**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**
| **x**                                                  | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934.**     |
|--------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|
| ** **                                             | ** ** | ** **                                                                                           |
| **For the fiscal year ended  December 31, 2006.** |
| ** **                                             | ** ** | ** **                                                                                           |
| **o**                                                  | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934.** |

 

**Forthe transitionperiod               to               .**

**CommissionFile Number**

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**IMAGEWARE SYSTEMS, INC.**

(Exact name of Registrant as Specified in its Charter)

| **Delaware**                                                    |   | **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)                            |

 

(Registrant’s telephone number, including areacode):   **(858) 673-8600**

**Securities registered pursuant toSection 12(b) of the Exchange Act:**
| **Title of Each Class**           | ** ** | **Name of Each Exchange**

**on Which Registered** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| Common Stock, $0.01 par value     |       | American Stock Exchange                            |       |
| Warrants to Purchase Common Stock |       | American Stock Exchange                            |       |

 

Securities registered pursuant to Section 12(g)of the Act: **None**

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act. Yes o     No x

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days. Yes x     No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K.  Yes x     No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.Large accelerated filer o     Acceleratedfiler o     Non-acceleratedfiler x

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).     Yes o   No x

Theaggregate market value of the voting and non-voting common equity held bynon-affiliates of the registrant, based on the closing sales price of theissuer’s Common Stock on June 30, 2006, as reported on the American StockExchange was approximately $22,555,987. Excluded from this computation were 388,315 shares of Common Stock heldby all current executive officers and directors and 1,586,987 shares held byeach person who is known by the registrant to own 5% or more of the outstandingCommon Stock.  Share ownershipinformation of certain persons known by the issuer to own greater than 5% ofthe outstanding Common Stock for purposes of the preceding calculation is basedsolely on information on Schedule 13G filed with the Commission and is asof June 30, 2006. Exclusion of shares held by any person or entity should notbe construed to indicate that such person or entity possesses the power,directly or indirectly, to direct or cause the direction of the management orthe policies of the Registrant.

Thenumber of shares of the registrant’s common stock outstanding as of April 11,2007 was 14,511,721.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portions of the Registrant’sdefinitive proxy statement for the 2007 Annual Meeting of Stockholders to befiled with the Securities and Exchange Commission pursuant to Regulation 14Aare incorporated by reference into Part III of this Form 10-K to theextent stated herein.

 

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**IMAGEWARE SYSTEMS, INC.**

**2006 ANNUAL REPORT ON FORM 10-K**

**TABLE OF CONTENTS**
| PART I                                      |   |                                                                                                                |   |   |
|---------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                        |   |                                                                                                                |   |   |
| Item 1.                                |   | Business                                                                                                            |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 1A.                               |   | Risk  Factors                                                                                                       |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 1B.                               |   | Unresolved Staff  Comments                                                                                          |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 2.                                |   | Properties                                                                                                          |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 3.                                |   | Legal  Proceedings                                                                                                  |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 4.                                |   | Submission of Matters to  a Vote of Security Holders                                                                |   |   |
|                                        |   |                                                                                                                |   |   |
| PART II                                     |   |                                                                                                                |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 5.                                |   | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 6.                                |   | Selected  Financial Data                                                                                            |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 7.                                |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 7A.                               |   | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 8.                                |   | Financial  Statements and Supplementary Data                                                                        |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 9.                                |   | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                               |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 9A.                               |   | Controls and  Procedures                                                                                            |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 9B.                               |   | Other Information                                                                                                   |   |   |
|                                        |   |                                                                                                                |   |   |
| PART III                                    |   |                                                                                                                |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 10.                               |   | Directors,  Executive Officers and Corporate Governance                                                             |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 11.                               |   | Executive  Compensation                                                                                             |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 12.                               |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 13.                               |   | Certain  Relationships and Related Transactions                                                                     |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 14.                               |   | Principal  Accountant Fees and Services                                                                             |   |   |
|                                        |   |                                                                                                                |   |   |
| PART IV                                     |   |                                                                                                                |   |   |
|                                        |   |                                                                                                                |   |   |
| Item 15.                               |   | Exhibits and  Financial Statement Schedules                                                                         |   |   |
|                                        |   |                                                                                                                |   |   |
| Exhibit  Index                              |   |                                                                                                                |
|                                        |   |                                                                                                                |   |   |
| Signatures                                  |   |                                                                                                                |
|                                        |   |                                                                                                                |   |   |
| Index to  Consolidated Financial Statements |   |                                                                                                                |
|                                             |        |                                                                                                                     |        |        |  |  |

 

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**Forward-Looking Statements**

The statements contained in this Annual Report ofForm 10-K that are not historical are forward-looking statements withinthe meaning of Section 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 “RiskFactors” below.

**Trademarks**

Capturethe Image that Captures the Crook, C.R.I.M.E.S., FACE ID, ImageWare, SuspectID, and Vehicle ID, are registered trademarks of the Company. Biometric Engine,WinBadge Aviation, and IWS Biometric Engine are trademarks of the Company.

All other trademarks, service marks and/or trade namesappearing in this document are the property of their respective holders.

**PART I**

**Item 1.  Business.**

**OVERVIEW**

ImageWare Systems, Inc. is a leader in theemerging market for software-based identity management solutions, providinggovernments, public safety and justice agencies, and commercial enterpriseswith biometric, secure credential and law enforcement technologies.  Our “flagship” product is the IWSTM BiometricEngineTM, a multi-modal biometric identity management solution specificallydesigned to enhance security, and eliminate identity theft and fraud.  Scalable for small city business or worldwidedeployment, our IWS Biometric Engine is a multi-biometric platform that ishardware and algorithm independent, enabling the enrollment and management ofunlimited population database sizes.  Ouridentification products are used to manage and issue secure credentialsincluding national IDs, passports, driver licenses, smart cards and accesscontrol credentials. Our law enforcement products provide law enforcement withintegrated mug shot, fingerprint Livescan and investigative capabilities.  Our biometric technology is now an integralpart of all markets we address, and all of our products are integrated into theIWS Biometric Engine Platform.  Elements of the IWS BiometricEngine can be used as investigative tools to law enforcement potentiallyutilizing multiple biometrics and forensic data elements, and to enhancesecurity and authenticity of public and private sector credentials such asHomeland Security Presidential Directive 12 (HSPD-12) Personal IdentityVerification (PIV) card.

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Our biometric technology is a core software componentof an organization’s security infrastructure and includes a multi-biometricidentity management solution for enrolling, managing, identifying and verifyingthe identities of people by the physical characteristics of the human body. Wedevelop, sell and support various identity management capabilities withingovernment (federal, state and local), law enforcement, commercial enterprises,transportation and aviation for identification and verification purposes. OurIWS Biometric Engine is an open architected and flexible biometric identitymanagement platform, enabling the management of population databases ofvirtually unlimited sizes. It is offered as a Software Development Kit (SDK)based search engine, enabling developers and systems integrators to implement abiometric identity management solution or integrate biometric capabilities intoexisting applications without having to derive biometric functionality frompre-existing applications. In addition to the SDK offering, an expanded suiteof application-specific solutions based upon the IWS Biometric Engine isavailable, allowing users to integrate a complete packaged solution orcomponents as needed. The IWS Biometric Engine combined with our securecredential solutions such as IWS EPI Builder or IWS Card Management, provides acomprehensive, integrated biometric and secure credential solution that can beleveraged for high-end applications such as civil and criminal identificationas well as border management and other secure environments.. It can also beutilized within our law enforcement systems to incorporate any number ofvarious multiple biometrics into one integrated solution.

Our law enforcement solutions enable agencies toquickly capture, archive, search, retrieve, and share digital images,fingerprints and criminal history records on a stand-alone, networked, wirelessor Web-based platform. We develop, sell and support a suite of modular softwareproducts used by law enforcement and public safety agencies to create andmanage criminal history records and to investigate crime. Our IWS LawEnforcement solution consists of seven software modules: A Capture andInvestigative module, which provides a criminal booking system and relateddatabase; A Facial Recognition module, which uses biometric facial recognitionto identify suspects; and Suspect ID, which facilitates the creation offull-color, photo-realistic suspect composites. In addition, we offer a wireless module, which provides access tocentrally stored records over the Internet in a connected or wireless fashion,a PDA add-on module which enables access to centrally stored records while inthe field on a handheld Pocket PC compatible device, and central repositoryservices which allows for inter-agency data sharing on a local, regional,and/or national level.  In 2005 we addeda new Livescan module which incorporates Livescan capabilities into IWS LawEnforcement, providing integrated fingerprint and palm print biometricmanagement for civil and law enforcement use.

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Our Secure Credential identity management solutionsempower customers to create highly-secure, “smart” identification documentswith complete ID systems. We develop, sell and support software and designsystems to help facilitate the production of personal identifications fromsimple ID cards to highly-secure credentials with multi-biometric encoding.

Our products in this market consist of IWS EPI Suite,IWS EPI Builder (SDK), Identifier for Windows, IWS Card Management System and IWS PrintFarm.  These products allow for the production of digitalidentification cards and related databases and records and can be used by,among others, governments, public safety, schools, airports, hospitals, andcommercial enterprises.

Ourenterprise authentication software includes the IWS Desktop Security softwaresolution which is a comprehensive authentication management infrastructurespecifically designed to provide enterprise networks with the most advancedauthentication mechanisms including biometrics, RFID technology, USB flashmemory modules, Trusted Platform Module (TPM), and smart cards.

IWSDesktop Security enables organizations to maintain a simplified, yet secure,method of seamlessly integrating various security devices within a centralizedauthentication platform.  Utilizing theplatform, organizations are able to replace passwords, strengthen userauthentication and condense existing authentication technologies and overseeauthentication policies for the entire network environment.

### **CORPORATE HISTORY**

ImageWare Systems, Inc., formerly known as ImageWareSoftware, Inc., was incorporated in the State of California onFebruary 6, 1987.  From theinception until 1995, we designed and sold software products for the photoentertainment industry.  In late 1994, wesold our photo entertainment line of products, and utilized our coretechnologies to develop and sell products to law enforcement agencies.  In 1994 our company was sold to a newownership and we embarked upon the design and creation of digital imaging basedsoftware products for law enforcement. From 1995 to early 2000 our business consisted only of our lawenforcement products.  We completed ourinitial public offering in April 2000. At that time we recognized that our core imaging technology and industryexpertise positioned us to enter other and larger markets, and we targeted thedigital 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, we acquired ImagingTechnology Corporation (“ITC”), a privately held developer of software andsoftware systems for digital identification documents.  On September 29, 2000, we purchasedGoddard Technology Corporation (“Goddard”), a privately held developer ofsoftware identification badging systems. On March 30, 2001, we purchasedsubstantially all the assets of G & A Imaging Ltd. (“G &A”), a privately held developer of software and software systems for digitalidentification documents.  These threeacquisitions, along with the internal development of digital ID solutions forsome of our law enforcement customers, firmly placed us in the market fordigital ID software.  In 2001, IDsoftware and systems became our largest product segment.

### **RECENT EVENTS**

Theterrorist attacks on September 11, 2001, impacted business.  The law enforcement and digitalidentification markets, although seen as markets which would ultimately benefitfrom increased spending on security, were negatively impacted in 2002 through2004 by the tendency for the delay in purchasing decisions, awaiting guidanceand funding from the government and the use of available funding for payment ofovertime expenditures incurred due to heightened security alerts.  As we recognized the impact September 11was having on our markets we continued our efforts to reduce costs throughcontinued consolidation of our businesses and cost reduction.  Since 2002 ,we have consolidated resources,closed offices and moved several operations to our offices in San Diego,California and Ottawa, Canada.

In the fourth quarter of 2003 we took actions toreposition our foreign sales offices to lower fixed costs and pursuesignificant international identification and secure credential projectsutilizing the Company’s software technologies as our primarydifferentiator.  ** **These offices had historically emphasized theresale of third party merchandise (hardware and consumables) which generatedlower gross margins than software and required significant fixed costs forsales, service and support.   Although these measures

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haveresulted in lower top line revenue in the short term, management believes thatwe will be able to replace the lost revenue with higher margin software saleswhile continuing to enjoy the lower fixed costs.

We have continued to reduce our costs with respect toour foreign sales offices in 2005 with the sale of our Singapore subsidiary inthe first quarter of 2005 and the fourth quarter decision to close our Germansales office in early 2006.  Theseactions were the result of our strategy to address international markets forlarge identity management projects through local and US based strategicpartners with a local sales and service presence and to manage internationalchannel partners for our boxed ID Software from our US offices.

In furtherance of our strategy to more efficientlyaddress both domestic and international markets for large identity managementprojects, in the fourth quarter of 2006, we completed the sale of our entireDigital Photography (“PDI”) product line. We sold this component because it incurred significant operating lossesin each of the last five years and has lost significant market share in thelast three years.  The assets soldconsisted primarily of a suite of software and related inventory including source,copyrights, trademarks, documentation and client base.

**INDUSTRY BACKGROUND**

***Biometrics andSecure Credential Markets***

We believe the biometric identity management marketwill continue to grow as the role of biometrics becomes more widely adopted forenhancing security and complying with new government regulations such asHSPD-12. Our biometric and secure credentialing solutions are meeting thedemands for true multi-modal biometric identity management systems, as well asproviding scalability to support evolving functionality.

As a result ofHSPD-12, government organizations are required to adopt new processes forverifying the identity of employees and contractors as well as controllingaccess to secure facilities and information systems. In response to the strictrequirements set forth by the Federal government, ImageWare enhanced its IWSBiometric Engine and secure credentialing product suite by adding cardmanagement and card printing modules which enable the offering of end-to-endsupport for PIV-I and PIV-II business processes, technical requirements, aswell as the ability to partner with leading physical and logical access controlvendors for logistics and deployment considerations.

Our technology also has applications in marketsrelated to secure credentials, identification and access control (physical andlogical) in the public and private sectors. Organizations concerned with security can use our technology to createsecure “smart” identification cards that can be instantly checked against a databaseof facial images or other biometrics to prevent unauthorized access to secureareas. We believe potential customers in these markets include, among others,large corporations, border crossings (land, air and sea), airports, hospitals,universities and government agencies.

Identification systems have historically been soldbased upon the cost-savings digital systems offer over traditional photo-basedsystems. We believe that the ability to easily capture images and data in adigital database and to enable immediate and widespread access to that databasefor remote identification/verification will be a functionality that customerswill require in the future and that such functionality will be one of theprimary drivers for future growth within this market. We are able to providefield-proven identification products with high quality reference accountsacross the board in terms of size and complexity of systems and userrequirements. When combined with our proven biometric and Web capabilities, webelieve we can provide a leading product offering into thebiometrically-enabled secure credential market.

***Law Enforcement andPublic Safety Markets***

The United States law enforcement and public safetymarkets are composed of federal, state and local law enforcement agencies.  Our target customers include local policedepartments, sheriffs’ 

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departmentsand offices, primary state law enforcement agencies, prisons, special policeagencies, county constable offices, and federal agencies such as the FBI andthe DEA.  We are also targeting agenciesin foreign countries for our biometric and law enforcement solutions.

We believe the September 11, 2001, terroristattacks and subsequent creation of the Department of Homeland Security hasaccelerated the adoption of digital identification systems. Law enforcementcustomers are demanding end-to-end solutions that incorporate robust featuresand functionalities such as biometric and secure credentialing capabilities, aswell as instant access to centrally maintained records for real timeverification of identity and privileges.

The U.S. federal government has promoted thedevelopment and use of nationwide criminal history record databases called theInterstate Identification Index (“III”) and the National Crime Information Center(“NCIC”), each consisting of on-line national and regional databases dedicatedto serving criminal justice agencies. The Interstate Identification Index ismaintained by the FBI and includes persons arrested for felonies or seriousmisdemeanors. The FBI has indicated that this index will accept photographs inthe future. We anticipate that the inclusion of digital images in thesedatabases will increase the value of digital booking systems and the demand forfacial recognition applications. Since the September 11, 2001, terroristattack on the U.S. there has been significant discussion at the federal andstate levels of government regarding the need for federal, state and localagencies to share information. We anticipate that the movement toward sharing ofinformation will accelerate the adoption of systems such as ImageWare’s by lawenforcement agencies at all levels.

**PRODUCTS AND SERVICES**

Ourmulti-biometric identity management and secure credentialing products providecomplete and interoperable solutions with features and functions requiredthroughout the entire identity management life-cycle, enabling users theflexibility to make use of any desired options, such as identity proofing andenrollment, card issuance, maintenance and access control. Our solutions offera significant benefit that one vendor’s solution is used throughout the variousstages, from establishing an applicant’s verified identity, to issuance ofsmart card based credentials, to the usage and integration to physical andlogical access control systems.

The solutionimproves the integrity and authenticity of access control to facilities andinformation systems, as well as enhance security, increase efficiency, reduceidentity fraud, and protect personal privacy.

We categorize our identity management products andservices into three basic markets: (1) Biometrics, (2) Secure Credential, and(3) Law Enforcement and Public Safety. Our biometric product line consists ofthe following:

***Biometrics***

**IWS BIOMETRIC ENGINE**

This is abiometric identity management platform for multi-biometric enrollment,management and authentication, managing population databases of unlimited sizeswithout regard to hardware or algorithm. Searches can be 1:1 (verification), 1:N (identification), X:N(investigative) and N:N (database integrity). IWS Biometric Engine istechnology and biometric agnostic, enabling the use of biometric devices andalgorithms from any vendor, and the support of the following biometric types:finger, face, iris, hand geometry, palm, signature, DNA, signature, voice, 3Dface and retina. IWS Biometric Engine is a second-generation solution fromImageWare Systems that is based on field-proven ImageWare technology solutionsthat have been used to manage millions of biometric records since 1997 and isideal for a variety of applications including: criminal booking, backgroundchecks (civil and criminal), watch list, visa/passport and border control (air,land and sea), physical and logical access control, and other highly-secureidentity management environments.

IWS Biometric Engine is scalable, and biometric imagesand templates can be enrolled either live 

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oroffline.   Because it stores the enrolledimages, a new algorithm can be quickly converted to support new or alternatealgorithms and capture devices. The Biometric Engine is built to be hardware“agnostic”, and currently supports over 107 hardware capture devices and over93 biometric algorithms.

In 2006, ImageWare launched an expanded suite ofapplication solutions based on the award-winning IWS Biometric Engine. The IWSBiometric Engine has previously been available as a Software Development Kit(SDK), as well as a platform for custom configurations to meet specificcustomer requirements. The added suite of products provide government, lawenforcement, border management and enterprise businesses, a wide variety ofapplication-specific solutions that address specific government mandates andtechnology standards. It also provides the ability to integrate into existinglegacy systems and expand based upon specific customer requirements. Thisenables users to integrate a complete solution or components as needed. The newapplication suite of products include complete packaged solutions for:

·                  HSPD-12 PersonalIdentity Verification (PIV)

·                  BorderManagement

·                  ePassport &eVisa

·                  ApplicantIdentity Vetting

·                  MobileAcquisition

·                  DisasterManagement

·                  Physical AccessControl

·                  Single-Sign-Onand Logical Access Control

**IWS PIV MANAGEMENT APPLICATION**

ImageWare provides a set of Enterprise Server products within ourcomplete PIV solution, and these software products supply server-based featuresand functions, while the use case for PIV requires client-based presentation ofPIV data and workflow.  The IWS PIV ManagementApplication supplies the web-based graphical user interface that presents theuser or client interface to the various server functions.  Furthermore, since the server-basedapplications perform specific functions for specific phases of the PIV life-cycle,these server-based applications need to be bound together with additionalworkflow processes.  Again, the IWS PIVManagement Application meets this need with software modules that interface andinterconnect the server-based applications.

**IWS PIV MIDDLEWARE**

The IWS PIVMiddleware product, which is NIST certified and listed on the GSA approvedproduct list, is a library of functions that connect a card reader & PIVcard on the hardware side with a software application. The library implementsthe specified PIV Middleware API functions that support interoperability of PIVCards.  This ImageWare software has beendeveloped in conformance with the FIPS-201 specification, and the software hasbeen certified by the NIST Personal Identification Verification Program (NPIVP)Validation Authority as being compliant.

**IWS BACKGROUND SERVER**

The IWS Background Server is a software applicationdesigned specifically for government and law enforcement organizations tosupport the first stage of biometric identity management functions such asidentity proofing and vetting. IWS Background Check Server automaticallyprocesses the submission of an applicant’s demographic and biographic data toinvestigative bureaus for background checks prior to issuing a credential.

**IWS DESKTOP SECURITY**

IWS DesktopSecurity is a highly flexible, scalable and modular authentication managementplatform that is optimized to enhance network security and usability. Thisarchitecture provides an additional layer of security to workstations, networksand systems through advanced encryption and authentication technologies.Biometric technologies (face, fingerprint, iris, voice or signature), can beseamlessly coupled with TPM chips to further enhance corporate security. USBtokens, smart cards and RFID technologies can also be readily integrated.****Additional features include:

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·                                       Supportfor multiple authentication tools including Public Key Infrastructure (PK1)within a uniformed  platform andprivilege Management Infrastructure (PMI) technology to provide more advancedaccess control services and assure authentication and data integrity.

·                                       Integrationwith IWS Biometric Engine for searching and match capabilities (1:1, 1:N andX:N)

·                                       Integrationwith IWS EPI Builder for the production and management of secure Credentials

·                                       Supportfor both BioAPI and BAPI standards

·                                        Supportsa single sign-on feature that securely manages Internet Explorer and Windowsapplication ID and password information.

·                                       Supportsfile and folder encryption features.

·                                       Supportsvarious operating systems, including Microsoft Windows 2000, Windows XP, AndWindows Server 2003.

**IWSBIOMETRIC QUALITY ASSESSMENT & ENHANCEMENT** (IWS BiometricIQA&E)

The IWS BiometricIQA&E is a biometric image enhancement and assessment solution that assistsgovernment organizations with the ability to evaluate and enrich millions ofbiometric images automatically, saving time and costs associated with biometricenrollment while maintaining image and database integrity.

The IWS Biometric IQA&E improves the accuracy andeffectiveness of biometric template enrollments. The software may be usedstandalone or in conjunction with the IWS Biometric Engine. IWS BiometricIQA&E provides automated image quality assessment with respect to relevantimage quality standards from organizations such as International Civil AviationOrganization (ICAO) National Institute of Standards and Technology (NIST),International Organization for Standards (ISO) and American Association ofMotor Vehicle Association (AAMVA). IWS Biometric IQA&E also enablesorganizations to conduct multi-dimensional facial recognition which furtherenhances accuracy for numerous applications including driver licenses,passports and watch lists.

IWS BiometricIQA&E automatically provides real-time biometric image quality analysis andfeedback to improve the overall effectiveness of biometric images thusincreasing the biometric verification performance, and maintaining database andimage data integrity. IWS Biometric IQA&E provides a complete platform thatincludes an image enhancement library for biometric types including face,finger and iris.

***Secure Credential***

Our Identification and Secure Credential Productsconsist of the following products:

**IWS CARD MANAGEMENT**

The IWS Card Management System (CMS) is acomprehensive solution to support and manage the issuance of smart cardscomplete with the following capabilities:

·                                          Biometricenrollment and identity proofing with Smart Card encoding of biometrics

·                                          Flexiblemodels of central or distributed issuance of credentials

·                                          Customizablecard life-cycle workflow managed by the CMS

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Integration of the CMSdata with other enterprise solutions, such as physical access control andlogical access control (i.e. Single-Sign-On – SSO)

**IWS EPI SUITE**

This is an ID software solution for producing,issuing, and managing secure credentials and personal identification cards.Users can efficiently manage large amounts of data, images and card designs, aswell as track and issue multiple cards per person; automatically populatemultiple cards, eliminating redundant data entry, IWS EPI Suite was designed tointegrate with our customers’ existing security and computing infrastructure.We believe that this compatibility may be an appealing feature to corporations,government agencies, transportation departments, school boards, and otherpublic institutions.

**IWS EPIBUILDER**

This is a softwaredeveloper’s kit and a leading secure credential component of identitymanagement and security solutions, providing all aspects of ID functionalityfrom image and biometric capture to the enrollment, issuance and management ofsecure documents. It contains components which developers or systemsintegrators can use to support and produce secure credentials includingnational IDs, passports, International Civil Aviation Office (ICAO)-complianttravel documents, smart cards and driver licenses. IWS EPI Builder enablesorganizations to develop custom identification solutions or incorporatesophisticated identification capabilities into existing applications includingthe ability to capture images, biometric and demographic data; enable biometricidentification and verification (1:1 and 1:X) as well as support numerousbiometric hardware and software venders. It also enables users to addelectronic identification functionality for other applications, includingaccess control, tracking of time and attendance, point of sale transactions,human resource systems, school photography systems, asset management, inventorycontrol, warehouse management, facilities management and card productionsystems.

**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 and governments.

**IWS PRINTFARM**

While it is the last stage of PIV Card Issuance, thePIV smart card printing process is by no means the least important stage.  Production printing of tens of thousands ofPIV cards requires a significant investment and a well-engineered system.  The IWS EPI PrintFarm software offers acost-effective yet high-performance method for high-volume card printing.

**IWS PIV ENCODER**

PIV smart cards must be programmed with specificmandatory data, digital signatures and programs in order to maintain theinteroperability as well as the security features specified for the cards. TheIWS PIV Encoder could be considered to be complex device driver that properlyprograms the PIV smart cards.  TheEncoder interacts with the Card Management System for data payload elements. Itinteracts with the Certificate Authority to encrypt or sign the PIV smart carddata with trusted certificates. Finally, it acts as the application-leveldevice driver to make the specific PIV smart card encoding system properlyprogram the smart card, regardless if the system is a standalone encodingsystem or one integrated into a card printer.

***Law Enforcement andPublic Safety***

We believe our integrated suite of software productssignificantly reduces the inefficiencies and expands the capabilities oftraditional booking and mugshot systems. Using our products, an agency cancreate a digital database of thousands of criminal history records, eachincluding one or more full-color facial images, finger and palm prints, textinformation and images of other distinctive physical features such as scars,marks and tattoos. This database can be quickly searched using text queries orby using our biometric facial recognition or AFIS technology which can comparebiometric characteristics of an unknown suspect with those in the database.

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Ourinvestigative software products can also be used to create, edit and enhancedigital images and to search databases of other agencies to which our customershave access.

Our IWS Law Enforcement solution consists of softwaremodules, which may also be purchased individually. The IWS Law EnforcementCapture and Investigative module make up our booking system and database. Ouradd-on modules include Livescan, Facial Recognition, Suspect ID, a Wirelessmodule, and a PDA add-on module.

**IWS LAWENFORCEMENT**

IWS LawEnforcement is a digital booking, identification and investigative solutionthat enables users to digitally capture, search, store and retrieve images anddemographic data including mug shots, scars, marks and tattoos (SMTs) andfingerprints. Law enforcement can submit fingerprint data directly to the StateAFIS, FBI criminal repository, or other agencies as required. Additionalfeatures and functionality include real-time access to images and data,creation of digital composite sketches, photo lineups, and production ofidentification cards and credentials. IWS Law Enforcement also uses off-the-shelf hardware and is designed tocomply with open industry standards so that it can operate on an array ofsystems ranging from a stand-alone personal computer to a wide area network. Toavoid duplication of entries, the system can be integrated easily with severalother information storage and retrieval systems, such as a records managementsystem or an automated fingerprint identification system.

**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.

**LIVESCAN**

This software module is FBI certified which complieswith the FBI Integrated Automated Fingerprint Identification System (IAFIS)Image Quality Specifications (IQS) while utilizing the latest FBI certifiedLivescan device from most major vendors. Livescan allows users to capturesingle to ten prints and palm data, providing an integrated biometricmanagement for civil and law enforcement use. By adding Livescan capabilities,law enforcement organizations further enhance the investigative process byproviding additional identifiers to identify suspects involved in a crime.  In addition, officers no longer need totravel to multiple booking stations to capture fingerprints and mug shots.  All booking information including images willbe located at a central designation and can be routed to the State AFIS or theFBI criminal history record repository.

**INVESTIGATIVE**

This software module allows users to search thedatabase created with IWS Law Enforcement. Officers can conduct text searchesin many fields, including file number, name, alias, distinctive features, andother information such as gang membership and criminal history. TheInvestigative module creates a catalogue of possible matches, allowing officersor witnesses to save time by looking only at mugshots that closely resemble thedescription of the suspect. This module can also be used to create a line-up ofsimilar facial images from which a witness may identify the suspect.

**FACIAL RECOGNITION**

This software module uses biometric facial recognitionand retrieval technology to help authorities identify possible suspects. Imagestaken from surveillance videos, digital sketches or photographs can be searchedagainst a digital database of facial images to retrieve any desired number offaces with similar characteristics. This module can also be used at the time ofbooking to identify persons using multiple aliases. Using biometrics-basedtechnology, the application can search through thousands of facial images in amatter of seconds, reducing the time it would otherwise take a witness to flipthrough a paper book of facial images that may or may not be similar to thedescription of the suspect. The Facial Recognition module then creates aselection of possible matches ranked in order of similarity to the suspect, anda percentage confidence level is attributed to each possible match. Theapplication incorporates search engine technology which we license from variousfacial recognition algorithm providers.

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**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.

**WIRELESS**

The Wireless module enables authorized personnel toaccess and search a county’s booking records stored in IWS Law Enforcementthrough a standard Web browser from within the county’s intranet. This moduleallows remote access to the IWS Law Enforcement database without requiring theuser to be physically connected to the customer’s network. This applicationrequires only that the user have access to the Internet and authorization toaccess the county’s intranet.

**PDA**

The PDA module is a powerful investigative tool thatallows officers to access IWS Law Enforcement booking photos and related datain the field on a handheld Pocket PC compatible device.

***Maintenance and Customer Support***

As part of our installation of a system, we offer totrain our customers’ employees as to the effective use of our products. Weoffer training both on-site and at our facilities. We offer on-site hardwaresupport to our customers, generally within 24 hours of the customerrequest. Customers can contract with us for technical support that enables themto use a toll-free number to speak with our technical support center for softwaresupport and general assistance 24 hours a day, seven days a week. As manyof our government customers operate around the clock and perceive our systemsas critical to their day-to-day operations, a very high percentage contract fortechnical support. Customer support services typically provide us with annualrevenue of 12% to 18% of the initial sales price of the hardware and softwarepurchased by our customers.  Maintenancerevenues typically account for approximately 21% to 25% of our total revenues. 

***Software Customization and Fulfillment***

We directly employ computer programmers and alsoretain independent programmers to develop our software and perform qualitycontrol. We provide customers with software that we specifically customize tooperate on their existing computer system. We work directly with purchasers ofour system to ensure that the system they purchase will meet their unique needs.We configure and test the system either at our facilities or on-site andconduct any customized programming necessary to connect the system with anylegacy systems already in place.  We canalso provide customers with a complete computer hardware system with oursoftware already installed and configured. In either case, the customer isprovided with a complete turnkey solution which can be used immediately. Whenwe provide our customers with a complete solution including hardware, we useoff-the-shelf computers, cameras and other components purchased from othercompanies such as IBM or Hewlett Packard. Systems are assembled and configuredeither at our facilities or at the customer’s location.

**OUR STRATEGY**

Key elements of our strategy for growth include thefollowing:

***Penetrate theBiometrics, Access Control and Identification Markets***

We believe security issues are becoming increasinglyimportant among public agencies, corporations, hospitals, universities andsimilar organizations. We believe that the September 11, 2001, 

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terroristattacks and the subsequent establishment of the Department of Homeland Securityand the movement by governments around the world to authenticate the identityof their citizens will accelerate the adoption of biometric identificationsystems that can provide secure credentials and instant access to centrallymaintained records for real time verification of identity and access (physicaland logical) privileges. Using our products, an organization can create securecredentials that correspond to images in a digital database. A border guard orcustoms agent can stop an individual to quickly and accurately verify hisidentity against a database of authorized persons, and either allow or denyaccess as required. Our technology can also be applied in other markets tofacilitate activities such as federal identification mandates while complyingwith personal identification verification standards (HSPD-12), InternationalCivil Aviation Organization (ICAO) standards, American Association of MotorVehicle Administrators (AAMVA) driver licenses, voter registration, immigrationcontrol and welfare fraud identification.

With the identity management market growing at a rapidpace, biometric identifiers are becoming recognized and accepted as integralcomponents to the identification process in the public and privatesectors.  As biometric technologies(facial recognition, fingerprint, iris, etc) are adopted, identificationsystems must be updated to enable their use in the field.  We have built our solutions to enable theincorporation of one or multiple biometrics, which can be associated with arecord and stored both in a database and on a card for later retrieval andverification without regard to the specific hardware employed.  We believe the increasing demand forbiometric technology will drive demand for our solutions which enable their useby end users.  Our identity managementproducts are built to accommodate the use of biometrics and meet the demandingrequirements across the entire identity life cycle.

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

We intend to use our successful installations withcustomers such as the Arizona Department of Public Safety, New South WalesPolice, and the Los Angeles County Sheriff’s Department as reference accountsand to aggressively market IWS Law Enforcement as a superior technologicalsolution. The majority of our recent sales have been and will be from sales ofIWS Law Enforcement.  Our recent additionof the Livescan module to IWS Law Enforcement 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 nearterm to establish IWS Law Enforcement as the integrated mug shot and Livescansystem adopted in as many countries, states, large counties and municipalitiesas possible. Once we have a system installed in a region, we intend to thensell additional systems or retrieval seats to other agencies within the primarycustomer’s region and in neighboring regions. In addition, we plan to marketour integrated investigative modules to the customer, including the FacialRecognition and Wireless modules, Suspect ID, Wireless module, and PDA module. 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 willcomplement our growth strategy and enhance our competitive position in ourcurrent markets and other markets that utilize our core imaging technology.

***Expand into RelatedApplications within the Law Enforcement and Public Safety Markets***

Our products can provide solutions to law enforcementand public safety agencies beyond our core application of police bookingsystems and related investigative products with minimal adaptation. Thetechnology behind our IWS Law Enforcement product line can be used to createdatabases of missing children and to compare the facial image of a lost childto the images in the database. Our system can be used to help correctionalfacilities track and control inmates as well as facilitate inmate release. Gunsellers could use our products to access available criminal databases and helpprevent the sale of guns to ineligible persons. Our technology can be used tomonitor persons on parole or probation without requiring them to travel totheir parole or probation officer. We anticipate that a parolee or probationerwill be able to have his photograph taken in a specially-designed kiosk whichuses biometrics-based technology to identify the person and inform his paroleor probation officer of his location.

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***Develop theInternet and Wireless Capabilities of Our Products***

One of our latest software modules, the Wirelessmodule, allows users to use the Internet or secure intranets to conductinvestigative searches of digital booking systems. This module includes themost frequently used investigative features of IWS Law Enforcement to allowusers to retrieve single images, conduct searches based on one or moreparameters, create digital line-ups and print retrieved records. We are alsocurrently developing an Internet-based version of Facial Recognition that willallow investigators to use the Internet to compare the digital image of anunknown suspect with a database of images using biometrics-based technology.Our Internet products will allow users to quickly access and share images viathe Internet while maintaining the security and integrity of databases, therebyencouraging the widespread dissemination and sharing of criminal informationamong law enforcement agencies. Since the September 11, 2001, terrorist attacksthere has been significant discussion at the federal and state levels ofgovernment regarding the need for federal, state and local agencies to shareinformation. We anticipate that the movement toward sharing of information willaccelerate the adoption of digital booking technology with Internet andwireless capabilities by law enforcement agencies at all levels.

We are also developing wireless PDA capabilities intoour products. Public agencies as well as private sector customers requireinformation to be available from remote locations. The PDA module is our firsthandheld application which can operate in the field on Pocket PC compatibledevices and accompany users wherever they are located. In order to facilitatethe transfer of records and information retrieval tools to employees in thefield, we plan to develop technology in cooperation with wirelesscommunications companies that will allow our products in the field to operateover wireless systems.

**SALES AND MARKETING**

We market and sell our products through our directsales force and through indirect distribution channels, including systemsintegrators. We have sales and account representatives based in Canada, anddomestically in Virginia, Maryland, Texas, Illinois, and California.Geographically, as of March 1, 2007, our sales and marketing force consists of13 persons in the United States and one person in Canada.

We sell through a direct sales organization which issupported by the marketing organization. Our sales professionals are supported by our technical experts who areavailable by telephone and conduct on-site customer presentations.

The typical sales cycle for IWS Biometric Engine andIWS Law Enforcement includes a pre-sale process to define the potentialcustomer’s needs and budget, an on-site demonstration and conversations betweenthe potential customer and existing customers. Government agencies aretypically required to purchase large systems by including a list ofrequirements in a Request For Proposal, known as an “RFP,” and by allowingseveral companies to openly bid for the project by responding to the RFP. Ifour response is selected, we enter into negotiations for the contract and, ifsuccessful, ultimately receive a purchase order from the customer. This processcan take anywhere from a few months to over a year.

Our Biometric and ID products are also sold to largeintegrators, direct via our sales force and to end users through distributors.Depending on the customer’s requirements, there may be instances that requirean RFP. The sales cycle can vary from a few weeks to a year.

In addition to our direct sales force, we havedeveloped relationships with a number of systems integrators who contract withgovernment agencies for the installation and integration of large computer andcommunication systems. By acting as a subcontractor to these systemsintegrators, we are able to avoid the time consuming and often-expensive taskof submitting proposals to government agencies, and we also gain access tolarge clients.

We also work with companies that offer complementaryproducts, where value is created through product integration. Through teamingarrangements we are able to enhance our products and to expand our customerbase through the relationships and contracts of our strategic partners.

We promote our products through trade journaladvertisements, direct mail and attendance at industry trade shows, includingthose sponsored by the Biometric Consortium, International Association forBiometrics, American Association of Motor Vehicle Administrators, InternationalAssociation for

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Identification, AmericanSociety of Industrial Security and the International Association of Chiefs ofPolice. We also target other media through public relations efforts, includingnon-industry publications, daily newspapers, local and national news programs,and television programs related to law enforcement. Articles regarding ourproducts have appeared in Business Week, Los Angeles Times, Chicago Tribune,The Wall Street Journal and a number of other publications.

We plan to continue to market and sell our productsinternationally. Some of the challenges and risks associated with internationalsales include the difficulty in protecting our intellectual property rights,difficulty in enforcing agreements through foreign legal systems and volatilityand unpredictability in the political and economic conditions of foreigncountries. We believe we can work to successfully overcome these challenges.

**CUSTOMERS**

We have a wide variety of domestic and internationalcustomers. Most of our IWS Law Enforcement customers are government agencies atthe federal, state and local levels in the United States. Our products are alsobeing used in Australia, Canada, the United Arab Emirates, Kuwait, Mexico,Colombia, Costa Rica, Venezuela, Singapore, Indonesia and the Philippines. Thecustomer base for our digital identification systems includes domestic andforeign government agencies, universities, airports, and private sectorcompanies, many of which are Fortune 500 or Fortune 1000 companies. In 2006,Raytheon Company accounted for approximately 21% of our revenues.  In 2005 and 2004, there was no singlecustomer who accounted for more than 10% of our revenues.

**COMPETITION**

***The Law Enforcementand Public Safety Markets***

Due to the fragmented nature of the law enforcementand public safety market and the modular nature of our product suite, we facedifferent degrees of competition with respect to each IWS Law Enforcementmodule. We believe the principal basis on which we compete with respect to allof our products are:

·                                          theunique ability to integrate our modular products into a complete biometric,Livescan, imaging and investigative system;

 

·                                          ourreputation as a reliable systems supplier;

 

·                                          theusability and functionality of our products; and

 

·                                          theresponsiveness, availability and reliability of our customer support.

Our law enforcement product line faces competitionfrom other companies such as Printrak International, Inc., DataWorks Plus,and Cogent Systems, Inc.  Internationally,there are often a number of local companies offering solutions in mostcountries. Many of our competitors’ products in this niche offer basic imagecapture and storage, but lack the functionality of integrated investigativeproducts, including facial recognition and image editing and enhancement.

***IdentificationMarkets***

Due to the breadth of our software offering in thesecure ID market space, we face differing degrees of competition in certainmarket segments. The strength of our competitive position is based upon:

·                                          ourstrong brand reputation with a customer base which includes small andmedium-sized businesses, Fortune 500 corporations and large governmentagencies;

 

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

 

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

Our software faces competition from DatacardCorporation, a privately held manufacturer of 

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hardware,software and consumables for the ID market. There are also a considerablenumber of smaller software competitors such as Number Five Software Ltd.,Loronix Information Systems, Inc. and Fox Technology Pty Ltd. whocompete in differing geographies, primarily in the packaged product segment.

***Biometric Market***

The market to provide biometric systems to theidentity management market is evolving and we face competition from a number ofsources. We believe that the strength of our competitive position is based on:

·                                          ourunique ability to provide a system which enables the enrollment, management andauthentication of multiple biometrics managing population databases ofunlimited sizes ;

 

·                                          searchescan be 1:1 (verification), 1:N (identification) and X:N (investigative); andN:N (database integrity)

 

·                                          the system istechnology and biometric agnostic, enabling the use of biometric devices andalgorithms from any vendor, and the support of the following biometric types:finger, face, iris, hand geometry, palm, DNA, signature, voice, and 3D face andretina;

Our multi-biometric product faces competition fromL-1Identity Solutions, Inc., Ireland-based Daon, and French-based Sagem neitherof which have offerings with the scope and flexibility of our IWS BiometricEngine.

**INTELLECTUAL PROPERTY**

We rely on trademark, patent, trade secret andcopyright laws and confidentiality and license agreements to protect ourintellectual property. We have several unregistered and federally registeredtrademarks including the trademark ImageWare, as well as trademarks for whichthere are pending trademark registrations with the United States, Canadian andother International Patent & Trademark Offices.  We hold several issued patents and haveseveral other patent applications pending for elements of our products.  We license and depend on intellectualproperty from third parties for our biometric products and modules whichutilizes third party biometric encoding and matching technologies.

We regard our software as proprietary and retain titleto and ownership of the software we develop. We attempt to protect our rights in the software primarily through tradesecrets.  We have not published the sourcecode of most of our software products and require employees and other third-partieswho have access to the source code, other trade secret information, to signconfidentiality agreements acknowledging our ownership and the nature of thesematerials as our trade secrets.

Despite these precautions, it may be possible forunauthorized parties to copy or reverse-engineer portions of our products.  While our competitive position could bethreatened by disclosure or reverse engineering of this proprietaryinformation, we believe that copyright and trademark protection are less importantthan other factors such as the knowledge, ability, and experience of ourpersonnel, name recognition and ongoing product development and support.

Our software products are licensed to end users undera perpetual, nontransferable, nonexclusive license that stipulates whichmodules can be used and how many concurrent users may use them.  These forms of licenses are typically notsigned by the licensee and may be more difficult to enforce than signedagreements in some jurisdictions.

Although our products have never been the subject ofan infringement claim, we cannot assure that third parties will not assertinfringement claims against us in the future or that any such assertion willnot require us to enter into royalty arrangements or result in costly litigation.

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**RESEARCH AND DEVELOPMENT**

Our research and development team is made up of 23programmers, engineers and other employees. We also contract with outsideprogrammers for specific projects as needed. We spent approximately$3.5million, $2.8 million and $2.3 million on research and development in2006, 2005 and 2004, respectively. We continually work to increase the speed,accuracy, and functionality of our existing products. We anticipate that ourresearch and development efforts will continue to focus on new technology andproducts for the identity management markets.

**EMPLOYEES**

As of March 1, 2007, we had a total of 74full-time employees. Our employees are not covered by any collective bargainingagreement, and we have never experienced a work stoppage. We believe that ourrelations with our employees are good.

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**Item1A.  Risk Factors**

*Aninvestment in our common stock involves a high degree of risk. before investingin our common stock, you should consider carefully the specific risks detailedin this “Risk Factors” section and any applicable prospectus supplement,together with all of the other information contained in this prospectus and anyprospectus supplement. If any of these risks occur, our business, results ofoperations and financial condition could be harmed, the price of our commonstock could decline, and you may lose all or part of your investment.*

**RISKSRELATED TO OUR BUSINESS**

**We havehad net losses in our five most recent fiscal years and currently havestockholder’s equity of less than $6,000,000, and as a result, the AmericanStock Exchange (“AMEX”), may consider suspending or delisting our securitiesfrom the exchange.**

The AMEX Company Guideprovides that AMEX will normally consider suspending dealings in, or removingfrom listing, securities of a company which sustains net losses in its fivemost recent fiscal years and has stockholders’ equity of less than $6,000,000,unless the company has total market capitalization of at least $50,000,000, ortotal assets and revenue of $50,000,000. We have sustained net losses duringour five most recent fiscal years, and as of the year ended December 31, 2006,our stockholders’ equity dropped to $1,319,890, from $3,365,602 for the yearended December 31, 2005. We do not currently meet the alternative minimummarket capitalization or total asset and revenue requirements. As a result, wemay be considered for suspension or delisting from AMEX. During May 2006, wereceived notification from AMEX that we were not in compliance with certainsections of the AMEX Company Guide. To maintain an AMEX listing, we wererequired to submit a plan to AMEX which demonstrates our ability to regaincompliance with the continued listing standards within a maximum of 18 months.We submitted our plan to AMEX in June 2006. The Listing QualificationsDepartment of AMEX evaluated our plan and in September 2006 notified us that wehad made a reasonable demonstration in the plan of an ability to regaincompliance with the continued listing standards by the end of the plan periods,which AMEX determined to be November 15, 2006 for Section 1003(a)(iv) of theAMEX Company Guide and November 30, 2007 for Sections 1003(a)(i), 10033(a)(ii)and 1003(a)(iii) of the AMEX Company Guide.  Accordingly, inSeptember 2006, AMEX notified us that they would continue the listing of theCompany subject to us making a public announcement disclosing the fact that weare not in compliance with the continued listing standards of the exchange andthat our listing is being continued pursuant to an extension and our providingcertain supporting documentation of key elements of our plan. We made therequired public announcement and provided the requested information. We aresubject to periodic review to determine if we are making progress consistentwith the plan. Failure to make progress consistent with the plan or regaincompliance with the continued listing standards by the end of the applicableextension periods could result in AMEX initiating delisting proceedings. Thereis no assurance that we will make progress consistent with the plan, or that wewill be able to continue our listing on AMEX.

**We havea history of significant recurring losses totaling approximately $70 million,and these losses may continue in the future.**

As of December 31, 2006,we had an accumulated deficit of $70.3 million, and these losses may continuein the future. We may need to raise capital to cover these losses, andfinancing may not be available to us on favorable terms. We expect to continueto incur significant sales and marketing, research and development, and generaland administrative expenses.

Our operating resultshave fluctuated in the past and are likely to fluctuate significantly in thefuture. We may experience fluctuations in our quarterly results of operationsas a result of:

·                  varying demandfor and market acceptance of our technology and products;

·                  changes in ourproduct or customer mix;

·                  the gain or lossof one or more key customers or their key customers, or significant changes inthe financial condition of one or more of our key customers or their keycustomers;

·                  our ability tointroduce, certify and deliver new products and technologies on a timely basis;

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·                  the announcementor introduction of products and technologies by our competitors;

·                  competitive pressureson selling prices;

·                  costs associatedwith acquisitions and the integration of acquired companies, products andtechnologies;

·                  our ability tosuccessfully integrate acquired companies, products and technologies;

·                  our accountingand legal expenses; and

·                  general economicconditions.

These factors, some ofwhich are not within our control, may cause the price of our stock to fluctuatesubstantially. To respond to these and other factors, we may need to makebusiness decisions that could result in failure to meet financial expectations.If our quarterly operating results fail to meet or exceed the expectations ofsecurities analysts or investors, our stock price could drop suddenly andsignificantly. Most of our expenses, such as employee compensation, inventoryand debt repayment obligations, are relatively fixed in the short term.Moreover, our expense levels are based, in part, on our expectations regardingfuture revenue levels. As a result, if our revenue for a particular period werebelow our expectations, we would not be able to proportionately reduce ouroperating expenses for that period. Any revenue shortfall would have adisproportionately negative effect on our operating results for the period.

**We havereceived a “going concern” opinion from our independent registered publicaccounting firm, which may negatively impact our business.**

We have received a reportfrom Stonefield Josephson, Inc., our independent registered public accountingfirm, regarding our consolidated financial statements for the fiscal year endedDecember 31, 2006, which included an explanatory paragraph stating that theconsolidated financial statements were prepared assuming we will continue as agoing concern. The report also stated that our substantial net losses and monetaryliabilities have raised substantial doubt about our ability to continue as agoing concern. Any failure to dispel any continuing doubts about our ability tocontinue as a going concern could adversely affect our ability to enter intocollaborative relationships with business partners, to raise additional capitaland to sell our products, and could have a material adverse effect on ourbusiness, financial condition and results of operations.

**Wecurrently have limited cash resources and we will require additional funding tofinance our working capital requirements for the next twelve months.**

We currently have limitedcash resources and we will require financing to fund our anticipated workingcapital requirements for at least the next twelve months. If we are not able togenerate positive cash flows from operations in the near future, we will berequired to seek additional funding through public or private equity or debtfinancing. There can be no assurance that additional financing will beavailable on acceptable terms, or at all. If we are required to sell equity toraise additional funds, our existing stockholders may incur substantialdilution and any shares so issued may have rights, preferences and privilegessuperior to the rights, preferences and privileges of our outstanding commonstock. Also, we may be required to obtain funds through arrangements with thirdparties that require us to relinquish rights to certain of our technologies orproducts that we would seek to develop or commercialize ourselves. In addition,our ability to raise additional capital may be dependent upon our common stockbeing listed on AMEX. We cannot guarantee that we will be able to satisfy thecriteria for continued listing on AMEX.

**Wedepend upon a small number of large system sales ranging from $500,000 to inexcess of $2,000,000, and we may fail to achieve one or more large system salesin the future.**

In the past three years,we have derived a substantial portion of our revenues from a small number ofsales of large, relatively expensive systems, typically ranging in price from$500,000 to $2,000,000. As a result, if we fail to receive orders for theselarge systems in a given sales cycle on a consistent basis, our business couldbe significantly harmed. Further, our quarterly results are difficult topredict because we cannot predict in which quarter, if any, large system saleswill occur in a given year. As a result, we believe that quarter-to-quartercomparisons of our results of operations are not a good indication of ourfuture performance. In some future quarters, our operating results may be belowthe expectations of securities analysts and investors, in which case the marketprice of our common stock may decrease significantly.

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**Ourlengthy sales cycle may cause us to expend significant resources for as long asone year in anticipation of a sale to certain customers, yet we still may failto complete the sale.**

When considering thepurchase of a large computerized identity management system, a governmentagency may take as long as one year to evaluate different systems and obtainapproval for the purchase. If we fail to complete a sale, we will have expendedsignificant resources and received no revenue in return. Generally, agenciesconsider a wide range of issues before committing to purchase our products,including product benefits, ability to operate with their current systems,product reliability and their own budgetary constraints. While potentialcustomers are evaluating our products and before they place an order with us,we may incur substantial selling costs and expend significant management effortto accomplish a sale.

**Asignificant number of our customers are government agencies that are subject tounique political and budgetary constraints and have special contractingrequirements which may affect our ability to obtain new government customers.**

A significant number ofour customers are government agencies. These agencies often do not set theirown budgets and therefore have little control over the amount of money they canspend. In addition, these agencies experience political pressure that maydictate the manner in which they spend money. Due to political and budgetaryprocesses and other scheduling delays that may frequently occur relating to thecontract or bidding process, some government agency orders may be canceled orsubstantially delayed, and the receipt of revenues or payments may besubstantially delayed. In addition, future sales to government agencies willdepend on our ability to meet government contracting requirements, certain ofwhich may be onerous or impossible to meet, resulting in our inability toobtain a particular contract. Common requirements in government contractsinclude bonding requirements, provisions permitting the purchasing agency tomodify or terminate at will the contract without penalty, and provisionspermitting the agency to perform investigations or audits of our businesspractices.

**We mayfail to create new applications for our products and enter new markets, whichmay affect our future success.**

We believe our futuresuccess depends in part on our ability to develop and market our technology forapplications other than booking systems for the law enforcement market. If wefail in these goals, our business strategy and ability to generate revenues andcash flow would be significantly impaired. We intend to expend significantresources to develop new technology, but the successful development of newtechnology cannot be predicted and we cannot guarantee we will succeed in thesegoals.

**Weoccasionally rely on systems integrators to manage our large projects, and ifthese companies do not perform adequately, we may lose business.**

We occasionally act as asubcontractor to systems integrators who manage large projects that incorporateour systems, particularly in foreign countries. We cannot control thesecompanies, and they may decide not to promote our products or may price theirservices in such a way as to make it unprofitable for us to continue ourrelationship with them. Further, they may fail to perform under agreements withtheir customers, in which case we might lose sales to these customers. If welose our relationships with these companies, our business may suffer.

**If thepatents we own or license, or our other intellectual property rights, do notadequately protect our products, we may lose market share to our competitorsand be unable to operate our business profitably.**

Our success dependssignificantly on our ability to protect our rights to the technologies used inour products. We rely on patent protection, trade secrets, as well as acombination of copyright and trademark laws and nondisclosure, confidentialityand other contractual arrangements to protect our technology. However, theselegal means afford only limited protection and may not adequately protect ourrights or permit us to gain or keep any competitive advantage. In addition, wecannot be assured that any of our pending patent applications will result inthe issuance of a patent to us. The U.S. Patent and Trademark Office (“PTO”)may deny or require significant narrowing of claims in our pending patentapplications, and patents issued as a result of the pending patentapplications, if any, may not provide us with significant commercial protectionor be issued in a form that is advantageous to us. We could also incursubstantial costs in proceedings before the PTO. These proceedings could resultin adverse decisions as to the claims included in our patents.

Our issued and licensedpatents and those that may be issued or licensed in the future may bechallenged, invalidated or circumvented, which could limit our ability to stopcompetitors from marketing related products. Additionally, upon expiration ofour issued or licensed patents, we may lose some of our rights to excludeothers from making, using, selling or

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importing products usingthe technology based on the expired patents. We also must rely on contractualrights with the third parties that license technology to us to protect ourrights in the technology licensed to us. Although we have taken steps toprotect our intellectual property and technology, there is no assurance thatcompetitors will not be able to design around our patents. We also rely onunpatented proprietary technology. We cannot assure you that we canmeaningfully protect all our rights in our unpatented proprietary technology orthat others will not independently develop substantially equivalent proprietaryproducts or processes or otherwise gain access to our unpatented proprietarytechnology. We seek to protect our know-how and other unpatented proprietarytechnology with confidentiality agreements and intellectual property assignmentagreements with our employees. However, such agreements may not providemeaningful protection for our proprietary information in the event ofunauthorized use or disclosure or other breaches of the agreements or in theevent that our competitors discover or independently develop similar oridentical designs or other proprietary information. In addition, we rely on theuse of registered and common law trademarks with respect to the brand names ofsome of our products. Our common law trademarks provide less protection thanour registered trademarks. Loss of rights in our trademarks could adverselyaffect our business, financial condition and results of operations.

Furthermore, the laws offoreign countries may not protect our intellectual property rights to the sameextent as the laws of the United States. If we fail to apply for intellectualproperty protection or if we cannot adequately protect our intellectualproperty rights in these foreign countries, our competitors may be able tocompete more effectively against us, which could adversely affect ourcompetitive position, as well as our business, financial condition and resultsof operations.

**If thirdparties claim that we infringe their intellectual property rights, we may incurliabilities and costs and may have to redesign or discontinue selling certainproducts.**

Whether a productinfringes a patent involves complex legal and factual issues, the determinationof which is often uncertain. We face the risk of claims that we have infringedon third parties’ intellectual property rights. Searching for existingintellectual property rights may not reveal important intellectual property andour competitors may also have filed for patent protection, which is not as yeta matter of public knowledge, or claimed trademark rights that have not beenrevealed through our availability searches. Our efforts to identify and avoidinfringing on third parties’ intellectual property rights may not always besuccessful. Any claims of patent or other intellectual property infringement,even those without merit, could:

·                  increase thecost of our products;

·                  be expensive andtime consuming to defend;

·                  result in usbeing required to pay significant damages to third parties;

·                  force us tocease making or selling products that incorporate the challenged intellectualproperty;

·                  require us toredesign, reengineer or rebrand our products;

·                  require us toenter into royalty or licensing agreements in order to obtain the right to usea third party’s intellectual property, the terms of which may not be acceptableto us;

·                  require us toindemnify third parties pursuant to contracts in which we have agreed toprovide indemnification to such parties for intellectual property infringementclaims;

·                  divert theattention of our management; and

·                  result in ourcustomers or potential customers deferring or limiting their purchase or use ofthe affected products until the litigation is resolved.

In addition, new patentsobtained by our competitors could threaten a product’s continued life in themarket even after it has already been introduced.

**Existingor future acquisitions of businesses could negatively affect our business,financial condition and results of operations if we fail to integrate theacquired businesses successfully into our existing operations or if we discoverpreviously undisclosed liabilities.**

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We completed theacquisitions of several companies, including G&A Imaging Ltd. (“G&A”),and we plan to continue to review potential acquisition candidates. Ourbusiness and our strategy include building our business through acquisitions.However, acceptable acquisition candidates may not be available in the futureor may not be available on terms and conditions acceptable to us.

Successful acquisitionsdepend upon our ability to identify, negotiate, complete and integrate suitableacquisitions and to obtain any necessary financing. Even if we completeacquisitions, we may experience:

·                  difficulties inintegrating any acquired companies, personnel and products into our existingbusiness;

·                  delays inrealizing the benefits of the acquired company or products;

·                  diversion of ourmanagement’s time and attention from other business concerns;

·                  limited or nodirect prior experience in new markets or countries we may enter;

·                  higher costs ofintegration than we anticipated; and

·                  difficulties inretaining key employees of the acquired business who are necessary to managethese acquisitions.

In addition, anacquisition could materially impair our operating results by causing us toincur debt or requiring us to amortize acquisition expenses and acquiredassets. We may also discover deficiencies in internal controls, data adequacyand integrity, product quality, regulatory compliance and product liabilitiesthat we did not uncover prior to our acquisition of such businesses, whichcould result in us becoming subject to penalties or other liabilities. Anydifficulties in the integration of acquired businesses or unexpected penaltiesor liabilities in connection with such businesses could have a material adverseeffect on our business, financial condition and results of operations.

**Weoperate in foreign countries and are exposed to risks associated with foreignpolitical, economic and legal environments and with foreign currency exchangerates.**

With our acquisition ofG&A, we have significant foreign operations.  As a result, we areexposed to risks, including among others, risks associated with foreignpolitical, economic and legal environments and with foreign currency exchangerates. Our results may be adversely affected by, among other things, changes ingovernment policies with respect to laws and regulations, anti-inflationmeasures, currency conversions, remittance abroad and rates and methods oftaxation.

**RISKSRELATED TO OWNING OUR STOCK**

**Theholders of our preferred stock have certain rights and privileges that aresenior to our common stock, and we may issue additional shares of preferredstock without stockholder approval that could have a material adverse effect onthe market value of the common stock.**

Our Board of Directorshas the authority to issue a total of up to 4,000,000 shares of preferred stockand to fix the rights, preferences, privileges, and restrictions, includingvoting rights, of the preferred stock, which typically are senior to the rightsof the common stockholders, without any further vote or action by you and theother common stockholders. Your rights will be subject to, and may be adverselyaffected by, the rights of the holders of the preferred stock that have beenissued, or might be issued in the future. Preferred stock also could have theeffect of making it more difficult for a third party to acquire a majority ofthe outstanding voting stock of ImageWare. This could delay, defer, or preventa change in control. Furthermore, holders of preferred stock may have otherrights, including economic rights, senior to the common stock. As a result,their existence and issuance could have a material adverse effect on the marketvalue of the common stock. We have in the past issued, and, may from time totime in the future issue, preferred stock for financing or other purposes withrights, preferences, or privileges senior to the common stock. At December 31,2006 we had two series of preferred stock outstanding, Series B preferred stockand Series C 8% convertible preferred stock. In March 2007, we issued 1,500 shares of the Company’s Series D 8%Convertible Preferred Stock (the “Series D Preferred Stock”) at a stated valueof $1,000 per share for aggregate gross proceeds of $1,500,000.

The provisions of ourSeries B preferred stock prohibit the payment of dividends on the common stockunless the dividends on those preferred shares are first paid. In addition,upon a liquidation, dissolution or sale of ImageWare’s business, the

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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 Bpreferred stock we are obligated to pay cumulative cash dividends on shares ofSeries B preferred stock from legally available funds at the annual rate of$0.2125 per share, payable in two semi-annual installments of $0.10625 each,which cumulative dividends must be paid prior to payment of any dividend on ourCommon Stock. As of December 31, 2006, the Company had cumulative undeclareddividends on the Series B preferred stock of approximately $9,000.

The Series C PreferredStock has a liquidation preference equal to its stated value, plus any accruedand unpaid dividends thereon and any other fees or liquidated damages owingthereon. The Series C Preferred Stock accrues cumulative dividends at the rateof 8.0% of the stated value per share per annum.  At the option of theCompany, the dividend payment may be made in the form of cash, after thepayment of cash dividends to the holders of Series B preferred stock, or commonstock issuable upon conversion of the Series C Preferred Stock.  Eachshare of Series C Preferred Stock is convertible at any time at the option ofthe holder into a number of shares of common stock equal to the stated value(initially $1,000 per share, subject to adjustment), plus any accrued andunpaid dividends, divided by the conversion price (initially $1.50 per share,subject to adjustment). Subject to certain limitations, the conversion priceper share shall be adjusted in the event of certain subsequent stock dividends,splits, reclassifications, dilutive issuances, rights offerings, andreclassifications.  The Series C Preferred Stock generally does not havevoting rights except as required by law, however, certain activities may not beundertaken by the Company without the affirmative vote of a majority of theholders of the outstanding shares of Series C Preferred Stock. As of December31, 2006, the Company had cumulative undeclared dividends on the Series CPreferred Stock of approximately $25,000.

**Ourstock price has been volatile, and your investment in our common stock couldsuffer a decline in value.**

There has beensignificant volatility in the market price and trading volume of equitysecurities, which is unrelated to the financial performance of the companiesissuing the securities. These broad market fluctuations may negatively affectthe market price of our common stock. You may not be able to resell your sharesat or above the price you pay for those shares due to fluctuations in themarket price of our common stock caused by changes in our operating performanceor prospects and other factors.

Some specific factorsthat may have a significant effect on our common stock market price include:

·                  actual oranticipated fluctuations in our operating results or future prospects;

·                  ourannouncements or our competitors’ announcements of new products;

·                  the public’sreaction to our press releases, our other public announcements and our filingswith the SEC;

·                  strategicactions by us or our competitors, such as acquisitions or restructurings;

·                  new laws orregulations or new interpretations of existing laws or regulations applicableto our business;

·                  changes inaccounting standards, policies, guidance, interpretations or principles;

·                  changes in ourgrowth rates or our competitors’ growth rates;

·                  developmentsregarding our patents or proprietary rights or those of our competitors;

·                  our inability toraise additional capital as needed;

·                  concern as tothe efficacy of our products;

·                  changes infinancial markets or general economic conditions;

·                  sales of commonstock by us or members of our management team; and

·                  changes in stockmarket analyst recommendations or earnings estimates regarding our commonstock, other comparable companies or our industry generally.

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**Ourfuture capital-raising activities could involve the issuance of equitysecurities, which would dilute your investment and could result in a decline inthe trading price of our common stock.**

We may sell securities inthe public or private equity markets if and when conditions are favorable, evenif we do not have an immediate need for additional capital at that time.Raising funds through the issuance of equity securities will dilute theownership of our existing stockholders. Furthermore, we may enter intofinancing transactions at prices that represent a substantial discount to themarket price of our common stock. A negative reaction by investors andsecurities analysts to any discounted sale of our equity securities couldresult in a decline in the trading price of our common stock.

**If registration rights that wehave previously granted are exercised, then the price of our common stock maybe adversely affected.**

We have agreed toregister with the SEC shares of common stock underlying our outstanding SeriesD Preferred Stock and warrants to purchase an aggregate of 848,676 shares ofcommon stock. In the event these securities are registered with the SEC, theymay be freely sold in the open market provided the registration statement underwhich such securities are registered remains effective and subject to tradingrestrictions to which our insiders holding the shares may be subject from timeto time. We expect that we also will be required to register any securitiessold in future private financings. The sale of a significant amount of sharesin the open market, or the perception that these sales may occur, could causethe trading price of our common stock to decline or become highly volatile.

**Our corporatedocuments and Delaware law contain provisions that could discourage, delay orprevent a change in control of our company.**

Provisions in ourcertificate of incorporation and bylaws may discourage, delay or prevent amerger or acquisition involving us that our stockholders may considerfavorable. For example, our certificate of incorporation authorizes preferredstocks, which carry special rights, including voting and dividend rights. Withthese rights, preferred stockholders could make it more difficult for a thirdparty to acquire us.

We are also subject tothe anti-takeover provisions of Section 203 of the Delaware GeneralCorporation Law. Under these provisions, if anyone becomes an “interestedstockholder,” we may not enter into a “business combination” with that personfor three years without special approval, which could discourage a third partyfrom making a takeover offer and could delay or prevent a change of control.For purposes of Section 203, “interested stockholder” means, generally,someone owning 15% or more of our outstanding voting stock or an affiliate ofours that owned 15% or more of our outstanding voting stock during the pastthree years, subject to certain exceptions as described in Section 203.

**Futuresales of our common stock could adversely affect its price.**

Sales of substantialamounts of common stock, or the perception that such sales could occur, couldadversely affect the prevailing market price of our common stock and ourability to raise capital. We may issue additional common stock in futurefinancing transactions or as incentive compensation for our executivemanagement and other key personnel, consultants and advisors. Issuing anyequity securities would be dilutive to the equity interests represented by ourthen-outstanding shares of common stock. The market price for our common stockcould decrease as the market takes into account the dilutive effect of any ofthese issuances.

**We donot expect to pay cash dividends on our common stock for the foreseeablefuture.**

We have never paid cashdividends on our common stock and do not anticipate that any cash dividendswill be paid on the common stock for the foreseeable future. The payment of anycash dividend by us will be at the discretion of our board of directors andwill depend on, among other things, our earnings, capital, regulatoryrequirements and financial condition. Furthermore, the terms of our Series Bpreferred stock and Series C Preferred Stock directly limit our ability to paycash dividends on our common stock.

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**Securitiesanalysts may not continue to cover our common stock or may issue negativereports, and this may have a negative impact on our common stock’s marketprice.**

There is no guaranteethat securities analysts will continue to cover our common stock. If securitiesanalysts do not cover our common stock, the lack of research coverage mayadversely affect our common stock’s market price. The trading market for ourcommon stock relies in part on the research and reports that industry orfinancial analysts publish about our business or us. If one or more of theanalysts who cover us downgrades our stock, our stock price may declinerapidly. If one or more of these analysts ceases coverage of ImageWare, wecould lose visibility in the market, which in turn could cause our stock priceto decline. In addition, rules mandated by the Sarbanes-Oxley Act of 2002, anda global settlement reached between the SEC, other regulatory analysts and anumber of investment banks in April 2003, may lead to a number of fundamentalchanges in how analysts are reviewed and compensated. In particular, manyinvestment banking firms will now be required to contract with independentfinancial analysts for their stock research. It may be difficult for companieswith smaller market capitalizations, such as our company, to attractindependent financial analysts that will cover our common stock, which couldhave a negative effect on our market price.

**Thelarge number of holders and lack of concentration of ownership of our commonstock may make it difficult for us to reach a quorum or obtain an affirmativevote of our stockholders at future stockholder meetings.**

Our stock is held in alarge number of individual accounts with no one registered holder or group ofregistered holders individually accounting for more than 5% of our outstandingcommon stock. As a result, it may be difficult for us to reach a quorum orobtain an affirmative vote of a majority of our stockholders where either ofthose thresholds are measured based on the total number of shares of our commonstock outstanding. Difficulty in obtaining a stockholder vote could impact ourability to complete any financing or strategic transaction requiringstockholder approval or effect basic corporate governance changes, such as anincrease in the authorized number of shares of our common stock.

**Item1B. Unresolved Staff Comments**

Not applicable.

**Item 2. Properties.**

Our corporate headquarters are located in San Diego,California where we occupy approximately 16,000 square feet of office space andapproximately 1,000 square feet of warehouse space. Our lease for this facilitycontinues through September 2008 at a cost of approximately $20,100 permonth.  We occupy 10,000 square feet inGatineau, Province of Quebec. These premises are leased until May 2009, ata cost of approximately $15,800 per month. We occupy 3,470 square feet ofoffice space in Portland, Oregon at a cost of approximately $7,200 permonth.  Our lease for this facilitycontinues through October 2009.

**Item 3. Legal Proceedings.**

We are periodically engagedin litigation in the ordinary course of business and do not believe that any ofsuch litigation is material to our ongoing operations.

**Item 4. Submission of Matters to aVote of Security Holders.**

Not applicable.

**PART II**

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

*Market Information.*

Our Common Stock trades under the symbol “IW” on theAmerican Stock Exchange.

The following table sets forth the high and low salesprices per share for our Common Stock as reported by the American StockExchange for each quarter in 2005 and 2006:
| 2005 Fiscal Quarters | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------|------------|----------|------------|---------|------------|
| First Quarter                  |       | $        | 3.380      |    | $          | 2.190 |   |
| Second Quarter                 |       | $        | 3.890      |    | $          | 3.000 |   |
| Third Quarter                  |       | $        | 3.390      |    | $          | 2.150 |   |
| Fourth Quarter                 |       | $        | 2.250      |    | $          | 1.520 |   |

 

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| 2006 Fiscal Quarters | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------|------------|----------|------------|---------|------------|
| First Quarter                  |       | $        | 2.540      |    | $          | 1.350 |   |
| Second Quarter                 |       | $        | 2.560      |    | $          | 1.580 |   |
| Third Quarter                  |       | $        | 2.300      |    | $          | 1.110 |   |
| Fourth Quarter                 |       | $        | 2.250      |    | $          | 1.200 |   |

 

There is no public trading market for our preferredstock.

*Holders.*

As of March 25, 2007, there were approximately2,400 holders of record of our Common Stock.

*Dividends.*

We have never declared or paid dividends on our CommonStock and do not anticipate paying any cash dividends on our shares of CommonStock in the foreseeable future. We are obligated to pay cumulative cashdividends on shares of Series B Preferred Stock from legally availablefunds at the annual rate of $0.2125 per share, payable in two semi-annualinstallments of $0.10625 each, which cumulative dividends must be paid prior topayment of any dividend on our Common Stock. The holders of our Series C Preferred Stock are entitled to receivecumulative dividends, at the option of the Company, payable (i) in common stockupon conversion of the Series C Preferred Stock, or (ii) in cash after thepayment of cash dividends to the holders of our Series B Preferred Stock at therate of 8% per annum (as a percentage of stated value per share).  As of December 31, 2006, the Company hadcumulative undeclared dividends of approximately $9,000 relating to our SeriesB Preferred Stock and approximately $25,000 relating to our Series C PreferredStock.

*Repurchases.*

We did not repurchase anyshares of our common stock during fiscal 2006.

**Item 6. Selected Consolidated Financial Data**

The following selected financial data should be readin conjunction with our Consolidated Financial Statements and the related notesand “Management’s Discussion and Analysis of Financial Condition and Results ofOperations” appearing elsewhere in this Form 10-K. The selected consolidatedstatement of operations data presented below for each of the years endedDecember 31, 2006, 2005, and 2004, and the consolidated balance sheet dataat December 31, 2006 and 2005 are derived from our Consolidated FinancialStatements that have been included elsewhere in this Form 10-K. The selectedconsolidated statement of operations data for the years ended December 31,2003 and 2002 and consolidated balance sheet data at December 31, 2004,2003, and 2002 are derived from audited consolidated financial statements notincluded in this Form 10-K.    Thehistorical results of operations are not necessarily indicative of futureresults.

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**STATEMENTOF OPERATIONS DATA:**
| ** **                                           | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                   | ** ** | **2005(1)** | ** ** | **2004(1)** | ** ** | **2003(1)** | ** ** | **2002(1)** | ** ** |
|                                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                             |       | $                                          | 10,189,566 |   | $ | 9,174,173 |   | $ | 9,176,865 |   | $ | 14,147,971 |   | $ | 16,506,727 |   |
| Cost of revenues                                     |       | $                                          | 3,180,166  |   | $ | 3,910,693 |   | $ | 3,106,256 |   | $ | 6,745,616 |   | $ | 7,515,211 |   |
| Gross profit                                         |       | $                                          | 7,009,400  |   | $ | 5,263,480 |   | $ | 6,070,609 |   | $ | 7,402,355 |   | $ | 8,991,516 |   |
| Operating  expenses                                  |       | $                                          | 12,082,482 |   | $ | 12,179,936 |   | $ | 9,824,470 |   | $ | 11,114,469 |   | $ | 12,144,457 |   |
| Interest  (income) expense, net                      |       | $                                          | 564,524    |   | $ | (53,288 | ) | $ | 5,172,193 |   | $ | 6,960,140 |   | $ | 655,033 |   |
| Other (income)  expense, net                         |       | $                                          | (119,330   | ) | $ | (166,390 | ) | $ | (187,640 | ) | $ | (207,046 | ) | $ | (53,575 | ) |
| Loss from  continuing operations before income taxes |       | $                                          | (5,518,276 | ) | $ | (6,696,778 | ) | $ | (8,738,414 | ) | $ | (10,465,208 | ) | $ | (3,754,399 | ) |
| Income tax  expense                                  |       | $                                          | —     |   | $ | — |   | $ | — |   | $ | 61,735 |   | $ | 120,341 |   |
| Loss from  continuing operations                     |       | $                                          | (5,518,276 | ) | $ | (6,696,778 | ) | $ | (8,738,414 | ) | $ | (10,526,943 | ) | $ | (3,874,740 | ) |
| Discontinued  operations                             |       | $                                          | (407,939   | ) | $ | (1,658,926 | ) | $ | (900,185 | ) | $ | (208,850 | ) | $ | (974,190 | ) |
| Net loss                                             |       | $                                          | (5,926,215 | ) | $ | (8,355,704 | ) | $ | (9,638,599 | ) | $ | (10,735,793 | ) | $ | (4,848,930 | ) |
|                                                 |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic loss per  share:                               |       |                                       |       |   |   |   |   |   |   |   |   |
| Net loss -  continuing operations                    |       | $                                          | (0.41      | ) | $ | (0.53 | ) | $ | (0.75 | ) | $ | (1.78 | ) | $ | (0.72 | ) |
| Net loss -  discontinued operations                  |       | $                                          | (0.03      | ) | $ | (0.13 | ) | $ | (0.08 | ) | $ | (0.04 | ) | $ | (0.18 | ) |
| Net loss                                             |       | $                                          | (0.44      | ) | $ | (0.66 | ) | $ | (0.83 | ) | $ | (1.81 | ) | $ | (0.90 | ) |
| Weighted-average shares  (basic and diluted)         |       | 13,592,841                                 |       | 12,731,304 |   | 11,739,819 |   | 5,953,801 |   | 5,483,973 |   |

 

**BALANCESHEET DATA:**
| Cash                             |   | $ | 938,553   |   | $ | 741,184   |   | $ | 2,911,765  |   | $ | 578,093    |   | $ | 214,934    |   |
|----------------------------------|--------|---|-----------|--------|---|-----------|--------|---|------------|--------|---|------------|--------|---|------------|--------|
| Accounts  receivable, net        |   | $ | 1,721,892 |   | $ | 1,340,154 |   | $ | 1,797,120  |   | $ | 1,449,968  |   | $ | 3,294,932  |   |
| Inventories, net                 |   | $ | 57,990    |   | $ | 207,833   |   | $ | 1,096,796  |   | $ | 804,526    |   | $ | 1,882,082  |   |
| Other current  assets            |   | $ | 137,609   |   | $ | 218,549   |   | $ | 247,548    |   | $ | 204,065    |   | $ | 422,382    |   |
| Property and  equipment, net     |   | $ | 351,700   |   | $ | 423,887   |   | $ | 510,270    |   | $ | 634,966    |   | $ | 1,040,915  |   |
| Other and  pension assets        |   | $ | 784,459   |   | $ | 738,238   |   | $ | 733,796    |   | $ | 726,414    |   | $ | 803,826    |   |
| Intangibles, net                 |   | $ | 141,294   |   | $ | 218,400   |   | $ | 764,125    |   | $ | 1,120,675  |   | $ | 1,561,545  |   |
| Goodwill                         |   | $ | 3,415,647 |   | $ | 3,415,647 |   | $ | 5,297,627  |   | $ | 5,297,627  |   | $ | 5,297,627  |   |
| Total assets                     |   | $ | 7,549,144 |   | $ | 7,303,892 |   | $ | 13,359,047 |   | $ | 10,816,334 |   | $ | 14,518,246 |   |
| Total current  liabilities       |   | $ | 5,212,961 |   | $ | 2,808,760 |   | $ | 4,281,140  |   | $ | 3,311,964  |   | $ | 6,958,314  |   |
| Long-term  liabilities           |   | $ | 1,016,293 |   | $ | 1,129,530 |   | $ | 811,688    |   | $ | 4,192,605  |   | $ | 1,658,432  |   |
| Total  liabilities               |   | $ | 6,299,254 |   | $ | 3,938,290 |   | $ | 5,092,828  |   | $ | 7,504,569  |   | $ | 8,616,746  |   |
| Total shareholders’  equity |   | $ | 1,319,890 |   | $ | 3,365,602 |   | $ | 8,266,219  |   | $ | 3,311,765  |   | $ | 5,901,500  |   |

 

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(1)Results of operations as presented have been restated to exclude the results ofoperations of our Digital Photography and Digital Imaging Asia Pacificcomponents due to these components being classified as discontinued operationsdue to their sale in November 2006 and March 2005, respectively.

***Item 7.   Management’s Discussion and Analysis of Financial Condition andResults of Operations.***

**FORWARD-LOOKINGSTATEMENTS**

The following discussion should be read inconjunction with our consolidated financial statements included elsewhere inthis report.  This discussion containsforward-looking statements that involve risks and uncertainties.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors including those set forth under “Risk Factors” in Item 1Aabove.  Due to such fluctuations,historical results and percentage relationships are not necessarily indicativeof the operating results for any future period.

**OVERVIEW**

ImageWareSystems, Inc. is a leader in the emerging market for software-basedidentity management solutions, providing biometric, secure credential and lawenforcement technologies.  Our “flagship”product is the IWS Biometric EngineTM. Scalable for small city business or worldwide deployment, our biometricengine is a multi-biometric platform that is hardware and algorithmindependent, enabling the enrollment and management of unlimited populationsizes.  Our identification products areused to manage and issue secure credentials including national IDs, passports,driver licenses, smart cards and access control credentials. Our lawenforcement products provide law enforcement with integrated mug shot, fingerprintLivescan and investigative capabilities. The biometric technology is now an integral part of all markets weaddress, and all of our products are integrated into the Biometric EnginePlatform.  Elements of the biometric engine can be

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usedas investigative tools to law enforcement potentially utilizing multiplebiometrics and forensic data elements, and to enhance security and authenticityof public and private sector credentials.

**CRITICALACCOUNTING ESTIMATES**

Thediscussion and analysis of our consolidated financial condition and results ofoperations are based on our consolidated financial statements, which have beenprepared in accordance with accounting principals generally accepted in theUnited States of America, or U.S. GAAP. The preparation of these consolidatedfinancial statements in accordance with U.S. GAAP requires us to utilizeaccounting policies and make certain estimates and assumptions that affect thereported amounts of assets and liabilities, the disclosure of contingencies asof the date of the consolidated financial statements and the reported amountsof revenue and expenses during a fiscal period. The SEC considers an accountingpolicy to be critical if it is important to a company’s financial condition andresults of operations, and if it requires significant judgment and estimates onthe part of management in its application. Although we believe that ourjudgments and estimates are appropriate and correct, actual resultsmay differ from those estimates.

The following are our critical accounting policiesbecause we believe they are both important to the portrayal of our financialcondition and results of operations and require critical management judgmentsand estimates about matters that are uncertain. If actual results or eventsdiffer materially from those contemplated by us in making these estimates, ourreported financial condition and results of operations for future periods couldbe materially affected.  For a detaileddiscussion on the application of these and other accounting policies, seeNote 1 in the Notes to the Consolidated Financial Statements in Item 8 ofthis Annual Report on Form 10-K, beginning on page F-7.

***Revenue Recognition***

Ourrevenue recognition policy is significant because our revenue is a keycomponent of our consolidated results of operations. We recognize revenue fromthe following major revenue sources:

·                  Long-termfixed-price contracts involving significant customization

·                  Fixed-pricecontracts involving minimal customization

·                  Softwarelicensing

·                  Salesof computer hardware and identification media

·                  Postcontractcustomer support (PCS)

TheCompany’s revenue recognition policies are consistent with U. S. GAAP includingStatements of Position 97-2 “Software Revenue Recognition” and 98-9 “Modificationof SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions”,Securities and Exchange Commission Staff Accounting Bulletin 104 , EmergingIssues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”,and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement ofPosition 97-2 to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software”. Accordingly, the Company recognizes revenuewhen all of the following criteria are met: persuasive evidence of anarrangement exists, delivery has occurred or services have been rendered, thefee is fixed or determinable, and collectibility is reasonably assured.

Werecognize 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. We also generate non-recurring revenue from thelicensing of our 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. We also generate revenue from the sale ofcomputer hardware and identification media. Revenue for these items isrecognized upon delivery of these products to the customer. Our revenue fromperiodic maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

28

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For a detailed discussion on the application of theseand other accounting policies, see Note 1 in the Notes to the ConsolidatedFinancial Statements in Item 8 of this Annual Report on Form 10-K,beginning on page F-7.

***Allowance for Doubtful Accounts***

We provide an allowance for our accounts receivablefor estimated losses that may result from our customers’ inability to pay.  We determine the amount of allowance byanalyzing historical losses, customer concentrations, customercreditworthiness, current economic trends, the age of the accounts receivablebalances, and changes in our customer payment terms when evaluating theadequacy of the allowance for doubtful accounts. Our accounts receivablesbalance was $2,032,000, net of allowance for doubtful accounts of $483,000 forthe year ended December 31, 2006.

***Valuation of Goodwill, OtherIntangible and Long-Lived Assets***

We assess impairment of goodwill and identifiableintangible assets whenever events or changes in circumstances indicate that thecarrying value may not be recoverable. Factors we consider important whichcould trigger an impairment review include the following:

·                                          Significantunderperformance relative to historical or expected future operating results;

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

·                                          Significantnegative industry or economic trends;

When we determine that the carrying value of goodwilland other intangible assets may not be recoverable based upon the existence ofone or more of the above indicators of impairment, we measure any impairmentbased upon fair value methodologies. Goodwill and other net intangible assetsamounted to approximately $3,557,000 for the year ended December 31, 2006.

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 performed aninitial 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 impairmentreview as of December 31, 2005, based upon our 2006 operating plan  This annual impairment review indicated therewas goodwill impairment in our Digital Photography segment as of December 31,2005, and accordingly, we recorded an impairment loss in the 2005 ConsolidatedStatement of Operations.  Both of thesetests were conducted by determining and comparing the fair value of ourreporting units, as defined in SFAS 142, to the reporting unit’s carrying valueas of that date.

With the sale of our Digital Photography component in2006, we reassessed the composition of our operating segments and determinedthat we no longer operate in separate, distinct market segments but rather operatein one market segment, such segment being identity management.  The Company’s determination was based onfundamental changes in the Company’s business structure due to theconsolidation of operations, restructuring of the Company’s operations and managementteam, and the integration of what where previously distinct, mutually exclusivetechnologies.  This has resulted inchanges in the manner by which the Company’s chief decision maker assessesperformance and makes decisions concerning resource allocation.  As a result of our operation in one marketsegment, such segment being identity management, our 2006 goodwill impairmentreview consisted of the comparison of the fair value of our identity managementsegment as determined by the quoted market prices of our common stock to thecarrying amount of the segment. As the fair value exceeded the carrying valueby a substantial margin, we determined that our goodwill was not impaired.

There are many management assumptions and estimatesunderlying the determination of an impairment loss, and estimates usingdifferent, but reasonable, assumptions could produce significantly differentresults. Significant assumptions include estimates of future levels of revenuesand operating expenses. Therefore, the timing and recognition of impairmentlosses by us in the future, if any, may be highly dependent upon our estimatesand assumptions.  There can be noassurance that goodwill impairment will not occur in the future.

We account for long-lived assets in accordance withthe provisions of SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets.”  This statementrequires that long-lived assets and certain identifiable

29

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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 be impaired,the impairment to be recognized is measured by the amount which the carryingamount 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 31,2006 and 2004. In 2005, we recorded an impairment charge of approximately$253,000 related to our intangible asset for certain trademark and tradenamescarried in our Identification segment. This loss reflects the amount by which the carrying value of this assetexceeded its estimated fair value determined by the assets’ future discountedcash flows.  The impairment loss isrecorded as a component of “Operating expenses” in the Statement of Operationsfor 2005.  There are many managementassumptions and estimates underlying the determination of an impairment loss,and estimates using different, but reasonable, assumptions could producesignificantly different results. Significant assumptions include estimates offuture levels of revenues and operating expenses. Therefore, the timing andrecognition of impairment losses by us in the future, if any, may be highlydependent upon our estimates and assumptions. There can be no assurance that intangible asset impairment will notoccur in the future.

***Stock-Based Compensation***

Uponadoption of SFAS 123R on January 1, 2006, we began estimating the value ofemployee stock options on the date of grant using the Black-Scholes model.Prior to the adoption of SFAS 123R, the value of each employee stock option wasestimated on the date of grant using the Black-Scholes model for the purpose ofthe pro forma financial disclosure in accordance with SFAS 123. Thedetermination of fair value of stock-based payment awards on the date of grantusing an option-pricing model is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited to the expected stock pricevolatility over the term of the awards and the actual and projected employeestock option exercise behaviors. The expected term of options granted isderived from historical data on employee exercises and post-vesting employmenttermination behavior. We calculated our expected volatility assumption requiredin the Black-Scholes model based on the historical volatility of our stock. Asof January 1, 2006 we have adopted the modified prospective transitionmethod and its effect is included in our consolidated financial statements forthe twelve months ended December 31, 2006. We will update these assumptions on at least an annual basis and on aninterim basis if significant changes to the assumptions are warranted.

30

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**YearEnded December 31, 2006 Compared to Year Ended December 31, 2005 and Year EndedDecember 31, 2005 Compared to Year Ended December 31, 2004**

Thefollowing management’s discussion and analysis or plan of operation is basedprimarily upon our Identity Management segment. Results as presented do not contain the results of our DigitalPhotography component nor our wholly-owned subsidiary, Digital Imaging AsiaPacific, due to these components being classified as discontinued operationsdue to the sale of Digital Photography in November 2006 and Digital ImagingAsia Pacific in the first fiscal quarter of 2005.

***Revenues***

***Product Revenues***
| ** **                              | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                              | ** ** | **2006**                          | ** ** | **Change** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|                                    | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Product  revenues:**                  |       |                              |       |   |   |   |   |   |   |   |   |
| Software and Royalties                  |       | $                                 | 5,889,262  |   |   | 46 | % |   | $ | 4,036,856 |   |   | -12 | % |   | $ | 4,591,854 |   |
| Percentage of total net product revenue |       | 77                                | %          |   | 21 | % |   | 57 | % |   | -6 | % |   | 63 | % |
| Hardware and consumables                |       | $                                 | 1,347,452  |   |   | -36 | % |   | $ | 2,108,411 |   |   | 5 | % |   | $ | 2,014,497 |   |
| Percentage of total net product revenue |       | 18                                | %          |   | -12 | % |   | 30 | % |   | 2 | % |   | 28 | % |
| Services                                |       | $                                 | 368,884    |   |   | -25 | % |   | $ | 488,852 |   |   | -29 | % |   | $ | 686,779 |   |
| Percentage of total net product revenue |       | 5                                 | %          |   | -2 | % |   | 7 | % |   | -3 | % |   | 9 | % |
| Patent Licensing                        |       | $                                 | —     |   |   | -100 | % |   | $ | 500,000 |   |   | 100 | % |   | $ | — |   |
| Percentage of total net product revenue |       | 0                                 | %          |   | -7 | % |   | 7 | % |   | 7 | % |   | 0 | % |
| Total net  product revenues             |       | $                                 | 7,605,598  |   |   | 7 | % |   | $ | 7,134,119 |   |   | -2 | % |   | $ | 7,293,130 |   |

 

Identitymanagement software and royalties increased 46% in 2006 from 2005.  This increase is reflective of increasedsales of our Biometric Engine and EPI identity management products into projectoriented solutions.  Also contributing tothis increase were royalties generated from our IWS Desktop Security productrelease in the fourth fiscal quarter of 2005.  The increase in project-oriented revenues was offset by a decrease insales of boxed product through our distribution channel.

Thedecrease in our Identity management software and royalties of 12% in 2005 from2004 is reflective of lower sales of identity management solutions to LawEnforcement customers due to decreased procurement by state and local governmentsoffset by an increase in sales of our Biometric Engine and Identity managementsoftware products into project-oriented solutions and an increase in boxedsoftware sold through our distribution channel.

Hardwareand consumable product sales decreased approximately 36% or $761,000 duringtwelve months ended December 31, 2006 as compared to the corresponding periodin 2005 and reflects the repositioning of our international sales office inGermany in order to lower fixed costs and pursue significant Identificationprojects utilizing the Company’s software technologies as our primarydifferentiator.  This office hadhistorically emphasized the resale of third-party merchandise (hardware andconsumables) which generated lower gross margins than software (as a percentageof revenue) and required significant fixed costs for sales, service andsupport.  In furtherance of thisstrategy, in December 2005, we decided to reorganize our German sales office byclosing our existing facility in order to reduce operating expenses. The effecton hardware and consumables revenues from the closure of this office was areduction of such revenues of approximately $732,000 in 2006 as compared to2005.

Hardwareand consumable product sales increased 5% in 2005 from 2004, reflecting anincrease in domestic sales of such products offset by reduced internationalsales due to the initiation of the closure of our German sales office.

We areof the opinion that foreign markets formerly served by this office will embraceour identification and biometric solutions for large-scale high-endinstallations.  We continue to be of theopinion that government agencies and private entities will react to heightenedsecurity concerns resulting from acts of terrorism by re-evaluating andupgrading their ability to positively identify and track their citizens,employees, consultants and visitors.  Weanticipate that these factors will continue to increase overall demand for ourIdentity management products, however, we cannot predict the timing of theshift in demand.

31

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Servicesrevenues are comprised primarily of software integration services, systeminstallation services and customer training. Such revenues decreased during the twelve months ended December 31, 2006as compared to the corresponding period of 2005 due primarily to thecomposition of our customer’s orders and a decrease in our installation ofhardware products.

Servicerevenues decreased 25% or $125,000 during the twelve months ended December 31,2005 as compared to the corresponding period in 2004 due to a decrease in bothsoftware and hardware installation services of identity management solutionssold including implementation services for a web-based, investigative lawenforcement system for the New South Wales Police Department completed duringthe first fiscal quarter of 2004.

Weexpect service revenues to increase in 2007 through our implementation oflarge-scale high-end installations.

Wegenerated revenues of $500,000 from sublicensing our Image Editing Systempatent within the computer video, web conferencing and cellular phone fields ofuse during the twelve months ended December 31, 2005.  There were no such revenues earned in thecomparable periods of 2006 or 2004.

Wefeel that we continue to remain well positioned for participation in one ormore large-scale domestic or international projects which will enable theCompany to achieve significant product revenue growth in our Identitymanagement segment.  In the past twelvemonths we have retooled our identity management suite of products to enablecustomization for large project applications, added the Biometric Engine forincorporation into large scale biometric installations and reoriented ourorganization to direct our resources and capabilities toward establishing afoothold in the market for large-scale secure identity management solutions.

Wefurther believe that continued incidents of terrorism have created heightenedinterest in the ability of law enforcement and other government agencies to beable to efficiently retrieve, analyze and share information from theirrespective identity management databases. We anticipate that these factors will increase overall demand for theCompany’s products; however, we cannot predict the timing of the shift indemand.

Ourbacklog of product orders as of December 31, 2006, was approximately$1,647,000.  At December 31, 2006, wealso had maintenance and support backlog of approximately $1,219,000 underexisting maintenance agreements.  Productrevenue is typically recognized within a three to six month period dependingupon the required degree of customization, if any.  Historically, we have experienced a veryminimal risk of order cancellation and do not anticipate order cancellations inexcess of 5%.  Our revenue frommaintenance agreements is generally recognized ratably over the respectivemaintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

***Maintenance Revenues***
| ** **            | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|-----------------------|------------|-----------------------------------|------------|
| ** **            | ** ** | **DECEMBER 31,**             | ** ** |
| ** **            | ** ** | **2006**                          | ** ** | **Change** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
| ** **            |       |                              |       |   |   |   |   |   |   |   |   |
| Maintenance  revenues |       | $                                 | 2,583,968  |   |   | 27 | % |   | $ | 2,040,054 |   |   | 8 | % |   | $ | 1,883,735 |   |
|                       |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Maintenancerevenues increased 27% for the twelve months ended December 31, 2006 ascompared to the corresponding period in 2005 and reflects the expansion of ourinstalled base resulting from the completion of significant project-orientedwork during the year ended December 31, 2006. Likewise, our increase in maintenance revenues for the twelve monthsended December 31, 2005 as compared to the corresponding period in 2004reflects the expansion of our installed base during 2005 combined with ourretention of existing maintenance customers.

Weanticipate continued growth of our installed base through the retention ofexisting customers combined with the completion of project-oriented work;however we cannot predict the timing of this anticipated growth.

32

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***Cost of Product Revenues***
| ** **                                                  | ** ** | **TWELVE MONTHS ENDED** | ** ** |       |
|-------------------------------------------------------------|------------|-----------------------------------|------------|------------|
| ** **                                                  | ** ** | **DECEMBER 31,**             | ** ** |       |
| ** **                                                  | ** ** | **2006**                          | ** ** | **Change** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |   |
| **Cost of  Product Revenues:**                              | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Software and Royalties                                      |       | $                                 | 1,225,300  |       |   | 32 | % |   | $ | 931,293 |   |   | 26 | % |   | $ | 740,187 |   |
| Percentage of software and royalty net product  revenue     |       | 21                                | %          |       | -2 | % |   | 23 | % |   | 7 | % |   | 16 | % |
| Hardware and consumables                                    |       | $                                 | 983,167    |       |   | -50 | % |   | $ | 1,965,269 |   |   | 36 | % |   | $ | 1,447,737 |   |
| Percentage of hardware and consumables net product  revenue |       | 73                                | %          |       | -20 | % |   | 93 | % |   | 21 | % |   | 72 | % |
| Services                                                    |       | $                                 | 7,455      |       |   | -63 | % |   | $ | 20,197 |   |   | -13 | % |   | $ | 23,130 |   |
| Percentage of services net product revenue                  |       | 2                                 | %          |       | -2 | % |   | 4 | % |   | 1 | % |   | 3 | % |
| Patent Licensing                                            |       | $                                 | —     |       | $ | — |   |   | $ | — |   |   |   |   |   |   |   |
| Percentage of patent licensing net product revenue          |       | 0                                 | %          |       |   |   |   | 0 | % |   |   |   |   | 0 | % |
| Total net product revenues                                  |       | $                                 | 2,215,921  |       |   | -24 | % |   | $ | 2,916,759 |   |   | 32 | % |   | $ | 2,211,054 |   |
| Percentage of  total net product revenues                   |       | 29                                | %          |       | -12 | % |   | 41 | % |   | 11 | % |   | 30 | % |
|                                                             |            |                                   |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thedollar increase in our costs of software and royalty product revenue ofapproximately 32% or $294,000 for the twelve months ended December 31, 2006 ascompared to the corresponding period of 2005 is reflective of increasedsoftware and royalty revenues being generated from project-oriented work whichincludes costs for third-party software licenses and contract programming feesfor software customization.  Such costsdecreased as a percentage of software and royalty product revenues byapproximately 2% during the twelve months ended December 31, 2006 as comparedto the corresponding period of 2005 due to higher software and royalty productrevenues in the 2006 year.

Costsof our software and royalty product revenues increased approximately $191,000or 26% for the twelve months ended December 31, 2005 as compared to thecorresponding period in 2004 despite a 12% reduction in software and productrevenues due to the 2004 year containing an uncharacteristically highpercentage of our identity management projects containing software onlysolutions without significant components of third-party software licenses.

Costsof product revenues of our hardware and consumables revenues decreasedapproximately 50% or $982,000 for the twelve months ended December 31, 2006 ascompared to the corresponding period of 2005 due to lower sales of hardware andconsumables.  This decrease in hardwareand consumables product revenues is reflective of our decision in late 2005 toclose our German sales office.  Thisoffice had historically emphasized the resale of third-party merchandise(hardware and consumables) which generated lower gross margins than software(as a percentage of revenue) and required significant fixed costs for sales,service and support  The 2005 year alsocontains approximately $251,000 in inventory write-down costs associated withthe closure of our German sales office.

Costsof product revenues of our hardware and consumables revenues increasedapproximately 36% or $517,000 for the twelve months ended December 31, 2005 ascompared to the corresponding period of 2004 due to both higher sales ofhardware and consumable products in 2005 as compared to 2004 combined with the2005 year containing inventory write-down costs of approximately $251,000associated with the closure of our German sales office in late 2005.

Costsof products also can vary as a percentage of product revenue from period toperiod depending upon product mix and the third party software license content,hardware content, and print media consumable content included in systemsinstalled during a given period.

***Maintenance Cost of Revenues***
| ** **                               | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|
| ** **                               | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                               | ** ** | **2006**                          | ** ** | **Change** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|                                     | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total  maintenance cost of revenues      |       | $                                 | 964,245    |   |   | -3 | % |   | $ | 993,934 |   |   | 11 | % |   | $ | 895,202 |   |
| Percentage of total maintenance revenues |       | 37                                | %          |   | -12 | % |   | 49 | % |   | 1 | % |   | 48 | % |
|                                          |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Costof maintenance revenues as a percentage of maintenance revenues decreasedapproximately 12% during the twelve months ended December 31, 2006 as comparedto the corresponding period of 2005 due primarily to higher maintenancerevenues to absorb fixed maintenance costs. The dollar decrease during the twelve months ended December 31, 2006 ascompared to the corresponding period in 2005 is reflective of a higherpercentage of our maintenance revenues being generated from maintenancecoverage on software only solutions which typically have lower maintenancecosts than solutions comprised of both software and hardware components.

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Costsof maintenance revenues as a percentage of maintenance revenues increasedapproximately 1% or $99,000 during the twelve months ended December 31, 2005 ascompared to the corresponding period of 2004 due primarily to highermaintenance revenues and related costs incurred to service our expandinginstalled base.

***Product Gross Profit***
| ** **                                              | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                              | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                                              | ** ** | **2006**                          | ** ** | **Change** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
| **Product  gross profit**                               | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software and royalties                                  |       | $                                 | 4,663,962  |   |   | 50 | % |   | $ | 3,105,563 |   |   | -19 | % |   | $ | 3,851,667 |   |
| Percentage of software and royalty product revenue      |       | 79                                | %          |   | 2 | % |   | 77 | % |   | -7 | % |   | 84 | % |
| Hardware and consumables                                |       | $                                 | 364,286    |   |   | 154 | % |   | $ | 143,142 |   |   | -75 | % |   | $ | 566,760 |   |
| Percentage of hardware and consumables product  revenue |       | 27                                | %          |   | 20 | % |   | 7 | % |   | -21 | % |   | 28 | % |
| Services                                                |       | $                                 | 361,429    |   |   | -23 | % |   | $ | 468,655 |   |   | -29 | % |   | $ | 663,649 |   |
| Percentage of services product revenue                  |       | 98                                | %          |   | 2 | % |   | 96 | % |   | -1 | % |   | 97 | % |
| Patent Licensing                                        |       | $                                 | —     |   |   | -100 | % |   | $ | 500,000 |   |   | 100 | % |   | $ | — |   |
| Percentage of Patent Licensing product revenue          |       | 0                                 | %          |   | -100 | % |   | 100 | % |   | 100 | % |   | 0 | % |
| Total product gross profit                              |       | $                                 | 5,389,678  |   |   | 28 | % |   | $ | 4,217,360 |   |   | -17 | % |   | $ | 5,082,076 |   |
| Percentage of  total product revenues                   |       | 71                                | %          |   | 12 | % |   | 59 | % |   | -11 | % |   | 70 | % |

 

Totalproduct gross profit as a percentage of product revenues increased approximately12% or $1,173,000 during the twelve months ended December 31, 2006 as comparedto the corresponding period during 2005 due primarily to higher product salesand a higher percentage of total revenues coming from the sales of software androyalties which typically have lower costs than solutions containingsignificant amounts of hardware and consumables.

Thedollar increase in gross profit of software and royalties of approximately 50%or $1,558,000 for the twelve months ended December 31, 2006 as compared to thecorresponding period in 2005 is reflective of higher sales of software androyalties into project-oriented work.

Softwareand royalty product gross profit decreased approximately 19% or $746,000 forthe twelve months ended December 31, 2005 as compared to the correspondingperiod in 2004 due to the 2004 year containing an uncharacteristically highpercentage of software only solutions. Costs of products can vary as a percentage of product revenue from periodto period depending upon product mix, hardware content and print mediaconsumable content included in systems installed during a given period.

Hardwareand consumable gross profit as a percentage of hardware and consumable productrevenue increased approximately 20% or $221,000 for the twelve months endedDecember 31, 2006 as compared to the corresponding period in 2005 despite lowersales due to the 2005 year containing approximately $251,000 in inventorywrite-down costs associated with the closure of our German sales office.

Hardwareand consumable gross profit as a percentage of hardware and consumable productrevenue decreased approximately 21% or $424,000 during the twelve months endedDecember 31, 2006 as compared to the corresponding period in 2005 due primarilyto the 2005 year containing inventory write-down costs associated with theclosure of our German sales office.

***Maintenance Gross Profit***
| ** **                                | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                                | ** ** | **2006**                          | ** ** | **Change** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
| **Maintenance  gross profit**             |       |                              |       |   |   |   |   |   |   |   |   |
| Total maintenance gross profit            |       | $                                 | 1,619,723  |   |   | 55 | % |   | $ | 1,046,120 |   |   | 6 | % |   | $ | 988,533 |   |
| Percentage of  total maintenance revenues |       | 63                                | %          |   | 12 | % |   | 51 | % |   | -1 | % |   | 52 | % |
|                                           |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Totalgross profit dollars related to maintenance revenues increased approximately$574,000 during the twelve months ended December 31, 2006 as compared to thecorresponding period in 2005 due to higher maintenance revenues to absorb fixedmaintenance costs combined with the 2006 year containing a larger percentage ofmaintenance revenues being generated from maintenance coverage on software onlysolutions which typically have lower maintenance costs than solutionscontaining both software and hardware.

34

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Totalgross profit dollars related to maintenance revenues increased approximately$57,000 during the twelve months ended December 31, 2005 as compared to thecorresponding period in 2004 due to higher maintenance revenues generatedduring the 2005 year offset by higher fixed maintenance costs incurred in 2005to service our expanding installed base.

***Operating Expenses***
| ** **                       | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|----------------------------------|------------|-----------------------------------|------------|
| ** **                       | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                       | ** ** | **2006**                          | ** ** | **Change** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|                             | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Operating  expenses:**         | ** ** | ** **                        | ** ** |   |   | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| General & administrative     |       | $                                 | 4,764,112  |   |   | -10 | % |   | $ | 5,271,784 |   |   | 28 | % |   | $ | 4,122,218 |   |
| Percentage of total net revenue  |       | 47                                | %          |   | -11 | % |   | 57 | % |   | 13 | % |   | 45 | % |
| Sales and marketing              |       | $                                 | 3,552,630  |   |   | 7 | % |   | $ | 3,320,307 |   |   | 17 | % |   | $ | 2,834,421 |   |
| Percentage of total net revenue  |       | 35                                | %          |   | -1 | % |   | 36 | % |   | 5 | % |   | 31 | % |
| Research & development       |       | $                                 | 3,461,417  |   |   | 25 | % |   | $ | 2,766,326 |   |   | 22 | % |   | $ | 2,266,467 |   |
| Percentage of total net revenue  |       | 34                                | %          |   | 4 | % |   | 30 | % |   | 5 | % |   | 25 | % |
| Impairment losses                |       | —                            |       |   | -100 | % |   | 253,000 |   |   | 100 | % |   | $ | — |   |
| Percentage of total net revenue  |       | 0                                 | %          |   | -3 | % |   | 3 | % |   | 3 | % |   | 0 | % |
| Depreciation and amortization    |       | $                                 | 304,323    |   |   | -46 | % |   | $ | 568,519 |   |   | -5 | % |   | $ | 601,364 |   |
| Percentage of  total net revenue |       | 3                                 | %          |   | -3 | % |   | 6 | % |   | 0 | % |   | 7 | % |

 

***General and Administrative Expenses***

Generaland administrative expenses are comprised primarily of salaries and otheremployee-related costs for executive, financial, and other infrastructurepersonnel. General legal, accounting and consulting services, insurance,occupancy and communication costs are also included with general andadministrative expenses.  Such expensesdecreased in 2006 due primarily to the closure of our sales office in Germanyresulting in reduced general and administrative expenses of approximately$735,000, decreases in allowance for bad debts of approximately $400,000 offsetby stock based compensation expenses recorded pursuant to the implementation ofSFAS 123(R) of approximately $347,000 and higher professional fees.  The percentage decrease is reflective of lowercosts combined with higher total net revenues during the year ended December31, 2006, as compared to the corresponding period in 2005.

Generaland administrative expenses increased approximately 28% or $1,150,000 duringthe twelve months ended December 31, 2005 as compared to the correspondingperiod in 2004 due to increases in allowance for bad debts of approximately$450,000, exit activity expenses of approximately $204,000 related to theclosing of our sales office located in Germany and higher fees paid toconsultants.

We arecontinuing to focus our efforts on achieving additional future operatingefficiencies by reviewing and improving upon existing business processes andevaluating our cost structure. We believe these efforts will allow us tocontinue to gradually decrease our level of general and administrative expensesexpressed as a percentage of total revenues.

***Sales and Marketing Expenses***

Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce.   We anticipate that the level ofexpenses incurred for sales and marketing during the twelve months ended December31, 2006, will continue as we pursue large project solution opportunities.

***Research and Development Expenses***

Researchand development costs consist primarily of salaries, employee benefits andoutside contractors for new product development, product enhancements andcustom integration work. Such expenses increased by approximately 25% or$695,000 during the twelve months ended December 31, 2006 as compared to thecorresponding period of 2005 due primarily to the accelerated development of anexpanded suite of applications utilizing our ImageWare Biometric Engine, thedevelopment of our Personal Identity Verification (PIV) solution, and continueddevelopment of our IWS desktop security program utilizing contract programmingservices in conjunction with internal research and development resources.

35

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Researchand development costs increased approximately 22% or $500,000 during the twelvemonths ended December 31, 2005 as compared to the corresponding period of 2004due to the accelerated development of our new Biometric Engine, the Webenablement of our CCS product line, development of our new Desktop Securityprogram (released in the fourth quarter of 2005) and products enhancements toour Digital Photography software suite of products utilizing internal researchand development resources and contract programming.

 Our level of expenditures in research anddevelopment reflects our belief that to maintain our competitive position inmarkets characterized by rapid rates of technological advancement, we mustcontinue to invest significant resources in new systems and software as well ascontinue to enhance existing products.

***Impairment Losses***

Impairmentlosses represent the amount by which the carrying amount of long-lived assetsexceeds their fair value.  Fair value isdetermined based on the best information available in the circumstances,including present value techniques.  TheCompany did not record any impairment losses during the twelve months endedDecember 31, 2006 and 2004.  During thetwelve months ended December 31, 2005, we recorded impairment losses of$1,245,000 for goodwill carried in our former Digital Photography segment and$253,000 for our trademark and tradename asset carried in our formerIdentification segment.

***Depreciation and Amortization***

Depreciationand amortization decreased during the twelve months ended December 31, 2006 ascompared to the corresponding period in 2005 due primarily to loweramortization of certain definite long-lived intangible assets due to asignificant portion of such assets being fully amortized at the end of ourfirst fiscal quarter of 2006.

Depreciationand amortization decreased during the twelve months ended December 31, 2005 ascompared to the corresponding period in 2004 due primarily to fully depreciatedoffice and computer equipment combine with lower amortization of certaindefinite long-lived intangible assets due to such assets being fully amortizedat the end of our third fiscal quarter of 2005.

***Interest Expense, Net***

For the year endedDecember 31, 2006, we recognized interest income of $28,000 and interestexpense of $593,000.  For the year endedDecember 31, 2005, we recognized interest income of $56,000 and interestexpense of $2,000.  Interest expense forthe year ended December 31, 2006, contains 3 components approximating $578,000related to our secured notes payable issued in March 2006: $89,000 of couponinterest, $408,000 in note discount amortization, and $81,000 in deferredfinancing fee amortization classified as interest expense.

For the year endedDecember 31, 2004, we recognized interest income of $16,000 and interestexpense of $5,188,000.  Interest expensefor the 2004 year contained approximately $4,472,000 of interest expenserelated to fair value accounting for our warrant liability due the registrationrights agreement associated with the underlying shares of our common stock tobe issued upon conversion of the warrants. During June 2004, we registered theunderlying shares of common Securities and Exchange Commission.  In accordance with EIFT 00-19, there will beno further interest expense or income incurred in conjunction with thesewarrants.  Interest expense for the 2004year also contains $713,000 in liquidated damages, which was classified asinterest expense. The liquidated damages were incurred as we did not meetcertain time requirements for the registration of shares of our common stockunder the registration rights agreements for our November 2003 and January 2004private placements.

***Liquidity and Capital Resources***

As ofDecember 31, 2006, we had total current assets of $2,856,000 and totalcurrent liabilities of $5,213,000, or negative working capital of $2,357,000.At December 31, 2006 and 2005, we had available cash of $939,000 and$741,000, respectively. As discussed more fully in Note 19 to the accompanyingconsolidated financial statements, in March 2007, we completed a preferredstock financing of approximately $1,500,000. We also received proceeds of approximately $1,105,000 from the exerciseof warrants to purchase our common stock. Upon receipt of the $1,500,000 in preferred stock financing proceeds, weused approximately $1,216,000 to repay in full our secured notes payable plusaccrued but unpaid interest on this obligation.

Netcash used in operating activities was $2,817,000 for the year endedDecember 31, 2006, as compared to $6,207,000 for the corresponding periodin 2005. We used cash to fund net losses of $3,990,000, excluding non-cash

36

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expenses(depreciation, amortization, debt issuance costs, debt discount, stock-basedcompensation, and provision for losses on accounts receivable less gains onsale of subsidiary) of $1,936,000 for the year ended December 31,2006.  We used cash to fund net losses of$5,026,000 excluding non-cash expenses (depreciation, amortization, stock-basedcompensation, restructuring charges, write-down of inventories and long-livedassets and provision for losses on accounts receivable expense less gains onsale of subsidiary) of $3,329,000 for the corresponding period in 2005. For theyear ended December 31, 2006, we used cash of $267,000 to fund increases incurrent assets offset by increases in current liabilities of $1,440,000(excluding debt). For the year ended December 31, 2005, we generated cashof $385,000 from reduction in current and other assets offset by reductions incurrent liabilities of $1,566,000 (excluding debt).

Netcash used by investing activities was $133,000 for the year endedDecember 31, 2006.  Net cashprovided by investing activities for the year ended December 31, 2005, was$899,000. For the year ended December 31, 2006, we used cash to fundcapital expenditures of computer equipment and software, furniture and fixturesand leasehold improvements of approximately $158,000. The level of equipmentpurchases resulted primarily from continued growth of the business andreplacement of older equipment.  For theyear ended December 31, 2006, we generated cash of $25,000 for the sale of ourwholly-owned Digital Photography component. In 2005, we used cash of $310,000 to fund capital expenditures of computerequipment and software, furniture and fixtures, and leasehold improvements, andgenerated cash of $1,300,000 for the sale of our wholly-owned Singaporesubsidiary. Digital Imaging Asia Pacific, offset by cash sold and directtransaction costs of $91,000.

Netcash provided by financing activities was $3,224,000 for the year endedDecember 31, 2006. We generated cash of $2,064,000 from our issuance ofpreferred stock in a private placement. We also generated cash of $1,550,000 from our issuance of senior securednotes payable offset by debt issuance costs of $98,000.  In 2006, we used cash of $240,000 to repaynotes payable and used cash of $52,000 for the payment of dividends on ourSeries B Preferred Stock.  Net cashprovided by financing activities was $3,225,000 for the year ended December 31,2005.  In 2005, we generated cash of$3,234,000 from our issuance of common stock in a private placement.  We also generated cash of $62,000 from theexercise of stock options.  In 2005, weused cash of $18,000 for repayment of notes payable and used cash of $53,000for the payment of dividends on our Series B Preferred Stock.

***Contractual Obligations and Commercial Commitments***

Weconduct operations in leased facilities under operating leases expiring atvarious dates through 2006.  Inconjunction with our performance on various software installation andimplementation contracts, we are contingently liable under an irrevocableletter of credit in the amount of $106,000. The letter of credit expiresDecember 26, 2008.  We also havevarious short-term notes payable and capital lease obligations due at varioustimes during 2009. The following table sets forth a summary of our obligationsunder operating leases, capital leases, notes payable and irrevocable lettersof credit for the next five years:
| ** **                                                           | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|-----------|------------|
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Minimum annual  lease payments under operating leases                |       | $        | 538,000    |     | $          | 462,000  |       | $        | 153,000    |     | $          | 0         |       | $ | 0 |   | $ | 1,153,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Minimum annual  payments under notes payable                         |       | $        | 1,310,000  |     | $          | 0        |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 1,310,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Other commercial  commitments:                                       |       |     |       |     |       |     |       |     |       |     |       |      |       |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Standby letters  of credit                                           |       | $        | 106,000    |     | $          | 0        |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 106,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Total contractual cash  obligations and other commercial commitments |       | $        | 1,954,000  |     | $          | 462,000  |       | $        | 153,000    |     | $          | 0         |       | $ | 0 |   | $ | 2,569,000 |   |

 

Thereport of the Company’s independent accountants included with this AnnualReport contains an explanatory paragraph regarding our ability to continue as agoing concern.  The Company is seekingadditional financing that we believe is necessary to fund our working capitalrequirements for at least the next twelve months in conjunction with thesuccessful implementation of our business plan. Our business plan includes,among other things, the monitoring and controlling of operating expenses,collection of significant trade and other accounts receivables, and controllingof capital expenditures.  If we areunable to secure additional financing or successfully implement our businessplan, we will be required to seek funding from alternate sources and/orinstitute cost reduction measures.  Wemay seek to sell equity or debt securities, secure a bank

37

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line of credit, orconsider strategic alliances.  The saleof equity or equity-related securities could result in additional dilution toour shareholders.  There can be noassurance that additional financing, in any form, will be available at all or,if available, will be on terms acceptable to us.  In addition, our ability to raise additionalcapital may be dependent upon our common stock being quoted on the AmericanStock Exchange.  There can be noassurance that the Company will be able to satisfy the criteria for continuedlisting on the American Stock Exchange. Insufficient funds may require us to delay, scale back or eliminate someor all of our activities, and if we are unable to obtain additional fundingthere is substantial doubt about our ability to continue as a going concern.

**Item 7A.Quantitative and Qualitative Disclosures about Market Risk**

***Foreign Currency Exchange Risk***

Marketrisk is the potential loss arising from adverse changes in market rates andprices, such as interest rates and foreign currency exchange rates.  Changes in foreign currency exchange rateshave an impact on our results of operations. Our exposure to adverse movementsin foreign currency exchange rates is primarily related to our subsidiariesoperating expense, primarily in Canada and Germany, denominated in therespective local currency. We currently do not enter into forward exchangecontracts to hedge exposures denominated in foreign currencies and do not usederivative financial instruments for trading or speculative purposes. Theeffect of an immediate 10% change in foreign currency exchange rates should nothave a material effect on our future operating results or cash flows; however,a long term change in foreign currency rates would likely result in increasedtechnical support and engineering expenses. The vast majority of our sales aretransacted in U. S. dollars.

**Item 8.Consolidated Financial Statements and Supplementary Data.**

The index to ourConsolidated Financial Statements and the Report of Independent RegisteredPublic Accounting Firm appears in Part IV of this Form 10-K.

**Item 9.Changes in and Disagreements With Accountants on Accounting and FinancialDisclosure.**

**               **Not applicable

**Item 9A.Controls and Procedures.**

*Evaluationof disclosure controls and procedures*.  Our chief executiveofficer and our chief financial officer, after evaluating the effectiveness ofour disclosure controls and procedures (as defined in Exchange Act Rule13a-15(e)) as of December 31, 2006 (the “Evaluation Date”), have concluded thatas of such date, our disclosure controls and procedures were adequate andeffective to ensure that information required to be disclosed in the reportsthat we file under the Securities and Exchange Act of 1934 is recorded,processed, summarized and reported within the time period specified in theCommission’s rules and forms.

*Changesin internal controls*.  There has been no change in our internalcontrols over financial reporting during the quarter ended December 31, 2006,that has materially affected, or is reasonably likely to materially affect ourinternal control over financial reporting.

**Item 9B.Other Information.**

InJune 2006, the Company began operating under a revised facilities lease foroffice space in Gatineau, Province of Quebec. This space is leased until May 2009, at a cost of approximately $15,800per month.  This facilities lease was executedin March 2007 and in included as an exhibit to this Annual Report on Form 10-K.

**PART III**

**Item 10.****              Directors, Executive Officers and CorporateGovernance**

**(a)  ***Identification of Directors.*    Theinformation under the caption “Election of Directors,” appearing in the ProxyStatement to be filed for the 2007 Annual Meeting of Stockholders isincorporated herein by reference.

**(b)  ***Identification of Executive Officers.*    Theinformation under the caption “Certain Information with Respect to ExecutiveOfficers,” appearing in the Proxy Statement to be filed for the 2007 AnnualMeeting of Stockholders is incorporated herein by reference.

**(c)  ***Compliance with Section 16(a) of the ExchangeAct.*    The information under the caption “Compliancewith Federal Securities Laws,” appearing in the Proxy Statement to be filed forthe 2007 Annual Meeting of Stockholders is incorporated herein by reference.

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**(d)  ***Code of Ethics.*    TheCompany has adopted a *Code of Business Conductand Ethics* policy that applies to our directors and employees(including the Company’s principal executive officer, principal financialofficer, principal accounting officer or    controller, or persons performing similar functions).  The Company intends to promptly disclose (i)the nature of any amendment to this code of ethics that applies to ourprincipal executive officer, principal financial officer, principal accountingofficer or controller, or persons performing similar functions and (ii) thenature of any waiver, including an implicit waiver, from a provision of thiscode of ethics that is granted to one of these specified individuals, the nameof such person who is granted the waiver and the date of the waiver on ourwebsite in the future.  A copy of ourCode of Business Conduct and Ethics can be obtained from our website athttp://www.iwsinc.com.

**(e)**  *Audit Committee.*** **The informationunder the caption “Information Regarding the Board and its Committees,”appearing in the Proxy Statement to be filed for the 2007 Annual Meeting ofStockholders is incorporated herein by reference.

**Item 11.****              Executive Compensation**

The information under theheading “Executive Compensation and Other Information” appearing in the ProxyStatement to be filed for the 2007 Annual Meeting of Stockholders isincorporated herein by reference.

**Item 12.****              Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

The information under theheading “Principal Stockholders” appearing in the Proxy Statement to be filedfor the 2007 Annual Meeting of Stockholders is incorporated herein byreference.

**Item 13.****              Certain Relationships and RelatedTransactions**

The information under theheading “Certain Relationships and Related Transactions,” appearing in theProxy Statement to be filed for the 2007 Annual Meeting of Stockholders isincorporated herein by reference.

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

The information under theheading “Principal Accountant Fees and Services,” appearing in the ProxyStatement to be filed for the 2007 Annual Meeting of Stockholders isincorporated herein by reference.

**PART IV**

**Item 15.*****                            *Exhibits and Financial Statement Schedules**

**(a)  **1.Index to Consolidated Financial Statements

See Index to ConsolidatedFinancial Statements and financial statement schedules.

**(a)  **2.Index to Financial Statement Schedules

Referto Schedule II, Valuation and Qualifying Accounts, hereto.

**(b)  **Exhibits

The following Exhibitsare filed as part of, or incorporated by reference into, this Report on Form10-K:
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                           |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1             |       | Stock Purchase Agreement, dated March 1, 2005,  between the Company and Argus Solutions Ltd. (incorporated by reference to  Exhibit 2.1 to the Company’s Current Report on Form 8-K, filed March 9,  2005).                                                          |
| 2.2             |       | Agreement and Plan of Merger, dated October 27, 2005  (incorporated by reference to Annex A to the Company’s Definitive Proxy  Statement on Schedule 14A, filed November 15, 2005).                                                                                  |
| 3.1             |       | Certificate of Incorporation (incorporated by  reference to Annex B to the Company’s Definitive Proxy Statement on Schedule  14A, filed November 15, 2005).                                                                                                          |
| 3.2             |       | Bylaws (incorporated by reference to Annex C to the  Company’s Definitive Proxy Statement on Schedule 14A, filed November 15,  2005).                                                                                                                                |
| 3.3             |       | Certificate of Designations of Preferences, Rights  and Limitations of Series C 8% Convertible Preferred Stock dated November 2,  2006, as amended (incorporated by reference to Exhibit 3.1 to the Company’s  Current Report on Form 8-K, filed November 20, 2006). |

 

39

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| 10.1  |   | Employment Agreement, dated September 27, 2005,  between the Company and S. James Miller (incorporated by reference to Exhibit  10.1 to the Company’s Current Report on Form 8-K, filed September 30, 2005                                                            |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2  |   | Employment Agreement, dated September 27, 2005,  between the Company and Wayne G. Wetherell (incorporated by reference to  Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed September 30,  2005).                                                      |
| 10.3  |   | Change of Control and Severance Benefits Agreement,  dated October 31, 2005, between Registrant and Charles Aubuchon (incorporated  by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K,  filed November 3, 2005).                               |
| 10.4  |   | Form of Indemnification Agreement entered into by  the registrant with its directors and executive officers (incorporated by  reference to Exhibit 10.4 to the Company’s Registration Statement on Form  SB-2 (No. 333-93131), filed December 20, 1999, as amended).  |
| 10.5  |   | 1994 Employee Stock Option Plan (incorporated by  reference to Exhibit 10.6 to the Company’s Registration Statement on Form  SB-2 (No. 333-93131), filed December 20, 1999, as amended).                                                                              |
| 10.6  |   | 1994 Nonqualified Stock Option Plan (incorporated by  reference to Exhibit 10.7 to the Company’s Registration Statement on Form  SB-2 (No. 333-93131), filed December 20, 1999, as amended).                                                                          |
| 10.7  |   | Amended and Restated 1999 Stock Plan Award  (incorporated by reference to Appendix B of the Company’s Definitive Proxy  Statement on Schedule 14A, filed April 29, 2005).                                                                                             |
| 10.8  |   | Form of Stock Option Agreement (incorporated by  reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed  July 14, 2005).                                                                                                                        |
| 10.9  |   | 2001 Equity Incentive Plan (incorporated by  reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-QSB,  filed November 14, 2001).                                                                                                                   |
| 10.10 |   | Form of Restricted Stock Bonus Agreement  (incorporated by reference to Exhibit 99.3 to the Company’s Registration  Statement on Form S-8, filed November 27, 2001).                                                                                                  |
| 10.11 |   | Form of Stock Option Agreement (incorporated by  reference to Exhibit 99.2 to the Company’s Registration Statement on Form  S-8, filed November 27, 2001)                                                                                                             |
| 10.12 |   | Warrant to Purchase Common Stock in favor of  Imperial Bank, dated January 15, 1998 (incorporated by reference to Exhibit  10.42 to the Company’s Registration Statement on Form SB-2 (No. 333-93131),  filed December 20, 1999, as amended).                         |
| 10.13 |   | Note and Warrant Purchase Agreement, dated May 22,  2002, by and between the Company and Perseus 2000 L.L.C. (“Perseus”)  (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on  Form 8-K, filed May 24, 2002).                     |
| 10.14 |   | Registration Rights Agreement, dated May 22, 2002,  by and between the Company and Perseus (incorporated by reference to Exhibit  10.3 to the Company’s Current Report on Form 8-K, filed May 24, 2002).                                                              |
| 10.15 |   | Warrant to Purchase Common Stock, dated May 22,  2002, issued by the Company to Perseus (incorporated by reference to Exhibit  10.5 to the Company’s Current Report on Form 8-K, filed May 24, 2002).                                                                 |
| 10.16 |   | Warrant to Purchase Common Stock, dated June 13,  2003, issued by the Company to L.F. Global Holdings, LLC (incorporated by  reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K, filed  June 20, 2003).                                            |
| 10.17 |   | Warrant to Purchase Common Stock, dated June 13,  2003, issued by the Company to Laurus Master Fund (incorporated by reference  to Exhibit 10.5 to the Company’s Current Report on Form 8-K, filed June 20,  2003).                                                   |
| 10.18 |   | Form of Securities Purchase Agreement dated November  14, 2003 (incorporated by reference to Exhibit 99.1 to the Company’s Current  Report on Form 8-K, filed February 9, 2004).                                                                                      |
| 10.19 |   | Form of Warrant dated November 24, 2003  (incorporated by reference to Exhibit 99.2 to the Company’s Current Report on  Form 8-K, filed February 9, 2004).                                                                                                            |
| 10.20 |   | Form of Registration Rights Agreement dated November  24, 2003 (incorporated by reference to Exhibit 99.3 to the Company’s Current  Report on Form 8-K, filed February 9, 2004).                                                                                      |
| 10.21 |   | Form of Registration Rights Agreement dated March  13, 2003 (incorporated by reference to Exhibit 10.2 to the Company’s  Quarterly Report on Form 10-QSB, filed May 15, 2003).                                                                                        |
| 10.22 |   | Form of Securities Purchase Agreement dated January  29, 2004 (incorporated by reference to Exhibit 99.4 to the Company’s Current  Report on Form 8-K, filed February 9, 2004).                                                                                       |
| 10.23 |   | Form of Warrant dated January 29, 2004 (incorporated  by reference to Exhibit 99.5 to the Company’s Current Report on Form 8-K,  filed February 9, 2004).                                                                                                             |
| 10.24 |   | Form of Registration Rights Agreement dated January  29, 2004 (incorporated by reference to Exhibit 99.8 to the Company’s Current  Report on Form 8-K, filed February 9, 2004).                                                                                       |
| 10.25 |   | Offer of Restricted Stock in Exchange for Certain  Stock Options Previously Granted — Offer Made to James Miller (incorporated  by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form  10-QSB, filed August 16, 2004).                          |
| 10.26 |   | Offer of Restricted Stock in Exchange for Certain  Stock Options Previously Granted — Offer Made to Wayne Wetherell, dated March  30, 2004 (incorporated by reference to Exhibit 10.3 to the Company’s  Quarterly Report on Form 10-QSB, filed August 16, 2004). |

 

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| 10.27 |   | Common Stock Purchase Warrant, dated September 28,  2004, issued to CD Investment Partners, Ltd. (incorporated by reference to  Exhibit 10.27 to the Company’s Quarterly Report on Form 10-KSB, filed March  31, 2005).                                                |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28 |   | Form of Securities Purchase Agreement dated July 22,  2005 and July 28, 2005 (incorporated by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K, filed July 26, 2005).                                                                            |
| 10.29 |   | Form of Warrant dated July 22, 2005 and dated July  28, 2005 (incorporated by reference to Exhibit A to Exhibit 10.1 to the  Company’s Current Report on Form 8-K, filed July 26, 2005).                                                                               |
| 10.30 |   | Security Agreement, dated March 17, 2006, executed  by the Company in favor of Little Bear Investments, LLC (incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed  March 23, 2006).                                           |
| 10.31 |   | Form of Warrant dated March 17, 2006 (incorporated  by reference to Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q,  filed May 22, 2006).                                                                                                                  |
| 10.32 |   | Form of Secured Promissory Note dated March 17, 2006  (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report  on Form 10-Q, filed May 22, 2006).                                                                                                 |
| 10.33 |   | Securities Purchase Agreement, dated November 14,  2006 by and among the Company, Gruber & McBaine Capital Management, LLC  and other investors (incorporated by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K, filed November 20, 2006). |
| 10.34 |   | Registration Rights Agreement, dated November 14,  2006 by and among the Company and certain investors (incorporated by  reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed  November 20, 2006).                                             |
| 10.35 |   | Form of Warrant to Purchase Common Stock dated  November 14, 2006 (incorporated by reference to Exhibit 10.3 to the Company’s  Current Report on Form 8-K, filed November 20, 2006).                                                                                   |
| 10.36 |   | Product Line Purchase Agreement, dated November 30,  2006, by and between the Company and PhotoLynx, Inc. (incorporated by  reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K, filed  December 26, 2006).                                          |
| 10.37 |   | Standard Commercial Lease, dated September 26, 2003,  by and between Thornmint I and the Company (incorporated by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-QSB, filed November  14, 2003).                                              |
| 10.38 |   | Amendment to Office Lease, dated June 12, 2006, by  and between Thornmint I and the Company (incorporated by reference to Exhibit  10.1 to the Company’s Quarterly Report on Form 10-Q, filed August 14, 2006).                                                        |
| 10.39 |   | Office Lease, dated September 7, 2006, by and  between Union Bank of California as Trustee for Quest Group Trust VII and the  Company (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly  Report on Form 10-Q, filed November 20, 2006).            |
| 10.40 |   | Office Space Lease between I.W. Systems Canada  Company and Dundeal Canada (GP) Inc. dated June 1, 2006                                                                                                                                                                     |
| 21.1  |   | Subsidiaries of the Company                                                                                                                                                                                                                                                 |
| 23.1  |   | Consent of Stonefield Josephson, Inc., Independent  Registered Public Accounting Firm                                                                                                                                                                                       |
| 31.1  |   | Certification of the Principal Executive Officer  pursuant to Rule 13a-14(a) and 15d-14(a)                                                                                                                                                                                  |
| 31.2  |   | Certification of the Principal Financial and  Accounting Officer pursuant to Rule 13a-14(a) and 15d-14(a)                                                                                                                                                                   |
| 32.1  |   | Certification by the Principal Executive Officer and  Principal Financial and Accounting Officer pursuant to 18 U.S.C. 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                           |

 

41

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**SIGNATURES**

In accordance with Section 13 or 15(d) of theExchange Act, the registrant caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
| ** **     | **IMAGEWARE SYSTEMS, INC.** |
|----------------|----------------------------------|
|           |                             |   |
|           |                             |   |
| April 17, 2007 | 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, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature**             | ** ** | **Title**                                                            | ** ** | **Date**       |
|---------------------------|------------|----------------------------------------------------------------------|------------|----------------|
|                      |       |                                                                 |       |           |
| /s/ S. JAMES  MILLER, JR. |       | Chief Executive Officer  and Chairman of the Board of Directors      |       | April 17, 2007 |
| S. James Miller,  Jr.     |       | *(Principal Executive Officer)*                                      | * *   | * *       |
|                      |       |                                                                 |       |           |
| /s/ WAYNE G.  WETHERELL   |       | Senior Vice President  of Administration and Chief Financial Officer |       | April 17, 2007 |
| Wayne G.  Wetherell       |       | *(Principal Financial and  Accounting Officer)*                      | * *   | * *       |
|                      |       |                                                                 |       |           |
| /s/ JOHN CALLAN           |       | Director                                                             |       | April 17, 2007 |
| John Callan               |       |                                                                 |       |           |
|                      |       |                                                                 |       |           |
| /s/ PATRICK J.  DOWNS     |       | Director                                                             |       | April 17, 2007 |
| Patrick J. Downs          |       |                                                                 |       |           |
|                      |       |                                                                 |       |           |
| /s/ JOHN L.  HOLLERAN     |       | Director                                                             |       | April 17, 2007 |
| John L. Holleran          |       |                                                                 |       |           |
|                      |       |                                                                 |       |           |
| /s/ DAVID LOESCH          |       | Director                                                             |       | April 17, 2007 |
| David Loesch              |       |                                                                 |       |           |
|                      |       |                                                                 |       |           |
| /s/ STEVE HAMM            |       | Director                                                             |       | April 17, 2007 |
| Steve Hamm                |       |                                                                 |       |           |
|                      |       |                                                                 |       |           |
| /s/ DAVID CAREY           |       | Director                                                             |       | April 17, 2007 |
| David Carey               |       |                                                                 |       |           |

 

42

----

**IMAGEWARE SYSTEMS, INC.**

**INDEX TO CCONSOLIDATED FINANCIALSTATEMENTS**
| REPORT OF INDEPENDENT  REGISTERED PUBLIC ACCOUNTING FIRM |   |
|----------------------------------------------------------|--------|
|                                                     |   |
| CONSOLIDA TED FINANCIAL  STATEMENTS:                     |   |
|                                                     |   |
| CONSOLIDATED BALANCE  SHEETS                             |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF OPERATIONS                   |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF CASH FLOW                    |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF COMPREHENSIVE LOSS           |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF SHAREHOLDERS’ EQUITY    |   |
|                                                     |   |
| NOTES TO  CONSOLIDATED FINANCIAL STATEMENTS              |   |

 

43

----

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

Board of Directors andShareholders

ImageWareSystems, Inc.

Wehave audited the accompanying consolidated balance sheets of ImageWare Systems,Inc. as of December 31, 2006 and 2005, and therelated consolidated statements of operations, comprehensive loss,shareholders’ equity, and cash flows for the twelve months ended December 31,2006, 2005 and 2004.  Our audits alsoincluded the consolidated financial statement schedule listed in the Index atItem 15(a)(2) as of and for the years ended December 31, 2006, 2005 and2004.  These consolidated financialstatements and consolidated schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements and consolidated schedule based on our audits.

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. The company is notrequired to have, nor were we engaged to perform, an audit of their internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting.  Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofImageWare Systems, Inc. as of December 31, 2006 and 2005, and the results oftheir operations and their cash flows for for the twelve months ended December31, 2006, 2005 and 2004 in conformity with accounting principles generallyaccepted in the United States of America. Also, in our opinion, the related consolidated financial statementschedule as of and for the years ended December 31, 2006, 2005 and 2004 whenconsidered in relation to the basic financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

Asdiscussed in Note 1 to the consolidated financial statements, in 2006 theCompany adopted Statement of Financial Accounting Standards No. 123 (Revised2004), Share-Based Payment.

Theaccompanying consolidated financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note 1 to theconsolidated financial statements, the Company has incurred substantial netlosses since inception and has substantial monetary liabilities in excess ofmonetary assets and an accumulated deficit of $70,332,702 as of December 31,2006. These matters, among others, raise substantial doubt about the Company’sability to continue as a going concern. Management's plans concerning thesematters are described in Note 1. These consolidated financial statements do notinclude any adjustments relating to the recoverability and classification ofrecorded assets, or the amounts and classification of liabilities that might benecessary in the event the Company cannot continue in existence. 

/s/Stonefield Josephson, Inc. 

Los Angeles, California

April 17,2007

 

 

44

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                                                                                                                                                                         | ** ** | **December 31,  2006** | ** **    | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|---------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                                         | ** ** | ** **                  | ** **    | ** **                  | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                                                         | ** ** | ** **                  | ** **    | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                                                                                                                    |       |                        |          |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                                                                               |       | $                           | 938,553       |                        | $          | 741,184 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $483,132 and $477,749  at December 31, 2006 and 2005, respectively                                                                                                                                                                                                                                            |       | 1,721,892                   |          | 1,340,154                   |       |
| Inventories, net                                                                                                                                                                                                                                                                                                                                                                   |       | 57,990                      |          | 207,833                     |       |
| Other current  assets                                                                                                                                                                                                                                                                                                                                                              |       | 137,609                     |          | 218,549                     |       |
| Total Current  Assets                                                                                                                                                                                                                                                                                                                                                              |       | 2,856,044                   |          | 2,507,720                   |       |
|                                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| Property and equipment,  net                                                                                                                                                                                                                                                                                                                                                       |       | 351,700                     |          | 423,887                     |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                       |       | 175,952                     |          | 215,263                     |       |
| Pension assets                                                                                                                                                                                                                                                                                                                                                                     |       | 608,507                     |          | 522,975                     |       |
| Intangible assets, net                                                                                                                                                                                                                                                                                                                                                             |       | 141,294                     |          | 218,400                     |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                                           |       | 3,415,647                   |          | 3,415,647                   |       |
| **Total  Assets**                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **$**                       | **7,549,144** | ** **                  | **$**      | **7,303,892** | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                                                         | ** ** | ** **                  | ** **    | ** **                  | ** ** |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                                     |       |                        |          |                        |       |
|                                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                                   |       | $                           | 1,718,820     |                        | $          | 690,460 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                                                   |       | 1,258,045                   |          | 1,083,554                   |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                                                   |       | 1,138,718                   |          | 1,034,746                   |       |
| Notes payable to  third parties                                                                                                                                                                                                                                                                                                                                                    |       | 1,097,378                   |          | —                      |       |
| Total Current  Liabilities                                                                                                                                                                                                                                                                                                                                                         |       | 5,212,961                   |          | 2,808,760                   |       |
|                                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                                                                                 |       | 1,016,293                   |          | 1,129,530                   |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                                                                  |       | 6,229,254                   |          | 3,938,290                   |       |
|                                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| Commitments and  contingencies                                                                                                                                                                                                                                                                                                                                                     |       | —                      |          | —                      |       |
|                                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| 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  239,400 and 249,400 shares outstanding at December 31, 2006 and 2005,  respectively, liquidation preference $598,500 and $623,500 at  December 31, 2006 and December 31, 2005, respectively |       | 2,394                       |          | 2,494                       |       |
| Preferred stock,  $.01 par value, authorized 4,000,000 shares, Series C convertible  non-redeemable preferred stock, designated 3,500 shares, 2,500 shares issued,  and 2,500 and 0 shares outstanding at December 31, 2006 and 2005,  respectively, liquidation preference $2,500,000 and $0 at December 31, 2006  and 2005, respectively                                         |       | 25                          |          | —                      |       |
| Common stock,  $.01 par value, 50,000,000 shares authorized, 13,700,849 and 13,554,366  shares issued at December 31, 2006 and 2005, respectively, 13,694,145 and  13,547,662 shares outstanding at December 31, 2006 and 2005,  respectively                                                                                                                                 |       | 135,759                     |          | 134,294                     |       |
|                                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| Additional paid in  capital                                                                                                                                                                                                                                                                                                                                                        |       | 71,553,329                  |          | 67,650,157                  |       |
| Treasury stock, at cost  - 6,704 shares                                                                                                                                                                                                                                                                                                                                            |       | (63,688                     | )             | (63,688                     | )          |
| Accumulated other  comprehensive income                                                                                                                                                                                                                                                                                                                                            |       | 24,773                      |          | (36,104                     | )          |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                                                |       | (70,332,702                 | )             | (64,321,551                 | )          |
| Total  shareholders’ equity                                                                                                                                                                                                                                                                                                                                                   |       | 1,319,890                   |          | 3,365,602                   |       |
|                                                                                                                                                                                                                                                                                                                                                                               |       |                        |          |                        |       |
| **Total Liabilities and  Shareholders’ Equity**                                                                                                                                                                                                                                                                                                                               | ** ** | **$**                       | **7,549,144** | ** **                  | **$**      | **7,303,892** | ** ** |

 

The accompanying notes are an integral part ofthese consolidated financial statements.

45

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**
| ** **                                                                                                                                                                                                                                                                | ** ** | **TWELVE MONTHS ENDED  December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                                                                                                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues:**                                                                                                                                                                                                                                                             |       |                                                 |       |   |   |   |   |
| Product                                                                                                                                                                                                                                                                   |       | $                                                    | 7,605,598  |   | $ | 7,134,119 |   | $ | 7,293,130 |   |
| Maintenance                                                                                                                                                                                                                                                               |       | 2,583,968                                            |       | 2,040,054 |   | 1,883,735 |   |
|                                                                                                                                                                                                                                                                      |       | 10,189,566                                           |       | 9,174,173 |   | 9,176,865 |   |
| **Cost of  revenues:**                                                                                                                                                                                                                                                    |       |                                                 |       |   |   |   |   |
| Product                                                                                                                                                                                                                                                                   |       | 2,215,921                                            |       | 2,916,759 |   | 2,211,054 |   |
| Maintenance                                                                                                                                                                                                                                                               |       | 964,245                                              |       | 993,934 |   | 895,202 |   |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Gross profit                                                                                                                                                                                                                                                              |       | 7,009,400                                            |       | 5,263,480 |   | 6,070,609 |   |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| **Operating  expenses:**                                                                                                                                                                                                                                                  |       |                                                 |       |   |   |   |   |
| General & administrative                                                                                                                                                                                                                                              |       | 4,764,112                                            |       | 5,271,784 |   | 4,122,218 |   |
| Sales and marketing                                                                                                                                                                                                                                                       |       | 3,552,630                                            |       | 3,320,307 |   | 2,834,421 |   |
| Research & development                                                                                                                                                                                                                                                |       | 3,461,417                                            |       | 2,766,326 |   | 2,266,467 |   |
| Impairment losses                                                                                                                                                                                                                                                         |       | —                                               |       | 253,000 |   | — |   |
| Depreciation and amortization                                                                                                                                                                                                                                             |       | 304,323                                              |       | 568,519 |   | 601,364 |   |
|                                                                                                                                                                                                                                                                      |       | 12,082,482                                           |       | 12,179,936 |   | 9,824,470 |   |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Loss from  operations                                                                                                                                                                                                                                                     |       | (5,073,082                                           | )          | (6,916,456 | ) | (3,753,861 | ) |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Interest  (income) expense, net                                                                                                                                                                                                                                           |       | 564,524                                              |       | (53,288 | ) | 5,172,193 |   |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Other income,  net                                                                                                                                                                                                                                                        |       | (119,330                                             | )          | (166,390 | ) | (187,640 | ) |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Loss from  continuing operations before income taxes                                                                                                                                                                                                                      |       | (5,518,276                                           | )          | (6,696,778 | ) | (8,738,414 | ) |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Income tax  benefit (expense)                                                                                                                                                                                                                                             |       | —                                               |       | — |   | — |   |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Loss from  continuing operations                                                                                                                                                                                                                                          |       | (5,518,276                                           | )          | (6,696,778 | ) | (8,738,414 | ) |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Discontinued  operations:                                                                                                                                                                                                                                                 |       |                                                 |       |   |   |   |   |
| Gain (loss) from operations of discontinued Digital  Photography and Digital Imaging Asia Component (including gain on disposal of  Digital Photography component of $19,956 in 2006 and gain on disposal of Digital  Imaging Asia Pacific Component of $232,508 in 2005) |       | $                                                    | (407,939   | ) | $ | (1,658,926 | ) | $ | (900,185 | ) |
| Income tax benefit (expense)                                                                                                                                                                                                                                              |       | —                                               |       | — |   | — |   |
| Gain (loss) on discontinued operations                                                                                                                                                                                                                                    |       | (407,939                                             | )          | (1,658,926 | ) | (900,185 | ) |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Net loss                                                                                                                                                                                                                                                                  |       | $                                                    | (5,926,215 | ) | $ | (8,355,704 | ) | $ | (9,638,599 | ) |
|                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Basic and  diluted loss per common share - see note 2                                                                                                                                                                                                                     |       | $                                                    | (0.44      | ) | $ | (0.66 | ) | $ | (0.82 | ) |
| Weighted-average shares  outstanding (basic and diluted)                                                                                                                                                                                                                  |       | 13,592,841                                           |       | 12,731,304 |   | 11,739,819 |   |

 

The accompanying notes are an integral part ofthese consolidated financial statements.

46

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**
| ** **                                                                                                | ** ** | **TWELVE MONTHS ENDED  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| **Cash  flows from operating activities**                                                                 |       |                                                 |       |   |   |   |   |
| Net loss                                                                                                  |       | $                                                    | (5,926,215 | ) | $ | (8,355,704 | ) | $ | (9,638,599 | ) |
| Adjustments to reconcile net loss to net cash used  by operating activities Depreciation and amortization |       | 307,118                                              |       | 599,950 |   | 718,587 |   |
| Amortization of debt discount and debt issuance  costs                                                    |       | 489,731                                              |       | — |   | 4,472,407 |   |
| Stock based compensation                                                                                  |       | 1,117,596                                            |       | 310,597 |   | 357,774 |   |
| Gain on sale of subsidiary                                                                                |       | (19,956                                              | )          | (232,508 | ) | — |   |
| Inventory write-down                                                                                      |       | 3,000                                                |       | 280,768 |   | — |   |
| Provision on losses on accounts receivable                                                                |       | 39,000                                               |       | 450,000 |   | 87,000 |   |
| Write-down of certain long-lived assets                                                                   |       | —                                               |       | 1,570,128 |   | — |   |
| Write-down of investment in equity securities                                                             |       | —                                               |       | 146,525 |   | — |   |
| Restructuring charges                                                                                     |       | —                                               |       | 204,000 |   | — |   |
| Gain on debt extinguishment                                                                               |       | —                                               |       | — |   | (100,000 | ) |
| Change in assets and liabilities                                                                          |       |                                                 |       |   |   |   |   |
| Accounts receivable                                                                                       |       | (420,738                                             | )          | (72,571 | ) | (434,152 | ) |
| Inventories                                                                                               |       | 141,799                                              |       | 365,853 |   | (292,270 | ) |
| Other current assets                                                                                      |       | 97,190                                               |       | 10,943 |   | (43,483 | ) |
| Pension assets                                                                                            |       | (85,532                                              | )          | 62,409 |   | (4,372 | ) |
| Other assets                                                                                              |       | —                                               |       | 18,105 |   | (52,225 | ) |
| Accounts payable                                                                                          |       | 1,028,360                                            |       | (529,661 | ) | 176,054 |   |
| Accrued expenses                                                                                          |       | 173,659                                              |       | (687,672 | ) | 291,371 |   |
| Deferred revenue                                                                                          |       | 174,491                                              |       | 38,735 |   | 197,129 |   |
| Contract costs                                                                                            |       | —                                               |       | (424,299 | ) | 424,299 |   |
| Pension obligation                                                                                        |       | 63,965                                               |       | 37,175 |   | 79,203 |   |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| Total adjustments                                                                                         |       | 3,109,683                                            |       | 2,148,477 |   | 5,877,322 |   |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| Net cash used by operating activities                                                                     |       | (2,816,532                                           | )          | (6,207,227 | ) | (3,761,277 | ) |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| **Cash  flows from investing activities**                                                                 |       |                                                 |       |   |   |   |   |
| Purchase of property and equipment                                                                        |       | (157,825                                             | )          | (309,415 | ) | (237,340 | ) |
| Restricted cash and cash equivalents                                                                      |       | —                                               |       | — |   | 49,215 |   |
| Proceeds from sales of subsidiary net of cash sold  and direct transaction costs                          |       | 25,000                                               |       | 1,208,630 |   | — |   |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| Net cash generated by (used in) investing activities                                                      |       | (132,825                                             | )          | 899,215 |   | (188,125 | ) |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| **Cash  flows from financing activities**                                                                 |       |                                                 |       |   |   |   |   |
| Proceeds from issuance of preferred stock, net of  issuance costs                                         |       | 2,063,176                                            |       | — |   | — |   |
| Proceeds from issuance of common stock, net of  issuance costs                                            |       | —                                               |       | 3,234,128 |   | 6,054,014 |   |
| Proceeds from issuance of notes payable with  warrants                                                    |       | 1,550,000                                            |       | — |   | — |   |
| Debt issuance costs                                                                                       |       | (97,500                                              | )          | — |   | — |   |
| Repayment of notes payable                                                                                |       | (240,000                                             | )          | (18,491 | ) | (63,485 | ) |
| Dividends paid                                                                                            |       | (51,935                                              | )          | (52,997 | ) | (211,989 | ) |
| Payment on advances from related stockholders                                                             |       | —                                               |       | — |   | (59,000 | ) |
| Proceeds from exercise of stock options                                                                   |       | —                                               |       | 62,652 |   | 496,579 |   |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| Net cash provided by financing activities                                                                 |       | 3,223,741                                            |       | 3,225,292 |   | 6,216,119 |   |
| Effect of exchange rate changes on cash                                                                   |       | (77,015                                              | )          | (87,861 | ) | 66,955 |   |
| Net increase (decrease) in cash                                                                           |       | 197,369                                              |       | (2,170,581 | ) | 2,333,672 |   |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| Cash at  beginning of period                                                                              |       | 741,184                                              |       | 2,911,765 |   | 578,093 |   |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| Cash at end of period                                                                                     |       | $                                                    | 938,553    |   | $ | 741,184 |   | $ | 2,911,765 |   |
|                                                                                                      |       |                                                 |       |   |   |   |   |
| Supplemental  disclosure of cash flow information:                                                        |       |                                                 |       |   |   |   |   |
| Cash paid for interest                                                                                    |       | $                                                    | 62,402     |   | $ | — |   | $ | — |   |
| Cash paid for income taxes                                                                                |       | $                                                    | —     |   | $ | — |   | $ | — |   |
| Summary of  non-cash investing and financing activities:                                                  |       |                                                 |       |   |   |   |   |
| Cancellation of shares previously issued pursuant to  shareholder note receivable write-off               |       | $                                                    | —     |   | $ | — |   | $ | 150,000 |   |
| Beneficial conversion feature of series C preferred  stock                                                |       | $                                                    | 33,000     |   | — |   | — |   |
| Exchange of common shares for marketable equity  securities                                               |       | $                                                    | —     |   | $ | 231,481 |   | $ | — |   |
| Changes in minimum pension liability                                                                      |       | $                                                    | (177,203   | ) | $ | 280,668 |   | $ | — |   |
| Unrealized holding losses on marketable securities                                                        |       | $                                                    | 39,311     |   | $ | — |   | $ | — |   |
| Conversion of Series B Preferred stock to common                                                          |       | $                                                    | 100        |   | $ | — |   | $ | — |   |
| Warrants issued  with notes payable                                                                       |       | $                                                    | 621,103    |   | $ | — |   | $ | — |   |

 

The accompanying notes are an integral part ofthese consolidated financial statements.

47

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**IMAGEWARESYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OFCOMPREHENSIVE LOSS**
| ** **                                                                | ** ** | **TWELVE MONTHS ENDED  DECEMBER 31,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                  |       | $                                                    | (5,926,215 | ) | $ | (8,355,704 | ) | $ | (9,638,599 | ) |
| Other  comprehensive income (loss):                                       |       |                                                 |       |   |   |   |   |
| Unrealized losses on available-for-sale securities  arising during period |       | (39,311                                              | )          | — |   | — |   |
| Additional minimum pension liability                                      |       | 177,203                                              |       | (280,668 | ) | — |   |
| Foreign currency translation adjustment                                   |       | (77,015                                              | )          | (87,861 | ) | 66,955 |   |
| Comprehensive loss                                                        |       | $                                                    | (5,865,338 | ) | $ | (8,724,233 | ) | $ | (9,571,644 | ) |

 

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

48

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**ImageWare Systems, Inc.**

**ConsolidatedStatements of Shareholders' Equity (Deficit)**

for the YearsEnded December 31, 2004, 2005 and 2006
| ** **                                                                                            | ** ** | **Series B** | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|------------------|------------|--------------------|------------|----------------|------------|-------------|------------|----------------|------------|---------------|------------|----------------|------------|------------------|------------|----------------|------------|--------------|------------|-----------------|------------|
| ** **                                                                                            | ** ** | **Convertible,**  | ** ** | **Series C**     | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | **Unearned**  | ** ** | **Share-**     | ** ** | **Accumulated**  | ** ** | ** **     | ** ** | ** **   | ** ** |
| ** **                                                                                            | ** ** | **Redeemable**    | ** ** | **Convertible,** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | **Additional** | ** ** | **Stock**     | ** ** | **holder**     | ** ** | **Other**        | ** ** | ** **     | ** ** | ** **   | ** ** |
| ** **                                                                                            | ** ** | **Preferred**     | ** ** | **Preferred**    | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-In**    | ** ** | **Based**   | ** ** | **Note**       | ** ** | Comprehensive | ** ** | Accumulated    | ** ** | ** **       | ** ** |
| ** **                                                                                            | ** ** | **Shares**        | ** ** | **Amount**       | ** ** | **Shares**       | ** ** | **Amount**         | ** ** | **Shares**     | ** ** | **Amount**  | ** ** | **Shares**     | ** ** | **Amount**    | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Receivable** | ** ** | **Loss**     | ** ** | **Deficit**     | ** ** | **Total** | ** ** |
| ** **                                                                                            | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | ** ** | ** ** |
| **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** | ** ** |
| ** **                                                                                            | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Issuance  of common stock for cash, net of financing commissions**                                  | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **1,818,332**  | ** ** | **18,183**  | ** ** | ** **     | ** ** | ** **    | ** ** | **6,035,831**  | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **6,054,014** | ** ** |
| **Issuance  of common stock pursuant to option and warrant exercise for cash**                        | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **207,080**    | ** ** | **2,071**   | ** ** | ** **     | ** ** | ** **    | ** ** | **494,507**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **496,578** | ** ** |
| **Issuance  of common stock as compensation**                                                         | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **38,640**     | ** ** | **386**     | ** ** | ** **     | ** ** | ** **    | ** ** | **148,379**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **148,765** | ** ** |
| **Issuance  of warrants as payment of liquidated damages in lieu of cash**                            | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **106,202**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **106,202** | ** ** |
| **Warrants  issued in conjunction with convertible debt and common stock**                            | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **7,932,527**  | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **7,932,527** | ** ** |
| **Write-off  of shareholder note receivable**                                                         | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | **150,000**    | ** ** | ** **   | ** ** | ** **      | ** ** | **150,000** | ** ** |
| **Cancellation  of shares previously issued pursuant to shareholder note receivable  write-off** | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **(25,000**    | **)**      | **(250**    | **)**      | ** **     | ** ** | ** **    | ** ** | **(149,750**   | **)**      | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **(150,000** | ) |
| **Dividends  on Series B Preferred stock**                                                            | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | **(211,989**    | **)**      | **(211,989** | ) |
| **Accumulated  other comprehensive loss**                                                             | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | **66,955**   | ** ** | ** **      | ** ** | **66,955** | ** ** |
| **Net loss**                                                                                          | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | **(9,638,599**  | **)**      | **(9,638,599** | ) |
| **Balance  at December 31, 2004**                                                                     | ** ** | **249,400**       | ** ** | **2,494**        | ** ** | **—**       | ** ** | **—**         | ** ** | **11,969,089** | ** ** | **118,442** | ** ** | **(6,704**     | **)**      | **(63,688**   | **)**      | **63,789,396** | ** ** | **—**       | ** ** | **—**     | ** ** | **332,425**  | ** ** | **(55,912,850** | **)**      | **8,266,219** | ** ** |
| **Issuance  of common stock for cash, net of financing commissions**                                  | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **1,397,287**  | ** ** | **13,973**  | ** ** | ** **     | ** ** | ** **    | ** ** | **3,220,155**  | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **3,234,128** | ** ** |
| **Issuance  of common stock as consideration for investment in equity securities**                    | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **71,225**     | ** ** | **712**     | ** ** | ** **     | ** ** | ** **    | ** ** | **230,769**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **231,481** | ** ** |
| **Issuance  of common stock as compensation**                                                         | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **90,481**     | ** ** | **905**     | ** ** | ** **     | ** ** | ** **    | ** ** | **347,447**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **348,352** | ** ** |
| **Issuance  of common stock pursuant to option and warrant exercise for cash**                        | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **26,284**     | ** ** | **263**     | ** ** | ** **     | ** ** | ** **    | ** ** | **62,390**     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **62,653** | ** ** |
| **Dividends  on Series B Preferred stock**                                                            | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | **(52,998**     | **)**      | **(52,998** | ) |
| **Additional  minimum pension liability**                                                             | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | **(280,668** | **)**      | ** **      | ** ** | **(280,668** | ) |
| **Foreign  currency translation adjustment**                                                          | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | **(87,861**  | **)**      | ** **      | ** ** | **(87,861** | ) |
| **Net loss**                                                                                          | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | **(8,355,704**  | **)**      | **(8,355,704** | ) |
| **Balance  at December 31, 2005**                                                                     | ** ** | **249,400**       | ** ** | **2,494**        | ** ** | **—**       | ** ** | **—**         | ** ** | **13,554,366** | ** ** | **134,295** | ** ** | **(6,704**     | **)**      | **(63,688**   | **)**      | **67,650,157** | ** ** | **—**       | ** ** | **—**     | ** ** | **(36,104**  | **)**      | **(64,321,552** | **)**      | **3,365,602** | ** ** |
| **Warrants  issued in conjunction with secured debt**                                                 | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **418,500**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **418,500** | ** ** |
| **Warrant  price reduction issued as consideration for debt acceleration waiver**                     | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **27,693**     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **27,693** | ** ** |
| **Warrants  issued as consideration for debt acceleration waiver**                                    | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **174,910**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **174,910** | ** ** |
| **Issuance  of preferred stock for cash, net of financing commissions**                               | ** ** | ** **        | ** ** | ** **       | ** ** | **2,500**        | ** ** | **25**             | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **2,063,151**  | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **2,063,176** | ** ** |
| **Beneficial  conversion feature of series C preferred stock**                                        | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **33,000**     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | **(33,000**     | **)**      | **—** | ** ** |
| **Preferred  Stock conversion to common stock**                                                       | ** ** | **(10,000**       | **)**      | **(100**         | **)**      | ** **       | ** ** | ** **         | ** ** | **1,895**      | ** ** | **19**      | ** ** | ** **     | ** ** | ** **    | ** ** | **81**         | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **—** | ** ** |
| **Issuance  of common stock as compensation**                                                         | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | **144,588**    | ** ** | **1,445**   | ** ** | ** **     | ** ** | ** **    | ** ** | **474,596**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **476,041** | ** ** |
| **Stock-based  compensation option expense**                                                          | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | **711,241**    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **711,241** | ** ** |
| **Dividends  on Series B Preferred stock**                                                            | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | **(51,935**     | **)**      | **(51,935** | ) |
| **Additional  minimum pension liability**                                                             | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | **177,203**  | ** ** | ** **      | ** ** | **177,203** | ** ** |
| **Unrealized  holding losses on securities**                                                          | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | **(39,311**  | **)**      | ** **      | ** ** | **(39,311** | ) |
| **Foreign  currency translation adjustment**                                                          | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | **(77,015**  | **)**      | ** **      | ** ** | **(77,015** | ) |
| **Net loss**                                                                                          | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **         | ** ** | ** **     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **       | ** ** | ** **     | ** ** | ** **   | ** ** | **(5,926,215**  | **)**      | **(5,926,215** | ) |
| **Balance at December 31, 2006**                                                                      | ** ** | **239,400**       | ** ** | **2,394**        | ** ** | **2,500**        | ** ** | **25**             | ** ** | **13,700,849** | ** ** | **135,759** | ** ** | **(6,704**     | **)**      | **(63,688**   | **)**      | **71,553,329** | ** ** | **—**       | ** ** | **—**     | ** ** | **24,773**   | ** ** | **(70,332,702** | **)**      | **1,319,890** | ** ** |

 

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

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**IMAGEWARE SYSTEMS, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31, 2006, 2005 AND 2004**

**1.****                                      DESCRIPTIONOF BUSINESS AND OPERATIONS**

ImageWare Systems, Inc. (the “Company”), formerlyknown as ImageWare Software, Inc., utilizes identity management technologyto provide stand alone, networked and web-based software solutions forbiometrics, law enforcement and secure credentials.

Our “flagship” product is the IWS BiometricEngineTM.  Scalable for small citybusiness or worldwide deployment, our biometric engine is a multi-biometricplatform that is hardware and algorithm independent, enabling the enrollmentand management of unlimited population sizes. Our identification products are used to manage and issue securecredentials including national IDs, passports, driver licenses, smart cards andaccess control credentials. Our law enforcement products provide lawenforcement with integrated mug shot, fingerprint Livescan and investigativecapabilities.  The biometric technologyis now an integral part of all markets we address, and all of our products areintegrated into the Biometric Engine Platform.  Elements of the biometricengine can be used as investigative tools to law enforcement potentiallyutilizing multiple biometrics and forensic data elements, and to enhancesecurity and authenticity of public and private sector credentials.

Our biometric technology is a core software componentof an organization’s security infrastructure and includes a multi-biometricidentity management solution for enrolling, managing, identifying and verifyingthe identities of people by the physical characteristics of the human body. Wedevelop, sell and support various identity management capabilities withingovernment (federal, state and local), law enforcement, commercial enterprises,and transportation and aviation markets for identification and verificationpurposes. Our IWS Biometric Engine is a biometric identity management platformfor multi-biometric enrollment, management and authentication, managingpopulation databases of virtually unlimited sizes. It is also offered as aSoftware Development Kit (SDK) based search engine, enabling developers andsystem integrators to implement a biometric solution or integrate biometriccapabilities into existing applications without having to derive biometricfunctionality from pre-existing applications. The IWS Biometric Engine combined with our secure credential platform,IWS EPI Builder, provides a comprehensive, integrated biometric and securecredential solution that can be leveraged for high-end applications such aspassports, driver licenses, national IDs, and other secure documents. It canalso be utilized within our law enforcement systems to incorporate any numberof various multiple biometrics into one system.

Our law enforcement solutions enable agencies toquickly capture, archive, search, retrieve, and share digital images,fingerprints and criminal history records on a stand-alone, networked, wirelessor Web-based platform. We develop, sell and support a suite of modular softwareproducts used by law enforcement and public safety agencies to create andmanage criminal history records and to investigate crime. Our IWS LawEnforcement solution consists of seven software modules: A Capture andInvestigative module, which provides a criminal booking system and relateddatabase; A Facial Recognition module, which uses biometric facial recognitionto identify suspects; and Suspect ID, which facilitates the creation offull-color, photo-realistic suspect composites. In addition, we offer a wireless module, which provides access tocentrally stored records over the Internet in a connected or wireless fashion,a PDA add-on module which enables access to centrally stored records while inthe field on a handheld Pocket PC compatible device, and central repositoryservices which allows for inter-agency data sharing on a local, regional,and/or national level.  In 2005 we addeda new Livescan module which incorporates Livescan capabilities into IWS LawEnforcement, providing integrated fingerprint and palm print biometricmanagement for civil and law enforcement use.

Our Secure Credential ID solutions empower customersto create 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 products in this market consist of IWS EPISuite, IWS EPI Builder (SDK), Identifier for Windows and ID Card Maker.  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 IWS Biometric Engine to our product line.

Ourenterprise authentication software includes the IWS Desktop Security softwaresolution which is a comprehensive authentication management infrastructurespecifically designed to provide enterprise networks with the most advancedauthentication mechanisms including biometrics, RFID technology, USB flashmemory modules, Trusted Platform Module (TPM), and smart cards.

50

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*Going Concern*

As reflected in the accompanying consolidatedfinancial statements, the Company has continuing losses and negative cash flowsfrom operations. These matters raise substantial doubt about the Company’sability to continue as a going concern to fund the cash requirements of theCompany’s operations for a reasonable period of time.

New financing will be required to fund working capitaland operations should the Company be unable to generate positive cash flow fromoperations in the near future. The Company is exploring the possible sale ofequity securities and/or debt financing, and believes that additional financingwill be available under terms and conditions that are acceptable to theCompany. However, there can be no assurance that additional financing will beavailable. In the event financing is not available in the time frame required,the Company will be forced to reduce its rate of growth, if any, reduceoperating expenses, curtail sales and marketing activities andreschedule research and development projects. In addition, the Companymight be required to sell certain of its assets or license its technologies toothers. These actions, while necessary for the continuance of operations duringa time of cash constraints and a shortage of working capital, could adverselyaffect the Company’s business.

In view of the matters described in the precedingparagraph, recoverability of a major portion of the recorded asset amountsshown 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 consolidated financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or amounts and classifications of liabilities that might be necessaryshould the Company be unable to continue its existence.

The Company operates in markets that are emerging andhighly competitive. There is no assurance that the Company will operate at aprofit in the future.

**2.****                                      SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

*Principles of consolidation*

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

*Use of estimates*

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of America (“U.S.GAAP”) requires management to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements, and the reportedamounts of revenue and expense during the reporting period. Significantestimates include the allowance for doubtful accounts receivable, calculationof our tax provision, inventory obsolescence reserve, the determination ofother than temporary impairment on our marketable securities, deferred taxasset valuation allowances, accounting for loss contingencies, recoverabilityof goodwill and acquired intangible assets and amortization periods, assumptionsused in the Black-Scholes model to calculate the fair value of share basedpayments, and revenue and cost of revenues recognized under the percentage ofcompletion method. Actual results could differ from estimates.

*Cash and Cash Equivalents*

Cash and cash equivalentsconsist primarily of cash on deposit, certificates of deposit, money marketaccounts, and investment grade commercial paper that are readily convertibleinto cash with original maturities of three months or less or that areredeemable upon demand.

*Allowancefor Doubtful Accounts*

TheCompany records its allowance for doubtful accounts based upon its assessmentof various factors. The Company considers historical experience, the age of theaccounts receivable balances, the credit quality of its customers, currenteconomic conditions and other factors that may affect customers’ abilityto pay to determine the level of allowance required.

*Fair Valueof Financial Instruments*

For certain of the Company’sfinancial instruments, including accounts receivable, accounts payable, accruedexpenses and deferred revenues the carrying amounts approximate fair value dueto their relatively short maturities.

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*Property, equipment and leaseholdimprovements*

Property and equipment, consisting of furniture and equipment,are stated 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. Expenditures for leasehold improvementsare capitalized. Depreciation of leasehold improvements is computed using thestraight-line method over the shorter of the remaining lease term or theestimated useful lives of the improvements.

*Goodwill:*

Goodwill arising from the acquisition of G & A Imaging and Castleworksand E-Focus was first attributed to developed technology, trademarks andtradenames, patents, agreements not-to-compete and customer relationship basedupon their estimated fair value at the date of acquisition. These intangibleassets are being amortized over their estimated useful lives, which range from3-15 years. Goodwill acquiredwill be reviewed for impairment pursuant to SFAS No. 142.

The Company accounts for itsintangible assets under the provisions of SFAS No. 142, “Goodwill andOther Intangible Assets”. In accordance with SFAS No. 142, intangibleassets with a definite life are accounted for impairment under SFASNo. 144 and intangible assets with an indefinite life are accounted forimpairment under SFAS No. 142. In accordance with SFAS No. 142,goodwill, or the excess of cost over fair value of net assets acquired, is nolonger amortized but is tested for impairment using a fair value approach atthe “reporting unit” level. A reporting unit is the operating segment, or abusiness one level below that operating segment (referred to as a component) ifdiscrete financial information is prepared and regularly reviewed by managementat the component level. The Company recognizes an impairment charge for anyamount by which the carrying amount of a reporting unit’s goodwill exceeds itsfair value. The Company uses fair value methodologies to establish fair values.When available and as appropriate, comparative market multiples to corroboratediscounted cash flow results is used. When a business within a reporting unitis disposed of, goodwill is allocated to the gain or loss on disposition usingthe relative fair value methodology.

For the twelve months endedDecember 31, 2005, the Company recorded goodwill impairment charges ofapproximately $1,245,000 for goodwill carried in the Company’s former DigitalPhotography segment. The impairment was a result of changes resulting from theeffect of projecting recent performance variances on future periods.  The Company did not record any goodwillimpairment charges for the twelve months ended December 31, 2006.

*Intangible and Long-lived assets*

In October 2001, the FASB issued SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”,which supersedes SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to Be Disposed Of”, and theaccounting and reporting provision of APB Opinion No. 30, “Reporting theResults of Operations-Reporting the Effects of Disposal of a Segment of aBusiness, and Extraordinary, Unusual and Infrequently Occurring Events andTransactions”, for the disposal of a segment of a business.  This statement also amends ARB No. 51, “ConsolidatedFinancial Statements”, to eliminate the exception to consolidation for asubsidiary for which control is likely to be impaired. SFAS No. 144requires that long-lived assets to be disposed of by sale, including those ofdiscontinued operations, be measured at the lower of carrying amount or fairvalue less cost to sell, whether reported in continuing operations or in discontinuedoperations. SFAS No. 144 broadens the reporting of discontinued operationsto include all components of an entity with operations that can bedistinguished from the rest of the entity and that will be eliminated from theongoing operations of the entity in a 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. AtDecember 31, 2005, the Company recorded impairment losses on certainlong-lived assets aggregating $253,000. At December 31, 2006, there was no impairment of the Company’sintangible or long-lived assets.

*Concentration of credit risk*

Financial instruments which potentially subject theCompany to concentrations of credit risk consist principally of cash and tradeaccounts receivable. The Company places its cash with high quality financialinstitutions and at times may exceed the FDIC $100,000 insurance limit.Sales are typically made on credit and the Company generally does not requirecollateral. The Company performs ongoing credit evaluations of its customers’financial condition and maintains an allowance for doubtful accounts. Accountsreceivable are presented net of an allowance for doubtful accounts of $483,132and $477,749 at December 31, 2006 and 2005, respectively.

For the twelve months ended December 31, 2006 onecustomer accounted for approximately 21% of total revenues.  For the twelve months ended 2005 and 2004,there were no customers who accounted for more than 10% of the Company’srevenues.

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As of December 31, 2006, there were three customerswho each accounted for more than 10% of total accounts receivable and whocollectively comprised approximately 52% of total accounts receivable.   At December 31, 2006, two of these accountswere in good standing with the third account fully reserved.   As of December 31, 2005, one customeraccounted from approximately 25% of total accounts receivable.

*Stock-based compensation*

AtDecember 31, 2006, the Company had three stock-based compensation plans foremployees and nonemployee directors which authorize the granting of variousequity-based incentives including stock options and restricted stock.

Priorto January 1, 2006, the Company accounted for the measurement and recognitionof stock-based compensation under the provisions of APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related Interpretations, permitted underStatement of Financial Accounting Standard No. 123, “Accounting for Stock-BasedCompensation” (SFAS No. 123). As a result, employee stock option basedcompensation was included as a pro forma disclosure in the Notes to the Company’sfinancial statements for prior year periods.

Priorto the adoption of Statement of Financial Accounting Standards No. 123(R), “Share-BasedPayment”, (SFAS 123(R)), the Company provided the disclosures required underSFAS No. 123. The pro forma effect on net income and net income per share as ifthe fair value of stock-based compensation had been recognized as compensationexpense for the twelve month periods ending December 31, 2005 and 2004 was asfollows:
| ** **                                                       | ** ** | **Twelve  Months Ended  December 31,** | ** ** | **Twelve  Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                       | ** ** | **2005**                                         | ** ** | **2004**                                         | ** ** |
|                                                             |       |                                             |       |                                             |       |
| Net Loss:                                                        |       |                                             |       |                                             |       |
| As reported                                                      |       | $                                                | (8,355,704 | )                                                | $          | (9,638,599 | ) |
| Stock-based compensation included in net loss                    |       | $                                                | 310,597    |                                             | $          | 357,774 |   |
| Stock-based employee compensation under fair value  based method |       | $                                                | (848,534   | )                                                | $          | (939,491 | ) |
| Pro forma net  loss                                              |       | $                                                | (8,893,641 | )                                                | $          | (10,220,316 | ) |
|                                                             |       |                                             |       |                                             |       |
| Basic and  diluted loss per common share:                        |       |                                             |       |                                             |       |
| As reported                                                      |       | $                                                | (0.66      | )                                                | $          | (0.82 | ) |
| Pro forma                                                        |       | $                                                | (0.70      | )                                                | $          | (0.88 | ) |

 

OnJanuary 1, 2006, the Company adopted the provisions of SFAS 123(R) using themodified prospective transition method. SFAS 123(R) requires companies to measure and recognized the cost ofemployee services received in exchange for awards of equity instruments basedon the grant date fair value of those awards. For share option instrumentsissued subsequent to the adoption of SFAS 123(R), compensation cost isrecognized ratably using the straight-line attribution method over the expectedvesting period. For equity options issued prior to the adoption of SFAS 123(R),compensation cost is recognized using a graded vesting attribution method. Inaddition, pursuant to SFAS 123(R), we are required to estimate the amount ofexpected forfeitures when calculating compensation costs, instead of accountingfor forfeitures as incurred, which was our previous method. Prior periods arenot restated under this transition method. Options previously awarded andclassified as equity instruments continue to maintain their equityclassification under SFAS 123(R).

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Theeffect of recording stock-based compensation for the twelve months endedDecember 31, 2006 was as follows:
|                                                                    | ** ** | **Twelve  Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **2006**                                         | ** ** |
|                                                               |       |                                             |       |
| Stock-based  compensation expense by type of award:                |       |                                             |       |
| Employee stock options                                             |       | $                                                | 711        |   |
| Restricted stock grants                                            |       | $                                                | 406        |   |
| Total employee  stock based compensation                           |       | $                                                | 1,117      |   |
| Tax effect on  stock-based compensation                            |       | —                                           |       |
| Tax effect on  net income                                          |       | —                                           |       |
| Stock-based  compensation included in net loss                     |       | $                                                | 1,117      |   |
|                                                               |       |                                             |       |
| Effect on loss  per common share:                                  |       |                                             |       |
| Basic                                                              |       | $                                                | (0.05      | ) |
| Diluted                                                            |       | $                                                | (0.05      | ) |

 

Priorto adopting SFAS No. 123(R), the Company presented all excess tax benefits, ifany, resulting from the exercise of stock options as operating cash flows inthe Statement of Cash Flows. SFAS No. 123(R) requires cash flows resulting fromexcess tax benefits to be classified as a financing activity. Excess taxbenefits are realized from tax deductions for exercised options in excess ofthe deferred tax asset attributable to stock compensation costs for suchoptions. The Company did not record any excess tax benefits as a result ofadopting SFAS 123(R) in the twelve months ended December 31, 2006 because theCompany is currently providing a full valuation on future tax benefits realizedin the United States until it can sustain a level of profitability thatdemonstrates its ability to utilize the assets.

SFASNo. 123(R) requires the use of a valuation model to calculate the fair value ofstock-based awards. For the twelve months ended December 31, 2006, the Companyhas elected to use the Black-Scholes option-pricing model, which incorporatesvarious assumptions including volatility, expected life, and interest rates.The Company is required to make various assumptions in the application of theBlack-Scholes option pricing model. The Company has determined that the bestmeasure of expected volatility is based on the historical weekly volatility ofthe Company’s common stock. Historical volatility factors utilized in theCompany’s Black-Scholes computations range from 82.1% to 98.5%. The Company haselected to estimate the expected life of an award based upon the SEC approved “simplifiedmethod” noted under the provisions of Staff Accounting Bulletin No. 107. Underthis formula, the expected term is equal to: ((weighted-average vesting term +original contractual term)/2). The expected term used by the Company ascomputed by this method range from 3.5 years to 6.1 years. The interest rateused is the risk free interest rate and is based upon U. S. Treasury ratesappropriate for the expected term. Interest rates used in the Company’sBlack-Scholes calculations range from 2.7% to 4.6%. Dividend yield is zero aswe do not expect to declare any dividends on our common shares in theforeseeable future.

Inaddition to the key assumptions used in the Black-Scholes model, the estimatedforfeiture rate at the time of valuation is a critical assumption.  The Company has estimated an annualizedforfeiture rate of 5.7% for corporate officers, 2.4% for members of the Boardof Directors and 25% for all other employees. The Company reviews the expected forfeiture rate annually to determineif that percent is still reasonable based on historical experience.

Asummary of the activity under the Company’s stock option plans for the twelvemonths ended December 31, 2006 is as follows:
| ** **                    | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** |
|-------------------------------|------------|-------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|
|                          |       |        |       |                                    |       |                                                              |       |
| Balance at  December 31, 2005 |       | 1,474,093   |       | $                                       | 2.68       |                                                              | 7.23       |   |
| Granted                       |       | 363,000     |       | $                                       | 1.90       |                                                              | 9.15       |   |
| Forfeited                     |       | (233,929    | )          | $                                       | 3.17       |                                                              | 5.96       |   |
| Exercised                     |       | —      |       | $                                       | —     |                                                              | —     |   |
|                          |       |        |       |                                    |       |                                                              |       |
| Balance at December 31,  2006 |       | 1,603,164   |       | $                                       | 2.45       |                                                              | 7.84       |   |

 

54

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Optionsexercisable at December 31, 2006 totaled 847,480 at a weighted-average price of$2.66, with a remaining weighted average contractual term of approximately 7.0years.

Theweighted-average grant date fair value of options granted during the twelvemonths ended December 31, 2006 was $1.38.

Thefollowing table sets forth a summary of the status and changes of the Company’sunvested shares related to its stock option plans as of and during the twelvemonths ended December 31, 2006:
| ** **                    | ** ** | **Options** | ** ** | **Weighted-  Average  Grant Date  Fair Value  Per Share** | ** ** |
|-------------------------------|------------|-------------|------------|--------------------------------------------------------------------------|------------|
|                          |       |        |       |                                                                     |       |
| Balance at  December 31, 2005 |       | 840,332     |       | $                                                                        | 1.85       |   |
| Granted                       |       | 363,000     |       | $                                                                        | 1.38       |   |
| Vested                        |       | (367,588    | )          | $                                                                        | 1.83       |   |
| Forfeited                     |       | (77,060     | )          | $                                                                        | 1.86       |   |
|                          |       |        |       |                                                                     |       |
| Balance at December 31,  2006 |       | 758,684     |       | $                                                                        | 1.63       |   |

 

AtDecember 31, 2006, the total remaining unrecognized compensation cost relatedto unvested stock options amounted to approximately $476,466, which will beamortized over the weighted-average remaining requisite service period of 1.08years.

OnMarch 30, 2004, the Company entered into a stock exchange agreement withcertain employees whereby the employees would receive 255,792 shares of restricted stock in exchangefor 426,321 options previously granted under various stock option plans. Underthe terms of the agreement, the employees will receive three shares ofrestricted stock for each five options exchanged. The restricted stock willvest over three years on a quarterly basis and will fully vest upon either achange in control or the sale of the Company.

On September 27, 2005,the Company issued to certain employees 162,300 shares of restricted stock. Therestricted stock will vest over three years on a quarterly basis and will fullyvest upon either a change in control or the sale of the Company.

In conjunction with theserestricted stock agreements, the Company has recognized stock-basedcompensation expense of $406,000, $311,000 and $358,000 for the twelve monthsended December 31, 2006, 2005 and 2004, respectively.

*Income taxes*

Current income tax expense or benefit is the amount ofincome taxes expected to be payable or refundable for the current year. Adeferred income tax asset or liability is computed for the expected futureimpact of differences between the financial reporting and tax bases of assetsand liabilities 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 ofthe Company’s foreign subsidiaries are measured using the foreign subsidiary’slocal currency as the functional currency. Revenues and expenses of suchsubsidiaries have been translated into U.S. dollars at average exchange ratesprevailing during the period. Assets and liabilities have been translated atthe rates of exchange on the balance sheet date. The resulting translation gainand loss adjustments are recorded directly as a separate component ofshareholders’ equity, unless there is a sale or complete liquidation of theunderlying foreign investments. The Company translates foreign currencies ofits German and Canadian subsidiaries. The cumulative translation adjustmentaccount, which is part of accumulated other comprehensive income,decreased approximately $77,000 for the twelve months ended December 31, 2006,decreased approximately $88,000 for the twelve months ended December 31,2005, and increased approximately $67,000 for the twelve months endedDecember 31, 2004.

*Comprehensive Income*

Comprehensive income consists of net gains and lossesaffecting shareholders’ equity that, under generally accepted accountingprinciples, are excluded from net income (loss). For the Company, the onlyitems are the cumulative translation

55

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adjustment,unrealized holding losses on marketable securities classified as available-for-saleand the additional minimum liability related to the Company’s defined benefitpension plan, recognized pursuant to Statement of Financial AccountingStandards No. 87 (“SFAS 87”), Employers’ Accounting for Pensions andStatement of Financial Accounting Standards No 158, “Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and132R)”.

*Revenue recognition*

The Company recognizes revenue from the followingmajor revenue sources:

·                  Long-termfixed-price contracts involving significant customization

·                  Fixed-pricecontracts involving minimal customization

·                  Softwarelicensing

·                  Sales ofcomputer hardware and identification media

·                  Postcontractcustomer support (PCS)

The Company’s revenue recognition policies areconsistent with U. S. GAAP including Statements of Position 97-2 “SoftwareRevenue Recognition” and 98-9 “Modification of SOP 97-2, Software RevenueRecognition With Respect to Certain Transactions”, Securities and ExchangeCommission Staff Accounting Bulletin 104 , Emerging Issues Task Force Issue00-21 “Revenue Arrangements with Multiple Deliverables”, and Emerging IssuesTask Force Issue 03-05 “Applicability of AICPA Statement of Position 97-2 toNon-Software Deliverables in an Arrangement Containing More-Than-IncidentalSoftware”. Accordingly, the Company recognizes revenue when all of thefollowing criteria are met: persuasive evidence of an arrangement exists,delivery has occurred or services have been rendered, the fee is fixed ordeterminable, and collectibility is reasonable assured.

The Company recognizes revenue and profit as workprogresses on long-term, fixed-price contracts involving significant amount ofhardware and software customization using the percentage of completion methodbased on costs incurred to date compared to total estimated costs atcompletion. Revenue from contracts for which we cannot reliably estimate totalcosts or there are not significant amounts of customization are recognized uponcompletion. The Company also generates non-recurring revenue from the licensingof its software. Software license revenue is recognized upon the execution of alicense agreement, upon deliverance, when fees are fixed and determinable, whencollectibility is probable and when all other significant obligations have beenfulfilled. The Company also generates revenue from the sale of computerhardware and identification media. Revenue for these items is recognized upondelivery of these products to the customer. Our revenue from periodicmaintenance agreements is generally recognized ratably over the respectivemaintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

*Capitalized software developmentcosts*

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

*Advertising costs*

The Company expenses advertising costs as incurred.Advertising expense totaled approximately $122,000, $68,000 and$94,000 for the years ended December 31, 2006, 2005 and 2004,respectively.

*Loss per share*

Basic loss per common share is calculated by dividingnet income (loss) available to common shareholders for the period by theweighted-average number of common shares outstanding during the period. Dilutedloss per common share is calculated by dividing net loss available to commonshareholders for the period by the weighted-average number of common sharesoutstanding during the period, increased to include, if dilutive, the number ofadditional common shares that would have been outstanding if the potentialcommon shares had been issued at the date of issuance. The dilutive effect ofoutstanding stock options is included in the calculation of diluted loss percommon share, if dilutive, using the treasury stock

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method.During the years ended December 31, 2006, 2005 and 2004, the Company hasexcluded the following securities from the calculation of diluted loss pershare, as their effect would have been anti-dilutive due to the Company’s netloss:
| Potential Dilutive Securities:     | ** ** | **Number of  Common Shares  Convertible into   at  December 31,   2006** | ** ** | **Number of  Common Shares  Convertible into   at  December 31,   2005** | ** ** | **Number of  Common Shares  Convertible into   at  December 31,   2004** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
|                                         |       |                                                                                                   |       |                                                                                                   |       |                                                                                                   |       |
| Convertible  preferred stock – Series B |       | 45,384                                                                                                 |       | 47,280                                                                                                 |       | 47,280                                                                                                 |       |
| Convertible  preferred stock – Series C |       | 1,666,664                                                                                              |       | —                                                                                                 |       | —                                                                                                 |       |
| Stock options                                |       | 1,603,164                                                                                              |       | 1,474,093                                                                                              |       | 894,359                                                                                                |       |
| Warrants                                     |       | 5,821,149                                                                                              |       | 4,293,305                                                                                              |       | 6,187,541                                                                                              |       |

 

The following table sets forth the computation ofbasic and diluted loss per share for the years ended December 31, 2006,2005 and 2004:
| ** **                                                            | ** ** | ** ** | ** ** | **TWELVE MONTHS ENDED  DECEMBER 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**   | ** ** | **2005**                                             | ** ** | **2004** | ** ** |
| Numerator – loss  from continuing operations:                    |       |       |       |                                                 |       |   |   |
| Net loss from continuing operations                                   |       | $          | (5,518,276 | )                                                    | $          | (6,696,778 | ) | $ | (8,738,414 | ) |
| Less preferred stock dividends                                        |       | (110,998   | )          | (52,997                                              | )          | (52,998 | ) |
| Net loss from continuing operations available to  common shareholders |       | $          | (5,629,274 | )                                                    | $          | (6,749,775 | ) | $ | (8,791,412 | ) |
|                                                                  |       |       |       |                                                 |       |   |   |
| Numerator – gain  (loss) from discontinued operations:           |       |       |       |                                                 |       |   |   |
| Net loss from discontinued operations                                 |       | (407,939   | )          | (1,658,926                                           | )          | (900,185 | ) |
|                                                                  |       |       |       |                                                 |       |   |   |
| Denominator                                                           |       |       |       |                                                 |       |   |   |
| Weighted-average shares outstanding                                   |       | 13,592,841 |       | 12,731,304                                           |       | 11,739,819 |   |
|                                                                  |       |       |       |                                                 |       |   |   |
| Basic and  Diluted loss per share:                                    |       |       |       |                                                 |       |   |   |
| Continuing operations                                                 |       | $          | (0.41      | )                                                    | $          | (0.53 | ) | $ | (0.74 | ) |
| Discontinued operations                                               |       | $          | (0.03      | )                                                    | $          | (0.13 | ) | $ | (0.08 | ) |
| Net loss per  share                                                   |       | $          | (0.44      | )                                                    | $          | (0.66 | ) | $ | (0.82 | ) |

 

*Segment information*

Prior to its acquisitions during 2001 of G &A, Castleworks and E-Focus, the Company operated in one business segment. Withits acquisition of G & A, Castleworks and E-Focus, the Companydetermined it was comprised of three reportable segments based on themanagement approach as prescribed by Statement of Financial AccountingStandards No. 131 (As Amended), “Disclosures about Segments of an Enterpriseand Related Information”, (“SFAS 131”). These segments were determined to be: Law Enforcement, Identificationand Digital Photography.  With the saleof its entire Digital Photography product line in November 2006, the Companyreassessed the composition of its operating segments and determined that it nolonger operates in separate, distinct market segments but rather operates inone market segment, that segment being identity management.  The Company’s determination was based onfundamental changes in the Company’s business structure due to theconsolidation of operations, restructuring of the Company’s operations andmanagement team, and the integration of what where previously distinct,mutually exclusive technologies.  Thishas resulted in changes in the manner by which the Company’s chief decisionmaker assesses performance and makes decisions concerning resource allocation.

As of result of the Company’s determination thatoperates in one market segment, that segment being identify management, theCompany will amend its segment disclosure beginning with its annual report asfiled on Form 10-K for the twelve months ended December 31, 2006.

*New Accounting Pronouncements*

InMarch 2006, the FASB issued SFAS No. 156, Accounting for Servicing ofFinancial Assets. The new standard, which is an amendment toSFAS No. 140, requires that all separately recognized servicingassets and servicing liabilities be initially measured at fair value, ifpracticable and permits, but does not require, the subsequent measurement ofseparately

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recognized servicingassets and servicing liabilities at fair value. If an entity uses derivativeinstruments to mitigate the risks inherent in servicing assets and servicingliabilities, it can simplify its accounting since SFAS No. 156permits income statement recognition of the potential offsetting changes infair value of those servicing assets and servicing liabilities and derivativeinstruments in the same accounting period. SFAS No. 156 is effectivefor all separately recognized servicing assets and liabilities acquired orissued after the beginning of an entity’s fiscal year that begins after15 September 2006. The Company does not expect its consolidated financialstatements to be significantly affected by this statement.

InJune 2006, the FASB issued Interpretation No. 48, Accounting forUncertainty in Income Taxes — an interpretation of FASB StatementNo. 109 (FIN 48). This interpretation prescribes a more likely thannot recognition threshold and a measurement attribute for the Financial Statementrecognition and measurement of a tax position taken or expected to be taken ina tax return.

FIN 48also provides guidance on derecognition of a tax position, classification of aliability for unrecognized tax benefits, accounting for interest and penalties,accounting in interim periods, and expanded income tax disclosures. FIN 48is effective for fiscal years beginning after 15 December 2006. TheCompany is currently evaluating the impact of this interpretation on itsconsolidated financial statements.

InSeptember 2006, the FASB issued SFAS No. 157, Fair ValueMeasurements, to increase consistency and comparability in fair valuemeasurements and to expand their disclosures. The new standard includes adefinition of fair value as well as a framework for measuring fair value. Thestandard is effective for fiscal periods beginning after 15 November 2007and should be applied prospectively, except for certain financial instrumentswhere it must be applied retrospectively as a cumulative-effect adjustment tothe balance of opening retained earnings in the year of adoption. The Companyis currently evaluating the impact of this standard on its consolidatedfinancial statements.

In February 2007, theFASB issued SFAS No. 159, The Fair Value Option for Financial Assetsand Financial Liabilities, including an amendment of FASB StatementNo. 115 (SFAS No. 159). This statement permits entities tochoose to measure many financial instruments and certain other items at fairvalue that are not currently required to be measured at fair value andestablishes presentation and disclosure requirements designed to facilitatecomparisons between entities that choose different measurement attributes forsimilar types of assets and liabilities. SFAS No. 159 is effectiveon January 1, 2008. The Company is currently evaluating the impact of thisstandard on its consolidated financial statements.

*Reclassifications*

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

**3.****                                      IntangibleAssets**

The following disclosure presents certain informationabout the Company’s acquired intangible assets as of December 31, 2006 and2005. All intangible assets are being amortized over their estimated usefullives, as indicated below, with no estimated residual values.
| **Acquired Intangible Assets** | ** ** | **Amortization  Period** | ** ** | **Gross  Carrying  Amount  After  Impairment  Charge** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balance** | ** ** |
|------------------------------------------|------------|--------------------------|------------|--------------------------------------------------------|------------|-------------------------------|------------|------------------|------------|
| At  December 31, 2006               |       |                     |       |                                                   |       |                          |       |             |       |
| Amortized  acquired intangible assets:   |       |                     |       |                                                   |       |                          |       |             |       |
| Technology                               |       | 5 years                  |       | $                                                      | 1,160,000  |                          | $          | (1,160,000       | )          | $ | — |   |
| Trademarks and tradenames                |       | 14.5 years               |       | 377,000                                                |       | (235,706                      | )          | 141,294          |       |
| Customer relationship                    |       | 5 years                  |       | 200,000                                                |       | (200,000                      | )          | —           |       |
| Non-compete Agreements                   |       | 3 years                  |       | 125,000                                                |       | (125,000                      | )          | —           |       |
| Patents                                  |       | 4 years                  |       | 60,000                                                 |       | (60,000                       | )          | —           |       |
|                                     |       |                     |       | $                                                      | 1,922,000  |                          | $          | (1,780,706       | )          | $ | 141,294 |   |
| At  December 31, 2005               |       |                     |       |                                                   |       |                          |       |             |       |
| Amortized  acquired intangible assets:   |       |                     |       |                                                   |       |                          |       |             |       |
| Technology                               |       | 5 years                  |       | $                                                      | 1,160,000  |                          | $          | (1,108,628       | )          | $ | 51,372 |   |
| Trademarks and tradenames                |       | 14.5 years               |       | 377,000                                                |       | (219,986                      | )          | 157,014          |       |
| Customer relationship                    |       | 5 years                  |       | 200,000                                                |       | (189,986                      | )          | 10,014           |       |
| Non-compete Agreements                   |       | 3 years                  |       | 125,000                                                |       | (125,000                      | )          | —           |       |
| Patents                                  |       | 4 years                  |       | 60,000                                                 |       | (60,000                       | )          | —           |       |
|                                     |       |                     |       | $                                                      | 1,922,000  |                          | $          | (1,703,600       | )          | $ | 218,400 |   |

 

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In 2005, werecorded an impairment charge of approximately $253,000 related to ourintangible asset for certain trademark and tradenames carried in our formerIdentification segment. This loss reflects the amount by which the carryingvalue of this asset exceeded its estimated fair value determined by the assets’future discounted cash flows. The impairment loss is recorded as a component of“Operating expenses” in the Consolidated Statement of Operations for 2005.  There were no impairment losses recorded forthe years ended December 31, 2006 and 2004.

Amortization expense for the twelve months endedDecember 31, 2006, 2005 and 2004, was approximately $77,000, $293,000 and$357,000, respectively.

The estimated acquired intangible amortization expensefor the next five fiscal years is as follows:
| Fiscal Year Ended December 31, | ** ** | **Estimated Amortization Expense** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------|------------|
| 2007                                               |       | 16,000                                       |       |
| 2008                                               |       | 16,000                                       |       |
| 2009                                               |       | 16,000                                       |       |
| 2010                                               |       | 16,000                                       |       |
| 2011                                               |       | 16,000                                       |       |
| Thereafter                                         |       | 61,294                                       |       |

 

**4.****                                      Goodwill**

The changes in the carrying amount of goodwill for theyears ended December 31, 2004, 2005 and 2006 are as follows:
|                                                           | ** ** | **Total**  | ** ** |
|-----------------------------------------------------------|------------|------------|------------|
| Balance of  Goodwill as of January 1, 2004           |       | $          | 5,297,627  |   |
|                                                      |       |       |       |
| Goodwill  acquired                                        |       | —     |       |
| Impairment  losses                                        |       | —     |       |
|                                                      |       |       |       |
| Balance of  Goodwill as of January 1, 2005           |       | $          | 5,297,627  |   |
|                                                      |       |       |       |
| Goodwill  acquired                                        |       | —     |       |
| Impairment  losses                                        |       | (1,245,353 | )          |
| Imaging Asia  Pacific component of Identification segment |       | (636,627   | )          |
| Balance of  goodwill as of December 31, 2005         |       | $          | 3,415,647  |   |
|                                                      |       |       |       |
| Goodwill  acquired                                        |       | —     |       |
| Impairment  losses                                        |       | —     |       |
|                                                      |       |       |       |
| Balance of Goodwill as  of December 31, 2006         |       | $          | 3,415,647  |   |

 

The Company annually, or more frequently if events orcircumstances indicate a need, tests the carrying amount of goodwill forimpairment. The Company performs its annual impairment test in the fourthquarter of each year. A two-step impairment test is used to first identifypotential goodwill impairment and then measure the amount of goodwillimpairment loss, if any. These tests were conducted by determining andcomparing the fair value of our reporting units, as defined in SFAS 142, to thereporting unit’s carrying value. In 2006, we determined that our only reportingunit is Identity Management. Based on the results of these impairment tests, wedetermined that our goodwill assets were not impaired as of December 31,2006.

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During 2005, the Company determined that because of achange in competitive dynamics the fair value of the Company’s former DigitalPhotography unit had been reduced to an amount less that the reporting unit’scarrying amount, and accordingly the Company recorded a pre-tax, non-cashgoodwill impairment charge of approximately $1,245,000 as a component ofgeneral and administrative expenses. The Company utilized the assistance of anunaffiliated third-party valuation specialist who employed various fair valuemethodologies, including present value techniques and prices of comparablebusinesses, to determine the implied fair value of the Company’s goodwill inits 2005 impairment testing.

**5.****                                      Investments**

In conjunction with the sale of the Company’swholly-owned subsidiary, as more fully described in Note 6 to theseconsolidated financial statements, the Company and Argus Solutions Ltd, eachagreed to purchase $250,000 of each others common stock at a per share priceequal to 108% of the closing price of each others’ stock as determined by theAmerican Stock Exchange and Australian Stock Exchange, respectively. As legalconsideration, each Company paid the other cash of $250,000. The Company andArgus consummated the transaction through the exchange of common shares. TheCompany exchanged 71,225 shares of its common stock for 1,929,914 shares ofcommon stock of Argus Solutions Ltd., which represents approximately onepercent of the voting equity of Argus. In accordance with Statement ofFinancial Accounting Standards No. 153, “Exchange of Nonmonetary Assets,an amendment of APB Opinion No. 29”, the Company has recorded thistransaction as a nonmonetary exchange based on the fair value of the sharesexchanged as determined by the closing price of the Company’s shares on theAmerican Stock Exchange on the transaction date of $3.25 or $231,000.

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 115, “Accounting for Certain Investments in Debtand Equity Securities” and based on our intentions regarding these instruments,we classify marketable equity securities into trading or available-for-salecategories. Marketable securities that are bought and held principally for thepurpose of selling them in the near term are classified as trading securitiesand are reported at fair value, with unrealized gains and losses recognized inearnings. Marketable securities not classified as trading are classified asavailable-for-sale and are carried at fair market value, with the unrealizedgains and losses, net of tax, included in the determination of comprehensiveincome and reported in shareholders’ equity. Marketable equity securities areincluded in other non-current assets. At December 31, 2006 and 2005, theCompany had classified $46,000 and $85,000, respectively, as available-for-salemarketable securities. These securities are reported at fair value asdetermined through quoted market sources. The Company reviews its marketableequity holdings in publicly-traded companies on a regular basis to determine ifany security has experienced an other-than-temporary decline in fair value. TheCompany considers the investee company’s cash position, earnings and revenueoutlook, and stock price performance, among other factors, in its review. If itis determined that an other-than-temporary decline exists in a marketableequity security, the Company writes down the investment to its market value andrecords the related write-down as an investment loss in its Statement ofOperations.

At December 31, 2006, the Company had recordedapproximately $39,000 as unrealized holding losses as a component of “Accumulatedother comprehensive income” in the Company’s Consolidated Balance Sheet.  At December 31, 2005, the Company wrotedown to fair market value its investment in Argus common stock. The write-downamounted to $146,000 and was due to a decline in the fair value of the equitysecurity which, in the opinion of management, was considered to be other thantemporary. The write-down is included in the caption “Other income, net” in theaccompanying Statement of Operations for the twelve months endedDecember 31, 2005.

**6.****                                      Saleof Businesses and Discontinued Operations**

On November 30,2006, the Company completed the sale of its entire Digital Photography (“PDI”)product line and inventory (the “PDI Products”) to an unaffiliated third partyfor a total of $400,000, including an initial cash payment of $25,000.  The purchaser is required to pay up to thefull remaining amount of $375,000 in a series of quarterly installments equalto 12.5% of all newly acquired sales and license revenues relating to the PDIproduct line (the “Percentage Payments”). Until such time when the Company has received the full purchase price of$400,000, during any 12-month period during which the aggregate PercentagePayments to the Company are less than $50,000, the purchaser will pay theCompany the difference between the Percentage Payments and $50,000.  This component of the Company’s business waspreviously classified as the Company’s Digital Photography segment.

The Companydecided to sell this component because it has incurred significant operatinglosses in each of the last five years and has lost significant market share inthe last three years.  The assets soldconsisted primarily of a suite of software and related inventory includingsource, copyrights, trademarks, documentation and client base.

In 2006, theCompany has recognized a gain of approximately $20,000 from the disposal ofthis component representing the cash proceeds received less the value of netassets sold.  At December 31, 2006, theCompany has recorded the fair value of the remaining amount due of $375,000offset by a full valuation allowance due to the uncertainty of the ultimatecollectibility of such amounts. This determination was based upon the maximumrepayment period of 7.5 years of

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amounts owing the Companycombined with the purchaser operating in a highly competitive businessenvironment evidenced by rapid technological change.  Accordingly, the Company has deferred any remaininggain from the disposal of this component until such time as the Companydetermines that the realization of the remaining amounts owed is reasonablyassured.

DigitalPhotography sales, reported in discontinued operations, for the years endedDecember 31, 2006, 2005 and 2004 were $176,000, $345,000, and $743,000,respectively.  Digital Photography’spretax loss, reported in discontinued operations for the years ended December31, 2006, 2005 and 2004 were $408,000, $1,881,000, and $967,000, respectively.

Net assets sold ofthe Digital Photography component were inventory and equipment of $5,000.  All software related assets such as source,copyrights, trademarks, documentation and client base were either fully expensedor fully amortized and had a net carrying value of zero at the date of sale.

On March 3, 2005, the Company sold itswholly-owned Singapore subsidiary, Digital Imaging Asia Pacific Pte. Ltd., forcash of $1,300,000, (the”DIAP transaction”). The Company decided to sell thissubsidiary as part of its overall strategic partnership with ArgusSolutions Ltd (“Argus”), as a means of strengthening its position in theAsia-Pacific region. In conjunction with this strategy, the Company enteredinto an International Distributor Agreement with Argus pursuant to which Arguswill distribute the Company’s biometric engine, law enforcement and securecredential solutions in the Asia-Pacific region, excluding Japan and Korea, fora period of three years. Argus will pay the Company a minimum license fee duringthe first three years of $1,400,000; $200,000 in year one; $400,000 in year twoand $800,000 in year three. In accordance with the provisions of Statement ofPosition 97-2, Software Revenue Recognition (“SOP 97-2”) regarding feedetermination and collectibility criteria, we recognized revenues of $333,000and $167,000 for the twelve months ended December 31, 2006 and 2005,respectively, and recorded deferred revenues of $33,000 as of December 31,2005, related to this minimum license fee.

In accordance with SFAS 144, this subsidiary,previously included in the Company’s former Identification segment, was treatedas a discontinued operation. The net loss for this subsidiary for the twelvemonths ended December 31, 2005 and 2004 are reflected in the Company’sConsolidated Statement of Operations as loss from discontinued operations.Included in the 2005 loss results is a gain on sale of subsidiary of $233,000net of direct transaction costs of $49,000 and including the allocation of$637,000 of goodwill.

The assets and liabilities sold as part of theDIAP transaction included the following:
| Cash                                            |   | $       | 41,000    |   |
|-------------------------------------------------|--------|---------|-----------|--------|
| Accounts  receivable                            |   | 80,000  |      |
| Inventories                                     |   | 242,000 |      |
| Prepaid expenses  and other current assets      |   | 18,000  |      |
| Property and  equipment, net                    |   | 17,000  |      |
| Goodwill                                        |   | 637,000 |      |
|                                            |   | $       | 1,035,000 |   |
|                                            |   |    |      |
| Accounts payable and  other current liabilities |   | $       | 17,000    |   |

 

Digital Imaging Asia Pacific’s sales, reported indiscontinued operations, for the twelve months ended December 31, 2005 and2004, were $42,000 and $604,000, respectively. Digital Imaging Asia Pacific’spretax loss, reported in discontinued operations for the twelve months endedDecember 31, 2005, was $10,000. Digital Imaging Asia Pacific’s pretaxincome for the twelve months December 31, 2004, was $66,000.

Prior period financial statements for the twelvemonths ended December 31, 2005 and 2004 have been restated to present theoperations of Digital Photography and Digital Imaging Asia Pacific asdiscontinued operations.

**7.****                                      Related Parties**

Subsequent to the Company’s sale of its wholly-ownedsubsidiary, Digital Imaging Asia Pacific Pte. Ltd., to Argus Solutions Ltd (“Argus’),as more fully described in Note 6 to these consolidated financial statements,the Company’s Chief Executive Officer accepted an invitation to become a memberof Argus’ Board of Directors. Prior to the closing of the Company’s saletransaction with Argus, the Company had no material relationship with ArgusSolutions.  Effective December 31, 2006,the Company’s Chief Executive Officer resigned from the Argus Board.

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**8.****                                      Inventory**

Inventories at December 31, 2006 and 2005 werecomprised of finished goods of $58,000 and $208,000 net of reserves of $52,000and $300,000, respectively. Appropriate consideration is given to obsolescence,excessive levels, deterioration, and other factors in evaluating net realizablevalue and required reserve levels.

**9.****                                      Property andEquipment**

Property and equipment at December 31, 2006 and2005, consists of:
| ** **                     | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|
| ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equipment                      |       | $          | 1,193,222  |       | $          | 1,762,103 |   |
| Leasehold  improvements        |       | 131,057    |       | 131,005    |       |
| Furniture                      |       | 161,808    |       | 328,360    |       |
|                           |       | 1,486,087  |       | 2,221,468  |       |
| Less accumulated  depreciation |       | (1,134,387 | )          | (1,797,581 | )          |
|                           |       | $          | 351,700    |       | $          | 423,887 |   |

 

During the twelve months 2006, the company wrote-offapproximately $892,000 in fully depreciated assets that were no longer beingutilized in the Company’s operations. Total depreciation expense for the yearsended December 31, 2006, 2005 and 2004 was approximately $230,000,$307,000 and $362,000, respectively.

**10.****                               Accrued Liabilities**

**Principal components of accruedliabilities consist of:**
| ** **                   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Compensated  absences        |       | $          | 236,161    |       | $          | 189,796 |   |
| Wages and sales  commissions |       | 146,436    |       | 192,848    |       |
| Customer  deposits           |       | 212,945    |       | —     |       |
| Liquidated  damages          |       | 279,896    |       | 279,896    |       |
| Professional  fees           |       | 52,637     |       | 67,918     |       |
| Other                        |       | 210,643    |       | 304,288    |       |
|                         |       | $          | 1,138,718  |       | $          | 1,034,746 |   |

 

**11.****                               Notes Payable and Lineof Credit**

Notespayable consist of the following:
|                                                                                                                                                                       | ** ** | **2006**   | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|----------|------------|
| Notes payable to third parties:                                                                                                                                       |       |       |       |     |       |
| Senior secured  promissory notes to accrue interest at 8%. Face value of note $1,310,000.  Discount on note at December 31, 2006 is $212,622. Note due March 17, 2006 |       | $          | 1,097,378  |     | $          | — |   |
| Short-term note  payable to certain vendors                                                                                                                           |       | $          | —     |     | $          | — |   |
| Total notes  payable to third parties                                                                                                                                 |       | 1,097,378  |       | —   |       |
|                                                                                                                                                                  |       |       |       |     |       |
| Total notes  payable                                                                                                                                                  |       | $          | 1,097,378  |     | $          | — |   |
| Less current  portion                                                                                                                                                 |       | (1,097,378 | )          | —   |       |
| Long-term notes payable                                                                                                                                               |       | $          | —     |     | $          | — |   |

 

InMarch 2006, the Company completed a secured debt financing in theaggregate amount of $1,550,000, with net proceeds to Company approximating$1,452,000. The Company issued a series of secured promissory notes (“theNotes”) aggregating $1,550,000 which bear interest at 8% per annum, withinterest compounded monthly and payable quarterly. The principal balancebecomes due in one year or earlier upon the occurrence of the followingcontractually defined events: (i) payments received by the Company inconnection with contracts with Grupo Inffinix and Argus Solutions or anyaffiliate thereof, or any extension, renewal or amendment of such contracts; or(ii) payments made against any new contract signed by the Company whichcontract amount is in excess of $1,500,000; or (iii) the receipt by theCompany of proceeds from the sale of equity or equity-linked securities by theCompany; or (iv) receipt of proceeds from the issuance by the Company ofany type of debt instruments, including lines of credit. In addition, theCompany may prepay the notes in whole or in part upon

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five days priorwritten notice.  As a condition to the loan,the Company entered into a security agreement whereby the Company granted asecurity interest in all of the Company’s goods and equipment, inventory,contract rights and general intangibles, accounts or other obligations owing tothe Company, and cash deposit accounts and other investment property to securepayment of the note.

Also acondition to the loan, the Company issued warrants to purchase 387,500 sharesof the Company’s common stock. Such warrants have a 5-year term and an exerciseprice $2.30 per share.  Common sharesunderlying the warrants have piggyback registration rights and cashlessexercise after 12 months from closing date if there is no effectiveregistration statement covering the underlying shares.

TheCompany initially recorded the secured debt financing net of a discount equalto the fair value allocated to the warrants using the relative fair valuemethod of approximately $419,000. The Company estimated the fair value of thewarrants using the Black-Scholes option pricing model and the followingassumptions: term of 5 years, a risk free interest rate of 4.52%, a dividendyield of 0%, and volatility of 82%.

Asmore fully discussed in Note 14 to these consolidated financial statements, inNovember and December 2006, the Company issued a total of 2,500 shares of itsSeries C Preferred Stock.  The issuanceof Series C preferred stock triggered a Right of Acceleration included in theNotes.  As consideration for the noteholders waiving this Right of Acceleration, the Company issued 200,250 warrantsto purchase common stock at an exercise price of $1.80 per share and reducedthe exercise price of 387,500 warrants to purchase common stock from $2.30 pershare to $1.80 per share.

TheCompany has calculated the fair value of the 200,250 warrants using theBlack-Scholes option pricing model with the following assumptions: risk freeinterest rate of 4.52%; dividend yield of 0%; volatility factor of the expectedmarket price of the Company’s common stock of 82%; and an expected life of thewarrant of 5 years.  The fair value ofthe warrants was approximately $175,000.

TheCompany has computed the fair value of the modification to the 387,500 warrantsto be approximately $28,000.  The Companycalculated the fair value of these warrants immediately before and after themodification using the Black-Scholes option pricing model with the followingassumptions: risk free interest rate of 4.52%; dividend yield of 0%; volatilityfactor of the expected market price of the Company’s common stock of 82%; andan expected life of the warrant of 5 years.

Thetotal of the fair value of the new warrants and the modification of existingwarrants of approximately $203,000 has been recorded as an increase to thediscount on the notes payable and an increase to additional paid incapital.  The discount will be amortizedover the remaining term of the note of four months.

Duringthe twelve months ended December 31, 2006, the Company recorded approximately$408,000 in debt discount amortization which is included as a component of netinterest expense in the Company’s Consolidated Statement of Operations.

**12.****                               Income Taxes**

The significant components of the income tax provision(benefit) are as follows:
|              | ** ** | **December 31,** | ** ** |
|--------------|------------|-----------------------|------------|
| ** **   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Current**  |       |                  |       |   |   |
| Federal      |       | $                     | —     |   | $ | — |   |
| State        |       | —                |       | — |   |
| Foreign      |       | —                |       | — |   |
|         |       |                  |       |   |   |
| **Deferred** |       |                  |       |   |   |
| Federal      |       | —                |       | — |   |
| State        |       | —                |       | — |   |
| Foreign      |       | —                |       | — |   |
|         |       |                  |       |   |   |
|         |       | $                     | —     |   | $ | — |   |

 

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The principal components of the Company’s deferred taxassets (liabilities) at December 31, 2006 and 2005 are as follows:
|                                   | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|-----------------------------------|------------|-------------|------------|-------------|------------|
|                              |       |        |       |        |       |
| Net operating  loss carryforwards |       | $           | 14,779,554 |        | $          | 12,907,871 |   |
| Research and  development credits |       | —      |       | 805,897     |       |
| Intangible Assets                 |       | 761,466     |       | 785,191     |       |
| Stock based  compensation         |       | 283,319     |       | —      |       |
| Reserves and  accrued expenses    |       | 203,273     |       | 193,416     |       |
| Other                             |       | (46,916     | )          | (48,548     | )          |
|                              |       | 15,980,696  |       | 14,643,827  |       |
| Less valuation  allowance         |       | (15,980,696 | )          | (14,643,827 | )          |
|                              |       |        |       |        |       |
| Net deferred tax  assets          |       | $           | —     |        | $          | — |   |

 

A reconciliation of the provision (benefit) for incometaxes to the amount computed by applying the statutory income tax rates to lossbefore income taxes is as follows:
|                                                 | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                            |       |      |       |      |       |
| Amounts computed  at statutory rates            |       | $         | (2,014,913 | )         | $          | (2,840,939 | ) |
| State income  tax, net of federal benefit       |       | (224,438  | )          | (289,610  | )          |
| Expiration of  net operating loss carryforwards |       | 382,645   |       | 0         |       |
| Non-deductible  goodwill impairment loss        |       | —    |       | 423,420   |       |
| Federal research  and development credit        |       | 513,013   |       | (63,103   | )          |
| Other                                           |       | 6,824     |       | 8,145     |       |
| Net change in  valuation allowance              |       | 1,336,869 |       | 2,762,087 |       |
|                                            |       |      |       |      |       |
|                                            |       | $         | —     |      | $          | — |   |

 

The Company has established a valuation allowanceagainst its deferred tax asset due to the uncertainty surrounding the realizationof such asset. Management periodically evaluates the recoverability of thedeferred tax asset. At such time as it is determined that is more likely thannot that deferred tax assets are realizable, the valuation allowance will bereduced.

At December 31, 2006 and 2005, the Company hadfederal net operating loss carryforwards of approximately $38,814,000 and$34,718,000, respectively, state net operating loss carryforwards ofapproximately $27,126,000 and $18,920,000, respectively, which may be availableto offset future taxable income for tax purposes. The federal net operatingloss carryforwards expire at various dates from 2007 through 2026. The statenet operating loss carryforwards expire at various dates from 2007 through2011.

The Internal Revenue Code (“the Code”) limits theavailability of certain tax credits that arose prior to certain cumulativechanges in a corporation’s ownership resulting in a change of control of theCompany.  The Company has reduced itsdeferred tax assets to zero relating to its federal and state research creditsbecause of such limitations.

The Code also limits the availability of net operatinglosses that arose prior to certain cumulative changes in a corporation’sownership resulting in a change of control of the Company. The Company’s use ofits net operating loss carryforwards and tax credit carryforwards will besignificantly limited because the Company underwent “ownership changes” in1991, 1995, 2000, 2003 and 2004.

**13.****                               Commitments andContingencies**

*Employment Agreements*

The Company has employment agreements with its ChiefExecutive Officer and Senior Vice President of Administration and ChiefFinancial Officer. The Company may terminate the agreements with orwithout cause. Subject to the conditions and other limitations set forth ineach respective employment agreement, each executive will be entitled to thefollowing severance benefits if we terminate the executive’s employment withoutcause or in the event of an involuntary termination  (as defined in the employment agreements) byus or by the executive: (i) a lump sum cash payment equal to twenty-fourmonths and twelve months of base salary, respectively; (ii) continuationof the executive’s fringe benefits and medical insurance for a period of threeyears; and (iii) immediate vesting of 50% of each executive’s outstandingstock options and restricted stock awards. In the event that the executive’semployment is terminated within the six months prior to

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or thethirteen months following a change of control (as defined in the employmentagreements), the executive is entitled to the severance benefits describedabove, except that 100% of each executive’s outstanding stock options andrestricted stock awards will immediately vest. Each executive’s eligibility toreceive any severance payments or other benefits upon his termination isconditioned upon him executing a general release of liability.

*Letter of Credit*

As collateral for performance on a softwareinstallation and implementation contract, the Company is contingently liableunder an irrevocable standby letter of credit in an amount of approximately$106,000. This letter of credit expires on December 26, 2008. As acondition, the bank requires the Company to invest an equal amount in theform of certificate of deposit. As of December 31, 2006, there wereno drawings against the outstanding balance. This certificate of deposit isincluded as a component of noncurrent other assets in the Company’sConsolidated Balance Sheets at December 31, 2006 and 2005.

*Litigation*

The Company is involved in certain legal proceedingsgenerally incidental to its normal business activities. While the outcome ofsuch proceedings cannot be accurately predicted, the Company does not believethe ultimate resolution of any such existing matters should have a materialeffect on its financial position, results of operations or cash flows.

*Leases*

The Company currently leases office and research anddevelopment space under operating leases which expire at various dates throughDecember 2008.

At December 31,2006, future minimum lease payments are as follows:
| 2007   |   | $ | 538,000   |   |
|--------|--------|---|-----------|--------|
| 2008   |   | $ | 462,000   |   |
| 2009   |   | $ | 153,000   |   |
| 2010   |   | $ | —    |   |
| 2011   |   | $ | —    |   |
|   |   | $ | 1,153,000 |   |

 

Rental expense from continuing operations incurredunder operating leases for the years ended December 31, 2006, 2005 and2004, was approximately $562,000, $750,000 and $592,000 respectively. Rentexpense for the year 2005 contains approximately $124,000 in accrued for exitactivity costs related to the closure of our office in Stuttgart, Germany asmore fully described in Note 17.

*Registration Payment Arrangements*

Aspart of the Series C preferred stock financing as more fully described in Note14, the Company entered into a Registration Payment Arrangement as defined byFinancial Accounting Standards Board Staff Position No. EITF 11-19-2, “Accountingfor Registration Payment Arrangements” (“FSP No. EITF 00-19-2”).  FSP No. EITF 00-19-2 specifies that thecontingent obligation to make future payments or otherwise transfer considerationunder a registration payment arrangement should be separately recognized andmeasured in accordance with Statement of Financial Accounting Standards No. 5, “Accountingfor Contingencies”.   FSP EITF 00-19-2 iseffective for registration payment arrangements entered into after December 21,2006 or for the fiscal year beginning after December 15, 2006, however earlyadoption is permitted for interim or annual periods for which financialstatements have not been issued.  TheCompany adopted the provisions of FSP EITF 00-19-2 for the annual period endingDecember 31, 2006.  The Companydetermined that no loss contingency was required to be recorded as of December31, 2006.

Aspart of the registration payment arrangement, the Company agreed to registerthe shares of common stock the Series C preferred stock is convertible into andthe shares of common stock underlying the warrants issued to the Series Cinvestors with the Securities and Exchange Commission (“the Commission”) withincertain contractually specified time periods. The Company also agreed to use its best efforts to keep the registrationstatement continuously effective until the earlier of either the fifth yearafter the date the registration statement is declared effective by theCommission or the date when all the common stock, including the common stockunderlying the warrants have been sold. If the Company is unable to register the shares of common stock with theCommission or keep the registration statement continuously effective in accordancewith the Securities Purchase Agreement, the Company is subject to a liquidatingdamage penalty equal to 1% of the aggregate purchase price paid for each monththe registration statement is not effective, provided that such liquidateddamages shall not exceed 12% of the aggregate purchase price.  The maximum exposure at December 31, 2006 is

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approximately$300,000. The Company has met the requirements of the Registration PaymentArrangement by registering the shares of common stock with the Commission withinthe specified time frame specified by the agreement and has kept theregistration continuously effective thereafter. Company management believes that it will be able to maintain currentfiling status with the Commission over the prescribed period.

Aspart of a private placement in July 2005, the Company entered into aregistration payment arrangement, whereby the Company agreed to register theshares of common stock with the Commission within certain contractuallyspecified time periods.  The Company alsoagreed to use its best efforts to keep the registration statement continuouslyeffective until the earlier of either the fifth year after the date theregistration statement is declared effective by the Commission or the date whenall the common stock, including the common stock underlying the warrants havebeen sold.  If the Company is unable toregister the shares of common stock with the Commission or keep theregistration statement continuously effective in accordance with the SecuritiesPurchase Agreement, the Company is subject to a liquidating damage penaltyequal to 1% of the aggregate purchase price paid for each month theregistration statement is not effective. The maximum exposure at December 31,2006 is approximately $378,000

 The Company has met the requirements of theRegistration Payment Arrangement by registering the shares of common stock withthe Commission within the specified time frame specified by the agreement andhas kept the registration continuously effective thereafter.  Company management believes that it will beable to maintain current filing status with the Commission over the prescribedperiod.

**14.****                               Equity**

The Company’s Articles of Incorporation were amendedeffective August 31, 1994 and authorize the issuance of two classes ofstock to be designated “Common Stock” and “Preferred Stock,” provide that bothCommon and Preferred Stock shall have a par value of $.01 per share andauthorize the Company to issue 50,000,000 shares of Common Stock and 4,000,000shares of Preferred Stock. The Preferred Stock may be divided into suchnumber of series and with the rights, preferences, privileges andrestrictions as the Board of Directors may determine.

*Series B Convertible,Redeemable Preferred Stock*

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

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

The holders of Series B, on an as-convertedbasis, have the same voting rights per share as the Company’s common shares;provided, that the holders of Series B has a special right to elect onedirector if the Company defaults in the payment of any dividend to the holdersof Series B. The holders of Series B are entitled to initialdistributions of $2.50 per share of Series B outstanding, upon liquidationand in preference to common shares and any other series of preferred stockplus all accrued but unpaid dividends.

Any time after December 31, 2000, the Company hasthe right to redeem all or some of the outstanding shares of Series B at aprice equal to the original issue price, plus all accrued but unpaid dividends.

The Company had 239,400 and 249,400 shares ofSeries B outstanding as of December 31, 2006 and 2005,respectively.  At December 31, 2006and 2005, the Company had cumulative undeclared dividends of approximately$9,000.

During the twelve months ended December 31, 2006,10,000 shares of Series B were converted into 1,895 shares of the Company’scommon stock.  There were no conversionsduring the corresponding period in 2005.

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*Series C Convertible,Non-Redeemable Preferred Stock*

In November 2006, the Company’s Articles ofIncorporation were amended to authorize 3,500 shares of Series CConvertible Preferred Stock (“Series C”). Each share of Series C hasa par value of $0.01, a stated value of $1,000 and is convertible into 666.66shares of the Company’s common stock. The Series C preferred stock does not have voting rights.

The holders of Series C are entitled to receivecumulative dividends, at the option of the Company, (i) in common stock uponconversion of the Series C preferred stock, or (ii) in cash after the paymentof cash dividends to the holders of Series B Preferred Stock at the rate pershare (as a percentage of the stated value per share) of 8% per annum.

The holders of Series C are entitled to initialdistributions of $1,000 per share of Series C outstanding, uponliquidation and in preference to common shares and any other series ofpreferred stock with the exception of Series B Preferred Stock, plus allaccrued but unpaid dividends.

At December 31, 2006, the Company had issued atotal of 2,500 shares of Series C and generated gross proceeds of $2.5million.  At December 31, 2006, theCompany had cumulative undeclared dividends relating to Series C preferredstock of approximately $25,000.

In conjunction with the issuance of the Series Cpreferred stock, the Company issued warrants to the holders of the Series Cpreferred stock to purchase 125,000 shares of the Company’s common stock at$1.58 per share.  The proceeds from theSeries C preferred stock financing were allocated to the warrants and theSeries C preferred stock based on the relative fair value of each on the dateof issuance.  This allocation processresulted in the recognition of a discount attributable to an embeddedbeneficial conversion feature of approximately $33,000.  The discount was amortized over the minimumperiod from the date of issuance to the date at which the preferredshareholders are permitted to convert as a dividend to the Series Cshareholders.

As compensation to theplacement agent for the Series C preferred stock, the Company agreed to issuewarrants to purchase 46,000 shares of common stock at $1.575 and pay $138,000in cash.  The warrants were classified asequity and the cash payment has been recorded as adjustment to additional paidin capital as a reduction of net proceeds.

*CommonStock*

Duringtwelve month periods ended December 31, 2006 and 2005, the Company issued144,588 and 90,481 shares of its common stock, respectively, pursuant tostock-based compensation agreements with certain employees and issued 1,895shares of its common stock pursuant to the conversion of 10,000 shares ofSeries B Preferred Stock.

*Warrants*

As of December 31, 2006, warrants to purchase5,821,149 shares of common stock at prices ranging from $1.43 to $5.48 wereoutstanding. All warrants are exercisable as of December 31, 2006, andexpire at various dates through November 2011.

Thefollowing table summarizes warrant activity for the following periods:
|                                        | ** ** | **Warrants**   | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|----------------|------------|---------------------------------------------|------------|
|                                   |       |           |       |                                        |       |
| **Balance  at December 31, 2004** | ** ** | **6,187,541**  | ** ** | **$**                                       | **6.62**   | ** ** |
| **Granted**                            | ** ** | **635,765**    | ** ** | **$**                                       | **3.45**   | ** ** |
| **Expired / Canceled**                 | ** ** | **(2,530,001** | **)**      | **$**                                       | **11.76**  | ** ** |
| **Exercised**                          | ** ** | **(0**         | **)**      | **$**                                       | **2.27**   | ** ** |
| **Balance  at December 31, 2005** | ** ** | **4,293,305**  | ** ** | **$**                                       | **2.94**   | ** ** |
| **Granted**                            | ** ** | **1,527,844**  | ** ** | **$**                                       | **1.70**   | ** ** |
| **Expired / Canceled**                 | ** ** | **(0**         | **)**      | **$**                                       | **0**      | ** ** |
| **Exercised**                          | ** ** | **(0**         | **)**      | **$**                                       | **0**      | ** ** |
| **Balance at December 31,  2006** | ** ** | **5,821,149**  | ** ** | **$**                                       | **2.37**   | ** ** |

 

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Thefollowing table summarized information about warrants outstanding andexercisable at December 31, 2006:
| Exercise Price | ** ** | **Number  Outstanding** | ** ** | **Weighted—Average  Remaining Life  (Years)** | ** ** | **Weighted—Average  Exercise Price** | ** ** |
|---------------------|------------|-------------------------|------------|---------------------------------------------------------|------------|------------------------------------------------|------------|
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 1.43       |                    | 75,149     |                                                    | 3.0        |                                           | $          | 1.43 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 1.50       |                    | 2,203,286  |                                                    | 2.5        |                                           | $          | 1.50 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 1.58       |                    | 171,000    |                                                    | 4.9        |                                           | $          | 1.58 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 1.80       |                    | 587,751    |                                                    | 4.4        |                                           | $          | 1.80 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 1.83       |                    | 29,070     |                                                    | 1.9        |                                           | $          | 1.83 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 2.14       |                    | 344,951    |                                                    | 1.9        |                                           | $          | 2.14 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 2.40       |                    | 466,737    |                                                    | 1.6        |                                           | $          | 2.40 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 2.58       |                    | 473,824    |                                                    | 1.9        |                                           | $          | 2.58 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 3.20       |                    | 685,395    |                                                    | 3.6        |                                           | $          | 3.20 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 3.21       |                    | 221,218    |                                                    | 0.4        |                                           | $          | 3.21 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 4.66       |                    | 63,012     |                                                    | 2.1        |                                           | $          | 4.66 |   |
|                |       |                    |       |                                                    |       |                                           |       |
| $                   | 5.48       |                    | 499,756    |                                                    | 2.1        |                                           | $          | 5.48 |   |
|                |       |                    |       |                                                    |       |                                           |       |
|                     |       | 5,821,149               |       |                                                    |       |                                           |       |

 

InMarch 2006, as a condition to the Company’s issuance of secured notes payable,the Company issued warrants to purchase 387,500 shares of the Company’s commonstock. Such warrants have a 5-year term and an exercise price $2.30 per share.This exercise price was subsequently reduced to $1.80 per share asconsideration for a waiver of the Right of Acceleration from the holders of theCompany’s Secured Promissory Notes dated March 17, 2006.  Additionally, as additional consideration, inNovember 2006, the Company issued 200,250 warrants to purchase common stock atan exercise price of $1.80 per share. See Note 11 to these consolidated financial statements.  Common shares underlying the warrants havepiggyback registration rights and cashless exercise after 12 months fromclosing date if there is no effective registration statement covering theunderlying shares.

In conjunction with theissuance of the Series C preferred stock, the Company issued warrants to theholders of the Series C preferred stock to purchase 125,000 shares of the Company’scommon stock at $1.58 per share.  Thesewarrants have been classified as equity and are accounted for in combinationwith the Series C preferred stock issuance.

In connection with the issuance of the Series Cpreferred stock, the Company was required to issue warrants to the placementagent for the purchase of 46,000 shares of common stock at an exercise price of$1.575 per share. The fair value of the warrants issued to the finders wasapproximately $44,429 as determined by the Black-Scholes option pricing modelwith the following assumptions: risk free interest rate of 2.90%; dividendyield of 0%; volatility factor of the expected market price of the Company’scommon stock of 82%; and an expected life of the of warrant of 5 years.  The fair value of the warrant was charged toadditional paid in capital as a reduction of the offering proceeds.

The Series C preferred stock financing triggeredcertain anti-dilution and exercise price reduction clauses in existing warrantagreements.  As a result of thesemodifications, the Company was required to issue an additional 769,094 warrantsand reduce the exercise price of certain previously issued warrants.  As these warrants were classified aspermanent equity and the adjustment was related to anti-dilution featureswithin these financial instruments, this increase in warrants and reduction ofexercise price resulted in no adjustment to the consolidated financialstatements.

**15.****                               Stock Option Plans**

On August 31, 1994, the directors of the Companyadopted the Company’s 1994 Employee Stock Option Plan (the “1994 Plan”) and the1994 Nonqualified Stock Option Plan (the “Nonqualified Plan”). The 1992 StockOption Plan and options previously granted were canceled by the Board ofDirectors.

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The 1994 Plan originally provided for officers andother key employees to receive nontransferable incentive stock options topurchase up to 170,616 shares of the Company’s common stock. The number ofstock options issued and outstanding and the number of stock options remainingavailable for future issuance are shown in the table below. The option priceper share must be at least equal to 100% of the market value of the Company’scommon stock on the date of grant and the term may not exceed ten years.

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

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

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

On September 12, 2001, the Company’s Board ofDirectors approved adoption of the 2001 Equity Incentive Plan (the “2001 Plan”).Under the terms of the 2001 Plan, the Company may issue stock awards toemployees, directors and consultants of the Company, and such stock awardsmay be given for non-statutory stock options (options not intended toqualify as an “incentive stock option” within the meaning of Section 422of the Internal Revenue Code of 1986, as amended), stock bonuses, and rights toacquire restricted stock. The Company originally reserved 1,000,000 shares ofits common stock for issuance under the 2001 Plan. The number of options issuedand outstanding and the number of options remaining available for futureissuance are shown in the table below.

The 2001 Plan is administered by the Board of Directorsor a Committee of the Board as provided in the 2001 Plan. Options granted underthe 2001 Plan shall not be less than 85% of the market value of the Company’scommon stock on the date of the grant, and, in some cases, may not be lessthan 110% of such fair market value. The term of options granted under the 2001Plan as well as their vesting are determined by the Board and to date, optionshave been granted with a ten year term and vesting over a three year period.While the Board may suspend or terminate the 2001 Plan at any time, if notterminated earlier, it will terminate on the day before its tenth anniversaryof the date of adoption.

On June 7, 2005, the shareholders approved theAmendment and Restatement of the 1999 Stock Award Plan. Key changes that weremade to the plan in the amendment and restatement included:

·                                          Weincreased the share reserve of the amended and restated 1999 plan by 883,000shares of our common stock. This number consists of an increase in the sharereserve of 800,000 of our shares of common stock and 83,000 shares of ourcommon stock that were reserved and available for grants under the 2001 EquityIncentive Plan, which we refer to as the 2001 plan. Prior to amendment, the1999 plan had 350,000 shares reserved for issuance under the 1999 plan.

·                                          Anyshares not issued in connection with awards outstanding under the 2001 plan orthe 1994 Employee Stock Option Plan (which we refer to as the 1994 plan) onJune 7, 2005, will become available for issuance under the amended andrestated 1999 plan.

·                                          Anyshares not issued in connection with awards granted under the 1999 plan, willbecome available for issuance under the amended and restated 1999 plan.

·                                          Theamended and restated 1999 plan prohibits the grant of stock option or stockappreciation right awards with an exercise price less than fair market value ofCommon Stock on the date of grant.

·                                          Theamended and restated 1999 plan also generally prohibits the “re-pricing” ofstock options or stock appreciation rights, although awards may be boughtout for a payment in cash or our stock.

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·                                          Theamended and restated 1999 plan permits the grant of stock based awards otherthan stock options, including the grant of “full value” awards such asrestricted stock, stock units and performance shares.

·                                          Theamended and restated 1999 plan permits the qualification of awards under theplan (payable in either stock or cash) as “performance-based compensation”within the meaning of Section 162(m) of the Internal Revenue Code.

# StockOption PlansAs of December 31, 2006

|                    | ** ** | **Number of securities to be  issued upon exercise of  outstanding options (a)** | ** ** | **Number of securities  remaining available for  future issuance under equity  compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|--------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 1994 Plan          |       | 43,770                                                                                                                   |       | -0-                                                                                                                                                                                                              |       |
| Nonqualified  Plan |       | —                                                                                                                   |       | -0-                                                                                                                                                                                                              |       |
| 1999 Plan          |       | 1,174,980                                                                                                                |       | 99,299                                                                                                                                                                                                           |       |
| 2001 Plan          |       | 384,414                                                                                                                  |       | -0-                                                                                                                                                                                                              |       |
| Total              |       | 1,603,164                                                                                                                |       | 99,299                                                                                                                                                                                                           |       |

 

The following table summarizes employee stock optionactivity since December 31, 2003:
| ** **                         | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|------------------------------------|------------|-------------|------------|---------------------------------------------|------------|
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2003 |       | 1,340,006   |       | $                                           | 4.44       |   |
| Granted                            |       | 396,750     |       | $                                           | 2.32       |   |
| Expired/canceled                   |       | (727,134    | )          | $                                           | 5.60       |   |
| Exercised                          |       | (115,263    | )          | $                                           | 2.11       |   |
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2004 |       | 894,359     |       | $                                           | 2.72       |   |
| Granted                            |       | 677,300     |       | $                                           | 2.59       |   |
| Expired/canceled                   |       | (71,282     | )          | $                                           | 2.32       |   |
| Exercised                          |       | (26,284     | )          | $                                           | 2.38       |   |
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2005 |       | 1,474,093   |       | $                                           | 2.68       |   |
|                               |       |        |       |                                        |       |
| Granted                            |       | 363,000     |       | $                                           | 1.90       |   |
| Expired/canceled                   |       | (233,929    | )          | $                                           | 3.17       |   |
| Exercised                          |       | —      |       | $                                           |       |   |
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2006 |       | 1,603,164   |       | $                                           | 2.45       |   |

 

At December 31, 2006, a total of 810,527 optionswere exercisable at a weighted average price of $2.66 per share. At December31, 2005, a total of 624,163 options were exercisable at a weighted averageprice of $2.87 per share. At December 31, 2004, a total of 575,686 optionswere exercisable at a weighted average price of $3.07 per share.

The intrinsic value of options exercised during thetwelve months ended December 31, 2006, 2005 and 2004 were $0, $22,000, and $112,000,respectively. The intrinsic value of options exercisable at December 31, 2006,2005 and 2004 were $0, $0 and $175,000, respectively.

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The following table summarizes information aboutemployee stock options outstanding and exercisable at December 31, 2006:
| ** **               | ** ** | **Options Outstanding** | ** ** | ** **                                           | ** ** | **Options Exercisable**                | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------------------------------|------------|---------------------------------------------|------------|
| **Exercise Price**  | ** ** | **Number  Outstanding**      | ** ** | **Weighted-  Average  Remaining Life  (Years)** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|                     |       |                         |       |                                                 |       |                                        |       |   |   |   |   |
| $ 1.65 -  1.71      |       | 149,000                      |       | 8.6                                                  |       | $                                           | 1.67       |   | — |   | $ | N/A |   |
| $ 1.97 –  2.15 |       | 248,020                      |       | 7.3                                                  |       | $                                           | 2.02       |   | 88,950 |   | $ | 2.07 |   |
| $ 2.20 –  2.45 |       | 542,300                      |       | 8.3                                                  |       | $                                           | 2.34       |   | 303,177 |   | $ | 2.37 |   |
| $ 2.62 –  2.74 |       | 434,180                      |       | 8.3                                                  |       | $                                           | 2.64       |   | 208,932 |   | $ | 2.64 |   |
| $ 3.00 –  6.51 |       | 229,664                      |       | 5.5                                                  |       | $                                           | 3.33       |   | 209,468 |   | $ | 3.35 |   |
| **Total**                | ** ** | **1,603,164**                | ** ** | ** **                                           |       |                                        | ** ** | **810,527** |   |   |   |

 

The weighted-average grant-date fair value per shareof options granted to employees during the years ended December 31, 2006and 2005 was $1.38 and $2.59, respectively.

**15.****          EmployeeBenefit Plan**

During 1995, the Company adopted a definedcontribution 401(k) retirement plan (the “Plan”). All U.S. based employees aged21 years and older are eligible to become participants after thecompletion of 60 days employment. The Plan provides for annual contributions bythe Company of 50% of employee contributions not to exceed 8% of employeecompensation.  Participantsmay contribute up to 100% of the annual contribution limitationsdetermined by the Internal Revenue Service.

Employees are fully vested in their share of theCompany’s contributions after the completion of five years of service. TheCompany made contributions in 2006 of approximately $15,000 for the 2005 planyear and $75,000 for the 2006 plan year and has accrued a contribution ofapproximately $28,000 for the 2006 plan year.

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**16.****          PensionPlan**

One ofthe Company’s foreign subsidiaries maintains a defined benefit pension planthat provides benefits based on length of service and final average earnings.

The following table sets forth the benefit obligation,fair value of plan assets, and the funded status of the Company’s plan; amountsrecognized in the Company’s consolidated financial statements; and theassumptions used in determining the actuarial present value of the benefitobligations as of December 31:
| ** **                                                                                                                                                                | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Change in  benefit obligation:                                                                                                                                            |       |       |       |       |       |       |       |
| Benefit  obligation at beginning of year                                                                                                                                  |       | $          | 1,520,238  |       | $          | 1,153,882  |       | $ | 708,105 |   |
| Service cost                                                                                                                                                              |       | 1,794      |       | 249        |       | 8,296      |       |
| Interest cost                                                                                                                                                             |       | 66,903     |       | 57,554     |       | 59,726     |       |
| Actuarial gain  (loss)                                                                                                                                                    |       | (173,963   | )          | 261,181    |       | 124,228    |       |
| Effect of  exchange rate changes                                                                                                                                          |       | 42,110     |       | 47,372     |       | 253,527    |       |
| Effect of  curtailment                                                                                                                                                    |       | —     |       | —     |       | —     |       |
| Benefits paid                                                                                                                                                             |       | —     |       | —     |       | —     |       |
| Benefit  obligation at end of year                                                                                                                                        |       | 1,457,082  |       | 1,520,238  |       | 1,153,882  |       |
|                                                                                                                                                                      |       |       |       |       |       |       |       |
| Change in plan  assets                                                                                                                                                    |       |       |       |       |       |       |       |
| Fair value of  plan assets at beginning of year                                                                                                                           |       | 390,708    |       | 342,194    |       | 304,594    |       |
| Actual return of  plan assets                                                                                                                                             |       | 9,474      |       | 8,261      |       | (104,215   | )          |
| Company  contributions                                                                                                                                                    |       | 40,608     |       | 40,253     |       | 141,815    |       |
| Benefits paid                                                                                                                                                             |       | —     |       | —     |       | —     |       |
| Fair value of  plan assets at end of year                                                                                                                                 |       | 440,790    |       | 390,708    |       | 342,194    |       |
|                                                                                                                                                                      |       |       |       |       |       |       |       |
| Funded status                                                                                                                                                             |       | (1,016,292 | )          | (1,129,530 | )          | (811,688   | )          |
| Unrecognized  actuarial loss (gain)                                                                                                                                       |       | 343,018    |       | 502,488    |       | —     |       |
| Unrecognized  prior service (benefit) cost                                                                                                                                |       | —     |       | —     |       | —     |       |
| Additional  minimum liability                                                                                                                                             |       | (343,018   | )          | (502,488   | )          | —     |       |
| Unrecognized  transition (asset) liability                                                                                                                                |       | —     |       | —     |       | —     |       |
| Net amount  recognized                                                                                                                                                    |       | $          | (1,016,292 | )          | $          | (1,129,530 | )          | $ | (811,688 | ) |
|                                                                                                                                                                      |       |       |       |       |       |       |       |
| The weighted  average assumptions used to determine benefit obligations for the years ended  December 31 were:                                                       |       |       |       |       |       |       |       |
| Discount rate                                                                                                                                                             |       | 4.60       | %          | 4.15       | %          | 4.5        | %          |
| Expected return  on plan assets                                                                                                                                           |       | 4.00       | %          | 4.5        | %          | 4.5        | %          |
| Rate of  compensation increase                                                                                                                                            |       | N/A        |       | N/A        |       | N/A        |       |
|                                                                                                                                                                      |       |       |       |       |       |       |       |
| Plan Assets                                                                                                                                                               |       |       |       |       |       |       |       |
| Pension plan  assets were comprised of the following asset categories at December 31,                                                                                |       |       |       |       |       |       |       |
| Equity  securities                                                                                                                                                        |       | 8.20       | %          | 9.90       | %          | 5.70       | %          |
| Debt securities                                                                                                                                                           |       | 87.90      | %          | 85.20      | %          | 88.80      | %          |
| Other                                                                                                                                                                     |       | 3.90       | %          | 4.90       | %          | 5.50       | %          |
| Total                                                                                                                                                                     |       | 100        | %          | 100        | %          | 100        | %          |
|                                                                                                                                                                      |       |       |       |       |       |       |       |
| Components of  net periodic benefit cost are as follows:                                                                                                                  |       |       |       |       |       |       |       |
| Service cost                                                                                                                                                              |       | 1,794      |       | 200        |       | 8,296      |       |
| Interest cost on  projected benefit obligations                                                                                                                           |       | 66,903     |       | 46,240     |       | 59,726     |       |
| Expected return  on plan assets                                                                                                                                           |       | —     |       | 76         |       | (23,943    | )          |
| Amortization of  prior service costs                                                                                                                                      |       | —     |       | —     |       | —     |       |
| Amortization of  actuarial loss                                                                                                                                           |       | —     |       | —     |       | —     |       |
| Net periodic  benefit costs                                                                                                                                               |       | 68,697     |       | 46,516     |       | 44,079     |       |
|                                                                                                                                                                      |       |       |       |       |       |       |       |
| The weighted  average assumptions used to determine net periodic benefit cost for the years  ended December 31, were                                                 |       |       |       |       |       |       |       |
| Discount rate                                                                                                                                                             |       | 4.60       | %          | 4.15       | %          | 4.5        | %          |
| Expected return  on plan assets                                                                                                                                           |       | 4.00       | %          | 4.5        | %          | 4.5        | %          |
| Rate of  compensation increase                                                                                                                                            |       | N/A        |       | N/A        |       | N/A        |       |
|                                                                                                                                                                      |       |       |       |       |       |       |       |
| The following  discloses information about our defined benefit pension plan that had an  accumulated benefit obligation in excess of plan assets as of  December 31, |       |       |       |       |       |       |       |
| Projected  benefit obligation                                                                                                                                             |       | 1,457,082  |       | 1,520,238  |       | 1,153,882  |       |
| Accumulated  benefit obligation                                                                                                                                           |       | 1,457,082  |       | 1,520,238  |       | 1,153,882  |       |
| Fair value of plan  assets                                                                                                                                                |       | 440,790    |       | 390,707    |       | 342,193    |       |

 

The following benefitpayments are expected to be paid as follows:
| 2006             |   | — |   |
|------------------|--------|--------|--------|
| 2007             |   | — |   |
| 2008             |   | — |   |
| 2009             |   | — |   |
| 2010             |   | — |   |
| 2011 — 2015 |   | 21,783 |   |

 

The Company expects to make contributions to the plan ofapproximately $32,500 during 2007.

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The investment objectives for the plan are thepreservation of capital, current income and long-term growth of capital. Allplan assets are managed in a policyholder pool in Germany by outside investmentmanagers. The expected long-term return on plan assets is between 4.0% to 4.5%.The measurement date used to determine the benefit information of the plan wasJanuary 1, 2007.

**17.****                               ExitActivities**

In October 2002, The Company initiated arestructuring plan to enhance operational efficiency and reduce operatingcosts. The plan included a reduction in workforce and excess facilities. TheCompany terminated its operating lease for 4,275 square feet of office spaceused to house our Digital Photography operations and moved these operations toits San Diego, California facility. The Company recorded a liability for theremaining lease payments under the operating lease net of estimated subleaserents of $132,000 and accrued $6,000 in severance as of December 31, 2002.

In May 2003, the Company entered into anagreement to sublet this office space. Under the terms of the sublease, theCompany will receive rents of $144,000 over the term of the sublease.

In December 2005, the Company initiated arestructuring plan to reduce operating costs, streamline and consolidateoperations and reallocate resources. The plan included a reduction in workforcethat will result in the termination of 4 employees and the closure of theCompany’s foreign sales office located in Stuttgart, Germany.

Charges for the reduction in workforce includeseverance and other termination costs. As part of the restructuring, theCompany will vacate its Germany office and record a charge related to theremaining liability under the associated lease. Cash payments for the remainingliability of approximately $131,000 as of December 31, 2005, for facilityexit activities will be made over the remaining life of the lease endingSeptember 2006. Cash payments to complete the workforce reduction ofapproximately $73,000 will be made through March 2006.

Exit activity expenses for all periods presented areshown as a component of general and administrative expenses in the Company’sConsolidated Statement of Operations.

The following table summarizes charges recorded andchanges in the exit activities reserve during 2004 and 2005:
| ** **                                                                      | ** ** | **2002**          | ** ** | **2005**          | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                      | ** ** | **Restructuring** | ** ** | **Restructuring** | ** ** | **Total**  | ** ** |
|                                                                            |       |              |       |              |       |       |       |
| Balances,  January 1, 2004                                                      |       | $                 | 73,000     |              | $          | —     |       | $ | 73,000 |   |
|                                                                            |       |              |       |              |       |       |       |
| Reductions to  exit activity reserve:                                           |       |              |       |              |       |       |       |
| Payments:                                                                       |       |              |       |              |       |       |       |
| Lease obligation, net of sublease income                                        |       | $                 | (37,000    | )                 | $          | 0          |       | $ | (37,000 | ) |
|                                                                            |       |              |       |              |       |       |       |
| Balances,  December 31, 2004                                                    |       | $                 | 36,000     |              | $          | —     |       | $ | 36,000 |   |
|                                                                            |       |              |       |              |       |       |       |
| Reductions to  exit activity reserve:                                           |       |              |       |              |       |       |       |
| Payments:                                                                       |       |              |       |              |       |       |       |
| Lease obligation, net of sublease income                                        |       | $                 | (23,000    | )                 | $          | —     |       | $ | (23,000 | ) |
| Difference in estimated obligation                                              |       | $                 | (13,000    | )                 | $          | —     |       | $ | (13,000 | ) |
|                                                                            |       |              |       |              |       |       |       |
| Additions to  exit activity reserve Charge to operations for 2005 restructuring |       | $                 | —     |              | $          | 204,000    |       | $ | 204,000 |   |
|                                                                            |       |              |       |              |       |       |       |
| Balances, December 31, 2005                                                     |       | $                 | —     |              | $          | 204,000    |       | $ | 204,000 |   |
|                                                                            |       |              |       |              |       |       |       |
| Reductions to exit activity reserve:                                            |       |              |       |              |       |       |       |
| Payments:                                                                       |       |              |       |              |       |       |       |
| Lease obligation, net of sublease income                                        |       | $                 | —     |              | $          | (125,600   | )          | $ | (125,600 | ) |
| Severance                                                                       |       | $                 | —     |              | $          | (75,300    | )          | $ | (75,300 | ) |
|                                                                            |       |              |       |              |       |       |       |
| Difference in estimated obligation                                              |       |              |       | $                 | (3,100     | )          | $          | (3,100 | ) |
|                                                                            |       |              |       |              |       |       |       |
| Balances, December 31,  2006                                                    |       | $                 | —     |              | $          | —     |       | $ | — |   |

 

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**18.          QuarterlyFinancial Data (Unaudited)**

The followingtable sets forth selected quarterly financial data for 2006 and 2005 (inthousands, except per share data):
| ** **                       | ** ** | **2006 (by quarter)** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **1**                           | ** ** | **2** | ** ** | **3** | ** ** | **4** | ** ** |
|                             |       |                            |       |   |   |   |   |   |   |
| Revenues                         |       | $                               | 2,764      |   | $ | 2,867 |   | $ | 2,177 |   | $ | 2,382 |   |
| Cost of Sales                    |       | 807                             |       | 889 |   | 712 |   | 773 |   |
| Operating  expenses              |       | 3,250                           |       | 3,050 |   | 2,964 |   | 2,818 |   |
| Loss from  Operations            |       | (1,293                          | )          | (1,072 | ) | (1,499 | ) | (1,209 | ) |
| Interest expense  (income), net  |       | 26                              |       | 157 |   | 156 |   | 225 |   |
| Other expense  (income), net     |       | (69                             | )          | (37 | ) | (5 | ) | (8 | ) |
| Loss from  continuing operations |       | (1,250                          | )          | (1,192 | ) | (1,650 | ) | (1,426 | ) |
| Discontinued  operations         |       | (98                             | )          | (134 | ) | (114 | ) | (62 | ) |
| Net loss                         |       | (1,348                          | )          | (1,326 | ) | (1,764 | ) | (1,488 | ) |
|                             |       |                            |       |   |   |   |   |   |   |
| Net loss per  share:             |       |                            |       |   |   |   |   |   |   |
| Loss from  continuing operations |       | $                               | (0.09      | ) | $ | (0.09 | ) | $ | (0.12 | ) | $ | (0.11 | ) |
| Discontinued  operations         |       | $                               | (0.01      | ) | $ | (0.01 | ) | $ | (0.01 | ) | $ | (0.00 | ) |
| Net loss per share               |       | $                               | (0.10      | ) | $ | (0.10 | ) | $ | (0.13 | ) | $ | (0.11 | ) |

 
| ** **                       | ** ** | **2005 (by quarter)** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **1**                           | ** ** | **2** | ** ** | **3** | ** ** | **4** | ** ** |
|                             |       |                            |       |   |   |   |   |   |   |
| Revenues                         |       | $                               | 2,727      |   | $ | 1,902 |   | $ | 2,384 |   | $ | 2,162 |   |
| Cost of Sales                    |       | 1,122                           |       | 824 |   | 893 |   | 1,072 |   |
| Operating  expenses              |       | 2,589                           |       | 2,827 |   | 2,845 |   | 3,918 |   |
| Loss from  Operations            |       | (984                            | )          | (1,749 | ) | (1,354 | ) | (2,828 | ) |
| Interest expense  (income), net  |       | (6                              | )          | (4 | ) | (31 | ) | (12 | ) |
| Other expense  (income), net     |       | (277                            | )          | (6 | ) | (85 | ) | 202 |   |
| Loss from  continuing operations |       | (701                            | )          | (1,739 | ) | (1,238 | ) | (3,018 | ) |
| Discontinued  operations         |       | $                               | (203       | ) | $ | (165 | ) | $ | (128 | ) | $ | (1,163 | ) |
| Net loss                         |       | $                               | (904       | ) | $ | (1,904 | ) | $ | (1,366 | ) | $ | (4,181 | ) |
|                             |       |                            |       |   |   |   |   |   |   |
| Net loss per  share:             |       |                            |       |   |   |   |   |   |   |
| Loss from  continuing operations |       | $                               | (0.06      | ) | $ | (0.14 | ) | $ | (0.09 | ) | $ | (0.22 | ) |
| Discontinued  operations         |       | $                               | (0.02      | ) | $ | (0.01 | ) | $ | (0.01 | ) | $ | (0.09 | ) |
| Net loss per  share              |       | $                               | (0.08      | ) | $ | (0.15 | ) | $ | (0.10 | ) | $ | (0.31 | ) |

 

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**19.****          Subsequent Event**

On March 9, 2007,ImageWare Systems, Inc. (the  “Company”) entered into a SecuritiesPurchase Agreement with certain accredited investors (the “Investors”) pursuantto which the Company sold to the Investors an aggregate of 1,500 shares of theCompany’s Series D 8% Convertible Preferred Stock (the “Series D PreferredStock”) at a stated value of $1,000 per share for aggregate gross proceeds of$1,500,000, and issued to the Investors warrants (the “Warrants”) to purchaseup to an aggregate of 59,207 shares of common stock of the Company with anexercise price of $2.33 per share (the “Financing”).  The Warrants may be exercised at any timefrom September 9, 2007 until September 9, 2012. In addition, the Warrantscontain a “cashless exercise” feature.

In connection withthe Financing, the Company also entered into a registration rights agreementwith certain of the Investors (the “Rights Agreement”) and has agreed to enterinto the Rights Agreement with the remaining Investors. Pursuant to the RightsAgreement, the Company agreed to file a registration statement (the “RegistrationStatement”) with the Securities and Exchange Commission (the “SEC”) on orbefore April 23, 2007 covering the resale of the shares of common stockunderlying the Series D Preferred Stock, all shares of common stock issuableupon exercise of the Warrants, all shares of common stock issuable as dividendson the Series D Preferred Stock, and all shares of common stock issuable uponany stock split, dividend or other distribution, recapitalization or similarevent contemplated by Rule 416 of the Securities Act of 1933, as amended (the “SecuritiesAct”), with respect to the foregoing, with certain exceptions described in theRights Agreement. The Company also agreed to use commercially reasonableefforts to have the Registration Statement declared effective as promptly aspossible after it is filed with the SEC and to keep the Registration Statementeffective.

In the event theRegistration Statement is not timely filed or declared effective within thetime periods described above, and under certain other circumstances, theCompany will be required to pay the Investors liquidated damages in the amountsprescribed in the Rights Agreement.

On March 17, 2006,the Company closed a loan (the “Loan”) pursuant to which the Company borrowedan aggregate of $1,550,000 from multiple lenders in consideration for theissuance of secured promissory notes (the “Notes”) to the lenders.  Underthe terms of the Notes, issuance of the Series D Preferred Stock caused allamounts outstanding under the Notes to become immediately due and payable infull.  As of March 9, 2007 there was$1,196,259 in principal and $19,319 in accrued but unpaid interest outstandingunder the Notes.  Upon receipt of thefunds from the Series D financing described above, the Company immediatelyrepaid, in full, all outstanding principal and accrued but unpaid interest dueunder the Notes. The Notes have terminated in their entirety.

DuringMarch 2007, the Company issued 785,956 shares of its common stock pursuant towarrant exercises.  Proceeds receivedwere approximately $1,105,000.

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