income), net              |   | $                            | 6,960,140   |   | $ | 652,392 |   |
| Other expense, net                          |   | $                            | (207,046    | ) | $ | (53,575 | ) |
| Loss before income taxes                    |   | $                            | (10,674,058 | ) | $ | (4,728,589 | ) |
| Income taxes                                |   | $                            | 61,735      |   | $ | 120,341 |   |
| Net loss                                    |   | $                            | (10,735,793 | ) | $ | (4,848,930 | ) |
| Basic (loss) per share:                     |   |                         |        |   |   |
| Net loss                                    |   | $                            | (1.81       | ) | (0.90 | ) |
| Weighted-average shares (basic and diluted) |   | 5,953,801                    |        | 5,483,973 |   |

 
|                            |   | **Year Ended  December 31,** |       |
|---------------------------------|--------|------------------------------|------------|
|                            |   | **2003**                     |       | **2002** |   |
| **BALANCE SHEET DATA:**         |   |                         |       |   |   |
| Cash                            |   | $                            | 578,093    |   | $ | 214,937 |   |
| Restricted cash                 |   | $                            | 155,215    |   | $ | 60,000 |   |
| Accounts receivable, net        |   | $                            | 1,449,968  |   | $ | 3,294,932 |   |
| Inventories                     |   | $                            | 804,526    |   | $ | 1,882,082 |   |
| Other current assets            |   | $                            | 204,065    |   | $ | 422,382 |   |
| Property and equipment, net     |   | $                            | 634,966    |   | $ | 1,040,915 |   |
| Other assets                    |   | $                            | 571,199    |   | $ | 743,826 |   |
| Intangibles, net                |   | $                            | 1,120,675  |   | $ | 1,561,545 |   |
| Goodwill                        |   | $                            | 5,297,627  |   | $ | 5,297,627 |   |
| Total assets                    |   | $                            | 10,816,334 |   | $ | 14,518,246 |   |
| Total current liabilities       |   | $                            | 3,311,964  |   | $ | 6,958,314 |   |
| Long-term liabilities           |   | $                            | 4,192,605  |   | $ | 1,658,432 |   |
| Total liabilities               |   | $                            | 7,504,569  |   | $ | 8,616,745 |   |
| Total shareholders’ equity |   | $                            | 3,311,765  |   | $ | 5,901,500 |   |

 

 

**YEARS ENDEDDECEMBER 31, 2003 AND 2002**

 

The following management’s discussion and analysis of financialcondition and results of operations is based upon our Law Enforcement,Identification and Digital Photography segments.

 
|                                    |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |       |     |   |            |   |
|-----------------------------------------|--------|----------------------------------------------|------------|----------|--------|-----------------|--------|
| **Net Product Revenues**                |   | **2003**                                     |       | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Product revenues:**                   |   |                                         |       |     |   |            |   |   |   |
| Law Enforcement                         |   | $                                            | 1,139,083  |     | $      | 2,065,121       |   | $ | (926,038 | ) | -45 | % |
| Percentage of total net product revenue |   | 8                                            | %          | 14       | %      |            |   |   |   |
| Identification Group                    |   | $                                            | 11,155,285 |     | $      | 12,160,050      |   | $ | (1,004,765 | ) | -8 | % |
| Percentage of total net product revenue |   | 83                                           | %          | 80       | %      |            |   |   |   |
| Digital Photography                     |   | $                                            | 1,176,261  |     | $      | 890,595         |   | $ | 285,666 |   | 32 | % |
| Percentage of total net product revenue |   | 9                                            | %          | 6        | %      |            |   |   |   |
| Total net product revenues              |   | $                                            | 13,470,629 |     | $      | 15,115,766      |   | $ | (1,645,137 | ) | -11 | % |

 

Product revenues decreased 11% from $15,116,000 for the year endedDecember 31, 2002 to $13,471,000 for the corresponding period in 2003.Product revenues related to our Law Enforcement products decreased 45% from$2,065,000 for the year ended December 31, 2002 to $1,139,000 for thecorresponding period in 2003. We believe that the decrease in Law Enforcementproduct revenues is reflective of a current decrease in government procurement.  We believe that recent increases in terrorismhas created heightened interest in the ability of law enforcement and othergovernment agencies to be able to efficiently retrieve, analyze and shareinformation from their respective criminal databases. We also believe thatgovernment agencies and private entities will react to the increased terrorismby reevaluating and upgrading their ability to positively identify and tracktheir employees, consultants and visitors. We anticipate that these factorswill increase overall demand for the Company’s products, however, we cannotpredict the timing of the shift in demand.

 

18

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Product revenues from Identification card systems, software and relatedconsumables decreased 8% from $12,160,000 for the year ended December 31,2002 to $11,155,000 for the corresponding period in 2003. Revenues decreaseddue to lower sales of hardware and print media consumables internationally,combined with a decrease in software sales through our domestic master distributorof our off-the-shelf photo ID badge design and management software.  We believe that government agencies andprivate entities will react to increased terrorism by reevaluating andupgrading their ability to positively identify and track their employees, consultantsand visitors.  We anticipate that thesefactors will continue to increase overall demand for the Company’sIdentification products, however, we cannot predict the timing of the shift indemand.

 

Revenues related to our Digital Photography products increased 32% or$286,000 for the twelve months ended December 31, 2003 as compared to thecorresponding period in 2002.  Thisincrease is reflective of an increase in custom software completed during thetwelve months ended December 31, 2003 as well as increased distributionthrough dealer networks.

 

Our backlog of product orders as of December 31, 2003 wasapproximately $602,000.

 
|                                        |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|---------------------------------------------|--------|----------------------------------------------|-----------|----------|--------|-----------------|--------|
| **Maintenance Revenues**                    |   | **2003**                                     |      | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance  revenues :**                 |   |                                         |      |     |   |            |   |   |   |
| Law Enforcement                             |   | $                                            | 2,133,918 |     | $      | 2,182,524       |   | $ | (48,606 | ) | -2 | % |
| Percentage of total net maintenance revenue |   | 77                                           | %         | 69       | %      |            |   |   |   |
| Identification Group                        |   | $                                            | 628,387   |     | $      | 928,403         |   | $ | (300,016 | ) | -32 | % |
| Percentage of total net maintenance revenue |   | 23                                           | %         | 30       | %      |            |   |   |   |
| Digital Photography                         |   | $                                            | 524       |     | $      | 29,000          |   | $ | (28,476 | ) | -98 | % |
| Percentage of total net maintenance revenue |   | 0                                            | %         | 1        | %      |            |   |   |   |
| Total net maintenance revenues              |   | $                                            | 2,762,829 |     | $      | 3,139,927       |   | $ | (377,098 | ) | -12 | % |

 

Maintenance revenues decreased 12% from $3,140,000 for the year endedDecember 31, 2002 to $2,763,000 for the corresponding period in 2003.Maintenance revenues related to Law Enforcement products decreased 2% from$2,183,000 for the year ended December 31, 2002 to $2,134,000 for thecorresponding period in 2003. This decrease is due primarily to the expirationof the New York City Police Department service and maintenance contract duringthe third quarter of 2003 offset by the expansion of our installed base in theLaw Enforcement market. Maintenance revenues related to Identification productsdecreased $300,000 during the year ended December 31, 2003 due primarilyto decreased demand for maintenance related services from our internationaloperations.  Our decrease in DigitalPhotography maintenance revenues of $28,476 for the twelve months endedDecember 31, 2003 as compared to the corresponding period in 2002 isreflective of our cessation of maintenance services during their relocation toour centralized maintenance service center in our Ottawa office.

 
|                                               |   | **TWELVE MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|----------------------------------------------------|--------|---------------------------------------------|-----------|----------|--------|-----------------|--------|
| **Cost of product revenues**                       |   | **2003**                                    |      | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Cost of Product  Revenues:**                     |   |                                        |      |     |   |            |   |   |   |
| Law Enforcement                                    |   | $                                           | 711,042   |     | $      | 787,819         |   | $ | (76,777 | ) | -10 | % |
| Percentage of Law Enforcement product revenue      |   | 62                                          | %         | 38       | %      |            |   |   |   |
| Identification Group                               |   | $                                           | 5,415,764 |     | $      | 6,073,574       |   | $ | (657,810 | ) | -11 | % |
| Percentage of Identification Group product revenue |   | 49                                          | %         | 50       | %      |            |   |   |   |
| Digital Photography                                |   | $                                           | 53,920    |     | $      | 198,738         |   | $ | (144,818 | ) | -73 | % |
| Percentage of Digital Photography product revenue  |   | 5                                           | %         | 22       | %      |            |   |   |   |
| Total product cost of revenues                     |   | $                                           | 6,180,726 |     | $      | 7,060,131       |   | $ | (879,405 | ) | -12 | % |
| Percentage of total product revenues               |   | 46                                          | %         | 47       | %      |            |   |   |   |

 

Cost of product revenues for our Law Enforcement segment decreased 10%or $77,000 from $788,000 or 38% of Law Enforcement product revenues for theyear ended December 31, 2002 to $711,000 or 62% or Law Enforcement productrevenues for the corresponding period in 2003. This percentage increase is due primarily to the smaller revenue base toabsorb fixed product costs.  Fixedproduct costs are comprised primarily of personnel and contract programmingcosts related to customization and integration.  Costs of products also can vary as a percentage of productrevenue from period to period depending upon product mix and the hardwarecontent, print media consumable content and software content included insystems installed during a given period.

 

19

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Costs of Identification products decreased 11% from $6,074,000, or 50%of Identification product revenue, for the year ended December 31, 2002 to$5,416,000, or 49% of Identification product revenue, for the correspondingperiod in 2003. Cost of Identification products as a percentage ofidentification product revenue can vary depending upon factors such as productmix, hardware and software content and amount of identification card mediasold. The dollar decrease of $658,000 reflects the decrease in Identificationproduct revenues of $1,005,000 for the twelve months ended December 31,2003 as compared to the corresponding period in 2002.

 

Costs of Digital Photography product revenues as a percentage ofDigital Photography product revenues decreased 73% from $199,000 or 22% ofDigital Photography revenues for the year ended December 31, 2002 to$54,000 or 5% for the corresponding period in 2003.  This decrease of $145,000 is reflective of our selling bothhardware and software through the first quarter of 2002 as compared to ourselling of software only solutions for the entire twelve month period endedDecember 31, 2003.

 
|                                                   |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|--------------------------------------------------------|--------|----------------------------------------------|-----------|----------|--------|-----------------|--------|
| **Maintenance cost of revenues**                       |   | **2003**                                     |      | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance cost of  revenues:**                     |   |                                         |      |     |   |            |   |   |   |
| Law Enforcement                                        |   | $                                            | 783,590   |     | $      | 786,348         |   | $ | (2,758 | ) | 0 | % |
| Percentage of Law Enforcement maintenance  revenue     |   | 37                                           | %         | 36       | %      |            |   |   |   |
| Identification Group                                   |   | $                                            | 418,120   |     | $      | 449,968         |   | $ | (31,848 | ) | -7 | % |
| Percentage of Identification maintenance  revenue      |   | 67                                           | %         | 48       | %      |            |   |   |   |
| Digital Photography                                    |   | $                                            | —    |     | $      | —          |   | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |   | —                                       | %         | —   | %      |            |   |   |   |
| Total maintenance cost of revenues                     |   | $                                            | 1,201,710 |     | $      | 1,236,316       |   | $ | (34,606 | ) | -3 | % |
| Percentage of total maintenance revenues               |   | 43                                           | %         | 39       | %      |            |   |   |   |

 

Cost of Law Enforcement maintenance revenue decreased $3,000 from$786,000, or 36% of Law Enforcement maintenance revenue for the year endedDecember 31, 2002 to $783,000, or 37% of Law Enforcement maintenancerevenues for the corresponding period in 2002. Increased costs to maintain ourexpanding installation based were offset by a reduction in costs related to theNew York City Police Department service and maintenance contract which expiredduring the third quarter of 2003.

 

Costs of Identification maintenance revenues decreased 7% from $450,000or 48% of Identification maintenance revenue for the year endedDecember 31, 2002 to $418,000 or 67% of Identification maintenancerevenues for the corresponding period in 2003. The dollar decrease of $32,000 is reflective of decreased Identificationmaintenance revenues.  The increase incost of Identification maintenance revenues as a percentage of Identificationmaintenance revenues from 48% for the twelve months ended December 31,2002 to 67% of maintenance revenues for the corresponding period in 2003 is dueto a smaller revenue base over which to absorb fixed maintenance costs.

 
|                                               |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|----------------------------------------------------|--------|----------------------------------------------|-----------|----------|--------|-----------------|--------|
| **Product gross profit**                           |   | **2003**                                     |      | **2002** |   | **$****Change** |   | **%****Change** |   |
| Law Enforcement                                    |   | $                                            | 428,042   |     | $      | 1,277,302       |   | $ | (849,260 | ) | -66 | % |
| Percentage of Law Enforcement product  revenue     |   | 38                                           | %         | 62       | %      |            |   |   |   |
| Identification Group                               |   | $                                            | 5,739,521 |     | $      | 6,086,476       |   | $ | (346,955 | ) | -5 | % |
| Percentage of Identification product  revenue      |   | 51                                           | %         | 50       | %      |            |   |   |   |
| Digital Photography                                |   | $                                            | 1,122,341 |     | $      | 691,857         |   | $ | 430,484 |   | 62 | % |
| Percentage of Digital Photography product  revenue |   | 95                                           | %         | 78       | %      |            |   |   |   |
| Total product gross profit                         |   | $                                            | 7,289,904 |     | $      | 8,055,635       |   | $ | (765,731 | ) | -9 | % |
| Percentage of total product revenues               |   | 54                                           | %         | 53       | %      |            |   |   |   |

 

20

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Law Enforcement product gross profit as a percentage of Law Enforcementproduct revenues decreased from 62% for the twelve months endedDecember 31, 2002 to 38% for the corresponding period in 2003. Thispercentage change is due both to the product mix of Law Enforcement product salesand a lower revenue base to absorb fixed product costs.  Gross profit of Law Enforcement products canvary as a percentage of product revenue from period to period depending uponproduct mix and the hardware content, print media consumable content and softwarecontent included in systems installed during a given period.  The dollar decrease of $849,000 or 66% forthe twelve months ended December 31, 2003 as compared to the correspondingperiod in 2002 reflects the decrease in Law Enforcement revenues in 2003.

 

Gross margins related to Identification products as a percentage ofIdentification product revenue increased from 50% of revenues for the yearended December 31, 2002 to 51% of revenues for the corresponding period in2003. 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 decrease of $347,000 reflects thedecrease in Identification product revenues during the twelve months endedDecember 31, 2003 as compared to the corresponding period in 2002.

 

Digital Photography gross profit as a percentage of Digital Photographyproduct revenue increased from 78% for the twelve months endedDecember 31, 2002 to 95% for the corresponding period in 2003.  This increase is reflective of our sellingof software only solutions during the entire twelve month period endedDecember 31, 2003 as compared to the corresponding period of 2002 whichcontained both hardware and software components.

 
|                                                   |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|--------------------------------------------------------|--------|----------------------------------------------|-----------|----------|--------|-----------------|--------|
| **Maintenance gross profit**                           |   | **2003**                                     |      | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance gross  profit**                          |   |                                         |      |     |   |            |   |   |   |
| Law Enforcement                                        |   | $                                            | 1,350,328 |     | $      | 1,396,177       |   | $ | (45,849 | ) | -3 | % |
| Percentage of Law Enforcement product  revenue         |   | 63                                           | %         | 64       | %      |            |   |   |   |
| Identification Group                                   |   | $                                            | 210,267   |     | $      | 478,434         |   | $ | (268,167 | ) | -56 | % |
| Percentage of Identification product  revenue          |   | 33                                           | %         | 52       | %      |            |   |   |   |
| Digital Photography                                    |   | $                                            | 524       |     | $      | 29,000          |   | $ | (28,476 | ) |   |   |
| Percentage of Digital Photography  maintenance revenue |   | 100                                          | %         | 100      | %      |            |   |   |   |
| Total maintenance gross profit                         |   | $                                            | 1,561,119 |     | $      | 1,903,611       |   | $ | (342,492 | ) | -18 | % |
| Percentage of total maintenance revenues               |   | 57                                           | %         | 61       | %      |            |   |   |   |

 

Gross profit related to Law Enforcement maintenance revenues decreased3% from $1,396,000 or 64% of Law Enforcement maintenance revenue for the twelvemonths ended December 31, 2002 to $1,350,000 or 63% of Law Enforcementrevenues for the corresponding period in 2003. This decrease is reflective of  the expiration of the New York City PoliceDepartment service and maintenance contract during the third quarter of 2003offset by the expansion of our installation base.

 

Gross profit related to Identification maintenance revenues decreased56% from $478,000 or 52% of Identification maintenance revenues for the yearended December 31, 2002 to $210,000 or 33% for the corresponding period in2003.  The dollar decrease of $268,000is reflective of decreased Identification maintenance revenues.  The decrease in Identification gross profitas a percentage of Identification maintenance revenues from 52% for the twelvemonths ended December 31, 2002 to 33% of maintenance revenues for thecorresponding period in 2003 is due to a smaller revenue base over which toabsorb fixed maintenance costs.

 
|                            |   | **TWELVE  MONTHS  ENDED  DECEMBER 31,** |      |     |   |            |   |
|---------------------------------|--------|----------------------------------------------|-----------|----------|--------|-----------------|--------|
| **Operating expenses**          |   | **2003**                                     |      | **2002** |   | **$****Change** |   | **%****Change** |   |
|                            |   |                                         |      |     |   |            |   |   |   |
| General & administrative    |   | $                                            | 6,106,438 |     | $      | 6,911,228       |   | $ | (804,790 | ) | -13 | % |
| Percentage of total net revenue |   | 38                                           | %         | 38       | %      |            |   |   |   |
| Sales and marketing             |   | $                                            | 3,820,595 |     | $      | 4,204,613       |   | $ | (384,018 | ) | -9 | % |
| Percentage of total net revenue |   | 24                                           | %         | 23       | %      |            |   |   |   |
| Research & development      |   | $                                            | 1,920,696 |     | $      | 2,078,777       |   | $ | (158,081 | ) | -8 | % |
| Percentage of total net revenue |   | 12                                           | %         | 11       | %      |            |   |   |   |
| Depreciation and amortization   |   | $                                            | 924,257   |     | $      | 894,400         |   | $ | 29,857 |   | 3 | % |
| Percentage of total net revenue |   | 6                                            | %         | 5        | %      |            |   |   |   |

 

21

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*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 were 38% for the year ended December 31, 2003and 2002.  The dollar decrease of$805,000 is reflective of our efforts in 2003 to consolidate certain functionsand existing infrastructures while maintaining operational efficiencies.  We are continuing to focus our efforts onachieving additional future operating efficiencies by reviewing and improvingupon existing business processes and evaluating our cost structure. We believethese efforts will allow us to continue to gradually decrease our level ofgeneral and administrative expenses expressed as a percentage of totalrevenues.

 

*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,were 23% for the year ended December 31, 2002 as compared to 24% of totalrevenues for the corresponding period of 2003. The dollar decrease of $384,000or 9% is due primarily to the lower headcount and reduced sales commissions dueto decreased revenues.

 

*Research and development expenses*

 

Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and certain custom integration work not billable to customers.Such expenses, as a percentage of total net revenues, increased from 11%, or$2,079,000 for the year ended December 31, 2002 to 12%, or $1,921,000 forthe corresponding period in 2003.  Thedollar reduction of $158,000 is due to reduced contract programming andheadcount.  Our level of research anddevelopment expenditures reflects our belief that to maintain our competitiveposition in markets characterized by rapid rates of technological advancement,we must continue to invest significant resources in new systems and software aswell as continue to enhance existing products.

 

*Depreciation and amortization*

 

Depreciation and amortization increased $30,000 from $894,000 for theyear ended December 31, 2002 to $924,000 for the corresponding period in2003.

 

*Interest expense, net*

 

For the year ended December 31, 2003, we recognized interestincome of $14,000 and interest expense of $6,974,000. For the year endedDecember 31, 2002, we recognized interest income of $49,000 and interestexpense of $701,000.  Interest expensefor the year ended December 31, 2003 contains $387,000 of interest expenserelated to fair value accounting for our warrant liability due to theregistration rights agreement associated with the underlying shares of theCompany’s common stock to be issued upon conversion of the warrants.  Interest expense for the year endedDecember 31, 2003 increased due to our issuance of senior secured andsubordinated convertible promissory notes payable, short-term demand notespayable and short-term borrowings under banking lines of credit.  Interest expense for the year endedDecember 31, 2003 also includes approximately of $6,160,000 of debt discountand deferred financing fee amortization classified as interest expense.  The following table sets forth the majorcomponents of net interest expense for the years ended December 31, 2003and 2002:

 

22

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|                                                                                                                                                                              |   | **TWELVE  MONTHS ENDED  December 31,** |      |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|-----------|
|                                                                                                                                                                              |   | **2003**                                    |      | **2002** |   |
| **Components of net interest expense  (income):**                                                                                                                                 |   |                                        |      |   |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Senior secured convertible promissory note  issued May 22, 2002, interest rate 12.5% due May 22, 2004; Principal amount  $2,000,000 (the “Note):                             |   |                                        |      |   |   |
| Coupon interest rate expense                                                                                                                                                      |   | $                                           | 198,552   |   | $ | 152,776 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                              |   | 373,845                                     |      | 163,106 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                       |   | 877,906                                     |      | 163,106 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                    |   | 267,272                                     |      | 116,610 |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Secured demand promissory note issued  September, 2002, interest rate 12.5%, due upon demand                                                                                      |   | 26,541                                      |      | 17,808 |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Subordinated convertible promissory notes  issued March 2003, interest rate 8.5%, due April 15, 2005;  principal amount $600,000, (“the Subordinated Notes”): |   |                                        |      |   |   |
| Coupon interest rate expense                                                                                                                                                      |   | 33,600                                      |      | — |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                       |   | 110,526                                     |      | — |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                    |   | 58,000                                      |      | — |   |
| Interest expense from induced conversion                                                                                                                                          |   | 109,895                                     |      |   |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, principal amount  $4,256,000; (“the New Notes):                    |   |                                        |      |   |   |
| Coupon interest rate expense                                                                                                                                                      |   | 426,862                                     |      | — |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                              |   | 1,752,384                                   |      | — |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                       |   | 1,752,384                                   |      | — |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                    |   | 540,823                                     |      | — |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Other note payable interest expense                                                                                                                                               |   | 58,016                                      |      | 87,868 |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                                           |   | 387,018                                     |      | — |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Total Interest Expense                                                                                                                                                            |   | 6,973,624                                   |      | 701,274 |   |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Interest income                                                                                                                                                                   |   | (13,484                                     | )         | (48,882 | ) |
|                                                                                                                                                                              |   |                                        |      |   |   |
| Net interest (income) expense                                                                                                                                                     |   | $                                           | 6,960,140 |   | $ | 652,392 |   |

 

*Liquidity and capital resources*

 

As of December 31, 2003, we had total current assets of $3,192,000and total current liabilities of $3,312,000, or negative working capital of$120,000. At December 31, 2003 and 2002, we had available cash of $578,000and $215,000, respectively. As of December 31, 2003, we also had $155,000in restricted cash securing our obligations on various software installationand implementation contracts.  Asdiscussed more fully in Note 16 to the accompanying consolidated financialstatements, in January 2004, we completed a private placement, whichinvolved the sale of units consisting of one share of common stock and awarrant to purchase 0.20 shares of common stock.  Each unit was priced at $3.65. We raised approximately $6,600,000 in gross proceeds from the privateplacement, and expect to use the net proceeds for working capital.

 

Net cash used in operating activities was $2,975,000 for the year endedDecember 31, 2003 as compared to $2,068,000 for the corresponding periodin 2002. We used cash to fund net losses of $3,359,000, excluding non-cashexpenses (depreciation, amortization and non-cash interest expense ) of$7,377,000 for the year ended December 31, 2003.  We used cash to fund net losses of $3,512,000 excluding non-cashexpenses (depreciation, amortization and non-cash interest expense) of$1,337,000 for the corresponding period in 2002. For the year endedDecember 31, 2003, we generated cash of $2,778,000 through reductions incurrent

 

23

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assets offset by increases in current and long-term liabilities of$2,394,000 (excluding debt).  In 2002,we generated cash of $880,000 through reductions in current assets and byincreases in current and long-term liabilities of $564,000 (excluding debt).

 

Net cash used by investing activities was $376,000 for the year endedDecember 31, 2003 as compared to $516,000 for the corresponding period in2002. For the year ended December 31, 2003, we used cash to fund capitalexpenditures of computer equipment and software, furniture and fixtures andleasehold improvements of approximately $137,000. The level of equipmentpurchases resulted primarily from continued growth of the business andreplacement of older equipment. In 2003, we also used cash of $203,000 to repayadvances from related stockholders.  In2003, we used cash of $95,000 through increases in restricted cash used tosecure our performance on various software installation and implementationcontracts.  For the year endedDecember 31, 2003, we also generated cash of $59,000 from the sale ofassets.   In 2002, we used cash of$355,000 to fund capital expenditures of computer equipment and software,furniture and fixtures and leasehold improvements.  In 2002, we also used cash of approximately $161,000 to repayadvances from related stockholders.

 

Net cash provided by financing activities was $3,561,000 for the yearended December 31, 2003.  Wegenerated cash of $4,856,000 from the proceeds of our issuance of seniorsecured convertible promissory notes payable offset by $554,000 in debtissuance costs.  We also generated cashof $6,203,000 from our issuance of common stock.  We used cash of $6,778,000 for the repayment of notespayable.  We also used cash of $166,000to repay short-term borrowings under two bank line of credit agreements.  In 2002, net cash provided by financingactivities was $2,262,000.  We generatedcash of $2,000,000 from the proceeds of our issuance of a senior securedconvertible promissory note payable offset by $384,000 in debt issuance costsand 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.  In 2002, we used cash of 21,000 for therepayment of notes payable.  We alsogenerated cash of $1,000 from the exercise of stock options.

 

We conduct operations in leased facilities under operating leasesexpiring at various dates through 2006. In conjunction with our performance on various software installation andimplementation contracts, we are contingently liable under two irrevocableletters of credit in the aggregate amount of $155,000. The letters of creditexpire an amount of $49,000 on April 19, 2004, with the remaining $106,000expiring on December 26, 2008.  Wealso have various short-term notes payable and capital lease obligations due atvarious times during 2004. The following table sets forth a summary of ourobligations under operating leases, capital leases, notes payable andirrevocable letters of credit for the next five years:

 
|                                                                 |   | **2004** |      | **2005** |   | **2005** |   | **2006** |    | **2007** |   | **Total** |   |
|----------------------------------------------------------------------|--------|----------|-----------|----------|--------|----------|--------|----------|---------|----------|--------|-----------|--------|
|                                                                 |   |     |      |     |   |     |   |     |    |     |   |      |   |
| Minimum annual lease payments under  operating leases                |   | $        | 780,000   |     | $      | 774,000  |   | $        | 830,000 |     | $      | 0         |   | $ | 0 |   | $ | 2,384,000 |   |
|                                                                 |   |     |      |     |   |     |   |     |    |     |   |      |   |
| Minimum annual payments under notes payable                          |   | $        | 244,000   |     | $      | 0        |   | $        | 0       |     | $      | 0         |   | $ | 0 |   | $ | 244,000 |   |
|                                                                 |   |     |      |     |   |     |   |     |    |     |   |      |   |
| Other commercial commitments:                                        |   |     |      |     |   |     |   |     |    |     |   |      |   |
|                                                                 |   |     |      |     |   |     |   |     |    |     |   |      |   |
| Standby letters of credit                                            |   | $        | 155,000   |     | $      | 0        |   | $        | 0       |     | $      | 0         |   | $ | 0 |   | $ | 155,000 |   |
|                                                                 |   |     |      |     |   |     |   |     |    |     |   |      |   |
| Total contractual cash obligations and  other commercial commitments |   | $        | 1,179,000 |     | $      | 774,000  |   | $        | 830,000 |     | $      | 0         |   | $ | 0 |   | $ | 2,783,000 |   |

 

Our planned operating expenses and capital expenditures may constitutea material use of our cash resources. In addition, we may utilize cash resources to fund acquisitions orinvestments in complementary businesses, technologies or product lines.

 

Asmore fully explained in Note 16 to the attached consolidated financialstatements, we completed a private placement of our common stock inJanuary 2004 in which we raised approximately $6.6 million. We believe that our current cash balanceswill satisfy our projected working capital and capital expenditure requirementsfor at least the next 12 months. Thereafter, we anticipate continuing touse cash, cash equivalents, and short-term investment balances to satisfy ourprojected working capital and capital expenditure requirements. However,because of our concern that currently weak economic conditions may continue

 

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through 2004, if not longer, we have taken andcontinue to take steps to limit our expenses and align our cost structure toour revenues. These steps include, among other things, considering and/ortaking steps, as needed, to restructure our business, consolidating ouroperations, negotiating volume pricing with vendors, centralizing certainservices, and standardizing products. We recognize that our operating expenselevels, including research, development, engineering, selling, marketing,general and administrative expenses, depend on anticipated business activitylevels. While research, development, engineering and marketing expenses arebased on anticipated investment levels in technology development, productdevelopment and market development activities, the appropriate expense levelsin selling, general and administrative expenses are dependant on the level ofinfrastructure required to support our anticipated business volume. We reviewour business plans periodically to determine the appropriate level of suchexpenses based on various business factors. In the past we have takenappropriate measures to control our expenses based on business circumstances.In the future we will continue to review our business plans from time to timeand make appropriate changes to our expense levels, as we have in the past, toreduce operating expenses where it is advantageous to do so to improveoperational efficiencies.

 

In order to takeadvantage of opportunities, we may find it necessary to obtain additionalequity financing, debt financing, or credit facilities although we do notbelieve at this time that our long-term working capital and capitalexpenditures will be of such a nature that we would be required to take stepspresently to remedy any such potential deficiency. If it were necessary toobtain additional financings or credit facilities, we may not be able to do so,or if these funds are available, they may not be available on satisfactoryterms.

 

*New Accounting Pronouncements*

 

In December 2003 the FASB concluded to revisecertain elements of FIN 46, primarily to clarify the required accounting forinterests in variable interest entities. FIN-46R replaces FIN-46, that was issued in January 2003. FIN-46Rexempts certain entities from its requirements and provides for specialeffective dates for entities that have fully or partially applied FIN-46 as ofDecember 24, 2003. In certain situations, entities have the option of applyingor continuing to apply FIN-46 for a short period of time before applyingFIN-46R. In general, for all entities that were previously considered specialpurpose entities, FIN 46 should be applied in periods ending after December 15,2003. Otherwise, FIN 46 is to be applied for registrants who file under RegulationSX in periods ending after March 15, 2004, and for registrants who file underRegulation SB, in periods ending after December 15, 2004. The Company does notexpect the adoption to have a material impact on the Company’s financialposition or results of operations.

 

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

 

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

 

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In May 2003, the Emerging Issues Task Force (EITF) finalized  Issue No. 00-21, “Accounting forRevenue Arrangements with Multiple Deliverables.” During  December 2003, the Securities andExchange Commission issued Staff Accounting Bulliten (SAB)  104, “Revenue Recognition,” whichincorporated  EITF 00-21.  This issue addresses determination ofwhether an arrangement involving more than one deliverable contains more thanone unit of accounting and how arrangement consideration should be measured andallocated to the separate units of accounting. The adoption of EITF 00-21 and SAB 104 was not material to the Company’sresults of operations or financial condition.

 

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

 

**ITEM 7. Financial Statements.**

 

The financial statements for fiscal years ended December 31, 2003and 2002 are included herein following Part III, Item 13, and are filed aspart of this report.

 

**ITEM 8. Changes in and Disagreements withAccountants on Accounting and Financial Disclosures.**

 

On July 29, 2003,the Audit Committee of the Board of Directors of ImageWare Systems, Inc. (the“Company”) dismissed PricewaterhouseCoopers LLP (“PwC”) as the Company’sindependent auditor, and on July 31, 2003, engaged Stonefield Josephson,Inc. as the Company’s independent auditor for the fiscal year endingDecember 31, 2003.

 

PwC’s report on theconsolidated financial statements of the Company and its subsidiaries for thetwo fiscal years ended December 31, 2002 includes a separate paragraphindicating that the Company’s losses from operations and net capital deficiencyraise substantial doubt about the Company’s ability to continue as a goingconcern.  Other than the foregoing,PwC’s reports on the financial statements for the past two years contained noadverse opinion or disclaimer of opinion and were not qualified or modified asto uncertainty, audit scope or accounting principles.

 

During the two fiscalyears ended December 31, 2001 and 2002, and in the subsequent periodthrough July 29, 2003, there were no disagreements between the Company andPwC on any matter of accounting principles or practices, financial statementdisclosure, or auditing scope or procedure, which disagreement, if not resolvedto PwC’s satisfaction, would have caused PwC to make reference to the subjectof the disagreement in connection with their reports on the financialstatements for such years; and for the same periods there were no reportableevents as described in Item 304(a)(1)(v) of Regulation S-K.

 

**ITEM 8A. Controls and procedures.**

 

*Evaluation ofdiscloser controls and procedures*. ImageWare’s chief executive officer and its chief financial officer,after evaluating the effectiveness of ImageWare’s disclosure controls andprocedures (as defined in Exchange Act Rule 13a-15(e)) as of December 31, 2003(the “Evaluation Date”), have concluded that as of such date, ImageWare’sdisclosure controls and procedures were adequate and sufficient to ensure thatinformation required to be disclosed by ImageWare in the reports that it filesunder the Securities and Exchange Act of 1934 is recorded, processed,summarized and reported within the time period specified in the Commission’srules and forms.

 

*Changes in internalcontrols*.  There has been no change in ImageWare’sinternal controls over financial reporting during the quarter ended December31, 2003 that has materially affected, or is reasonably likely to materiallyaffect ImageWare’s internal control over financial reporting.

 

26

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**PART III**

 

**Item 9.****Directors, Executive Officers, Promoters and ControlPersons; Compliance With Section 16(a) of the Exchange Act.**

 

*Board of Directors*

 

The following table sets forth information regarding members of theCompany’s board of directors as of March 19, 2004. 

 
| **NAME**             |   | **AGE** |   | **POSITION  CURRENTLY HELD WITH THE COMPANY**                   |   |
|----------------------|--------|---------|--------|-----------------------------------------------------------------|--------|
| S. James Miller, Jr. |   | 50      |   | Chief Executive Officer and  Chairman of the Board of Directors |   |
| John Callan          |   | 57      |   | Director                                                        |   |
| Patrick Downs        |   | 67      |   | Director                                                        |   |
| John Holleran        |   | 77      |   | Director                                                        |   |
| David Loesch         |   | 59      |   | Director                                                        |   |
| Yukuo Takenaka       |   | 61      |   | Director                                                        |   |

 

*S. James Miller, Jr.* has served as theCompany’s Chief Executive Officer of the Company since 1990 and Chairman of theBoard since 1996.  He also served as theCompany’s President from 1990 until 2003. From 1980 to 1990, Mr. Miller was an executive with Oak Industries,Inc., a manufacturer of components for the telecommunications industry.  While at Oak Industries, Mr. Miller servedas a director and as General Counsel, Corporate Secretary andChairman/President of Oak Industries’ Pacific Rim subsidiaries. Mr. Miller hasa J.D. from the University of San Diego School of Law and a B.A. from theUniversity of California, San Diego.

 

*John Callan* waselected to the board in September 2000. Since 2001, Callan has been a principal in the strategy consulting firm,Ursa Major Associates, LLC.  From 1997to 2001 he as an independent business strategy consultant in the imaging andlogistics fields.  From 1995 to 1997, heserved as Chief Operating Officer for Milestone Systems, a shipping systemssoftware company, and from 1987 to 1995, served as a senior executive atPolaroid Corporation.

 

*Patrick Downs* was elected to the board inAugust 1994.  Since 1997, Mr. Downshas been Chairman of Control Commerce, LLC, an internet e-commercebusiness.  He is also a foundingshareholder of NTN Communications, Inc., an interactive television Company, andserved as its Chairman and Chief Executive Officer from 1983 to 1997.  Since 1999, Mr. Downs has also served on theBoard of Directors of Tullamore Corp., a video services company.  In 2002, Mr. Downs co-founded DNA ProtectiveCorporation, a private company involved in marketing DNA testing services tothe general public through the use of DNA technology which previously was onlyavailable to researchers.  Mr. Downsserves as Chairman and CEO of DNA Protective Corporation.

 

*John Holleran* was elected to the board in May1996.  Since 1974, Mr. Holleran has beena management and investment consultant. Prior to consulting, Mr. Holleran served as the Chief Financial Officer,Executive Vice President and Chief Operating Officer of Southwest GasCorporation.  He served as ExecutiveVice President of the Hawaii Corporation, a diversified holding company, and asPresident and Chairman of Property Research Financial Corporation, a realestate investment and syndication firm, from 1972 to 1974.  Mr. Holleran has also served as a directorof Kilroy Industries, a national office building and office park developer, asa director of Walker & Lee, a national full service real estate firm, andas a director of NTN Communications, Inc., a company engaged in the interactivetelevision business.  In 1949, Mr.Holleran started his business career by establishing his own CPA firm.

 

*David Loesch* was elected to the board inSeptember 2001 after 29 years of service as a Special Agent with theFederal Bureau of Investigations (FBI). At the time of his retirement from theFBI, Mr. Loesch was the Assistant Director in Charge of the Criminal JusticeInformation Services Division of the FBI. Mr. Loesch was awarded the Presidential Rank Award for MeritoriousExecutive in 1998 and has served on the board of directors of the SpecialAgents Mutual Benefit Association since 1996. He is also a member of theInternational Association of Chiefs of Police and the Society of Former SpecialAgents of the FBI, Inc.  He is currentlya private consultant on Public Safety Strategies.  Mr. Loesch served in the United States Army as an Officer withthe 101st Airborne Division in

 

27

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Vietnam. He holds a Bachelor’s degree from Canisius College and aMaster’s degree in Criminal Justice from George Washington University.

 

*Yukuo Takenaka* was elected to the board inApril 1997.  Mr. Takenaka is afounder and has served as Chairman of The Takenaka Partners Group, a globalinvestment banking and advisory organization with headquarters in Los Angelessince 1989.  From 1973 to 1989, Mr.Takenaka was a partner of KPMG Peat Marwick where he was the National Directorof their Japanese Practice.  Mr.Takenaka is a member of the American Institute of Certified Public Accountantsand the California Society of Certified Public Accountants.

 

*Audit Committee Members; Audit CommitteeFinancial Expert.*

 

The Company has a separately designated standing Audit Committee thatoversees the Company’s corporateaccounting and financial reporting processes and audits of the financialstatements of the Company.  Threedirectors comprise the Audit Committee: Messrs. Loesch, Holleran and Takenaka.  The Audit Committee metfive (5) times during 2003.  All membersof the Company’s Audit Committee are independent (as defined in the AmericanStock Exchange listing standards). The Company’s board of directors hasdetermined that Mr. Takenaka qualifies as an “audit committee financialexpert,” as defined in the applicable rules of the United States Securities andExchange Commission (“SEC”).  The Boardmade a qualitative assessment of Mr. Takenaka’s level of knowledge andexperience based on a number of factors, including his background in publicaccounting.

 

*Executive Officers*

 

The following table sets forth the names, ages and positions of theCompany’s executive officers as of March 19, 2004.

 
| **NAME**                 |   | **AGE** |   | **PRINCIPAL  POSITION HELD WITH THE COMPANY**                                  |
|--------------------------|--------|---------|--------|--------------------------------------------------------------------------------|
| Mr. S. James Miller, Jr. |   | 50      |   | Chief Executive Officer andChairman of the Board of Directors                  |
| Mr. Wayne Wetherell      |   | 51      |   | Sr. Vice President, Administration and Chief Financial Officer                 |
| Mr. Paul Devermann       |   | 48      |   | Senior Vice President and General Manager, Professional Digital  Imaging Group |
| Ms. Lori Rodriguez       |   | 39      |   | Senior Vice President, Operations                                              |
| Mr. Joe Schuler          |   | 62      |   | Senior Vice President, Sales and Marketing                                     |
| Mr. William Willis       |   | 44      |   | Senior Vice President, Technology and Business Development                     |

 

*Wayne Wetherell* has served as the Company’sSenior Vice President, Administration and Chief Financial Officer since May2001.  From 1996 to May 2001, he servedas Vice President of Finance and Chief Financial Officer.  From 1991 to 1996, Mr. Wetherell was theVice President and Chief Financial Officer of Bilstein Corporation of America,a manufacturer and distributor of automotive parts.  Mr. Wetherell holds a B.S. degree in Management and a M.S. degreein Finance from San Diego State University.

 

*Paul Devermann* has served as Senior VicePresident and General Manager, Professional Digital Imaging Group sinceOctober 2003. From August 2001 to October 2003, Mr. Devermannserved as President of ImageWare Digital Photography Systems LLC. FromMarch 2001 to August 2001, Mr. Devermann served as Senior VicePresident of Corporate Development. From 1997 to March 2001, Mr. Devermann served as Vice President ofSales and Business Development.  From1992 to 1997, Mr. Devermann served as the managing director and foundingpartner of Intra-International Trade and Transactions, an internationalconsulting and trading company that facilitates business transactions betweenUnited States and Japanese companies. Mr. Devermann holds a B.S. degree in Marketing from Northern IllinoisUniversity and an M.B.A. from the University of Puget Sound.

 

*Lori Rodriguez* has served as Senior VicePresident, Operations since October 2003. From October 2002 toOctober 2003, Ms. Rodriguez served as President of the Company’s LawEnforcement Solutions Group.  Prior tothat, Ms. Rodriguez served as President of the Company’s Americas Group fromJanuary 2002 to October 2002 and prior to that, as Vice President ofSales and Marketing for the Company. From 1998 until joining the Company in

 

28

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March 2001, Ms. Rodriguez served as Chief Operating Officer ofSDCR Business Systems, a point-of-sale systems integrator for the retail andfoodservice industries.  From 1996 to1998, Ms. Rodriguez served as the Executive Director of Sales and Marketing atSDCR Business Systems. Ms. Rodriguez holds a B.S. degree in Marketing and anExecutive M.B.A. from San Diego State University.

 

*Joe Schuler* has served as Senior VicePresident, Sales and Marketing since October 2003. From October 2002to October 2003, Mr. Schuler served as President of the Company’s IDSolutions Group.  From 1999 to 2002 Mr.Schuler was Director of Business Development for Fargo Electronics, amanufacturer of plastic card printers and encoding systems.  During 1997 and 1998, Mr. Schuler wasCorporate Director and Senior Vice President of Sales & Marketing for ThePathways Group. Other previous positions held by Mr. Schuler include Directorof Sales & Marketing and Project Management for Schlumberger Smart Cardsand Systems; President/CEO for Gemplus Card International Corp (North America);Vice President and General Manager for DataCard Corporation; Director of SmartCard Planning for Visa International; and Vice President of Product Developmentfor Citicorp.  Mr. Schuler is a graduateof the Carlson School of Management.

 

*William Willis* hasserved as Senior Vice President, Technology and Business Development sinceJuly 2003.  From 2001 untilJuly 2003, Mr. Willis served as the Chief Technology Officer for IridianTechnologies, a developer of authentication technologies based on irisrecognition.  From 2000 to 2001, Mr.Willis was the Chief Operating Officer of e-dn.com. From 1993 to 2000, Mr.Willis served as Chief Technology Officer and Vice President of Engineering ofAccess360 (formerly known as Enable Solutions).

 

*Section 16(a) Beneficial Ownership Reporting Compliance*

### ** **

Section 16(a) of the Securities ExchangeAct of 1934, as amended, requires the Company’s directors and executiveofficers, and persons who own more than ten percent of a registered class ofthe Company’s equity securities, to file with the SEC initial reports ofownership and reports of changes in ownership of common stock and other equitysecurities of the Company.  Officers,directors and greater than ten percent shareholders are required by SECregulation to furnish the Company with copies of all Section 16(a) formsthey file.

 

To the Company’s knowledge, based solely on areview of the copies of such reports furnished to the Company and written representationsthat no other reports were required, during the fiscal year endedDecember 31, 2003, all Section 16(a) filing requirements applicableto its officers, directors and greater than ten percent beneficial owners werecomplied with.

 

*Code of Ethics*

 

The Companyhas adopted a Code of Business Conduct and Ethics policy that applies to ourdirectors and employees (including the Company’s principal executive officer,principal financial officer, principal accounting officer or controller, orpersons performing similar functions), and has included a copy of this code ofethics as an exhibit to this annual report on Form 10-KSB. The Company intendsto promptly disclose (i) the nature of any amendment to this code of ethicsthat applies to our principal executive officer, principal financial officer,principal accounting officer or controller, or persons performing similarfunctions and (ii) the nature of any waiver, including an implicit waiver, froma provision of this code of ethics that is granted to one of these specifiedindividuals, the name of such person who is granted the waiver and the date ofthe waiver on our website in the future. The Company’s website address is http://www.iwsinc.com.

 

**Item10****. ExecutiveCompensation.**

 

*Compensation of Directors*

### ** **

Each non-employee director of the Companyreceives a monthly retainer of $2,000 for serving on the Board.  The members of the Board of Directors arealso eligible for reimbursement for their expenses incurred in attending Boardmeetings in accordance with Company policy. For the fiscal year ended December 31, 2003, the total amounts paidto non-employee directors were $139,212.20.

 

Non-employee directors of the Company arealso eligible to receive stock option grants under the Company’s 1994Nonqualified Stock Option Plan (the “Directors’ Plan”) or the Company’s 2001Equity Incentive Plan (the “2001 Plan”). Only non-employee directors of the Company or an affiliate of suchdirectors (as defined in the Internal Revenue Code) are eligible to receiveoptions under the

 

29

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Directors’ Plan.  Optionsgranted under the Directors’ Plan and the 2001 Plan are intended by the Companynot to qualify as incentive stock options under the Internal Revenue Code.

 

Underthe Director’s Plan, the Company has issued options to purchase 18,957 sharesat a weighted average exercise price of $8.39. The plan is administered by the Company’s board of directors.  Subject to the provisions of this plan, theboard determines who will receive options, the number of options granted, themanner of exercise and the exercise price of the options. The term of theoptions granted under the Director’s Plan may not exceed five years.  No options may be granted afterAugust 31, 2004.  The exerciseprice of the options granted under this plan must be equal to or greater than85% of the fair market value of the shares of the Company’s common stock on thedate the option is granted.  Theterm of options granted under the 2001 Plan is 10 years.  In the event of a merger of the Company withor into another corporation or a consolidation, acquisition of assets or otherchange-in-control transaction involving the Company, an equivalent option willbe substituted by the successor corporation, provided, however, that theCompany may cancel outstanding options upon consummation of the transaction bygiving at least thirty (30) days notice.

 

During the last fiscal year, the Company granted options under the 2001Plan covering an aggregate of 10,000 shares to non-employee directors of theCompany.  Each of John Callan, PatrickDowns, John Holleran, Yukuo Takenaka and David Loesch was granted 2,000 optionsat an exercise price per share of $3.03. The fair market value of such common stock on the date of these grantswas $3.03 per share (based on the closing sales price reported on the AmericanStock Exchange for the date of grant). As of March 19, 2004, no options had been exercised by non-employeedirectors under the Directors’ Plan or the 2001 Plan.

 

*Compensation ofExecutive Officers*

 

The following table shows, for the fiscalyears ended December 31, 2001, 2002 and 2003, compensation awarded or paidto, or earned by, the Company’s Chief Executive Officer and its other four mosthighly compensated executive officers at December 31, 2003  (the “Named Executive Officers”):

 

**SummaryCompensation Table**

 
|                                                                            |   | **Annual  Compensation** |   | **Long-Term  Compensation** |   |           |   |
|---------------------------------------------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|----------------|--------|
| **Name and Principal  Position**                                                |   | **Fiscal  Year**         |   | **Salary  ($)**             |   | **Bonus  ($)** |   | **Other  Annual  Compen-  sation($)** |   | **Securities  Underlying  Options (#)** |   | **All Other  Compen-  sation ($)** |   |
| Mr. S. James  Miller, Jr                                                        |   | 2003                     |   | 275,699                     |   | —         |   |   |   | 25,000 |   | 504 |   |
| Chief  Executive Officer                                                        |   | 2002                     |   | 266,535                     |   | —         |   |   |   | 50,000 |   | 1,022 | (1) |
|                                                                            |   | 2001                     |   | 253,614                     |   | —         |   |   |   | 103,500 |   | 37,029 |   |
|                                                                            |   |                     |   |                        |   |           |   |   |   |   |   |   |   |
| Mr. Wayne  Wetherell                                                            |   | 2003                     |   | 164,947                     |   | —         |   |   |   | 10,000 |   | 705 |   |
| Senior Vice  President of                                                       |   | 2002                     |   | 159,466                     |   | —         |   |   |   | 25,000 |   | 705 | (2) |
| Administration  and Chief Financial Officer                                     |   | 2001                     |   | 149,453                     |   | —         |   |   |   | 47,000 |   | 36,539 |   |
|                                                                            |   |                     |   |                        |   |           |   |   |   |   |   |   |   |
| Mr. William  Ibbetson                                                           |   | 2003                     |   | 142,380                     |   | —         |   |   |   | — |   | 232 |   |
| Chief  Technical Officer and                                                    |   | 2002                     |   | 142,380                     |   | —         |   |   |   | 12,500 |   | 232 | (3) |
| Vice  President of Research Development                                         |   | 2001                     |   | 133,552                     |   | —         |   |   |   | 24,000 |   | 1,462 |   |
|                                                                            |   |                     |   |                        |   |           |   |   |   |   |   |   |   |
| Mr. Paul  Devermann                                                             |   | 2003                     |   | 153,770                     |   | —         |   |   |   | — |   | 504 |   |
| Senior Vice  President and                                                      |   | 2002                     |   | 155,101                     |   | —         |   |   |   | — |   | 504 | (4) |
| General  Manager,   Professional Digital Imaging Group                          |   | 2001                     |   | 142,002                     |   | —         |   |   |   | 34,000 |   | 36,510 |   |
|                                                                            |   |                     |   |                        |   |           |   |   |   |   |   |   |   |
| Ms. Lori  Rodriguez                                                             |   | 2003                     |   | 166,517                     |   | —         |   |   |   | — |   | 504 |   |
| Senior Vice  President,                                                         |   | 2002                     |   | 159,536                     |   | —         |   |   |   | — |   | 504 | (5) |
| Operations                                                                      |   | 2001                     |   | 102,854                     |   | —         |   |   |   | 80,000 |   | 368 |   |
|                                                                            |   |                     |   |                        |   |           |   |   |   |   |   |   |   |
| Mr. Bill  Willis (6)  Sr. Vice President of Technology and Business Development |   | 2003                     |   | 98,837                      |   | —         |   | — |   | 67,500 |   | 504 | (1) |
|                                                                            |   |                     |   |                        |   |           |   |   |   |   |   |   |   |
| Mr. Joseph  Schuler (7)                                                         |   | 2003                     |   | 165,000                     |   | —         |   | — |   | — |   | 504 | (1) |
| Sr. VP Sales  and Marketing                                                     |   | 2002                     |   | 88,158                      |   | —         |   | — |   | 80,000 |   | — |   |

 

30

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(1)                                  Amountrepresents payment for term life insurance premium.

(2)                                  Amountrepresents payment for term life insurance premium.

(3)                                  Amountrepresents payment for term life insurance premium.

(4)                                  Amountrepresents payment for term life insurance premium.

(5)                                  Amountrepresents payment for term life insurance premium.

(6)                                  Mr. Willis was first employed by the Companyin  July  2003.

(7)                                  Mr. Schuler was first employed by the Companyin October 2002.

 

*Stock Option Grants And Exercises*

### ** **

The Company grants options to its executive officers and employeesunder its 2001 Plan, its 1999 Stock Option Plan (the “1999 Plan”), and its 1994Employee Stock Option Plan (the “1994 Plan”). As of March 19, 2004, options to purchase a total of 82,465 shareswere outstanding and options to purchase 67,488 shares remained available forgrant under the 1994 plan.  Additionally,options to purchase a total of 312,000 shares were outstanding and options topurchase 37,060 shares remained available for grant under the 1999 Plan.   Lastly, options to purchase a total of829,790 shares were outstanding and options to purchase 120,796 remainedavailable for grant under the 2001 Plan.

 

The following tables show for the fiscal year ended December 31,2003, certain information regarding options granted to, exercised by, and heldat year-end by, the Named Executive Officers:

 

**OptionGrants in Last Fiscal Year**

 
| **Name**             |   | **Number of  Securities  Underlying Options** |   | **% of Total  Options(1)** |   | **Exercise  Or Base  Price ($/Sh)** |   | **Expiration  Date** |       |
|----------------------|--------|-----------------------------------------------|--------|----------------------------|--------|-------------------------------------|--------|----------------------|------------|
| S. James Miller, Jr. |   | 25,000                                        |   | 12                         | %      | $                                   | 1.97   |                 | 5/28/2013  |   |
| Wayne Wetherell      |   | 10,000                                        |   | 5                          | %      | $                                   | 1.97   |                 | 5/28/2013  |   |
| William Willis       |   | 67,500                                        |   | 33                         | %      | $                                   | 2.65   |                 | 10/01/2013 |   |
| Paul Devermann       |   | 0                                             |   | —                     |   | —                              |   | —               |       |
| Joe Schuler          |   | 0                                             |   | —                     |   | —                              |   | —               |       |
| Lori Rodriguez       |   | 0                                             |   | —                     |   | —                              |   | —               |       |

 

----

(1)                                  Percentagecalculated based upon a total of 203,750 options granted to employees of thecompany in 2003.

 

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**Aggregated Option Exercises in LastFiscal Year, and Fiscal Year-End Option Values**

 
| **Name**             |   | **Number of  Securities  Underlying Unexercised  Options at Fiscal Year-End(1)  (#) Exercisable/Unexercisable** |   | **Value of  Unexercised  In-the-Money Options(2) at Fiscal  Year-End ($)  Exercisable/Unexercisable** |   |
|----------------------|--------|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------|--------|
| S. James Miller, Jr. |   | 232,850/306,936                                                                                                 |   | $0/$25,750                                                                                            |   |
| Wayne Wetherell      |   | 134,797/168,801                                                                                                 |   | $0/$10,300                                                                                            |   |
| Joe Schuler          |   | 26,666/80,000                                                                                                   |   | $26,933/$53,867                                                                                       |   |
| Paul Devermann       |   | 110,466/120,801                                                                                                 |   | $0/$0                                                                                                 |   |
| Lori Rodriguez       |   | 60,002/80,000                                                                                                   |   | $0/$0                                                                                                 |   |
| Bill Willis          |   | 0/67,500                                                                                                        |   | $0/$23,625                                                                                            |   |

 

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(1)                                  None of theNamed Executive Officers exercised Options during 2003.

 

(2)                                  The “Value ofUnexercised In-The-Money Options” is the aggregate, calculated on a grant bygrant basis, of the product of the number of unexercised options at the end offiscal year 2003, multiplied by the difference between the exercise price forthe grant and the closing price of a share of common stock on the last day ofthe 2003 fiscal year ($3.00), excluding grants for which the exercise price isgreater than the closing price of a share of common stock on that day.  The actual value, if any, that will berealized upon the exercise of an option will depend upon the difference betweenthe exercise price of the option and the market price of the common stock onthe date that the option is exercised.

 

*Employment, Severance and Change of Control Agreements*

### ** **

In September 2000, we entered into anamended employment agreement with Mr. Miller pursuant to which Mr. Miller willserve as President and Chief Executive officer. This agreement is for athree-year term ending December 31, 2004, which period is renewed annuallyon December 31 of each year for a three-year term unless we give Mr.Miller prior notice of termination. This agreement provides for annual basecompensation in the amount of $234,000, which amount will be increased based oncost-of-living increases.  Currently,Mr. Miller’s annual salary is $261,506. Under this agreement, we will reimburseMr. Miller for reasonable expenses incurred in connection with our business.Mr. Miller may, within 30 days of a change in control, terminate his employmentas of a date not more than 60 days from the date of such change in control bygiving 30 days advance written notice. In such event, he will be entitled to payment of his entire unpaid BaseSalary for the remaining term of his Employment Agreement, paid in one lumpsum, in addition to immediate vesting of all unvested options with, sixty daysto exercise the options and a continuation of all of his benefits for a periodof 3 years.

 

On March 1, 1999, we entered into anamended employment agreement with Mr. Wetherell pursuant to which Mr. Wetherellwill serve as our Chief Financial Officer. This agreement was for a term endingApril 30, 2002, and has been extended to a term ending April 30, 2003and extended thereafter for additional one year terms unless either party gives30 days notice prior to the expiration of a term. This agreement provides forannual base salary in the amount of $112,144, which amount will be increasedbased on cost-of-living increases and may also be increased based onperformance reviews. Currently, Mr. Wetherell’s annual salary is $156,457.Under this agreement, we will reimburse Mr. Wetherell for reasonable expensesincurred in connection with our business. Additionally, Mr. Wetherell will be entitled to the full amount of hisrespective base salary for a period of one year in the event his employmentwith the Company is involuntarily terminated other than for cause.  Upon a change of control, Mr. Wetherell mayterminate his employment by giving 30 days advance written notice. In suchevent he will be entitled to payment of his entire unpaid Base Salary for aperiod of one year from the date of his termination of employment.

 

On March 1, 1999, we entered into anamended employment agreement with Mr. Devermann pursuant to which Mr. Devermannwill serve as our Vice President of Sales and Business Development.  This agreement was for a term endingFebruary 28, 2002, and has been extended to a term ending March 1,2003 and extended thereafter for additional one year terms unless either partygives 30 days notice prior to the expiration of a term.** **This agreement provides for annual base salary in the amountof $103,731, which amount will be increased based on cost-of-living 

 

32

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increases and may also be increased based on performance reviews.Currently, Mr. Devermann’s annual salary is $150,869. Under this agreement, wewill reimburse Mr. Devermann for reasonable expenses incurred in connectionwith our business.  Additionally, Mr.Devermann will be entitled to the full amount of his respective base salary fora period of one year in the event his employment with the Company isinvoluntarily terminated other than for cause. If there is a change of control, Mr. Devermann may terminate hisemployment by giving 30 days advance written notice. If he does this, he willbe entitled to payment of his entire unpaid Base Salary for a period of oneyear from the date of his termination of employment.

 

On April 15, 2001, we entered into anemployment agreement with Lori Rodriguez pursuant to which Ms. Rodriguez willserve as our Vice President of Sales and Marketing. The agreement is for a termending April 15, 2004.  Thisagreement provides for an annual base salary of $130,000, which amount will beincreased based on cost-of-living increases and may also be increased based onperformance reviews.  Currently, Ms.Rodriguez’s annual salary is $157,946. Under this agreement, we will reimburseMs. Rodriguez for reasonable expenses in connection with our business.Additionally, Ms. Rodriguez is entitled to the full amount of her respectivebase salary for a period of one year in the event her employment with theCompany is involuntarily terminated other than for cause.  Upon a change of control, Ms. Rodriguez mayterminate her employment by giving 30 days advance written notice. In suchevent she will be entitled to payment of her entire unpaid Base Salary for aperiod of one year from the date of her termination of employment.

 

“Change of control” is defined in each of theemployment agreements as the occurrence of any of the following events: (i) theacquisition by a person of 50% or more of the voting power of the Company, (ii)a merger or consolidation of the Company with any other corporation (other thana merger or consolidation that would result in the voting securities of theCompany outstanding immediately prior thereto continuing to represent 50% ormore of the total voting power), (iii) the election to the Board of Directorsof a majority of directors not nominated by the Company’s management, or (iv)the approval by the Company’s shareholders of a plan of complete liquidation orsale of substantially all of the Company’s assets.

 

**Item11. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters.**

 

Theinformation concerning securities authorized for issuance under equitycompensation plans is set forth in Item 5 above.

 

The following table sets forth certaininformation regarding the ownership of the Company’s common stock as ofMarch 19, 2004 by: (i) each director; (ii) each of the Named ExecutiveOfficers; (iii) all executive officers and directors of the Company as a group;and (iv) all those known by the Company to be beneficial owners of more thanfive percent of its common stock.

 
|                                                                                                       |   | **Beneficial  Ownership(1)** |   |
|------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
| **Name and Address of Beneficial  Owner**                                                                  |   | **Number of  Shares**        |   | **Percent of  Class** |   |
| S. James Miller, Jr.(2)                                                                                    |   | 376,148                      |   | 3.1 | % |
| John Callan(3)                                                                                             |   | 35,575                       |   |   | * |
| Patrick Downs(4)                                                                                           |   | 58,247                       |   |   | * |
| John Holleran(5)                                                                                           |   | 10,736                       |   |   | * |
| David Loesch(6)                                                                                            |   | 14,661                       |   |   | * |
| Yukuo Takenaka(7)                                                                                          |   | 11,404                       |   |   | * |
| Wayne Wetherell(8)                                                                                         |   | 172,642                      |   | 1.4 | % |
| Paul Devermann(9)                                                                                          |   | 140,313                      |   | 1.2 | % |
| Lori Rodriguez(10)                                                                                         |   | 67,069                       |   |   | * |
| Joe Schuler(11)                                                                                            |   | 51,998                       |   |   | * |
| William Willis                                                                                             |   | 0                            |   |   | * |
| Crestview Capital Fund II, L.P. (12)  95 Revere Drive  Suite F    Northbrook, IL 60062                |   | 1,130,540                    |   | 9.3 | % |
| Lagunitas Partners (13)   c/o Gruber & McBaine    50 Osgood Place    San Francisco, CA 94133 |   | 1,277,085                    |   | 10.6 | % |
| Total Shares Held By Directors And  Executive Officers                                                     |   | 938,793                      |   | 7.7 | % |

 

33

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*                                         Lessthan one percent.

(1)                                  This table is basedupon information supplied by officers, directors and principal shareholders andSchedules 13D and 13G filed with the Securities and Exchange Commission (the“SEC”).  Unless otherwise indicated inthe footnotes to this table and subject to community property laws whereapplicable, the Company believes that each of the shareholders named in thistable has sole voting and investment power with respect to the shares indicatedas beneficially owned.  Applicablepercentages are based on 11,790,347 shares of common stock outstanding onMarch 19, 2004, calculated on an as-converted basis and adjusted asrequired by rules promulgated by the SEC. Unless otherwise indicated, theaddress for each listed shareholder is c/o ImageWare Systems, Inc. 10883Thornmint Road, San Diego, CA  92127.

(2)                                  Mr. Miller serves asChairman of the Board of Directors and Chief Executive Officer of theCompany.  Includes 84,679 shares heldjointly with spouse and by sons and 249,807 options exercisable within 60 daysof the date reported.

(3)                                  Includes 10,575options exercisable within 60 days of the date reported.

(4)                                  Includes 10,074options exercisable within 60 days of the date reported.

(5)                                  Includes 10,074options exercisable within 60 days of the date reported.

(6)                                  Includes 10,161options exercisable within 60 days of the date reported.

(7)                                  Includes 10,835options exercisable within 60 days of the date reported.

(8)                                  Includes 142,879options exercisable within 60 days of the date reported.

(9)                                  Includes 113,299options exercisable within 60 days of the date reported.

(10)                            Includes 66,669 optionsexercisable within 60 days of the date reported.

(11)                            Includes 39,998 optionsexercisable within 60 days of the date reported.

(12)                            Includes 345,565 sharesissuable upon the exercise of warrants.

(13)                            Includes 213,332 sharesissuable upon the exercise of warrants.

 

**Item12. Certain Relationships and Related Transactions.**

 

In addition to the employment agreements described inItem 10 above, the Company has entered into indemnity agreements with certainofficers and directors which provide, among other things, that the Company willindemnify such officer or director, under the circumstances and to the extentprovided for therein, for expenses, damages, judgments, fines and settlementshe or she may be required to pay in actions or proceedings which he or she isor may be made a party by reason of his or her position as a director, officeror other agent of the Company, and otherwise to the fullest extent permittedunder California law and the Company’s Bylaws.

 

**Item13. Exhibits and Reports on 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)                                                                                                                     |
| 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)                                                                |

 

 

34

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| 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)                                                                                                                         |
| 10.12 |   | 1999 Stock Option Plan(1)                                                                                                                                      |
| 10.13 |   | 2001 Equity Incentive Plan(8)                                                                                                                                  |
| 10.14 |   | Lease between Thornmint I and the Company dated September 26,  2003(13)                                                                                   |
| 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 |   | Note and Warrant Purchase Agreement dated May 22, 2002 (Perseus)(10)                                                                                           |
| 10.19 |   | Pledge and Security Agreement for ImageWare Systems, Inc. dated May  22, 2002 (Perseus)(10)                                                                    |
| 10.20 |   | Registration Rights Agreement dated May 22, 2002 (Perseus)(10)                                                                                                 |
| 10.21 |   | Senior Secured Convertible Promissory Note dated May 22,  2002(Perseus)(10)                                                                                    |
| 10.22 |   | Warrant to  Purchase Common Stock dated May 22, 2002 (Perseus)(10)                                                                                             |
| 10.23 |   | Warrant to  Purchase 1,021,687 shares of Common Stock, dated June 13, 2003(11)                                                                                 |
| 10.24 |   | Warrant to  Purchase 578,313 shares of Common Stock, dated June 13, 2003(11)                                                                                   |
| 10.25 |   | Form of  Securities Purchase Agreement dated November 14, 2003(12)                                                                                             |
| 10.26 |   | Form of  Warrant dated November 24, 2003(12)                                                                                                                   |
| 10.27 |   | Form of  Registration Rights Agreement dated November 24, 2003(12)                                                                                             |
| 10.28 |   | Registration  Rights Agreement, dated March 13, 2003(14)                                                                                                       |
| 21.1  |   | Subsidiaries of the Small Business Issuer                                                                                                                      |
| 23.1  |   | Consent of PricewaterhouseCoopers LLP, independent accountants                                                                                                 |
| 32.1  |   | Certification by Chief Executive Officer and Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act                                        |

_________________________________________________

 
| (1)  |   | Incorporated by reference to the Registration Statement on Form SB-2,  as filed with the Commission on December 20, 1999 (No. 333-93131), as  amended. |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  |   | Incorporated by reference to the Registration Statement on Form S-3,  as filed with the Commission on June 29, 2001 (No. 333-64192).                   |
| (3)  |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on August 14, 2002.                                       |
| (4)  |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on 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 by reference to the Current Report, Form 8-K as filed  with the Commission on May 24, 2002.                                               |
| (11) |   | Incorporated by reference to the Current Report, Form 8-K as filed  with the Commission on June 20, 2003.                                              |
| (12) |   | Incorporated by reference to the Current Report, Form 8-K as filed  with the Commission on February 9, 2004.                                           |
| (13) |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on November 14, 2003.                                     |
| (14) |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on May 15, 2003.                                          |

 

†             Certain confidential portions of this Exhibit havebeen omitted pursuant to a request for confidential treatment. Omitted portionshave been filed separately with the Securities and Exchange Commission.

 

(b) Reports on Form 8-K.

 

During the last quarter of the year ended December 31, 2003, we filedone report on Form 8-K.

 

We filed a report on Form 8-K on November 17, 2004 to report todisclose information concerning the issuance of common shares in a privateplacement of common stock to institutional investors.

 

35

----

 

**Item 14.****Principal Accountant Fees and Services.**

 

*Independent Auditors’ Fees*

 

The following table represents aggregate feesbilled to the Company for the fiscal year ended December 31, 2003 byStonefield Josephson, Inc. the Company’s principal accountant for the fiscalyear ended December 31, 2003, and the aggregate fees billed to the Companyfor the fiscal year ended December 31, 2002 by PricewaterhouseCoopers LLP,the Company’s principal accountant for the fiscal year ended December 31,2002. 

 

|                                                            |   | **Fiscal  Year Ended  (in thousands)** |    |
|-----------------------------------------------------------------|--------|----------------------------------------|---------|
|                                                            |   | **2003**                               |    | **2002** |   |
| Audit Fees                                                      |   | $                                      | 65,000  |   | $ | 112,393 |   |
|                                                            |   |                                   |    |   |   |
| Audit-related Fees for quarterly review  services and consents. |   | 54,349                                 |    | 46,868 |   |
|                                                            |   |                                   |    |   |   |
| Tax Fees                                                        |   |                                   |    |   |   |
|                                                            |   |                                   |    |   |   |
| All Other Fees                                                  |   |                                   |    |   |   |
|                                                            |   |                                   |    |   |   |
| Total Fees                                                      |   | $                                      | 119,349 |   | $ | 159,261 |   |

 

All fees described above were approved by theAudit Committee of the Company’s board of directors.

 

*Pre-Approval Policies and Procedures.*

 

The Audit Committee has adopted a policy and procedures for thepre-approval of audit and non-audit services rendered by our independentauditor, Stonefield Josephson, Inc. The policy generally pre-approves specifiedservices in the defined categories of audit services, audit-related services,and tax services up to specified amounts. Pre-approval may also be given aspart of the Audit Committee’s approval of the scope of the engagement of theindependent auditor or on an individual explicit case-by-case basis before theindependent auditor is engaged to provide each service. The pre-approval ofservices may be delegated to one or more of the Audit Committee’s members, butthe decision must be reported to the full Audit Committee at its next scheduledmeeting.

 

36

----

 

**SIGNATURES**

 

In accordance with Section 13 or 15(d)of the Exchange Act, the registrant caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                | **IMAGEWARE  SYSTEMS, INC.** |
|---------------------|-----------------------------------|
|                |                              |   |
|                |                              |   |
| March 30, 2004 | By:                               | /s/ **S. JAMES MILLER, JR.** |
|                |                              | **S. James Miller, Jr.** |
|                |                              | Chief Executive Officer and  Chairman of the Board of Directors |

 

In accordance with the Exchange Act, thisreport has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**            |   | **Title**                                                                   |   | **Date**            |
|--------------------------|--------|-----------------------------------------------------------------------------|--------|---------------------|
|                     |   |                                                                        |   |                |
| /s/ S. JAMES MILLER, JR. |   | Chief Executive Officer and Chairman of the Board of  Directors   |   | March 30, 2004 |
| S.James Miller, Jr.      |   | *(Principal  Executive Officer)*                                            |   |                |
|                     |   |                                                                        |   |                |
| /s/ WAYNE G. WETHERELL   |   | Senior Vice President of Administration and Chief Financial Officer         |   | March 30, 2004 |
| Wayne G. Wetherell       |   | *(Principal  Financial and Accounting Officer)*                             |   |                |
|                     |   |                                                                        |   |                |
| /s/ JOHN CALLAN          |   | Director                                                                    |   | March 30, 2004 |
| John Callan              |   |                                                                        |   |                |
|                     |   |                                                                        |   |                |
| /s/ PATRICK J. DOWNS     |   | Director                                                                    |   | March 30, 2004 |
| Patrick J. Downs         |   |                                                                        |   |                |
|                     |   |                                                                        |   |                |
| /s/ JOHN L. HOLLERAN     |   | Director                                                                    |   | March 30, 2004 |
| John L. Holleran         |   |                                                                        |   |                |
|                     |   |                                                                        |   |                |
| /s/ DAVID LOESCH         |   | Director                                                                    |   | March 30, 2004 |
| David Loesch             |   |                                                                        |   |                |
|                     |   |                                                                        |   |                |
| /s/ YUKUO TAKENAKA       |   | Director                                                                    |   | March 30, 2004 |
| Yukuo Takenaka           |   |                                                                        |   |                |

 

37

----

 

**IMAGEWARE SYSTEMS, INC.**

 

**INDEX TO FINANCIAL STATEMENTS**

 
| REPORT OF INDEPENDENT AUDITORS             | F-1    |
|--------------------------------------------|--------|
|                                       |   |
| CONSOLIDATED FINANCIAL STATEMENTS:         |   |
|                                       |   |
| BALANCE SHEETS                             | F-3    |
|                                       |   |
| STATEMENTS OF OPERATIONS                   | F-4    |
|                                       |   |
| STATEMENTS OF CASH FLOW                    | F-5    |
|                                       |   |
| STATEMENTS OF COMPREHENSIVE LOSS           | F-5    |
|                                       |   |
| STATEMENTS OF SHAREHOLDERS’ EQUITY    | F-6    |
|                                       |   |
| NOTES TO CONSOLIDATED FINANCIAL STATEMENTS | F-7    |

 

----

 

INDEPENDENT AUDITORS’ REPORT

 

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

 

We have audited the accompanying consolidated balance sheet of ImageWare Systems, Inc. as of December 31, 2003 and the related consolidated statements of operations, stockholders’ equity and cash flows for the year then ended.  These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

 

We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audit provides a reasonable basis for our opinion.

 

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

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

 

F-1

----

 

**REPORT OF INDEPENDENT ACCOUNTANTS**

 

To Board of Directors andShareholders’ of

ImageWare Systems, Inc.

 

In our opinion, theaccompanying consolidated balance sheet and the related consolidated statementsof operations, of shareholders’ equity and of cash flows present fairly, in allmaterial respects, the financial position of ImageWare Systems, Inc. and itssubsidiaries (the “Company”) at December 31, 2002, and the results of theiroperations and their cash flows for the year then ended in conformity withaccounting principles generally accepted in the United States of America.  These financial statements are theresponsibility of the Company’s management; our responsibility is to express anopinion on these financial statements based on our audit.  We conducted our audit of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audit provide a reasonable basis for our opinion.

 

The accompanying financialstatements have been prepared assuming that the Company will continue as agoing concern.  As discussed in Note 1to the financial statements, the Company has suffered losses from operationsand has a net capital deficiency that raise substantial doubt about its abilityto continue as a going concern. Management’s plans in regard to these matters are also described in Note1.  The financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.

 

 
| San Diego,  California |
|------------------------|
| April 11,  2003        |

 

F-2

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

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

 

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

 

 

F-3

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 

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

 

F-4

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**

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

 

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

 

F-5

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

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

 

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

 

F-6

----

 

**ImageWareSystems, Inc.**

**ConsolidatedStatements of Shareholders’ Equity**

for the Years Ended December 31, 2003and 2002

 

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

 

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

 

F-7

----

 

**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**DECEMBER 31, 2003 AND 2002**

 

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

 

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

 

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

 

ImageWare’s ID solutions empower customers tocreate secure and smart digital identification documents with complete IDsystems. We develop, sell and support software and design systems which utilizedigital imaging in the production of photo identification cards and credentialsand identification systems. Our sales in the digital identification market weredeveloped through our acquisitions of ITC, Goddard and G & A(discussed below). Our products in this market consist of EpiSuite, EpiWeb,EpiWeb Enterprise, EpiBuilder (SDK), Identifier for Windows, ID Card Maker,Winbadge NT and Winbadge Aviation. These products allow for the production ofdigital identification cards and related databases and records and can be usedby, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added theability to incorporate multiple biometrics into the ID systems we offer withthe addition of our new Omni Biometric Engine to our product line.

 

ImageWare’s Digital Photography (“PDI”) product line consists of asuite of software for the professional photography market. The software allowsprofessional photographers to digitally capture images, manipulate them tocreate a custom package or layout, then store the images with an associateddatabase. They can then print the digital images themselves or send them viathe Internet or CD to a professional lab for processing. Our products includePC Pro, PC Event, PDI School Days+, PDI Studio, PDI Pro Lab and PDI GreenScreen. Our customers use the software products in a wide variety of waysincluding retail studio environments, on-location event photography and“picture day” at schools and day care centers. Our software products are soldthrough a dealer network and directly to major accounts. The PDI group alsooperates an e-commerce service, Picturemore.com, used by professionalphotographers to allow their customers to order re-prints and various serviceitems. Our sales in the digital photography market were developed as a resultof our acquisition of Castleworks and E-Focus West in August, 2001.

 

*Going Concern*

 

As reflected in the accompanying consolidatedfinancial statements, the Company has losses and negative cash flows fromoperations and negative working capital. These matters raise substantial doubtabout the Company’s ability to continue as a going concern.

 

In view of the matters described in thepreceding paragraph, recoverability of a major portion of the recorded assetamounts shown in the accompanying consolidated balance sheet is dependent uponcontinued operations of the Company, which, in turn, is dependent upon theCompany’s ability to continue to raise capital and generate positive cash flowsfrom operations.  The consolidatedfinancial statements do not include any adjustments relating to therecoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

 

Subsequent to year end, the Company has completed a private placementin which the Company raised gross proceeds of approximately $6.6 million.  The Company believes that its current cashbalances will satisfy its projected working capital and capital requirementsfor at least the next twelve months. See Note 16 for further details.

 

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

 

*Principles of consolidation*

 

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

 

*Use of estimates*

 

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

 

*Fair Value of FinancialInstruments:*

 

For certain of the Company’s financial instruments, including accountsreceivable, accounts payable, accrued expenses and deferred revenues thecarrying amounts approximate fair value due to their relatively shortmaturities.

 

*Property and equipment*

 

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

 

*Goodwill:*

 

Goodwill arising from theacquisition of G & A Imaging and Castleworks and E-Focus was firstattributed to developed technology, trademarks and tradenames, patents,agreements not-to-compete and customer relationship based upon their estimatedfair value at the date of acquisition. These intangible assets are being amortized over their estimated usefullives, which range from 3-15 years.  Goodwill acquired will bereviewed for impairment pursuant to SFAS No. 142.

 

The Company accounts for its intangible assetsunder the provisions of SFAS No. 142, “Goodwill and Other IntangibleAssets”.  In accordance with SFAS No.142, intangible assets with a definite life are accounted for impairment underSFAS No. 144 and intangible assets with indefinite life are accounted forimpairment under SFAS No. 142.  Inaccordance with SFAS No. 142, goodwill, or the excess of cost over fair valueof net assets acquired, is no longer amortized but is tested for impairmentusing a fair value approach at the “reporting unit” level.  A reporting unit is the operating segment,or a business one level below that operating segment (referred to as acomponent) if discrete financial information is prepared and regularly reviewedby management at the component level. The Company recognizes an impairment charge for any amount by which thecarrying amount of a reporting unit’s goodwill exceeds its fair value.  The Company uses discounted cash flows toestablish fair values.  When availableand as appropriate, comparative market multiples to corroborate discounted cashflow results is used.  When a businesswithin a reporting unit is disposed of, goodwill is allocated to the gain orloss on disposition using the relative fair value methodology.

 

The Company did not record any goodwill impairmentcharges for the years ended December 31, 2003 and 2002.

 

*Intangible and Long-lived assets*

 

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

 

F-8

----

 

*Concentration of credit risk*

 

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

 

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

 

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

 

*Stock-based compensation*

 

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

 

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

 

The fair value of each option grant isestimated on the date of grant using the Black-Scholes method with thefollowing assumptions:  risk freeinterest rate ranging from 4.00% to 6.32%; dividend yield of 0% for each of theyears 2003 and 2002; volatility factor of the expected market price of theCompany’s common stock of 65% for 2003 and 2002; and an expected life of theoptions of 5 years for 2003 and 2002. The volatility of the Company’s common stock underlying the options wasnot considered for options granted up to March 31, 2000 because the Company’sstock was not publicly traded.

 

If the Company had elected to recognizecompensation expense based upon the fair value at the grant date for awardsunder the Stock Option Plan consistent with the methodology prescribed by SFASNo. 123, the Company’s net loss and loss per share would have beenincreased to the pro forma amounts indicated below for the years ended December31, 2003 and 2002:

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

 

*Income taxes*

 

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

 

*Foreign currency translation*

 

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

 

F-9

----

 

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

 

*Comprehensive Income*

 

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

 

*Revenue recognition*

 

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

 

*Capitalized software development costs*

 

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

 

*Earnings (loss) per share*

 

Basic earnings (loss) per common share is calculated by dividing netincome (loss) available to common shareholders for the period by theweighted-average number of common shares outstanding during the period. Dilutedearnings (losses) per common share is calculated by dividing net income (loss)available to common shareholders for the period by the weighted-average numberof common shares outstanding during the period, increased to include, ifdilutive, the number of additional common shares that would have beenoutstanding if the potential common shares, if dilutive, had been issued at thebeginning of the year.  The dilutiveeffect of outstanding stock options is included in the calculation of dilutedearnings (losses) per common share, if dilutive, using the treasury stockmethod. During the years ended December 31, 2003 and 2002, the Company hasexcluded the following securities from the calculation of diluted loss pershare, as their effect would have been antidilutive due to the Company’s netloss:

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

 

F-10

----

 

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

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

 

*Segment information*

 

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

 

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

 

There are no intersegment transactions.

 

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

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

 

F-11

----

 

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

 

*New Accounting Pronouncements*

 

In December 2003 the FASB concluded to revisecertain elements of FIN 46, primarily to clarify the required accounting forinterests in variable interest entities. FIN-46R replaces FIN-46, that was issued in January 2003. FIN-46Rexempts certain entities from its requirements and provides for specialeffective dates for entities that have fully or partially applied FIN-46 as ofDecember 24, 2003. In certain situations, entities have the option of applyingor continuing to apply FIN-46 for a short period of time before applyingFIN-46R. In general, for all entities that were previously considered specialpurpose entities, FIN 46 should be applied in periods ending after December 15,2003. Otherwise, FIN 46 is to be applied for registrants who file underRegulation SX in periods ending after March 15, 2004, and for registrants whofile under Regulation SB, in periods ending after December 15, 2004. TheCompany does not expect the adoption to have a material impact on the Company’sfinancial position or results of operations.

 

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

 

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

 

In May 2003, the Emerging Issues Task Force (EITF) finalized  Issue No. 00-21, “Accounting forRevenue Arrangements with Multiple Deliverables.” During December 2003,the Securities and Exchange Commission issued Staff Accounting Bulletin(SAB)  104, “Revenue Recognition,” whichincorporated  EITF 00-21.  This issue addresses determination ofwhether an arrangement involving more than one deliverable contains more thanone unit of accounting and how arrangement consideration should be measured andallocated to the separate units of accounting. The adoption of EITF 00-21 and SAB 104 was not material to the Company’sresults of operations or financial condition.

 

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

 

F-12

----

 

*Reclassifications*

 

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

 

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

 

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

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

 

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

 

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

 

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

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

 

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

 

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

 

F-13

----

 

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

 

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

 

At December 31, 2003 and 2002, the Company had $155,000 and$60,000, respectively, of restricted cash and cash equivalents which serves ascollateral for irrevocable standby letter of credits that provide financialassurance that the Company will fulfill its obligations under certaincommitments discussed in Note 9. The cash is held in custody by theissuing bank, is restricted as to withdrawal or use, and is currently investedin time certificates of deposits. Income from these investments is paid to the Company.

 

**5.****             Inventory**

 

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

 

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

 

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

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

 

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

 

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

 

Notes payable consist of the following:

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

 

In May 2002, the Company issued a senior secured promissory note for$2,000,000 at an interest rate of 12.5%, due May 22, 2004 (the “Note”).  The Note initially was convertible into commonshares of the Company at $4.31 per share. In conjunction with the note, the Company issued a warrant to purchase150,000 shares of common stock at $4.74 per share.  The Company recorded the note net of a discount equal to the fairvalue allocated to the warrants issued of approximately $537,000.

 

F-14

----

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

In accordance with EITF 00-27,the Company first determined the fair value of the New Notes and the fair valueof the detachable warrants issued in connection with these notes.  The estimated value of thewarrants of $2,770,000 was determined using the Black-Scholes option pricing modeland the following assumptions: term of 6 years, a risk free interest rate of2.53%, a dividend yield of 0% and volatility of 82%. The face amount of the New Notes of$4,256,000 was proportionately allocated to the New Notes and the warrants inthe amount of $2,218,000 and $2,038,000, respectively.  The amount allocated to the warrantsof $2,038,000 was recorded as a discount on the New Notes and as additionalpaid-in capital.  The value of the New Notes was then allocatedbetween the New Notes and the beneficial conversion feature, which amounted to$166,000 and $2,052,000, respectively. The amount allocated to thebeneficial conversion feature of $2,052,000 was recorded as a discount on theNew Notes and as additional paid-in capital. The Company accreted the discounts on the New Notes as interest expenseover the life of the notes.

 

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

 

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

 

F-15

----

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

F-16

----

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

 

The estimated warrant liabilityand subsequent valuations were determined using the Black-Scholes optionpricing model and the following assumptions: term of 5-6 years, a risk freeinterest rate of 2.53%, a dividend yield of 0% and volatility of 82% - 85%.

 

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

 

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

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

 

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

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

 

F-17

----

 

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

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

 

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

 

At December 31, 2003 and 2002, the Company had federal netoperating loss carryforwards of approximately $23,104,000 and $18,534,000,respectively, state net operating loss carryforwards of approximately$10,022,000 and $12,534,000, respectively, which may be available to offsetfuture taxable income for tax purposes. The federal net operating loss carryforwards expire at various datesfrom 2004 through 2023.  The state netoperating loss carryforwards expire at various dates from 2004 through2008.  In addition, the Company hadforeign operating losses carryforwards of approximately $659,000 atDecember 31, 2003.

 

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

 

The Internal Revenue Code (the “Code”) limits the availability of netoperating losses and certain tax credits that arose prior to certain cumulativechanges  in a corporations’s 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, 2000 and 2003.  The effect of the existing limitation hasbeen reflected in the above summary of the deferred tax assets.

 

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

 

*Employment Agreements*

 

The Company has employment agreements with its Chief Executive Officer,Senior Vice President of Administration and Chief Financial Officer,  Vice President of Research and Development,President of ImageWare Systems Law Enforcement Group, and President ofImageWare Systems Digital Photography. The Company may terminate the agreementswith or without cause. Should the Company terminate the agreements withoutcause, the officers are entitled to compensation ranging from 12 to 36 monthsof salary.

 

*Letter of Credit*

 

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

 

F-18

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

 

*Litigation*

 

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

 

*Leases*

 

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

 

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

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

 

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

 

----

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

 

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

 

**10.****          Equity**

 

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

 

*Series B Convertible, RedeemablePreferred Stock*

 

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

 

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

 

F-19

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

 

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

 

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

 

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

 

*Common Stock*

 

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

 

*Warrants*

 

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

 

The followingtable summarizes warrant activity since 2001:

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

 

The followingtable summarized information about warrants outstanding and exercisable atDecember 31, 2003:

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

 

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

 

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

 

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

 

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

 

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

 

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

 

F-20

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

 

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

 

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

 

# Stock Option Plans

# As of December 31,2003

#  

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

 

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

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

 

F-21

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

F-22

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

 

The Company adopted the provisions of Statement of Financial AccountingStandard (“SFAS”) No. 146 — Accounting for Costs Associated with Exit orDisposal Activities in the fourth fiscal quarter of the year endedDecember 31, 2002.  The Company terminated its operating lease for 4,275square feet of office space used to house our Digital Photography operationsand moved these operations to its San Diego, California facility.  In connection with this exit activity, theCompany also reduced headcount.  TheCompany has recorded a liability for the remaining lease payments under theoperating lease net of estimated sublease rents of $132,000 and accrued $6,000in severance as of December 31, 2002. These expenses are classified as part of general and administrativeexpenses as of December 31, 2002.

 

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

 

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

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

 

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

 

F-23

----

 

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

 

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

 

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

 

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

 

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

 

On January 29, 2004, the Company completed a private placement,which involved the sale of units consisting of one share of common stock and awarrant to purchase 0.20 shares of common stock.  Each unit was priced at $3.65. The warrants, which are first exercisable six-months after the closingdate, have a five-year term and an exercise price of $5.48 per share.  As a result of this transaction, the Companyissued an aggregate of approximately 1,818,000 new shares of common stock andwarrants to purchase up to approximately 364,000 shares of common stock.  In connection with this transaction, theCompany also issued to certain placement agents warrants to purchase anadditional 199,000 shares of common stock. The Company raised approximately $6.6 million from the privateplacement, and expects to use the net proceeds for working capital.

 

F-24

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