**SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

 

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**FORM 10-KSB**

 

| **ý** | ** ** | **ANNUAL REPORT UNDER SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**     |
|------------|------------|-----------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                    |
| ** ** | ** ** | **For the fiscal year ended December 31, 2004.**                                         |
| ** ** | ** ** | ** **                                                                                    |
| **o**      | ** ** | **TRANSITION REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |

 

**For the transitionperiod               to               .**

 

**Commission File Number**

 

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**IMAGEWARE SYSTEMS, INC.**

(Nameof Small Business Issuer in Its Charter)

 

| **California**                                                  | ** ** | **33-0224167**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State  or Other Jurisdiction of Incorporation or Organization) |       | (I.R.S.  Employer Identification No. |
|                                                            |       |                                 |
| **10883 Thornmint Road, San Diego, California**                 | ** ** | **92127**                            |
| (Address  of Principal Executive Offices)                       |       | (Zip  Code)                          |

 

**(858) 673-8600**

(Issuer’sTelephone Number, Including Area Code)Securities registered under Section 12(b) of the Exchange Act:

 
| **Title of Each Class**           | ** ** | **Name of Each Exchange   on Which Registered** | ** ** |
|-----------------------------------|------------|-------------------------------------------------|------------|
| Common Stock, $0.01 par value     |       | American Stock Exchange                         |       |
| Warrants to Purchase Common Stock |       | American Stock Exchange                         |       |

 

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

 

Check whether the issuer:(1) filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 

Yes ý   No o

 

Check if no disclosure ofdelinquent filers in response to Item 405 of Regulation S-B iscontained in this form, and no disclosure will be contained, to the best of theregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB. ý

 

The issuer’s revenues forthe fiscal year ended December 31, 2004 were $10,523,313.

 

The aggregate market valueof the voting and non-voting common equity held by non-affiliates of theissuer, based on the closing sales price of the issuer’s Common Stock onMarch 25, 2005 as reported on the American Stock Exchange wasapproximately $31,787,661.  Excluded fromthis computation were 283,530 shares of Common Stock held by all currentexecutive officers and directors and 1,490,558 shares held by each person whois known by the registrant to own 5% or more of the outstanding CommonStock.  Share ownership information ofcertain persons known by the issuer to own greater than 5% of the outstandingCommon Stock for purposes of the preceding calculation is based solely oninformation on Schedule 13G filed with the Commission and is as of March25, 2005. Exclusion of shares held by any person or entity should not beconstrued to indicate that such person possesses the power, directly orindirectly, to direct or cause the direction of the management or the policiesof the Registrant.

 

The number of shares ofCommon Stock outstanding as of March 25, 2005 was 12,099,397.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Certain Exhibits filed withthe Small Business Issuer’s Registrant’s Registration Statement on Form SB-2(333-93131), Registration Statement on Form S-3 (333-64192), and portions ofthe definitive proxy statement for its Annual Meeting of Stockholders to befiled with the Commission within 120 days after the close of its fiscal year,are incorporated by reference into Part III of this Form 10-KSB.

 

Transitional Small Business Disclosure Format(check one):

 

Yes o   No ý

 

 

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**IMAGEWARE SYSTEMS, INC.**

 

**2004 ANNUAL REPORT ON FORM 10-KSB**

 

**TABLE OF CONTENTS**

 
| PART I  |   |     |   |                                                                                                                   |   |
|--------------|--------|----------|--------|------------------------------------------------------------------------------------------------------------------------|--------|
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 1.  |   | Description of Business                                                                                                |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 2.  |   | Description of Property                                                                                                |   |
|         |   |     |   |                                                                                                                   |   |
| PART II      |   |     |   |                                                                                                                   |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 5.  |   | Market for Common Equity and Related Stockholder  Matters                                                              |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 6.  |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                            |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 7.  |   | Financial  Statements                                                                                                  |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 8A. |   | Controls  and Procedures                                                                                               |   |
|         |   |     |   |                                                                                                                   |   |
| PART  III    |   |     |   |                                                                                                                   |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 9.  |   | Directors,  Executive Officers, Promoters and Control Persons; Compliance with  Section 16(a) of the Exchange Act |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 10. |   | Executive  Compensation                                                                                                |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 11. |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                       |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 12. |   | Certain  Relationships and Related Transactions                                                                        |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 13. |   | Exhibits                                                                                                               |   |
|         |   |     |   |                                                                                                                   |   |
|         |   | ITEM 14. |   | Principal  Accountant Fees and Services                                                                                |   |

 

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IWSTM Biometric Engine , IWSTMLaw Enforcement Suspect ID®,  IWSTM EPITMBuilder®, IWSTM EPITM Suite®, IDXTM, Castleworks®, ImageWare® and IDentifier® forWindows, are registered trademarks of the Company. IWSTM Aviation, IWSTM PC Pro,IWSTM PC Event, IWSTM School Days+, IWSTM ProLab, IWSTM Studio, IWSTMGreen Screen, and IWS Picturemore.comTM are trademarks of the Company.

 

All other trademarks,service marks and/or trade names appearing in this document are the property oftheir respective holders.

**PART I**

 

The statements contained inthis Annual Report of Form 10-KSB that are not historical areforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended (the “Securities Act”), and Section 21Eof the Securities Exchange Act of 1934, as amended (the “Exchange Act”),including statements regarding our expectations, beliefs, intentions orstrategies regarding the future. Forward-looking statements include, withoutlimitation, statements regarding the extent and timing of future revenues andexpenses and customer demand, statements regarding deployment of our products,and statements regarding reliance on third parties. All forward-lookingstatements included in this report are based on information available to us asof the date hereof and we assume no obligation to update any forward-lookingstatements. Forward-looking statements involve known or unknown risks,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.

 

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

 

**Overview**

 

ImageWare Systems, Inc.is a global leader in software-based identity management solutions, providingbiometric, secure credential, law enforcement and digital imaging technologies.Scalable for worldwide deployment, our biometric product line includes amulti-biometric engine that is hardware and algorithm independent, enabling theenrollment and management of unlimited population sizes. Our identificationproducts are used to manage and issue secure credentials including nationalIDs, passports, driver licenses, smart cards and access control credentials.Our digital booking products provide law enforcement with integrated mug shot,fingerprint Livescan and investigative capabilities. We also providecomprehensive digital workflow solutions for the professional photographyindustry.  The biometric product is nowpart of all markets addressed by us.  Elements of the biometricproduct can be used as an investigative tool tolaw enforcement potentially utilizing multiple biometrics andforensic data elements.  It can also be used to enhance the sale ofphotography products by locating and identifying individual photographs from alarge repository taken at events or vacation visits.

 

Our biometric product is a core software component of an organizations’security infrastructure and includes a multi-biometric identity managementsolution for enrolling, managing and identifying people by the physicalcharacteristics of the human body. We develop, sell and support variousidentity management capabilities within government, law enforcement, corporateorganizations and even entertainment for identification and verificationpurposes. Our IWS Biometric Engine is a biometric identity management platformfor multi-biometric enrollment, management and authentication, managingpopulation databases of unlimited sizes. It’s also offered as an SoftwareDevelopment Kit based search engine, enabling developers and system integratorsto implement a biometric solution or integrate biometric capabilities intoexisting applications without having to derive biometric functionality frompre-existing applications. IWS Biometric Engine combined with our securecredential platform, IWS EPI Builder, provides a comprehensive, integratedbiometric and secure credential solution that can be leveraged for high-endapplications such as passports, driver licenses, national IDs, and other securedocuments. It can also be utilized within our law enforcement systems toincorporate any number of various multiple biometrics into one system, as wellas within our digital imaging products to enable the entertainment industrysuch as cruise lines to help increase photo sales.

 

Our law enforcementsolutions enable agencies to quickly capture, archive, search, retrieve, andshare digital images and criminal history records on a stand alone, networked,wireless or web-based platform. We develop, sell and support a suite of modularsoftware products used by law enforcement and public safety agencies to createand manage criminal history records and to investigate crime. Our IWS LawEnforcement solution consists of seven software modules: A Capture and InvestigativeModule, which provide a criminal booking system and related database; A FacialRecognition module, which uses biometric facial recognition to identifysuspects; and Suspect ID, which facilitates the creation of full-color,photo-realistic suspect composites.  Inaddition, we offer a Wireless module, which provides 

 

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accessto centrally stored records over the Internet in a connected or wirelessfashion, a PDA add-on module which enables access to centrally stored recordswhile in the field on a handheld Pocket PC compatible device, and centralrepository services which allows for inter-agency data sharing on a local,regional, and/or national level.  We recentlyadded a new Livescan module which incorporates Livescan capabilities into IWSLaw Enforcement, providing integrated fingerprint and palmprint biometricmanagement for civil and law enforcement use.

 

Our ID solutions empowercustomers to create secure and smart digital identification documents withcomplete ID systems. We develop, sell and support software and design systemswhich utilize digital imaging in the production of photo identification cardsand credentials and identification systems. Our sales in the digitalidentification market were initially developed through our acquisitions of ITC,Goddard and G & A (discussed below). Our products in this marketconsist of IWS EPI Suite, IWS EPI Builder (SDK), Identifier for Windows, IDCard Maker, and IWS Aviation. These products allow for the production ofdigital identification cards and related databases and records and can be usedby, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added theability to incorporate multiple biometrics into the ID systems we offer withthe addition of our new IWS Biometric Engine to our product line.

 

Our Digital Imaging productline consists of a suite of software for the professional photography market.The software provides professional photographers with a complete workflowsolution which enables them to digitally capture and manipulate images, createa custom package or layout and store the images with an associated database.They can then print the digital images themselves or send them via the Internetor CD to a professional lab for processing. Our products include IWS PC Pro,IWS PC Event, IWS School Days+, IWS Studio and IWS GreenScreen. Our customersuse the software products in a wide variety of ways including retail studioenvironments, on-location event photography and “picture day” at schools andday care centers. Our software products are sold through a dealer network anddirectly to major accounts. We also operate an e-commerce service, IWSPicturemore.com, used by professional photographers, labs and mini-labs toallow their customers to order re-prints and various specialty items. Our salesin the digital photography market were initially developed as a result of ouracquisition of Castleworks and E-Focus West in August, 2001.

 

ImageWare Systems, Inc., formerlyknown as ImageWare Software, Inc., was incorporated in the State ofCalifornia on February 6, 1987. From its inception until 1995, we designed and sold software productsfor the photo entertainment industry.  Inlate 1994, we sold our photo entertainment line of products, and utilized ourcore technologies to develop and sell products to law enforcementagencies.  From 1995 to early 2000 ourbusiness consisted of only its law enforcement product line.  We completed our initial public offering in April 2000.  At that time we recognized that our coreimaging technology and know-how could be extended into other markets, and wetargeted the digital identification market for diversification.  It was a fragmented market which offered usthe opportunity to establish market share through an acquisition program.  On August 22, 2000, 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.  In 2001 we began a program to consolidate ourdigital ID businesses and rationalize our costs with respect to that segment.

 

We identified digitalimaging systems for professional photographers as another market into which ourcore technology and capabilities could be extended.   This too was a fragmented industry whichoffered the opportunity to establish a significant market position throughacquisition. On August 10, 2001, we acquired Castleworks LLC, a Nevadalimited liability company (“Castleworks”), and E-Focus West LLC, a Nevadalimited liability company (“E-Focus”), privately held providers of digitalimaging software and systems for professional photographers.

 

The terrorist attacks on September 11,2001 impacted all three of our business segments.  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.  Theattacks slowed the economy in general which had a negative impact on ourprofessional photography segment.  As 

 

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werecognized the impact September 11 was having on our markets we continuedour efforts to reduce costs through continued consolidation of our businessesand cost reduction.  In early 2002 weclosed our Massachusetts offices and moved the digital ID operations that werehoused in that facility into our South Carolina offices.  In late 2002 we closed our Costa Mesa,California facility which housed our professional photography systems businessand moved those operations into our facility in San Diego, California.  In mid 2003, we closed our South Carolinaoffices and moved those operations to our offices in San Diego, California andOttawa, Canada.  In conjunction with theclosing of the South Carolina offices, local South Carolina management chose toleave the Company and establish themselves as a value added reseller of theCompany’s technology.  We agreed tosub-lease our South Carolina facilities and sell certain assets includingfurniture and fixtures, office equipment, and inventory to their newcompany.  In the fourth quarter of 2003we took actions to reposition our foreign sales offices to lower fixed costsand pursue significant international ID projects utilizing the Company’ssoftware technologies as our primary differentiator.  ** **These offices had historically emphasized the resale of third partymerchandise (hardware and consumables) which generated lower gross margins thansoftware and required significant fixed costs for sales, service and support.   Although these measures have resulted in lowertop line revenue in the short term, management believes that we will be able toreplace the lost revenue with higher margin software sales while continuing toenjoy the lower fixed costs.

 

 

**IndustryBackground**

 

***Biometric, Law Enforcement and PublicSafety Markets***

 

The United States lawenforcement and public safety markets are composed of federal, state and locallaw enforcement agencies.  Our targetcustomers include local police departments, sheriffs’ departments and offices,primary state law enforcement agencies, special police agencies, countyconstable offices, and federal agencies such as the FBI and the DEA.  We are also targeting agencies in foreigncountries for our law enforcement solutions.

 

The federal government haspromoted the development and use of nationwide criminal history recorddatabases called the Interstate Identification Index (“III”) and the NationalCrime Information Center (“NCIC”), each consisting of on-line national andregional databases dedicated to serving criminal justice agencies. TheInterstate Identification Index is maintained by the FBI and includes personsarrested for felonies or serious misdemeanors. The FBI has indicated that thisindex will accept photographs in the future. We anticipate that the inclusionof digital images in these databases will increase the value of digital bookingsystems and the demand for facial recognition applications. Since theSeptember 11, 2001 terrorist attack on the US there has been significantdiscussion at the federal and state levels of government regarding the need forfederal, state and local agencies to share information. We anticipate that themovement toward sharing of information will accelerate the adoption of systemssuch as ImageWares’ by law enforcement agencies at all levels.

 

We anticipate significantstate and federal funding to be made available to law enforcement with thecreation of the Department of Homeland Security .

 

***Identification Markets***

 

We believe our technologyalso has emerging applications in markets related to secure credentials,identification and access control. Organizations concerned with security issuescan use our technology to create secure smart identification cards that can beinstantly checked against a database of facial images or other biometrics toprevent unauthorized access to secure areas. We believe potential customers inthese markets include, among others, large corporations, airports, hospitals,universities and government agencies.

 

ID systems have historicallybeen sold based upon the cost-savings digital systems offer over traditionalphoto-based systems. We believe that the ability to easily capture images anddata in a digital database and to enable immediate and widespread access tothat database for remote identification/verification will be a functionalitythat customers will require in the future and that such functionality will bethe primary driver for future growth within this market. With the acquisitionsof ITC, Goddard and G & A, we are able to provide field-proven digitalID 

 

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productswith high quality reference accounts across the board in terms of size andcomplexity of systems and user requirements. When combined with the provenbiometric and web capabilities we currently offer, we believe we can provide aleading product offering into the ID market.

 

As with our law enforcementproduct offering, we believe that the September 11, 2001 terrorist attacksand subsequent creation of the Homeland Defense Department will accelerate theadoption of digital identification systems that can provide secure credentialsand instant access to centrally maintained records for real time verificationof identity and privileges.

 

***Digital Photography Market***

 

We believe our technologyalso has potential applications in markets related to professional photography.Professional photographers, studios and labs can use our software to capturedigital photos of subjects, allow re-touching of photos, manipulate the photosto change light, color, etc. and combine them with other photos, templates andtext to create custom collages.  Inaddition our professional photography customers can gain significantefficiencies from the work flow capabilities built into our products.

 

We believe the use ofdigital photography software and systems by professional photographers isgrowing because it allows them to capture quality images and either output themimmediately or create a database with associated textual information that thencan be efficiently printed by themselves or professional labs.

 

With the acquisition ofCastleworks and E-Focus West we believe we are able to provide proven softwareand systems that allow professional photographers, labs and studios the abilityto more efficiently manage their business through the use of digital images andassociated databases. As camera, computer hardware and memory capabilities growand their associated costs come down we anticipate the adoption of digitaltechnology by the professional photography community to accelerate.

 

**Productsand Services**

 

***Biometrics***

 

We categorize our products and services into four basic markets: (1)Biometrics, (2) Law Enforcement and Public Safety, (3) Identification and (4)Digital Photography. Our biometric product line consists of the following:

 

IWS BIOMETRIC ENGINE.  This is a biometric identity managementplatform for multi-biometric enrollment, management and authentication,managing population databases of unlimited sizes. Searches can be 1:1(verification), 1:N (identification) and X:N (investigative). IWS BiometricEngine is technology and biometric agnostic, enabling the use of biometricdevices and algorithms from any vendor, and the support of the followingbiometric types: finger, face, iris, hand geometry, palm, DNA, signature,voice, 3D face and retina. IWS Biometric Engine is a second-generation solutionfrom ImageWare Systems that is based on field-proven ImageWare technologysolutions that have been used to manage millions of biometric records since1997 and is ideal for a variety of applications including: criminal booking,background checks (civil and criminal), watch list, visa/passport and bordercontrol (air, land and sea) and even entertainment.

 

IWS Biometric Engine isscalable, and biometric images and templates can be enrolled either live oroffline.   Because it stores the enrolledimages, a new algorithm can be quickly converted to support new or alternatealgorithms and capture devices.  IWSBiometric Engine additionally has a full-featured SDK that allows it to readilyintegrate with existing applications.

 

***Law Enforcement and Public Safety***

 

We believe our integratedsuite of software products significantly reduces the inefficiencies and expandsthe capabilities of traditional booking and mugshot systems. Using ourproducts, an agency can create a digital database of thousands of criminalhistory records, each including one or more full-color facial images, fingerand palm prints, text information and images of other distinctive physicalfeatures such as scars, marks and tattoos. This database can be quicklysearched using text queries or by using our biometric facial recognition orAFIS technology which can compare biometric characteristics of an unknownsuspect 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 Enforcementsolution consists of software modules, which may also be purchasedindividually. The IWS Law Enforcement Capture and Investigative module make upour booking system and database. Our add-on modules include Livescan, FacialRecognition, Suspect ID, a Wireless module, and a PDA add-on module.

 

IWS LAW ENFORCEMENT. 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, creationof digital composite sketches, photo lineups, and production of identificationcards and credentials IWS Law Enforcement also uses off-the-shelf hardware andis designed to comply with open industry standards so that it can operate on anarray of systems ranging from a stand-alone personal computer to a wide areanetwork. To avoid duplication of entries, the system can be integrated easilywith several other information storage and retrieval systems, such as a recordsmanagement system or an automated fingerprint identification system.

 

CAPTURE. This softwaremodule allows users to capture and store facial images as well as images ofdistinguishing features such as scars, tattoos and other marks. Each entrycontains both images and text information in an easy-to-view format made up ofdistinct fields. Current customers of this module range from agencies thatcapture a few thousand mugshots per year to those that capture hundreds ofthousands of mugshots each year.

 

LIVESCAN. This softwaremodule is FBI certified which complies with the FBI Integrated AutomatedFingerprint Identification System (IAFIS) Image Quality Specifications (IQS)while utilizing the latest FBI certified Livescan device from most majorvendors. Livescan allows users to capture single to ten prints and palm data,providing an integrated biometric management for civil and law enforcement use.By adding Livescan capabilities, law enforcement organizations further enhancethe investigative process by providing additional identifiers to identifysuspects involved in a crime.  Inaddition, officers no longer need to travel to multiple booking stations tocapture fingerprints and mug shots.  Allbooking information including images will be located at a central designationand can be routed to the State AFIS or the FBI criminal history recordrepository.

 

INVESTIGATIVE. This softwaremodule allows users to search the database created with IWS Law Enforcement.Officers can conduct text searches in many fields, including file number, name,alias, distinctive features, and other information such as gang membership andcriminal history. The Investigative module creates a catalogue of possiblematches, allowing officers or witnesses to save time by looking only atmugshots that closely resemble the description of the suspect. This module canalso be used to create a line-up of similar facial images from which a witnessmay identify the suspect.

 

FACIAL RECOGNITION. Thissoftware module uses biometric facial recognition and retrieval technology tohelp authorities identify possible suspects. Images taken from surveillancevideos, digital sketches or photographs can be searched against a digitaldatabase of facial images to retrieve any desired number of faces with similarcharacteristics. This module can also be used at the time of booking toidentify persons using multiple aliases. Using biometrics-based technology, theapplication can search through thousands of facial images in a matter ofseconds, reducing the time it would otherwise take a witness to flip through apaper book of facial images that may or may not be similar to the descriptionof the suspect. The Facial Recognition module then creates a selection ofpossible matches ranked in order of similarity to the suspect, and a percentageconfidence level is attributed to each possible match. The applicationincorporates search engine technology which we license from various facialrecognition algorithm providers.

 

SUSPECT ID. This softwaremodule allows officers and witnesses to quickly create full-color,photo-realistic suspect composites. The digital composites are constructed fromlibraries of facial features based upon actual color photographs of suchfeatures. Suspect ID allows officers with minimal computer training andartistic talent to create a suspect composite by pointing and clicking with amouse. This module can be installed on a laptop computer and taken into thefield, allowing officers to conduct interviews and create composites beforewitnesses’ memories fade. For rapid identification, officers can distributecompleted composites within minutes via fax or e-mail.

 

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WIRELESS. The Wirelessmodule enables authorized personnel to access and search a county’s bookingrecords stored in IWS Law Enforcement through a standard web browser fromwithin the county’s intranet. This module allows remote access to the IWS LawEnforcement database without requiring the user to be physically connected tothe customer’s network. This application requires only that the user haveaccess to the Internet and authorization to access the county’s intranet.

 

PDA. The PDA module is apowerful investigative tool that allows officers to access IWS Law Enforcementbooking photos and related data in the field on a handheld Pocket PC compatibledevice.

 

***Identification***

 

Our Digital IdentificationProducts consist of the following products:

 

IWS EPI SUITE. This is an IDsoftware solution for producing, issuing, and managing secure credentials andpersonal identification cards. Users can efficiently manage large amounts ofdata, images and card designs, as well as track and issue multiple cards perperson; automatically populate multiple cards, eliminating redundant dataentry, IWS EPI Suite was designed to integrate with our customers’ existingsecurity and computing infrastructure. We believe that this compatibility maybe an appealing feature to corporations, government agencies, transportationdepartments, school boards, and other public institutions.

 

IWS EPI BUILDER. This is asoftware developer’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. Thisfamily of products combines the ability to capture photographic imagesdigitally with the ability to create a database and to print identificationcards. Identifier for Windows offers a powerful, versatile, and user-friendlyapplication which can be used by schools, hospitals, corporations orgovernments.

 

ID CARD MAKER. The ID CardMaker family of products provides substantially the same capabilities asIdentifier for Windows and is sold and supported by Polaroid Corporation’sauthorized dealers throughout the world.

 

In addition to the software systems listedabove, we may provide our customers with hardware (printers, laminators,cameras) and/or cardware (cards, security features, printer ribbons) purchasedfrom third parties.  Internationally wesell these products under the EdiGuard tradename.

 

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***Digital Photography***

 

Our professionalphotographer products consist of the following products:

 

IWS PC PRO.  This software allows professionalphotographers to reduce, enlarge, crop, retouch, density-correct, colorbalance, manipulate, adjust and change digital photos. Users can also createmulti-image compositions and design layouts. This software allows aphotographer to create collages and layouts, along with personalized text or graphics.Photos can be rendered for output to printers or for posting to a photographer’swebsite. This software is used by photographers for a variety of uses includingfor taking pictures in the studio of individuals and families.

 

IWS PC EVENT.  This software allows for on location eventphotography such as sporting events, team photos and dances. Images can beoutputted at the remote site, a photographer’s studio or a centralized labfacility.

 

IWS SCHOOL DAYS+.  This software allows professional photographerswho market their services to schools to efficiently capture students’ imagesand associated text. Then the images can be printed or sent to a lab forprocessing via CD or the Internet. Also the images can be used for ID badges,class rosters and other associated uses. A photographer can also use thecapture module to photograph dances and other events.

 

IWS STUDIO – The softwareallows for a seamless workflow of digital images in a studio environment.  A professional photographer or their staffcaptures an image using a digital camera, transfers the image into thepresentation software where it is reviewed with the customer and added to apackage or order, then printed on-site or output to a lab for touch-up andprinting.  The product includes a databasefor order tracking and customer information. That database can be used in a stand-alone mode or integrated withpoint-of-sale, accounting or other management software.

 

IWS GREEN SCREEN.  This software is a plug-in option to both IWSPC PRO and IWS PC EVENT that allows for the digital capture of images against ablank “green screen” background so that the image can be digitally transposedonto a fantasy layout.

 

IWS PICTUREMORE.COM.  IWS Picturemore.com is an easy-to-use onlinephoto management and fulfillment workflow solution that enables the customersof professional photographers, professional labs and mini-labs to view, andorder high-quality pictures and photo gifts online. Photographers and labs havethe flexibility to customize their site to reflect their corporate image,enhancing customer loyalty and increasing sales

 

***Maintenance and Customer Support***

 

As part of our installationof a system, we offer to train our customers’ employees as to the effective useof our products. We offer training both on-site and at our facilities. We offeron-site hardware support to our customers, generally within 24 hours ofthe customer request. Customers can contract with us for technical support thatenables them to use a toll free number to speak with our technical supportcenter for software support and general assistance 24 hours a day, sevendays a week. As many of our government customers operate around the clock andperceive our systems as critical to their day to day operations, a very highpercentage contract for technical support. Providing customer support servicestypically provides us with annual revenue of 15% to 20% of the initial salesprice of the hardware and software purchased by our customers.

 

***Software Customization and Fulfillment***

 

We directly employ computerprogrammers and also retain independent programmers to develop our software andperform quality control. We provide customers with software that wespecifically customize to operate on their existing computer system. We workdirectly with purchasers of our system to ensure that the system they purchasewill meet their unique needs. We configure and test the system either 

 

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atour facilities or on-site and conduct any customized programming necessary toconnect the system with any legacy systems already in place.  We can also provide customers with a completecomputer hardware system with our software already installed and configured. Ineither case, the customer is provided with a complete turnkey solution whichcan be used immediately. When we provide our customers with a complete solutionincluding hardware, we use off-the-shelf computers, cameras and othercomponents purchased from other companies such as IBM or Hewlett Packard.Systems are assembled and configured either at our facilities or at thecustomer’s location.

 

**OurStrategy**

 

Key elements of our strategyfor growth include the following:

 

***Penetrate the Biometrics, Access Controland Identification Markets***

 

We believe security issuesare becoming increasingly important among public agencies, corporations,hospitals, universities and similar organizations. We believe that theSeptember 11, 2001 terrorist attacks and the subsequent establishment ofthe Department of Homeland Security and the movement by governments around theworld to authenticate the identity of their citizens will accelerate theadoption of digital identification systems that can provide secure credentialsand instant access to centrally maintained records for real time verificationof identity and privileges. Using our products, an organization can createsecure credentials that correspond to images in a digital database. A borderguard or customs agent can stop an individual and quickly and accurately checkhis identity 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), licensing, voterregistration, immigration control and welfare fraud identification.

 

We believe that biometricidentifiers are becoming recognized and accepted as integral components to theidentification process.  As biometrictechnologies (facial recognition, fingerprint, iris, etc) are adopted,identification systems 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 identificationproducts are built to accommodate the use of biometrics.

 

***Fully Exploit the Expanding Law Enforcementand Public Safety Markets***

 

We intend to use oursuccessful installations with customers such as the Arizona Department ofPublic Safety, New South Wales Police, and the Los Angeles County Sheriff’sDepartment as reference accounts and to aggressively market IWS Law Enforcementas a superior technological solution. The majority of our recent sales havebeen and will be from sales of IWS Law Enforcement.  Our recent addition of the Livescan module toIWS Law Enforcement will enhance its functionality and value to the lawenforcement customer as well as increase the potential revenue the Company cangenerate from a system sale.  We willfocus our sales effort in the near term to establish IWS Law Enforcement as theintegrated mug shot and Livescan system adopted in as many countries, statesand large counties and municipalities as possible. Once we have a system installedin a region, we intend to then sell additional systems or retrieval seats toother agencies within the primary customer’s region and in neighboring regions.In addition, we plan to market our integrated investigative modules to thecustomer, including the Facial Recognition and Wireless modules, Suspect ID,Wireless module, and PDA module. As customer databases of digital mug shotsgrow, we expect that the perceived value of our investigative modules, andcorresponding revenues from sales of those modules, will also grow.

 

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

 

We may acquire additionalbusinesses that will complement our growth strategy and enhance our 

 

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competitiveposition in our current markets and other markets that utilize our core imagingtechnology.

 

***Expand into Related Applications within theLaw Enforcement and Public Safety Markets***

 

Our products can providesolutions to law enforcement and public safety agencies beyond our coreapplication of police booking systems and related investigative products withminimal adaptation. The technology behind our IWS Law Enforcement product linecan be used to create databases of missing children and to compare the facialimage of a lost child to the images in the database. Our system can be used tohelp correctional facilities track and control inmates as well as facilitateinmate release. Gun sellers could use our products to access available criminaldatabases and help prevent the sale of guns to ineligible persons. Ourtechnology can be used to monitor persons on parole or probation withoutrequiring them to travel to their parole or probation officer. We anticipatethat a parolee or probationer will be able to have his photograph taken in aspecially-designed kiosk which uses biometrics-based technology to identify theperson and inform his parole or probation officer of his location.

 

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

 

One of our latest softwaremodules, the Wireless module, allows users to use the Internet or secureintranets to conduct investigative searches of digital booking systems. Thismodule includes the most frequently used investigative features of IWS LawEnforcement to allow users to retrieve single images, conduct searches based onone or more parameters, create digital line-ups and print retrieved records. Weare also currently developing an Internet-based version of Facial Recognitionthat will allow investigators to use the Internet to compare the digital imageof an unknown suspect with a database of images using biometrics-basedtechnology. Our Internet products will allow users to quickly access and shareimages via the Internet while maintaining the security and integrity ofdatabases, thereby encouraging the widespread dissemination and sharing ofcriminal information among law enforcement agencies. Since theSeptember 11, 2001 terrorist attacks there has been significant discussionat the federal and state levels of government regarding the need for federal,state and local agencies to share information. We anticipate that the movementtoward sharing of information will accelerate the adoption of digital bookingtechnology with Internet and wireless capabilities by law enforcement agencies atall levels.

 

We are also developingwireless PDA capabilities into our products. Public agencies as well as privatesector customers require information to be available from remote locations. ThePDA module is our first handheld application which can operate in the field onPocket PC compatible devices and accompany users wherever they are located. Inorder to facilitate the transfer of records and information retrieval tools toemployees in the field, we plan to develop technology in cooperation with wirelesscommunications companies that will allow our products in the field to operateover wireless systems.

 

As part of the acquisitionof Castleworks, we acquired IWS PictureMore.com. This web service allowsprofessional photographers, labs, mini-labs or ImageWare PAL lab members to usethe Internet to increase their revenues by posting photos of their customersfor re-orders, additional copies or orders from friends and relatives. IWSPictureMore.com collects the payments, uses a professional lab to fulfill theorders and ships the products to the consumer. In return we receive a fee basedupon the revenue collected.

 

***Enhance Our Position In The ProfessionalDigital Photography Market***

 

We believe that the rate atwhich professional photographers, photo labs and studios are transitioning fromtraditional film based photography to digital imaging is growing. This growthgenerates a demand for software solutions to manage the customer informationand create the output layout and images. Further, we believe that we haveestablished a solid base of customers for our software, and we intend toexploit the market growth and demand for software. Our software and systemsallow professional photographers to quickly and easily take photos and create adatabase of information that can be sent to labs for processing. The labs canalso use our software for helping to manage the orders from the photographers.In this process, it is possible for both labs and photographers to save money.

 

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**Sales andMarketing**

 

We market and sell ourproducts through our direct sales force and through indirect distributionchannels, including systems integrators. We have sales and accountrepresentatives based in Canada and Germany, and domestically in Florida,Virginia, Maryland, Texas, Pennsylvania, and California.  Geographically, our sales and marketing forceconsists of 16 persons in the United States, 1 person in Canada and 1 person inGermany.

 

We sell through a directsales organization which is supported by the marketing organization.  Our sales professionals are supported by ourtechnical experts who are available by telephone and conduct on-site customerpresentations.

 

The typical sales cycle forIWS Biometric Engine and IWS Law Enforcement includes a pre-sale process todefine the potential customer’s needs and budget, an on-site demonstration andconversations between the potential customer and existing customers. Governmentagencies are typically required to purchase large systems by including a listof requirements 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 IDproducts are also sold to large integrators, direct via our sales force and toend users through distributors. Depending on the customer’s requirements, theremay be instances that require an RFP. The sales cycle can vary from a few weeksto a year.

 

In addition to our directsales force, we have developed relationships with a number of systemsintegrators who contract with government agencies for the installation andintegration of large computer and communication systems. By acting as asubcontractor to these systems integrators, we are able to avoid the timeconsuming and often-expensive task of submitting proposals to governmentagencies, and we also gain access to large clients.

 

We also work with companiesthat offer complementary products, where value is created through productintegration. Through teaming arrangements we are able to enhance our productsand to expand our customer base through the relationships and contracts of ourstrategic partners.

 

We promote our productsthrough trade journal advertisements, direct mail and attendance at industrytrade shows, including those sponsored by the Biometric Consortium,International Association for Biometrics, American Association of Motor VehicleAdministrators, International Association forIdentification, American Society of Industrial Security and theInternational Association of Chiefs of Police. In the professional photographymarket, we also attend the Professional Photographers’ Association and thePhotography Marketing Association trade shows. We also target other mediathrough public relations efforts, including non-industry publications, dailynewspapers, local and national news programs, and television programs relatedto law enforcement. Articles regarding our products have appeared in BusinessWeek, Los Angeles Times, Chicago Tribune, The Wall Street Journal and a numberof other publications.

 

We plan to continue tomarket and sell our products internationally. Some of the challenges and risksassociated with international sales include the difficulty in protecting ourintellectual property rights, difficulty in enforcing agreements through foreignlegal systems and volatility and unpredictability in the political and economicconditions of foreign countries. We believe we can work to successfullyovercome these challenges.

 

**Customers**

 

We have a wide variety ofdomestic and international customers. Most of our IWS Law Enforcement customersare government agencies at the federal, state and local levels in the UnitedStates. Our products are also being used in Australia, Canada, the United ArabEmirates, Kuwait, Mexico, Colombia, Costa Rica, Venezuela, Singapore, Indonesiaand the Philippines. The customer base for our digital identification systemsincludes domestic and foreign government agencies, universities, airports, andprivate sector companies, many of which are Fortune 500 or Fortune 1000 companies.Customers for our IWS Law Enforcement products may be customers for ouridentification systems as well. Our current customer base for digitalphotography systems includes professional photographers, labs and studios inthe US and Canada.  In 2004 and 2003,there were no customers who accounted for more than 10% of our revenues.

 

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**Competition**

 

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

 

Due to the fragmented natureof the law enforcement and public safety market and the modular nature of ourproduct suite, we face different degrees of competition with respect to eachIWS Law Enforcement module. We believe the principal basis on which we competewith respect to all of 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 productline faces competition from other companies such as PrintrakInternational, Inc., DataWorks Plus, and Digital DescriptorSystems, Inc. Internationally, there are often a number of local companiesoffering solutions in most countries. Many of our competitors’ products in thisniche offer basic image capture and storage, but lack the functionality ofintegrated investigative products, including facial recognition and imageediting and enhancement.

 

***Identification Markets***

 

Due to the breadth of oursoftware offering in the secure ID market space, we face differing degrees ofcompetition in certain market segments. The strength of our competitiveposition is based upon:

 

•                                          our strong brand reputation with a customerbase which includes small and medium sized businesses, Fortune 500 corporationsand large government agencies;

 

•                                          the ease of integrating our technology intoother complex applications; and

 

•                                          the leveraged strength that comes fromoffering customers software tools, packaged solutions and web-based serviceapplications that support a wide range of hardware peripherals.

 

Our software facescompetition from Datacard Corporation, a privately held manufacturer ofhardware, software and consumables for the ID market. There are also aconsiderable number of smaller software competitors such as Number FiveSoftware Ltd., Loronix Information Systems, Inc. and Fox TechnologyPty Ltd. who compete in differing geographies, primarily in the packagedproduct segment.

 

***Biometric Market***

 

The market to providebiometric systems to the identity management market is evolving and we facecompetition from a number of sources. We believe that the strength of ourcompetitive position is based on:

 

•                                          our unique ability to provide a system whichenables the enrollment, management and authentication of multiple biometricsmanaging population databases of unlimited sizes ;

 

•                                          searches canbe 1:1 (verification), 1:N (identification) and X:N (investigative).;

 

•                                          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, 3D face andretina;

 

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Our multi biometric productfaces competition from Ireland based Daon, and French based Sagem neither ofwhich have offerings with the scope and flexibility of our IWS BiometricEngine.

 

***Digital Photography Market***

 

The market to providedigital systems to the professional photography market is evolving and we facecompetition from a number of sources. We believe that the strength of ourcompetitive position is based on:

 

•                                          a strong product mix comprised of applicationsfor photographers, labs and studios;

 

•                                          our dealer and lab network;

 

•                                          our support and training infrastructure;

 

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

 

•                                          the usability and functionality of our products.

 

Our software facescompetition from Express Digital Inc., Photolynx and Australian basedPixel Photographies.

 

**IntellectualProperty**

 

We rely on trademark, patent,trade secret and copyright laws and confidentiality and license agreements toprotect our intellectual property. We have several unregistered and federallyregistered trademarks including the trademark ImageWare, as well as trademarksfor which there are pending trademark registrations with the United States,Canadian and other 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 which utilizesthird party biometric encoding and matching technologies.

 

**Researchand Development**

 

Our research and developmentteam is made up of 23 programmers, engineers and other employees. We alsocontract with outside programmers for specific projects as needed. We spentapproximately $ 2.6 million and $1.9 million on research and developmentin 2004 and 2003, 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 law enforcement, identification and digital photographymarkets.

 

**Employees**

 

As of March 15, 2005,we had a total of 83 full-time employees. Our employees are not covered by anycollective bargaining agreement, and we have never experienced a work stoppage.We believe that our relations with our employees are good.

 

**RISKFACTORS**

 

**WE HAVE AHISTORY OF SIGNIFICANT RECURRING LOSSES TOTALLING APPROXIMATELY $55.9 MILLION,AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

 

As of December 31 2004,we had an accumulated deficit of $55.9 million, and these losses maycontinue in the future. We may need to raise capital to cover these losses, andfinancing may not be 

 

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availableto us on favorable terms. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and may never achieve profitability.

 

**THE HOLDERSOF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS AND PRIVILEGES THAT ARE SENIOR TOTHE COMMON STOCK, AND WE MAY ISSUE ADDITIONAL SHARES OF PREFERRED STOCK WITHOUTSHAREHOLDER APPROVAL THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON THE MARKETVALUE OF THE COMMON STOCK.**

 

Our Board of Directors hasthe authority to issue a total of up to 4,000,000 shares of preferred stock andto fix the rights, preferences, privileges, and restrictions, including votingrights, of the preferred stock, which typically are senior to the rights of thecommon shareholders, without any further vote or action by you and the othercommon shareholders. 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.

 

The provisions of ouroutstanding Series B Preferred Stock prohibit the payment of dividends onthe common stock unless the dividends on those preferred shares are first paid.In addition, upon a liquidation, dissolution or sale of ImageWare’s business,the holders of the Series B Preferred Stock will be entitled to receive,in preference to any distribution to the holders of common stock, initialdistributions of $2.50 per share, plus all accrued but unpaid dividends.

 

Pursuant to the terms of ourSeries B Preferred Stock we are obligated to pay cumulative cash dividends onshares of Series B Preferred Stock from legally available funds at the annualrate of $0.2125 per share, payable in two semi-annual installments of $0.10625each, which cumulative dividends must be paid prior to payment of any dividendon our Common Stock.  As of December 31,2004, the Company had cumulative undeclared dividends of approximately $9,000.

 

**WE DEPENDUPON A SMALL NUMBER OF LARGE SYSTEM SALES RANGING FROM $500,000 TO IN EXCESS OF$2,000,000, AND WE MAY FAIL TO ACHIEVE ONE OR MORE LARGE SYSTEM SALES IN THEFUTURE.**

 

In the past three years wehave derived a substantial portion of our revenues from a small number of salesof large, relatively expensive systems, typically ranging in price from $500,000to $2,000,000. As a result, if we fail to receive orders for these largesystems in a given sales cycle on a consistent basis, our business could besignificantly harmed. Further, our quarterly results are difficult to predictbecause we cannot predict in which quarter, if any, large system sales willoccur 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.

 

**OUR LENGTHYSALES CYCLE MAY CAUSE US TO EXPEND SIGNIFICANT RESOURCES FOR AS LONG AS ONEYEAR IN ANTICIPATION OF A SALE, YET WE STILL MAY FAIL TO COMPLETE THE SALE.**

 

When considering thepurchase of a large computerized booking or identification system, a governmentagency may take as long as a 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 

 

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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 of ourcustomers are government agencies. These agencies often do not set their ownbudgets 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 MAY FAILTO CREATE NEW APPLICATIONS FOR OUR PRODUCTS AND ENTER NEW MARKETS, WHICH MAYAFFECT 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 are occasionally 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.

 

**WE HAVE U.S. AND FOREIGN PATENTPROTECTION FOR ELEMENTS OF CERTAIN OF OUR PRODUCTS, AND HAVE PATENTAPPLICATIONS IN PROCESS, HOWEVER, A COMPETITOR MAY STILL BE ABLE TO REPLICATEOUR TECHNOLOGY.**

 

Our business is based in large part on ourtechnology, and our success depends in part on our ability and efforts toprotect our intellectual property rights. If we do not adequately protect ourintellectual property through copyrights, patents and various trade secretprotections afforded to us by law, our business will be seriously harmed. Wehave patent protection for elements of certain of our products and patentapplications on file. We license certain elements of our trademarks, trade dress, copyrights, patentsand other intellectual property to third parties. We attempt to ensure that ourrights in our trade names and the quality of third party uses of our names aremaintained by these third parties. However, these third parties may takeactions that could significantly impair the value of our intellectual propertyand our reputation and goodwill. In addition, international intellectual property laws differ from country tocountry. Any foreign rights we have in our technology are limited by what hasbeen afforded to us under the applicable foreign intellectual property laws.Also, under the laws of certain foreign jurisdictions, in order to haverecognizable intellectual property rights, we may be required to fileapplications with various foreign agencies or officials to register ourintellectual property. Accordingly, our ability to operate and exploit ourtechnology overseas could be significantly hindered.

 

 

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**WE HAVEACQUIRED SEVERAL BUSINESSES AND FACE RISKS ASSOCIATED WITH INTEGRATING THESEBUSINESSES AND POTENTIAL FUTURE BUSINESSES THAT WE MAY ACQUIRE.**

 

We completed theacquisitions of several companies, and we plan to continue to review potentialacquisition candidates.  Our business andour strategy includes building our business through acquisitions. However,acceptable acquisition candidates may not be available in the future or may notbe available on terms and conditions acceptable to us.

 

Acquisitions involvenumerous risks, including among others, difficulties and expenses incurred inthe consummation of acquisitions and assimilation of the operations, personneland services and products of the acquired companies. Additional risksassociated with acquisitions include the difficulties of operating newbusinesses, the diversion of management’s attention from other businessconcerns and the potential loss of key employees of the acquired company. If wedo not successfully integrate the businesses we may acquire in the future, ourbusiness will suffer.

 

**WE OPERATEIN 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 and are accordinglyexposed 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.

 

 

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

 

Our corporate headquartersare located in San Diego, California where we occupy approximately 16,000square feet of office space and approximately 1,000 square feet of warehousespace. Our lease for this facility continues through September 2006 at acost of approximately $18,200 per month. We occupy approximately 26,685 squarefeet of office space in Stuttgart, Germany until September 2006 at a costof approximately $21,000 per month. We occupy 10,000 square feet in Gatineau,Province of Quebec. These premises are leased until May 2006 at a cost ofapproximately $13,000 per month. We previously occupied approximately 5,500square feet in Greenville, South Carolina. These premises are leased untilDecember 2006 at a cost of approximately $5,400 per month.  In July 2003, we sublet this property ata rate of approximately $5,400 per month through December 2006.  We have under lease approximately 4,489 ofoffice space in Costa Mesa, California at a cost of approximately $10,500 permonth. These premises are leased until July 2005. In the fourth quarter of2002, we moved this operation to our San Diego, California office and in May2003, we sublet this property at approximately $7,100 per month throughJuly 2005.

 

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**PART II**

 

**ITEM 5****.Market for Common Equity and Related Stockholder Matters.**

 

*Market Information.*

 

Our Common Stock is quotedunder the symbol “IW” on the American Stock Exchange.

 

The following table setsforth the high and low sales prices for our Common Stock as reported by theAmerican Stock Exchange for each quarter in 2003 and 2004:

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

 
| **2004 Fiscal Quarters** | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|----------|------------|---------|------------|
| First Quarter            |       | $        | 5.250      |    | $          | 2.850 |   |
| Second Quarter           |       | $        | 5.320      |    | $          | 1.920 |   |
| Third Quarter            |       | $        | 2.990      |    | $          | 1.960 |   |
| Fourth Quarter           |       | $        | 3.550      |    | $          | 2.190 |   |

 

There is no public trading marketfor our preferred stock.

 

*Holders.*

 

As of March 25, 2005there were approximately 2,033 holders of record of our Common Stock.

 

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*Dividends.*

 

We have never declared orpaid dividends on our Common Stock and do not anticipate paying any cashdividends on our shares of Common Stock in the foreseeable future. We areobligated to pay cumulative cash dividends on shares of Series B PreferredStock from legally available funds at the annual rate of $0.2125 per share,payable in two semi-annual installments of $0.10625 each, which cumulativedividends must be paid prior to payment of any dividend on our CommonStock.  As of December 31, 2004, theCompany had cumulative undeclared dividends of approximately $9,000.

 

*Securities Authorized forIssuance Under Equity Compensation Plans.*

 

# **EquityCompensation Plan InformationAs of December 31, 2004**

 
| **Plan Category**                                                                       | ** ** | **Number of securities to   be   issued upon exercise of   outstanding options,   warrants   and rights** | ** ** | **Weighted-average exercise   price of outstanding   options,   warrants and rights** | ** ** | **Number of securities remaining   available for future issuance under   equity compensation plans   (excluding   securities reflected in column (a))** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **(a)**                                                                                                   | ** ** | **(b)**                                                                               | ** ** | **(c)**                                                                                                                                                 | ** ** |
| Equity compensation plans approved by  security holders 1994 Employee Stock Option Plan |       | 111,750                                                                                                   |       | $                                                                                     | 2.15       |                                                                                                                                                    | 0          |   |
| 1994 Nonqualified Stock Option Plan                                                     |       | 2,465                                                                                                     |       | $                                                                                     | 8.39       |                                                                                                                                                    | 0          |   |
| 1999 Stock Option Plan                                                                  |       | 243,500                                                                                                   |       | $                                                                                     | 2.42       |                                                                                                                                                    | 105,560    |   |
| Equity compensation plans not approved by  security holders 2001 Equity Incentive Plan  |       | 753,797                                                                                                   |       | $                                                                                     | 3.01       |                                                                                                                                                    | 137,566    |   |
| Total                                                                                   |       | 1,111,512                                                                                                 |       | $                                                                                     | 2.81       |                                                                                                                                                    | 243,126    |   |

 

*Plan Descriptions:*

 

*2001 Equity Incentive Plan*:  For asummary of the material terms of the 2001 Equity Incentive Plan, please seeNote 11 to the financial statements included in this annual report on Form10-KSB.

 

**ITEM 6****.Management’s Discussion and Analysis of Financial Condition and Results ofOperations.**

 

**FORWARD-LOOKING STATEMENTS**

 

Thefollowing discussion should be read in conjunction with our financialstatements included elsewhere in this report. This discussion contains forward-looking statements that involve risksand uncertainties.  Our actual resultscould differ materially from those anticipated in these forward-lookingstatements as a result of various factors including those set forth under “RiskFactors” herein.  Due to such fluctuations, historical resultsand percentage relationships are not necessarily indicative of the operatingresults for any future period.

 

**OVERVIEW**

 

We utilize our imagingtechnology to develop software used to create booking and investigativesoftware solutions, smart and secure identification systems and documents, andsoftware for professional 

 

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

 

**Critical Accounting Policies andEstimates**

 

Our consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of these financialstatements requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and the disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.

 

We have identified thepolicies below as critical to our business operations and the understanding ofour results of operations. For a detailed discussion on the application ofthese and other accounting policies, see Note 1 in the Notes to theConsolidated Financial Statements in Item 7 of this Annual Report onForm 10-KSB, beginning on page F-7.

 

*Revenue recognition*

 

Our revenue recognitionpolicy is significant because our revenue is a key component of our results ofoperations. ImageWare Systems, Inc. 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. Determining when a contract should be accounted for using thepercentage of completion method involves judgment. Critical items that areconsidered in this process are the degree of customization and related laborhours necessary to complete the required work as well as ongoing estimates ofthe future labor hours needed to complete the contract. 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. The Company alsogenerates non-recurring revenue from the licensing of its software. Software licenserevenue is recognized upon the execution of a license agreement, upondeliverance, fees are fixed and determinable, collectibility is probable andwhen all other significant obligations have been fulfilled. The Company alsogenerates revenue from the sale of identification card media and othersoftware. Revenue for these items is recognized upon delivery of these productsto the customer. The Company also generates revenue from the sale ofprofessional digital photography software. Revenue for these items isrecognized upon delivery of these products to the customer.

 

*Allowance for doubtfulaccounts*

 

Our management must makeestimates of the uncollectibility of our accounts receivables. Managementspecifically analyzes accounts receivable and analyzes historical bad debts,customer concentrations, customer credit-worthiness, current economic trendsand changes in our customer payment terms when evaluating the adequacy of theallowance for doubtful accounts. Our accounts receivables balance was $1,950,000,net of allowance for doubtful accounts of $303,000 as of December 31,2004.

 

*Valuation of goodwill andother intangible assets*

 

We assess impairment ofgoodwill and identifiable intangible assets whenever events or changes incircumstances indicate that the carrying value may not be recoverable. Factorswe consider important which could trigger an impairment review include the following:

 

•              Significantunderperformance relative to historical or expected future operating results;

 

•                                          Significant changes in the manner of our useof the acquired assets or the strategy of our overall business;

 

•              Significantnegative industry or economic trends;

 

20

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When we determine that thecarrying value of goodwill and other intangible assets may not be recoverablebased upon the existence of one or more of the above indicators of impairment,we measure any impairment based upon fair value methodologies. Goodwill andother net intangible assets amounted to $6,062,000 as of December 31,2004.

 

In 2002, Statement ofFinancial Accounting Standards (“SFAS”) No. 142, “Goodwill and OtherIntangible Assets” became effective and as a result, we ceased to amortizegoodwill. In lieu of amortization, we performed an initial impairment review ofour goodwill in June, 2002 and will perform an annual impairment reviewthereafter in the fourth quarter of our fiscal year.  Completion of our initial impairment testindicated there was no goodwill impairment. We also performed our annual impairment review as of December 31,2003 and 2004 based upon our 2004 and 2005 operating plans, respectively.  This annual impairment review indicated therewas no goodwill impairment.  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. Our reporting units are Law Enforcement, Identification andDigital Photography. 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 no assurancethat goodwill impairment will not occur in the future.

 

The Company accounts forlong-lived assets in accordance with the provisions of SFAS no. 144, Accountingfor the Impairment or Disposal of Long-Lived Assets.  This statement requires that long-livedassets and certain identifiable intangible assets be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparisonof the carrying amount of an asset to future net undiscounted cash flowsexpected to be generated by the asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount which the carrying amount of the assetsexceeds the fair value of the assets. Fair value is determined based on discounted cash flows or appraisedvalues, depending upon the nature of the asset. Assets to be disposed of are reported at the lower of the carryingamount of fair value less costs to sell. We recorded no impairment losses for long-lived or intangible assetsduring the twelve months ended December 31, 2004 or 2003.

 

The selected statement ofoperations data and balance sheet data presented below set forth a summary ofdata relating to our results of operations. This data has been derived from ouraudited consolidated financial statements and should be read in conjunctionwith the financial statements and notes included elsewhere in this report.

 

**STATEMENT OF OPERATIONS DATA:**

 
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **2004**                    | ** ** | **2003** | ** ** |
| Revenues                                    |       | $                           | 10,523,313 |   | $ | 16,233,458 |   |
| Cost of revenues                            |       | $                           | 3,581,842  |   | $ | 7,382,436 |   |
| Gross profit                                |       | $                           | 6,941,471  |   | $ | 8,851,022 |   |
| Operating expenses                          |       | $                           | 11,595,284 |   | $ | 12,771,986 |   |
| Loss from operations                        |       | $                           | (4,653,813 | ) | $ | (3,920,964 | ) |
| Interest expense (income), net              |       | $                           | 5,172,426  |   | $ | 6,960,140 |   |
| Other expense, net                          |       | $                           | (187,640   | ) | $ | (207,046 | ) |
| Loss before income taxes                    |       | $                           | (9,638,599 | ) | $ | (10,674,058 | ) |
| Income taxes                                |       | $                           | —     |   | $ | 61,735 |   |
| Net loss                                    |       | $                           | (9,638,599 | ) | $ | (10,735,793 | ) |
| Basic (loss) per share:                     |       |                        |       |   |   |
| Net loss                                    |       | $                           | (0.83      | ) | (1.81 | ) |
| Weighted-average shares (basic and diluted) |       | 11,739,819                  |       | 5,953,801 |   |

 
| ** **                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------|------------|-----------------------------|------------|
| ** **                      | ** ** | **2004**                    | ** ** | **2003** | ** ** |
| **BALANCE SHEET DATA:**         | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Cash                            |       | $                           | 2,911,765  |   | $ | 578,093 |   |
| Restricted cash                 |       | $                           | 106,000    |   | $ | 155,215 |   |
| Accounts receivable, net        |       | $                           | 1,797,120  |   | $ | 1,449,968 |   |
| Inventories                     |       | $                           | 1,096,796  |   | $ | 804,526 |   |
| Other current assets            |       | $                           | 247,548    |   | $ | 204,065 |   |
| Property and equipment, net     |       | $                           | 510,270    |   | $ | 634,966 |   |
| Other assets                    |       | $                           | 627,796    |   | $ | 571,199 |   |
| Intangibles, net                |       | $                           | 764,125    |   | $ | 1,120,675 |   |
| Goodwill                        |       | $                           | 5,297,627  |   | $ | 5,297,627 |   |
| Total assets                    |       | $                           | 13,359,047 |   | $ | 10,816,334 |   |
| Total current liabilities       |       | $                           | 4,281,140  |   | $ | 3,311,964 |   |
| Long-term liabilities           |       | $                           | 811,688    |   | $ | 4,192,605 |   |
| Total liabilities               |       | $                           | 5,092,828  |   | $ | 7,504,569 |   |
| Total shareholders’ equity |       | $                           | 8,266,219  |   | $ | 3,311,765 |   |

 

21

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**YEARS ENDED DECEMBER 31,2004 AND 2003**

 

The following management’sdiscussion and analysis or plan of operation is based upon our Law Enforcement,Identification and Digital Photography segments.

 
| ** **                              | ** ** | **TWELVE MONTHS   ENDED   DECEMBER 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|-----------------------------------------|------------|-----------------------------------------------|------------|------------|------------|-----------------|------------|
| **Net Product Revenues**                | ** ** | **2004**                                      | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **Product revenues:**                   |       |                                          |       |       |       |            |       |   |   |
| Law Enforcement                         |       | $                                             | 2,541,208  |       | $          | 1,139,083       |       | $ | 1,402,125 |   | 123 | % |
| Percentage of total net product revenue |       | 30                                            | %          | 8          | %          |            |       |   |   |
| Identification Group                    |       | $                                             | 5,197,051  |       | $          | 11,155,285      |       | $ | (5,958,234 | ) | (53 | )% |
| Percentage of total net product revenue |       | 61                                            | %          | 83         | %          |            |       |   |   |
| Digital Photography                     |       | $                                             | 721,183    |       | $          | 1,176,261       |       | $ | (455,078 | ) | (39 | )% |
| Percentage of total net product revenue |       | 9                                             | %          | 9          | %          |            |       |   |   |
| Total net product revenues              |       | $                                             | 8,459,442  |       | $          | 13,470,629      |       | $ | (5,011,187 | ) | (37 | )% |

 

Product revenues decreased37% from $13,471,000 for the year ended December 31, 2003 to $8,459,000for the corresponding period in 2004. Product revenues related to our LawEnforcement products increased 123% from $1,139,000 for the year endedDecember 31, 2003 to $2,541,000 for the corresponding period in 2004.  This increase is due primarily to revenuesfrom our implementations of a browser-based, investigative law enforcementsystem for the New South Wales Police Department and increased sales of our CCSand Face ID products.   We believe thatrecent increases in terrorism has created heightened interest in the ability oflaw enforcement and other government agencies to be able to efficientlyretrieve, analyze and share information from their respective criminaldatabases. We also believe that government agencies and private entities willreact to the increased terrorism by reevaluating and upgrading their ability topositively identify and track their employees, consultants and visitors. Weanticipate that these factors will increase overall demand for the Company’sproducts, however, we cannot predict the timing of the shift in demand.

 

Product revenues fromIdentification card systems, software and related consumables decreased 53%from $11,155,000 for the year ended December 31, 2003 to $5,197,000 forthe corresponding period in 2004. Domestically, Identification product revenuesdecreased approximately $1, 059,000, or 23%. The decrease in domestic revenue is reflective of decrease inproject-oriented work and a decrease in boxed software sold throughdistribution channels.  In mid 2003, weestablished a master distributor to handle our domestic sales of our EPI lineof boxed software.  The masterdistributor model did not produce the results we anticipated, and we haveterminated that arrangement effective June 2004 and have re-established directsales to our distribution channel. Internationally, our Identification revenues decreased approximately$4,899,000.  This decrease is a result ofactions taken in the fourth quarter of 2003 to reposition our foreign salesoffices in Germany and Singapore to lower fixed costs and pursue significantIdentification projects utilizing the Company’s software technologies as ourprimary differentiator.  These officeshad historically 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.  Revenues from these two officeswere $5,240,000 below their levels in 2003; however fixed costs during thisperiod were approximately $1,792,000 lower than the previous year.  Management feels that foreign markets servedby these offices will embrace our identification and biometric solutions forlarge-scale high-end installations.  Wecontinue to be of the opinion that government agencies and private entitieswill react to heightened security concerns resulting from acts of terrorism byre-evaluating and upgrading their ability to positively identify and tracktheir citizens, employees, consultants and visitors.  We anticipate that these factors willcontinue to increase overall demand for our Identification products, however,we cannot predict the timing of the shift in demand.

 

Revenues related to ourDigital Photography products decreased 39% or $455,000 for the twelve 

 

22

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monthsended December 31, 2004 as compared to the corresponding period in2003.  This decrease is due primarily tolower revenues from custom contract programming during the twelve months endedDecember 31, 2004 as compared to the corresponding period in 2003.

 

Our backlog of productorders as of December 31, 2004 was approximately $2,141,000.  At December 31, 2004, we also had maintenanceand support backlog of approximately $808,000 under existing maintenanceagreements.  Product revenue is typicallyrecognized within a three to six month period depending upon the requireddegree of customization, if any. Historically, we have experienced a very minimal risk of ordercancellation.  Our revenue frommaintenance agreements is generally recognized ratably over the respectivemaintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

 
| ** **                                  | ** ** | **TWELVE MONTHS   ENDED   DECEMBER 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|---------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance Revenues**                    | ** ** | **2004**                                      | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **Maintenance revenues :**                  |       |                                          |       |       |       |            |       |   |   |
| Law Enforcement                             |       | $                                             | 1,844,533  |       | $          | 2,133,918       |       | $ | (289,385 | ) | (14 | )% |
| Percentage of total net maintenance revenue |       | 89                                            | %          | 77         | %          |            |       |   |   |
| Identification Group                        |       | $                                             | 197,951    |       | $          | 628,387         |       | $ | (430,436 | ) | (68 | )% |
| Percentage of total net maintenance revenue |       | 10                                            | %          | 23         | %          |            |       |   |   |
| Digital Photography                         |       | $                                             | 21,387     |       | $          | 524             |       | $ | 20,863 |   | 3981 | % |
| Percentage of total net maintenance revenue |       | 1                                             | %          | 0          | %          |            |       |   |   |
| Total net maintenance revenues              |       | $                                             | 2,063,871  |       | $          | 2,762,829       |       | $ | (698,958 | ) | (25 | )% |

 

Maintenance revenuesdecreased 25% from $2,763,000 for the year ended December 31, 2003 to$2,064,000 for the corresponding period in 2004. Maintenance revenues relatedto Law Enforcement products decreased 14% from $2,134,000 for the year endedDecember 31, 2003 to $1,845,000 for the corresponding period in 2004. Thisdecrease is due primarily to the expiration of the New York City PoliceDepartment service and maintenance contract during the third quarter of 2003offset by the expansion of our installed base in the Law Enforcement market.

 

Maintenance revenues relatedto Identification products decreased $430,000, or 68% for the year endedDecember 31, 2004 from $628,000 or the year ended December 31, 2003 to $198,000for the corresponding period in 2004. This decrease is due primarily to the shift in our strategy in late 2003to outsource international service and maintenance for hardware.  This shift has enabled the Company to reducecosts and focus its resources on expanding our international sales effort ofDigital Identification, Biometric, Law Enforcement and Digital Photographysolutions.

 

Our increase in DigitalPhotography maintenance revenues of $21,000 for the twelve months endedDecember 31, 2004 as compared to the corresponding period in 2003 isreflective of software maintenance services on custom contract programmingprojects completed in 2004.

 
| ** **                                          | ** ** | **TWELVE MONTHS   ENDED   DECEMBER 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|-----------------|------------|
| **Cost of product revenues**                        | ** ** | **2004**                                      | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **Cost of Product Revenues:**                       |       |                                          |       |       |       |            |       |   |   |
| Law Enforcement                                     |       | $                                             | 806,126    |       | $          | 711,042         |       | $ | 95,084 |   | 13 | % |
| Percentage of Law Enforcement product  revenue      |       | 32                                            | %          | 62         | %          |            |       |   |   |
| Identification Group                                |       | $                                             | 1,678,919  |       | $          | 5,415,764       |       | $ | (3,736,845 | ) | (69 | )% |
| Percentage of Identification Group product  revenue |       | 32                                            | %          | 49         | %          |            |       |   |   |
| Digital Photography                                 |       | $                                             | 115,934    |       | $          | 53,920          |       | $ | 62,014 |   | 115 | % |
| Percentage of Digital Photography product  revenue  |       | 16                                            | %          | 5          | %          |            |       |   |   |
| Total product cost of revenues                      |       | $                                             | 2,600,980  |       | $          | 6,180,726       |       | $ | (3,579,746 | ) | (58 | )% |
| Percentage of total product revenues                |       | 31                                            | %          | 46         | %          |            |       |   |   |

 

23

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Total cost of productrevenues as a percentage of product revenues decreased from 46% for the twelvemonth period ended December 31, 2003 to 31% of product revenues for thecorresponding period in 2004.  Thisdecrease is due primarily to product mix with a greater percentage of productrevenues being from software.

 

Cost of product revenues forour Law Enforcement segment increased 13% or $95,000 from $711,000 or 62% ofLaw Enforcement product revenues for the year ended December 31, 2003 to$806,000 or 32% of Law Enforcement product revenues for the correspondingperiod in 2004.  The dollar increase isreflective of higher Law Enforcement product revenues for the twelve monthsended December 31, 2004 as compared to the comparable period in 2003.  The percentage decrease, as a percentage ofLaw Enforcement product revenues, is due primarily to the larger revenue baseto absorb fixed product costs and a product mix with an uncharacteristically highpercentage of software only solutions. Fixed product costs are comprised primarily of personnel and contractprogramming costs related to customization and integration.  Costs of products also can vary as apercentage of product revenue from period to period depending upon product mixand the hardware content, print media consumable content and software contentincluded in systems installed during a given period.

 

24

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Costs of Identificationproducts decreased 69% from $5,416,000, or 49% of Identification productrevenue, for the twelve months ended December 31, 2003 to $1,679,000, or32% of Identification product revenue, for the corresponding period in 2004.The dollar decrease of $3,737,000 is reflective of lower Identificationrevenues both domestically and internationally in the twelve month period endedDecember 31, 2004 as compared to the corresponding period in 2003.  The decrease in Identification cost of productrevenues as a percentage of Identification revenues from 49% for the twelvemonth period ended December 31, 2003 to 32% for the corresponding period in2004 is reflective of higher sales of software only solutions and lower salesof hardware and consumables caused by procurement problems relating to ourprimary identification card printer and related print media consumables, whichcaused significant delays in our ability to ship identification printers andrelated media.  Cost of Identificationproducts as a percentage of identification product revenue can vary dependingupon factors such as product mix, hardware and software content and amount ofidentification card media sold.

 

Cost of product revenues forour Digital Photography segment increased 115% or $62,000 from $54,000 or 5% ofDigital Photography product revenues for the twelve months endedDecember 31, 2003 to $116,000 or 16% of Digital Photography productrevenues for the corresponding period in 2004. Both the dollar increase of $62,000 and the percentage increase in costof Digital Photography revenues as a percentage of Digital Photography revenuesfrom 5% for the twelve month period ended December 31, 2003 to 16% for thecorresponding period in 2004 are reflective of the 2004 Digital Photographyproduct mix containing hardware components as compared to the 2003 periodcontaining software only solutions.

 
| ** **                                             | ** ** | **TWELVE MONTHS   ENDED   DECEMBER 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance cost of revenues**                       | ** ** | **2004**                                      | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **Maintenance cost of revenues:**                      |       |                                          |       |       |       |            |       |   |   |
| Law Enforcement                                        |       | $                                             | 808,914    |       | $          | 783,590         |       | $ | 25,324 |   | 3 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 44                                            | %          | 37         | %          |            |       |   |   |
| Identification Group                                   |       | $                                             | 171,947    |       | $          | 418,120         |       | $ | (246,173 | ) | (59 | )% |
| Percentage of Identification maintenance  revenue      |       | 87                                            | %          | 67         | %          |            |       |   |   |
| Digital Photography                                    |       | $                                             | —     |       | $          | —          |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |       | —                                        | %          | —     | %          |            |       |   |   |
| Total maintenance cost of revenues                     |       | $                                             | 980,861    |       | $          | 1,201,710       |       | $ | (220,849 | ) | (18 | )% |
| Percentage of total maintenance revenues               |       | 48                                            | %          | 43         | %          |            |       |   |   |

 

Cost of Law Enforcementmaintenance revenue increased $25,000 from $784,000, or 37% of Law Enforcementmaintenance revenue for the year ended December 31, 2003 to $808,000, or44% of Law Enforcement maintenance revenues for the corresponding period in2004. The dollar increase of $25,000 for the year ended 2004 as compared to thecorresponding period in 2003 is reflective of increased costs to maintain ourexpanding installation based partially offset by a reduction in costs relatedto the New York City Police Department service and maintenance contract whichexpired during the third quarter of 2003. The percentage increase in cost of Law Enforcement maintenance revenuesas a percentage of Law Enforcement maintenance revenues from 37% for the yearended December 31, 2003 to 44% for the corresponding period in 2004 isreflective of lower Law Enforcement revenues available to absorb fixedmaintenance costs.

 

Costs of Identificationmaintenance revenues decreased 59% from $418,000 or 67% of Identificationmaintenance revenue for the year ended December 31, 2003 to $172,000 or87% of Identification maintenance revenues for the corresponding period in2003.  The dollar decrease of $246,000 isreflective of decreased Identification maintenance revenues due primarily tothe shift in strategy to outsource international hardware service andmaintenance in late 2003.  The increasein cost of 

 

25

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Identificationmaintenance revenues as a percentage of Identification maintenance revenuesfrom 67% for the twelve months ended December 31, 2003 to 87% ofmaintenance revenues for the corresponding period in 2004 is due to a smallerrevenue base over which to absorb fixed maintenance costs.

 
| ** **                                         | ** ** | **TWELVE MONTHS  ENDED   DECEMBER 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|----------------------------------------------------|------------|----------------------------------------------|------------|------------|------------|-----------------|------------|
| **Product gross profit**                           | ** ** | **2004**                                     | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| Law Enforcement                                    |       | $                                            | 1,735,081  |       | $          | 428,042         |       | $ | 1,307,039 |   | 305 | % |
| Percentage of Law Enforcement product  revenue     |       | 68                                           | %          | 38         | %          |            |       |   |   |
| Identification Group                               |       | $                                            | 3,518,132  |       | $          | 5,739,521       |       | $ | (2,221,389 | ) | (39 | )% |
| Percentage of Identification product  revenue      |       | 68                                           | %          | 51         | %          |            |       |   |   |
| Digital Photography                                |       | $                                            | 605,249    |       | $          | 1,122,341       |       | $ | (517,092 | ) | (46 | )% |
| Percentage of Digital Photography product  revenue |       | 84                                           | %          | 95         | %          |            |       |   |   |
| Total product gross profit                         |       | $                                            | 5,858,462  |       | $          | 7,289,904       |       | $ | (1,431,442 | ) | (20 | )% |
| Percentage of total product revenues               |       | 69                                           | %          | 54         | %          |            |       |   |   |

 

Law Enforcement productgross profit as a percentage of Law Enforcement product revenues increased from38% for the twelve months ended December 31, 2003 to 68% for thecorresponding period in 2004. This percentage change increase is due both tothe product mix of Law Enforcement product sales containing anuncharacteristically high percentage of software the comparable period in 2003as well as a larger revenue base to absorb fixed product costs.  Gross profit of Law Enforcement products canvary as a percentage of product revenue from period to period depending uponproduct mix and the hardware content, print media consumable content andsoftware content included in systems installed during a given period.  The dollar increase of $1,307,000 or 3056%for the twelve months ended December 31, 2004 as compared to thecorresponding period in 2003 reflects the increase in Law Enforcement revenuesin 2004.

 

Identification gross profitas a percentage of Identification product revenue increased from 51% for theyear ended December 31, 2003 to 68% for the corresponding period in 2004.  This increase is due primarily to our productmix containing higher percentages of software than the comparable period in 2003.  The shift in product mix is a result of lowersales in the period of hardware and consumables due, in part, to actions takenin the fourth quarter of 2003 to reposition our international sales strategytowards significant Identification projects using the Company’s software as ourprimary differentiator.  Ourinternational offices had historically emphasized the resale of third partymerchandise.  Gross profit ofIdentification products as a percentage of identification product revenue canvary depending upon factors such as product mix, hardware and software contentand amount of identification card media. The dollar decrease of $2,221,000 reflects the decrease inIdentification product revenues during the twelve months endedDecember 31, 2004 as compared to the corresponding period in 2003.

 

Digital Photography grossprofit as a percentage of Digital Photography product revenue decreased from95% for the twelve months ended December 31, 2003 to 84% for thecorresponding period in 2004.  Thisdecrease is reflective of the inclusion of hardware into Digital Photography’sproduct mix during the year ended December 31, 2004 as compared to thecomparable period in 2003 which contained software only solutions.

 

26

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| ** **                                             | ** ** | **TWELVE MONTHS   ENDED   DECEMBER 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance gross profit**                           | ** ** | **2004**                                      | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **Maintenance gross profit**                           |       |                                          |       |       |       |            |       |   |   |
| Law Enforcement                                        |       | $                                             | 1,035,618  |       | $          | 1,350,328       |       | $ | (314,710 | ) | (23 | )% |
| Percentage of Law Enforcement product  revenue         |       | 56                                            | %          | 63         | %          |            |       |   |   |
| Identification Group                                   |       | $                                             | 26,004     |       | $          | 210,267         |       | $ | (184,263 | ) | (88 | )% |
| Percentage of Identification product  revenue          |       | 13                                            | %          | 33         | %          |            |       |   |   |
| Digital Photography                                    |       | $                                             | 21,387     |       | $          | 524             |       | $ | 20,863 |   | 398 | % |
| Percentage of Digital Photography  maintenance revenue |       | 100                                           | %          | 100        | %          |            |       |   |   |
| Total maintenance gross profit                         |       | $                                             | 1,083,009  |       | $          | 1,561,119       |       | $ | (478,110 | ) | (31 | )% |
| Percentage of total maintenance revenues               |       | 52                                            | %          | 57         | %          |            |       |   |   |

 

Gross profit related to LawEnforcement maintenance revenues decreased 23% from $1,350,000 or 63% of LawEnforcement maintenance revenue for the twelve months ended December 31,2003 to $1,036,000 or 56% of Law Enforcement revenues for the correspondingperiod in 2004. This decrease is reflective of the expiration of the New YorkCity Police Department service and maintenance contract during the thirdquarter of 2003 offset by the expansion of our installation base.

 

Gross profit related toIdentification maintenance revenues decreased 88% from $210,000 or 33% ofIdentification maintenance revenues for the year ended December 31, 2003to $26,000 or 13% for the corresponding period in 2004.  The dollar decrease of $184,000 is reflectiveof lower international identification maintenance revenues due to our decisionin late 2003 to outsource international hardware service and maintenance.  The decrease in Identification gross profitas a percentage of Identification maintenance revenues from 33% for the twelvemonths ended December 31, 2003 to 13% of maintenance revenues for thecorresponding period in 2004 is due to a smaller revenue base over which toabsorb fixed maintenance costs.

 
| ** **                      | ** ** | **TWELVE MONTHS  ENDED   DECEMBER 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|------------|------------|-----------------|------------|
| **Operating expenses**          | ** ** | **2004**                                     | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
|                            |       |                                         |       |       |       |            |       |   |   |
| General & administrative    |       | $                                            | 4,605,920  |       | $          | 6,106,438       |       | $ | (1,500,518 | ) | (25 | )% |
| Percentage of total net revenue |       | 44                                           | %          | 38         | %          |            |       |   |   |
| Sales and marketing             |       | $                                            | 3,695,530  |       | $          | 3,820,595       |       | $ | (125,065 | ) | (3 | )% |
| Percentage of total net revenue |       | 35                                           | %          | 24         | %          |            |       |   |   |
| Research & development      |       | $                                            | 2,575,247  |       | $          | 1,920,696       |       | $ | 654,551 |   | 34 | % |
| Percentage of total net revenue |       | 24                                           | %          | 12         | %          |            |       |   |   |
| Depreciation and amortization   |       | $                                            | 718,587    |       | $          | 924,257         |       | $ | 205,670 |   | (22 | )% |
| Percentage of total net revenue |       | 7                                            | %          | 6          | %          |            |       |   |   |

 

*General and administrativeexpenses*

 

General and administrativeexpenses are comprised primarily of salaries and other employee-related costsfor executive, financial, and other infrastructure personnel. General legal,accounting and consulting services, insurance, occupancy and communicationcosts are also included with general and administrative expenses.  Such expenses decreased 25% or $1,501,000,from $6,106,000 for the year ended December 31, 2003 to $4,606,000 for thecorresponding period in 2004.  Suchexpenses, as a percentage of total net revenues, increased from 38% for the yearended December 31, 2003 to 44% for the corresponding period in 2004.  This percentage increase is reflective oflower total net revenues during the year ended December 31, 2004 as compared tothe corresponding period in 2003.  Thedollar reduction of $1,501,000 is reflective of the consolidation of our SouthCarolina office into our San Diego office combined with headcount reductions atour San Diego, California and Stuttgart, Germany offices and lower occupancycosts at our San Diego, California office. We are continuing to focus our efforts on achieving additional futureoperating efficiencies by reviewing and improving upon existing businessprocesses and evaluating our cost structure. We believe these efforts willallow us to continue to gradually decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

 

27

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*Sales and marketingexpenses*

 

Sales and marketing expensesconsist primarily of the salaries, commissions, other incentive compensation,employee benefits and travel expenses of our sales force. Such expensesdecreased 3%, or $125,000 from $3,821,000 for the year ended December 31, 2003to $3,696,000 for the corresponding period in 2004.  Such expenses, as a percentage of totalrevenues, increased from 24% for the year ended December 31, 2003 to 35% forthe corresponding period in 2004.  Thispercentage increase is reflective of lower total net revenues during the yearended December 31, 2004 as compared to the corresponding period in 2003.  The dollar decrease of $125,000 is dueprimarily to reduced headcount and lower sales commissions during the first sixmonths of 2004.  These reductions wereoffset, beginning in the third quarter, by increases in headcount and paymentsto sales consultants (including lobbyists). The increase in headcount and amounts paid to sales consultants reflectsrequired resources needed to pursue large project solution opportunities.  The headcount reduction during the first six monthsof 2004 reflects the consolidation in 2003 of our product lines and sales forceunder the direction of our San Diego office. We anticipate that the level of expenses incurred for sales andmarketing during the third and fourth quarter of 2004 will continue as wepursue large project solution opportunities.

 

*Research and developmentexpenses*

 

Research and developmentcosts consist primarily of salaries, employee benefits and outside contractorsfor new product development, product enhancements and certain customintegration work not billable to customers. Such expenses increased 34% or$655,000 from $1,921,000 for the year ended December 31, 2003 to $2,575,000 forthe corresponding period in 2004 due primarily to the accelerated developmentof our new ImageWare Biometric Engine and the web enablement of our CCS productline utilizing contract programming services in conjunction with internalresearch and development resources.  Ourlevel of research and development expenditures reflects our belief that tomaintain our competitive position in markets characterized by rapid rates oftechnological advancement, we must continue to invest significant resources innew systems and software as well as continue to enhance existing products.

 

*Depreciation and amortization*

 

Depreciation andamortization decreased $205,000 from $924,000 for the year endedDecember 31, 2003 to $719,000 for the corresponding period in 2004.  This decrease is due primarily to loweramortization of intangible assets due to such assets being fully amortized andlower depreciation expense related to fixed assets previously utilized in ourSouth Carolina office, which was closed in June 2003.

 

*Interest expense, net*

 

For the year ended December 31, 2004, we recognized interestincome of $16,000 and interest expense of $5,188,000. For the year endedDecember 31, 2003, we recognized interest income of $14,000 and interestexpense of $6,974,000.  Interest expensefor the year ended December 31, 2004 contains approximately $4,472,000 ofinterest expense related to fair value accounting for our warrant liability duethe registration rights agreement associated with the underlying shares of theCompany’s common stock to be issued upon conversion of the warrants.  During June 2004, the Company registered theunderlying shares of common stock with the Securities and ExchangeCommission.  In accordance with EITF00-19, there will be no further interest expense or income incurred inconjunction with these warrants. Interest expense for the year ended December 31, 2004 also contains$713,000 in liquidated damages, which were classified as interest expense.  The liquidated damages were incurred as theCompany did not meet certain time requirements for the registration of sharesof the Company’s common stock under the registration rights agreements for theNovember 2003 and January 2004 private placements.

 

Interest expense for the year ended December 31, 2003 contains$387,000 of interest expense related to fair value accounting for our warrantliability due to the registration rights agreement associated with theunderlying shares of the Company’s common stock to be issued upon conversion ofthe warrants.  Interest expense for theyear ended December 31, 2003 increased due to our issuance of seniorsecured and 

 

28

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subordinated convertible promissory notes payable, short-term demandnotes payable and short-term borrowings under banking lines of credit.  Interest expense for the year endedDecember 31, 2003 also includes approximately of $6,160,000 of debtdiscount and deferred financing fee amortization classified as interestexpense.  The following table sets forththe major components of net interest expense for the years endedDecember 31, 2004 and 2003:

 

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| ** **                                                                                                                                                                        | ** ** | **TWELVE MONTHS ENDED   December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **2004**                                    | ** ** | **2003** | ** ** |
| **Components of net interest expense  (income):**                                                                                                                                 |       |                                        |       |   |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Senior secured convertible promissory note  issued May 22, 2002, interest rate 12.5% due May 22, 2004; Principal amount  $2,000,000 (the “Note):                             |       |                                        |       |   |   |
| Coupon interest rate expense                                                                                                                                                      |       | $                                           | —     |   | $ | 198,552 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                              |       | —                                      |       | 373,845 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                       |       | —                                      |       | 877,906 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                    |       | —                                      |       | 267,272 |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Secured demand promissory note issued  September, 2002, interest rate 12.5%, due upon demand                                                                                      |       | —                                      |       | 26,541 |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Subordinated convertible promissory notes  issued March 2003, interest rate 8.5%, due April 15, 2005;  principal amount $600,000, (“the Subordinated Notes”): |       |                                        |       |   |   |
| Coupon interest rate expense                                                                                                                                                      |       | —                                      |       | 33,600 |   |
| Amortization to interest expense of note discount  related to beneficial conversion feature                                                                                       |       | —                                      |       | 110,526 |   |
|   Interest  expense from amortization of deferred financing fees                                                                                                             |       | —                                      |       | 58,000 |   |
|   Interest  expense from induced conversion                                                                                                                                  |       | —                                      |       | 109,895 |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, principal amount  $4,256,000; (“the New Notes):                    |       |                                        |       |   |   |
| Coupon interest rate expense                                                                                                                                                      |       | —                                      |       | 426,862 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                              |       | —                                      |       | 1,752,384 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                       |       | —                                      |       | 1,752,384 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                    |       | —                                      |       | 540,823 |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Other note payable interest expense                                                                                                                                               |       | 2,290                                       |       | 58,016 |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                                           |       | 4,472,407                                   |       | 387,018 |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Interest expense from incurrence of  penalties related to non-timely registration of common stock                                                                                 |       | 713,493                                     |       | — |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Total Interest Expense                                                                                                                                                            |       | 5,188,190                                   |       | 6,973,624 |   |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Interest income                                                                                                                                                                   |       | (15,764                                     | )          | (13,484 | ) |
|                                                                                                                                                                              |       |                                        |       |   |   |
| Net interest (income) expense                                                                                                                                                     |       | $                                           | 5,172,426  |   | $ | 6,960,140 |   |

 

*Liquidity and capitalresources*

 

As of December 31,2004, we had total current assets of $6,159,000 and total current liabilitiesof $4,281,000, or working capital of $1,878,000. At December 31, 2004 and2003, we had available cash of $2,912,000 and $578,000, respectively. As ofDecember 31, 2004, we also had $106,000 in restricted cash securing ourobligations on a software installation and implementation contract.  As discussed more fully in Note 16 to theaccompanying consolidated financial statements, in March 2005, wecompleted the sale of our wholly-owned subsidiary, Digital Imaging Asia Pacificto Argus Solutions for approximately $1.3 million.

 

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Net cash used in operatingactivities was $3,761,000 for the year ended December 31, 2004 as comparedto $2,975,000 for the corresponding period in 2003. We used cash to fund netlosses of $4,190,000, excluding non-cash expenses (depreciation, amortizationand stock-based compensation less gains on debt extinguishment) of $5,449,000for the year ended December 31, 2004. We used cash to fund net losses of $3,359,000 excluding non-cashexpenses (depreciation, amortization and non-cash charges interest expense) of$7,337,000 for the corresponding period in 2003. For the year endedDecember 31, 2004, we used cash of $739,000 to fund increases in current

 

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assets offset by increases in current andlong-term liabilities of $1,168,000 (excluding debt).  In 2003, we generated cash of $2,778,000through reductions in current assets offset by decreases in current andlong-term liabilities of $2,394,000 (excluding debt).

 

Net cash used by investingactivities was $247,000 for the year ended December 31, 2004 as comparedto $376,000 for the corresponding period in 2003. For the year endedDecember 31, 2004, we used cash to fund capital expenditures of computerequipment and software, furniture and fixtures and leasehold improvements ofapproximately $237,000. The level of equipment purchases resulted primarilyfrom continued growth of the business and replacement of older equipment. In2004, we also used cash of $59,000 to repay advances from related stockholdersand generated cash of $49,000 from reductions in restricted cash used to secureour performance on a software installation and implementation contract.  In 2003, we used cash of $136,000 to fundcapital expenditures of computer equipment and software, furniture and fixturesand leasehold improvements.  In 2003, wealso used cash of approximately $203,000 to repay advances from related stockholdersand used cash of $95,000 through increases in restricted cash used to secureour performance on various software installation and implementationcontracts.  For the year endedDecember 31, 2003, we also generated cash of $59,000 from the sale ofassets.

 

Net cash provided byfinancing activities was $6,275,000 for the year ended December 31, 2004.  We generated cash of $6,054,000 from ourissuance of common stock in a private placement.  We also generated cash of $497,000 from theexercise of stock options and stock purchase warrants.  In 2004, we used cash of $212,000 for thepayment of dividends on our Series B Preferred Stock and used cash of $64,000for the repayment of notes payable.  In2003, net cash provided by financing activities was $3,561,000 for the yearended December 31, 2003.  Wegenerated cash of $4,856,000 from the proceeds of our issuance of seniorsecured convertible promissory notes payable offset by $554,000 in debtissuance costs.  We also generated cashof $6,203,000 from our issuance of common stock.  We used cash of $6,778,000 for the repaymentof notes payable.  We also used cash of$166,000 to repay short-term borrowings under two bank line of creditagreements.

 

We conduct operations inleased facilities under operating leases expiring at various dates through 2006.  In conjunction with our performance onvarious software installation and implementation contracts, we are contingentlyliable under an irrevocable letter of credit in the amount of $106,000. Theletter of credit expires December 26, 2008.  We also have various short-term notes payableand capital lease obligations due at various times during 2005. The followingtable sets forth a summary of our obligations under operating leases, capitalleases, notes payable and irrevocable letters of credit for the next fiveyears:

 
| ** **                                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|-----------|------------|
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Minimum annual lease payments under  operating leases                |       | $        | 792,000    |     | $          | 859,000  |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 1,651,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Minimum annual payments under notes payable                          |       | $        | 18,000     |     | $          | 0        |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 18,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Other commercial commitments:                                        |       |     |       |     |       |     |       |     |       |     |       |      |       |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Standby letters of credit                                            |       | $        | 106,000    |     | $          | 0        |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 106,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Total contractual cash obligations and  other commercial commitments |       | $        | 916,000    |     | $          | 859,000  |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 1,775,000 |   |
|                                                                      |            |          |            |          |            |          |            |          |            |          |            |           |            |  |  |  |  |  |  |  |

 

Our planned operatingexpenses and capital expenditures may constitute a material use of our cashresources.  In addition, we may utilizecash resources to fund acquisitions or investments in complementary 

 

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businesses,technologies or product lines.

 

As more fully explained in Note 16 to the attachedconsolidated financial statements, we completed the sale of our wholly-ownedsubsidiary, Digital Imaging Asia Pacific, Pte. Ltd., in March 2005, for $1.3million in cash. We believe that our current cash balances will satisfy ourprojected working capital and capital expenditure requirements for at least thenext 12 months. Thereafter, we anticipate continuing to use cash, cashequivalents, and short-term investment balances to satisfy our projectedworking capital and capital expenditure requirements. However, because of ourconcern that currently weak economic conditions may continue

 

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through2005, if not longer, we have taken and continue to take steps to limit ourexpenses and align our cost structure to our revenues. These steps include,among other things, considering and/or taking steps, as needed, to restructureour business, consolidating our operations, negotiating volume pricing withvendors, centralizing certain services, and standardizing products. Werecognize that our operating expense levels, including research, development,engineering, selling, marketing, general and administrative expenses, depend onanticipated business activity levels. While research, development, engineeringand marketing expenses are based on anticipated investment levels in technologydevelopment, product development and market development activities, theappropriate expense levels in selling, general and administrative expenses aredependant on the level of infrastructure required to support our anticipatedbusiness volume. We review our business plans periodically to determine theappropriate level of such expenses based on various business factors. In thepast we have taken appropriate measures to control our expenses based onbusiness circumstances. In the future we will continue to review our businessplans from time to time and make appropriate changes to our expense levels, aswe have in the past, to reduce operating expenses where it is advantageous todo so to improve operational efficiencies.

 

In order to take advantage of opportunities, we mayfind it necessary to obtain additional equity financing, debt financing, orcredit facilities although we do not believe at this time that our long-termworking capital and capital expenditures will be of such a nature that we wouldbe required to take steps presently to remedy any such potential deficiency. Ifit were necessary to obtain additional financings or credit facilities, we maynot be able to do so, or if these funds are available, they may not beavailable on satisfactory terms.

 

*New AccountingPronouncements*

 

In November 2004, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS151”), which is effective beginning January 1, 2006.  SFAS 151 requires that abnormal amounts ofidle facility expense, freight, handling costs and wasted material berecognized as current period charges. The Statement also requires that the allocation of fixed production overheadbe based on the normal capacity of the production facilities.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.

 

In December 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123R, “Share-Based Payment (“SFAS 123R”),which is effective beginning July 1, 2005. SFAS 123R requires all share-based payments to employees to be expensedover the requisite service period based on the grant-date fair value of theawards.  The Statement allows for eitherprospective or retrospective adoption and requires that the unvested portion ofall outstanding awards upon adoption be recognized using the same fair valueand attribution methodologies previously determined under Statement No 123, “Accountingfor Stock-Based Compensation”.  TheCompany is currently evaluating transition alternatives and valuationmethodologies for future grants.  As aresult, pro forma compensation expense, as reflected in Note 1, may not beindicative of future expense to be recognized under SFAS 123R.  The effect of adoption of 123R on the Company’sfinancial position or results of operations has not yet been determined.

 

In December 2004, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards No. 153, “Exchange of NonmonetaryAssets, an amendment of APR Opinion No. 29” (“SFAS 153”).  The guidance in APB Opinion No. 29, “Accountingfor Nonmonetary Transactions” is based on the principle that exchanges ofnonmonetary assets should be measured based on the fair value of the assetsexchanged.  The guidance in that Opinion,however, included certain exceptions to that principle.  SFAS 153 amends Opinion 29 to eliminate theexception for nonmonetary assets that do not have commercial substance.  A nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. The provisions of SFAS 153 shall be effective for nonmonetary assetexchanges occurring in fiscal periods beginning after June 15, 2005.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.

 

34

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In December 2004 the Financial Accounting Standards Board issued twoFASB Staff Positions—FSP FAS 109-1, *Applicationof FASB Statement 109 “Accounting for Income Taxes” to the Tax Deduction onQualified Production Activities Provided by the American Jobs Creation Act of2004,* and FSP FAS 109-2 *Accountingand Disclosure Guidance for the Foreign Earnings Repatriation Provision withinthe American Jobs Creation Act of 2004.* Neither of these affectedthe Company as it does not participate in the related activities

 

35

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

 

The financial statements forfiscal years ended December 31, 2004 and 2003 are included hereinfollowing Part III, Item 13, and are filed as part of this report.

 

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

 

*Evaluation of disclosure controlsand procedures*.  ImageWare’s chief executive officer and itschief financial officer, after evaluating the effectiveness of ImageWare’sdisclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e))as of December 31, 2004 (the “Evaluation Date”), have concluded that as of suchdate, ImageWare’s disclosure controls and procedures were adequate andsufficient to ensure that information required to be disclosed by ImageWare inthe reports that it files under the Securities and Exchange Act of 1934 isrecorded, processed, summarized and reported within the time period specifiedin the Commission’s rules and forms.

 

*Changes in internal controls*.  Therehas been no change in ImageWare’s internal controls over financial reportingduring the quarter ended December 31, 2004 that has materially affected, or isreasonably likely to materially affect ImageWare’s internal control overfinancial reporting.

 

**PART III**

 

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

 

The information concerning the identification and business experienceof our directors is set forth in the definitive proxy statement for the 2005Annual Meeting of Shareholders under the heading “Proposal I – “Election ofDirectors,” which information is incorporated herein by reference.

 

The information concerningthe identification and business experience of our executive officers is setforth in the definitive proxy statement for the 2005 Annual Meeting ofShareholders under the heading “Executive Officers,” which information isincorporated herein by reference.

 

The information concerning compliance with Section 16(a) of theExchange Act is set forth in ImageWare’s definitive proxy statement for the2005 Annual Meeting of Shareholders under the heading “Security Ownership ofCertain Beneficial Owners and Management – Section 16(a) Beneficial OwnershipReporting Compliance,” which information is incorporated herein by reference.

 

**Item 10****. Executive Compensation.**

 

*Compensationof Directors*

### ** **

Theinformation concerning executive compensation is set forth in the definitiveproxy statement of the 2005 Annual Meeting of Shareholders under the heading “ExecutiveCompensation,” which information is incorporated herein by reference.

 

**Item 11****. Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters.**

 

The information concerningsecurities authorized for issuance under equity compensation plans is set forthin Item 5 above.

 

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The information concerningsecurity ownership of certain beneficial owners and management is set forth inthe definitive proxy statement for the 2005 Annual Meeting of Shareholdersunder the heading “Security Ownership of Certain Beneficial Owners andManagement,” which information is incorporated herein by reference.

 

**Item 12****. Certain Relationships and Related Transactions.**

 

The informationconcerning certain relationships and related transactions is set forth in thedefinitive proxy statement for the 2005 Annual Meeting of Shareholders underthe heading “Certain Transactions,” which information is incorporated herein byreference.

 

**Item 13****. Exhibits**

 

(a)           Exhibits.

 
| **Exhibit** | ** ** | **Number Description**                                                                                                                                       |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | Amended and Restated Articles of Incorporation(1)                                                                                                            |
| 3.2         |       | Bylaws(1)                                                                                                                                                    |
| 4.1         |       | Form of Common Stock Certificate(1)                                                                                                                          |
| 4.2         |       | Form of Public Warrant(1)                                                                                                                                    |
| 4.3         |       | Form of Representatives’ Warrant(1)                                                                                                                     |
| 4.4         |       | Form of Warrant and Unit Agreement(1)                                                                                                                        |
| 4.5         |       | Warrant to Purchase Common Stock in favor of Imperial Bank(1)                                                                                                |
| 10.1        |       | Employment Agreement with S. James Miller dated January 1, 1996, as  amended September 2000(2)                                                               |
| 10.2        |       | Employment Agreement with Wayne G. Wetherell dated April 1, 1997, as  amended March 1, 1999(1)                                                               |
| 10.3        |       | Amendment, dated April 27, 2002, to the Employment Agreement between  Registrant and Wayne G. Wetherell dated April 1, 1997, as amended on March 1,  1999(3) |

 

37

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| 10.4  |   | Form of Indemnity Agreement entered into by the registrant with its  directors and executive officers(1)                      |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------|
| 10.5  |   | 1994 Employee Stock Option Plan(1)                                                                                            |
| 10.6  |   | 1994 Nonqualified Stock Option Plan(1)                                                                                        |
| 10.7  |   | 1999 Stock Option Plan(1)                                                                                                     |
| 10.8  |   | 2001 Equity Incentive Plan(8)                                                                                                 |
| 10.9  |   | Lease between Thornmint I and the Company dated September 26,  2003(13)                                                  |
| 10.10 |   | Sublease between Castleworks LLC and Paine and Associates dated  September 28, 1998(9)                                        |
| 10.11 |   | Commercial Lease between I.W. Systems Canada Company and 3840743  Canada, Inc. dated April 12, 2001(2)                        |
| 10.12 |   | Commercial Lease  between BOS GmbH & Co. KG and Digital Imaging International GmbH dated  June 20, 2001(9)                |
| 10.13 |   | Note and Warrant Purchase Agreement dated May 22, 2002 (Perseus)(10)                                                          |
| 10.14 |   | Registration Rights Agreement dated May 22, 2002 (Perseus)(10)                                                                |
| 10.15 |   | Warrant to Purchase Common  Stock dated May 22, 2002 (Perseus)(10)                                                            |
| 10.16 |   | Warrant to Purchase  1,021,687 shares of Common Stock, dated June 13, 2003(11)                                                |
| 10.17 |   | Warrant to Purchase  578,313 shares of Common Stock, dated June 13, 2003(11)                                                  |
| 10.18 |   | Form of Securities  Purchase Agreement dated November 14, 2003(12)                                                            |
| 10.19 |   | Form of Warrant dated  November 24, 2003(12)                                                                                  |
| 10.20 |   | Form of Registration  Rights Agreement dated November 24, 2003(12)                                                            |
| 10.21 |   | Registration Rights  Agreement, dated March 13, 2003(14)                                                                      |
| 10.22 |   | Form of Securities  Purchase Agreement date January 29, 2004(12)                                                              |
| 10.23 |   | Form of Warrant dated  January 29, 2004(12)                                                                                   |
| 10.24 |   | Form of Registration  Rights Agreement dated January 29, 2004(12)                                                             |
| 10.25 |   | Offer of Restricted Stock  in Exchange for Certain Stock Options Previously Granted – Offer Made to  James Miller(15)    |
| 10.26 |   | Offer of Restricted Stock  in Exchange for Certain Stock Options Previously Granted – Offer Made to  Wayne Wetherell(15) |
| 10.27 |   | Form of Warrant dated  September 28, 2004                                                                                     |
| 21.1  |   | Subsidiaries of the Small Business Issuer                                                                                     |
| 23.2  |   | Consent of Stonefield Josephson, Inc., Independent accountants                                                                |
| 31.1  |   | Certification by Chief Executive Officer pursuant to Exchange Act  Rules 13a-15(e) and 15d-15(e))                             |
| 31.2  |   | Certification by Chief Financial Officer pursuant to Exchange Act  Rules 13a-15(e) and 15d-15(e))                             |
| 32.1  |   | Certification by Chief Executive Officer pursuant to Section 906 of  the Sarbanes-Oxley Act                                   |
| 32.2  |   | Certification by Chief Financial Officer pursuant to Section 906 of  the Sarbanes-Oxley Act                                   |

 

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| (1)  |   | Incorporated by  reference to the Registration Statement on Form SB-2, as filed with the  Commission on December 20, 1999 (No. 333-93131), as amended. |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  |   | Incorporated by reference to the Registration Statement on Form S-3,  as filed with the Commission on June 29, 2001 (No. 333-64192).                   |
| (3)  |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on August 14, 2002.                                       |
| (8)  |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on November 14, 2001.                                     |
| (9)  |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on August 14, 2001.                                       |
| (10) |   | Incorporated by reference to the Current Report, Form 8-K as filed  with the Commission on May 24, 2002.                                               |
| (11) |   | Incorporated by reference to the Current Report, Form 8-K as filed  with the Commission on June 20, 2003.                                              |
| (12) |   | Incorporated by reference to the Current Report, Form 8-K as filed  with the Commission on February 9, 2004.                                           |
| (13) |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on November 14, 2003.                                     |
| (14) |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on May 15, 2003.                                          |
| (15) |   | Incorporated by reference to the Quarterly Report, Form 10-QSB as  filed with the Commission on August 16, 2004.                                       |

 

38

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

 

*IndependentAuditors’ Fees*

 

Thefollowing table represents aggregate fees billed to the Company for the fiscalyear ended December 31, 2004 by Stonefield Josephson, Inc. the Company’sprincipal accountant for the fiscal year ended December 31, 2004 and 2003.

 
| ** **                                                      | ** ** | **Fiscal Year Ended   (in thousands)** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                               | ** ** | **2003** | ** ** |
| Audit Fees                                                      |       | $                                      | 49,207     |   | $ | 65,000 |   |
|                                                            |       |                                   |       |   |   |
| Audit-related Fees for quarterly review  services and consents. |       | 43,275                                 |       | 54,349 |   |
|                                                            |       |                                   |       |   |   |
| Tax Fees                                                        |       | 3,415                                  |       | — |   |
|                                                            |       |                                   |       |   |   |
| All Other Fees                                                  |       | —                                 |       | — |   |
|                                                            |       |                                   |       |   |   |
| Total Fees                                                      |       | $                                      | 95,897     |   | $ | 119,349 |   |

 

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

 

*Pre-ApprovalPolicies and Procedures.*

 

TheAudit Committee has adopted a policy and procedures for the pre-approval ofaudit and non-audit services rendered by our independent auditor, StonefieldJosephson, Inc. The policy generally pre-approves specified services in thedefined categories of audit services, audit-related services, and tax servicesup to specified amounts. Pre-approval may also be given as part of the AuditCommittee’s approval of the scope of the engagement of the independent auditoror on an individual explicit case-by-case basis before the independent auditoris engaged to provide each service. The pre-approval of services may bedelegated to one or more of the Audit Committee’s members, but the decisionmust be reported to the full Audit Committee at its next scheduled meeting.

 

39

----

 

**SIGNATURES**

 

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

 
|                | **IMAGEWARE SYSTEMS, INC.** |
|---------------------|----------------------------------|
|                |                             |   |
|                |                             |   |
| March 31, 2005 | By:                              | /s/  **S. JAMES MILLER, JR.** |
|                |                             | **S. James Miller, Jr.** |
|                |                             | Chief  Executive Officer and  Chairman of the Board of Directors |

 

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

 
| **Signature**             | ** ** | **Title**                                                              | ** ** | **Date**             |
|---------------------------|------------|------------------------------------------------------------------------|------------|----------------------|
|                      |       |                                                                   |       |                 |
| /s/  S. JAMES MILLER, JR. |       | Chief Executive Officer  and Chairman of the Board of Directors   |       | March 31,  2005 |
| S.James  Miller, Jr.      |       | *(Principal Executive Officer)*                                        |       |                 |
|                      |       |                                                                   |       |                 |
| /s/  WAYNE G. WETHERELL   |       | Senior Vice President of  Administration and Chief Financial Officer   |       | March 31,  2005 |
| Wayne  G. Wetherell       |       | *(Principal Financial and  Accounting Officer)*                        |       |                 |
|                      |       |                                                                   |       |                 |
| /s/  JOHN CALLAN          |       | Director                                                               |       | March 31,  2005 |
| John  Callan              |       |                                                                   |       |                 |
|                      |       |                                                                   |       |                 |
| /s/  PATRICK J. DOWNS     |       | Director                                                               |       | March 31,  2005 |
| Patrick  J. Downs         |       |                                                                   |       |                 |
|                      |       |                                                                   |       |                 |
| /s/  JOHN L. HOLLERAN     |       | Director                                                               |       | March 31,  2005 |
| John  L. Holleran         |       |                                                                   |       |                 |
|                      |       |                                                                   |       |                 |
| /s/  DAVID LOESCH         |       | Director                                                               |       | March 31,  2005 |
| David  Loesch             |       |                                                                   |       |                 |
|                      |       |                                                                   |       |                 |
| /s/  STEVE HAMM           |       | Director                                                               |       | March 31,  2005 |
| Steve  Hamm               |       |                                                                   |       |                 |

 

40

----

 

**IMAGEWARE SYSTEMS, INC.**

 

**INDEX TO FINANCIAL STATEMENTS**

 

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

 

----

 

## ***REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM***

## *** ***

** **

**ToThe Board Of Directors And Stockholders Of Imageware Systems, Inc. **San Diego, California 

 

We have audited theaccompanying consolidated balance sheets of Imageware Systems, Inc. as ofDecember 31, 2004 and 2003 and the related consolidated statements ofoperations, stockholders’ equity and cash flows for each of the two years thenended . These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits. 

 

We conducted our audits inaccordance with standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion. 

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Imageware Systems,Inc. as of December 31, 2004  and 2003and the consolidated results of their operations and their cash flows for eachof the two years then ended, in conformity with accounting principles generallyaccepted in the United States of America. 

 
| */s/ Stonefield Josephson, Inc.* | * * |
|----------------------------------|----------|
| * *                         |
| Stonefield  Josephson, Inc.      |
| Certified  Public Accountants    |
| February 18,  2005               |

 

F-1

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                                                                                                                           | ** ** | **December 31,  2004** | ** **     | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|----------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                                           | ** ** | ** **                  | ** **     | ** **                  | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                           | ** ** | ** **                  | ** **     | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                                                                                      |       |                        |           |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                                                 |       | $                           | 2,911,765      |                        | $          | 578,093 |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                                                                                                 |       | 106,000                     |           | 155,215                     |       |
| Accounts receivable, net of allowance for  doubtful accounts of $302,731 and $483,254 at December 31, 2004 and  2003, respectively                                                                                                                                                                                                              |       | 1,797,120                   |           | 1,449,968                   |       |
| Inventories, net                                                                                                                                                                                                                                                                                                                                     |       | 1,096,796                   |           | 804,526                     |       |
| Other current assets                                                                                                                                                                                                                                                                                                                                 |       | 247,548                     |           | 204,065                     |       |
| Total Current Assets                                                                                                                                                                                                                                                                                                                                 |       | 6,159,229                   |           | 3,191,867                   |       |
|                                                                                                                                                                                                                                                                                                                                                 |       |                        |           |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                                                          |       | 510,270                     |           | 634,966                     |       |
| Other assets                                                                                                                                                                                                                                                                                                                                         |       | 627,796                     |           | 571,199                     |       |
| Intangible assets, net                                                                                                                                                                                                                                                                                                                               |       | 764,125                     |           | 1,120,675                   |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                             |       | 5,297,627                   |           | 5,297,627                   |       |
| **Total Assets**                                                                                                                                                                                                                                                                                                                                     | ** ** | **$**                       | **13,359,047** | ** **                  | **$**      | **10,816,334** | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                           | ** ** | ** **                  | ** **     | ** **                  | ** ** |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                       |       |                        |           |                        |       |
|                                                                                                                                                                                                                                                                                                                                                 |       |                        |           |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                                                 |       |                        |           |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                     |       | $                           | 1,228,916      |                        | $          | 1,052,862 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                     |       | 1,044,819                   |           | 847,690                     |       |
| Billings in excess of costs and estimated  earnings on uncompleted contracts                                                                                                                                                                                                                                                                         |       | 424,299                     |           | —                      |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                     |       | 1,551,865                   |           | 1,067,379                   |       |
| Accrued interest                                                                                                                                                                                                                                                                                                                                     |       | 12,750                      |           | 103,057                     |       |
| Notes & advances payable to bank and  third parties                                                                                                                                                                                                                                                                                              |       | 18,491                      |           | 181,976                     |       |
| Notes payable to related parties                                                                                                                                                                                                                                                                                                                     |       | —                      |           | 59,000                      |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                                                                            |       | 4,281,140                   |           | 3,311,964                   |       |
|                                                                                                                                                                                                                                                                                                                                                 |       |                        |           |                        |       |
| Warrant liability                                                                                                                                                                                                                                                                                                                                    |       | —                      |           | 3,460,120                   |       |
| Pension obligation                                                                                                                                                                                                                                                                                                                                   |       | 811,688                     |           | 732,485                     |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                                    |       | 5,092,828                   |           | 7,504,569                   |       |
|                                                                                                                                                                                                                                                                                                                                                 |       |                        |           |                        |       |
| Shareholders’ equity                                                                                                                                                                                                                                                                                                                            |       |                        |           |                        |       |
| Preferred stock, $.01 par value, authorized  4,000,000 shares Series B convertible redeemable preferred stock, designated 750,000  shares, 389,400 shares issued, and 249,400 and 249,400 shares outstanding at  December 31, 2004 and 2003 respectively, liquidation preference $623,500  at December 31, 2004 and December 31, 2003 |       | 2,494                       |           | 2,494                       |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 11,969,089 shares issued, 11,962,385 and 9,923,333 shares  outstanding at December 31, 2004 and 2003, respectively                                                                                                                                                                 |       | 118,442                     |           | 98,051                      |       |
|                                                                                                                                                                                                                                                                                                                                                 |       |                        |           |                        |       |
| Additional paid in capital                                                                                                                                                                                                                                                                                                                           |       | 63,789,396                  |           | 49,221,700                  |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                                               |       | (63,688                     | )              | (63,688                     | )          |
| Shareholder note receivable                                                                                                                                                                                                                                                                                                                          |       | —                      |           | (150,000                    | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                                                                               |       | 332,425                     |           | 265,470                     |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                  |       | (55,912,850                 | )              | (46,062,262                 | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                                                                                      |       | 8,266,219                   |           | 3,311,765                   |       |
|                                                                                                                                                                                                                                                                                                                                                 |       |                        |           |                        |       |
| **Total Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                                                                  | ** ** | **$**                       | **13,359,047** | ** **                  | **$**      | **10,816,334** | ** ** |

 

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

 

F-2

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                               | ** ** | **TWELVE MONTHS ENDED  December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                                               | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| **Revenues:**                                            |       |                                       |       |   |   |
| Product                                                  |       | $                                          | 8,459,442  |   | $ | 13,470,629 |   |
| Maintenance                                              |       | 2,063,871                                  |       | 2,762,829 |   |
|                                                     |       | 10,523,313                                 |       | 16,233,458 |   |
| **Cost of revenues:**                                    |       |                                       |       |   |   |
| Product                                                  |       | 2,600,981                                  |       | 6,180,726 |   |
| Maintenance                                              |       | 980,861                                    |       | 1,201,710 |   |
|                                                     |       |                                       |       |   |   |
| Gross profit                                             |       | 6,941,471                                  |       | 8,851,022 |   |
|                                                     |       |                                       |       |   |   |
| **Operating expenses:**                                  |       |                                       |       |   |   |
| General & administrative                             |       | 4,605,920                                  |       | 6,106,438 |   |
| Sales and marketing                                      |       | 3,695,530                                  |       | 3,820,595 |   |
| Research & development                               |       | 2,575,247                                  |       | 1,920,696 |   |
| Depreciation and amortization                            |       | 718,587                                    |       | 924,257 |   |
|                                                     |       | 11,595,284                                 |       | 12,771,986 |   |
|                                                     |       |                                       |       |   |   |
| Loss from operations                                     |       | (4,653,813                                 | )          | (3,920,964 | ) |
|                                                     |       |                                       |       |   |   |
| Interest expense, net                                    |       | 5,172,426                                  |       | 6,960,140 |   |
|                                                     |       |                                       |       |   |   |
| Other income, net                                        |       | (187,640                                   | )          | (207,046 | ) |
|                                                     |       |                                       |       |   |   |
| Loss before income taxes                                 |       | (9,638,599                                 | )          | (10,674,058 | ) |
|                                                     |       |                                       |       |   |   |
| Income tax expense                                       |       | —                                     |       | 61,735 |   |
|                                                     |       |                                       |       |   |   |
| Net loss                                                 |       | $                                          | (9,638,599 | ) | $ | (10,735,793 | ) |
|                                                     |       |                                       |       |   |   |
| Basic and diluted loss per common share -  see note 2    |       | $                                          | (0.83      | ) | $ | (1.81 | ) |
| Weighted-average shares outstanding (basic  and diluted) |       | 11,739,819                                 |       | 5,953,801 |   |

 

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

 

F-3

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                                | ** ** | **TWELVE MONTHS ENDED  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                                                                      |       |                                  |       |   |   |
| **Cash flows from operating activities**                                                                  |       |                                  |       |   |   |
| Net loss                                                                                                  |       | $                                     | (9,638,599 | ) | $ | (10,735,793 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities Depreciation and amortization |       | 718,587                               |       | 924,257 |   |
| Non cash interest and amortization of debt  discount and debt issuance costs                              |       | 4,472,407                             |       | 6,136,480 |   |
| Stock based compensation                                                                                  |       | 357,774                               |       | 48,000 |   |
| Other non-cash charges                                                                                    |       | —                                |       | 268,317 |   |
| Gain on debt extinguishment                                                                               |       | (100,000                              | )          | — |   |
| Change in assets and liabilities                                                                          |       |                                  |       |   |   |
| Accounts receivable                                                                                       |       | (347,152                              | )          | 1,756,784 |   |
| Inventories                                                                                               |       | (292,270                              | )          | 897,418 |   |
| Other current assets                                                                                      |       | (43,483                               | )          | 218,320 |   |
| Other assets                                                                                              |       | (56,597                               | )          | (94,922 | ) |
| Accounts payable                                                                                          |       | 176,054                               |       | (2,096,017 | ) |
| Accrued expenses                                                                                          |       | 381,678                               |       | (433,670 | ) |
| Accrued expenses - related parties                                                                        |       | —                                |       | (2,722 | ) |
| Accrued interest                                                                                          |       | (90,307                               | )          | (59,378 | ) |
| Deferred revenue                                                                                          |       | 197,129                               |       | (128,356 | ) |
| Contract costs                                                                                            |       | 424,299                               |       | — |   |
| Pension obligation                                                                                        |       | 79,203                                |       | 326,364 |   |
|                                                                                                      |       |                                  |       |   |   |
| Total adjustments                                                                                         |       | 5,877,322                             |       | 7,760,875 |   |
|                                                                                                      |       |                                  |       |   |   |
| Net cash used by operating activities                                                                     |       | (3,761,277                            | )          | (2,974,918 | ) |
|                                                                                                      |       |                                  |       |   |   |
| **Cash flows from investing activities**                                                                  |       |                                  |       |   |   |
| Purchase of property and equipment                                                                        |       | (237,340                              | )          | (135,964 | ) |
| Restricted cash and cash equivalents                                                                      |       | 49,215                                |       | (95,215 | ) |
| Payment on advances from related  stockholders                                                            |       | (59,000                               | )          | (203,243 | ) |
| Sale of property and equipment                                                                            |       | —                                |       | 58,526 |   |
|                                                                                                      |       |                                  |       |   |   |
| Net cash used by investing activities                                                                     |       | (247,125                              | )          | (375,896 | ) |
|                                                                                                      |       |                                  |       |   |   |
| **Cash flows from financing activities**                                                                  |       |                                  |       |   |   |
| Proceeds from issuance of notes payable  with warrants                                                    |       | —                                |       | 4,856,000 |   |
| Proceeds from issuance of common stock, net  of issuance costs                                            |       | 6,054,014                             |       | 6,203,080 |   |
| Repayment of convertible notes payable                                                                    |       | (63,485                               | )          | (6,777,996 | ) |
| Debt issuance costs                                                                                       |       | —                                |       | (554,078 | ) |
| Dividends paid                                                                                            |       | (211,989                              | )          | — |   |
| Proceeds from (repayment of) bank line of  credit                                                         |       | —                                |       | (165,625 | ) |
| Proceeds from exercise of options and  warrants                                                           |       | 496,579                               |       | — |   |
|                                                                                                      |       |                                  |       |   |   |
| Net cash provided by financing activities                                                                 |       | 6,275,119                             |       | 3,561,381 |   |
| Effect of exchange rate changes on cash                                                                   |       | 66,955                                |       | 152,589 |   |
| Net increase (decrease) in cash                                                                           |       | 2,333,672                             |       | 363,156 |   |
|                                                                                                      |       |                                  |       |   |   |
| Cash at beginning of period                                                                               |       | 578,093                               |       | 214,937 |   |
|                                                                                                      |       |                                  |       |   |   |
| Cash at end of period                                                                                     |       | $                                     | 2,911,765  |   | $ | 578,093 |   |
|                                                                                                      |       |                                  |       |   |   |
| Supplemental disclosure of cash flow  information:                                                        |       |                                  |       |   |   |
| Cash paid for interest                                                                                    |       | $                                     | —     |   | $ | 651,955 |   |
| Summary of non-cash investing and financing  activities:                                                  |       |                                  |       |   |   |
| Cancellation of shares previously issued  pursuant to shareholder note receivable write-off               |       | $                                     | 150,000    |   | $ | — |   |
| Conversion of trade accounts payable to  notes payable                                                    |       | $                                     | —     |   | $ | 98,661 |   |
| Conversion of convertible notes and accrued  interest to common stock                                     |       | $                                     | —     |   | $ | 632,001 |   |
| Conversion of preferred stock to common  stock                                                            |       | $                                     | —     |   | $ | 200 |   |

 

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

 

F-4

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**

 
| ** **                              | ** ** | **TWELVE MONTHS ENDED  DECEMBER 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                              | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Net loss                                |       | $                                          | (9,638,599 | ) | $ | (10,735,793 | ) |
| Other comprehensive income:             |       |                                       |       |   |   |
| Foreign currency translation adjustment |       | 66,955                                     |       | 152,589 |   |
| Comprehensive loss                      |       | $                                          | (9,571,644 | ) | $ | (10,583,204 | ) |

 

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

 

F-5

----

 

**ImageWare Systems, Inc.**

**Consolidated Statements of Shareholders’Equity**

for the Years Ended December 31, 2004and 2003

 
| ** **                                                                                   | ** ** | **Series  B  Convertible,  Redeemable  Preferred** | ** ** | **Common  Stock** | ** ** | **Treasury  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Share-    holder  Note  Receivable** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Accumulated  Deficit** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|-------------------|------------|---------------------|------------|----------------------------------|------------|----------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------|------------|
| ** **                                                                                   | ** ** | **Shares**                                         | ** ** | **Amount**        | ** ** | **Shares**          | ** ** | **Amount**                       | ** ** | **Shares**                             | ** ** | **Amount**                                           |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Balance  at December 31, 2002                                                           |       | 269,400                                            |       | $                 | 2,694      |                | 5,496,094  |                             | $          | 53,712                                 |       | (6,704                                               | )          | $                        | (63,688    | )         | $          | 41,272,370 |   | (150,000 | ) | $ | 112,881 |   | $ | (35,326,469 | ) | $ | 5,901,500 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Preferred  Stock conversion to common stock                                                  |       | (20,000                                            | )          | (200              | )          | 4,804               |       | 48                               |       | —                                 |       | —                                               |       | 152                      |       | —    |       | — |   | — |   | — |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Issuance  of  common stock for cash, net of issuance costs                                   |       | —                                             |       | —            |       | 4,069,484           |       | 40,695                           |       | —                                 |       | —                                               |       | 6,162,385                |       | —    |       | — |   | — |   | 6,203,080 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Conversion of  convertible notes payable and accrued unpaid interest into common stock       |       | —                                             |       | —            |       | 334,392             |       | 3,344                            |       | —                                 |       | —                                               |       | 632,001                  |       | —    |       | — |   | — |   | 635,345 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Issuance of  common stock for professional services                                |       | —                                             |       | —            |       | 25,263              |       | 252                              |       | —                                 |       | —                                               |       | 47,748                   |       | —    |       | — |   | — |   | 48,000 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Warrants  issued in conjunction with convertible debt and common stock                       |       | —                                             |       | —            |       | —              |       | —                           |       | —                                 |       | —                                               |       | (990,530                 | )          | —    |       | — |   | — |   | (990,530 | ) |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Beneficial  conversion feature of convertible debt                                           |       | —                                             |       | —            |       | —              |       | —                           |       | —                                 |       | —                                               |       | 3,088,417                |       | —    |       | — |   | — |   | 3,088,417 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Reacquisition   value of beneficial conversion feature                                       |       | —                                             |       | —            |       | —              |       | —                           |       | —                                 |       | —                                               |       | (1,100,737               | )          | —    |       | — |   | — |   | (1,100,737 | ) |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Induced  conversion expense of convertible debt                                              |       | —                                             |       | —            |       | —              |       | —                           |       | —                                 |       | —                                               |       | 109,894                  |       | —    |       | — |   | — |   | 109,894 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Foreign currency translation  adjustment                                                     |       | —                                             |       | —            |       | —              |       | —                           |       | —                                 |       | —                                               |       | —                   |       | —    |       | 152,589 |   | — |   | 152,589 |   |
| Net  loss                                                                                    |       | —                                             |       | —            |       | —              |       | —                           |       | —                                 |       | —                                               |       | —                   |       | —    |       |   |   | (10,735,793 | ) | (10,735,793 | ) |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Balance  at December 31, 2003                                                           |       | 249,400                                            |       | $                 | 2,494      |                | 9,930,037  |                             | $          | 98,051                                 |       | (6,704                                               | )          | $                        | (63,688    | )         | $          | 49,221,700 |   | $ | (150,000 | ) | $ | 265,470 |   | $ | (46,062,262 | ) | $ | 3,311,765 |   |
| Issuance  of  common stock for cash, net of issuance costs                                   |       | —                                             |       |              | —     |                | 1,818,332  |                             |       | 18,184                                 |       | —                                               |       |                     | —     |      |       | 6,035,831 |   |   | — |   |   | — |   |   | — |   |   | 6,054,015 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Issuance  of  common stock pursuant to option and warrant exercises 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 |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| 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) |   |
|                                                                                         |       |                                               |       |              |       |                |       |                             |       |                                   |       |                                                 |       |                     |       |      |       |   |   |   |   |   |   |
| Foreign currency  translation adjustment                                                     |       | —                                             |       |              | —     |                | —     |                             |       | —                                 |       | —                                               |       |                     | —     |      |       | — |   |   | — |   |   | 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 |   |
|--------------------------------|--------|---------|--------|--------|---|-------|--------|------------|--------|--------|---|---------|--------|--------|---|--------|---|---------|---|--------|---|------------|--------|--------|---|--------|--------|--------|---|---------|--------|--------|---|-------------|---|--------|---|-----------|--------|

 

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

 

F-6

----

 

**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**DECEMBER 31, 2004 AND 2003**

 

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

 

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

 

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

 

ImageWare’s IDsolutions empower customers to create secure and smart digital identificationdocuments with complete ID systems. We develop, sell and support software anddesign systems which utilize digital imaging in the production of photoidentification credentials and identification systems.  Our products in this market consist ofEpiSuite, EpiWeb, EpiWeb Enterprise, EpiBuilder (SDK), Identifier for Windows,ID Card Maker, Winbadge NT and Winbadge Aviation. These products allow for theproduction of digital identification cards and related databases and recordsand can be used by, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added theability to incorporate multiple biometrics into the ID systems we offer withthe addition of our new Imageware Biometric Engine to our product line.

 

ImageWare’s Digital Photography (“PDI”) product line consists of asuite of software for the professional photography market. The software allowsprofessional photographers to digitally capture images, manipulate them tocreate a custom package or layout, then store the images with an associateddatabase. They can then print the digital images themselves or send them viathe Internet or CD to a professional lab for processing. Our products includePC Pro, PC Event, PDI School Days+, PDI Studio, PDI Pro Lab and PDI GreenScreen. Our customers use the software products in a wide variety of waysincluding retail studio environments, on-location event photography and “pictureday” at schools and day care centers. Our software products are sold through adealer network and directly to major accounts. The PDI group also operates ane-commerce service, Picturemore.com, used by professional photographers toallow their customers to order re-prints and various service items. 

 

*Going Concern*

 

As reflectedin the accompanying consolidated financial statements, the Company hascontinuing losses and negative cash flows from operations.  These matters raise doubt about the Company’sability to continue as a going concern.

 

In view of thematters described in the preceding paragraph, recoverability of a major portionof the recorded asset amounts shown in the accompanying consolidated balancesheet is dependent upon continued operations of the Company, which, in turn, isdependent upon the Company’s ability to continue to raise capital and generatepositive cash flows from operations.  Theconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

 

Subsequent to year end, theCompany has completed the sale of its wholly-owned subsidiary, Digital ImagingAsia Pacific, Pte. Ltd.,  for $1.3million in cash.  The Company believesthat its current cash balances will satisfy its projected working capital andcapital requirements for at least the next twelve months.  See Note 17 for further details.

 

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

 

*Principles of consolidation*

 

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

 

F-7

----

 

*Use of estimates*

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements, and the reported amounts of revenueand expense during the reporting period. Significant estimates includeallowance for doubtful accounts receivable, deferred tax asset valuationallowances, accounting for loss contingencies, recoverability of goodwill andacquired intangible assets and amortization periods, and revenue and cost ofrevenues recognized under the percentage of completion method. Actual resultscould differ from estimates.

 

*Fair Value of 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.

 

*Property and equipment*

 

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

 

*Goodwill:*

* *

Goodwill arising from the acquisition of G & AImaging and Castleworks and E-Focus was first attributed to developedtechnology, trademarks and tradenames, patents, agreements not-to-compete andcustomer relationship based upon their estimated fair value at the date ofacquisition.  These intangible assets arebeing amortized over their estimated useful lives, which range from 3-15years.  Goodwill acquired will be reviewed for impairmentpursuant to SFAS No. 142.

 

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

 

The Company did not recordany goodwill impairment charges for the years ended December 31, 2004 and 2003.

 

*Intangible and Long-lived assets*

 

In October 2001, the FASB issued SFAS No. 144, “Accounting forImpairment of Disposal of Long-Lived Assets”, which supercedes SFAS No. 121, “Accountingfor the Impairment of Long-Lived Assets and for Long-Lived Assets to BeDisposed Of”, and the accounting and reporting provision of APB Opinion No. 30,“Reporting the Results of Operations-Reporting the Effects of Disposal of aSegment of a Business, and Extraordinary, Unusual and Infrequently OccurringEvents and Transactions”, 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. 144 requires that long-lived assetsto be disposed of by sale, including those of discontinued operations, bemeasured at the lower of carrying amount or fair value less cost to sell,whether reported in continuing operations or in discontinued operations. SFASNo. 144 broadens the reporting of discontinued operations to include allcomponents of an entity with operations that can be distinguished from the restof the entity and that will be eliminated from the ongoing operations of the entityin 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.  At December 31, 2004 and 2003, there was noimpairment of the Company’s intangible or long-lived assets.

 

F-8

----

* *

*Concentration of credit risk*

 

Financial instruments which potentially subject the Company to concentrationsof credit risk consist principally of cash and trade accounts receivable.  The Company places its cash with high qualityfinancial institutions and at times may exceed the FDIC $100,000 insurancelimit.  Sales are typically made oncredit and the Company generally does not require collateral. The Companyperforms ongoing credit evaluations of its customers’ financial condition andmaintains an allowance for doubtful accounts. Accounts receivable are presentednet of an allowance for doubtful accounts of $302,731 and $483,254 and atDecember 31, 2004 and 2003, respectively.

 

For the twelve months ended December 31, 2004 and 2003, there were nocustomers who accounted for more than 10% of the Company’s revenues.  

 

As of December 31, 2004, one customer accounted from approximately23% of total accounts receivable. At December 31, 2003, there were nocustomers who accounted for more than 10% of total accounts receivable.

 

*Stock-based compensation*

 

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

 

SFAS No. 123, “Accounting for Stock-BasedCompensation,” establishes and encourages the use of the fair value basedmethod of accounting for stock-based compensation arrangements under whichcompensation cost is determined using the fair value of stock-basedcompensation determined as of the date of grant and is recognized over theperiods in which the related services are rendered. The statement also permitscompanies to elect to continue using the current intrinsic value accounting methodspecified in Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees,” to account for stock-based compensation. TheCompany has elected to use the intrinsic value based method and has disclosedthe pro forma effect of using the fair value based method to account for itsstock-based compensation issued to employees. For options granted to employeeswhere the exercise price is less than the fair value of the stock at the dateof grant, the Company recognizes an expense in accordance with APB 25.  For non-employee stock basedcompensation the Company recognizes an expense in accordance with SFAS No. 123and values the equity securities based on the fair value of the security on thedate of grant. For stock-based awards the value is based on the market valuefor the stock on the date of grant. Stock option awards are valued using theBlack-Scholes option-pricing model.

 

The fair valueof each option grant is estimated on the date of grant using the Black-Scholesmethod with the following assumptions: risk free interest rate ranging from 4.00% to 6.32%; dividend yield of0% for each of the years 2004 and 2003; volatility factor of the expectedmarket price of the Company’s common stock of between 82% to 65% for 2004 and2003; and an expected life of the options of 5 years for 2003 and 2002.  The volatility of the Company’s common stockunderlying the options was not considered for options granted up to March 31,2000 because the Company’s stock was not publicly traded.

 

If the Companyhad elected to recognize compensation expense based upon the fair value at thegrant date for awards under the Stock Option Plan consistent with themethodology prescribed by SFAS No. 123, the Company’s net loss and lossper share would have been increased to the pro forma amounts indicated belowfor the years ended December 31, 2004 and 2003:

 
| ** **                                                       | ** ** | **2004**   | ** **  | **2003**   | ** ** |
|------------------------------------------------------------------|------------|------------|-------------|------------|------------|
| NET LOSS:                                                        | ** ** | ** ** | ** **  | ** ** | ** ** |
| As reported                                                      |       | $          | (9,638,599  | )          | $          | (10,735,793 | ) |
| Stock based compensation included in net  loss                   |       | 357,774    |        | —     |       |
| Stock based employee compensation under  fair value based method |       | (939,491   | )           | (527,374   | )          |
| Pro forma net loss                                               |       | $          | (10,220,316 | )          | $          | (11,263,167 | ) |
| Basic loss per common share:                                     |       |       |        |       |       |
| As reported                                                      |       | $          | (0.83       | )          | $          | (1.81 | ) |
| Pro forma                                                   |       | (0.88      | )           | (1.90      | )          |

 

On March 30, 2004, the Company entered into a stock exchangeagreement with certain employees whereby the employees would receive 255,792 shares ofrestricted stock in exchange for 426,321 options previously granted undervarious stock option plans.  Under theterms of the agreement, the employees will receive three shares of restrictedstock for each five options exchanged. The restricted stock will vest over three years on a quarterly basis andwill fully vest upon either a change in control, the sale of the Company, ortermination of employment unless such termination is for cause.

 

Inaccordance with Financial Accounting Standards Board Interpretation No. 44 —Accounting for Certain Transactions Involving Stock Compensation (“FIN 44”),the Company will recognize stock-based compensation expense ratably over thevesting period of the restricted stock. Such compensation expense was $0 for the three months ended March 31,2004 due to the commencement of the vesting period on March 30, 2004;$82,000 for the three months ended June 30, 2004; $187,000 for the threemonths ended September 30, 2004; and $89,000 for the three months endedDecember 31, 2004.  Compensation expensefor the three months ended September 30, 2004 and December 31, 2004 reflects$115,000 and $17,000, respectively, for the immediate vesting of shares ofcertain participants due to their termination of employment.

 

Thedifferential between the number of shares underlying the options exchanged of426,321 and the number of restricted shares issued of 255,792 are subject tovariable accounting treatment under the provisions of FIN 44 should any optiongrants be awarded to the 

 

F-9

----

 

participantsof this stock exchange agreement for a six month period beginningMarch 30, 2004.  No options weregranted to the participants of this stock exchange agreement during the periodMarch 30, 2004 to September 30, 2004.

 

*Income taxes*

 

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

 

*Foreign currency translation*

 

The financial position and results of operations of the Company’sforeign subsidiaries are measured using the foreign subsidiary’s local currencyas the functional currency. Revenues and expenses of such subsidiaries havebeen translated into U.S. dollars at average exchange rates prevailing duringthe period. Assets and liabilities have been translated at the rates ofexchange on the balance sheet date. The resulting translation gain and lossadjustments are recorded directly as a separate component of shareholders’equity, unless there is a sale or complete liquidation of the underlyingforeign investments. The Company translates foreign currencies of its German,Canadian and Singapore subsidiaries. The cumulative translation adjustmentaccount, which is part of accumulated other comprehensive income, increased$67,000 for the twelve months ended December 31, 2004 and $153,000 for thetwelve months ended 2003.

 

*Comprehensive Income*

 

Comprehensive income consists of net gains and losses affecting shareholders’equity that, under generally accepted accounting principles, are excluded fromnet income (loss). For the Company, the only item is the cumulative translationadjustment.

 

*Revenue recognition*

 

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

 

*Capitalized software development costs*

 

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

 

*Advertising costs*

* *

TheCompany expenses advertising costs as incurred.  Advertising expense totaled approximately$94,000 and $57,000  for the years ended December 31, 2004  and 2003, respectively.

 

F-10

----

 

*Earnings (loss) per share*

 

Basic earnings (loss) per common share is calculated by dividing netincome (loss) available to common shareholders for the period by theweighted-average number of common shares outstanding during the period. Dilutedearnings (losses) per common share is calculated by dividing net income (loss)available to common shareholders for the period by the weighted-average numberof common shares outstanding during the period, increased to include, ifdilutive, the number of additional common shares that would have beenoutstanding if the potential common shares, if dilutive, had been issued at thebeginning of the year.  The dilutiveeffect of outstanding stock options is included in the calculation of dilutedearnings (losses) per common share, if dilutive, using the treasury stockmethod. During the years ended December 31, 2004 and 2003, the Company hasexcluded the following securities from the calculation of diluted loss pershare, as their effect would have been antidilutive due to the Company’s netloss:

 
| **Potential Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  December 31, 2004** | ** ** | **Number of  Common Shares  Convertible into at  December 31, 2003** | ** ** |
|------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
|                               |       |                                                                      |       |                                                                      |       |
| Convertible  preferred stock       |       | 47,280                                                                    |       | 60,017                                                                    |       |
| Stock  options                     |       | 894,359                                                                   |       | 912,895                                                                   |       |
| Convertible  notes payable    |       | —                                                                    |       | —                                                                    |       |
| Warrants                           |       | 6,187,541                                                                 |       | 5,772,229                                                                 |       |

 

The following table sets forth the computation of basic and dilutedloss per share for the years ended December 31, 2004 and 2003:

 
| ** **                                 | ** ** | **TWELVE  MONTHS ENDED  DECEMBER 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                    | ** ** | **2003** | ** ** |
| Numerator                                  |       |                                        |       |   |   |
| Net  loss                                  |       | $                                           | (9,638,599 | ) | $ | (10,735,793 | ) |
| Less  Series B preferred dividends         |       | (52,998                                     | )          | (61,356 | ) |
| Net  loss available to common shareholders |       | $                                           | (9,691,597 | ) | $ | (10,797,149 | ) |
|                                       |       |                                        |       |   |   |
| Denominator                                |       |                                        |       |   |   |
| Weighted-average  shares outstanding       |       | 11,739,819                                  |       | 5,953,801 |   |
|                                       |       |                                        |       |   |   |
| Basic  and diluted loss per share          |       | $                                           | (0.83      | ) | $ | (1.81 | ) |

 

*Segment information*

 

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

 

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

 

There are no intersegment transactions.

 

The table below summarizes information about reportable segments forthe years ended December 31, 2004 and 2003:

 

F-11

----

 
| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| Revenues:                            |       |                             |       |   |   |
| Law Enforcement                      |       | $                                | 4,385,741  |   | $ | 3,273,001 |   |
| Identification                       |       | 5,395,002                        |       | 11,783,672 |   |
| Digital Photography                  |       | 742,570                          |       | 1,176,785 |   |
| Total consolidated revenues          |       | $                                | 10,523,313 |   | $ | 16,233,458 |   |
| Operating profit (loss):             |       |                             |       |   |   |
| Law Enforcement                      |       | $                                | (364,933   | ) | $ | (459,243 | ) |
| Identification                       |       | (3,322,335                       | )          | (3,170,974 | ) |
| Digital Photography                  |       | (966,545                         | )          | (290,747 | ) |
| Other unallocated amounts:           |       |                             |       |   |   |
| Interest expense (income)            |       | 5,172,426                        |       | 6,960,140 |   |
|                                 |       |                             |       |   |   |
| Other expense (income)               |       | (187,640                         | )          | (207,046 | ) |
| Loss before taxes                    |       | $                                | (9,638,599 | ) | $ | (10,674,058 | ) |
| Total Assets by Segment:             |       |                             |       |   |   |
| Law Enforcement                      |       | $                                | 1,145,450  |   | $ | 528,175 |   |
| Identification                       |       | 8,277,009                        |       | 8,238,539 |   |
| Digital Photography                  |       | 1,476,045                        |       | 1,502,936 |   |
| Total assets for reportable segments |       | 10,898,504                       |       | 10,269,650 |   |
| Corporate                            |       | 2,460,543                        |       | 546,684 |   |
| Total consolidated assets            |       | $                                | 13,359,047 |   | $ | 10,816,334 |   |

 

The Company has total assets in foreign locations as follows:$2,010,000 in Germany, $166,000 in Canada and $683,000 in Singapore. Revenuesgenerated from the Company’s foreign locations were $1,733,000 and $6,973,000for years ended December 31, 2004 and 2003, respectively.

 

*New Accounting Pronouncements*

 

In November2004, the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4” (“SFAS 151”), which is effective beginning January 1, 2006.  SFAS 151 requires that abnormal amounts ofidle facility expense, freight, handling costs and wasted material berecognized as current period charges. The Statement also requires that the allocation of fixed productionoverhead be based on the normal capacity of the production facilities.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.  

 

In December 2004, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards No. 123R, “Share-Based Payment (“SFAS123R”), which is effective beginning July 1, 2005.  SFAS 123R requires all share-based paymentsto employees to be expensed over the requisite service period based on thegrant-date fair value of the awards.  TheStatement allows for either prospective or retrospective adoption and requiresthat the unvested portion of all outstanding awards upon adoption be recognizedusing the same fair value and attribution methodologies previously determinedunder Statement No 123, “Accounting for Stock-Based Compensation”.  The Company is currently evaluatingtransition alternatives and valuation methodologies for future grants.  As a result, pro forma compensation expense,as reflected in Note 1, may not be indicative of future expense to berecognized under SFAS 123R.  The effectof adoption of 123R on the Company’s financial position or results ofoperations has not yet been determined.  

 

In December2004, the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 153, “Exchange of Nonmonetary Assets, an amendment ofAPR Opinion No. 29” (“SFAS 153”).  Theguidance in APB Opinion No. 29, “Accounting for Nonmonetary Transactions” isbased on the principle that exchanges of nonmonetary assets should be measuredbased on the fair value of the assets exchanged.  The guidance in that Opinion, however,included certain exceptions to that principle. SFAS 153 amends Opinion 29 to eliminate the exception for nonmonetary assetsthat do not have commercial substance.  Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange.  The provisions of SFAS 153 shall be effectivefor nonmonetary asset exchanges occurring in fiscal periods beginning afterJune 15, 2005.  The effect of thisStatement on the Company’s financial position or results of operations has notyet been determined.  

 

In December2004 the Financial Accounting Standards Board issued two FASB StaffPositions—FSP FAS 109-1, *Application of FASB Statement109 "Accounting for Income Taxes" to the Tax Deduction on QualifiedProduction Activities Provided by the American Jobs Creation Act of 2004, andFSP FAS 109-2 Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provision within the American Jobs Creation Act of 2004.*Neither of these affected the Company as it does not participate in the relatedactivities.

 

F-12

----

 

*Reclassifications*

 

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

 

**3.****             Acquisitionsand Goodwill**

 

The following disclosure presents certain information about the Company’sacquired intangible assets as of December 31, 2004 and 2003.  All intangible assets are being amortizedover their estimated useful lives, as indicated below, with no estimatedresidual values.

 
| **Acquired Intangible Assets**        | ** ** | **Amortization  Period** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balance** | ** ** |
|---------------------------------------|------------|--------------------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
| At December 31, 2004             |       |                     |       |                        |       |                          |       |             |       |
| Amortized acquired intangible assets: |       |                     |       |                        |       |                          |       |             |       |
| Technology                            |       | 5 years                  |       | $                           | 1,160,000  |                          | $          | (909,020         | )          | $ | 250,980 |   |
| Trademarks and tradenames             |       | 14.5 years               |       | 630,000                     |       | (175,615                      | )          | 454,385          |       |
| Customer relationship                 |       | 5 years                  |       | 200,000                     |       | (149,990                      | )          | 50,010           |       |
| Non-compete Agreements                |       | 3 years                  |       | 125,000                     |       | (125,000                      | )          | —           |       |
| Patents                               |       | 4 years                  |       | 60,000                      |       | (51,250                       | )          | 8,750            |       |
|                                  |       |                     |       | $                           | 2,175,000  |                          | $          | (1,410,875       | )          | $ | 764,125 |   |
| At December 31, 2003             |       |                     |       |                        |       |                          |       |             |       |
| Amortized acquired intangible assets: |       |                     |       |                        |       |                          |       |             |       |
| Technology                            |       | 5 years                  |       | $                           | 1,160,000  |                          | $          | (678,288         | )          | $ | 481,712 |   |
| Trademarks and tradenames             |       | 14.5 years               |       | 630,000                     |       | (128,119                      | )          | 501,881          |       |
| Customer relationship                 |       | 5 years                  |       | 200,000                     |       | (109,998                      | )          | 90,002           |       |
| Non-compete Agreements                |       | 3 years                  |       | 125,000                     |       | (101,670                      | )          | 23,330           |       |
| Patents                               |       | 4 years                  |       | 60,000                      |       | (36,250                       | )          | 23,750           |       |
|                                  |       |                     |       | $                           | 2,175,000  |                          | $          | (1,054,325       | )          | $ | 1,120,675 |   |

 

Amortization expense for the twelve months ended December 31, 2004was approximately $357,000.

 

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

 

| **Fiscal Year Ended  December 31,** | ** ** | **Estimated Amortization Expense** | ** ** |
|------------------------------------------|------------|------------------------------------|------------|
| 2005                                     |       | 253,000                            |       |
| 2006                                     |       | 50,000                             |       |
| 2007                                     |       | 40,000                             |       |
| 2008                                     |       | 40,000                             |       |
| 2009                                     |       | 40,000                             |       |

 

 

The balance of the Company’s goodwill was $5,297,627 atDecember 31, 2004 and 2003.

 

In June 2002, we completed our transitional goodwill and purchasedintangibles impairment tests outlined under SFAS 142 which required theassessment of goodwill and purchased intangibles for impairment as ofJanuary 1, 2002 and in December 2003 and 2004, we completed ourannual impairment tests.  These testswere conducted by determining and comparing the fair value of our reportingunits, as defined in SFAS 142, to the reporting unit’s carrying value as ofthat date.  Our reporting units are LawEnforcement, Identification and Digital Photography.  Based on the results of these impairmenttests, we determined that our goodwill assets and purchased intangible assetswere not impaired as of January 1, 2002 or during December 2003 andDecember 2004.  We plan to conductour annual impairment tests in the fourth quarter of every year, unlessimpairment indicators exist sooner.

 

**4.****             RestrictedCash**

 

At December 31, 2004 and 2003, the Company had $106,000 and$155,000, respectively, of restricted cash and cash equivalents which serves ascollateral for an irrevocable standby letter of credit that provide financialassurance that the Company will fulfill its obligations under certaincommitments discussed in Note 9. The cash is held in custody by theissuing bank, is restricted as to withdrawal

 

F-13

----

 

or use, and is currently invested in time certificates ofdeposits.  Income from these investmentsis paid to the Company.

 

**5.****             Inventory**

 

Inventories at December 31, 2004 and 2003 were comprised offinished goods of $892,000 and $805,000 net of reserves of $47,000 and$316,000, respectively.  Work in processinventories were $205,000 and $0 at December 31, 2004 and 2003,respectively.  Work in process inventoriesat December 31, 2004 relate to the Company’s in process long-term contractsbeing accounted for under the percentage of completion method.  Inventories are stated at the lower of costor market.  Market is determined based onnet realizable value.  Appropriateconsideration is given to obsolescence, excessive levels, deterioration, andother factors in evaluating net realizable value.

 

**6.             ContractCosts**

 

Costs and estimated billings on uncompleted contracts and relatedamounts billed as of December 31, 2004 and 2003 are as follows:

 
| ** **                              | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|
| ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Costs incurred on uncompleted contracts |       | $          | 707,787    |       | $          | — |   |
| Estimated earnings                      |       | 474,414    |       | —     |       |
|                                    |       | 1,182,201  |       | —     |       |
| Less: Billings to date                  |       | (1,606,500 | )          | —     |       |
|                                    |       | $          | 424,299    |       | $          | — |   |

 

Such amounts are included in the accompanying Balance Sheets atDecember 31, 2004 and 2003 under the caption “Billings in excess of costs andestimated earnings on uncompleted contracts”.

 

**7.****             Propertyand Equipment**

 

Property and equipment at December 31, 2004 and 2003 consists of:

 
| ** **                    | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|
| ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equipment                     |       | $          | 1,551,149  |       | $          | 1,649,901 |   |
| Leasehold improvements        |       | 126,594    |       | 119,930    |       |
| Furniture                     |       | 398,501    |       | 219,685    |       |
|                          |       | 2,076,244  |       | 1,989,516  |       |
| Less accumulated depreciation |       | (1,565,974 | )          | (1,354,550 | )          |
|                          |       | $          | 510,270    |       | $          | 634,966 |   |

 

Total depreciation expense for the years ended December 31, 2004and 2003 was $362,000 and $483,000, respectively.

 

**8.****             NotesPayable and Line of Credit**

 

Notes payable consist of the following:

 
| ** **                                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Notes payable to  bank and third parties:                                                            |       |     |       |     |       |
| Short-term note payable to third party to  accrue interest at 10%. Note due upon demand              |       | $        | —     |     | $          | 100,000 |   |
| Short-term notes payable to certain vendors                                                          |       | 18,491   |       | 81,976   |       |
| Total notes payable to bank and third  parties                                                       |       | 18,491   |       | 181,976  |       |
|                                                                                                 |       |     |       |     |       |
| Notes payable to related parties:                                                                    |       |     |       |     |       |
| Short-term note payable to ITC shareholder.  Such note accrues interest at 7% and is due upon demand |       | —   |       | 59,000   |       |
| Total notes payable to related parties                                                               |       | —   |       | 59,000   |       |
|                                                                                                 |       |     |       |     |       |
| Total notes payable                                                                                  |       | $        | 18,491     |     | $          | 240,976 |   |
| Less current portion                                                                                 |       | (18,491  | )          | (240,976 | )          |
| Long-term notes payable                                                                              |       | $        | —     |     | $          | — |   |

 

At December 31, 2003, the Company had notes payable to a related partyof $59,000.  Under the terms of the note,the Company is required to make monthly payments of $15,000 until the note ispaid in full.  During 2004, the Companyrepaid this note in full. 

 

During 2004, the Company fulfilled its obligation pursuant to asettlement agreement dated February 28, 2003. It is the opinion of legal counsel that the settlement agreementreleased the Company from indebtedness in the form of short-term notes payableof $100,000.  Accordingly, the Companyhas recorded debt extinguishment of $100,000 plus accrued interest as otherincome.

 

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

 

Future maturities of notes payable as of December 31, 2004 are$18,491 due at various dates in 2005 and $0 due thereafter.

 

**9.****             Warrant Liability**

 

In conjunction with the Company’s issuance ofsecured convertible promissory notes in June 2003, 

 

F-14

----

 

(“the Notes”), the Company agreed to register with the Securities andExchange Commission the shares of common stock underlying the warrants issuedin connection with the New Notes.  Inconjunction with the Company’s issuance of common stock in separate privateplacement transactions in November 2003 and January 2004, the Company agreed toregister with the Securities and Exchange Commission the shares of common stockunderlying the warrants issued as part of the private placement transactions.  In accordance with the Financial AccountingStandards Board Emerging Issue Task Force 00-19 (“EITD 00-19”), the Company hasrecorded a long-term liability for the allocated value of the warrants.  Accordingly, the Company is accounting forthe liability under fair value accounting. During the three months ended June 30, 2004, the Company registered withthe Securities and Exchange Commission the shares of common stock underlyingthe warrants issued in connection with both the notes and private placement transactions.  In accordance with EITF 00-19, the Companyhas reclassified the fair value of the warrant liability as determined on theeffective date of the registration statements to additional paid in capital.  The following table sets forth the changes infair value, resulting interest income or expense of this liability asdetermined under fair value accounting and amount reclassified to additionalpaid in capital during 2004:

 
| ** **                                                                                                                                                                                                           | ** ** | **Warrant  Liability  in Conjunction  with warrants  issued with  New Notes** | ** ** | **Interest  Expense  (Income)  from warrant  revaluation  of New Notes  Warrants** | ** ** | **Warrant  Liability  in Conjunction  with warrants  issued with  November 2003  Private  Placement** | ** ** | **Interest  Expense  (Income)  from warrant  revaluation of  November 2003  Private  Placement  Warrants** | ** ** | **Warrant  Liability  in Conjunction  with warrants  issued with  January 2004  Private  Placement** | ** ** | **Interest  Expense  (Income)  from warrant  revaluation of  January 2004  Private  Placement  Warrants** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|-----------|------------|
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability  at December 31, 2003                                                                                                                                                                         |       | $                                                                             | 2,046,000  |                                                                               |       |                                                                                                       | $          | 1,414,000                                                                                                       |       |                                                                                                      |       | $                                                                                                              | —     |      |       |   | $ | 3,460,000 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability  at date of inception of warrants issued in January 2004 private  placement of securities                                                                                                     |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       | $                                                                                                         | 1,080,000  |                                                                                                           |       |      | $          | 1,080,000 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Change in fair  value of warrant liability                                                                                                                                                                           |       | $                                                                             | 669,000    |                                                                               | $          | 669,000                                                                                                    |       | $                                                                                                               | 309,000    |                                                                                                      | $          | 309,000                                                                                                        |       | $         | (113,000   | ) | $ | (113,000 | ) | $ | 865,000 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability  at March 31, 2004                                                                                                                                                                            |       | $                                                                             | 2,715,000  |                                                                               |       |                                                                                                       | $          | 1,723,000                                                                                                       |       |                                                                                                      |       | $                                                                                                              | 967,000    |      |       |   | $ | 5,405,000 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Change in fair  value of warrant liability due to final valuation of warrant liability upon  registration of underlying shares with Securities and Exchange Commission  during three months ended June 30, 2004 |       | $                                                                             | 2,516,000  |                                                                               | $          | 2,516,000                                                                                                  |       | $                                                                                                               | 1,248,000  |                                                                                                      | $          | 1,248,000                                                                                                      |       | $         | (157,000   | ) | $ | (157,000 | ) | $ | 3,607,000 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability  at date of final valuation                                                                                                                                                                        |       | $                                                                             | 5,231,000  |                                                                               |       |                                                                                                       | $          | 2,971,000                                                                                                       |       |                                                                                                      |       | $                                                                                                              | 810,000    |      |       |   | $ | 9,012,000 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Reclassification  of warrant liability to additional paid-in-capital                                                                                                                                                 |       | $                                                                             | (5,231,000 | )                                                                                  |       |                                                                                                       | $          | (2,971,000                                                                                                      | )          |                                                                                                      |       | $                                                                                                              | (810,000   | )         |       |   | $ | (9,012,000 | ) |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability  at December 31, 2004                                                                                                                                                                         |       | $                                                                             | (0         | )                                                                                  |       |                                                                                                       | $          | 0                                                                                                               |       |                                                                                                      |       | $                                                                                                              | 0          |      |       |   | $ | 0 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Interest Expense  (Income) from revaluation of warrant liability for twelve months ended  December 31, 2004                                                                                                     |       |                                                                          |       | $                                                                                  | 3,185,000  |                                                                                                       |       |                                                                                                            | $          | 1,557,000                                                                                                 |       |                                                                                                           |       | $         | (270,000   | ) | $ | 4,472,000 |   |

 

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

 

F-15

----

 

**10.****          IncomeTaxes**

 

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

 
| ** **   | ** ** | **December 31,** | ** ** |
|--------------|------------|-----------------------|------------|
| ** **   | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Current**  |       |                  |       |   |   |
| Federal      |       | $                     | —     |   | $ | — |   |
| State        |       | —                |       | — |   |
| Foreign      |       | —                |       | — |   |
|         |       |                  |       |   |   |
| **Deferred** |       |                  |       |   |   |
| Federal      |       | —                |       | — |   |
| State        |       | —                |       | — |   |
| Foreign      |       | —                |       | 61,735 |   |
|         |       |                  |       |   |   |
|         |       | $                     | —     |   | $ | 61,735 |   |

 

The principal components of the Company’s deferred tax assets(liabilities) at December 31, 2004 and 2003 are as follows:

 
| ** **                       | ** ** | **2004**    | ** ** | **2003**   | ** ** |
|----------------------------------|------------|-------------|------------|------------|------------|
|                             |       |        |       |       |       |
| Net operating loss carryforwards |       | $           | 10,556,565 |       | $          | 8,586,589 |   |
| Research and development credits |       | 698,985     |       | 607,614    |       |
| Intangible Assets                |       | 622,246     |       | 534,656    |       |
| Reserves and accrued expenses    |       | 52,491      |       | 248,875    |       |
| Other                            |       | (48,548     | )          | (48,550    | )          |
|                             |       | 11,881,739  |       | 9,929,184  |       |
| Less valuation allowance         |       | (11,881,739 | )          | (9,929,184 | )          |
|                             |       |        |       |       |       |
| Net deferred tax assets          |       | $           | —     |       | $          | — |   |

 

F-16

----

 

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

 
| ** **                               | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------------------|------------|-----------|------------|-----------|------------|
|                                     |       |      |       |      |       |
| Amounts computed at statutory rates      |       | $         | (3,276,580 | )         | $          | (3,649,626 | ) |
| State income tax, net of federal benefit |       | (182,883  | )          | (201,348  | )          |
| Foreign tax                              |       | 0         |       | 61,735    |       |
| Non-deductible interest                  |       | 1,556,727 |       | 1,823,746 |       |
| Other                                    |       | (49,819   | )          | (13,930   | )          |
| Net change in valuation allowance        |       | 1,952,555 |       | 2,039,910 |       |
|                                     |       |      |       |      |       |
|                                     |       | $         | 0          |      | $          | 60,487 |   |

 

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

 

At December 31, 2004 and 2003, the Company had federal net operatingloss carryforwards of approximately $28,398,000 and $23,104,000, respectively,state net operating loss carryforwards of approximately $15,445,000 and$12,534,000, respectively, which may be available to offset future taxableincome for tax purposes.  The federal netoperating loss carryforwards expire at various dates from 2005 through2024.  The state net operating losscarryforwards expire at various dates from 2005 through 2009.  In addition, the Company had foreignoperating losses carryforwards of approximately $659,000 at December 31,2004.

 

The Company also had federal research credit carryforwards ofapproximately $450,000 and $396,000 and state research credit carryforwards ofapproximately $249,000 and $212,000 for tax purposes at December 31, 2004and 2003, respectively.  The federalcarryforwards will begin to expiring, if unused, in 2008.

 

The Internal Revenue Code (the “Code”) limits the availability of netoperating losses and certain tax credits that arose prior to certain cumulativechanges in a corporations’s ownership resulting in a change of control of theCompany.  The Company’s use of its netoperating loss carryforwards and tax credit carryforwards will be significantlylimited because the Company underwent “ownership changes” in 1991, 1995, 2000,2003 and 2004.  

 

**11.****          Commitmentsand Contingencies**

 

*Employment Agreements*

 

The Company has employment agreements with its Chief Executive Officer,Senior Vice President of Administration and Chief Financial Officer,  The Company may terminate the agreements withor without cause. Should the Company terminate the agreements without cause,the officers are entitled to compensation ranging from 12 to 36 months ofsalary.

 

*Letter of Credit*

 

As collateral for performance on a software installation andimplementation contract, the Company is contingently liable under anirrevocable standby letter of credit in an amount of approximately $106,000.This letter of credit expires on December 26, 2008.  As a condition, the bank requires the Companyto invest an equal amount in the form of certificate of deposit.  As of December 31, 2004, there were nodrawings against the outstanding balance.

 

*Litigation*

 

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

 

F-17

----

 

*Leases*

 

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

 

At December 31, 2004, future minimum lease payments are asfollows:

 
| 2005   |   | $ | 792,000   |   |
|--------|--------|---|-----------|--------|
| 2006   |   | $ | 859,000   |   |
| 2007   |   | $ | —    |   |
| 2008   |   | $ | —    |   |
| 2009   |   | $ | —    |   |
|   |   | $ | 1,651,000 |   |

 

The Company is committedto a three year lease for office space housing its Digital Photographyoperations in Costa Mesa, California which is for 4,275 square feet. During 2002, the Company consolidated these operations into its corporateheadquarters in San Diego, California and vacated the premises.  The Company does not intend to occupy this spaceand has sub-let this space.  During 2002,the Company recorded an estimated loss on its lease commitment totaling$132,416. In determining this estimated loss for its lease commitment, theCompany was required to make various assumptions, including occupancy dates fornew tenants, sub-lease rental rates, tenant improvement allowances, abandonedleasehold improvements and commission payments, that involve estimates andjudgments.  In formulating its assumptions, the Company took into accountcurrent and projected real estate market conditions.  During May 2003, theCompany entered into an agreement to sublet this office space.  Under the terms of the sublease, the Companywill receive rents of $144,000 over the term of the sublease.  As a result of this sublease, the Companyrecorded an additional $38,000 in estimated loss on its lease commitment in2003 and $0 in 2004.  If the Company’sestimates and related assumptions change in the future, the Company may berequired to revise this estimated loss on its lease commitment.  If anyrevisions to its estimated loss are necessary, then an additional loss or abenefit will be recorded.

 

The Company is committedto a five year lease for office space housing its South Carolina office.  This lease is for 5,500 square feet andexpires in December 2006.  The Companyconsolidated these operations into its corporate headquarters in San Diego,California and sublet this premises during 2003.  Concurrent with our departure, the Companysublet this premises under the same terms for which it was obligated.  

 

Rental expense under operating leases for the years endedDecember 31, 2003 and 2004 was approximately $608,000 and $828,000respectively.

 

**12.****          Equity**

 

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

 

*Series B Convertible, RedeemablePreferred Stock*

 

In April 1995, the Company’s Articles of Incorporation wereamended to authorize 750,000 shares of Series B Convertible RedeemablePreferred Stock (“Series B”).  Each 5.275shares of Series B are convertible into one share of the Company’s commonstock. As of December 31, 2004, the Company had 249,400 shares ofSeries B outstanding.

 

The holders of Series B are entitled to cumulative preferreddividends payable at the rate of $.2125 per share per annum commencingApril 30, 1996, subject to legally available funds. The Series B plusaccrued but unpaid dividends are convertible at the option of the holder intoshares of common stock at a conversion price equal to the originalSeries B issue price as adjusted to prevent dilution. The Series Bwill automatically be converted into shares of common stock upon the closing ofan underwritten public offering at a price per common share of not less than$31.65. If the public offering price is less than $31.65 but at least $21.10per share, the conversion shall still be automatic upon written consent of amajority of the then outstanding shareholders of Series B.

 

The holders of Series B, on an as-converted basis, have the samevoting rights per share as the Company’s common shares; provided, that theholders of Series B has a special right to elect one director if theCompany defaults in the payment of any dividend to the holders ofSeries 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 stock plusall 

 

F-18

----

 

accrued but unpaid dividends.

 

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

 

The Company had 249,400 shares of Series B outstanding as ofDecember 31, 2003 and 2004. At December 31, 2004 and 2003, theCompany had cumulative undeclared dividends of approximately $9,000 and$174,000, respectively.

 

*Common Stock*

 

On January 29, 2004, the Company completed a private placement,which involved the sale of units consisting of one share of common stock and awarrant to purchase 0.20 shares of common stock.  Each unit was priced at $3.65.  The warrants, which are first exercisablesix-months after the closing date, have a five-year term and an exercise priceof $5.48 per share.  As a result of thistransaction, the Company issued an aggregate of approximately 1,818,000 newshares of common stock and warrants to purchase up to approximately 364,000shares of common stock.  In connectionwith this transaction, the Company also issued to certain placement agentswarrants to purchase an additional 199,000 shares of common stock.  The Company raised approximately $6.6 millionfrom the private placement, and has used the net proceeds for working capital.

 

During twelve month period ended December 31, 2004, the Company issued25,263 shares of its common stock pursuant to stock-based compensationagreements.  In accordance with Financial AccountingStandards Board Interpretation No. 44 — Accounting for Certain TransactionsInvolving Stock Compensation (“FIN 44”), the Company will recognize stock-basedcompensation expense ratably over the vesting period of the restricted stockbased on the intrinsic value of the award at the measurement date.  The intrinsic value of the award at themeasurement date was $3.85 per share based on the closing price of theCompany's Common Shares as reported by the American Stock Exchange.

 

Effective December 31, 2004, the Company rescinded a shareholder notereceivable in the amount of $150,000. The Company had held 25,000 shares of its common stock as collateral forthis note.  As a result of thisrecission, the Company has cancelled 25,000 of previously issued common shares.

 

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

 

*Warrants*

 

As of December 31, 2004, warrants to purchase 6,328,181 shares ofcommon stock at prices ranging from $1.83 to $16.46 were outstanding. Allwarrants are exercisable as of December 31, 2004 and expire at variousdates through January 2010.

 

The following table summarizes warrantactivity since 2002:

 
| ** **                       | ** ** | **Warrants**  | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|----------------------------------|------------|---------------|------------|----------------------------------------|------------|
|                             |       |          |       |                                   |       |
| **Balance at December 31, 2002** | ** ** | **2,915,508** | ** ** | **$**                                  | **10.87**  | ** ** |
| **Granted**                      | ** ** | **2,887,721** | ** ** | **$**                                  | **2.32**   | ** ** |
| **Expired / Canceled**           | ** ** | **(31,000**   | **)**      | **$**                                  | **6.25**   | ** ** |
| **Exercised**                    | ** ** | **—**    | ** ** | **$**                                  | **—** | ** ** |
| **Balance at December 31, 2003** | ** ** | **5,772,229** | ** ** | **$**                                  | **6.62**   | ** ** |
| **Granted**                      | ** ** | **647,768**   | ** ** | **$**                                  | **5.07**   | ** ** |
| **Expired / Canceled**           | ** ** | **(140,639**  | **)**      | **$**                                  | **8.05**   | ** ** |
| **Exercised**                    | ** ** | **(91,817**   | **)**      | **$**                                  | **2.27**   | ** ** |
| **Balance at December 31, 2004** | ** ** | **6,187,541** | ** ** | **$**                                  | **6.49**   | ** ** |

 

F-19

----

 

The following table summarized informationabout warrants outstanding and exercisable at December 31, 2004:

 
| **Exercise Price** | ** **                    | **Number  Outstanding** | ** ** | **Weighted—Average  Remaining Life (Years)** | ** ** | **Weighted—Average  Exercise Price** | ** ** |
|--------------------|-------------------------------|-------------------------|------------|---------------------------------------------------|------------|-------------------------------------------|------------|
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     1.83  |                    | 29,070     |                                              | 3.9        |                                      | $          | 2.11 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     2.11  |                    | 1,566,323  |                                              | 4.45       |                                      | $          | 2.11 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     2.41  |                    | 344,951    |                                              | 3.9        |                                      | $          | 2.41 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     2.58  |                    | 855,561    |                                              | 3.9        |                                      | $          | 2.58 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     3.00  |                    | 85,000     |                                              | 2.09       |                                      | $          | 3.00 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     3.55  |                    | 200,282    |                                              | 2.39       |                                      | $          | 3.55 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     4.66  |                    | 63,012     |                                              | 4.08       |                                      | $          | 4.66 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     5.48  |                    | 499,755    |                                              | 4.08       |                                      | $          | 5.48 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     7.91  |                    | 13,586     |                                              | 5.04       |                                      | $          | 7.91 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     9.60  |                    | 181,339    |                                              | 0.24       |                                      | $          | 9.60 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     10.86 |                    | 176,273    |                                              | 0.83       |                                      | $          | 10.86 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     12.00 |                    | 2,162,389  |                                              | 0.37       |                                      | $          | 12.00 |   |
|               |                          |                    |       |                                              |       |                                      |       |
| $                  |     15.00 |                    | 10,000     |                                              | 0.69       |                                      | $          | 15.00 |   |
|               |                          |                    |       |                                              |       |                                      |       |
|               |                          | 6,187,541               |       |                                              |       |                                      |       |

 

**13.****          StockOption Plans**

 

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

 

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

 

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

 

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

 

F-20

----

 

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

 

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

 

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

 

# **Stock Option PlansAs of December 31, 2004**

# ** **

 
| ** **        | ** ** | **Number of securities to be  issued upon exercise of  outstanding options** | ** ** | **Number of securities  remaining available for  future issuance under equity  compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|-------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **        | ** ** | **(a)**                                                                      |       | **(b)**                                                                                                                                              |       |
| 1994 Plan         |       | 111,750                                                                      |       | -0-                                                                                                                                                  |       |
| Nonqualified Plan |       | 2,465                                                                        |       | -0-                                                                                                                                                  |       |
| 1999 Plan         |       | 243,500                                                                      |       | 105,560                                                                                                                                              |       |
| 2001 Plan         |       | 536,644                                                                      |       | 97,568                                                                                                                                               |       |
| Total             |       | 894,359                                                                      |       | 203,128                                                                                                                                              |       |

 

The following table summarizes employee stock option activity sinceDecember 31, 2002:

 
| ** **                        | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|-----------------------------------|------------|-------------|------------|----------------------------------------|------------|
|                              |       |        |       |                                   |       |
| Balance at December 31, 2002 |       | 1,397,678   |       | $                                      | 4.59       |   |
| Granted                           |       | 203,750     |       | $                                      | 2.52       |   |
| Expired/canceled                  |       | (261,422    | )          | $                                      | 3.77       |   |
| Exercised                         |       | (0          | )          | $                                      | 0          |   |
|                              |       |        |       |                                   |       |
| Balance at December 31, 2003 |       | 1,340,006   |       | $                                      | 4.44       |   |
| 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       |   |

 

F-21

----

 

AtDecember 31, 2004, a total of 575,686 options were exercisable at aweighted average price of $3.07 per share. At December 31, 2003, a totalof 912,895 options were exercisable at a weighted average price of $5.03 pershare.

 

The following table summarizes information about employee stock optionsoutstanding and exercisable at December 31, 2004:

 
| ** **         | ** ** | **Options Outstanding** | ** ** | ** **                                      | ** ** | **Options Exercisable**                | ** ** |
|--------------------|------------|-------------------------|------------|-------------------------------------------------|------------|----------------------------------------|------------|
| **Exercise Price** | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining Life  (Years)** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|               |       |                    |       |                                            |       |                                   |       |   |   |   |   |
| $1.97 - 2.15       |       | 205,084                 |       | 6.26                                            |       | $                                      | 2.10       |   | 53,017 |   | $ | 2.05 |   |
| $2.30 – 3.25  |       | 646,788                 |       | 8.27                                            |       | $                                      | 2.70       |   | 467,603 |   | $ | 2.78 |   |
| $5.28 – 11.00 |       | 42,487                  |       | 6.53                                            |       | $                                      | 5.97       |   | 55,066 |   | $ | 6.51 |   |
|               |       |                    |       |                                            |       |                                   |       |   |   |   |   |
| **Total**          | ** ** | **894,359**             | ** ** | ** **                                      |       |                                   |       | **575,686** |   |   |   |

 

The weighted-average grant-date fair value per share of options grantedto employees during the years ended December 31, 2004 and 2003 was $1.82and $1.61, respectively.

 

**14.****          EmployeeBenefit Plan**

 

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

 

Employees are fully vested in their share of the Company’s contributionsafter the completion of five years of service. The Company made a contributionin 2004 of approximately $45,000 for the 2003 plan year and has accrued acontribution of approximately $40,000 for the 2004 plan year.

 

**15.****          PensionPlan**

 

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

 

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

 

F-22

----

 
| ** **                                                                                                                                                          | ** ** | **2004**  | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------|------------|
| Change in benefit obligation:                                                                                                                                       |       |      |       |     |       |
| Benefit obligation at beginning of year                                                                                                                             |       | $         | 708,105    |     | $          | 883,483 |   |
| Service cost                                                                                                                                                        |       | 8,296     |       | 72,200   |       |
| Interest cost                                                                                                                                                       |       | 59,726    |       | 78,795   |       |
| Actuarial gain (loss)                                                                                                                                               |       | 124,228   |       | (66,520  | )          |
| Effect of exchange rate changes                                                                                                                                     |       | 253,527   |       | 150,277  |       |
| Effect of curtailment                                                                                                                                               |       | —    |       | (410,130 | )          |
| Benefits paid                                                                                                                                                       |       | —    |       | —   |       |
| Benefit obligation at end of year                                                                                                                                   |       | 1,153,882 |       | 708,105  |       |
|                                                                                                                                                                |       |      |       |     |       |
| Change in plan assets                                                                                                                                               |       |      |       |     |       |
| Fair value of plan assets at beginning of  year                                                                                                                     |       | 304,594   |       | 235,211  |       |
| Actual return of plan assets                                                                                                                                        |       | (104,215  | )          | (29,357  | )          |
| Company contributions                                                                                                                                               |       | 141,815   |       | 98,740   |       |
| Benefits paid                                                                                                                                                       |       | —    |       | —   |       |
| Fair value of plan assets at end of year                                                                                                                            |       | 342,194   |       | 304,594  |       |
|                                                                                                                                                                |       |      |       |     |       |
| Funded status                                                                                                                                                       |       | (811,688  | )          | (406,121 | )          |
| Unrecognized actuarial loss (gain)                                                                                                                                  |       | 236,105   |       | (326,364 | )          |
| Unrecognized prior service (benefit) cost                                                                                                                           |       | —    |       | —   |       |
| Unrecognized transition (asset) liability                                                                                                                           |       | —    |       | —   |       |
| Net amount recognized                                                                                                                                               |       | $         | (575,583   | )        | $          | (732,485 | ) |
|                                                                                                                                                                |       |      |       |     |       |
| The weighted average assumptions used to  determine benefit obligations for the years ended December 31 were:                                                  |       |      |       |     |       |
| Discount rate                                                                                                                                                       |       | 4.5       | %          | 5.5      | %          |
| Expected return on plan assets                                                                                                                                      |       | 4.5       | %          | 6.0      | %          |
| Rate of compensation increase                                                                                                                                       |       | N/A       |       | 1.5      | %          |
|                                                                                                                                                                |       |      |       |     |       |
| Plan Assets                                                                                                                                                         |       |      |       |     |       |
| Pension plan assets were comprised of the  following asset categories at December 31                                                                                |       |      |       |     |       |
| Equity securities                                                                                                                                                   |       | 5.70      | %          | 7.10     | %          |
| Debt securities                                                                                                                                                     |       | 88.80     | %          | 86.90    | %          |
| Other                                                                                                                                                               |       | 5.50      | %          | 6.00     | %          |
| Total                                                                                                                                                               |       | 100       | %          | 100      | %          |
|                                                                                                                                                                |       |      |       |     |       |
| Components of net periodic benefit cost are  as follows:                                                                                                            |       |      |       |     |       |
| Service cost                                                                                                                                                        |       | 8,296     |       | 72,200   |       |
| Interest cost on projected benefit  obligations                                                                                                                     |       | 59,726    |       | 78,795   |       |
| Expected return on plan assets                                                                                                                                      |       | (23,943   | )          | (24,006  | )          |
| Amortization of prior service costs                                                                                                                                 |       | —    |       | —   |       |
| Amortization of actuarial loss                                                                                                                                      |       | —    |       | —   |       |
| Net periodic benefit costs                                                                                                                                          |       | 44,079    |       | 126,989  |       |
|                                                                                                                                                                |       |      |       |     |       |
| The weighted average assumptions used to  determine net periodic benefit cost for the years ended December 31, were                                                 |       |      |       |     |       |
| Discount rate                                                                                                                                                       |       | 4.5       | %          | 5.5      | %          |
| Expected return on plan assets                                                                                                                                      |       | 4.5       | %          | 6.0      | %          |
| Rate of compensation increase                                                                                                                                       |       | N/A       |       | 1.5      | %          |
|                                                                                                                                                                |       |      |       |     |       |
| 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                                                                                                                                        |       | 1,153,882 |       | 708,105  |       |
| Accumulated benefit obligation                                                                                                                                      |       | 1,153,882 |       | 950,383  |       |
| Fair value of plan assets                                                                                                                                           |       | 342,193   |       | 304,594  |       |

 

The following benefit payments are expected tobe paid as follows:

 
| 2005        |   | 567     |   |
|-------------|--------|---------|--------|
| 2006        |   | 1,896   |   |
| 2007        |   | 3,446   |   |
| 2008        |   | 5,280   |   |
| 2009        |   | 7,460   |   |
| 2010 - 2014 |   | 105,995 |   |

 

F-23

----

 

**16.****          ExitActivities**

 

The Company adopted the provisions of Statement of Financial AccountingStandard (“SFAS”) No. 146 — Accounting for Costs Associated with Exit orDisposal Activities in the fourth fiscal quarter of the year endedDecember 31, 2002.  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.  Inconnection with this exit activity, the Company also reduced headcount.  The Company has recorded a liability for theremaining lease payments under the operating lease net of estimated subleaserents of $132,000 and accrued $6,000 in severance as of December 31,2002.  These expenses are classified aspart of general and administrative expenses as of December 31, 2002.

 

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

 

The following table summarizes charges recorded and changes in the exitactivities reserve during 2003 and 2004:

 

| Accrued for exit activities at  December 31, 2002 |   | $       | 138,000 |   |
|--------------------------------------------------------|--------|---------|---------|--------|
|                                                   |   |    |    |
| Reductions to exit activity reserve:                   |   |    |    |
| Payments:                                              |   |    |    |
| Severance                                              |   | (6,000  | )       |
| Lease Obligation, net of Sublease income               |   | (97,000 | )       |
|                                                   |   |    |    |
| Additions to exit activity reserve:                    |   |    |    |
| Additions to reserve based on sublease  finalization   |   | 38,000  |    |
|                                                   |   |    |    |
| Accrued for exit activities at December 31,  2003      |   | 73,000  |    |
|                                                   |   |    |    |
| Reductions to exit activity reserve:                   |   |    |    |
| Payments:                                              |   |    |    |
| Lease Obligation, net of Sublease income               |   | (37,000 | )       |
|                                                   |   |    |    |
| Accrued for exit activities at  December 31, 2004 |   | $       | 36,000  |   |

 

 

F-24

----

 

**17.****          SubsequentEvent (Unaudited)**

 

On March 3, 2005, the Company entered into a Stock Purchase Agreementwith Argus Solutions, Ltd., a New South Wales, Australia corporation (“Argus”),for the sale to Argus of our wholly-owned Singapore subsidiary, Digital ImagingAsia Pacific Pte. Ltd., for cash of $1.3 million.  The sale closed on March 3, 2005.  

 

We also purchased USD $250,000 of shares of stock of Argus at a priceof AUD $0.162 per share, which represents approximately one percent of thevoting equity of Argus.  As part of theagreement, our Chairman and CEO will join Argus’ Board of Directors during thefirst quarter of 2005.  In addition,Argus purchased 71,225 shares of the Company’s common stock at a price of USD$3.51 per share for a total of approximately USD $250,000 in an unregisteredoffering.  

 

Subsequent to December 31, 2004, the Company issued 65,787 shares ofcommon stock pursuant to stock option exercises and issuances of restrictedstock to certain employees.

 

F-25

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