United
States Securities and Exchange Commission


Washington,
D.C.  20549




FORM
10-K




þ
            Annual Report Pursuant to
      Section 13 or 15(d) of the Securities Exchange Act of
      1934


For the
fiscal year ended June 30, 2009





or





 ̈
            Transition Report Pursuant to
      Section 13 or 15(d) of the Securities Exchange Act of
      1934


For the
transition period from __________ to ____________





Commission
File No.  001-33407




IsoRay,
Inc.


(Exact
name of registrant as specified in its charter)




Minnesota
                            (State
      of incorporation)
                          41-1458152
                            (I.R.S.
      Employer Identification No.)350 Hills St., Suite 106
                            Richland, Washington
                            (Address
      of principal executive offices)
                          99354
                            (Zip
      code)





Registrant's
telephone number, including area code:  (509)
375-1202





Securities
registered pursuant to Section 12(b) of the Exchange Act – Common Stock – $0.001
par value


(NYSE
Amex)





Securities
registered pursuant to Section 12(g) of the Exchange Act – Series C Preferred
Share Purchase Rights





Number of shares outstanding
of each of the issuer's classes of common equity:





Class
              
              Outstanding as of September 14,
      2009Common
      stock, $0.001 par value
              
              22,942,088





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




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes o No x




Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes x No
o




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files). Yes x No o




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  o




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.


Large
accelerated filer o       Accelerated
filer o       Non-accelerated
filer o


Smaller
reporting company x





Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Act):
YesoNox




State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant’s most recently completed second fiscal
quarter – $4,509,712 as of December 31, 2008.




Documents
incorporated by reference – none.








ISORAY,
INC.





Table
of Contents




PageITEM
      1 – BUSINESS
                        1ITEM
      1A – RISK FACTORS
                        23ITEM
      1B – UNRESOLVED STAFF COMMENTS
                        31ITEM
      2 – PROPERTIES
                        31ITEM
      3 – LEGAL PROCEEDINGS
                        31ITEM
      4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
                        31ITEM
      5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
      ISSUER PURCHASES OF EQUITY SECURITIES
                        32ITEM
      6 – SELECTED FINANCIAL DATA
                        33ITEM
      7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS
                        34ITEM
      7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK
                        46ITEM
      8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
                        46ITEM
      9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
      FINANCIAL DISCLOSURE
                        46ITEM
      9A – CONTROLS AND PROCEDURES
                        46ITEM
      9B – OTHER INFORMATION
                        47ITEM
      10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE
                        47ITEM
      11 – EXECUTIVE COMPENSATION
                        51ITEM
      12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
      RELATED STOCKHOLDER MATTERS
                        54ITEM
      13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
      INDEPENDENCE
                        55ITEM
      14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES
                        56ITEM
      15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
                        57SIGNATURES
                        61





Caution Regarding
Forward-Looking Information





In
addition to historical information, this Form 10-K contains certain
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 (PSLRA).  This statement is included for the
express purpose of availing IsoRay, Inc. of the protections of the safe harbor
provisions of the PSLRA.





All
statements contained in this Form 10-K, other than statements of historical
facts, that address future activities, events or developments are
forward-looking statements, including, but not limited to, statements containing
the words "believe," "expect," "anticipate," "intends," "estimate," "forecast,"
"project," and similar expressions.  All statements other than statements
of historical fact are statements that could be deemed forward-looking
statements, including any statements of the plans, strategies and objectives of
management for future operations; any statements concerning proposed new
products, services, developments or industry rankings; any statements regarding
future revenue, economic conditions or performance; any statements of belief;
and any statements of assumptions underlying any of the foregoing.  These
statements are based on certain assumptions and analyses made by us in light of
our experience and our assessment of historical trends, current conditions and
expected future developments as well as other factors we believe are appropriate
under the circumstances.  However, whether actual results will conform to
the expectations and predictions of management is subject to a number of risks
and uncertainties described under Item 1A – Risk Factors beginning on page 23
below that may cause actual results to differ materially.





Consequently,
all of the forward-looking statements made in this Form 10-K are qualified by
these cautionary statements and there can be no assurance that the actual
results anticipated by management will be realized or, even if substantially
realized, that they will have the expected consequences to or effects on our
business operations.  Readers are cautioned not to place undue reliance on
such forward-looking statements as they speak only of the Company's views as of
the date the statement was made.  The Company undertakes no obligation to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise.





PART
I





As used
in this Form 10-K, unless the context requires otherwise, “we” or “us” or the
“Company” means IsoRay, Inc. and its subsidiaries.





ITEM
1 – BUSINESS





General





Century
Park Pictures Corporation (Century) was organized under Minnesota law in
1983.  Century had no operations since its fiscal year ended September 30,
1999 through June 30, 2005.





On July
28, 2005, IsoRay Medical, Inc. (Medical) became a wholly-owned subsidiary of
Century pursuant to a merger.  Century changed its name to IsoRay, Inc.
(IsoRay or the Company).  In the merger, the Medical stockholders received
approximately 82% of the then outstanding securities of the
Company.





Medical,
a Delaware corporation, was incorporated on June 15, 2004 to develop,
manufacture and sell isotope-based medical products and devices for the
treatment of cancer and other malignant diseases.  Medical is headquartered
in Richland, Washington.





IsoRay
International LLC (International), a Washington limited liability company, was
formed on November 27, 2007 and is a wholly-owned subsidiary of the
Company.  International has not had any significant transactions since its
inception.


1





Available
Information





The
Company electronically files its annual reports on Form 10-K, quarterly reports
on Form 10-Q, current reports on Form 8-K, and all amendments to these reports
and other information with the Securities and Exchange Commission (SEC). 
These reports can be obtained by accessing the SEC’s website at
www.sec.gov.  The public can also obtain copies by visiting the SEC’s
Public Reference Room at 100 F Street NE, Washington, DC 20549 or by calling the
SEC at 1-800-SEC-0330.  In addition, the Company makes copies of its annual
and quarterly reports available to the public at its website at
www.isoray.com.  Information on this website is not a part of this
report.





Business
Operations





Overview





In 2003,
IsoRay obtained clearance from the FDA for treatment for all solid tumor
applications using Cesium-131 (Cs-131).  Such applications include prostate
cancer; ocular melanoma; head, neck and lung tumors; and breast, liver, brain
and pancreatic cancer.  The seed may be used in surface, interstital and
intracavity applications for tumors with known radio sensitivity. 
Management believes its Cs-131 technology will allow it to become a leader in
the brachytherapy market.  Management believes that the IsoRay Proxcelan
Cesium-131 brachytherapy seed represents the first major advancement in
brachytherapy technology in over 21 years with attributes that could make it the
long-term “seed of choice” for internal radiation therapy
procedures.





IsoRay
began production and sales of Proxcelan Cesium-131 brachytherapy seeds in
October 2004 for the treatment of prostate cancer after clearance of its
premarket notification (510(k)) by the Food and Drug Administration (FDA). 
In December 2007, IsoRay began selling its Proxcelan Cs-131 seeds for the
treatment of ocular melanoma.  On June 1, 2009, the Company again expanded
its application of Cs-131 with the treatment of a head and neck tumor that could
not be accessed by other treatment modalities.  More recently the Company
has focused on other applications which require revising the delivery system
from those historically used by the Company.





In August
2009, IsoRay Medical received clearance from the FDA for its Premarket
Notification (510(k)) for ProxcelanTM Cesium-131 brachytherapy seeds that are
preloaded into bioabsorbable braided strands. This clearance permits the product
to be commercially distributed for treatment of lung, head and neck tumors as
well as tumors in other organs.  While Cs-131 brachytherapy seeds
themselves have been cleared for treatment in all organs since 2003, this 510(k)
allows Cs-131 seeds to be delivered in a convenient and sterile format that can
be implanted without additional seed loading by the facility.  The 510(k)
also clears the application of braided strands onto a bioabsorbable mesh matrix
to further facilitate the implant procedure.





Brachytherapy
seeds are small devices used in an interstital radiation procedure.  The
procedure has become one of the primary treatments for prostate cancer. 
The brachytherapy procedure places radioactive seeds as close as possible to (in
or near) the cancerous tumor (the word “brachytherapy” means close
therapy).  The seeds deliver therapeutic radiation thereby killing the
cancerous tumor cells while minimizing exposure to adjacent healthy
tissue.  This procedure allows doctors to administer a higher dose of
radiation directly to the tumor.  Each seed contains a radioisotope sealed
within a welded titanium capsule.  When brachytherapy is the only treatment
(monotherapy), approximately 70 to 120 seeds are permanently implanted in the
prostate in an outpatient procedure lasting less than one hour.  The number
of seeds used varies based on the size of the prostate and the activity level
specified by the physician. When brachytherapy is combined with external beam
radiation or intensity modulated radiation therapy (dual therapy), then
approximately 40-80 seeds are used in the procedure.  The isotope decays
over time and eventually the seeds become inert.  The seeds may be used as
a primary treatment or in conjunction with other treatment modalities, such as
chemotherapy, or as treatment for residual disease after excision of primary
tumors.  The number of seeds for other treatment sites will vary from as
few as 10-12 to as many at 80-100 depending on the location of the tumor being
treated.


2





Brachytherapy
Isotope Comparison





Increasingly,
prostate cancer patients and their doctors who decide on seed brachytherapy
choose Cs-131 because of its significant advantages over Palladium-103 (Pd-103)
and Iodine-125 (I-125), two other isotopes currently in use.  These
advantages include:





Higher
Energy


Cs-131
has a higher average energy than any other commonly used prostate brachytherapy
isotope on the market.  Energy is a key factor in how uniformly the
radiation dose can be delivered throughout the prostate.  This quality of a
prostate implant is known as homogeneity.  Early studies demonstrate Cs-131
implants are able to deliver the required dose while maintaining homogeneity
across the gland itself and potentially reducing unnecessary dose to critical
structures such as the urethra and rectum. (Prestidge B.R., Bice W.S., Jurkovic
I., et al. Cesium-131
Permanent Prostate Brachytherapy:  An Initial Report.  Int. J. Radiation Oncology Biol.
Phys. 2005:  63 (1) 5336-5337.)





Shorter
Half-Life


Cs-131
has the shortest half-life of any commonly used prostate brachytherapy isotope
at 9.7 days.  Cs-131 delivers 90% of the prescribed dose in just 33 days
compared to 58 days for Pd-103 and 204 days for I-125.  By far the most
commonly reported side effects of prostate brachytherapy are irritative and
obstructive symptoms in the acute phase post-implant (Neill B, et al. The Nature
and Extent of Urinary Morbidity in Relation to Prostate Brachytherapy Urethral
Dosimetry. Brachytherapy 2007:6(3)173-9.).  The short half-life of Cs-131
reduces the duration of time during which the patient experiences the irritating
effects of the radiation.





Improved Coverage of the
Prostate


Permanent
prostate brachytherapy utilizing Cs-131 seeds allows for better dose homogeneity
and sparing of the urethra and rectum while providing comparable prostate
coverage compared to I-125 or Pd-103 seeds with comparable or fewer seeds and
needles.  Several studies have demonstrated dosimetric advantages of Cs-131
over the other commonly used prostate brachytherapy isotopes. (Musmacher JS, et
al. Dosimetric Comparison of Cesium-131 and Palladium-103 for Permanent Prostate
Brachytherapy. Int. J. Radiation Oncology Biol. Phys. 2007:69(3)S730-1.)
(Yaparpalvi R, et al. Is Cs-131 or I-125 or Pd-103 the “Ideal” Isotope for
Prostate Boost Brachytherapy? A Dosimetric View Point. Int. J. Radiation
Oncology Biol. Phys. 2007:69(3)S677-8) (Sutlief S, et al.  Cs-131 Prostate
Brachytherapy and Treatment Plan Parameters. Medical Physics 2007:34(6)2431.)
(Yang R, et al.  Dosimetric Comparison of Permanent Prostate Brachytherapy
Plans Utilizing Cs-131, I-125 and Pd-103 Seeds. Medical Physics
2008:35(6)2734.)





Rapid Resolution of Side
effects


Studies
demonstrate that objective measures of common side-effects showed an early peak
in symptoms in the 2-week to 1-month time frame.  Resolution of morbidity
resolved rapidly within 4-6 months. (Prestidge B, et. al. Clinical Outcomes of a
Phase-II, Multi-institutional Cesium-131 Permanent Prostate Brachytherapy Trial.
Brachytherapy. 2007: 6
(2)78.) (Moran B, et al.  Cesium-131 Prostate Brachytherapy: An Early
Experience.  Brachytherapy 2007:6(2)80.) (Jones A, et al. IPSS Trends for
Cs-131 Permanent Prostate Brachytherapy. Brachytherapy 2008:7(2)194.) (DeFoe SG,
et al. Is There Decreased Duration of Acute Urinary and Bowel Symptoms after
Prostate Brachytherapy with Cesium 131 Radioisotope?  Int. J. Radiation
Oncology Biol. Phys. 2008:72(S1)S317.)  More stringent studies are underway
to more fully characterize any advantage in side effect resolution experienced
by patients undergoing Cs-131 prostate brachytherapy versus brachytherapy with
other isotopes.


3





Higher Biologically
Effective Dose


Another
benefit to the short half-life of Cs-131 is what is known as the “biological
effective dose” or BED.  BED is a way for health care providers to predict
how an isotope will perform against cancers exhibiting different characteristics
– for instance, slow versus fast growing tumors.  Studies have shown Cs-131
is able to deliver a higher BED across a wide range of tumor types than either
I-125 or Pd-103. Although prostate cancer is typically viewed as a slow growing
cancer it can present with aggressive features.  Cs-131’s higher BED may be
particularly beneficial in such situations.  (Armpilia CI, Dale RG, Coles
IP et al.  The
Determination of Radiobiologically Optimized Half-lives for Radionuclides Used
in Permanent Brachytherapy Implants.  Int. J. Radiation Oncology Biol.
Phys. 2003; 55 (2):  378-385.)





PSA
Control


Investigators
tracking PSA in both single arm and randomized trials have concluded Cs-131’s
PSA response rates show similar early tumor control to I-125, long considered
the gold standard in permanent seed brachytherapy.  Longitudinal PSA
measurements from ongoing Cs-131 clinical series demonstrate trends very similar
to those seen with other isotopes. (Moran B, et. al. Cesium-131 Prostate
Brachytherapy” An Early Experience. Brachytherapy. 2007:6(2)80.)
(Bice W, et. al.  Recommendations for permanent prostate brachytherapy with
131Cs: a consensus report from the Cesium Advisory Group. Brachytherapy
2008:7(4)290-296.) (Platta CS, et al. Early Outcomes of Prostate Seed Implants
with 131Cs: Toxicity and Initial PSA Dynamics from a Single Institution. Int. J.
Radiation Oncology Biol. Phys. 2008:72(S1)S323-4.)





Industry
Information





Incidence
of Prostate Cancer





The
prostate is a walnut-sized gland surrounding the male urethra, located below the
bladder and adjacent to the rectum.  Prostate cancer is a malignant tumor
that begins most often in the periphery of the gland and, like other forms of
cancer, may spread beyond the prostate to other parts of the body. 
According to the American Cancer Society, approximately one in six men will be
diagnosed with prostate cancer during his lifetime.  It is the most common
form of cancer in men after skin cancer, and the second leading cause of cancer
deaths in men following lung and bronchus cancers that account for 30% of deaths
from cancer in men.  The American Cancer Society estimates there will be
about 192,280 new cases of prostate cancer diagnosed and an estimated 27,360
deaths associated with the disease in the United States in 2009.  Because
of early detection techniques (e.g., screening for prostate specific antigen, or
PSA), approximately nine out of ten prostate cancers are found in the local and
regional stages (local means it is still confined to the prostate; regional
means it has spread from the prostate to nearby areas, but not to distant sites,
such as bone).





Prostate
cancer accounts for about 9% of cancer related deaths in men.  Prostate
cancer incidence and mortality increase with age.  The National Cancer
Institute has reported that the incidence of prostate cancer increases
dramatically in men over the age of 55.  At the age of 70, the chance of
having prostate cancer is 12 times greater than at age 50.





The
American Cancer Society recommends that men without symptoms, risk factors and
who have a life expectancy of at least ten years, should begin regular annual
medical exams at the age of 50, and believes that health care providers should
offer as part of the exam the prostate-specific antigen (PSA) blood test and a
digital rectal examination.  The PSA blood test determines the amount of
prostate specific antigen present in the blood.  PSA is found in a protein
secreted by the prostate, and elevated levels of PSA can be associated with
either prostatitis (a noncancerous inflammatory condition) or a proliferation of
cancer cells in the prostate.  Transrectal ultrasound tests and biopsies
are typically performed on patients with elevated PSA readings to confirm the
existence of cancer.  Early screening has fostered a decline in the
prostate cancer death rate since 1990.  When compared to men of the same
age and race who do not have cancer (called relative survival), the 5-year
relative survival rate for men when the cancer is found in the local and
regional stages is nearly 100%.  During this past year the national press
publicized a meeting among urologists at the annual American Urology Association
meeting debating the need for annual PSA testing.  Results of this
publicity may result in future recommendations to begin testing at a later age
and not test annually unless there are risk factors.  Based on its own
industry knowledge, management believes this could lead to an increase in
prostate cancer, which has not been experienced since 2000.


4





Incidence
of Lung Cancer





An
estimated 219,440 new cases of lung cancer are expected in 2009, accounting for
15% of all cancer diagnoses in the United States.  Lung cancer accounts for
the most cancer related deaths in both men and women in the United States. 
An estimated 159,390 deaths, accounting for about 28% of all cancer deaths, are
expected to occur in 2009.  This exceeds the combined number of deaths from
the leading causes of cancer (breast, prostate, and colon cancers).  It
also accounts for 6% of all deaths from any source in the United States. 
(Cancer Management: A Multidisciplinary Approach, 11th Edition (2008). Richard
Pazdur, Lawrence R. Coia, William J. Hoskins, Lawrence D. Wagman; American
Cancer Society, 2009.)





Cigarette smoking is the most important
risk factor for lung cancer.  Risk increases with quantity and length of
time a person has smoked during his or her life time.  Other risk factors
include occupational or environmental exposure to secondhand smoke, radon,
asbestos (particularly among smokers), certain metals (chromium, cadmium,
arsenic), some organic chemicals, radiation, air pollution, and a history of
tuberculosis.  Genetic susceptibility plays a contributing role in the
development of lung cancer, especially in those who develop the disease at a
younger age.(American Cancer Society,
2009)





The
1-year relative survival for lung cancer increased from 35% in 1975-1979 to 41%
in 2001-2004, largely due to improvements in surgical techniques and combined
therapies.  However, the 5-year survival rate for all stages combined is
only 15%.  The 5-year survival rate is 50% for cases detected when the
disease is still localized, but only 16% of lung cancers are diagnosed at this
early stage.  (American Cancer Society, 2009)





Incidence
of Head and Neck Cancers





In 2008 it was estimated that there
were a total of 47,560 head and neck cancer cases, which includes 22,900 cases
of oral cavity cancer, 12,250 cases of laryngeal cancer, and 12,410 cases of
pharyngeal cancer, diagnosed in the United States.  (Cancer Management: A
Multidisciplinary Approach, 11th Edition (2008). Richard Pazdur, Lawrence R.
Coia, William J. Hoskins, Lawrence D. Wagman; American Cancer Society,
2009.)





Symptoms
may include a sore in the throat or mouth that bleeds easily and does not heal,
a lump or thickening, ear pain, a neck mass, coughing up blood, and a red or
white patch that persists.  Difficulties in chewing, swallowing, or moving
the tongue or jaws are often late symptoms.  (American Cancer Society,
2009)





Known
risk factors include all forms of smoked and smokeless tobacco products and
excessive consumption of alcohol.  Many studies have reported a synergism
between smoking and alcohol use, resulting in more than a 30-fold increased risk
in individuals who both smoke and drink heavily.  HPV infection is
associated with certain types of oropharyngeal cancer.  (American Cancer
Society, 2009)





Incidence
of Ocular Melanoma





The
American Cancer Society estimates that 2,350 new cases of cancers of the eye and
orbit (primarily melanoma) will be diagnosed in 2009 and about 230 deaths from
cancer of the eye will occur in 2009.  Eye cancer can occur at any age but
typically occurs in people over 50 years of age.  (American Cancer Society,
2009)


5


Eye
cancer may not present symptoms unless it grows in certain parts of the eye or
is in an advanced stage.  Some signs and symptoms may include decreased
ability to see, floaters or flashes of light, visual field loss, a glowing dark
spot on the iris, change in position of the eyeball within its socket, bulging
of the eye, and/or change in the movement of the eye within the socket. 
Known risk factors for ocular melanoma include sun exposure, certain occupations
(e.g. welders, farmers, fishermen, and chemical workers), race/ethnicity/eye
color, and certain inherited conditions such as dysplastic nevus syndrome. 
(American Cancer Society, 2009)





Prostate
Brachytherapy





There is
a large potential market for the Company’s products.  Several significant
clinical and market factors are contributing to the increasing popularity of the
brachytherapy procedure.  Over 61,000 procedures were forecasted to occur
in the U.S. in 2007 (Source: iData Research, Inc., 2008).  In 1996 only 4%
of prostate cancer cases were treated with brachytherapy, or about 8,000
procedures.  The number of brachytherapy cases has consistently increased
and in 2007 approximately 61,000 brachytherapy procedures were performed to
treat prostate cancer. (Source: iData Research Inc., 2008)





Minimally
invasive brachytherapy has significant advantages over competing treatments
including lower cost, equal or better survival data, fewer side effects, faster
recovery time and the convenience of a single outpatient implant procedure that
generally lasts less than one hour (Merrick, et al., Techniques in Urology, Vol.
7, 2001; Potters, et al., Journal of Urology, May 2005; Sharkey, et al., Current
Urology Reports, 2002).





Treatment
Options and Protocol





In
addition to brachytherapy, localized prostate cancer can be treated with
prostatectomy surgery (RP for radical prostatectomy), external beam radiation
therapy (EBRT), intensity modulated radiation therapy (IMRT), dual or
combination therapy, high dose rate brachytherapy (HDR), cryosurgery, hormone
therapy, and watchful waiting.  The success of any treatment is measured by
the feasibility of the procedure for the patient, morbidities associated with
the treatment, overall survival, and cost.  When the cancerous tissue is
not completely eliminated, the cancer typically returns to the primary site,
often with metastases to other areas of the body.





Prostatectomy Surgery Options.Historically the most common treatment option for prostate cancer,
radical prostatectomy is the removal of the prostate gland and some surrounding
tissue through an invasive surgical procedure.  RP is performed under
general anesthesia and involves a hospital stay of three days on average for
patient observation and recovery.  Possible side affects of RP include
impotence and incontinence.  According to a study published in the Journal of the American Medical Association
in January 2000, approximately 60% of men who had a RP reported erectile
dysfunction as a result of surgery.  This same study stated that
approximately 40% of the patients observed reported at least occasional
incontinence.  New methods such as laparoscopic and robotic prostatectomy
surgeries are currently being used more frequently in order to minimize the
nerve damage that leads to impotence and incontinence, but these techniques
require a high degree of surgical skill.  RP and laparoscopic prostatectomy
are projected to decrease approximately 31% in the U.S. from the 2004 high of
66,567 to 20,838 procedures in 2014.  However, robotic surgeries are
projected to more than replace the decrease in the RP and laparoscopic
procedures (Source: iData Research Inc., 2008).





Primary External Beam Radiation
Therapy.  EBRT involves directing a beam of radiation from outside
the body at the prostate gland to destroy cancerous tissue.  EBRT
treatments are received on an outpatient basis five days per week usually over a
period of eight or nine weeks.  Some studies have shown, however, that the
ten-year disease free survival rates with treatment through EBRT are less than
the disease free survival rates after RP or brachytherapy treatment.  Side
effects of EBRT can include diarrhea, rectal leakage, irritated intestines,
frequent urination, burning while urinating, and blood in the urine.  Also
the incidence of incontinence and impotence five to six years after EBRT is
comparable to that for surgery.  EBRT procedures are projected to increase
slightly from 22,000 procedures in 2006 to 24,900 in 2012 (Source: Millennium
Research Group, 2008).


6





Intensity Modulated Radiation
Therapy.IMRT is considered a more advanced form of EBRT in which
sophisticated computer control is used to aim the beam at the prostate from
multiple different angles and to vary the intensity of the beam.  Thus,
damage to normal tissue and critical structures is minimized by distributing the
unwanted radiation over a larger geometric area.  This course of treatment
is similar to EBRT and requires daily doses over a period of seven to eight
weeks to deliver the total dose of radiation prescribed to kill the tumor. 
Because IMRT is a new treatment, less clinical data regarding treatment
effectiveness and the incidence of side effects is available.  One
advantage of IMRT, and to some extent EBRT, is the ability to treat cancers that
have begun to spread from the tumor site.  An increasingly popular therapy
for patients with more advanced prostate cancer is a combination of IMRT with
seed brachytherapy, known as combination or dual therapy.  IMRT in the U.S.
(including dual therapy) is projected to grow 9% per year from 31,500 procedures
in 2007 to 48,500 procedures in 2012 (Source: Millennium Research Group,
2008).  IMRT is generally more expensive than other common treatment
modalities.





Dual or Combination Therapy.Dual therapy is the combination of IMRT or 3-dimensional conformal
external beam radiation and seed brachytherapy to treat extra-prostatic
extensions or high risk prostate cancers that have grown outside the
prostate.  Combination therapy treats high risk patients with a full course
of IMRT or EBRT over a period of several weeks.  When this initial
treatment is completed, the patient must then wait for several more weeks to
months to have the prostate seed implant.





With the
arrival of Proxcelan Cs-131, with its short half life, patients may now complete
their course of treatment sooner and have shorter duration of
side-effects.  Management estimates that at least 30% of all prostate
implants are now dual therapy cases.





High Dose Rate Temporary
Brachytherapy.  HDR temporary brachytherapy involves placing very
tiny plastic catheters into the prostate gland, and then giving a series of
radiation treatments through these catheters.  The catheters are then
removed, and no radioactive material is left in the prostate gland.  A
computer-controlled machine inserts a single highly radioactive iridium seed
into the catheters one by one.  This procedure is typically repeated at
least three times while the patient is hospitalized for at least 24 hours. 
HDR is projected to grow approximately 1.3% per year from 26,200 procedures in
2007 through 2012 (Source: Millennium Research Group, 2008).





Cryosurgery.Cryosurgery involves placing cold metal probes into the prostate and
freezing the tissue in order to destroy the tumor.  Cryosurgery patients
typically stay in the hospital for a day or two and have had higher rates of
impotence and other side effects than those who have used seed implant
brachytherapy.  Market research firms project that cryosurgery will grow
steadily through 2012.  To date the market has remained almost flat
(Source: Millennium Research Group, 2008).





Additional Treatments.Additional treatments include hormone therapy and chemotherapy. 
Hormone therapy is generally used to shrink the tumor or make it grow more
slowly but will not eradicate the cancer.  Likewise, chemotherapy will not
eradicate the cancer but can slow the tumor growth.  Generally, these
treatment alternatives are used by doctors to extend patients’ lives once the
cancer has reached an advanced stage or in conjunction with other treatment
methods.  Hormone therapy can cause impotence, decreased libido, and breast
enlargement.  Most recently, hormone therapy has been linked to an
increased risk of cardiovascular disease in men with certain pre-existing
conditions such as heart disease or diabetes.  Chemotherapy can cause
anemia, nausea, hair loss, and fatigue.





Watchful Waiting.Watchful waiting is not a treatment but might be suggested by some
healthcare providers depending on the age and life expectancy of the
patient.  Watchful waiting may be recommended if the cancer is diagnosed as
localized and slow growing, and the patient is asymptomatic.  Generally,
this approach is chosen when patients are trying to avoid the side affects
associated with other treatments or when they are not candidates for current
therapies due to other health issues.  Healthcare providers will carefully
monitor the patient’s PSA levels and other symptoms of prostate cancer and may
decide on active treatments at a later date.


7





Comparing
Cs-131 to I-125 and Pd-103 Clinical Results





Long-term
survival data is now available for brachytherapy with I-125 and Pd-103, which
support the efficacy of brachytherapy.  Clinical data indicate that
brachytherapy offers success rates for early-stage prostate cancer treatment
that are equal to or better than those of RP or EBRT.  While clinical
studies of brachytherapy to date have focused primarily on results from
brachytherapy with I-125 and Pd-103, management believes that these data are
also relevant for brachytherapy with Cs-131.  In fact, it appears that
Cs-131 offers improved clinical outcomes over I-125 and Pd-103, given its
shorter half-life and higher energy.





Improved patient
outcomes.  A number of published studies describing the use of I-125
and Pd-103 brachytherapy in the treatment of early-stage prostate cancer have
been very positive.  A recent study of 2,963 prostate cancer patients who
underwent brachytherapy as their sole therapeutic modality at 11 institutions
across the U.S. concluded that low-risk patients (who make up the preponderance
of localized cases) who underwent adequate implants experienced rates of PSA
relapse survival of greater than 90% between eight and ten years (Zelefsky MJ,
Kuban DA, et al, “Multi-institutional analysis of long-term outcome for stages
T1-T2 prostate cancer treated with permanent seed implantation” 
International Journal of Radiation Oncology Biology Physics, Volume 67, Issue 2,
2007, 327-333).





Other
recent studies have demonstrated similar, durably high rates of control
following brachytherapy for localized prostate cancer out to 15 years
post-treatment (Sylvester J, et al. “15-year biochemical relapse free survival
in clinical stage T1-T3 prostate cancer following combined external beam
radiotherapy and brachytherapy; Seattle experience”, International Journal of
Radiation Oncology Biology Physics, Vol. 67, Issue 1, 2007, 57-64.).  The
cumulative effect of these series has been the conclusion by leaders in the
field that brachytherapy offers a disease control rate as high as surgery,
though with a lesser side-effect profile than surgery (Ciezki JP. 
“Prostate brachytherapy for localized prostate cancer” Current Treatment Options
in Oncology, Volume 6, 2005, 389-393).





Reduced Incidence of Side
Effects.  Sexual impotence and urinary incontinence are two major
concerns men face when choosing among various forms of treatment for prostate
cancer.  Studies have shown that brachytherapy with existing sources
results in lower rates of impotence and incontinence than surgery (Frank,
Buron).  Combined with the high disease control rates described in many
studies, these findings have driven the adoption of brachytherapy as a
front-line therapy for localized prostate cancer.





It has
been noted, however, that a significant proportion of patients who undergo I-125
or Pd-103 brachytherapy experience acute urinary irritative symptoms following
treatment – in fact more so than with surgery or external beam radiation therapy
(Frank SJ, Pisters LL, et al, “An assessment of quality of life following
radical prostatectomy, high dose external beam radiation therapy, and
brachytherapy iodine implantation as monotherapies for localized prostate
cancer” Journal of Urology, Volume 177, 2007, 2151-2156).  It has been
postulated that Cs-131, with the shortest available half-life for a low-dose
rate therapy isotope, will result in a quicker resolution of these irritative
symptoms based on the shorter time interval over which normal tissue receives
radiation from the implanted sources.





Preliminary
data drawn from several clinical studies suggest that patients treated with
Cs-131 do in fact experience a faster resolution of these side effects in
comparison to similar studies published for other isotopes (Defoe SG, et al, “Is
there a decreased duration of acute urinary and bowel symptoms after prostate
brachytherapy with Cesium 131 isotope?", International Journal of Radiation
Oncology Biology Physics, Volume 72 (Supplement 1), S317; Jones A, et al, "IPSS
Trends for Cs-131 Permanent Prostate Brachytherapy" Brachytherapy, Volume 7,
Issue 2, 194; Platta CS, et al, “Early Outcomes of Prostate Seed Implants with
131Cs: Toxicity and Initial PSA Dynamics from a Single Institution"
International Journal of Radiation Oncology Biology Physics, Volume 72
(Supplement 1), 2008, S323-4).





A Cs-131
monotherapy trial for the treatment of prostate cancer was fully enrolled in
February 2007.  The trial was a 100 patient multi-institutional study that
sought to (1) document the dosimetric characteristics of Cs-131, (2) to
summarize the side effect profile of Cs-131 treatment, and (3) to track
biochemical (PSA) results in patients following Cs-131
therapy.


8





The
investigators responsible for conducting the study have concluded based on the
results of the monotherapy trial that Cs-131 is a viable alternative as an
isotope for permanent seed prostate brachytherapy (Prestidge BR, Bice WS,
“Clinical outcomes of a Phase II, multi-institutional Cesium-131 permanent
prostate brachytherapy trial”. Brachytherapy, Volume 6, Issue 2, April-June 2007, Page
78).





Some of
the significant and specific findings were as follows:





§
            Patient
      reported irritative urinary symptoms (IPSS Scores) were mild to moderate
      with relatively rapid resolution within 4-6 months.  The figure below
      depicts the symptom scores in the Cs-131 study as compared to published
      reports of patients who underwent I-125 brachytherapy.  Especially
      notable is the steep drop in the Cs-131 group scores (purple line) as
      opposed to the more gradual drop in the I-125 group scores (green and blue
      lines).








9





§
            Prostate
      Specific Antigen, or PSA, response over 36 months has been very
      encouraging to date with similar tumor control rates to that of
      I-125.  (Prestidge BR, Bice WS, “Clinical outcomes of a Phase II,
      multi-institutional Cesium-131 permanent prostate brachytherapy trial”.
      Brachytherapy, Volume 6, Issue
      2, April-June
      2007, Page 78).  The graph below depicts the median PSAs
      to date from the 100 patient Cs-131 brachytherapy series as compared to
      previously published I-125 series.  There have been no PSA failures
      in the Cs-131 monotherapy study to date.  (A PSA failure is a rise in
      the blood level of PSA in prostate cancer patients after treatment with
      radiation or surgery.)











§
            Gland
      coverage was excellent and the dose delivered to critical structures
      outside the prostate was well within acceptable limits. (Bice WS,
      Prestidge BR, “Cesium-131 permanent prostate brachytherapy: The dosimetric
      analysis of a multi-institutional Phase II trial”.  Brachytherapy
      2007(6); 88-89.).





Several
other series have been reported that have compared dosimetric parameters
(indicators of dose) among Cs-131, Pd-103, and I-125.  These comparative
studies have shown a clear advantage to Cesium-131 from a dosimetric
point-of-view, in terms of successful gland coverage obtained (typically
measured by D90) while keeping unnecessary gland over-dosing (typically measured
by V150 or V200) to a minimum (Musmacher JS, et al, "Dosimetric Comparison of
Cesium-131 and Palladium-103 for Permanent Prostate Brachytherapy" International
Journal of Radiation Oncology Biology Physics, Volume 69, (Supplement 3), 2007,
S730-1; Yaparpalvi R, et al, "Is Cs-131 or I-125 or Pd-103 the Ideal Isotope for
Prostate Boost Brachytherapy? A Dosimetric View Point." International Journal of
Radiation Oncology Biology Physics, Volume 69 (Supplement 3), 2007, S677-8;
Sutlief S and Wallner K,   "Cs-131 Prostate Brachytherapy and
Treatment Plan Parameters." Medical Physics, Volume 34, 2007, 2431; Kurtzman S,
"Dosimetric Evaluation of Permanent Prostate Brachytherapy Using Cs-131 Sources"
International Journal of Radiation Oncology Biology Physics, Volume 66
(Supplement 3), S395).





The
monotherapy Cs-131 trial will continue to follow patients with annual updates on
symptoms and patient long-term survival data.  The Company anticipates
maintaining this ongoing monitoring over several years to prove the long-term
effectiveness of Cs-131.





The
prospective randomized monotherapy trial headed by Dr. Brian Moran of The
Chicago Prostate Cancer Center directly compared Cs-131 to I-125 PSA response
and treatment related morbidities following brachytherapy for localized
carcinoma of the prostate in low to intermediate risk patients.  Dr. Moran
concluded that prostate brachytherapy with Cs-131 is effective and
well-tolerated; both PSA response and the acute morbidity profile were very
encouraging.  Dr. Moran will continue to track these patients in order to
collect long-term outcomes.


10





Recently
accepted for publication was the Cs-131 Advisory Group’s (CAG) article entitled
“Recommendations for permanent prostate brachytherapy with 131Cs: a
consensus report from the Cesium Advisory Group”.  The objective of the
article was toprovide consensus
recommendations for Cs-131 prostate brachytherapy based on experience to date
for physicians still unfamiliar with Cs-131.  The recommendations are based
on three clinical trials, one of which has completed accrual and has been
published in the peer reviewed literature, and combined CAG experience of more
than 1,200 Cs-131 implants.  The recommendations from the group are
designed to aid practitioners in the safe and effective delivery of Cs-131
prostate brachytherapy.  The Consensus Paper was published in Brachytherapy
in the fourth quarter of calendar year 2008.  The CAG is sponsored by the
Company.





The
Company has also commissioned a dual therapy protocol.  This
multi-institutional trial observes the dosimetric characteristics of Cs-131 and
health related quality of life (HRQOL) results following combined Cs-131
transperineal permanent prostate brachytherapy and external beam radiotherapy in
patients with intermediate to high risk prostate cancer.  This protocol is
being conducted to confirm clinically what radiobiological data suggests
regarding this treatment modality.  The quantified dosimetric variables
collected will be correlated to the reported HRQOL data and ultimately compared
to existing data in the literature for similar investigations using I-125 and
Pd-103.  Patient enrollment for this study began in April 2007 and 65
patients had been enrolled through June 30, 2009.





In
addition to establishing the dosimetric and quality of life impact of Proxcelan
Cesium-131 brachytherapy seeds in different treatment modalities, all trials
have been designed to collect ongoing PSA results for the purposes of
establishing long-term survival rates using Cs-131 seed implant
brachytherapy.





Lung
Cancer Treatment Options





Lung
cancer has historically been treated by surgery and chemotherapy but in recent
years various forms of radiation have also been used.  Surgery generally
involves removing a portion of the lung or the entire lung.  Chemotherapy
may be used either as a primary treatment or a secondary treatment depending on
the type and stage of the lung cancer.  External beam radiation therapy is
sometimes used as the primary treatment if the tumor cannot be removed by
surgery due to the tumor’s location or the patient’s health.





Brachytherapy
is now being used in conjunction with surgery to kill small areas of cancer that
might be missed during surgery.  The Company believes that Cs-131, with its
shorter half-life and high energy, is better suited for treating lung cancer
than either I-125 or Pd-103.  The bioabsorbable mesh used in this procedure
generally dissolves after about 45 days.  Cs-131 delivers 90% of its dose
in 33 days and is therefore well-suited to use with the bioabsorbable mesh in
this procedure.





Head
and Neck Cancer Treatment Options





Most head
and neck cancers are treated with some combination of surgery, chemotherapy, and
radiation therapy.  Surgery is the most common option and takes many
different forms in an effort to remove any cancerous tissue.  Chemotherapy
is often used in conjunction with surgery or radiation therapy depending on the
type and stage of the cancer.  External beam radiation therapy and
brachytherapy have been used together or in combination with surgery or
chemotherapy.





Ocular
Melanoma Treatment Options





In
addition to brachytherapy to treat ocular melanoma, other treatment options
include surgery, external beam radiation, and laser therapy.  Surgery could
include removal of part of the iris, a portion of the outer eyeball, or the
removal of the entire eyeball.  External beam radiation (including proton
beam radiation therapy and stereotactic radiosurgery) involves sending radiation
from a source outside the body that is focused on the cancer but has not been as
widely used to date for ocular melanoma.  Laser therapy burns the cancerous
tissue by using a highly focused, high-energy light beam and is effective for
small melanomas near the optic nerve as it causes less nerve damage. (American
Cancer Society, 2009)


11





Brachytherapy
using Cs-131, I-125, or Pd-103 is done by placing the seeds in a plaque (shaped
like a small cap) that is attached to the eyeball with minute stitches for 2 to
5 days.  The patient generally stays in the hospital until the plaque is
removed from the eye.  Brachytherapy cures approximately 9 out of 10 small
tumors and can preserve the vision of some patients.  (American Cancer
Society, 2009)





Our
Strategy





The key
elements of IsoRay’s strategy for fiscal year 2010 include:





§
            Continue to introduce the
      Proxcelan Cs-131 brachytherapy seed into the U.S. market. 
      Utilizing our direct sales organization, IsoRay intends to continue
      expanding the use of Proxcelan Cs-131 seeds in brachytherapy procedures
      for prostate cancer by increasing the number of treatment centers offering
      Cs-131 and increasing the number of patients treated at each center using
      Cs-131.  IsoRay hopes to capture much of the incremental market
      growth in seed implant brachytherapy and take market share from existing
      competitors.





§
            Work with our distribution
      partner, BrachySciences, to increase prostate market
      penetration.  With
      BrachyScience’s additional sales personnel, IsoRay expects to reach an
      increasing number of centers and physicians across the country that have
      not had access to a sales representative in their area.  IsoRay
      received its first order from BrachySciences in August 2009.  The
      increases from this distribution channel have been slow due to many of the
      same issues that IsoRay’s direct sales force encounters (e.g. facility
      license amendments).  However, management believes that distribution
      sales will become an important sales channel in the
  future.





§
            Increase utilization of Cs-131
      in treatment of other solid tumor applications such as head and neck and
      lung cancers.IsoRay Medical has received clearance from the
      FDA for its Premarket Notification, (510(k)) for ProxcelanTM brachytherapy
      seeds that are preloaded into bioabsorbable braided strands. This order
      clears the product for commercial distribution for treatment of lung and
      head and neck tumors as well as tumors in other organs.  IsoRay has
      received interest from some physicians who wish to use Cs-131 for other
      tumor sites including lung, and head and neck, due to the short half life
      that may potentially help reduce the migration of the radioactivity to the
      other parts of the body before the treatment dose has been delivered to
      the tumor.  While Cs-131 brachytherapy seeds themselves have been
      cleared for these applications since 2003, this current 510(k) allows
      Cesium-131 seeds to be delivered in a convenient and sterile format that
      can be implanted without additional seed loading by the facility. 
      The 510(k) also permits the application of the braided strands onto a
      bioabsorbable mesh matrix to further facilitate the implant
      procedure.  The material (mesh) used to hold the flexible suture
      material in place dissolves within 45 days.  With the treatment dose
      from Cs-131 being delivered in 33 days, many physicians feel confident
      that the treatment dose needed to treat the tumor will be delivered prior
      to the mesh dissolving.  IsoRay will continue to explore joint
      ventures with other companies to develop the appropriate technologies and
      therapeutic delivery systems for treatment of other solid tumors such as
      breast, liver, pancreas, and brain
cancers.





§
            Continue to develop an
      enriched barium manufacturing process.  Working with leading
      scientists, IsoRay is working to design and create a proprietary process
      for manufacturing enriched barium, a key source material for Cs-131. 
      This will ensure adequate future supply of Cs-131 and greater efficiencies
      in producing the isotope.





§
            Continue to develop data on
      Cs-131 for treatment of ocular melanoma.  The Company’s
      first sale for ocular melanoma occurred in late 2007 and periodic sales
      have occurred since then.  IsoRay is sponsoring a prospective review
      of the patients treated with Cs-131 to date.  This clinical data is
      expected to be available for the American Brachytherapy Society annual
      meeting in the Spring of 2010.  Although the ocular melanoma market
      is not a large one, this application of Cs-131 shows potential viability
      for other solid tumors.


12





§
            Support clinical research and
      sustained product development.  The Company plans to structure
      and support clinical studies on the therapeutic benefits of Cs-131 for the
      treatment of solid tumors and other patient benefits.  We are and
      will continue to support clinical studies with several leading radiation
      oncologists to clinically document patient outcomes, provide support for
      our product claims, and compare the performance of our seeds to competing
      seeds.  IsoRay plans to sustain long-term growth by implementing
      research and development programs with leading medical institutions in the
      U.S. and other countries to identify and develop other applications for
      IsoRay’s core radioisotope
technology.





·
            Introduce Proxcelan Cesium-131
      brachytherapy seeds to the Canadian and Russian markets. 
      Health Canada’s Therapeutic Products Directorate has approved IsoRay’s
      Class 3 Medical Device License Applications for Model CS-1 Proxcelan TM
      (Cesium-131) brachytherapy seeds and the ProxcelanTM Sterile Implant
      Devices containing Model CS-1 Seeds.  This allows IsoRay to market
      its brachytherapy seeds and related preloaded brachytherapy seeds
      throughout Canada.  IsoRay will conduct a search to look for a viable
      distribution partner in Canada.  Approval to market Cesium-131 seeds
      in Russia was also obtained in 2009; however, the economic downturn in
      Russia has slowed the Company’s market penetration efforts.  The
      Company is now focusing on the Canadian and Russian markets and is no
      longer pursuing sales in the European Union (EU).  Management no
      longer believes a strategic alliance with IBt, SA, a Belgian company, will
      be consummated nor will management leverage IBt’s distribution channels in
      the EU.





§
            Maintain ISO 13485
      certification.  In August 2008, the Company obtained its ISO
      13485 certification.  This was an important step to allow the Company
      to register and eventually sell its Proxcelan Cs-131 brachytherapy seeds
      in Canada and Russia.  The Company completed its registrations of
      Proxcelan Cs-131 brachytherapy seeds in Canada and Russia during fiscal
      year 2009.





Products





IsoRay
markets the Proxcelan Cs-131brachytherapy
seed for the treatment of prostate cancer, ocular melanomas, and head and neck
cancers, and intends to market Cs-131 for the treatment of other malignant
disease, such as lung, in the near future.  Additionally, the Company is
investigating its ability to market other radioactive isotopes.





Competitive
Advantages of Proxcelan Cs-131





Management
believes that the Proxcelan Cesium-131 brachytherapy seed has specific clinical
advantages for treating cancer over I-125 and Pd-103, the other isotopes
currently used in brachytherapy seeds.  The table below highlights the key
differences of the three seeds.  The Company believes that the short
half-life, high-energy characteristics of Cs-131 will increase industry growth
and facilitate meaningful penetration into the treatment of other forms of
cancer such as lung cancer.





Isotope
      Delivery Over TimeIsotope
              
              Half-Life
              
              Energy
              
              90%
      Dose
              
              Total
      DoseCs-131
              
              9.7
      days
              
              30.4
      KeV
              
              33
      days
              
              115
      GyPd-103
              
              17
      days
              
              20.8
      KeV
              
              58
      days
              
              125
      GyI-125
              
              60
      days
              
              28.5
      KeV
              
              204
      days
              
              145
      Gy





Cs-131
Manufacturing Process and Suppliers





Product Overview. Cs-131 is a
radioactive isotope that can be produced by the neutron bombardment of
Barium-130 (Ba-130).  When placed into a nuclear reactor and exposed to a
flux of neutrons, Ba-130 becomes Ba-131, the radioactive material that is the
parent isotope of Cs-131.  The radioactive isotope Cs-131 is normally
produced by placing a quantity of stable non-radioactive barium (ideally barium
enriched in isotope Ba-130) into the neutron flux of a nuclear reactor. 
The irradiation process converts a small fraction of this material into a
radioactive form of barium (Ba-131).  The Ba-131 decays by electron capture
to the radioactive isotope of interest (Cs-131).


13





To
produce the Proxcelan seed, the purified Cs-131 isotope is adsorbed onto a
ceramic core containing a gold X-ray marker. This internal core assembly is
subsequently inserted into a titanium capsule that is then welded shut and
becomes a sealed radioactive source and a biocompatible medical device. The
dimensional tolerances for the ceramic core, gold X-ray marker, and the titanium
capsule are extremely important.  To date the Company has used sole-source
providers for certain components such as the gold X-ray marker and the titanium
capsule as these suppliers have been validated by our quality department and
they have been cost effective.





Barium Enrichment
Device.  The Company has retained an independent contractor to
develop an enrichment device to produce “enriched barium” having a higher
concentration of the Ba-130 isotope than is found in naturally occurring
barium.  Irradiating enriched barium will result in higher yields of
Cs-131.  The Company anticipates the use of enriched barium will also
streamline the manufacturing process and reduce Cs-131 production costs. 
The Company’s prototype enrichment device has experienced development delays, is
now 18 months beyond its original completion date and is now expected to be
tested in the Fall of 2009, but there is no assurance this testing will occur by
then or whether it will be successful.  The Company will owe an additional
$56,610 to the contractor upon completion of a successful demonstration of the
enrichment process and will determine following the demonstration whether the
prototype model will be capable of producing sufficient quantities of enriched
barium.  If the prototype model will not produce sufficient quantities,
then the Company will need to spend $100,000 to $150,000 for a larger production
model.





Isotope Suppliers.  Due
to the short half-life of both the Ba-131 and Cs-131 isotopes, potential
suppliers must be capable of removing irradiated materials from the reactor core
on a routine basis for subsequent processing to produce ultra-pure Cs-131. 
In addition, the supplier’s nuclear reactor facility must have sufficient
irradiation capacity to accommodate barium targets and the nuclear reactors must
have sufficient neutron flux to economically produce commercially viable
quantities of Cs-131.  Ideally, the irradiation facility will also have a
radiochemical separation infrastructure to carry out the initial separation
steps.  The Company has identified key reactor facilities in the U.S. and
in Russia that are capable of meeting these requirements.  In order to
manage the Russian supply more effectively IsoRay entered into an agreement with
UralDial, LLC (a Russian LLC) to provide Cs-131 isotope from Russia to the
Company’s facility in Richland, WA.  UralDial obtains Cs-131 from two
suppliers.  The Company also continues to receive irradiated barium from
the MURR reactor located in the United States.  For the fiscal year ended
June 30, 2009, approximately sixty-five percent (65%) of our Cs-131 was supplied
by one of two Russian supply sources and 35% from domestic sources.





The
Company plans to expand Cs-131 manufacturing capability at the MURR reactor but
will continue to obtain Cs-131 from multiple suppliers.  Failure to obtain
deliveries of Cs-131 from at least one of its Russian suppliers could have a
material adverse effect on seed production.  Management believes it will
continue to rely solely on its existing suppliers in the near future and
shutdowns from these suppliers could cause delays in deliveries and
production.





Quality Controls.  We
have established procedures and controls to comply with the FDA’s Quality System
Regulation.  The Company constantly monitors these procedures and controls
to ensure that they are operating properly, thereby working to maintain a
high-quality product.  Also, the quality, production, and customer service
departments maintain open communications to ensure that all regulatory
requirements for the FDA, DOT, and applicable nuclear radiation and health
authorities are fulfilled.





In July
2008, IsoRay had its baseline inspection by the FDA at its manufacturing and
administrative offices in Richland, WA.  This inspection was carried out
over a five day period of time during which the investigator performed a
complete inspection following Quality Systems Inspection Techniques
(QSIT).  At the end of the inspection no report of deviations from Good
Manufacturing Practices or list of observations (form FDA 483) was issued to
IsoRay.


14





Order Processing.  The
Company has implemented a just-in-time production process that is responsive to
customer input and orders to ensure that individual customers receive a higher
level of customer service than received from our competitors who have the luxury
of longer lead times due to longer half-life products.  Time from order
confirmation to completion of product manufacture is reduced to several working
days, including receipt of irradiated barium (from a supplier’s reactor),
separation of Cs-131, isotope labeling of the core, and loading of cores into
pre-welded titanium “cans” for final welding, testing, quality assurance and
shipping.





It is up
to each physician to determine the dosage necessary for implants and acceptable
dosages vary among physicians.  Many of the physicians who order our seeds
order more seeds than necessary to assure themselves that they have a sufficient
quantity.  Upon receipt of an order, the Company either delivers the seeds
from its facility directly to the physician or sends the order to an independent
preloading service that delivers the seeds preloaded into needles or cartridges
just prior to implant.  If the implant is postponed or rescheduled, the
short half-life of the seeds makes them unsuitable for use and therefore they
must be re-ordered.





Due to
the lead time for obtaining and processing the Cs-131 isotope and the short
half-life, the Company relies on sales forecasts and historical knowledge to
estimate the proper inventory levels of isotope needed to fulfill all customer
orders.  Consequently, some portion of the isotope is lost through decay
and is not used in an end product.  Management continues to reduce the
variances between ordered isotope and isotope deliveries and is continually
improving its ordering process efficiencies.





Automated
Manufacturing Process





In fiscal
2009, IsoRay automated certain aspects of its manufacturing line identified by
management to provide process efficiencies, cost savings and consistent
manufacturing quality.  The Company will continue to evaluate and implement
automation in the future that supports process improvement and resource
management.   In addition, management plans to implement processes and
automation in support of additional treatment sites such as head and neck and
lung in 2009-2010.  The Company also has a contract with a third party to
outsource certain sub-processes.





Manufacturing
Facility





The
Company maintains a production facility located at Applied Process Engineering
Laboratory (APEL).  The APEL facility became operational in September
2007.  The production facility has over 15,000 square feet and includes
space for isotope separation, seed production, order dispensing, a clean room
for radiopharmacy work, and a dedicated shipping area.  A description of
the lease terms for the APEL facility is located in the Other Commitments and
Contingencies section of Item 7 below.  Management believes that the APEL
facility will be utilized for manufacturing space through fiscal year 2016 which
is the original lease term plus the two three-year renewal options. 
Management currently anticipates exercising both three-year renewal options to
extend the APEL facility lease through April 2016.





Management
no longer believes that the shuttle system at Idaho's Advanced Test Reactor
(ATR) will provide the conditions necessary for Cs-131 production.  The
facility's capacity is fully allocated to the Navy and management believes it
would be difficult to have IsoRay's commercial operations at the same facility
as these military operations, even if the shuttle was certified for use in
IsoRay operations, which has not occurred.


15





Repackaging
Services





Most
brachytherapy manufacturers offer their seed product to the end user packaged in
five principal configurations provided in a sterile or non-sterile package
depending on the customer’s preference.  These include:





§
            Loose
    seeds


§
            Pre-loaded needles
      (loaded typically with three to five seeds and
  spacers)


§
            Pre-loaded Mick
      cartridges (fits the Mick
applicator)


§
            Strands of seeds
      (consists of seeds and spacers in a biocompatible “shrink
      wrap”)


§
            Preloaded Strands(strands loaded into the
needle)





In 2008,
the Millenium Research Group reported that the estimated market shares for each
of the five packaging types are: loose seeds and preloaded loose seeds (8%),
Mick cartridges (26%), and all strand configurations including preloaded
strands (66%).  Market trends indicate significant movement toward the
stranded configuration, as there are some clinical data suggesting less
potential for post-implant seed migration when a stranded configuration is
used.





The role
of the preloading service is to package, assay and certify the contents of the
final product configuration shipped to the customer.  A commonly used
method of providing this service is through independent radiopharmacies.
 Manufacturers send loose seeds along with the physician's instructions to
the radiopharmacy which, in turn, loads needles and/or strands the seeds
according to the doctor's instructions.  These radiopharmacies then
sterilize the product and certify the final packaging prior to shipping directly
to the end user.





IsoRay
currently has agreements with
several independent radiopharmacies to assay, preload, and
sterilize loose seeds.  Shipping to independent pharmacies creates
additional loss of our isotope through decay. While the Company pre-loads
many of its current orders, we have continued to utilize loading services to
supplement our own custom preloading operation and to meet the requests of the
ordering physicians.





We
currently load approximately 95% of Mick cartridges in our own facility which in
fiscal year 2009 accounted for approximately 60% of seeds sold.  The
remaining approximately 40% of seeds sold are strand configurations including
preloaded strands.  During fiscal year 2008, the Company began offering a
100% confirmation assay performed by in-house analytical services. 
Providing the assay and ultimately the preloading services in-house allows the
Company to eliminate approximately 25% loss in isotope activity due to
radioactive decay.  The cost of priority overnight shipment of each order
of seeds to a third-party provider is also eliminated.  However, we will
continue to utilize the independent radiopharmacies to back up our own
preloading operation, to handle periodic increases in demand, and to cater to
certain doctors’ preferences.





With a
clearance from the FDA for preloading flexible braided strands and bioabsorbable
mesh, IsoRay will become the second company in the industry that has 510(k)
clearance to preload both the strands and the mesh.  This will allow IsoRay
to keep these services in house, reduce costs and provide these services
directly to our customers.





Independent
radiopharmacies usually provide the final packaging of the product delivered to
the end user thereby eliminating the opportunity for reinforcing the
"branding" of our seed product.  By providing our own repackaging
service, we will preserve the product branding opportunity and eliminate
any concerns related to the handling of our product by a third party prior
to delivery to the end user.





Providing
custom packaging configurations enhances our product while providing an
additional revenue stream and incremental margins to the Company through pricing
premiums charged to our customers.  The end users of these packaging
options are willing to pay a premium because of the savings they realize by
eliminating the need for loose seed handling and loading capabilities on site,
eliminating the need for additional staffing to sterilize seeds and needles, and
eliminating the expense of additional assaying of the seeds.


16





Marketing
and Sales





Marketing
Strategy





The
Company is marketing Proxcelan Cesium-131 brachytherapy seeds as the “seed of
choice” for prostate brachytherapy.  Based on current and preliminary
clinical studies, management believes there is no apparent clinical reason to
use other isotopes when Cs-131 is available.  The advantages associated
with a higher energy and shorter half-life isotope are generally accepted within
the clinical community and the Company intends to help educate potential
patients about the clinical benefits from Cs-131 for their brachytherapy seed
treatment.





IsoRay
has chosen to identify its proprietary Cs-131 seed with the trademarked brand of
“Proxcelan.”  Management is using this brand to differentiate Cs-131 seeds
from seeds using the other isotopes.  We continue to target the competing
isotope products of iodine and palladium rather than the various manufacturers
and distributors of these isotopes.  Using this strategy, the choice of
brachytherapy isotopes should be less dependent on the name and distribution
strengths of the various iodine and palladium manufacturers and distributors and
more dependent on the therapeutic benefits of Cs-131.





The
professional and patient market segments each play a role in the ultimate choice
of cancer treatment and the specific isotope chosen for seed brachytherapy
treatment.  The Company has developed a customized brand message for each
audience.  In 2009, the Company’s website www.isoray.com was substantially
updated to include sections for clinicians, product information, and
resources.  IsoRay also maintains print and visual medias (including
physician brochures discussing the clinical advantages of Cs-131, clinical
information binders, informational DVDs, single sheet glossies with targeted
clinical data, etc.), and advertisements in the leading medical journals. 
In addition, the Company attends national professional meetings, including the
following:


§
            American
      Brachytherapy Society (ABS);


§
            American
      Society for Therapeutic Radiation and Oncology
  (ASTRO);


§
            Association
      of American Physicists in Medicine (AAPM);
and


§
            Various
      local chapter meetings.





The
Company also continues to consult with noted contributors from the medical
physics community and will have articles submitted to professional journals such
as Medical Physics, the
Brachytherapy Journal, and the International Journal of
Radiation Oncology, Biology, and
Physics regarding the benefits of and clinical trials involving
Cs-131.





Beginning
in January 2008, IsoRay implemented a variety of physician Cs-131 training
outreach programs including the following:  a two day training course held
approximately three times per year at Chicago Prostate Cancer Center (CPCC);
proctoring and mentoring programs led by Steve Kurtzman, MD, IsoRay’s Medical
Director; and a training DVD for physicians who choose not to leave their
practices to attend a training course.  The objective of the training
programs is to increase the physician’s confidence in using the
product.





In
today’s U.S. health care market, patients are more informed and involved in the
management of their health than in the past.  Many physicians relate
incidents of their patients coming for consultations armed with articles
researched on the Internet and other sources describing new treatments and
medications.  In many cases, these patients are demanding a certain therapy
or drug and the physicians are complying when medically
appropriate.


17


Because
of this consumer-driven market factor, we also promote our products directly to
the general public.  We target the prostate cancer patient, his spouse,
family and care givers.  We emphasize to these segments the specific
advantages of the Proxcelan Cesium-131 brachytherapy seed through our websites
(located at www.isoray.com and www.proxcelan.com), patient advocacy efforts,
informational patient brochures and DVDs with patient testimonials, patient
focused informational website (www.proxcelan.com), and advertisements in
specific markets supporting brachytherapy.  None of our websites should be
considered a part of this report.





In
addition, the Company continues to promote the clinical findings of the various
protocols through presentations by respected thought leaders.  The Company
will continually review and update all marketing materials as more clinical
information is gathered from the protocols and studies.





Apart
from clinical studies and papers sponsored by the Company, several physicians
across the country are now independently publishing papers and studies extolling
the benefits of Cs-131.





Sales
and Distribution





According
to a recent industry survey, approximately 2,000 hospitals and free standing
clinics are currently offering radiation oncology services in the United
States.  Not all of these facilities offer seed brachytherapy
services.  These institutions are staffed with radiation oncologists and
medical physicists who provide expertise in radiation therapy treatments and
serve as consultants for urologists and prostate cancer patients.  We
target the radiation oncologists and the medical physicists as well as
urologists as key clinical decision-makers in the type of radiation therapy
offered to prostate cancer patients.





IsoRay
has a direct sales organization to introduce Proxcelan Cesium-131 brachytherapy
seeds to radiation oncologists and medical physicists.  Currently IsoRay
has four direct sales persons and a VP of Business Development.  These
sales people include those experienced in the brachytherapy market and the
medical device market.  In 2008, the Company had six direct sales persons
and a National Sales Director; however, the Company has experienced some
turnover in the sales force due to changes in the sales compensation program,
termination of those who failed to sell sufficient amounts of products, and the
travel demands required by the position.  The Company is currently actively
recruiting one to two additional sales persons.





In 2009,
IsoRay entered into an exclusive distribution agreement with BrachySciences to
market Cs-131 seeds in the U.S.  BrachySciences has a sales force of
approximately 6 sales persons and a manager bringing the total sales personnel
selling Proxcelan Cs-131 brachytherapy seeds in the U.S. to approximately
12.  The BrachySciences sales force sold its first Cs-131 prostate implant
in August 2009; but it has taken longer than anticipated for BrachySciences’
customers to obtain the license amendments required for the Cs-131
product.





The
Company expects to continue to expand its customer base outside the U.S. market,
through use of established distributors in the key markets of other
countries.  This strategy should reduce the time and expenses required to
identify, train and penetrate the key implant centers and establish
relationships with the key opinion leaders in these markets.  Using
established distributors also should reduce the time spent acquiring the proper
radiation handling licenses and other regulatory requirements of these
markets.





Reimbursement





Payment
for IsoRay products comes from third-party payers including the Centers for
Medicare and Medicaid Services (CMS) and private insurance companies. 
These payers reimburse the hospitals and clinics via well-established payment
procedures.  In 2003, the Company was approved for an initial HCPCS code
for Cs-131 brachytherapy seeds.  In July 2007, CMS divided the HCPCS code
into two codes for all manufacturers of brachytherapy seeds.  The current
method has assigned one HCPCS code for loose seeds and a second HCPCS code for
stranded seeds.  Medicare is the most significant U.S. payer for prostate
brachytherapy services, and is the payer in approximately 65% of all U.S.
prostate brachytherapy cases.


18





Prostate
brachytherapy is typically performed in an outpatient setting, and as such, is
covered by the CMS Outpatient Prospective Payment System.  Currently, when
charges for the seeds are correctly submitted to CMS, the total cost of the
seeds is reimbursed to the hospital or clinic by CMS.  CMS proposed in July
2009 to implement a fixed price per seed reimbursement following the HCPCS
methodology.  Its proposal is to pay one price for loose seeds and another
for stranded seeds.  Iodine, palladium and cesium would each have their own
pricing.  In 2008, CMS previously proposed that a fixed price per seed be
used for reimbursement; however, Congress (after postponing a decision on the
Medical Bill which included brachytherapy seed reimbursement) voted on July 15,
2008 to continue the pass-through reimbursement for brachytherapy seeds through
December 31, 2009.  Management believes that Congress will again intervene
to maintain current reimbursement practices.  Other insurance companies
have historically followed CMS’s reimbursement policies.





Other
Information





Customers





Customers
representing ten percent or more of total Company sales for the twelve months
ended June 30, 2009 include:





Various
      Northern California facilities (1)
              22.6%
      of revenueChicago
      Prostate Cancer Center             
        Westmont, IL
              12.4%
      of revenue





(1)
            The
      following facilities located in northern California are used by one doctor
      (the Company’s Medical Director):  Community Hospital of Los Gatos
      (8.0% of total revenue), Fremont Surgery Center (5.9%), Mills Peninsula
      Health Services (3.6%), El Camino Hospital (3.6%) and all others used by
      this doctor combined (1.5%).





The loss
of any of these significant customers would have an adverse effect on the
Company’s revenues, which would continue until the Company located new customers
to replace them.





Proprietary
Rights





The
Company relies on a combination of patent, copyright and trademark laws, trade
secrets, software security measures, license agreements and nondisclosure
agreements to protect its proprietary rights.  Some of the Company’s
proprietary information may not be patentable.  The Company has a
registered U.S. trademark for Proxcelan.





The
Company intends to vigorously defend its proprietary technologies, trademarks,
and trade secrets.  Members of management, employees, and certain equity
holders have previously signed non-disclosure, non-compete agreements, and
future employees, consultants, advisors, with whom the Company engages, and who
are privy to this information, will be required to do the same.  A patent
for the cesium separation and purification process was granted on May 23, 2000
by the U.S. Patent and Trademark Office (USPTO) under Patent Number 6,066,302,
with an expiration date of May 23, 2020.  The process was developed by Lane
Bray, Chief Chemist and a shareholder of the Company, and has been assigned
exclusively to IsoRay.  IsoRay’s predecessor also filed for patent
protection in four European countries under the Patent Cooperation Treaty. 
Those patents have been assigned to IsoRay.





Our
management believes that certain aspects of the IsoRay seed design and
construction techniques are patentable innovations.  These innovations have
been documented in IsoRay laboratory records, and a patent application was filed
with the USPTO on November 12, 2003.  In August 2008, this patent was
granted by the USPTO under Patent Number 7,410,458, with an expiration date of
November 12, 2023.  Certain methodologies regarding isotope production,
separation, and seed manufacture are retained as trade secrets and are embodied
in IsoRay’s procedures and documentation.  In June 2004, July 2004, and
February 2007, five patent applications were filed relating to methods of
deriving Cs-131 developed by IsoRay employees.  The Company is currently
working on developing and patenting additional methods of deriving Cs-131 and
other isotopes.


19





There are
specific conditions attached to the assignment of the Cs-131 patent from Lane
Bray.  In particular, the associated Royalty Agreement provides for 1% of
gross profit payment from seed sales to Lane Bray and 1% of gross profit from
any use of the Cs-131 process patent for non-seed products.  If IsoRay
reassigns the Royalty Agreement to another company, these royalties increase to
2%.  The Royalty Agreement has an anti-shelving clause which requires
IsoRay to return the patent if IsoRay permanently abandons sales of products
using the invention.  During fiscal years 2009 and 2008, the Company
recorded royalty expense of $20,063 and $21,219, respectively, related to this
patent.





The terms
of a license agreement with the Lawrence Family Trust (successor to Don
Lawrence) for a patent application and related “know-how” require the payment of
a royalty based on the Net Factory Sales Price, as defined in the agreement, of
licensed product sales.  Because the licensor’s patent application was
ultimately abandoned, only a 1% “know-how” royalty remains applicable. To date,
management believes that there have been no product sales incorporating the
“know-how;” and therefore believes no royalty is due pursuant to the terms of
the agreement.  Management believes that ultimately no royalties should be
paid under this agreement as there is no intent to use this “know-how” in the
future.





The
Lawrence Family Trust has disputed management’s contention that it is not using
this “know-how”.  On September 25, 2007 and again on October 31, 2007, the
Company participated in nonbinding mediation regarding this matter; however, no
settlement was reached with the Lawrence Family Trust.  After additional
settlement discussions, which ended in April 2008, the parties failed to reach a
settlement.  The parties may demand binding arbitration at any
time.





Research
and Development





During
the three-year period ended June 30, 2009, IsoRay and its predecessor companies
incurred more than $3.7 million in costs related to research and development
activities.  The Company expects to continue ongoing research and
development activities for the foreseeable future.





Whether
successful or not, the Company anticipates ending its major research and
development project to develop a proprietary separation process to manufacture
enriched barium during fiscal year 2010.  During fiscal year 2009, the
Company incurred approximately $39,000 on this project.  The remaining
project costs are anticipated to be approximately $100,000 to $150,000 for a
production model (if required) in addition to the $56,610 payment to be made for
the prototype if the demonstration is successful.





Government
Regulation





The
Company's present and future intended activities in the development, manufacture
and sale of cancer therapy products are subject to extensive laws, regulations,
regulatory approvals and guidelines.  Within the United States, the
Company's therapeutic radiological devices must comply with the U.S. Federal
Food, Drug and Cosmetic Act, which is enforced by the FDA.  The Company is
also required to adhere to applicable FDA Quality System Regulations, also known
as the Good Manufacturing Practices, which include extensive record keeping and
periodic inspections of manufacturing facilities.  The Company's
predecessor obtained FDA 510(k) clearance in March 2003 to market the Proxcelan
Cs-131 seed for the treatment of localized solid tumors and other malignant
disease and IsoRay obtained FDA 510(k) clearance in November 2006 to market
preloaded brachytherapy seeds.





In the
United States, the FDA regulates, among other things, new product clearances and
approvals to establish the safety and efficacy of these products.  We are
also subject to other federal and state laws and regulations, including the
Occupational Safety and Health Act and the Environmental Protection
Act.


20


The
Federal Food, Drug, and Cosmetic Act and other federal statutes and regulations
govern or influence the research, testing, manufacture, safety, labeling,
storage, record keeping, approval, distribution, use, reporting, advertising and
promotion of such products.  Noncompliance with applicable requirements can
result in civil penalties, recall, injunction or seizure of products, refusal of
the government to approve or clear product approval applications,
disqualification from sponsoring or conducting clinical investigations,
preventing us from entering into government supply contracts, withdrawal of
previously approved applications, and criminal prosecution.





In the
United States, medical devices are classified into three different categories
over which the FDA applies increasing levels of regulation: Class I, Class II,
and Class III.  Most Class I devices are exempt from premarket notification
(510(k)); most Class II devices require premarket notification (510(k)); and
most Class III devices require premarket approval.  Our Proxcelan Cs-131
seed is a Class II device and received 510(k) clearance in March
2003.





Approval
of new Class III medical devices is a lengthy procedure and can take a number of
years and require the expenditure of significant resources.  There is a
shorter FDA review and clearance process for Class II medical devices, the
premarket notification or 510(k) process, whereby a company can market certain
Class II medical devices that can be shown to be substantially equivalent to
other legally marketed devices.  Since brachytherapy seeds have been
classified by the FDA as a Class II device, we have been able to achieve market
clearance for our Cs-131 seed using the 510(k) process.





As a
registered medical device manufacturer with the FDA, we are subject to
inspection to ensure compliance with their current Good Manufacturing Practices,
or cGMP.  These regulations require that we and any of our contract
manufacturers design, manufacture and service products, and maintain documents
in a prescribed manner with respect to manufacturing, testing, distribution,
storage, design control, and service activities.  Modifications or
enhancements that could significantly affect the safety or effectiveness of a
device or that constitute a major change to the intended use of the device
require a new 510(k) notice for any product modification.





The
Medical Device Reporting regulation requires that we provide information to the
FDA on deaths or serious injuries alleged to be associated with the use of our
devices, as well as product malfunctions that are likely to cause or contribute
to death or serious injury if the malfunction were to recur.  Labeling and
promotional activities are regulated by the FDA and, in some circumstances, by
the Federal Trade Commission.





As a
medical device manufacturer, we are also subject to laws and regulations
administered by governmental entities at the federal, state and local
levels.  For example, our facility is licensed as a medical product
manufacturing facility in the State of Washington and is subject to periodic
state regulatory inspections.  Our customers are also subject to a wide
variety of laws and regulations that could affect the nature and scope of their
relationships with us.





In
support of IsoRay’s global strategy to expand marketing to Canada and Russia, we
initiated the process in fiscal year 2008 to obtain the European CE Mark,
Canadian registration, and certification to ISO 13485, an internationally
recognized quality system.  European law requires that medical devices sold
in any EU Member State comply with the requirements of the European Medical
Device Directive (MDD) or the Active Implantable Medical Device Directive
(AIMDD).  IsoRay’s products are classified in Europe as an active
implantable and are subject to the AIMDD.  Compliance with AIMDD and
obtaining a CE Mark involves being certified to ISO 13485 and obtaining approval
of the product technical file by a notified body that is recognized by competent
authorities of a Member State.  Compliance with ISO 13485 is also required
for registration of a company for sale of its products in Canada.  Many of
the recognized EU Notified Bodies are also recognized by Health Canada to
conduct the ISO 13485 inspections for Canadian registration.  During fiscal
year 2009, the Company received its certification to ISO 13485 and obtained
approval from Health Canada for its Canadian registration.  The Company is
now focusing on the Canadian and Russian markets and is no longer pursuing sales
in the European Union (EU).  Management no longer believes a strategic
alliance with IBt, SA, a Belgian company, will be consummated nor will
management leverage IBt’s distribution channels in the EU.


21





In the
United States, as a manufacturer of medical devices and devices utilizing
radioactive byproduct material, we are subject to extensive regulation by not
only federal governmental authorities, such as the FDA, but also by state and
local governmental authorities, such as the Washington State Department of
Health,to ensure
such devices are safe and effective.  In Washington State, the Department
of Health, by agreement with the federal Nuclear Regulatory Commission (NRC),
regulates the possession, use, and disposal of radioactive byproduct material as
well as the manufacture of radioactive sealed sources to ensure compliance with
state and federal laws and regulations.  Our Cs-131 brachytherapy seeds
constitute both medical devices and radioactive sealed sources and are subject
to these regulations.





Moreover,
our use, management, and disposal of certain radioactive substances and wastes
are subject to regulation by several federal and state agencies depending on the
nature of the substance or waste material.  We believe that we are in
compliance with all federal and state regulations for this purpose.





Seasonality





The
Company believes that some seed implantation procedures are deferred around
physician vacations (particularly in the summer months), holidays, and medical
conventions and conferences resulting in a seasonal influence on the Company’s
business.  These factors cause a momentary decline in revenue which
management believes is ultimately realized later.  Because almost thirty
percent (30%) of the Company's business relies on three physicians, simultaneous
vacations by these three physicians could cause significant drops in the
Company's productivity during those periods.





Employees





As of
September 14, 2009, IsoRay employed 37 full-time individuals and one part-time
individual.  The Company's future success will depend, in part, on its
ability to attract, retain, and motivate highly qualified sales, technical and
management personnel.  From time to time, the Company may employ
independent consultants or contractors to support its research and development,
marketing, sales, and administrative organizations.  None of the Company's
employees are represented by any collective bargaining unit.  The Company
estimates that successful implementation of its growth plan will result in up to
three to five additional employees by the end of fiscal year 2010.





In 2008,
the Company had six direct sales persons and a National Sales Director; however,
the Company has experienced some turnover in the sales force due to changes in
the sales compensation program, termination of those who failed to sell
sufficient quantities of product, and the travel demands required by the
position.  The Company currently has four direct sales persons and a VP,
Business Development and is actively recruiting one to two additional sales
persons.





Competition





The
Company competes in a market characterized by technological innovation,
extensive research efforts, and significant competition.  In general, the
Proxcelan Cesium-131 brachytherapy seed competes with conventional methods of
treating localized cancer, including, but not limited to, all forms of
prostatectomy surgery and external beam radiation therapy which includes
intensity modulated radiation therapy, as well as competing permanent
brachytherapy devices.  Surgery has historically represented the most
common medical treatment for early-stage, localized prostate cancer but radical
prostatectomies have declined in recent years.  EBRT is also a
well-established method of treatment and is widely accepted for patients who
represent a poor surgical risk or whose prostate cancer has advanced beyond the
stage for which surgical treatment is indicated.  Management believes that
if general conversion from these treatment options (or other established or
conventional procedures) to the Proxcelan Cesium-131 brachytherapy seed does
occur, such conversion will likely be the result of a combination of equivalent
or better efficacy, reduced incidence and duration of side effects and
complications, lower cost, better quality of life outcomes, and pressure by
health care providers and patients.


22





History
has shown the advantage of being the first to market a new brachytherapy
product.  For example, Theragenics Corp., which introduced the original
Pd-103 seed, currently claims over 59% of the Pd-103 market share (through CR
Bard, other distributors, and direct distribution).  (Source: 
Millennium Research Corp, 2008).  Although factors other than being first
to market contribute to becoming a market leader, the Company believes it has
the opportunity to obtain a similar and significant advantage by being the first
to introduce a Cs-131 seed.





The
Company’s patented Cs-131 separation process is likely to provide a sustainable
competitive advantage.  Production of Cs-131 also requires specialized
facilities that represent high cost and long lead time if not readily
available.  In addition, a competitor would need to develop a method for
isotope attachment and seed assembly, would need to conduct testing to meet NRC
and FDA requirements, and would need to obtain regulatory clearances before
marketing a competing device.





Several
companies have obtained regulatory clearance to produce and distribute Pd-103
and I-125 seeds, which compete directly with our seed.  It is possible that
three or four of the current I-125 or Pd-103 seed manufacturers (e.g., CR Bard,
Oncura, Theragenics, etc.) are capable of producing and marketing a Cs-131 seed,
but none have reported efforts to do so.  Best Medical obtained a seed core
patent in 1992 that named ten different isotopes, including Cs-131, for use in
their seeds.  Best Medical received FDA 510(k) clearance to market a Cs-131
seed on June 6, 1993 but to date has not produced any products for sale. 
In addition to the FDA and the NRC, Best Medical would be required to submit a
Cs-131 seed to the TG-43 task group of the American Association of Physicists in
Medicine to determine the seed’s characteristics such as anisotropy, dose rate
constant, etc.  To date there has been no submission to the TG-43 task
group for a competing Cs-131 seed.





Additional
Growth Opportunities





Management
of the Company sees growth opportunities through expansion into international
markets and additional treatment applicability to cancers other than
prostate.  The Company plans to introduce Cs-131 for prostate brachytherapy
initially into Canada and Russia and later into other international markets
through partnerships and strategic alliances with channel partners for
manufacturing and distribution.





Cs-131
has FDA clearance to be used for treatments for a broad spectrum of cancers
including breast, brain, lung, and liver cancer, and the Company believes that a
major opportunity exists as an adjunct therapy for the treatment of residual
lung, head and neck, and other cancers.  The Company has already begun
treating ocular melanoma and is just beginning to treat lung and head and neck
tumors.  The Company has had discussions with prominent physicians and is
looking at treatments for other cancer sites.





There is
also an opportunity to develop and market other radioactive isotopes to the
United States market, and to market Cs-131 isotope itself, separate from its use
in our seeds.  The Company is also in the preliminary stages of exploring
alternate methods of delivering our isotopes to various organs of the body, as
it may be advantageous to use delivery methods other than a
titanium-encapsulated seed to deliver radiation to certain organs.





ITEM
1A – RISK FACTORS





Our Revenues Depend Upon One
Product.  Until such time as we develop additional products, our
revenues depend upon the successful production, marketing, and sales of the
Proxcelan Cs-131 brachytherapy seed.  The rate and level of market
acceptance of this product may vary depending on the perception by physicians
and other members of the healthcare community of its safety and efficacy as
compared to that of competing products, if any; the clinical outcomes of the
patients treated; the effectiveness of our sales and marketing efforts in the
United States, Canada, and Russia; any unfavorable publicity concerning our
product or similar products; our product’s price relative to other products or
competing treatments; any decrease in current reimbursement rates from the
Centers for Medicare and Medicaid Services or third-party payers; regulatory
developments related to the manufacture or continued use of the product;
availability of sufficient supplies of enriched barium (now coming from Russia)
for Cs-131 seed production; ability to produce sufficient quantities of this
product; and the ability of physicians to properly utilize the device and avoid
excessive levels of radiation to patients.  Because of our reliance on this
product as the sole source of our revenue, any material adverse developments
with respect to the commercialization of this product may cause us to continue
to incur losses rather than profits in the future.


23


Although Cleared To Treat Any
Malignant Tissue, Our Sole Product Is Currently Used To Treat Two Types Of
Cancer.  Currently, the Proxcelan Cs-131 seed is used
exclusively for the treatment of prostate cancer (over ninety-nine percent of
our sales) and ocular melanoma (less than one percent of our
sales).  We believe the Proxcelan Cs-131 seed will be used to treat
other types of cancers (and have treated a single head and neck tumor and a
single lung tumor to date), as is currently the case with our competitors’ I-125
and Pd-103 seeds.  However, we believe that clinical data gathered by
select groups of physicians under treatment protocols specific to other organs
will be needed prior to widespread acceptance of our product for treating other
cancer sites.  If our current and future products do not become
accepted in treating cancers of other sites, our sales will depend solely on
treatment of prostate cancer and will require ever increasing market share to
increase revenues.





We Have Increasing Cash
Requirements.IsoRay has generated
material operating losses since inception.  We expect to continue to
experience significant net operating losses.  Due to previous capital
investments and substantial cost reductions, management believes cash and cash
equivalents on hand at June 30, 2009 will be sufficient to meet our
anticipated cash requirements for operations, debt service, and capital
expenditure requirements through at least the next twelve months.  If
operating costs expand proportionately with revenue increases, other
applications are pursued for seed usage outside the prostate market, protocols
are expanded to support the integrity of our product, and marketing expenses
increase, management believes approximately $1.0 million in monthly revenue will
be needed to reach break-even.  This is a decrease from the previous
estimate of $1.5 million in monthly revenue due to recent improvements in the
Company’s production operating efficiencies and its cost structure implemented
by new management.  However, there is no assurance as to when
break-even will occur.  If we are unable to generate profits and unable to
obtain additional financing to meet our working capital requirements, we may
have to curtail our business.





We Rely Heavily On A Limited Number
Of Suppliers.  Some materials used in our products are
currently available only from a limited number of suppliers.  In
fiscal 2009, approximately sixty-five percent (65%) of our Cs-131 was supplied
through UralDial from reactors located in Russia.  Unless the Company
substantially increases its purchase requirements resulting from significant
increases in demand for its product, the cost of Cs-131 in Russia could increase
from current pricing.  Our current contract with UralDial terminates
in December 2009 and will have to be renegotiated.  Management will
seek to negotiate favorable pricing but there is no assurance as to the outcome
of these negotiations.





If the
development of barium enrichment capabilities is successful, the Company plans
to expand Cs-131 manufacturing capability at the MURR reactor in the United
States. Reliance on any single supplier increases the risks associated with
concentrating isotope production at a single reactor facility which can be
subject to unanticipated shutdowns. Failure to obtain deliveries of Cs-131 from
multiple sources could have a material adverse effect on seed production and
there may be a delay before we could locate alternative suppliers beyond the
three currently used.





We may
not be able to locate additional suppliers outside of Russia capable of
producing the level of output of cesium at the quality standards we require.
Additional factors that could cause interruptions or delays in our source of
materials include limitations on the availability of raw materials or
manufacturing performance experienced by our suppliers and a breakdown in our
commercial relations with one or more suppliers.  Some of these
factors may be completely out of our and our suppliers’
control.


24


Virtually
all titanium tubing used in brachytherapy seed manufacture comes from a single
source, Accellent Corporation.  We currently obtain a key component of
our seed core from another single supplier.  We do not have formal
written agreements with Accellent Corporation.  Any interruption or
delay in the supply of materials required to produce our products could harm our
business if we were unable to obtain an alternative supplier or substitute
equivalent materials in a cost-effective and timely manner.  To
mitigate any potential interruptions, the Company continually evaluates its
inventory levels and management believes that the Company maintains a sufficient
quantity on hand to alleviate any potential disruptions.





Industry Trends. Several
factors which occurred in fiscal 2009 caused our revenues to significantly
decline and these factors are still contributing to our failure to improve sales
in the prostate market.  Beginning in the Fall of 2008, U.S. consumers
significantly curtailed all spending (even for life saving medical procedures)
which impacted the brachytherapy industry as a whole.  In February of
2009 noted urologists announced at a medical conference that PSA testing was not
as necessary as previously believed.  Their statements were widely
publicized.  Management believes that many people have been influenced
by these statements to cut back on PSA testing thereby decreasing in the short
term the number of procedures performed.  The final factor which
occurred was the emergence of IMRT as the preferred treatment alternative as a
result of a much higher reimbursement rate to physicians compared to
brachytherapy treatments.  Each of these factors is continuing to
impact the performance of the Company in the prostate market and the industry as
a whole during fiscal 2010 and there is no assurance that they will not continue
to impact sales of the Company.





Future Production Increases Will
Depend on Our Ability to Acquire Larger Quantities of Cs-131 and Hire More
Employees.IsoRay currently obtains
Cs-131 through its contract with UralDial and through reactor irradiation of
natural barium and subsequent separation of Cs-131 from the irradiated barium
targets.  The amount of Cs-131 that can be produced from a given
reactor source is limited by the power level and volume available within the
reactor for irradiating targets.  This limitation can be overcome by
utilizing barium feedstock that is enriched in the stable isotope
Ba-130.  However, the number of suppliers of enriched barium is
limited and they may be unable to produce this material in sufficient quantities
at a reasonable price.





IsoRay
has entered into an exclusive agreement (effective through December 31, 2009)
with UralDial in Russia to provide Cs-131 in quantities sufficient to supply a
significant percentage of future demand for this isotope.  Due to the
purchase of enriched barium in June 2007, IsoRay has access to sufficient
quantities of enriched barium that may be recycled to increase the production of
Cs-131.  Although the UralDial agreement provides for supplying Cs-131
in significant quantities, there is no assurance that this will result in IsoRay
gaining access to a continuing sufficient supply of enriched barium
feedstock.  If we were unable to obtain supplies of isotopes from
Russia in the future, our overall supply of Cs-131 would be reduced
significantly unless the Company has a source of enriched barium for utilization
in domestic reactors.





We Have Entered Into An Agreement
With A Single Distributor For Our Cesium-131 From Russia.  We
previously obtained the majority of our Cs-131 from either the Institute of
Nuclear Materials (INM) or the Russian Research Institute of Atomic Reactors
(RIAR), both of which are located in Russia.  In December 2008, we
entered into an agreement with UralDial to purchase Cs-131 directly from
UralDial instead of from INM and RIAR.  As a result, we now rely on
UralDial to obtain Cs-131 from Russian sources.  UralDial has agreed
to maintain at least two Russian sources of its Cs-131, and our agreement with
UralDial has lower minimum purchase requirements than our prior agreements with
INM and RIAR, and these lower minimum purchase requirements are being met at
this time.  Through the UralDial agreement, we have obtained set
pricing for our Russian Cs-131 through the end of 2009.  There can be
no guarantee that UralDial will always be able to supply us with sufficient
Cs-131, which could be due in part to risks associated with foreign operations
and beyond our and UralDial's control, and if we were unable to obtain supplies
of isotopes from Russia in the future, our overall supply of Cs-131 would be
reduced significantly unless we have a source of enriched barium for utilization
in domestic reactors.


25


We Are Subject To Uncertainties
Regarding Reimbursement For Use Of Our Products.  Hospitals and
freestanding clinics may be less likely to purchase our products if they cannot
be assured of receiving favorable reimbursement for treatments using our
products from third-party payers, such as Medicare and private health insurance
plans.  Currently, Medicare reimburses hospitals, clinics and
physicians for the cost of seeds used in brachytherapy procedures on a pass
through basis, and will continue this method of reimbursement through December
31, 2009.  Historically, private insurers have followed Medicare
guidelines in establishing reimbursement rates.  However, third-party
payers are increasingly challenging the pricing of certain medical services or
devices, and we cannot be sure that they will reimburse our customers at levels
sufficient for us to maintain favorable sales and price levels for our
products.  There is no uniform policy on reimbursement among
third-party payers, and we can provide no assurance that our products will
continue to qualify for reimbursement from all third-party payers or that
reimbursement rates will not be reduced.  A reduction in or
elimination of third-party reimbursement for treatments using our products would
likely have a material adverse effect on our revenues.





In 2003,
we applied to the Centers for Medicare and Medicaid Services (CMS) and received
a reimbursement code for use of our Cs-131 seed.  As of July 1, 2007,
CMS revised the coding system for brachytherapy seeds and separated the single
code into two codes – one code for loose seeds and a second code for stranded
seeds.  This methodology was applied to all companies manufacturing
and distributing brachytherapy seeds.  Reimbursement amounts are
reviewed and revised annually.  Adjustments could be made to these
reimbursement amounts or policies, which could result in reduced reimbursement
for brachytherapy services, which could negatively affect market demand for our
products.





Furthermore,
any federal and state efforts to reform government and private healthcare
insurance programs could significantly affect the purchase of healthcare
services and products in general and demand for our products in
particular.  Medicare is the payer in approximately 70% of all U.S.
prostate brachytherapy cases and management anticipates this percentage to
increase annually.  We are unable to predict whether potential
healthcare reforms will be enacted, whether other healthcare legislation or
regulations affecting the business may be proposed or enacted in the future or
what effect any such legislation or regulations would have on our business,
financial condition or results of operations.





Our Operating Results Will Be
Subject To Significant Fluctuations.  Our quarterly revenues,
expenses, and operating results are likely to fluctuate significantly in the
future.  Fluctuation may result from a variety of factors, which are
discussed in detail throughout this “RISK FACTORS” section,
including:


§
            our
      achievement of product development objectives and
    milestones;


§
            demand
      and pricing for the Company’s
products;


§
            effects
      of aggressive competitors;


§
            hospital,
      clinic and physician buying
decisions;


§
            research
      and development and manufacturing
expenses;


§
            patient
      outcomes from our therapy;


§
            physician
      acceptance of our products;


§
            government
      or private healthcare reimbursement
policies;


§
            our
      manufacturing performance and
capacity;


§
            incidents,
      if any, that could cause temporary shutdown of our manufacturing
      facility;


§
            the
      amount and timing of sales orders;


§
            rate
      and success of future product
approvals;


§
            timing
      of FDA clearance, if any, of competitive products and the rate of market
      penetration of competing products;


§
            seasonality
      of purchasing behavior in our
market;


§
            overall
      economic conditions; and


§
            the
      successful introduction or market penetration of alternative
      therapies.





We Have Limited Data on the Clinical
Performance of Cs-131.  As of July 31, 2009, the Proxcelan
Cs-131 seed has been implanted in over 4,000patients and research
papers are being published on the use of the Proxcelan seed.  However,
we have less statistical data than is available for I-125 and Pd-103
seeds.  While this limited data may prevent us from drawing
statistically significant conclusions, the side effects experienced by these
patients were less severe than side effects observed in seed brachytherapy with
I-125 and Pd-103 and in other forms of treatment such as radical
prostatectomy.  These early results indicate that the onset of side
effects generally occurs between one and three weeks post-implant, and the side
effects are resolved between five and eight weeks post-implant, more quickly
than the resolution of side effects that occur with competing seeds or with
other forms of treatment.  These limited findings support management’s
belief that the Cs-131 seed will result in less severe side effects than
competing treatments, but we may have to gather data on outcomes from additional
patients before we can establish statistically valid conclusions regarding the
incidence of side effects from our seeds.


26


We Are Subject To The Risk That
Certain Third Parties May Mishandle Our Product.  We rely on
third parties, such as Federal Express, to deliver our Proxcelan Cs-131 seed,
and on other third parties, including various radiopharmacies, to package our
Proxcelan Cs-131 seed in certain specialized packaging forms requested by
customers.  We are subject to the risk that these third parties may
mishandle our product, which could result in adverse effects, particularly given
the radioactive nature of our product.





It Is Possible That Other Treatments
May Be Deemed Superior To Brachytherapy.  Our Proxcelan Cs-131
seed faces competition not only from companies that sell other radiation therapy
products, but also from companies that are developing alternative therapies for
the treatment of cancers.  It is possible that advances in the
pharmaceutical, biomedical, or gene therapy fields could render some or all
radiation therapies, whether conventional or brachytherapy,
obsolete.  If alternative therapies are proven or even perceived to
offer treatment options that are superior to brachytherapy, physician adoption
of our product could be negatively affected and our revenues from our product
could decline.





Our Industry Is Intensely
Competitive.  The medical device industry is intensely
competitive.  We compete with both public and private medical device,
biotechnology and pharmaceutical companies that have been in existence longer
than we have, have a greater number of products on the market, have greater
financial and other resources, and have other technological or competitive
advantages.  In addition, centers that wish to offer the Proxcelan
Cs-131 seed must comply with licensing requirements specific to the state in
which they do business and these licensing requirements may take a considerable
amount of time to comply with.  Certain centers may choose to not
offer our Proxcelan Cs-131 seed due to the time required to obtain
necessary license amendments.  We also compete with academic
institutions, government agencies, and private research organizations in the
development of technologies and processes and in acquiring key
personnel.  Although we have patents granted and patents applied for
to protect our isotope separation processes and Cs-131 seed manufacturing
technology, we cannot be certain that one or more of our competitors will not
attempt to obtain patent protection that blocks or adversely affects our product
development efforts.  To minimize this potential, we have entered into
exclusive agreements with key suppliers of isotopes and isotope precursors,
which are subject to becoming non-exclusive as we have failed to meet minimum
purchase requirements.





We May Be Unable To Adequately
Protect Or Enforce Our Intellectual Property Rights Or Secure Rights To
Third-Party Patents.  Our ability and the abilities of our
partners to obtain and maintain patent and other protection for our products
will affect our success.  We are assigned, have rights to, or have
exclusive licenses to patents and patents pending in the U.S. and numerous
foreign countries.  The patent positions of medical device companies
can be highly uncertain and involve complex legal and factual
questions.  Our patent rights may not be upheld in a court of law if
challenged.  Our patent rights may not provide competitive advantages
for our products and may be challenged, infringed upon or circumvented by our
competitors.  We cannot patent our products in all countries or afford
to litigate every potential violation worldwide.





Because
of the large number of patent filings in the medical device and biotechnology
field, our competitors may have filed applications or been issued patents and
may obtain additional patents and proprietary rights relating to products or
processes competitive with or similar to ours.  We cannot be certain
that U.S. or foreign patents do not exist or will not be issued that would harm
our ability to commercialize our products and product
candidates.


27


The Value Of Our Granted Patents,
and Our Patents Pending, Is Uncertain.  Although our management
strongly believes that our patent on the process for producing Cs-131, our
patents on additional methods for producing Cs-131 and other isotopes, our
patent pending on the manufacture of the brachytherapy seed, and anticipated
future patent applications, which have not yet been filed, have significant
value, we cannot be certain that other like-kind processes may not exist or be
discovered, that any of these patents is enforceable, or that any of our patent
applications will result in issued patents.





Failure To Comply With Government
Regulations Could Harm Our Business.  As a medical device and
medical isotope manufacturer, we are subject to extensive, complex, costly, and
evolving governmental rules, regulations and restrictions administered by the
FDA, by other federal and state agencies, and by governmental authorities in
other countries.  Compliance with these laws and regulations is
expensive and time-consuming, and changes to or failure to comply with these
laws and regulations, or adoption of new laws and regulations, could adversely
affect our business.





In the
United States, as a manufacturer of medical devices and devices utilizing
radioactive by-product material, we are subject to extensive regulation by
federal, state, and local governmental authorities, such as the FDA and the
Washington State Department of Health,to ensure such devices
are safe and effective.  Regulations promulgated by the FDA under the
U.S. Food, Drug and Cosmetic Act, or the FDC Act, govern the design,
development, testing, manufacturing, packaging, labeling, distribution,
marketing and sale, post-market surveillance, repairs, replacements, and recalls
of medical devices.  In Washington State, the Department of Health, by
agreement with the federal Nuclear Regulatory Commission (NRC), regulates the
possession, use, and disposal of radioactive byproduct material as well as the
manufacture of radioactive sealed sources to ensure compliance with state and
federal laws and regulations.  Our Proxcelan Cs-131 brachytherapy
seeds constitute both medical devices and radioactive sealed sources and are
subject to these regulations.





Under the
FDC Act, medical devices are classified into three different categories, over
which the FDA applies increasing levels of regulation: Class I,
Class II, and Class III.  Our Proxcelan Cs-131 seed has been
classified as a Class II device and has received clearance from the FDA through
the 510(k) pre-market notification process.  Any modifications to the
device that would significantly affect safety or effectiveness, or constitute a
major change in intended use, would require a new 510(k)
submission.  As with any submittal to the FDA, there is no assurance
that a 510(k) clearance would be granted to the Company.





In
addition to FDA-required market clearances and approvals for our products, our
manufacturing operations are required to comply with the FDA's Quality System
Regulation, or QSR, which addresses requirements for a company's quality program
such as management responsibility, good manufacturing practices, product and
process design controls, and quality controls used in
manufacturing.  Compliance with applicable regulatory requirements is
monitored through periodic inspections by the FDA Office of Regulatory Affairs
(ORA).  We anticipate both announced and unannounced inspections by
the FDA.  Such inspections could result in non-compliance reports
(Form 483) which, if not adequately responded to, could lead to enforcement
actions.  The FDA can institute a wide variety of enforcement actions,
ranging from public warning letters to more severe sanctions such as fines,
injunctions, civil penalties, recall of our products, operating restrictions,
suspension of production, non-approval or withdrawal of pre-market clearances
for new products or existing products, and criminal
prosecution.  There can be no assurance that we will not incur
significant costs to comply with these regulations in the future or that the
regulations will not have a material adverse effect on our business, financial
condition and results of operations.





The
marketing of our products in foreign countries will, in general, be regulated by
foreign governmental agencies similar to the FDA.  Foreign regulatory
requirements vary from country to country.  The time and cost required
to obtain regulatory approvals could be longer than that required for FDA
clearance in the United States and the requirements for licensing a product in
another country may differ significantly from FDA requirements.  We
will rely, in part, on foreign distributors to assist us in complying with
foreign regulatory requirements.  We may not be able to obtain these
approvals without incurring significant expenses or at all, and the failure to
obtain these approvals would prevent us from selling our products in the
applicable countries.  This could limit our sales and
growth.


28


Our Business Exposes Us To Product
Liability Claims.  Our design, testing, development,
manufacture, and marketing of products involve an inherent risk of exposure to
product liability claims and related adverse publicity.  Insurance
coverage is expensive and difficult to obtain, and, although we currently have a
five million dollar policy, in the future we may be unable to obtain or renew
coverage on acceptable terms, if at all.  If we are unable to obtain
or renew sufficient insurance at an acceptable cost or if a successful product
liability claim is made against us, whether fully covered by insurance or not,
our business could be harmed.





Our Business Involves Environmental
Risks.  Our business involves the controlled use of hazardous
materials, chemicals, biologics, and radioactive
compounds.  Manufacturing is extremely susceptible to product loss due
to radioactive, microbial, or viral contamination; material or equipment
failure; vendor or operator error; or due to the very nature of the product’s
short half-life.  Although we believe that our safety procedures for
handling and disposing of such materials comply with state and federal standards
there will always be the risk of accidental contamination or
injury.  In addition, radioactive, microbial, or viral contamination
may cause the closure of the respective manufacturing facility for an extended
period of time.  By law, radioactive materials may only be disposed of
at state-approved facilities.  At our leased facility we use
commercial disposal contractors.  We may incur substantial costs
related to the disposal of these materials.  If we were to become
liable for an accident, or if we were to suffer an extended facility shutdown,
we could incur significant costs, damages, and penalties that could harm our
business.





We Rely Upon Key
Personnel. Our success will depend,
to a great extent, upon the experience, abilities and continued services of our
executive officers, sales staff and key scientific personnel.  If we
lose the services of several officers, sales personnel, or key scientific
personnel, our business could be harmed.  Our success also will depend
upon our ability to attract and retain other highly qualified scientific,
managerial, sales, and manufacturing personnel and their ability to develop and
maintain relationships with key individuals in the
industry.  Competition for these personnel and relationships is
intense and we compete with numerous pharmaceutical and biotechnology companies
as well as with universities and non-profit research
organizations.  We may not be able to continue to attract and retain
qualified personnel.





Our Ability To Operate In Foreign
Markets Is Uncertain.  Our future growth will depend in part on
our ability to establish, grow and maintain product sales in foreign markets,
particularly in Canada and Russia.  However, we have limited
experience in marketing and distributing products in other
countries.  Any foreign operations would subject us to additional
risks and uncertainties, including our customers’ ability to obtain
reimbursement for procedures using our products in foreign markets; the burden
of complying with complex and changing foreign regulatory requirements; speedy
delivery requirements due to the short half-life of our product; language
barriers and other difficulties in providing long-range customer service;
potentially longer accounts receivable collection times; significant currency
fluctuations, which could cause third-party distributors to reduce the number of
products they purchase from us because the cost of our products to them could
fluctuate relative to the price they can charge their customers; reduced
protection of intellectual property rights in some foreign countries; and the
possibility that contractual provisions governed by foreign laws would be
interpreted differently than intended in the event of a contract
dispute.  Any future foreign sales of our products could also be
adversely affected by export license requirements, the imposition of
governmental controls, political and economic instability, trade restrictions,
changes in tariffs, and difficulties in staffing and managing foreign
operations.  Many of these factors may also affect our ability to
import Cs-131 from Russia under our contract with UralDial.





Our Ability To Expand Operations And
Manage Growth Is Uncertain.  Our efforts to expand our
operations will result in new and increased responsibilities for management
personnel and will place a strain upon the entire company.  To compete
effectively and to accommodate growth, if any, we may be required to continue to
implement and to improve our management, manufacturing, sales and marketing,
operating and financial systems, procedures and controls on a timely basis and
to expand, train, motivate and manage our employees.  There can be no
assurance that our personnel, systems, procedures, and controls will be adequate
to support our future operations.  If the Proxcelan Cs-131 seed were
to rapidly become the “seed of choice,” it is unlikely that we could meet
demand.  We could experience significant cash flow difficulties and
may have difficulty obtaining the working capital required to manufacture our
products and meet demand.  This would cause customer discontent and
invite competition.


29


Our Reporting Obligations As A
Public Company Are Costly.  Operating a public company involves
substantial costs to comply with reporting obligations under federal securities
laws that are continuing to increase as provisions of the Sarbanes Oxley Act of
2002 are implemented.  As a smaller reporting company, the Company
needs to implement additional provisions of the Sarbanes Oxley Act during fiscal
year 2010.  These reporting obligations will increase our operating
costs.





Our Stock Price Is Likely To Be
Volatile.  There is generally significant volatility in the
market prices and limited liquidity of securities of early stage companies, and
particularly of early stage medical product companies.  Contributing
to this volatility are various events that can affect our stock price in a
positive or negative manner.  These events include, but are not
limited to: governmental approvals of or refusals to approve regulations or
actions; market acceptance and sales growth of our products; litigation
involving the Company or our industry; developments or disputes concerning our
patents or other proprietary rights; changes in the structure of healthcare
payment systems; departure of key personnel; future sales of our securities;
fluctuations in our financial results or those of companies that are perceived
to be similar to us; swings in seasonal demands of purchasers; investors’
general perception of us; and general economic, industry and market
conditions.  If any of these events occur, it could cause our stock
price to fall.





Our Reduced Stock Price May
Adversely Affect Our Liquidity.  Our common stock has been
trading at less than $1.00 per share periodically in recent
months.  Many market makers are reluctant to make a market in stock
with a trading price of less than $1.00 per share.  To the extent that
we have fewer market makers for our common stock, our volume and liquidity will
likely decline, which could further depress our stock price.





Future Sales By Shareholders, Or The
Perception That Such Sales May Occur, May Depress The Price Of Our Common
Stock.The sale or availability
for sale of substantial amounts of our shares in the public market, including
shares issuable upon conversion of outstanding preferred stock or exercise of
common stock warrants and options, or the perception that such sales could
occur, could adversely affect the market price of our common stock and also
could impair our ability to raise capital through future offerings of our
shares.  As of June 30, 2009, we had 22,942,088 outstanding shares of
common stock, and the following additional shares were reserved for issuance:
2,708,166 shares upon exercise of outstanding options, 3,216,644 shares upon
exercise of outstanding warrants, and 59,065 shares upon conversion of preferred
stock.  Any decline in the price of our common stock may encourage
short sales, which could place further downward pressure on the price of our
common stock and may impair our ability to raise additional capital through the
sale of equity securities.





The Issuance Of Shares Upon Exercise
Of Derivative Securities May Cause Immediate And Substantial Dilution To Our
Existing Shareholders. The issuance of shares
upon conversion of the preferred stock and the exercise of common stock warrants
and options may result in substantial dilution to the interests of other
shareholders since these selling shareholders may ultimately convert or exercise
and sell all or a portion of the full amount issuable upon
exercise.  If all derivative securities were converted or exercised
into shares of common stock, there would be approximately an additional
6,000,000 shares of common stock outstanding as a result.  The
issuance of these shares will have the effect of further diluting the
proportionate equity interest and voting power of holders of our common
stock.





We Do Not Expect To Pay Any
Dividends For The Foreseeable Future. We do not anticipate
paying any dividends to our shareholders for the foreseeable
future.  The terms of certain of our and our subsidiary's outstanding
indebtedness substantially restrict the ability of either company to pay
dividends.  Accordingly, shareholders must be prepared to rely on
sales of their common stock after price appreciation to earn an investment
return, which may never occur.  Any determination to pay dividends in
the future will be made at the discretion of our Board of Directors and will
depend on our results of operations, financial conditions, contractual
restrictions, restrictions imposed by applicable laws and other factors our
Board deems relevant.


30


Certain Provisions of Minnesota Law
and Our Charter Documents Have an Anti-Takeover Effect. There exist certain
mechanisms under Minnesota law and our charter documents that may delay, defer
or prevent a change of control.  Anti-takeover provisions of our
articles of incorporation, bylaws and Minnesota law could diminish the
opportunity for shareholders to participate in acquisition proposals at a price
above the then-current market price of our common stock.  For example,
while we have no present plans to issue any preferred stock, our Board of
Directors, without further shareholder approval, may issue shares of
undesignated preferred stock and fix the powers, preferences, rights and
limitations of such class or series, which could adversely affect the voting
power of the common shares.  In addition, our bylaws provide for an
advance notice procedure for nomination of candidates to our Board of Directors
that could have the effect of delaying, deterring or preventing a change in
control.  Further, as a Minnesota corporation, we are subject to
provisions of the Minnesota Business Corporation Act, or MBCA, regarding
“business combinations,” which can deter attempted takeovers in certain
situations.  Pursuant to the terms of a shareholder rights plan
adopted in February 2007, each outstanding share of common stock has one
attached right.  The rights will cause substantial dilution of the
ownership of a person or group that attempts to acquire the Company on terms not
approved by the Board of Directors and may have the effect of deterring hostile
takeover attempts.  The effect of these anti-takeover provisions may
be to deter business combination transactions not approved by our Board of
Directors, including acquisitions that may offer a premium over the market price
to some or all shareholders.  We may, in the future, consider adopting
additional anti-takeover measures.  The authority of our Board to
issue undesignated preferred or other capital stock and the anti-takeover
provisions of the MBCA, as well as other current and any future anti-takeover
measures adopted by us, may, in certain circumstances, delay, deter or prevent
takeover attempts and other changes in control of the Company not approved by
our Board of Directors.





ITEM
1B – UNRESOLVED STAFF COMMENTS





As a
smaller reporting company, the Company is not required to provide Item 1B
disclosure in this Annual Report.





ITEM
2 – PROPERTIES





The
Company’s executive offices are located at 350 Hills Street, Suite 106,
Richland, WA 99354, (509) 375-1202, where IsoRay currently leases approximately
16,400 square feet of office and laboratory space for approximately $23,500 per
month plus monthly janitorial expenses of approximately $460 from Energy
Northwest, the owner of the Applied Process Engineering Laboratory (the APEL
facility).  The Company is not affiliated with this
lessor.  The monthly rent is subject to annual increases based on the
Consumer Price Index.  The current lease was entered into in May 2007,
expires on April 30, 2010, and has two three-year renewal options.





The
Company’s management believes that all facilities occupied by the Company are
adequate for present requirements, and that the Company’s current equipment is
in good condition and is suitable for the operations involved.





ITEM
3 – LEGAL PROCEEDINGS





The
Company is not involved in any material legal proceedings as of the date of this
Report.





ITEM
4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS





No matter
was submitted to a vote of the Company’s security holders during the fourth
quarter of the fiscal year covered by this Annual Report.


31


PART
II





ITEM
5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES





The
Company’s Articles of Incorporation provide that the Company has the authority
to issue 200,000,000 shares of capital stock, which are currently divided into
two classes as follows: 194,000,000 shares of common stock, par value of $0.001
per share; and 6,000,000 shares of preferred stock, par value of $0.001 per
share.  As of September 14, 2009, we had 22,942,088 outstanding shares
of Common Stock and 59,065 outstanding shares of Preferred Stock.





On April
19, 2007, our common stock began trading on the American Stock Exchange (now the
NYSE Amex) under the symbol "ISR."  Even though we have obtained our
NYSE Amex listing, there is still limited trading activity in our
securities.





The
following table sets forth, for the fiscal quarters indicated, the high and low
sales prices for our common stock as reported on the NYSE Amex.





Year
      ended June 30, 2009
                    
                    High
                    
                    
                    LowFirst
      quarter
                    
                    $
                    0.90
                    
                    
                    $
                    0.35Second
      quarter
                    
                    
                    0.70
                    
                    
                    
                    0.20Third
      quarter
                    
                    
                    0.32
                    
                    
                    
                    0.15Fourth
      quarter
                    
                    
                    0.39
                    
                    
                    
                    0.19Year
      ended June 30, 2008
                    
                    High
                    
                    
                    LowFirst
      quarter
                    
                    $
                    5.20
                    
                    
                    $
                    3.44Second
      quarter
                    
                    
                    3.51
                    
                    
                    
                    1.85Third
      quarter
                    
                    
                    2.27
                    
                    
                    
                    1.00Fourth
      quarter
                    
                    
                    1.00
                    
                    
                    
                    0.55





The
Company has never paid any cash dividends on its Common Stock and does not plan
to pay any cash dividends in the foreseeable future.  On February 1,
2007, the Board of Directors declared a dividend on the Series B Preferred Stock
of all outstanding and cumulative dividends through December 31,
2006.  There is no Series A Preferred Stock
outstanding.  The total Series B accrued dividends of $38,458 were
paid on February 15, 2007.   At June 30, 2009, there were 59,065
Series B preferred shares outstanding and cumulative dividends in arrears were
$26,565.  There is no Series A Preferred Stock
outstanding.





As of
September 14, 2009, we had approximately 320 shareholders of record, exclusive
of shares held in street name.





Equity Compensation
Plans





On May
27, 2005, the Company adopted the 2005 Stock Option Plan (the Option Plan) and
the 2005 Employee Stock Option Plan (the Employee Plan), pursuant to which it
may grant equity awards to eligible persons.  On August 15, 2006, the
Company adopted the 2006 Director Stock Option Plan (the Director Plan) pursuant
to which it may grant equity awards to eligible persons.  Each of the
Plans has subsequently been amended.  The Option Plan allows the Board
of Directors to grant options to purchase up to 1,800,000 shares of common stock
to directors, officers, key employees and service providers of the Company, and
the Employee Plan allows the Board of Directors to grant options to purchase up
to 2,000,000 shares of common stock to officers and key employees of the
Company.  The Director Plan allows the Board of Directors to grant
options to purchase up to 1,000,000 shares of common stock to directors of the
Company.  Options granted under all of the Plans have a ten year
maximum term, an exercise price equal to at least the fair market value of the
Company’s common stock (based on the trading price on the NYSE Amex) on the date
of the grant, and with varying vesting periods as determined by the
Board.


32


As of
June 30, 2009, the following options had been granted under the option
plans.





Number
      of
                
                
                Weighted-
                
                
                Number
      ofsecurities
      to
                
                
                average
                
                
                securitiesbe
      issued on
                
                
                exercise
                
                
                remainingexercise
      of
                
                
                price
      of
                
                
                available
      foroutstanding
                
                
                outstanding
                
                
                futureoptions,
                
                
                options,
                
                
                issuancewarrants,
                
                
                warrants,
                
                
                under
      equityand
      rights
                
                
                and
      rights
                
                
                compensationPlan Category
                
                #
                
                
                $
                
                
                plansEquity
      compensation plans approved by shareholders
                
                
                N/A
                
                
                
                N/A
                
                
                
                N/AEquity
      compensation plans not approved by shareholders
                
                
                2,708,166
                
                
                $
                2.08
                
                
                
                1,225,051Total
                
                
                2,708,166
                
                
                $
                2.08
                
                
                
                1,225,051





Issuer Purchases of Equity
Securities





In June
2008, the Board of Directors of IsoRay authorized the repurchase of up to
1,000,000 shares of the Company’s common stock (FY2009 Plan).  The
FY2009 Plan expired on June 30, 2009.  The table below shows the
activity in the FY2009 Plan from inception to June 30, 2009.  There
were no shares purchased during fiscal year 2008 other than in June 2008 and no
shares purchased during fiscal year 2009 other than in July 2009.





FY 2009
PLAN





Total
                                        Number
      of
                                        Shares
                                        Purchased
                                      
                                      
                                      Maximum
                                        Number
      of
                                        Shares
      thatPeriod
                                      
                                      Total
                                        Number
                                      
                                      
                                      Average
                                        Price
                                      
                                      
                                      as
      Part of
                                        Publicly
                                      
                                      
                                      May
      Yet be
                                        PurchasedBeginning
                                      
                                      Ending
                                      
                                      of Shares
                                        Purchased
                                      
                                      
                                      Paid
                                        per
      Share
                                      
                                      
                                      Announced
                                        Plan
                                      
                                      
                                      Under
      the
                                        Plan
      (1)June
      1, 2008
                                      
                                      June
      30, 2008
                                      
                                      
                                      5,000
                                      
                                      
                                      $
                                      0.731
                                      
                                      
                                      
                                      5,000
                                      
                                      
                                      
                                      995,000July
      1, 2008
                                      
                                      July
      31, 2008
                                      
                                      
                                      8,200
                                      
                                      
                                      $
                                      0.577
                                      
                                      
                                      
                                      13,200
                                      
                                      
                                      
                                      986,800Total
                                      
                                      
                                      
                                      
                                      13,200
                                      
                                      
                                      $
                                      0.636
                                      
                                      
                                      
                                      13,200
                                      
                                      
                                      
                                      986,800





(1)
            In
      June 2008, the Company announced a new stock repurchase plan to purchase
      up to 1,000,000 shares of the Company's common stock.  The Plan
      expired on June 30, 2009.





Sales of Unregistered
Securities





All sales
of unregistered securities were previously reported.





ITEM
6 – SELECTED FINANCIAL DATA





As a
smaller reporting company, the Company is not required to provide Item 6
disclosure in this Annual Report.


33


ITEM
7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





Critical Accounting Policies
and Estimates





Management’s
discussion and analysis of the Company’s financial condition and results of
operations is based upon its consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America.  The preparation of these financial
statements requires management to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosures of contingent liabilities.  On an on-going basis,
management evaluates past judgments and estimates, including those related to
bad debts, inventories, accrued liabilities, and
contingencies.  Management bases its estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources.  Actual results may differ from
these estimates under different assumptions or conditions.





The
Company believes the following critical accounting policies affect its more
significant judgments and estimates used in the preparation of its consolidated
financial statements.





Short-Term
Investments





The
Company invests certain excess cash in marketable securities consisting
primarily of commercial paper, auction rate securities, certificates of deposit,
and money market funds.  The Company classifies all debt securities as
“available-for-sale” and records the debt securities at fair value with
unrealized gains and temporary unrealized losses included in other comprehensive
income/loss within shareholders’ equity, if material.  Declines in
fair values that are considered other than temporary are recorded in the
Consolidated Statements of Operations.





Fair Value of Financial
Instruments





Effective
July 1, 2008, the Company implemented Statement of Financial Accounting
Standards (SFAS) No. 157, Fair
Value Measurements.  SFAS 157 defines fair value,
establishes a framework for measuring fair value in accordance with accounting
principles generally accepted in the United States, and expands disclosures
about fair value measurements.  The Company elected to implement this
Statement with the one-year deferral permitted by FASB Staff Position (FSP)
157-2 for nonfinancial assets and nonfinancial liabilities measured at fair
value, except those that are recognized or disclosed on a recurring
basis.  This deferral applies to fixed assets and intangible asset
impairment testing and initial recognition of asset retirement obligations for
which fair value is used.  The Company does not expect any significant
impact to our consolidated financial statements when we implement SFAS 157 for
these assets and liabilities.





SFAS 157
requires disclosures that categorize assets and liabilities measured at fair
value into one of three different levels depending on the observability of the
inputs employed in the measurement.  Level 1 inputs are quoted prices
in active markets for identical assets or liabilities.  Level 2 inputs
are observable inputs other than quoted prices included within Level 1 for the
asset or liability, either directly or indirectly through market-corroborated
inputs.  Level 3 inputs are unobservable inputs for the asset or
liability reflecting significant modifications to observable related market data
or our assumptions about pricing by market participants.





At June
30, 2009, all of the Company’s financial assets and liabilities are accounted
and reported at fair value using Level 1 inputs.


34


Also
effective July 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities Including an Amendment of FASB Statement No.
115.  The statement allows entities to value many financial
instruments and certain other items at fair value.  SFAS 159 provides
guidance over the election of the fair value option, including the timing of the
election and specific items eligible for the fair value
accounting.  If the fair value option is elected then unrealized gains
and losses are reported in earnings at each subsequent reporting
date.  The Company elected not to measure any additional financial
instruments or other items at fair value as of July 1, 2008 in accordance with
SFAS 159.  Accordingly, the adoption of SFAS 159 did not impact our
consolidated financial statements.  The Company did elect to fair
value its ARS rights that were received in October 2008 and exercised in January
2009 in accordance with SFAS 159.





Accounts
Receivable





Accounts
receivable are stated at the amount that management of the Company expects to
collect from outstanding balances.  Management provides for probable
uncollectible amounts through an allowance for doubtful
accounts.  Additions to the allowance for doubtful accounts are based
on management’s judgment, considering historical write-offs, collections and
current credit conditions.  Balances which remain outstanding after
management has used reasonable collection efforts are written off through a
charge to the allowance for doubtful accounts and a credit to the applicable
accounts receivable.  Payments received subsequent to the time that an
account is written off are considered bad debt recoveries.





Inventory





Inventory
is reported at the lower of cost or market.  Cost of raw materials is
determined using the weighted average method.  Cost of work in process
and finished goods is computed using standard cost, which approximates actual
cost, on a first-in, first-out basis.





Fixed
Assets





Fixed
assets are capitalized and carried at the lower of cost or net realizable
value.  Normal maintenance and repairs are charged to expense as
incurred.  When assets are sold or otherwise disposed of, the cost and
accumulated depreciation are removed from the accounts and any resulting gain or
loss is recognized in operations.





Depreciation
is computed using the straight-line method over the following estimated useful
lives:


Production
      equipment
                  3
      to 7 yearsOffice
      equipment
                  2
      to 5 yearsFurniture
      and fixtures
                  2
      to 5 years





Leasehold
improvements and capital lease assets are amortized over the shorter of the life
of the lease or the estimated useful life of the asset.





Management
of the Company periodically reviews the net carrying value of all of its
equipment on an asset by asset basis.  These reviews consider the net
realizable value of each asset to determine whether an impairment in value has
occurred, and the need for any asset impairment write-down.





Although
management has made its best estimate of the factors that affect the carrying
value based on current conditions, it is reasonably possible that changes could
occur which could adversely affect management's estimate of net cash flows
expected to be generated from its assets, and necessitate asset impairment
write-downs.





Deferred Financing
Costs





Financing
costs related to the acquisition of debt are deferred and amortized over the
term of the related debt using the effective interest method.Deferred financing costs
include the fair value of common shares issued to certain shareholders for their
guarantee of certain Company debt in accordance with Accounting Principles Board
(APB) Opinion No. 21, Interest
on Receivables and Payables and Emerging Issues Task Force (EITF) Issue
No. 95-13, Classification of
Debt Issue Costs in the Statement of Cash Flows.  The value of
the shares issued was the estimated market price of the shares as of the date of
issuance.  Amortization of deferred financing costs, totaling $37,035
and $30,504 for the years ended June 30, 2009 and 2008, respectively, is
included in financing expense on the statements of operations.


35


Licenses





Amortization
of licenses is computed using the straight-line method over the estimated
economic useful lives of the assets.  In fiscal year 2006, the Company
entered into an agreement with IBt, SA, a Belgian company (IBt) to use IBt’s
proprietary “Ink Jet” production process and its proprietary polymer seed
technology for use in brachytherapy procedures using Cesium-131
(Cs-131).  The Company paid license fees of $225,000 and $275,000
during fiscal years 2008 and 2006, respectively.  During fiscal year
2009, the Company determined that the entire remaining value of the IBt license
was impaired and recorded an impairment charge of $425,434.





Amortization
of licenses was $30,067 and $43,452 for the years ended June 30, 2009 and 2008,
respectively.  Based on the licenses recorded at June 30, 2009, and
assuming no subsequent impairment of the underlying assets, the annual
amortization expense for each fiscal year ending June 30 is expected to be as
follows:  $11,867 for 2010, $0 for all years thereafter.





Other
Assets





Other
assets, which include deferred charges and patents, are stated at cost, less
accumulated amortization.  Amortization of patents is computed using
the straight-line method over the estimated economic useful lives of the
assets.  The Company periodically reviews the carrying values of
patents and any impairments are recognized when the expected future operating
cash flows to be derived from such assets are less than their carrying
value.





Based on
the patents and other intangible assets recorded in other assets at June 30,
2009, and assuming no subsequent impairment of the underlying assets, the annual
amortization expense for each fiscal year ending June 30 is expected to be as
follows: $16,861 for 2010, $15,139 for 2011, $15,139 for 2012, $15,139 for 2013,
$15,139 for 2014, and $157,768 thereafter.





Asset Retirement
Obligation





The fair
value of the future retirement costs of the Company’s leased assets are recorded
as a liability on a discounted basis when they are incurred and an equivalent
amount is capitalized to property and equipment.  The initial recorded
obligation is discounted using the Company’s credit-adjusted risk free-rate and
is reviewed periodically for changes in the estimated future costs underlying
the obligation.  The Company amortizes the initial amount capitalized
to property and equipment and recognizes accretion expense in connection with
the discounted liability over the estimated remaining useful life of the leased
assets.





In fiscal
year 2006, the Company established an initial asset retirement obligation of
$63,040 which represented the discounted cost of cleanup that the Company
anticipated it would have to incur at the end of its equipment and property
leases in its old production facility.  This amount was determined
based on discussions with qualified production personnel and on historical
evidence.  During fiscal year 2007, the Company reevaluated its
obligations based on discussions with the Washington Department of Health and
determined that the initial asset retirement obligation should be increased by
an additional $56,120.  During the second quarter of fiscal year 2008,
the Company removed all radioactive residuals and tenant improvements from its
old production facility and returned the facility to the lessor.  The
Company had an asset retirement obligation of $135,120 accrued for this facility
but total costs incurred to decommission the facility were $274,163 resulting in
an additional expense of $139,043 that is included in cost of products
sold.  The additional expense was mainly due to unanticipated
construction costs to return the facility to its previous state.  The
Company originally believed that the lessor would retain many of the leasehold
improvements in the building, but the lessor instead required their
removal.


36


In
September 2007, another asset retirement obligation of $473,096 was established
representing the discounted cost of the Company’s estimate of the obligations to
remove any residual radioactive materials and all leasehold improvements at the
end of the lease term at its new production facility.  The estimate
was developed by qualified production personnel and the general contractor of
the new facility.  The Company has reviewed the estimate again based
on its experience with decommissioning its old facility and believes that the
original estimate continues to be applicable.





During
the years ended June 30, 2009 and 2008, the asset retirement obligations changed
as follows:





2009
                    
                    
                    2008Beginning
      balance
                    
                    $
                    506,005
                    
                    
                    $
                    131,142New
      obligation
                    
                    
                    –
                    
                    
                    
                    473,096Settlement
      of existing obligation
                    
                    
                    –
                    
                    
                    
                    (135,120
                    )Accretion
      of discount
                    
                    
                    47,466
                    
                    
                    
                    36,887Ending
      balance
                    
                    $
                    553,471
                    
                    
                    $
                    506,005





Because
the Company does not expect to incur any expenses related to its asset
retirement obligations in fiscal year 2010, the entire balance as of June 30,
2009 is classified as a noncurrent liability.





Financial
Instruments





The
Company discloses the fair value of financial instruments, both assets and
liabilities, recognized and not recognized in the balance sheet, for which it is
practicable to estimate the fair value.  The fair value of a financial
instrument is the amount at which the instrument could be exchanged in a current
transaction between willing parties, other than a forced liquidation
sale.





The
carrying amounts of financial instruments, including cash and cash equivalents,
short-term investments, accounts receivable, accounts payable, notes payable,
and capital lease obligations, approximated their fair values at June 30, 2009
and 2008.





Revenue
Recognition





The
Company applies the provisions of SEC Staff Accounting Bulletin (SAB)
No. 104, Revenue
Recognition. SAB No. 104 provides guidance on the recognition,
presentation and disclosure of revenue in financial statements.  SAB
No. 104 outlines the basic criteria that must be met to recognize revenue
and provides guidance for the disclosure of revenue recognition
policies.  The Company recognizes revenue related to product sales
when (i) persuasive evidence of an arrangement exists, (ii) shipment
has occurred, (iii) the fee is fixed or determinable, and
(iv) collectability is reasonably assured.




Revenue
for the fiscal years ended June 30, 2009 and 2008 was derived solely from sales
of the Proxcelan Cs-131 brachytherapy seed, which is used in the treatment of
cancer.  The Company recognizes revenue once the product has been
shipped to the customer.  Prepayments, if any, received from customers
prior to the time that products are shipped are recorded as deferred revenue. In
these cases, when the related products are shipped, the amount recorded as
deferred revenue is then recognized as revenue.  The Company accrues
for sales returns and other allowances at the time of
shipment.  Although the Company does not have an extensive operating
history upon which to develop sales returns estimates, we have used the
expertise of our management team, particularly those with extensive industry
experience and knowledge, to develop a proper methodology.


37


Stock-Based
Compensation





The
Company measures and recognizes expense for all share-based payments at fair
value.  The Company uses the Black-Scholes option valuation model to
estimate fair value for all stock options on the date of grant.  For
stock options that vest over time, the Company recognizes compensation cost on a
straight-line basis over the requisite service period for the entire
award.





Research and Development
Costs





Research
and development costs, including salaries, research materials, administrative
expenses and contractor fees, are charged to operations as
incurred.  The cost of equipment used in research and development
activities which has alternative uses is capitalized as part of fixed assets and
not treated as an expense in the period acquired.  Depreciation of
capitalized equipment used to perform research and development is classified as
research and development expense in the year recognized.





Legal
Contingencies





In the
ordinary course of business, the Company is involved in legal proceedings
involving contractual and employment relationships, product liability claims,
patent rights, environmental matters, and a variety of other
matters.  The Company is also subject to various local, state, and
federal environmental regulations and laws due to the isotopes used to produce
the Company’s product.  As part of normal operations, amounts are
expended to ensure that the Company is in compliance with these laws and
regulations.  While there have been no reportable incidents or
compliance issues, the Company believes that if it relocates its current
production facilities then certain decommissioning expenses will be incurred and
has recorded an asset retirement obligation for these expenses.





The
Company records contingent liabilities resulting from asserted and unasserted
claims against it, when it is probable that a liability has been incurred and
the amount of the loss is reasonably estimable.  Estimating probable
losses requires analysis of multiple factors, in some cases including judgments
about the potential actions of third-party claimants and
courts.  Therefore, actual losses in any future period are inherently
uncertain.  Currently, the Company does not believe any probable legal
proceedings or claims will have a material adverse effect on its financial
position or results of operations.  However, if actual or estimated
probable future losses exceed the Company’s recorded liability for such claims,
it would record additional charges as other expense during the period in which
the actual loss or change in estimate occurred.





Income
Taxes





Income
taxes are accounted for under the liability method.  Under this
method, the Company provides deferred income taxes for temporary differences
that will result in taxable or deductible amounts in future years based on the
reporting of certain costs in different periods for financial statement and
income tax purposes.  This method also requires the recognition of
future tax benefits such as net operating loss carryforwards, to the extent that
realization of such benefits is more likely than not.  Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled.  The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in operations in the period
that includes the enactment of the change.





On July
1, 2007, the Company adopted Financial Accounting Standards Board Interpretation
No. 48, Accounting for
Uncertainty in Income Taxes (FIN No. 48).  FIN No. 48 clarifies
the accounting for uncertainty in income taxes recognized in accordance with
SFAS No. 109 Accounting for
Income Taxes, prescribing a recognition threshold and measurement
attribute for the recognition and measurement of a tax position taken or
expected to be taken in a tax return.  In the course of its
assessment, management has determined that the Company, its subsidiary, and its
predecessors are subject to examination of their income tax filings in the
United States and state jurisdictions for the 2005 through 2008 tax
years.  In the event that the Company is assessed penalties and or
interest, penalties will be charged to other operating expense and interest will
be charged to interest expense.


38


The
Company adopted FIN No. 48 using the modified prospective transition method,
which requires the application of the accounting standard as of July 1,
2007.  There was no impact on the financial statements as of and for
the year ended June 30, 2008 as a result of the adoption of FIN No.
48.  In accordance with the modified prospective transition method,
the financial statements for prior periods have not been restated to reflect,
and do not include, the impact of FIN No. 48.





Income (Loss) Per Common
Share





Basic
earnings per share is calculated by dividing net income (loss) available to
common shareholders by the weighted average number of common shares outstanding,
and does not include the impact of any potentially dilutive common stock
equivalents.  Common stock equivalents, including warrants and options
to purchase the Company's common stock, are excluded from the calculations when
their effect is antidilutive.  At June 30, 2009 and 2008, the
calculation of diluted weighted average shares does not include preferred stock,
common stock warrants or options that are potentially convertible into common
stock as those would be antidilutive due to the Company’s net loss
position.





Securities
that could be dilutive in the future as of June 30, 2009 and 2008 are as
follows:





2009
                  
                  
                  2008Preferred
      stock
                  
                  
                  59,065
                  
                  
                  
                  59,065Common
      stock warrants
                  
                  
                  3,216,644
                  
                  
                  
                  3,245,082Common
      stock options
                  
                  
                  2,708,166
                  
                  
                  
                  2,803,393Total
      potential dilutive securities
                  
                  
                  5,983,875
                  
                  
                  
                  6,107,540





Subsequent
Events





Effective
April 1, 2009, the Company adopted SFAS No. 165, Subsequent
Events.  This Statement establishes the accounting for, and
disclosure of, material events that occur after the balance sheet date, but
before the financial statements are issued.  In general, these events
will be recognized if the condition existed at the date of the balance sheet,
and will not be recognized if the condition did not exist at the balance sheet
date.  Disclosure is required for nonrecognized events if required to
keep the financial statements from being misleading.  The guidance in
this Statement is very similar to current guidance provided in accounting
literature and, therefore, will not result in significant changes in
practice.  Subsequent events have been evaluated through the date our
financial statements were issued—the filing time and date of our 2009 Annual
Report on Form 10-K.





Use of
Estimates





The
preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America requires management of the
Company to make estimates and assumptions that affect the amounts reported in
the financial statements and accompanying notes.  Accordingly, actual
results could differ from those estimates and affect the amounts reported in the
financial statements.





Results of
Operations





Financial
Presentation





The
following sets forth a discussion and analysis of the Company’s financial
condition and results of operations for the two years ended June 30, 2009 and
2008.  This discussion and analysis should be read in conjunction with
our consolidated financial statements appearing elsewhere in this Annual Report
on Form 10-K.  The following discussion contains forward-looking
statements.  Our actual results may differ significantly from the
results discussed in such forward-looking statements.  Factors that
could cause or contribute to such differences include, but are not limited to,
those discussed in “Item 1A — Risk Factors,” beginning on page 24 of
this Annual Report on Form 10-K.


39


Year ended June 30, 2009
compared to year ended June 30, 2008





Product
sales.  Sales for the year ended June 30, 2009 were $5,417,815
compared to sales of $7,158,690 for the year ended June 30, 2008.  The
decrease of $1,740,875 or 24% was mainly due to decreased sales volume of the
Company’s Proxcelan Cs-131 brachytherapy seeds along with an increased
percentage of loose seed sales as compared to stranded and a lower average
invoice price due to physicians using less seeds.  Loose seeds
(including seeds loaded in Mick cartridges) sell at a lower price than stranded
due to the additional processing time and expense required for stranded
seeds.  About 3% of the decrease is due to physicians ordering less
seeds per implant as they have become more efficient with use of the isotope and
its characteristics.  The Company will need to increase the number of
total implants to increase sales.  Management believes that other
treatment options with higher reimbursement rates, such as IMRT, put pressure on
Proxcelan Cs-131 seed sales as well as other brachytherapy seed
sales.  During the year ended June 30, 2009 the Company sold its
Cs-131 seeds to 72 different medical centers as compared to 99 centers during
the fiscal year ended June 30, 2008.





Cost of product
sales.  Cost of product sales were $5,771,147 for the year
ended June 30, 2009 which represents a decrease of $1,538,977 or 21% compared to
cost of product sales of $7,310,124 for the year ended June 30,
2008.  Materials expense decreased approximately $631,000 mainly due
to ordering and using less isotope in the year ended June 30, 2009 compared to
the year ended June 30, 2008.  Personnel expenses, including payroll,
benefits, and related taxes, decreased approximately $603,000 due to a reduction
in the average production headcount levels.  Preload expenses
decreased approximately $378,000 due to lower sales volumes and due to increased
in-house loading.  Small tools expenses decreased approximately
$90,000 mainly due to expensing items in the prior year that were part of
equipping the new facility that became operational in September
2007.  Share-based compensation decreased approximately $92,000 mainly
due to the forfeiture of unvested options by the Company’s former
EVP-Operations.





These
decreases were offset by an impairment of the Company’s IBt license for $425,434
that was recorded in December 2008.  Management completed its review
of the license and associated technology related to this alternative seed
encapsulation process in December 2008 and determined that the adoption of this
process would entail an overhaul of the Company’s existing manufacturing
procedures.  In addition, there is no assurance that physicians would
accept this new technology without extensive education and
marketing.  As there are no anticipated future revenues from the
license and the Company cannot sell or transfer the license, its entire value
was written off in the accompanying financial statements.





During
the year ended June 30, 2008, the Company removed all radioactive residuals and
tenant improvements from its old production facility and returned the facility
to the lessor.  The Company had an asset retirement obligation of
$135,120 accrued for this facility but total costs incurred to decommission the
facility were $274,163 resulting in an additional expense of $139,043 that is
included in cost of products sold for the year ended June 30,
2008.  This additional expense incurred in the year ended June 30,
2008 was mainly due to unanticipated construction costs to return the facility
to its previous state.  The Company originally believed that the
lessor would retain many of the leasehold improvements in the building, but
instead required their removal.





Gross loss.  Gross
loss was $353,332 for the year ended June 30, 2009.  This represents
an increase of $201,898 or 133% over the prior year’s gross loss of
$151,434.  Included in the gross loss for the year ended June 30, 2009
is the one-time IBt license impairment loss of $425,434.  Without this
one-time expense, the Company would have recognized a gross margin of $72,102
for the year ended June 30, 2009.  Included in the gross loss for the
year ended June 30, 2008 is the one-time decommissioning expense of
$139,043.  Without this one-time expense, the Company would have
recognized a gross loss of $12,391 for the year ended June 30,
2008.


40


Research and development
expenses.  Research and development expenses for the year ended
June 30, 2009 were $958,665 which represents a decrease of $399,410 or 29% less
than the research and development expenses of $1,358,075 for the year ended June
30, 2008.  The major components of the decrease were personnel,
consulting, and travel expenses.  Personnel expenses, including
payroll, benefits, and related taxes, decreased approximately $172,000 due to
lower headcount.  Consulting expenses decreased approximately $455,000
as the Company’s project to improve the efficiency of isotope production is
currently progressing slowly and the Company has discontinued most funding until
the final prototype testing trial.  Travel expenses decreased
approximately $44,000 due to less international travel than occurred in the
prior year.  These decreases were partially offset by an increase in
protocol expenses of approximately $217,000 mainly due to the Company’s
dual-therapy study and its continued monitoring and updating of the mono-therapy
study.  Also in the year ended June 30, 2009, the Company finalized
its on-going strategy regarding foreign patents and trademarks and wrote-off
$85,818 of previously capitalized costs.  The Company had pursued
prosecution of these patents and trademarks in various foreign countries
including Australia, Japan, and China; however, the Company no longer believes
that pursuing patents and trademarks in these foreign countries is fundamental
to its business strategy.





Sales and marketing
expenses.  Sales and marketing expenses were $2,365,973 for the
year ended June 30, 2009.  This represents a decrease of $1,359,191 or
36% compared to the year ended June 30, 2008 when sales and marketing expenses
were $3,725,164.  Personnel expenses, including payroll, benefits, and
related taxes, decreased approximately $603,000 due to a lower sales headcount
and lower commissions due to lower revenues and a revised sales compensation
plan that was originally introduced in April 2008 and subsequently amended in
October 2008.  Travel expenses also decreased approximately $148,000
due to the decrease in average headcount.  Consulting expenses
decreased approximately $214,000, mainly due to reduced reliance on
third-parties as part of the Company’s expense reduction
initiatives.  Marketing and advertising decreased approximately
$179,000 as during the prior year the Company updated its marketing literature
to incorporate new data published from the protocols, developed additional
websites for patients and doctors, and updated its sales
booth.  Share-based compensation decreased approximately $90,000 due
to the forfeiture of unvested options.





General and administrative
expenses.  General and administrative expenses for the year
ended June 30, 2009 were $2,792,611 compared to general and administrative
expenses of $3,568,048 for the year ended June 30, 2008.  The decrease
of $775,437 or 22% is primarily due to decreases in personnel costs, public
company expenses, share-based compensation, legal expenses, and travel expenses
partially offset by increases in consulting and bad debt
allowance.  Personnel costs decreased approximately $452,000 mainly
due to the resignation of the Company’s CEO in February 2008 and lower
headcounts.  The Company’s new CEO was a consultant from March 2008
through February 2009 and became an employee in March 2009.  Public
company expenses decreased approximately $124,000 due to lower investor
relations costs partially offset by increased board
compensation.  Legal expenses decreased by approximately $211,000 as
in the year ended June 30, 2008 the Company incurred legal fees for contract
drafting and review of the Company’s interest in UralDial, the IBt strategic
global alliance agreements, settlement agreements with former officers and
directors, and for mediation costs.  These decreased legal costs were
partially offset by legal fees incurred in settling a lawsuit with a former
employee.  Travel expenses also decreased approximately
$65,000.  These decreases were partially offset by increased expense
related to bad debt allowance of approximately $54,000 and increased consulting
expenses of approximately $100,000 mainly due to compensation paid to the
Company’s interim CEO and the costs of the Company’s ISO 13458 and CE mark audit
that was conducted in July 2008.


41


Operating loss.  The
Company continues to focus its resources on improving sales while retaining the
necessary administrative infrastructure to increase the level of demand for the
Company’s product.  These objectives and resulting costs have resulted
in operating losses since the Company’s inception.  For the year ended
June 30, 2009, the Company had an operating loss of $6,470,581 which is a
decrease of $2,332,140 or 26% below the operating loss of $8,802,721 for the
year ended June 30, 2008.





Interest
income.  Interest income was $111,047 for the year ended June
30, 2009 compared to interest income of $612,077 for the year ended June 30,
2008.  Interest and investment income is mainly derived from excess
funds held in money market and investment accounts.  The decrease of
$501,030 or 82% was due to the lower average cash and short-term investment
balances during the year ended June 30, 2009 and decreased interest
rates.





Gain (loss) on the fair value of
short-term investments.    The gain of $274,000 for
the year ended June 30, 2009 is due to the receipt of the Company’s rights
related to its auction rate securities (ARS) issued by its broker in October
2008.  The gain is calculated as the fair value amount of the put
rights as estimated on the date of receipt plus the changes in their fair value
offset by additional realized losses on the Company’s ARS.





Financing and interest
expense.  Financing and interest expense for the year ended
June 30, 2009 was $75,307 or a decrease of $17,556 or 19% compared to financing
expense of $92,863 for the year ended June 30, 2008.  Included in
financing expense is interest expense of approximately $38,000 and $62,000 for
the years ended June 30, 2009 and 2008, respectively.  The decrease is
due to the lower average debt balances in the year ended June 30,
2009.  The remaining balance of financing expense represents the
amortization of deferred financing costs.





Liquidity and capital
resources.  We have historically financed our operations
through the sale of common stock and related warrants.  During fiscal
year 2009, the Company primarily used existing cash reserves to fund its
operations and capital expenditures.





Cash
flows from operating activities





Cash used
in operating activities was approximately $3.9 million in fiscal year 2009
compared to approximately $7.7 million in fiscal year 2008, a decrease of
approximately $3.8 million.  Cash used by operating activities is net
loss adjusted for non-cash items and changes in operating assets and
liabilities.





Cash
flows from investing activities





Cash
provided by investing activities was approximately $2.2 million and $2.5 million
for the years ended June 30, 2009 and 2008, respectively.  Cash
expenditures for fixed assets were approximately $58,000 in fiscal year 2009 and
approximately $3.1 million in fiscal year 2008 (due to completing our current
production facility).  The Company sold its remaining auction rate
securities in January 2009 which generated $4.0 million of cash
proceeds.  The Company reinvested most of these proceeds in money
market funds and certificates of deposit with maturities of less than 3 months
which are classified as cash equivalents on the balance sheet.





Cash
flows from financing activities





Cash used
in financing activities was approximately $102,000 for the year ended June 30,
2009 and was used mainly for payments of debt and capital
leases.


42


Projected
2010 Liquidity and Capital Resources





At June
30, 2009, cash and cash equivalents amounted to $2,990,744 and short-term
investments amounted to $1,679,820 compared to $4,820,033 of cash and cash
equivalents and $3,726,000 of short-term investments at June 30,
2008.





The
Company had approximately $3.3 million of cash and $960,000 of short-term
investments as of September 14, 2009.  As of that date management
believed that the Company’s monthly required cash operating expenditures were
approximately $350,000 which represents a significant decrease of approximately
$150,000 to $200,000 from average monthly expenses in fiscal year
2008.  Management believes that less than $100,000 will be spent on
capital expenditures for the entire fiscal year 2010, but there is no assurance
that unanticipated needs for capital equipment may not arise.





The
Company’s loan with BFEDD matures in fiscal year 2010 and will be paid in full
by the end of the second quarter.  The balance of the loan at June 30,
2009 was $115,898 and is included in current liabilities.





If the
Company is able to complete its major research and development project to
develop a proprietary separation process to manufacture enriched barium, this
process should improve isotope production efficiency during fiscal year
2010.  The Company will owe an additional $56,610 to the contractor
upon completion of a successful demonstration of the enrichment
process.  Once a successful demonstration of the enrichment process
has occurred, the Company will have to decide if the smaller test model will
produce sufficient quantities of enriched barium or if an additional investment
of $100,000 to $150,000 will be required to build a larger production
model.





During
fiscal year 2010, the Company intends to continue its existing protocol studies
and begin new protocol studies on lung cancer treatment using
Cs-131.  Currently, the Company has budgeted approximately $220,000 in
fiscal year 2010 for protocol expenses relating to lung cancer as well as
continued work on the dual therapy and mono therapy prostate
protocols.





Assuming
operating costs expand proportionately with revenue increases, we continue
pursuing other applications for seed usage outside the prostate market,
protocols are continued supporting the integrity of our product and sales and
marketing expenses remain steady, management believes the Company will reach
breakeven with revenues of approximately $1.0 million per month.





Based on
the foregoing assumptions, management believes cash, cash equivalents, and
short-term investments on hand at June 30, 2009 will be sufficient to meet
our anticipated cash requirements for operations, debt service, and capital
expenditure requirements through at least the next twelve
months.  Management’s plans to attain breakeven and generate
additional cash flows include increasing revenues from both new and existing
customers (through our direct sales channels and through our distributors),
expanding into other market applications which initially will include head and
neck and lung, and maintaining cost control.  However, there can be no
assurance that the Company will attain profitability or that the Company will be
able to attain its revenue targets.  If we do not experience the
necessary increases in sales or if we experience unforeseen manufacturing
constraints, we may need to obtain additional funding.





The
Company expects to finance its future cash needs through solicitation of warrant
holders to exercise their warrants, the sale of equity securities and possibly
strategic collaborations or debt financing or through other sources that may be
dilutive to existing shareholders.  If the Company needs to raise
additional money to fund its operations, funding may not be available to it on
acceptable terms, or at all. If the Company is unable to raise additional funds
when needed, it may not be able to market its products as planned or continue
development and regulatory approval of its future products.  If the
Company raises additional funds through warrant exercises or equity sales, these
sales may be dilutive to existing investors.


43


Long-Term
Debt and Capital Lease Agreements





The
Company has two loan facilities in place as of June 30, 2009.  The
first loan is from the Benton-Franklin Economic Development District (BFEDD) in
an original principal amount of $230,000 and was funded in December
2004.  It bears interest at eight percent and has a final balloon
payment due in October 2009, which the Company intends to pay in full at that
time.  As of June 30, 2009, the principal balance owed was
$115,898.  This loan is secured by certain equipment, materials and
inventory of IsoRay, and also required personal guarantees, for which the
guarantors were issued approximately 70,455 shares of common
stock.  The second loan is from the Hanford Area Economic Investment
Fund Committee (HAEIFC) and was originated in June 2006.  The loan
originally had a total facility of $1,400,000 which was reduced in September
2007 to the amount of the Company’s initial draw of $418,670.  The
principal balance owed on the loan as of June 30, 2009 was
$221,562.  This loan is secured by receivables, equipment, materials
and inventory, and certain life insurance policies and also required personal
guarantees.  The final payment on the HAEIFC loan will be due in
September 2013.





The
Company is in violation of certain covenants of the BFEDD loan as of June 30,
2009.  The Company has not requested a waiver as the loan is due in
less than six months and is classified as current on the Company’s balance
sheet.  The Company is currently in violation of the covenants
regarding paying officers in excess of $100,000 per year, paying rent in excess
of $45,000 per year at its current location, and repurchasing any of its
outstanding stock.  Under the terms of the loan agreement, BFEDD can
raise the interest rate to 13 percent or request repayment of the entire amount
outstanding after giving the Company 15 days notice.  If BFEDD were to
take these measures, the Company would immediately repay the remaining balance
of the loan.





HAEIFC
has granted the Company a waiver from enforcing a fixed charge coverage
ratio.  The waiver is effective through June 30, 2010.





The
Company no longer has any capital leases as of June 30, 2009.





Other
Commitments and Contingencies





On May 2,
2007, Medical entered into a lease for its new production facility with Energy
Northwest, the owner of the Applied Process Engineering Laboratory (the APEL
lease).  The APEL lease has a three-year term expiring on April 30,
2010, an option to renew for two additional three-year terms, and original
monthly rent of approximately $26,700, subject to annual increases based on the
Consumer Price Index, plus monthly janitorial expenses of approximately
$700.  This new facility became operational in September
2007.  Due to a reduction in some lab and office space at APEL, the
rent has been reduced to approximately $23,500 per month plus monthly janitorial
expenses of approximately $460.





Future
minimum lease payments under operating leases, including the two three-year
renewals of the APEL lease, are as follows:





Year ending June 30,2010
                  
                  $
                  305,9082011
                  
                  
                  302,2352012
                  
                  
                  290,9932013
                  
                  
                  288,4672014
                  
                  
                  288,467Thereafter
                  
                  
                  528,857$
                  2,004,927





In
February 2006, the Company signed a license agreement with International
Brachytherapy SA (IBt), a Belgian company, covering North America and providing
the Company with access to IBt’s Ink Jet production process and its proprietary
polymer seed technology for use in brachytherapy procedures using
Cs-131.  Under the original agreement royalty payments were to be paid
on net sales revenue incorporating the technology.


44


On
October 12, 2007, the Company entered into Amendment No. 1 (the Amendment) to
its License Agreement dated February 2, 2006 with IBt.  The Company
paid license fees of $275,000 (under the original agreement) and $225,000 (under
the Amendment) during fiscal years 2006 and 2008, respectively.  The
Amendment eliminates the previously required royalty payments based on net sales
revenue, and the parties originally intended to negotiate terms for future
payments by the Company for polymer seed components to be purchased at IBt's
cost plus a to-be-determined profit percentage.  Management no longer
believes that introducing Cs-131 polymer seeds is a viable strategy due to
concerns regarding physician acceptance and the costs to revamp the Company’s
existing manufacturing procedures to incorporate this technology.  In
December 2008, the Company recorded an impairment charge to write down this
license based on its current intentions to not utilize this
technology.





In
November 2008, a subsidiary of the Company entered into a written contract with
a contractor based in the Ukraine to formalize a research and development
project originally begun over three years ago to develop a proprietary
separation process to manufacture enriched barium.  There is no
assurance that this process can be developed.  The contract called for
an initial payment of $17,800 and a payment of $56,610 upon completion of a
successful demonstration.  The Company’s initial demonstration has
been postponed due to an electrical problem that damaged equipment and due to
economic difficulties in the Ukraine that have protracted the contractor’s
efforts.  The Company anticipates that the device will be tested in
the Fall of 2009 but there is no assurance this testing will occur by then or
whether it will be successful.  After a successful demonstration, the
Company will decide if the prototype model will produce sufficient quantities of
enriched barium or if a larger production model will need to be built for an
additional $100,000 to $150,000.





The
Company is subject to various local, state, and federal environmental
regulations and laws due to the isotopes used to produce the Company’s
product.  As part of normal operations, amounts are expended to ensure
that the Company is in compliance with these laws and
regulations.  While there have been no reportable incidents or
compliance issues, the Company believes that if it relocates its current
production facilities then certain decommissioning expenses will be
incurred.  An asset retirement obligation was established in the first
quarter of fiscal year 2008 for the Company’s obligations at its new production
facility.  This asset retirement obligation will be for obligations to
remove any residual radioactive materials and to remove all leasehold
improvements.





The
industry that the Company operates in is subject to product liability
litigation.  Through its production and quality assurance procedures,
the Company works to mitigate the risk of any lawsuits concerning its
product.  The Company also carries product liability insurance to help
protect it from this risk.





The
Company has no off-balance sheet arrangements.





Inflation





Management
does not believe that the current levels of inflation in the United States have
had a significant impact on the operations of the Company.  If current
levels of inflation hold steady, management does not believe future operations
will be negatively impacted.





New Accounting
Standards





In
December 2007, the FASB issued statement No. 160, Noncontrolling Interests in
Consolidated Financial Statements – an amendment of ARB No. 51 (SFAS
160).  The statement requires noncontrolling interests or minority
interests to be treated as a separate component of equity, not as a liability or
other item outside of permanent equity.  Upon a loss of control, the
interest sold, as well as any interest retained, is required to be measured at
fair value, with any gain or loss recognized in earnings.  Based on
SFAS 160, assets and liabilities will not change for subsequent purchase or
sales transactions with noncontrolling interests as long as control is
maintained.  Differences between the fair value of consideration paid
or received and the carrying value of noncontrolling interests are to be
recognized as an adjustment to the parent interest’s equity.  SFAS 160
is effective for fiscal years beginning on or after December 15, 2008 and
earlier adoption is prohibited.  The adoption of this statement is not
expected to have a material effect on the Company’s financial
statements.


45


In May
2008, FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles.  SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States.  It was effective November 15, 2008, following the
SEC’s approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, The Meaning of
Present Fairly in Conformity With Generally Accepted Accounting
Principles.  The adoption of this statement did not have a
material effect on the Company’s financial statements.





The FASB
issued SFAS No. 168, The
FASB Standards Codification and the Hierarchy of Generally Accepted Accounting
Principles—a replacement of FASB Statement 162, in late
June 2009.  The FASB Accounting Standards Codification will
become the source of authoritative U.S. generally accepted accounting principles
(GAAP) and will supersede all then-existing non-SEC accounting and
reporting standards on the effective date, September 15,
2009.  The Codification will not change GAAP, but consolidates it into
a logical and consistent structure.  The Company will be required to
revise our references to GAAP in our financial statements beginning with the
first quarter of fiscal year 2010.





ITEM
7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





As a
smaller reporting company, the Company is not required to provide Item 7A
disclosure in this Annual Report.





ITEM
8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





The
required accompanying financial statements begin on page F-1 of this
document.




ITEM
9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE





There
were no disagreements or reportable events with DeCoria, Maichel & Teague,
P.S.




ITEM
9A – CONTROLS AND PROCEDURES





Disclosure
Controls and Procedures





Under the
supervision and with the participation of our management, including our
principal executive officer and principal financial officer, we conducted an
evaluation of the design and operation of our disclosure controls and
procedures, as such term is defined under Rules 13a-14(c) and 15d-14(c)
promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), as of June 30, 2009.  Based on that evaluation, our principal
executive officer and our principal financial officer concluded that the design
and operation of our disclosure controls and procedures were effective in timely
alerting them to material information required to be included in the Company's
periodic reports filed with the SEC under the Exchange Act.  The
design of any system of controls is based in part upon certain assumptions about
the likelihood of future events, and there can be no assurance that any design
will succeed in achieving its stated goals under all potential future
conditions, regardless of how remote.  However, management believes
that our system of disclosure controls and procedures is designed to provide a
reasonable level of assurance that the objectives of the system will be
met.


46


Management’s
Report on Internal Control over Financial Reporting





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rule 13a-15(f) of
the Exchange Act.  Under the supervision and with the participation of
our management, including our principal executive officer and principal
financial officer, we conducted an evaluation of the effectiveness of our
internal control over financial reporting based on the framework in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.  Based on our evaluation under the framework in
Internal Control – Integrated
Framework, our management concluded that our internal control over
financial reporting was effective as of June 30, 2009.





This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
registered public accounting firm pursuant to temporary rules of the Securities
and Exchange Commission that permit us to provide only management’s report in
this annual report.





Changes
in Internal Control over Financial Reporting





There
have not been any changes in our internal control over financial reporting (as
such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act)
during the most recent fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.





Limitations
on the Effectiveness of Controls





Our
management, including our principal executive officer and principal financial
officer, does not expect that our disclosure controls and internal controls will
prevent all errors and all fraud.  A control system, no matter how
well conceived and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met.  Further,
the design of a control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to their
costs.  Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the Company have been
detected.  These inherent limitations include the realities that
judgments in decision making can be faulty, and that breakdowns can occur
because of a simple error or mistake.  Additionally, controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people, or by management or board override of the control.





The
design of any system of controls also is based in part upon certain assumptions
about the likelihood of future events, and there can be no assurance that any
design will succeed in achieving its stated goals under all potential future
conditions; over time, controls may become inadequate because of changes in
conditions, or the degree of compliance with the policies or procedures may
deteriorate.  Because of the inherent limitations in a cost-effective
control system, misstatements due to error or fraud may occur and not be
detected.





ITEM
9B – OTHER INFORMATION





There
were no items required to be disclosed in a report on Form 8-K during the fourth
quarter of the fiscal year ended June 30, 2009 that have not been already
disclosed on a Form 8-K filed with the SEC.





PART
III




ITEM
10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





Each
member of the Board of Directors serves a one-year term and is subject to
reelection at the Company’s Annual Meeting of Shareholders held each
year.


47


Board
Committees





The Board
has established an Audit Committee consisting of Thomas LaVoy (Chairman), Robert
Kauffman, and Albert Smith; a Compensation Committee consisting of Albert Smith
(Chairman) and Robert Kauffman; and a Nominating Committee consisting of Robert
Kauffman (Chairman), Thomas LaVoy, and Albert Smith.  No other
committees have been formed.





Audit
Committee





The Audit
Committee was established on December 8, 2006, the date on which its Charter was
adopted.  The Audit Committee Charter lists the purposes of the Audit
Committee as overseeing the accounting and financial reporting processes of the
Company and audits of the financial statements of the Company and providing
assistance to the Board of Directors in monitoring (1) the integrity of the
Company’s financial statements, (2) the Company’s compliance with legal and
regulatory requirements, (3) the independent auditor’s qualifications and
independence, and (4) the performance of the Company’s internal audit function,
if any, and independent auditor.





The Board
of Directors has determined that Mr. LaVoy and Mr. Kauffman are each
an “audit committee financial expert” as defined in Item 407(d)(5) of Regulation
S-K promulgated by the Securities and Exchange Commission, and each Audit
Committee member is independent.  The Board’s conclusions regarding
the qualifications of Mr. LaVoy as an audit committee financial expert were
based on his service as a chief financial officer of a public company, his
experience as a certified public accountant and his degree in
accounting.  The Board’s conclusions regarding the qualifications of
Mr. Kauffman as an audit committee financial expert were based on his
service as a chief executive officer of multiple public companies, his active
supervision of the principal financial and accounting officers of the public
companies for which he served as chief executive officer, and his M.B.A. in
Finance.





Executive
Officers and Directors





The
executive officers and directors serving the Company as of June 30, 2009 were as
follows:





Name
                  
                  Age
                  
                  Position
      Held
                  
                  Term*Dwight
      Babcock
                  
                  61
                  
                  Chairman,
      Chief Executive Officer
                  
                  AnnualJonathan
      Hunt
                  
                  42
                  
                  Chief
      Financial Officer, TreasurerLori
      Woods
                  
                  47
                  
                  Chief
      Operating OfficerRobert
      Kauffman
                  
                  68
                  
                  Vice-Chairman
                  
                  AnnualThomas
      LaVoy
                  
                  49
                  
                  Director
                  
                  AnnualAlbert
      Smith
                  
                  65
                  
                  Director
                  
                  Annual





* For
directors only





Dwight
Babcock – Mr. Babcock was appointed CEO of the Company on February 18,
2009.  He was previously appointed Chairman and Interim CEO of the
Company on February 26, 2008 and has served as a Director of the Company since
2006.  Mr. Babcock has served as Chairman and Chief Executive Officer
of Apex Data Systems, Inc., an information technology company, since
1975.  Apex Data Systems automates the administration and claims
adjudication needs of insurance companies both nationally and
internationally.  Mr. Babcock was formerly President and CEO of
Babcock Insurance Corporation (BIC) from 1974 until 1985.  BIC was a
nationally recognized third party administrator operating within 35
states.  Mr. Babcock has knowledge and experience in the equity arena
and has participated in various activities within the venture capital, private
and institutional capital markets.  Mr. Babcock studied marketing and
economics at the University of Arizona where he currently serves on the
University of Arizona Astronomy Board.


48





Jonathan
Hunt – Mr. Hunt has over 15 years of finance and accounting experience,
including financial reporting, SEC knowledge, and operational
analysis.  Before joining IsoRay in 2006, he was employed by Hypercom
Corporation, a global provider of electronic payment solutions and manufacturer
of credit card terminals, serving as its Assistant Corporate Controller from
2005 to 2006.  His finance background also includes serving as both a
Manager and Director of Financial Reporting and a Director of Operational
Planning and Analysis for Circle K Corporation and its affiliates from 2000 to
2005 and working for PricewaterhouseCoopers LLP from 1992 to 1999 where his last
position held was Business Assurance Manager.  Mr. Hunt holds Masters
of Accountancy and Bachelor of Science degrees from Brigham Young University and
is a Certified Public Accountant.





Lori
Woods – Ms. Woods joined the Company in July 2006, was appointed Acting Chief
Operating Officer on February 26, 2008, and was appointed Chief Operating
Officer on February 18, 2009.  Ms. Woods has over 20 years experience
in medical device technology and healthcare services.  Ms. Woods
served as the CEO of Pro-Qura, a medical services company focusing on
brachytherapy quality assurance and education, from 2002 until joining the
Company.  During her tenure at Pro-Qura, Ms. Woods developed its
business strategy, expanded its business portfolio in quality assurance beyond
prostate brachytherapy into other areas of cancer, and increased funding by
50%.  Prior to this, she served as the Vice President of Sales at ATI
Medical in 2002, Vice President of Sales – West and Vice President of Marketing
and Business Development for Imagyn Medical Technologies from 2000 to 2002,
Director of Business Development for Seattle Prostate Institute from 1998 to
2000, and Regional Vice President and Regional Manager of Interdent from 1994 to
1998.  Ms. Woods holds a Bachelor of Science degree in Business
Administration – Marketing from Loma Linda University.





Robert
Kauffman – Mr. Kauffman has been a Director of the Company since 2005 and was
appointed Vice-Chairman of the Company on February 26,
2008.  Mr. Kauffman has served as Chief Executive Officer and
Chairman of the Board of Alanco Technologies, Inc. (NASDAQ: ALAN), an
Arizona-based information technology company, since July 1,
1998.  Mr. Kauffman was formerly President and Chief Executive
Officer of NASDAQ-listed Photocomm, Inc., from 1988 until 1997 (since renamed
Kyocera Solar, Inc.).  Photocomm was the nation’s largest publicly
owned manufacturer and marketer of wireless solar electric power systems with
annual revenues in excess of $35 million.  Prior to Photocomm,
Mr. Kauffman was a senior executive of the Atlantic Richfield Company
(ARCO) whose varied responsibilities included Senior Vice President of ARCO
Solar, Inc., President of ARCO Plastics Company and Vice President of ARCO
Chemical Company.  Mr. Kauffman earned an M.B.A. in Finance at
the Wharton School of the University of Pennsylvania, and holds a B.S. in
Chemical Engineering from Lafayette College, Easton, Pennsylvania.





Thomas
LaVoy – Mr. LaVoy has been a Director of the Company since 2005.  Mr.
LaVoy has served as Chief Financial Officer of SuperShuttle International, Inc.,
since July 1997 and as Secretary since March 1998.  SuperShuttle is
one of the largest providers of shuttle services in major cities throughout the
West and Southwest regions of the United States.  He has also served
as a director of Alanco Technologies, Inc. (NASDAQ: ALAN) since
1998.  From September 1987 to February 1997, Mr. LaVoy served as Chief
Financial Officer of NASDAQ-listed Photocomm, Inc.  Mr. LaVoy was a
Certified Public Accountant with the firm of KPMG Peat Marwick from 1980 to
1983.  Mr. LaVoy has a Bachelor of Science degree in Accounting from
St. Cloud University, Minnesota, and is a Certified Public
Accountant.





Albert
Smith – Mr. Smith has been a Director of the Company since 2006.  Mr.
Smith was the co-founder of and served as Vice Chairman of CSI Leasing, Inc., a
private computer leasing company from 1972 until March 2005.  He
founded Extreme Video Solutions, LLC, a private video conferencing company with
headquarters in Scottsdale, Arizona in December 2005.  In January
2008, he formed Face to Face Live, Inc. (successor to Extreme Video Solutions)
where he presently serves as CEO.  Mr. Smith presently serves as
Chairman of the Board for Doulos Ministries, Inc.  Mr. Smith has
extensive experience in marketing and sales having managed a national sales
force of over fifty people while at CSI Leasing, Inc.  Mr. Smith holds
a BS in Business Administration from Ferris State College.


49





The
Company’s directors, as named above, will serve until the next annual meeting of
the Company’s shareholders or until their successors are duly elected and have
qualified.  Directors will be elected for one-year terms at the annual
shareholders meeting.  There is no arrangement or understanding
between any of the directors or officers of the Company and any other person
pursuant to which any director or officer was or is to be selected as a director
or officer, and there is no arrangement, plan or understanding as to whether
non-management shareholders will exercise their voting rights to continue to
elect the current directors to the Company’s board.  There are also no
arrangements, agreements or understandings between non-management shareholders
that may directly or indirectly participate in or influence the management of
the Company’s affairs.





There are
no agreements or understandings for any officer or director to resign at the
request of another person, and none of the officers or directors are acting on
behalf of, or will act at the direction of, any other person.  There
are no family relationships among our executive officers and
directors.





Significant
Employees





Certain
significant employees of our subsidiary, IsoRay Medical, Inc., and their
respective ages as of the date of this report are set forth in the table
below.  Also provided is a brief description of the experience of each
significant employee during the past five years.





Name
              
              Age
              
              Position Held and TenureFredric
      Swindler
              
              61
              
              VP,
      Regulatory Affairs and Quality AssuranceLane
      Bray
              
              81
              
              ChemistAnthony
      Pasqualone
              
              54
              
              VP,
      Business Development





Fredric
Swindler – Mr. Swindler joined the Company in October 2006 and has over 30 years
experience in manufacturing and regulatory compliance.  Mr. Swindler
served as VP, Quality Assurance and Regulatory Affairs for Medisystems
Corporation, a manufacturer and distributor of medical devices, from 1994 until
joining the Company.  During his tenure at Medisystems Corporation,
Mr. Swindler developed a quality system to accommodate vertically integrated
manufacturing, developed regulatory strategies, policies and procedures, and
submitted nine pre-market notifications (510(k)) to the FDA.  Prior to
this, Mr. Swindler held various positions with Marquest Medical Products from
1989 to 1994, Sherwood Medical Products from 1978 to 1989, Oak Park
Pharmaceuticals in 1978, and Mead Johnson & Company from 1969 to
1978.  Mr. Swindler holds a Bachelor of Science degree in Biomedical
Engineering from Rose Hulman Institute of Technology and a Masters of Business
Administration from the University of Evansville.





Lane Bray
– Mr. Bray is known nationally and internationally as a technical expert in
separations, recovery, and purification of isotopes and is a noted authority in
the use of cesium and strontium ion exchange for Department of Energy’s West
Valley and Hanford nuclear waste cleanup efforts.  In 2000,
Mr. Bray received the ’Radiation Science and Technology’ award from the
American Nuclear Society.  Mr. Bray has authored or co-authored
over 110 research publications, 12 articles for nine technical books, and holds
24 U.S. and foreign patents.  Mr. Bray patented the USDOE/PNNL
process for purifying medical grade Yttrium-90 that was successfully
commercialized in 1999.  Mr. Bray also invented and patented the
proprietary isotope separation and purification process that is assigned to
IsoRay.  Mr. Bray was elected ‘Tri-Citian of the Year’ in 1988,
nominated for ‘Engineer of the Year’ by the American Nuclear Society in 1995,
and was elected ‘Chemist of the Year for 1997’ by the American Chemical Society,
Eastern Washington Section.  Mr. Bray retired from the Pacific
Northwest National Laboratory in 1998.  Since retiring in 1998,
Mr. Bray worked part time for PNNL on special projects until devoting all
of his efforts to IsoRay in 2004.  Mr. Bray has been a Washington
State Legislator, a Richland City Councilman, and a Mayor of
Richland.  Mr. Bray has a B.A. in Chemistry from Lake Forest
College.


50


Anthony
Pasqualone – Mr. Pasqualone joined the Company in November 2008 and has been
involved in marketing brachytherapy extensively since 1989 when brachytherapy
started to gain attention as a viable treatment option for prostate
cancer.  Prior to joining IsoRay, Mr. Pasqualone served as the
National Oncology Development Manager at Calypso Medical from April 2007 to
November 2008.  Prior to that Mr. Pasqualone was a consultant with
BrachySciences from December 2005 to April 2007.  He also served as a
VP of Strategic Markets from May 2003 to December 2005 in the Urology Division
of CR Bard.  From April 1997 to May 2003 he was a principal and Vice
President of Sales at SourceTech Medical, which developed and introduced
SeedLink to the brachytherapy market in 2003.  He started his career
managing brachytherapy sales as the National Sales Manager at Theragenics
Corporation, where he helped develop market acceptance of Pd-103.  In
1995 he brought the first stranded product to market while working with the team
at Oncura (Amersham Corporation).  Mr. Pasqualone is an alumnus of
Fordham University with a BS in Science.





Section 16(a) Beneficial
Ownership Reporting Compliance





Section
16(a) of the Securities Exchange Act of 1934 (the Exchange Act) requires the
Company’s directors and executive officers, and persons who beneficially own
more than ten percent of a registered class of our equity securities, to file
with the Securities and Exchange Commission (the Commission) initial reports of
beneficial ownership and reports of changes in beneficial ownership of our
Common Stock.  The rules promulgated by the Commission under Section
16(a) of the Exchange Act require those persons to furnish us with copies of all
reports filed with the Commission pursuant to Section 16(a).  The
information in this section is based solely upon a review of Forms 3, Forms 4,
and Forms 5 received by us.





We
believe that IsoRay’s executive officers, directors and 10% shareholders timely
complied with their filing requirements during the year ended June 30, 2009
except as follows: Dwight Babcock (two Form 4s), Jonathan Hunt (one Form 4), Al
Smith (one Form 4), and Lori Woods (one Form 4).  We believe all of
these forms have been filed as of the date of this Report.





Code of
Ethics





We have
adopted a Code of Conduct and Ethics that applies to all of our officers,
directors and employees and a separate Code of Ethics for Chief Executive
Officer and Senior Financial Officers that supplements our Code of Conduct and
Ethics.  The Code of Conduct and Ethics was previously filed as
Exhibit 14.1 to our Form 10-KSB for the period ended June 30, 2006, and the Code
of Ethics for Chief Executive Officer and Senior Financial Officers was
previously filed as Exhibit 14.2 to this same report.  The Code of
Ethics for Chief Executive Officer and Senior Financial Officers is also
available to the public on our website at
http://www.isoray.com/ethicsForCeo.htm.  Each of these policies
comprises written standards that are reasonably designed to deter wrongdoing and
to promote the behavior described in Item 406 of Regulation S-K promulgated by
the Securities and Exchange Commission.





Nominating
Procedures





There
have been no material changes to the procedures by which our shareholders may
recommend nominees to the Board of Directors during our last fiscal
year.





ITEM
11 – EXECUTIVE COMPENSATION





The
following summary compensation table sets forth information concerning
compensation for services rendered in all capacities during our past two fiscal
years awarded to, earned by or paid to each of the following
individuals.  Salary and other compensation for these officers,
employees and former officers are set by the Compensation Committee of the Board
of Directors, except for employee compensation which is set by officers of the
Company.


51





Summary
Compensation Table





Name and principal position
                                    
                                    Year
                                    
                                    Salary
                                      ($)
                                    
                                    
                                    Bonus
                                      ($)
                                    
                                    
                                    Stock
                                      awards
                                      ($)
                                    
                                    
                                    Option
                                      awards
                                      ($)(1)
                                    
                                    
                                    Nonequity
                                      incentive plan
                                      compensation
                                      ($)
                                    
                                    
                                    Nonqualified
                                      deferred
                                      compensation
                                      earnings
                                      ($)
                                    
                                    
                                    All other
                                      compensation
                                      ($)
                                    
                                    
                                    Total
                                      ($)Dwight Babcock,
      Chairman and CEO(2)
                                    
                                    2009
                                    
                                    
                                    140,308
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    50,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    190,3082008
                                    
                                    
                                    22,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    70,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    92,000Jonathan
      Hunt, Chief Financial Officer
                                    
                                    2009
                                    
                                    
                                    144,119
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    21,900
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    166,0192008
                                    
                                    
                                    139,616
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    139,616Lori
      Woods, Chief Operating Officer
                                    
                                    2009
                                    
                                    
                                    185,296
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    21,900
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    207,1962008
                                    
                                    
                                    179,615
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    179,615Robert
      Bilella, Territory Sales Manager
                                    
                                    2009
                                    
                                    
                                    86,722
                                    
                                    
                                    
                                    106,550
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    2,448
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    195,7202008
                                    
                                    
                                    117,283
                                    
                                    
                                    
                                    121,150
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    238,433




(1)
            Amounts
      represent the FAS 123R valuation for the fiscal years ended June 30, 2009
      and 2008, respectively.  All such options were awarded under one
      of the Company’s stock option plans.  All options awarded (with
      the exception of Mr. Babcock’s stock option grants that were immediately
      vested on the grant date) vest in three equal annual installments
      beginning with the first anniversary from the date of grant and expire ten
      years after the date of grant.  All options were granted at the
      fair market value of the Company’s stock on the date of grant and the
      Company used a Black-Scholes methodology as discussed in the footnotes to
      the financial statements to value the
options.


(2)
            Mr.
      Babcock became the Chairman and Interim CEO on February 26, 2008 and was
      appointed CEO on February 18, 2009.  He was serving as Interim
      CEO on a contract basis.  Mr. Babcock also received compensation
      as a Director of the Company until his appointment as CEO on February 18,
      2009 which is disclosed in the Non-Employee Director Compensation
      table.





Ms. Woods
has an employment contract with the Company dated February 14,
2007.  The agreement was for an initial term of two years, was
extended for an additional year, and will be automatically extended for an
additional year on each anniversary date unless terminated in accordance with
the provisions of the agreement.  The agreement entitles Ms. Woods to
a salary of at least $160,000 with increases as determined by the Compensation
Committee of the Board and annual bonus payments under a bonus plan as
established by the Compensation Committee.  In the event that Ms.
Woods is terminated without cause, becomes disabled, or terminates her
employment for good reason, she will be entitled to her salary and benefits for
the remaining term of the agreement or 18 months, whichever is
shorter.  Good reason is defined in the agreement to mean a reduction
of salary or benefits, a change in Ms. Woods’ title, position, authority, or
responsibilities, causing Ms. Woods to relocate, or any breach by the Company of
this agreement.  If Ms. Woods is terminated within one year of a
change of control then she shall be entitled to her salary and benefits for the
remaining term of the agreement or 18 months, whichever is longer, in addition
to a one-time payment equal to her most recently received bonus.  In
the event of Ms. Woods’ termination without cause or termination within one year
of a change of control, all of her unvested stock options shall immediately vest
in full and shall be exercisable as provided in the applicable stock option
plan.  The agreement also includes certain restrictive covenants that
prohibit Ms. Woods from providing services to a competing business for the
period of this agreement plus one year.





Mr. Hunt
has an employment contract with the Company dated May 19, 2009.  The
agreement is for an initial term of one year and will extend automatically for
additional one-year terms on each anniversary of the effective date of the
agreement unless terminated by either party with 90 days prior
notice.  In the event that Mr. Hunt is terminated without cause,
becomes disabled, or terminates his employment for good reason, he will be
entitled to his salary and benefits for 12 months.  Good reason is
defined in the agreement to mean a reduction of salary or benefits, a change in
Mr. Hunt’s title, position, authority, or responsibilities, causing Mr. Hunt to
relocate, or any breach by the Company of this agreement.  If Mr. Hunt
is terminated within one year of a change of control then he shall be entitled
to his salary and benefits for 18 months.  In the event of Mr. Hunt’s
termination without cause or termination within one year of a change of control,
all of his unvested stock options shall immediately vest in full and shall be
exercisable as provided in the applicable stock option plan.  The
agreement also includes certain restrictive covenants that prohibit Mr. Hunt
from providing services to a competing business for the period of this agreement
plus one year.


52





Outstanding
Equity Awards at Fiscal Year-End





OptionawardsName
                                              
                                              Numberof
                                                securities
                                                underlying
                                                unexercised
                                                options
                                                (#)
                                                exercisable
                                              
                                              
                                              Numberof
                                                securities
                                                underlying
                                                unexercised
                                                options
                                                (#)
                                                unexercisable
                                              
                                              
                                              Equity
                                                incentiveplan
                                                awards:
                                                Numberof
                                                securities
                                                underlying
                                                unexercised
                                                unearned
                                                options
                                                (#)
                                              
                                              
                                              Option
                                                exercise
                                                price
                                                ($)
                                              
                                              Option
                                                expiration
                                                dateDwight
      Babcock, Chairman and CEO
                                              
                                              
                                              50,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              6.30
                                              
                                              3/31/201650,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              3.80
                                              
                                              6/23/201650,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              3.11
                                              
                                              8/15/2016100,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.75
                                              
                                              5/13/2018200,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.26
                                              
                                              6/1/2019Jonathan
      Hunt, Chief Financial Officer
                                              
                                              
                                              30,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              5.50
                                              
                                              5/1/201633,333
                                              
                                              
                                              
                                              16,667
                                              (2)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              3.10
                                              
                                              10/17/201610,000
                                              
                                              
                                              
                                              5,000
                                              (3)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4.40
                                              
                                              3/2/201713,333
                                              
                                              
                                              
                                              6,667
                                              (4)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4.14
                                              
                                              6/1/2017-
                                              
                                              
                                              
                                              10,000
                                              (5)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.65
                                              
                                              7/1/2018-
                                              
                                              
                                              
                                              100,000
                                              (6)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.26
                                              
                                              6/1/2019Lori
      Woods, Chief Operating Officer
                                              
                                              
                                              33,333
                                              
                                              
                                              
                                              16,667
                                              (1)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              3.50
                                              
                                              7/5/201633,333
                                              
                                              
                                              
                                              16,667
                                              (2)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              3.10
                                              
                                              10/17/201610,000
                                              
                                              
                                              
                                              5,000
                                              (3)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4.40
                                              
                                              3/2/201713,333
                                              
                                              
                                              
                                              6,667
                                              (4)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4.14
                                              
                                              6/1/2017-
                                              
                                              
                                              
                                              10,000
                                              (5)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.65
                                              
                                              7/1/2018-
                                              
                                              
                                              
                                              100,000
                                              (6)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.26
                                              
                                              6/1/2019Robert
      Bilella, Territory Sales Manager
                                              
                                              
                                              84,236
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4.15
                                              
                                              6/23/2015-
                                              
                                              
                                              
                                              18,000
                                              (6)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.26
                                              
                                              6/1/2019


(1)
            Represents
      a July 5, 2006 grant, one-third of which became exercisable on July 1,
      2007, one-third of which became exercisable on July 1, 2008, and the final
      third will become exercisable on July 1,
2009.


(2)
            Represents
      the October 17, 2006 grant, one-third of which became exercisable on
      October 17, 2007, one-third of which became exercisable on October 17,
      2008, and the final third will become exercisable on October 17,
      2009.


(3)
            Represents
      the March 2, 2007 grant, one-third of which became exercisable on March 2,
      2008, one-third of which became exercisable on March 2, 2009, and the
      final third will become exercisable on March 2,
  2010.


(4)
            Represents
      the June 1, 2007 grant, one-third of which became exercisable on June 1,
      2008, one-third of which became exercisable on June 1, 2009, and the final
      third will become exercisable on June 1,
2010.


(5)
            Represents
      a July 1, 2008 grant, one-third of which became exercisable on July 1,
      2009, one-third of which will become exercisable on July 1, 2010, and the
      final third will become exercisable on July 1,
  2011.


(6)
            Represents
      a June 1, 2009 grant, one-third of which will become exercisable on June
      1, 2010, one-third of which will become exercisable on June 1, 2011, and
      the final third will become exercisable on June 1,
  2012.





The
Company has a 401(k) plan that covers all eligible full-time employees of the
Company.  Contributions to the 401(k) plan are made by participants to
their individual accounts through payroll withholding.  Additionally,
the 401(k) plan provides for the Company to make contributions to the 401(k)
plan in amounts at the discretion of management.  The Company has not
made any contributions to the 401(k) plan and does not maintain any other
retirement plans for its executives or employees.


53




Non-Employee
Director Compensation





Name
                      
                      Fees
                        earned or
                        paid incash
                        ($)
                      
                      
                      Stock
                        awards
                        ($)
                      
                      
                      Option
                        awards
                        ($)
                      
                      
                      Non-equity
                        incentive plan
                        compensation
                        ($)
                      
                      
                      Non-qualified
                        deferred
                        compensation
                        earnings
                        ($)
                      
                      
                      All other
                        compensation
                        ($)
                      
                      
                      Total
                        ($)Dwight
      Babcock
                      
                      
                      50,500
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      50,500Robert
      Kauffman
                      
                      
                      64,500
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      64,500Thomas
      LaVoy
                      
                      
                      52,500
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      52,500Albert
      Smith
                      
                      
                      38,500
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      38,500




Beginning
in fiscal year 2008, each non-employee director received cash compensation of
$3,000 per month.  In addition, each non-employee director received
$1,000 per Board meeting attended in person or $500 per Board meeting attended
via telephone and $500 per committee meeting attended.  Beginning in
March 2008, Mr. Babcock (until his appointment as CEO on February 18, 2009)
began receiving an additional $3,000 per month for serving as Chairman, Mr.
Kauffman began receiving an additional $2,000 per month for serving as
Vice-Chairman, and Mr. LaVoy began receiving an additional $1,000 per month for
serving as Audit Committee Chairman.





Each
director had stock options to purchase 150,000 shares of the Company’s common
stock outstanding as of June 30, 2009, except for Mr. Babcock who was granted
options to purchase an additional 100,000 shares of the Company’s common stock
on May 13, 2008 for serving as Interim CEO and an additional 200,000 shares of
the Company’s common stock on June 1, 2009 for serving as CEO.  These
grants of 100,000 and 200,000 shares are noted in the executives’ Outstanding
Equity Awards at Fiscal Year-End table above.





Compensation Committee
Interlocks and Insider Participation





As a
smaller reporting company, the Company is not required to provide this
disclosure.





Compensation Committee
Report





As a
smaller reporting company, the Company is not required to provide this
disclosure.





ITEM
12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS




The
following tables set forth certain information regarding the beneficial
ownership of the Company’s common stock and preferred stock as of September 14,
2009 for (a) each person known by the Company to be a beneficial owner of five
percent or more of the outstanding common or preferred stock of the Company, (b)
each executive officer, director and nominee for director of the Company, and
(c) directors and executive officers of the Company as a group.  As of
September 14, 2009, the Company had 22,942,088 shares of common stock and 59,065
shares of preferred stock outstanding.  Except as otherwise indicated
below, the address for each listed beneficial owner is c/o IsoRay, Inc., 350
Hills Street, Suite 106, Richland, Washington 99354.


54




Common
Stock Share Ownership
 
 Common StockOptionsCommon Shares
                  
                  
                  Exercisable Within
                  
                  
                  Common
                  
                  
                  Percent ofName of Beneficial Owner
                  
                  Owned
                  
                  
                  60 Days
                  
                  
                  Warrants
                  
                  
                  Class (1)Dwight
      Babcock (2)
                  
                  
                  130,856
                  
                  
                  
                  450,000
                  
                  
                  
                  12,500
                  
                  
                  
                  2.54
                  %Lori
      Woods
                  
                  
                  8,000
                  
                  
                  
                  126,665
                  
                  
                  
                  -
                  
                  
                  
                  —
                  %Jonathan
      Hunt
                  
                  
                  -
                  
                  
                  
                  106,665
                  
                  
                  
                  -
                  
                  
                  
                  —
                  %Robert
      Kauffman
                  
                  
                  63,802
                  
                  
                  
                  150,000
                  
                  
                  
                  -
                  
                  
                  
                  —
                  %Thomas
      LaVoy
                  
                  
                  40,423
                  
                  
                  
                  150,000
                  
                  
                  
                  -
                  
                  
                  
                  —
                  %Albert
      Smith
                  
                  
                  198,101
                  
                  
                  
                  150,000
                  
                  
                  
                  -
                  
                  
                  
                  1.51
                  %Directors
      and Executive Officers as a group
                  
                  
                  441,182
                  
                  
                  
                  1,133,330
                  
                  
                  
                  12,500
                  
                  
                  
                  6.59
                  %





(1)
            Percentage
      ownership is based on 22,942,088 shares of Common Stock outstanding on
      September 14, 2009.  Shares of Common Stock subject to stock
      options or warrants which are currently exercisable or will become
      exercisable within 60 days after September 14, 2009 are deemed outstanding
      for computing the percentage ownership of the person or group holding such
      options or warrants, but are not deemed outstanding for computing the
      percentage ownership of any other person or
  group.


(2)
            Mr.
      Babcock’s common shares owned include 2,695 shares owned by his
      spouse.





Preferred
Stock Share Ownership
 
 PreferredShares
                    
                    
                    Percent ofName of Beneficial Owner
                    
                    Owned
                    
                    
                    Class (1)Aissata
      Sidibe (2)
                    
                    
                    20,000
                    
                    
                    
                    33.86
                    %William
      and Karen Thompson Trust (3)
                    
                    
                    14,218
                    
                    
                    
                    24.07
                    %Jamie
      Granger (4)
                    
                    
                    10,529
                    
                    
                    
                    17.83
                    %Hostetler
      Living Trust (5)
                    
                    
                    9,479
                    
                    
                    
                    16.05
                    %Leslie
      Fernandez (6)
                    
                    
                    3,688
                    
                    
                    
                    6.24
                    %





(1)
            Percentage
      ownership is based on 59,065 shares of Preferred Stock outstanding on
      September 14, 2009.


(2)
            The
      address of Ms. Sidibe is 229 Lasiandra Ct, Richland, WA
    99352.


(3)
            The
      address of the William and Karen Thompson Trust is 285 Dondero Way, San
      Jose, CA 95119.


(4)
            The
      address of Jamie Granger is 53709 South Nine Canyon Road, Kennewick, WA
      99337.


(5)
            The
      address of the Hostetler Living Trust is 9257 NE 175th Street, Bothell, WA
      98011.


(6)
            The
      address of Leslie Fernandez is 2615 Scottsdale Place, Richland, WA
      99352.





No
officers or directors beneficially own shares of Preferred Stock.





ITEM
13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE





IsoRay
Medical, Inc.’s patent rights to its Cs-131 process were acquired from Lane
Bray, a shareholder and employee of the Company, and are subject to a 1% royalty
on gross profits and certain contractual restrictions.  Pursuant to
the royalty agreement, the Company must also pay a royalty of 2% of Gross Sales,
as defined, for any sub-assignments of the aforesaid patented process to any
third parties.  The royalty agreement will remain in force until the
expiration of the patents on the assigned technology, unless earlier terminated
in accordance with the terms of the underlying agreement.  The Company
recorded royalty expense of $20,063 and $21,219 for the years ended June 30,
2009 and 2008, respectively, related to these payments.


55





Roger
Girard, the Company’s former Chairman and CEO, had personally guaranteed $20,000
of the BFEDD loan, which was funded in December 2004.  In exchange for
his personal guaranty, Mr. Girard received 5,728 shares of common
stock.  As a condition of his resignation in February 2008, the
Company prepaid $20,000 on the BFEDD loan and obtained Mr. Girard’s release and
Mr. Girard in turn surrendered the 5,728 shares to the Company.  As
part of his settlement, Mr. Girard also surrendered 30,072 shares of common
stock he had received in 2004 for personally guaranteeing a portion of a line of
credit for the Company.





Mr.
Girard and David Swanberg, the Company’s former Executive VP – Operations,
personally guaranteed a portion of the HAEIFC loan.  As part of their
resignations, the Company obtained their releases from these personal guarantees
by prepaying $60,000 and $40,000, respectively.





Patent and Know-How Royalty
License Agreement





Effective
August 1, 1998, Pacific Management Associates Corporation (PMAC) transferred its
entire right, title and interest in an exclusive license agreement with Donald
Lawrence to IsoRay, LLC (a predecessor company) in exchange for a membership
interest.  The terms of the license agreement require the payment of a
royalty based on the Net Factory Sales Price, as defined in the agreement, of
licensed product sales.  Because the licensor’s patent application was
ultimately abandoned, only a 1% “know-how” royalty based on Net Factory Sales
Price, as defined, remains applicable.  To date, management believes
that there have been no product sales incorporating the “know-how” and that
therefore no royalty is due pursuant to the terms of the
agreement.  Management believes that ultimately no royalties should be
paid under this agreement as there is no intent to use this “know-how” in the
future.





The
licensor of the Lawrence “know-how” has disputed management’s contention that it
is not using this “know-how”.  On September 25, 2007 and again on
October 31, 2007, the Company participated in nonbinding mediation regarding
this matter; however, no settlement was reached with the Lawrence Family
Trust.  After additional settlement discussions which ended in April
2008, the parties still failed to reach a settlement.  The parties may
demand binding arbitration at any time.





Director
Independence




Using the
standards of the NYSE Amex, the Company's Board has determined
that Mr. Kauffman, Mr. LaVoy, and Mr. Smith each qualify under
such standards as an independent director.  Mr. Kauffman, Mr.
LaVoy and Mr. Smith each meet the NYSE Amex listing standards for independence
both as a director and as a member of the Audit Committee, and Mr. Kauffman and
Mr. Smith each meet the NYSE Amex listing standards for independence both as a
director and as a member of the Compensation Committee.  No other
directors are independent under these standards.  The Company did not
consider any relationship or transaction between itself and these
independent directors not already disclosed in this report in making this
determination.




ITEM
14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES




The
Company paid or accrued the following fees in each of the prior two fiscal years
to its principal accountant, DeCoria, Maichel & Teague, P.S.:





Year ended
                  
                  
                  Year endedJune 30,
                  
                  
                  June 30,2009
                  
                  
                  20081.   
      Audit fees
                  
                  $
                  32,047
                  
                  
                  $
                  42,1072.   
      Audit-related fees
                  
                  
                  –
                  
                  
                  
                  –3.   
      Tax fees
                  
                  
                  7,900
                  
                  
                  
                  7,7504.   
      All other fees
                  
                  
                  –
                  
                  
                  
                  –Totals
                  
                  $
                  39,947
                  
                  
                  $
                  49,857


56





Audit
fees include fees for the audit of our annual financial statements, reviews of
our quarterly financial statements, and related consents for documents filed
with the SEC.  Tax fees include fees for the preparation of our
federal and state income tax returns.




As part
of its responsibility for oversight of the independent registered public
accountants, the Audit Committee has established a pre-approval policy for
engaging audit and permitted non-audit services provided by our independent
registered public accountants, DeCoria, Maichel & Teague, P.S.  In
accordance with this policy, each type of audit, audit-related, tax and other
permitted service to be provided by the independent auditors is specifically
described and each such service, together with a fee level or budgeted amount
for such service, is pre-approved by the Audit Committee.  The Audit
Committee has delegated authority to its Chairman to pre-approve additional
non-audit services (provided such services are not prohibited by applicable law)
up to a pre-established aggregate dollar limit.  All services
pre-approved by the Chairman of the Audit Committee must be presented at the
next Audit Committee meeting for review and ratification.  All of the
services provided by DeCoria, Maichel & Teague, P.S. described above were
approved by our Audit Committee.





The
Company’s principal accountant, DeCoria, Maichel & Teague P.S., did not
engage any other persons or firms other than the principal accountant’s
full-time, permanent employees.




ITEM
15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES





(Except
as otherwise indicated, all exhibits were previously filed)




Exhibit #
              
              Description2.1
              
              Merger
      Agreement dated as of May 27, 2005, by and among Century Park Pictures
      Corporation, Century Park Transitory Subsidiary, Inc., certain
      shareholders and IsoRay Medical, Inc. incorporated by reference to the
      Form 8-K filed on August 3, 2005.2.2
              
              Certificate
      of Merger, filed with the Delaware Secretary of State on July 28, 2005
      incorporated by reference to the Form 8-K filed on August 3,
      2005.3.1
              
              Articles
      of Incorporation and By-Laws are incorporated by reference to the Exhibits
      to the Company's Registration Statement of September 15,
    1983.3.2
              
              Certificate
      of Designation of Rights, Preferences and Privileges of Series A and B
      Convertible Preferred Stock, filed with the Minnesota Secretary of State
      on June 29, 2005 incorporated by reference to the Form 8-K filed on August
      3, 2005.3.3
              
              Restated
      and Amended Articles of Incorporation incorporated by reference to the
      Form 10-KSB filed on October 11, 2005.3.4
              
              Text
      of Amendments to the Amended and Restated By-Laws of the Company,
      incorporated by reference to the Form 8-K filed on February 7,
      2007.3.5
              
              Amended
      and Restated By-Laws of the Company dated as of January 8, 2008,
      incorporated by reference to the Form 8-K filed on January 14,
      2008.4.2
              
              Intentionally
      Omitted.4.3
              
              Intentionally
      Omitted.4.4
              
              Intentionally
      Omitted.4.5
              
              Intentionally
      Omitted.4.6
              
              Intentionally
      Omitted.4.7
              
              Amended
      and Restated 2005 Stock Option Plan incorporated by reference to the Form
      S-8 filed on August 19, 2005.4.8
              
              Amended
      and Restated 2005 Employee Stock Option Plan incorporated by reference to
      the Form S-8 filed on August 19, 2005.4.9
              
              Intentionally
      Omitted.4.10
              
              Intentionally
      Omitted.4.11
              
              Form
      of IsoRay, Inc. Common Stock Purchase Warrant, incorporated by reference
      to the Form SB-2/A1 filed on March 24, 2006.




57




4.12
              
              2006
      Director Stock Option Plan, incorporated by reference to the Form S-8
      filed on August 18, 2006.4.13
              
              Intentionally
      Omitted.4.14
              
              Form
      of IsoRay, Inc. Common Stock Purchase Warrant, dated August 9, 2006,
      incorporated by reference to the Form 8-K filed on August 18,
      2006.4.15
              
              Intentionally
      Omitted.4.16
              
              Amended
      and Restated 2006 Director Stock Option Plan, incorporated by reference to
      the Form S-8/A1 filed on December 18, 2006.4.17
              
              Amended
      and Restated 2005 Stock Option Plan, incorporated by reference to the Form
      S-8/A1 filed on December 18, 2006.4.18
              
              Intentionally
      Omitted.4.19
              
              Rights
      Agreement, dated as of February 1, 2007, between the Computershare Trust
      Company N.A., as Rights Agent, incorporated by reference to Exhibit 1 to
      the Company’s Registration Statement on Form 8-A filed on February 7,
      2007.4.20
              
              Certificate
      of Designation of Rights, Preferences and Privileges of Series C Junior
      Participating Preferred Stock, incorporated by reference to Exhibit 1 to
      the Company’s Registration Statement on Form 8-A filed February 7,
      2007.4.21
              
              2008
      Employee Stock Option Plan, incorporated by reference to the Form S-8
      filed on January 14, 2008.10.2
              
              Universal
      License Agreement, dated November 26, 1997 between Donald C. Lawrence and
      William J. Stokes of Pacific Management Associates Corporation,
      incorporated by reference to the Form SB-2 filed on November 10,
      2005.10.3
              
              Royalty
      Agreement of Invention and Patent Application, dated July 12, 1999 between
      Lane A. Bray and IsoRay LLC, incorporated by reference to the Form SB-2
      filed on November 10, 2005.10.4
              
              Intentionally
      Omitted.10.5
              
              Section
      510(k) Clearance from the Food and Drug Administration to market Lawrence
      CSERION Model CS-1, dated March 28, 2003, incorporated by reference to the
      Form SB-2 filed on November 10, 2005.10.6
              
              Intentionally
      Omitted.10.7
              
              Intentionally
      Omitted.10.8
              
              Intentionally
      Omitted.10.9
              
              Development
      Loan Agreement for $230,000, dated September 15, 2004 between
      Benton-Franklin Economic Development District and IsoRay Medical, Inc.,
      incorporated by reference to the Form SB-2/A2 filed on April 27,
      2006.10.10
              
              Registry
      of Radioactive Sealed Sources and Devices Safety Evaluation of Sealed
      Source, dated September 17, 2004, incorporated by reference to the Form
      SB-2/A2 filed on April 27, 2006.10.11
              
              Intentionally
      Omitted.10.12
              
              Intentionally
      Omitted.10.13
              
              Intentionally
      Omitted.10.14
              
              Intentionally
      Omitted.10.15
              
              Intentionally
      Omitted.10.16
              
              Intentionally
      Omitted.10.17
              
              Intentionally
      Omitted.10.18
              
              State
      of Washington Radioactive Materials License dated October 6, 2005,
      incorporated by reference to the Form SB-2 filed on November 10,
      2005.10.19
              
              Express
      Pricing Agreement Number 219889, dated October 5, 2005 between FedEx and
      IsoRay Medical, Inc., incorporated by reference to the Form 10-QSB filed
      on November 21, 2005.10.20
              
              Intentionally
      Omitted.10.21
              
              Intentionally
      Omitted.10.22
              
              Agreement
      dated August 9, 2005 between the Curators of the University of Missouri
      and IsoRay Medical, Inc., incorporated by reference to the Form SB-2/A2
      filed on April 27, 2006 (confidential treatment
  requested).




58





10.23
              
              Intentionally
      Omitted.10.24
              
              Intentionally
      Omitted.10.25
              
              Economic
      Development Agreement, dated December 14, 2005, by and between IsoRay,
      Inc. and the Pocatello Development Authority, incorporated by reference to
      the Form 8-K filed on December 20, 2005.10.26
              
              License
      Agreement, dated February 2, 2006, by and between IsoRay Medical, Inc. and
      IBt SA, incorporated by reference to the Form 8-K filed on March 24, 2006
      (confidential treatment requested).10.27
              
              Intentionally
      Omitted.10.28
              
              Service
      Agreement between IsoRay, Inc. and Advanced Care Medical, Inc., dated
      March 1, 2006, incorporated by reference to the Form SB-2/A2 filed on
      April 27, 2006.10.29
              
              Intentionally
      Omitted.10.30
              
              Intentionally
      Omitted.10.31
              
              Loan
      Agreement, dated June 15, 2006, by and between IsoRay Medical, Inc. and
      the Hanford Area Economic Investment Fund Committee, incorporated by
      reference to the Form 8-K filed on June 21, 2006.10.32
              
              Commercial
      Security Agreement, dated June 15, 2006, by and between IsoRay Medical,
      Inc. and the Hanford Area Economic Investment Fund Committee, incorporated
      by reference to the Form 8-K filed on June 21, 2006.10.33
              
              Common
      Stock and Warrant Purchase Agreement among IsoRay, Inc. and the other
      signatories thereto, dated August 9, 2006, incorporated by reference to
      the Form 8-K filed on August 18, 2006.10.34
              
              Intentionally
      Omitted.10.35
              
              Form
      of Officer and Director Indemnification Agreement, incorporated by
      reference to the Form SB-2 Post Effective Amendment No. 2 filed on October
      13, 2006.10.36
              
              Intentionally
      Omitted.10.37
              
              Intentionally
      Omitted.10.38
              
              Form
      of Securities Purchase Agreement by and among IsoRay, Inc. and the
      Buyers dated March 22, 2007, incorporated by reference to the Form
      8-K filed on March 23, 2007.10.39
              
              Form
      of Common Stock Purchase Warrant dated March 21, 2007, incorporated by
      reference to the Form 8-K filed on March 23, 2007.10.40
              
              Intentionally
      Omitted.10.41
              
              Intentionally
      Omitted.10.42
              
              Intentionally
      Omitted.10.43
              
              Intentionally
      Omitted.10.44
              
              Intentionally
      Omitted.10.45
              
              Intentionally
      Omitted.10.46
              
              Amendment
      No. 1 to License Agreement, dated October 12, 2007, by and between IsoRay
      Medical, Inc. and IBt, SA, incorporated by reference to the Form 8-K filed
      on October 17, 2007.10.47
              
              Intentionally
      Omitted.10.48
              
              Intentionally
      Omitted.10.49
              
              Contract,
      dated December 10, 2008, by and between IsoRay Medical, Inc. and UralDial
      LLC, incorporated by reference to the Form 8-K filed on December 12, 2008
      (confidential treatment requested for redacted
  portions).10.50
              
              Distribution
      Agreement, dated February 18, 2009, by and between IsoRay Medical, Inc.
      and Biocompatibles, Inc., incorporated by reference to the Form 8-K filed
      on February 24, 2009 (confidential treatment requested for redacted
      portions).10.51
              
              Amendment
      No. 1 to Service Agreement, dated February 18, 2009, by and between IsoRay
      Medical, Inc. and Biocompatibles, Inc., incorporated by reference to the
      Form 8-K filed on February 24, 2009 (confidential treatment requested for
      redacted portions).10.52
              
              Executive
      Employment Agreement between IsoRay, Inc. and Jonathan Hunt, dated May 19,
      2009, incorporated by reference to the Form 8-K filed on May 26,
      2009.10.53
              
              Loan
      Covenant Waiver Letter dated August 24, 2009 from the Hanford Area
      Economic Investment Fund Committee, filed
  herewith.




59




21.1
              
              Subsidiaries
      of the Company, filed herewith.23.1
              
              Consent
      of DeCoria, Maichel & Teague, P.S., filed herewith.31.1
              
              Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief
      Executive Officer, filed herewith.31.2
              
              Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief
      Financial Officer, filed herewith.32.1
              
              Certifications
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed
      herewith.





Reports on Form
8-K





On May
18, 2009, the Company filed a Current Report on Form 8-K announcing its
financial results for the third quarter of fiscal year 2009.





On May
26, 2009, the Company filed a Current Report on Form 8-K announcing an
employment agreement entered into with Mr. Hunt.


60


IsoRay,
Inc.


Index
to Financial Statements





PageReport
      of Independent Registered Public Accounting Firm
                      F-2Financial
      Statements:Consolidated
      Balance Sheets as of June 30, 2009 and 2008
                      F-3Consolidated
      Statements of Operations for the years endedJune
      30, 2009 and 2008
                      F-4Consolidated
      Statement of Changes in Shareholders’ Equity for the yearsended
      June 30, 2009 and 2008
                      F-5Consolidated
      Statements of Cash Flows for the years ended June 30,2009
      and 2008
                      F-6Notes
      to Consolidated Financial Statements
                      F-7




F-1


Report
of Independent Registered Public Accounting Firm





Board of
Directors and Shareholders


IsoRay,
Inc.


Richland,
Washington





We have
audited the accompanying consolidated balance sheets of IsoRay, Inc. and
Subsidiaries (“the Company”) (see Note 1) as of June 30, 2009 and 2008, and the
related consolidated statements of operations, changes in shareholders’ equity
and cash flows for the years then ended. These financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these financial statements based on our audits.





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





In our
opinion the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of IsoRay, Inc. and
Subsidiaries as of June 30, 2009 and 2008, and the consolidated results of their
operations and their cash flows for the years then ended, in conformity with
accounting principles generally accepted in the United States of
America.





/s/
DeCoria, Maichel & Teague, P.S.





Spokane,
Washington


September
22, 2009


F-2





IsoRay,
Inc. and Subsidiaries


Consolidated
Balance Sheets





June 30,2009
                      
                      
                      2008ASSETSCurrent
      assets:Cash
      and cash equivalents
                      
                      $
                      2,990,744
                      
                      
                      $
                      4,820,033Short-term
      investments
                      
                      
                      1,679,820
                      
                      
                      
                      3,726,000Accounts
      receivable, net of allowance for doubtful accounts of $86,931 and
      $33,031, respectively
                      
                      
                      746,568
                      
                      
                      
                      1,016,495Inventory
                      
                      
                      789,246
                      
                      
                      
                      899,964Prepaid
      expenses and other current assets
                      
                      
                      151,077
                      
                      
                      
                      267,001Total
      current assets
                      
                      
                      6,357,455
                      
                      
                      
                      10,729,493Fixed
      assets, net of accumulated depreciation and amortization
                      
                      
                      4,891,484
                      
                      
                      
                      6,040,641Deferred
      financing costs, net of accumulated amortization
                      
                      
                      28,186
                      
                      
                      
                      65,221Licenses,
      net of accumulated amortization
                      
                      
                      11,867
                      
                      
                      
                      455,646Restricted
      cash
                      
                      
                      178,615
                      
                      
                      
                      175,852Other
      assets, net of accumulated amortization
                      
                      
                      273,959
                      
                      
                      
                      345,040Total
      assets
                      
                      $
                      11,741,566
                      
                      
                      $
                      17,811,893LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable and accrued expenses
                      
                      $
                      698,882
                      
                      
                      $
                      751,402Accrued
      payroll and related taxes
                      
                      
                      188,703
                      
                      
                      
                      344,612Notes
      payable, due within one year
                      
                      
                      161,437
                      
                      
                      
                      64,486Capital
      lease obligations, due within one year
                      
                      
                      -
                      
                      
                      
                      25,560Total
      current liabilities
                      
                      
                      1,049,022
                      
                      
                      
                      1,186,060Notes
      payable, due after one year
                      
                      
                      176,023
                      
                      
                      
                      344,898Asset
      retirement obligation, noncurrent
                      
                      
                      553,471
                      
                      
                      
                      506,005Total
      liabilities
                      
                      
                      1,778,516
                      
                      
                      
                      2,036,963Commitments
      and contingencies (Note 18)Shareholders'
      equity:Preferred
      stock, $.001 par value; 6,000,000 shares authorized:Series
      A: 1,000,000 shares allocated; no shares issued and
      outstanding
                      
                      
                      -
                      
                      
                      
                      -Series
      B: 5,000,000 shares allocated; 59,065 shares issued and
      outstanding
                      
                      
                      59
                      
                      
                      
                      59Common
      stock, $.001 par value; 194,000,000 shares authorized;22,942,088
      shares issued and outstanding
                      
                      
                      22,942
                      
                      
                      
                      22,942Treasury
      stock, at cost, 13,200 and 5,000 shares
                      
                      
                      (8,390
                      )
                      
                      
                      (3,655
                      )Additional
      paid-in capital
                      
                      
                      47,818,203
                      
                      
                      
                      47,464,507Accumulated
      deficit
                      
                      
                      (37,869,764
                      )
                      
                      
                      (31,708,923
                      )Total
      shareholders' equity
                      
                      
                      9,963,050
                      
                      
                      
                      15,774,930Total
      liabilities and shareholders' equity
                      
                      $
                      11,741,566
                      
                      
                      $
                      17,811,893





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


F-3





IsoRay,
Inc. and Subsidiaries


Consolidated
Statements of Operations





June 30,2009
                    
                    
                    2008Product
      sales
                    
                    $
                    5,417,815
                    
                    
                    $
                    7,158,690Cost
      of product sales
                    
                    
                    5,771,147
                    
                    
                    
                    7,310,124Gross
      loss
                    
                    
                    (353,332
                    )
                    
                    
                    (151,434
                    )Operating
      expenses:Research
      and development expenses
                    
                    
                    958,665
                    
                    
                    
                    1,358,075Sales
      and marketing expenses
                    
                    
                    2,365,973
                    
                    
                    
                    3,725,164General
      and administrative expenses
                    
                    
                    2,792,611
                    
                    
                    
                    3,568,048Total
      operating expenses
                    
                    
                    6,117,249
                    
                    
                    
                    8,651,287Operating
      loss
                    
                    
                    (6,470,581
                    )
                    
                    
                    (8,802,721
                    )Non-operating
      income (expense):Interest
      income
                    
                    
                    111,047
                    
                    
                    
                    612,077Gain
      (loss) on fair value of short-term investments
                    
                    
                    274,000
                    
                    
                    
                    (274,000
                    )Financing
      and interest expense
                    
                    
                    (75,307
                    )
                    
                    
                    (92,863
                    )Non-operating
      income, net
                    
                    
                    309,740
                    
                    
                    
                    245,214Net
      loss
                    
                    $
                    (6,160,841
                    )
                    
                    $
                    (8,557,507
                    )Basic
      and diluted loss per share
                    
                    $
                    (0.27
                    )
                    
                    $
                    (0.37
                    )Weighted
      average shares used in computing net loss per share:Basic
      and diluted
                    
                    
                    22,942,088
                    
                    
                    
                    23,028,075





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


F-4


IsoRay,
Inc. and Subsidiaries


Consolidated
Statement of Changes in Shareholders' Equity





Series B Preferred Stock
                          
                          
                          Common Stock
                          
                          
                          Treasury Stock
                          
                          
                          Additional Paid-
                          
                          
                          AccumulatedShares
                          
                          
                          Amount
                          
                          
                          Shares
                          
                          
                          Amount
                          
                          
                          Shares
                          
                          
                          Amount
                          
                          
                          in Capital
                          
                          
                          Deficit
                          
                          
                          TotalBalances
      at June 30, 2007
                          
                          
                          59,065
                          
                          
                          $
                          59
                          
                          
                          
                          22,789,324
                          
                          
                          $
                          22,789
                          
                          
                          
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          45,844,793
                          
                          
                          $
                          (23,151,416
                          )
                          
                          $
                          22,716,225Issuance
      of common stock pursuant to exercise of warrants
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          290,876
                          
                          
                          
                          291
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          1,010,622
                          
                          
                          
                          
                          
                          
                          
                          1,010,913Issuance
      of common stock pursuant to exercise of options
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          10,000
                          
                          
                          
                          10
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          11,890
                          
                          
                          
                          
                          
                          
                          
                          11,900Repurchase
      of Company common stock (see Note 13)
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          5,000
                          
                          
                          
                          (3,655
                          )
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (3,655
                          )Cancellation
      of shares (see Note 12)
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (148,112
                          )
                          
                          
                          (148
                          )
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          148
                          
                          
                          
                          
                          
                          
                          
                          -Share-based
      compensation
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          597,054
                          
                          
                          
                          
                          
                          
                          
                          597,054Net
      loss
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (8,557,507
                          )
                          
                          
                          (8,557,507
                          )Balances
      at June 30, 2008
                          
                          
                          59,065
                          
                          
                          $
                          59
                          
                          
                          
                          22,942,088
                          
                          
                          $
                          22,942
                          
                          
                          
                          5,000
                          
                          
                          $
                          (3,655
                          )
                          
                          $
                          47,464,507
                          
                          
                          $
                          (31,708,923
                          )
                          
                          $
                          15,774,930Repurchase
      of Company common stock (see Note 13)
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          8,200
                          
                          
                          
                          (4,735
                          )
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (4,735
                          )Share-based
      compensation
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          353,696
                          
                          
                          
                          
                          
                          
                          
                          353,696Net
      loss
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (6,160,841
                          )
                          
                          
                          (6,160,841
                          )Balances
      at June 30, 2009
                          
                          
                          59,065
                          
                          
                          $
                          59
                          
                          
                          
                          22,942,088
                          
                          
                          $
                          22,942
                          
                          
                          
                          13,200
                          
                          
                          $
                          (8,390
                          )
                          
                          $
                          47,818,203
                          
                          
                          $
                          (37,869,764
                          )
                          
                          $
                          9,963,050





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


F-5


IsoRay,
Inc. and Subsidiaries


Consolidated
Statements of Cash Flows





Year ended June 30,2009
                    
                    
                    2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                    
                    $
                    (6,160,841
                    )
                    
                    $
                    (8,557,507
                    )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Depreciation
      and amortization of fixed assets
                    
                    
                    1,206,935
                    
                    
                    
                    1,103,940Impairment
      of IBt license
                    
                    
                    425,434
                    
                    
                    
                    -Write-off
      of certain foreign patents and trademarks
                    
                    
                    85,818
                    
                    
                    
                    -Impairment
      of fixed assets
                    
                    
                    -
                    
                    
                    
                    85,000Amortization
      of deferred financing costs and other assets
                    
                    
                    79,563
                    
                    
                    
                    107,555Amortization
      of discount on short-term investments
                    
                    
                    -
                    
                    
                    
                    (150,621
                    )(Gain)
      loss on fair value of short-term investments
                    
                    
                    (274,000
                    )
                    
                    
                    274,000Settlement
      of asset retirement obligation
                    
                    
                    -
                    
                    
                    
                    (135,120
                    )Accretion
      of asset retirement obligation
                    
                    
                    47,466
                    
                    
                    
                    36,887Share-based
      compensation
                    
                    
                    353,696
                    
                    
                    
                    597,054Changes
      in operating assets and liabilities:Accounts
      receivable, net
                    
                    
                    269,927
                    
                    
                    
                    76,430Inventory
                    
                    
                    110,718
                    
                    
                    
                    (19,130
                    )Prepaid
      expenses and other current assets
                    
                    
                    114,777
                    
                    
                    
                    191,122Accounts
      payable and accrued expenses
                    
                    
                    (52,520
                    )
                    
                    
                    (1,196,578
                    )Accrued
      payroll and related taxes
                    
                    
                    (155,909
                    )
                    
                    
                    (114,456
                    )Deferred
      revenue
                    
                    
                    -
                    
                    
                    
                    (23,874
                    )Net
      cash used by operating activities
                    
                    
                    (3,948,936
                    )
                    
                    
                    (7,725,298
                    )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of fixed assets
                    
                    
                    (57,778
                    )
                    
                    
                    (3,090,934
                    )Additions
      to licenses and other assets
                    
                    
                    (37,773
                    )
                    
                    
                    (293,303
                    )Change
      in restricted cash
                    
                    
                    (2,763
                    )
                    
                    
                    (175,852
                    )Purchase
      of short-term investments
                    
                    
                    (1,679,820
                    )
                    
                    
                    (13,273,653
                    )Proceeds
      from the sale or maturity of short-term investments
                    
                    
                    4,000,000
                    
                    
                    
                    19,367,114Net
      cash provided by investing activities
                    
                    
                    2,221,866
                    
                    
                    
                    2,533,372CASH
      FLOWS FROM FINANCING ACTIVITIES:Principal
      payments on notes payable
                    
                    
                    (71,924
                    )
                    
                    
                    (168,074
                    )Principal
      payments on capital lease obligations
                    
                    
                    (25,560
                    )
                    
                    
                    (194,855
                    )Proceeds
      from cash sales of common stock, pursuant to exercise of
      warrants
                    
                    
                    -
                    
                    
                    
                    1,010,913Proceeds
      from cash sales of common stock, pursuant to exercise of
      options
                    
                    
                    -
                    
                    
                    
                    11,900Repurchase
      of Company common stock
                    
                    
                    (4,735
                    )
                    
                    
                    (3,655
                    )Net
      cash (used) provided by financing activities
                    
                    
                    (102,219
                    )
                    
                    
                    656,229Net
      decrease in cash and cash equivalents
                    
                    
                    (1,829,289
                    )
                    
                    
                    (4,535,697
                    )Cash
      and cash equivalents, beginning of year
                    
                    
                    4,820,033
                    
                    
                    
                    9,355,730CASH
      AND CASH EQUIVALENTS, END OF YEAR
                    
                    $
                    2,990,744
                    
                    
                    $
                    4,820,033Supplemental
      disclosures of cash flow information:Cash
      paid for interest
                    
                    $
                    38,752
                    
                    
                    $
                    63,818Non-cash
      investing and financing activities:Increase
      in fixed assets related to asset retirement obligation
                    
                    $
                    -
                    
                    
                    $
                    473,096





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




F-6





IsoRay,
Inc.


Notes
to Consolidated Financial Statements


For
the years ended June 30, 2008 and 2007





1.
            Organization





Century
Park Pictures Corporation (Century) was organized under Minnesota law in
1983.  Century had no operations during the period from September 30,
1999 through June 30, 2005.





On July
28, 2005, IsoRay Medical, Inc. (Medical) became a wholly-owned subsidiary of
Century pursuant to a merger.  Century changed its name to IsoRay,
Inc. (IsoRay or the Company).  In the merger, the Medical stockholders
received approximately 82% of the then outstanding securities of the
Company.





Medical,
a Delaware corporation, was incorporated effective June 15, 2004 to develop,
manufacture and sell isotope-based medical products and devices for the
treatment of cancer and other malignant diseases.  Medical is
headquartered in Richland, Washington.





IsoRay
International LLC, a Washington limited liability company, was formed on
November 27, 2007 to serve as an owner in a Russian LLC that will distribute the
Company’s products to the Russian market and also license the Company’s
technology for use in manufacturing Cs-131 brachytherapy seeds in
Russia.  During fiscal year 2009, the Company divested its ownership
in the Russian LLC.





2.
            Summary
      of Significant Accounting Policies





Consolidation





The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries (collectively the
Company).  All significant intercompany accounts and transactions have
been eliminated.





Cash
Equivalents





The
Company considers all highly liquid investments with original maturities of
three months or less when purchased to be cash equivalents.





Short-Term
Investments





The
Company invests certain excess cash in marketable securities consisting
primarily of commercial paper, auction rate securities, certificates of deposit,
and money market funds.  The Company classifies all debt securities as
“available-for-sale” and records the debt securities at fair value with
unrealized gains and temporary unrealized losses included in other comprehensive
income/loss within shareholders’ equity, if material.  Declines in
fair values that are considered other than temporary are recorded in the
Consolidated Statements of Operations.





Fair Value of Financial
Instruments





Effective
July 1, 2008, the Company implemented Statement of Financial Accounting
Standards (SFAS) No. 157, Fair
Value Measurements.  SFAS 157 defines fair value,
establishes a framework for measuring fair value in accordance with accounting
principles generally accepted in the United States, and expands disclosures
about fair value measurements.  The Company elected to implement this
Statement with the one-year deferral permitted by FASB Staff Position (FSP)
157-2 for nonfinancial assets and nonfinancial liabilities measured at fair
value, except those that are recognized or disclosed on a recurring
basis.  This deferral applies to fixed assets and intangible asset
impairment testing and initial recognition of asset retirement obligations for
which fair value is used.  The Company does not expect any significant
impact to our consolidated financial statements when we implement SFAS 157 for
these assets and liabilities.


F-7





SFAS 157
requires disclosures that categorize assets and liabilities measured at fair
value into one of three different levels depending on the observability of the
inputs employed in the measurement.  Level 1 inputs are quoted prices
in active markets for identical assets or liabilities.  Level 2 inputs
are observable inputs other than quoted prices included within Level 1 for the
asset or liability, either directly or indirectly through market-corroborated
inputs.  Level 3 inputs are unobservable inputs for the asset or
liability reflecting significant modifications to observable related market data
or our assumptions about pricing by market participants.





At June
30, 2009, all of the Company’s financial assets and liabilities are accounted
and reported at fair value using Level 1 inputs.





Also
effective July 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities Including an Amendment of FASB Statement No.
115.  The statement allows entities to value many financial
instruments and certain other items at fair value.  SFAS 159 provides
guidance over the election of the fair value option, including the timing of the
election and specific items eligible for the fair value
accounting.  If the fair value option is elected then unrealized gains
and losses are reported in earnings at each subsequent reporting
date.  The Company elected not to measure any additional financial
instruments or other items at fair value as of July 1, 2008 in accordance with
SFAS 159.  Accordingly, the adoption of SFAS 159 did not impact our
consolidated financial statements.  The Company did elect to fair
value its ARS rights that were received in October 2008 and exercised in January
2009 in accordance with SFAS 159 (see Note 3).





Accounts
Receivable





Accounts
receivable are stated at the amount that management of the Company expects to
collect from outstanding balances.  Management provides for probable
uncollectible amounts through an allowance for doubtful
accounts.  Additions to the allowance for doubtful accounts are based
on management’s judgment, considering historical write-offs, collections and
current credit conditions.  Balances which remain outstanding after
management has used reasonable collection efforts are written off through a
charge to the allowance for doubtful accounts and a credit to the applicable
accounts receivable.  Payments received subsequent to the time that an
account is written off are considered bad debt recoveries.





Inventory





Inventory
is reported at the lower of cost or market.  Cost of raw materials is
determined using the weighted average method.  Cost of work in process
and finished goods is computed using standard cost, which approximates actual
cost, on a first-in, first-out basis.





Fixed
Assets





Fixed
assets are capitalized and carried at the lower of cost or net realizable
value.  Normal maintenance and repairs are charged to expense as
incurred.  When assets are sold or otherwise disposed of, the cost and
accumulated depreciation are removed from the accounts and any resulting gain or
loss is recognized in operations.





Depreciation
is computed using the straight-line method over the following estimated useful
lives:


Production
      equipment
              3
      to 7 yearsOffice
      equipment
              2
      to 5 yearsFurniture
      and fixtures
              2
      to 5 years





Leasehold
improvements and capital lease assets are amortized over the shorter of the life
of the lease or the estimated useful life of the asset.


F-8





Management
of the Company periodically reviews the net carrying value of all of its
equipment on an asset by asset basis.  These reviews consider the net
realizable value of each asset to determine whether an impairment in value has
occurred, and the need for any asset impairment write-down.





Although
management has made its best estimate of the factors that affect the carrying
value based on current conditions, it is reasonably possible that changes could
occur which could adversely affect management's estimate of net cash flows
expected to be generated from its assets, and necessitate asset impairment
write-downs.





Deferred Financing
Costs





Financing
costs related to the acquisition of debt are deferred and amortized over the
term of the related debt using the effective interest method.Deferred financing costs
include the fair value of common shares issued to certain shareholders for their
guarantee of certain Company debt (see Note 10) in accordance with Accounting
Principles Board (APB) Opinion No. 21, Interest on Receivables and
Payables and Emerging Issues Task Force (EITF) Issue No. 95-13, Classification of Debt Issue Costs
in the Statement of Cash Flows.  The value of the shares issued
was the estimated market price of the shares as of the date of
issuance.  Amortization of deferred financing costs, totaling $37,035
and $30,504 for the years ended June 30, 2009 and 2008, respectively, is
included in financing expense on the statements of operations.





Licenses





Amortization
of licenses is computed using the straight-line method over the estimated
economic useful lives of the assets.  In fiscal year 2006, the Company
entered into an agreement with IBt, SA, a Belgian company (IBt) to use IBt’s
proprietary “Ink Jet” production process and its proprietary polymer seed
technology for use in brachytherapy procedures using Cesium-131
(Cs-131).  The Company paid license fees of $225,000 and $275,000
during fiscal years 2008 and 2006, respectively.  During fiscal year
2009, the Company determined that the entire remaining value of the IBt license
was impaired and recorded an impairment charge of $425,434 (see Note
7).





Amortization
of licenses was $30,067 and $43,452 for the years ended June 30, 2009 and 2008,
respectively.  Based on the licenses recorded at June 30, 2009, and
assuming no subsequent impairment of the underlying assets, the annual
amortization expense for each fiscal year ending June 30 is expected to be as
follows:  $11,867 for 2010, $0 for all years thereafter.





Other
Assets





Other
assets, which include deferred charges and patents, are stated at cost, less
accumulated amortization.  Amortization of patents is computed using
the straight-line method over the estimated economic useful lives of the
assets.  The Company periodically reviews the carrying values of
patents and any impairments are recognized when the expected future operating
cash flows to be derived from such assets are less than their carrying
value.





Based on
the patents and other intangible assets recorded in other assets at June 30,
2009, and assuming no subsequent impairment of the underlying assets, the annual
amortization expense for each fiscal year ending June 30 is expected to be as
follows: $16,861 for 2010, $15,139 for 2011, $15,139 for 2012, $15,139 for 2013,
$15,139 for 2014, and $157,768 thereafter.





Asset Retirement
Obligation





The fair
value of the future retirement costs of the Company’s leased assets are recorded
as a liability on a discounted basis when they are incurred and an equivalent
amount is capitalized to property and equipment.  The initial recorded
obligation is discounted using the Company’s credit-adjusted risk free-rate and
is reviewed periodically for changes in the estimated future costs underlying
the obligation.  The Company amortizes the initial amount capitalized
to property and equipment and recognizes accretion expense in connection with
the discounted liability over the estimated remaining useful life of the leased
assets.


F-9





In fiscal
year 2006, the Company established an initial asset retirement obligation of
$63,040 which represented the discounted cost of cleanup that the Company
anticipated it would have to incur at the end of its equipment and property
leases in its old production facility.  This amount was determined
based on discussions with qualified production personnel and on historical
evidence.  During fiscal year 2007, the Company reevaluated its
obligations based on discussions with the Washington Department of Health and
determined that the initial asset retirement obligation should be increased by
an additional $56,120.  During the second quarter of fiscal year 2008,
the Company removed all radioactive residuals and tenant improvements from its
old production facility and returned the facility to the lessor.  The
Company had an asset retirement obligation of $135,120 accrued for this facility
but total costs incurred to decommission the facility were $274,163 resulting in
an additional expense of $139,043 that is included in cost of products
sold.  The additional expense was mainly due to unanticipated
construction costs to return the facility to its previous state.  The
Company originally believed that the lessor would retain many of the leasehold
improvements in the building, but the lessor instead required their
removal.





In
September 2007, another asset retirement obligation of $473,096 was established
representing the discounted cost of the Company’s estimate of the obligations to
remove any residual radioactive materials and all leasehold improvements at the
end of the lease term at its new production facility.  The estimate
was developed by qualified production personnel and the general contractor of
the new facility.  The Company has reviewed the estimate again based
on its experience with decommissioning its old facility and believes that the
original estimate continues to be applicable.





During
the years ended June 30, 2009 and 2008, the asset retirement obligations changed
as follows:





2009
                  
                  
                  2008Beginning
      balance
                  
                  $
                  506,005
                  
                  
                  $
                  131,142New
      obligation
                  
                  
                  –
                  
                  
                  
                  473,096Settlement
      of existing obligation
                  
                  
                  –
                  
                  
                  
                  (135,120
                  )Accretion
      of discount
                  
                  
                  47,466
                  
                  
                  
                  36,887Ending
      balance
                  
                  $
                  553,471
                  
                  
                  $
                  506,005





Because
the Company does not expect to incur any expenses related to its asset
retirement obligations in fiscal year 2010, the entire balance as of June 30,
2009 is classified as a noncurrent liability.





Financial
Instruments





The
Company discloses the fair value of financial instruments, both assets and
liabilities, recognized and not recognized in the balance sheet, for which it is
practicable to estimate the fair value.  The fair value of a financial
instrument is the amount at which the instrument could be exchanged in a current
transaction between willing parties, other than a forced liquidation
sale.





The
carrying amounts of financial instruments, including cash and cash equivalents,
short-term investments, accounts receivable, accounts payable, notes payable,
and capital lease obligations, approximated their fair values at June 30, 2009
and 2008.





Revenue
Recognition





The
Company applies the provisions of SEC Staff Accounting Bulletin (SAB)
No. 104, Revenue
Recognition. SAB No. 104 provides guidance on the recognition,
presentation and disclosure of revenue in financial statements.  SAB
No. 104 outlines the basic criteria that must be met to recognize revenue
and provides guidance for the disclosure of revenue recognition
policies.  The Company recognizes revenue related to product sales
when (i) persuasive evidence of an arrangement exists, (ii) shipment
has occurred, (iii) the fee is fixed or determinable, and
(iv) collectability is reasonably assured.


F-10




Revenue
for the fiscal years ended June 30, 2009 and 2008 was derived solely from sales
of the Proxcelan Cs-131 brachytherapy seed, which is used in the treatment of
cancer.  The Company recognizes revenue once the product has been
shipped to the customer.  Prepayments, if any, received from customers
prior to the time that products are shipped are recorded as deferred revenue. In
these cases, when the related products are shipped, the amount recorded as
deferred revenue is then recognized as revenue.  The Company accrues
for sales returns and other allowances at the time of
shipment.  Although the Company does not have an extensive operating
history upon which to develop sales returns estimates, we have used the
expertise of our management team, particularly those with extensive industry
experience and knowledge, to develop a proper methodology.





Shipping and Handling
Costs





Shipping
costs include charges associated with delivery of goods from the Company’s
facilities to its customers and are reflected in cost of product
sales.  Shipping costs paid to the Company by our customers are
classified as product sales.





Stock-Based
Compensation





The
Company measures and recognizes expense for all share-based payments at fair
value.  The Company uses the Black-Scholes option valuation model to
estimate fair value for all stock options on the date of grant.  For
stock options that vest over time, the Company recognizes compensation cost on a
straight-line basis over the requisite service period for the entire
award.





Research and Development
Costs





Research
and development costs, including salaries, research materials, administrative
expenses and contractor fees, are charged to operations as
incurred.  The cost of equipment used in research and development
activities which has alternative uses is capitalized as part of fixed assets and
not treated as an expense in the period acquired.  Depreciation of
capitalized equipment used to perform research and development is classified as
research and development expense in the year recognized.





Advertising and Marketing
Costs





Advertising
costs are expensed as incurred except for the cost of tradeshows and related
marketing materials which are deferred until the tradeshow
occurs.  Advertising and marketing costs expensed (including
tradeshows) were $376,319 and $598,663 for the years ended June 30, 2009 and
2008, respectively.  Marketing costs of $5,800 were included in
prepaid expenses at June 30, 2009.





Legal
Contingencies





In the
ordinary course of business, the Company is involved in legal proceedings
involving contractual and employment relationships, product liability claims,
patent rights, environmental matters, and a variety of other
matters.  The Company is also subject to various local, state, and
federal environmental regulations and laws due to the isotopes used to produce
the Company’s product.  As part of normal operations, amounts are
expended to ensure that the Company is in compliance with these laws and
regulations.  While there have been no reportable incidents or
compliance issues, the Company believes that if it relocates its current
production facilities then certain decommissioning expenses will be incurred and
has recorded an asset retirement obligation for these expenses.





The
Company records contingent liabilities resulting from asserted and unasserted
claims against it, when it is probable that a liability has been incurred and
the amount of the loss is reasonably estimable.  Estimating probable
losses requires analysis of multiple factors, in some cases including judgments
about the potential actions of third-party claimants and
courts.  Therefore, actual losses in any future period are inherently
uncertain.  Currently, the Company does not believe any probable legal
proceedings or claims will have a material adverse effect on its financial
position or results of operations.  However, if actual or estimated
probable future losses exceed the Company’s recorded liability for such claims,
it would record additional charges as other expense during the period in which
the actual loss or change in estimate occurred.


F-11





Income
Taxes





Income
taxes are accounted for under the liability method.  Under this
method, the Company provides deferred income taxes for temporary differences
that will result in taxable or deductible amounts in future years based on the
reporting of certain costs in different periods for financial statement and
income tax purposes.  This method also requires the recognition of
future tax benefits such as net operating loss carryforwards, to the extent that
realization of such benefits is more likely than not.  Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled.  The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in operations in the period
that includes the enactment of the change.





On July
1, 2007, the Company adopted Financial Accounting Standards Board Interpretation
No. 48, Accounting for
Uncertainty in Income Taxes (FIN No. 48).  FIN No. 48 clarifies
the accounting for uncertainty in income taxes recognized in accordance with
SFAS No. 109 Accounting for
Income Taxes, prescribing a recognition threshold and measurement
attribute for the recognition and measurement of a tax position taken or
expected to be taken in a tax return.  In the course of its
assessment, management has determined that the Company, its subsidiary, and its
predecessors are subject to examination of their income tax filings in the
United States and state jurisdictions for the 2005 through 2008 tax
years.  In the event that the Company is assessed penalties and or
interest, penalties will be charged to other operating expense and interest will
be charged to interest expense.





The
Company adopted FIN No. 48 using the modified prospective transition method,
which requires the application of the accounting standard as of July 1,
2007.  There was no impact on the financial statements as of and for
the year ended June 30, 2008 as a result of the adoption of FIN No.
48.  In accordance with the modified prospective transition method,
the financial statements for prior periods have not been restated to reflect,
and do not include, the impact of FIN No. 48.





Income (Loss) Per Common
Share





Basic
earnings per share is calculated by dividing net income (loss) available to
common shareholders by the weighted average number of common shares outstanding,
and does not include the impact of any potentially dilutive common stock
equivalents.  Common stock equivalents, including warrants and options
to purchase the Company's common stock, are excluded from the calculations when
their effect is antidilutive.  At June 30, 2009 and 2008, the
calculation of diluted weighted average shares does not include preferred stock,
common stock warrants or options that are potentially convertible into common
stock as those would be antidilutive due to the Company’s net loss
position.





Securities
that could be dilutive in the future as of June 30, 2009 and 2008 are as
follows:





2009
                  
                  
                  2008Preferred
      stock
                  
                  
                  59,065
                  
                  
                  
                  59,065Common
      stock warrants
                  
                  
                  3,216,644
                  
                  
                  
                  3,245,082Common
      stock options
                  
                  
                  2,708,166
                  
                  
                  
                  2,803,393Total
      potential dilutive securities
                  
                  
                  5,983,875
                  
                  
                  
                  6,107,540


F-12


Subsequent
Events





Effective
April 1, 2009, the Company adopted SFAS No. 165, Subsequent
Events.  This Statement establishes the accounting for, and
disclosure of, material events that occur after the balance sheet date, but
before the financial statements are issued.  In general, these events
will be recognized if the condition existed at the date of the balance sheet,
and will not be recognized if the condition did not exist at the balance sheet
date.  Disclosure is required for nonrecognized events if required to
keep the financial statements from being misleading.  The guidance in
this Statement is very similar to current guidance provided in accounting
literature and, therefore, will not result in significant changes in
practice.  Subsequent events have been evaluated through the date our
financial statements were issued—the filing time and date of our 2009 Annual
Report on Form 10-K.





Use of
Estimates





The
preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America requires management of the
Company to make estimates and assumptions that affect the amounts reported in
the financial statements and accompanying notes.  Accordingly, actual
results could differ from those estimates and affect the amounts reported in the
financial statements.





Impact of Recently Issued
Accounting Pronouncements





In
December 2007, the FASB issued statement No. 160, Noncontrolling Interests in
Consolidated Financial Statements – an amendment of ARB No. 51 (SFAS
160).  The statement requires noncontrolling interests or minority
interests to be treated as a separate component of equity, not as a liability or
other item outside of permanent equity.  Upon a loss of control, the
interest sold, as well as any interest retained, is required to be measured at
fair value, with any gain or loss recognized in earnings.  Based on
SFAS 160, assets and liabilities will not change for subsequent purchase or
sales transactions with noncontrolling interests as long as control is
maintained.  Differences between the fair value of consideration paid
or received and the carrying value of noncontrolling interests are to be
recognized as an adjustment to the parent interest’s equity.  SFAS 160
is effective for fiscal years beginning on or after December 15, 2008 and
earlier adoption is prohibited.  The adoption of this statement is not
expected to have a material effect on the Company’s financial
statements.





In May
2008, FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles.  SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States.  It was effective November 15, 2008, following the
SEC’s approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, The Meaning of
Present Fairly in Conformity With Generally Accepted Accounting
Principles.  The adoption of this statement did not have a
material effect on the Company’s financial statements.





The FASB
issued SFAS No. 168, The
FASB Standards Codification and the Hierarchy of Generally Accepted Accounting
Principles—a replacement of FASB Statement 162, in late
June 2009.  The FASB Accounting Standards Codification will
become the source of authoritative U.S. generally accepted accounting principles
(GAAP) and will supersede all then-existing non-SEC accounting and
reporting standards on the effective date, September 15,
2009.  The Codification will not change GAAP, but consolidates it into
a logical and consistent structure.  The Company will be required to
revise our references to GAAP in our financial statements beginning with the
first quarter of fiscal year 2010.


F-13




3.
            Short-Term
      Investments





The
Company’s short-term investments consisted of the following at June 30, 2009 and
2008:





2009
                  
                  
                  2008Certificates
      of deposit
                  
                  $
                  1,679,820
                  
                  
                  $
                  –Municipal
      debt securities
                  
                  
                  –
                  
                  
                  
                  3,726,000$
                  1,679,820
                  
                  
                  $
                  3,726,000





Beginning
in February 2008, the uncertainties in the credit markets prevented the Company
from liquidating its ARS (consisting of various student loan
portfolios).  The securities continued to pay interest according to
their stated terms and were all AAA/Aaa rated investments.  Through
September 2008, the Company classified these securities as available-for-sale
and recorded them at fair market value.  The Company recognized a
decline in the fair value of these securities (which was caused by the market
uncertainties) as other than temporary and recorded the loss in the statement of
operations.





In
October 2008, the Company accepted an offer from UBS to provide the Company with
certain Rights pertaining to our ARS.  The Rights were a put option
allowing the Company to sell its ARS to UBS at par value at any time from
January 2, 2009 to January 4, 2011.  The Rights did not meet the
definition of a derivative under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, as there is no net settlement
method.  The Rights also did not meet the definition of a security
under SFAS No. 115, Accounting for
Certain Investments in Debt and Equity Securities.  The Company
elected to measure the Rights under the fair value option of SFAS 159 on the
date they were received (see Note 2) and classified them as short-term
investments.





Also in
October 2008, the Company reclassified its ARS from available-for-sale to
trading and recorded all changes in fair value to these securities in the
statement of operations.  The Company felt this reclassification was
appropriate given that it accepted the offer of the Rights, it did not intend to
hold these investments to maturity, and there was no longer an active market to
permit their sale in the normal course of business.





On
January 2, 2009, the Company exercised its put option with UBS to redeem its ARS
at par value.  The entire $4 million of cash was deposited into the
Company’s account on January 5, 2009.





4.
            Inventory





Inventory
consisted of the following at June 30, 2009 and 2008:





2009
                  
                  
                  2008Raw
      materials
                  
                  $
                  609,932
                  
                  
                  $
                  696,958Work
      in process
                  
                  
                  155,827
                  
                  
                  
                  191,684Finished
      goods
                  
                  
                  23,487
                  
                  
                  
                  11,322$
                  789,246
                  
                  
                  $
                  899,964





The cost
of materials and production costs contained in inventory that are not useable
due to the passage of time, and resulting loss of bio-effectiveness, are written
off to cost of product sales at the time it is determined that the product is
not useable.





In June
2007, the Company purchased $469,758 of enriched barium that will be used in
future production of our isotope.  The enriched barium is held at an
off-site storage location in Richland, Washington and is included in raw
materials at June 30, 2009 and 2008.


F-14


5.
            Prepaid
      Expenses





Prepaid
expenses consisted of the following at June 30, 2009 and 2008:





2009
                  
                  
                  2008Prepaid
      contract work
                  
                  $
                  –
                  
                  
                  $
                  60,107Prepaid
      insurance
                  
                  
                  30,625
                  
                  
                  
                  38,059Prepaid
      rent
                  
                  
                  24,402
                  
                  
                  
                  24,199Other
      prepaid expenses
                  
                  
                  61,900
                  
                  
                  
                  106,960Other
      current assets
                  
                  
                  34,150
                  
                  
                  
                  37,676$
                  151,077
                  
                  
                  $
                  267,001





6.
            Fixed
      Assets





Fixed
assets consisted of the following at June 30, 2009 and 2008:





2009
                  
                  
                  2008Production
      equipment
                  
                  $
                  3,089,793
                  
                  
                  $
                  2,786,748Office
      equipment
                  
                  
                  169,890
                  
                  
                  
                  153,215Furniture
      and fixtures
                  
                  
                  148,265
                  
                  
                  
                  148,265Leasehold
      improvements (a)
                  
                  
                  4,643,965
                  
                  
                  
                  4,622,136Capital
      lease assets (b)
                  
                  
                  –
                  
                  
                  
                  222,911Construction
      in progress
                  
                  
                  3,359
                  
                  
                  
                  64,2198,055,272
                  
                  
                  
                  7,997,494Less
      accumulated depreciation
                  
                  
                  (3,163,788
                  )
                  
                  
                  (1,956,853
                  )$
                  4,891,484
                  
                  
                  $
                  6,040,641





(a)
            Balance
      includes asset retirement addition of $473,096 as of June 30, 2009 and
      2008.


(b)
            The
      Company’s capital leases were properly terminated during fiscal year
      2009.  The Company now has ownership of these assets and
      continues to use them in its facilities.  Therefore, the Company
      reclassified these assets to production equipment during fiscal year
      2009.  Accumulated amortization of capital lease assets totaled
      $0 and $166,328 at June 30, 2009 and 2008,
  respectively.





Depreciation
and amortization expense related to fixed assets totaled $1,206,935 and
$1,103,940 for 2009 and 2008, respectively.





The
Company recorded an impairment charge of $85,000 in fiscal year 2008 for a hot
cell that is not currently in use.  This impairment charge is included
in cost of product sales on the Consolidated Statement of
Operations.  The Company estimated its fair market value based on
values for similar assets.





7.
            Impairment
      of IBt License





In
December 2008, the Company reevaluated its license agreement with International
Brachytherapy SA (IBt) in connection with an overall review of its present cost
structure and projected market and manufacturing strategies (see Note 18 for
further details on the IBt license agreement).  Management determined
through this review that it does not currently intend to utilize the IBt license
as part of its market strategy due to the cost of revamping its manufacturing
process to incorporate the technology and as there can be no assurance that
physicians would accept this new technology without extensive education and
marketing costs.  However, the Company does not intend to cancel the
license agreement at this time; therefore, the license was reviewed in terms of
an “abandoned asset” for purposes of SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets.As there are no
anticipated future revenues from the license and the Company cannot sell or
transfer the license, it was determined that the entire value was
impaired.  Therefore, the Company recorded an impairment charge of
$425,434 in December 2008 that is included in cost of product sales for the year
ended June 30, 2009.


F-15




8.
            Restricted
      Cash




The
Washington Department of Health, effective October 2007, has required the
Company to provide collateral for the decommissioning of its
facility.  To satisfy this requirement, the Company funded two
certificates of deposits (CDs) totaling $172,500 in separate
banks.  The CDs both have original maturities of three months but are
classified as long-term as the Company does not anticipate decommissioning the
facility until the end of the current lease plus the lease option
periods.  Interest earned on the CDs is rolled-over at the maturity of
each CD and becomes part of the restricted cash balance.  Interest
earned and added to restricted cash during the fiscal year ended June 30, 2009
and 2008 was $2,763 and  $3,352, respectively.  These funds
will be used to settle a portion of the Company’s remaining asset retirement
obligations (Note 2).





9.
            Other
      Assets





Other
assets, net of accumulated amortization, consisted of the following at June 30,
2009 and 2008:





2009
                  
                  
                  2008Deferred
      charges
                  
                  $
                  40,496
                  
                  
                  $
                  322,319Patents
      and trademarks, net of accumulated amortization of $25,244 and
      $19,094
                  
                  
                  233,463
                  
                  
                  
                  22,721$
                  273,959
                  
                  
                  $
                  345,040





Deferred
charges consist of prepaid legal fees for patents which have not yet been
obtained, and prepayments and deposits on fixed assets and
contracts.  Amortization of patents and trademarks was $6,150 and
$2,631 for the years ended June 30, 2009 and 2008, respectively.





During
fiscal year 2009, the Company performed a review of its prepaid legal fees for
patents and trademarks that have not been obtained and are classified within
other assets on the consolidated balance sheet.  The focus of the
review was patent and trademark applications that the Company had been pursuing
in foreign countries.  The Company decided to limit its foreign
applications to Canada, Europe, and Russia, as well as the continued protection
of the US patents and trademarks.  This resulted in the write-off of
$85,818 of other patent and trademark application fees relating to other
countries during fiscal year 2009 that is included in research and development
expenses.


F-16


10.
            Notes
      Payable





Notes
payable consisted of the following at June 30, 2009 and 2008:





2009
                  
                  
                  2008Benton-Franklin
      Economic Development District (BFEDD) note payable (a)
                  
                  $
                  115,898
                  
                  
                  $
                  145,745Hanford
      Area Economic Investment Fund Committee (HAEIFC) note payable (b)
                  
                  
                  221,562
                  
                  
                  
                  263,639337,460
                  
                  
                  
                  409,384Less
      amounts due within one year
                  
                  
                  (161,437
                  )
                  
                  
                  (64,486
                  )Amounts
      due after one year
                  
                  $
                  176,023
                  
                  
                  $
                  344,898





(a)
            The
      note payable to BFEDD, which is collateralized by substantially all of the
      Company’s assets, and guaranteed by certain shareholders, was executed
      pursuant to a Development Loan Agreement.  The note contains
      certain restrictive covenants relating to: working capital; levels of
      long-term debt to equity; incurrence of additional indebtedness; payment
      of compensation to officers and directors; and payment of
      dividends.  The note is payable in monthly installments
      including interest at 8.0% per annum with a final balloon payment due in
      October 2009.  At June 30, 2009, the Company was not in
      compliance with certain of the covenants and the entire balance has been
      classified as a current liability.





(b)
            In
      June 2006, the Company entered into a note payable with HAEIFC, which is
      collateralized by receivables, inventory, equipment, and certain life
      insurance policies.  The loan originally had a total facility of
      $1,400,000 which was reduced in September 2007 to the amount of the
      Company’s initial draw of $418,670.  The note contains certain
      restrictive covenants relating to: financial ratios; payment of
      compensation to officers and directors; and payment of
      dividends.  The note accrues interest at 9% and is payable in
      monthly installments with the final installment due in July 2016. At June
      30, 2009, the Company was not in compliance with certain of the
      covenants.  The Company has obtained a waiver from HAEIFC,
      relating to these covenants, through June 30,
  2010.





Principal
maturities on notes payable as of June 30, 2009 are as follows:





Year ending June 30,2010
                      
                      $
                      161,4372011
                      
                      
                      49,4452012
                      
                      
                      54,0592013
                      
                      
                      59,1542014
                      
                      
                      13,365Thereafter
                      
                      
                      –$
                      337,460


F-17


11.
            Share-Based
      Compensation





The
following table presents the share-based compensation expense recognized in
accordance with SFAS 123R during the years ended June 30, 2009 and
2008:





Year ended June 30,2009
                  
                  
                  2008Cost
      of product sales
                  
                  $
                  17,619
                  
                  
                  $
                  109,578Research
      and development
                  
                  
                  23,450
                  
                  
                  
                  43,885Sales
      and marketing expenses
                  
                  
                  148,407
                  
                  
                  
                  238,230General
      and administrative expenses
                  
                  
                  164,220
                  
                  
                  
                  205,361Total
      share-based compensation
                  
                  $
                  353,696
                  
                  
                  $
                  597,054





The total
value of the stock options awards is expensed ratably over the service period of
the employees receiving the awards.  As of June 30, 2009, total
unrecognized compensation cost related to stock-based options and awards was
$223,295 and the related weighted-average period over which it is expected to be
recognized is approximately 0.96 years.





The
Company currently provides share-based compensation under three equity incentive
plans approved by the Board of Directors: the Amended and Restated 2005 Stock
Option Plan (the Option Plan), the Amended and Restated 2005 Employee Stock
Option Plan (the Employee Plan), and the 2006 Director Stock Option Plan (the
Director Plan).  The Option Plan allows the Board of Directors to
grant options to purchase up to 1,800,000 shares of common stock to directors,
officers, key employees and service providers of the Company.  The
Employee Plan allows the Board of Directors to grant options to purchase up to
2,000,000 shares of common stock to officers and key employees of the
Company.  The Director Plan allows the Board of Directors to grant
options to purchase up to 1,000,000 shares of common stock to directors of the
Company.  Options granted under all of the plans have a ten year
maximum term, an exercise price equal to at least the fair market value of the
Company’s common stock on the date of the grant, and varying vesting periods as
determined by the Board.  For stock options with graded vesting terms,
the Company recognizes compensation cost on a straight-line basis over the
requisite service period for the entire award.





On June
1, 2007, the Company issued an option grant to employees and
directors.  The options had an exercise price of $4.14 which was the
closing market price of the Company’s stock on the grant date.  The
options issued to the employees vest over three years while the options granted
to the non-employee directors were immediately vested.





The
Company’s former CEO, who also served as Chairman of the Board, was granted
150,000 options, and the former Executive Vice President Operations
(EVP–Operations), who also served as a director, was granted 100,000 options,
and all non-employee directors were granted 50,000 options each.  On
July 25, 2007, the Board discussed the issue of director compensation and each
director (including the employee directors) elected to cancel 50,000 of their
options from the June 1, 2007 grant.  After the cancellation, the
former CEO and former EVP–Operations had 100,000 and 50,000 options,
respectively, and the non-employee directors had no options from the June 1,
2007 grant.  The terms of these remaining options for the former CEO
and former EVP–Operations were not changed as part of the
cancellation.





In
accordance with SFAS 123R, all of the options that were cancelled have been
accounted for as cancellation of options with no consideration.  No
additional compensation cost associated with the former CEO’s and
EVP–Operations’ options will be recognized after the cancellation date of July
25, 2007.  Cancelled options that had been granted to non-employee
directors were immediately vested on the date of grant; therefore all related
compensation cost was recognized in fiscal year 2007.





All of
these subsequently cancelled options are included in the options outstanding as
of July 1, 2007 and are included in the options cancelled in fiscal year 2008
(see Note 12).


F-18


A summary
of stock option activity within the Company’s share-based compensation plans for
the year ended June 30, 2009 is as follows:





Shares
                  
                  
                  Price (a)
                  
                  
                  Life (b)
                  
                  
                  Value (c)Outstanding
      at June 30, 2009
                  
                  
                  2,708,166
                  
                  
                  $
                  2.08
                  
                  
                  
                  7.92
                  
                  
                  $
                  –Vested
      and expected to vest at June 30, 2009
                  
                  
                  2,615,395
                  
                  
                  $
                  2.14
                  
                  
                  
                  7.85
                  
                  
                  $
                  –Vested
      and exercisable at June 30, 2009
                  
                  
                  1,837,018
                  
                  
                  $
                  2.74
                  
                  
                  
                  7.12
                  
                  
                  $
                  –





(a)
            Weighted
      average exercise price per share.


(b)
            Weighted
      average remaining contractual life.


(c)
            Aggregate
      intrinsic value.  As of June 30, 2009, all options outstanding
      have an exercise price greater than the closing market price of
      $0.25.





The
aggregate intrinsic value of options exercised during the years ended June 30,
2009 and 2008 was $0 and $25,300, respectively.  The Company’s current
policy is to issue new shares to satisfy option exercises.





The
weighted average fair value of stock option awards granted and the key
assumptions used in the Black-Scholes valuation model to calculate the fair
value are as follows for the year ended June 30, 2009 and 2008:





Years ended June 30,2009
                  
                  
                  2008Weighted
      average fair value of options granted
                  
                  $
                  0.21
                  
                  
                  $
                  0.70Key
      assumptions used in determining fair value:Weighted
      average risk-free interest rate
                  
                  
                  2.55
                  %
                  
                  
                  3.17
                  %Weighted
      average life of the option (in years)
                  
                  
                  4.66
                  
                  
                  
                  6.00Weighted
      average historical stock price volatility
                  
                  
                  128.23
                  %
                  
                  
                  141.67
                  %Expected
      dividend yield
                  
                  
                  0.00
                  %
                  
                  
                  0.00
                  %





The
Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable.  In addition, option valuation models require the input
of highly subjective assumptions, including the expected stock price
volatility.  Although the Company is using the Black-Scholes option
valuation model, management believes that because changes in the subjective
input assumptions can materially affect the fair value estimate, this valuation
model does not necessarily provide a reliable single measure of the fair value
of its stock options.  The risk-free interest rate is based on the
U.S. treasury security rate with an equivalent term in effect as of the date of
grant.  The expected option lives, volatility, and forfeiture
assumptions are based on historical data of the Company.





12.
            Shareholders’
      Equity





The
authorized capital structure of the Company consists of $.001 par value
preferred stock and $.001 par value common stock.





Preferred
Stock





The
Company's Articles of Incorporation authorize 6,000,000 shares of $0.001 par
value preferred stock available for issuance with such rights and preferences,
including liquidation, dividend, conversion, and voting rights, as described
below.


F-19





Series A





Series A
preferred shares are entitled to a 10% dividend annually on the stated par value
per share.  These shares are convertible into shares of common stock
at the rate of one share of common stock for each share of Series A preferred
stock, and are subject to automatic conversion into common stock upon the
closing of an underwritten public offering pursuant to an effective registration
statement under the Securities Act of 1933 covering the offer and sale of common
stock in which the gross proceeds to the Company are at least $4
million.  Series A preferred shareholders have voting rights equal to
the voting rights of common stock, except that the vote or written consent of a
majority of the outstanding preferred shares is required for any changes to the
Company’s Articles of Incorporation, Bylaws or Certificate of Designation, or
for any bankruptcy, insolvency, dissolution or liquidation of the
Company.  Upon liquidation of the Company, the Company’s assets are
first distributed ratably to the Series A preferred shareholders.  At
June 30, 2009, there were no Series A preferred shares outstanding.





Series B





Series B
preferred shares are entitled to a cumulative 15% dividend annually on the
stated par value per share.  These shares are convertible into shares
of common stock at the rate of one share of common stock for each share of
Series B preferred stock, and are subject to automatic conversion into common
stock upon the closing of an underwritten public offering pursuant to an
effective registration statement under the Securities Act of 1933 covering the
offer and sale of common stock in which the gross proceeds to the Company are at
least $4 million.  Series B preferred shareholders have voting rights
equal to the voting rights of common stock, except that the vote or written
consent of a majority of the outstanding preferred shares is required for any
changes to the Company’s Articles of Incorporation, Bylaws or Certificate of
Designation, or for any bankruptcy, insolvency, dissolution or liquidation of
the Company.  Upon liquidation of the Company, the Company’s assets
are first distributed ratably to the Series A preferred shareholders, then to
the Series B preferred shareholders.





On
February 1, 2007, the Board of Directors declared a dividend on the Series B
Preferred Stock of all outstanding and cumulative dividends through December 31,
2006.  The total dividends of $38,458 were paid on February 15,
2007.  The Company does not anticipate paying any cash dividends on
the Series B Preferred Stock in the foreseeable future.  At June 30,
2009, there were 59,065 Series B preferred shares outstanding and cumulative
dividends in arrears were $26,565.





In
addition to the previously outstanding shares of common stock and Series B
preferred stock, the Company had the following transactions that affected
shareholders’ equity during the years ended June 30, 2009 and 2008.





Cancellation of Common
Shares





In March
2008, the Company cancelled 148,112 shares of common stock held by Roger Girard,
the Company’s former CEO, due to the release of Mr. Girard from certain personal
guarantees of Company debt and due to Mr. Girard’s resignation as Chairman,
President, and CEO.  The shares were originally issued in connection
with Mr. Girard’s personal guarantee of Company debt or were contingent on his
employment through August 2008.


F-20


Warrants to Purchase Common
Stock





In
connection with the various common stock offerings and at other times the
Company has issued warrants for the purchase of common stock.  The
warrants activity is summarized as follows:





2009
                  
                  
                  2008Warrants
                  
                  
                  Price (a)
                  
                  
                  Warrants
                  
                  
                  Price (a)Beginning
      balance outstanding
                  
                  
                  3,245,082
                  
                  
                  $
                  5.50
                  
                  
                  
                  3,627,764
                  
                  
                  $
                  5.31Cancelled/expired
                  
                  
                  (28,438
                  )
                  
                  
                  0.70
                  
                  
                  
                  (91,806
                  )
                  
                  
                  4.18Exercised
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  (290,876
                  )
                  
                  
                  3.48Ending
      balance outstanding
                  
                  
                  3,216,644
                  
                  
                  $
                  5.55
                  
                  
                  
                  3,245,082
                  
                  
                  $
                  5.50





(a)
            Weighted
      average exercise price per share.





On August
20, 2008, the Board of Directors extended the expiration dates of warrants
issued pursuant to the Company’s private placement memorandums dated October 17,
2005 and February 1, 2006 for an additional one-year period.  The
Board of Directors had previously retroactively extended these warrants on
January 8, 2008 for a one-year period beyond their initial expiration dates of
October 2007 to February 2008.  Based on these extensions, the
warrants will now expire between October 2009 and February 2010.  No
other terms or conditions of the warrants were changed.  The change in
expiration dates affected outstanding warrants to purchase 2,102,142 shares of
common stock.  Of these outstanding warrants, there were warrants to
purchase 12,500 common shares held by the Chairman and CEO of the
Company.  Prior to the original extension, warrants to purchase
1,186,219 shares of common stock had passed their original expiration
dates.





The
change in expiration date was a modification of the original warrant based on
market conditions and was accounted for as a financing transaction similar to an
extension of time in the offering of shares in a stock
sale.  Therefore there was no effect on the statement of operations as
the Company had previously determined that under SFAS 133 and EITF 00-19 these
warrants were equity instruments rather than derivatives.





The
following table summarizes additional information about the Company’s common
warrants outstanding as of June 30, 2009:





Number of Warrants
                                
                                
                                Range of Exercise Prices
                                
                                
                                Expiration Date53,000
                                
                                
                                $
                                6.00
                                
                                
                                October
      2009162,500
                                
                                
                                $
                                6.00
                                
                                
                                November
      2009909,469
                                
                                
                                $
                                6.00
                                
                                
                                December
      2009700,250
                                
                                
                                $
                                6.00
                                
                                
                                January
      2010276,923
                                
                                
                                $
                                6.00
      to $6.50
                                
                                
                                February
      201056,876
                                
                                
                                $
                                0.70
                                
                                
                                March
      2010826,100
                                
                                
                                $
                                5.00
                                
                                
                                March
      2011206,526
                                
                                
                                $
                                4.40
                                
                                
                                March
      201225,000
                                
                                
                                $
                                2.00
                                
                                
                                July
      20153,216,644


F-21


Common Stock
Options





A summary
of the Company’s stock option activity and related information for the years
ended June 30, 2009 and 2008 is as follows:





2009
                  
                  
                  2008Shares
                  
                  
                  Price (a)
                  
                  
                  Shares
                  
                  
                  Price (a)Beginning
      balance outstanding
                  
                  
                  2,803,393
                  
                  
                  $
                  2.62
                  
                  
                  
                  3,683,439
                  
                  
                  $
                  2.86Granted
      (b)
                  
                  
                  993,900
                  
                  
                  
                  0.31
                  
                  
                  
                  100,000
                  
                  
                  
                  0.75Cancelled
                  
                  
                  (1,089,127
                  )
                  
                  
                  1.86
                  
                  
                  
                  (970,046
                  )
                  
                  
                  3.35Exercised
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  (10,000
                  )
                  
                  
                  1.19Ending
      balance outstanding
                  
                  
                  2,708,166
                  
                  
                  $
                  2.08
                  
                  
                  
                  2,803,393
                  
                  
                  $
                  2.62Exercisable
      at end of year
                  
                  
                  1,837,018
                  
                  
                  $
                  2.74
                  
                  
                  
                  2,442,001
                  
                  
                  $
                  2.42





(a)
            Weighted
      average exercise price per share.


(b)
            All
      options granted had exercise prices equal to or greater than the ending
      market price of the Company’s common stock on the grant
    date.





The
following table summarizes additional information about the Company’s stock
options outstanding as of June 30, 2009:





Options Outstanding
                        
                        
                        Options ExercisableRange of Exercise Prices
                        
                        
                        Shares
                        
                        
                        Price (a)
                        
                        
                        Life (b)
                        
                        
                        Shares
                        
                        
                        Price (a)$
                        0.26
                        
                        
                        
                        898,900
                        
                        
                        $
                        0.26
                        
                        
                        
                        9.93
                        
                        
                        
                        200,000
                        
                        
                        $
                        0.26$
                        0.65
      to $0.75
                        
                        
                        
                        130,000
                        
                        
                        
                        0.73
                        
                        
                        8.90 yrs
                        
                        
                        
                        100,000
                        
                        
                        
                        0.75$
                        1.00
      to $1.19
                        
                        
                        
                        272,802
                        
                        
                        
                        1.05
                        
                        
                        6.57 yrs
                        
                        
                        
                        222,802
                        
                        
                        
                        1.06$
                        1.96
      to $2.00
                        
                        
                        
                        342,118
                        
                        
                        
                        2.00
                        
                        
                        5.35 yrs
                        
                        
                        
                        342,118
                        
                        
                        
                        2.00$
                        3.10
      to $3.11
                        
                        
                        
                        440,400
                        
                        
                        
                        3.11
                        
                        
                        6.86 yrs
                        
                        
                        
                        407,066
                        
                        
                        
                        3.11$
                        3.50
      to $3.85
                        
                        
                        
                        150,000
                        
                        
                        
                        3.70
                        
                        
                        7.00 yrs
                        
                        
                        
                        133,333
                        
                        
                        
                        3.73$
                        4.14
      to $4.15
                        
                        
                        
                        189,431
                        
                        
                        
                        4.14
                        
                        
                        6.82 yrs
                        
                        
                        
                        165,187
                        
                        
                        
                        4.15$
                        4.40
                        
                        
                        
                        63,265
                        
                        
                        
                        4.40
                        
                        
                        7.37 yrs
                        
                        
                        
                        45,262
                        
                        
                        
                        4.40$
                        5.50
      to $6.50
                        
                        
                        
                        221,250
                        
                        
                        
                        6.06
                        
                        
                        5.48 yrs
                        
                        
                        
                        221,250
                        
                        
                        
                        6.06Total
      options
                        
                        
                        
                        2,708,166
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        1,837,018





(a)
            Weighted
      average exercise price.


(b)
            Weighted
      average remaining contractual life.





13.
            Treasury
      Stock





In June
2008, the Board of Directors of IsoRay authorized the repurchase of up to
1,000,000 shares of the Company’s common stock.  The Company
repurchased 8,200 shares of its common stock for $4,735 during the year ended
June 30, 2009 and 5,000 shares of its common stock for $3,655 during the year
ended June 30, 2008.





14.
            Income
      Taxes





The
Company recorded no income tax provision or benefit for the years ended June 30,
2009 and 2008.





1.  The
Company had a net deferred tax asset of approximately $11.3 and $9.3 million as
of June 30, 2009 and 2008, respectively.  The deferred tax asset has
arisen principally from net operating loss carryforwards, share-based
compensation, depreciation and amortization, and accrued
compensation.  The deferred tax asset was calculated based on the
currently enacted 34% statutory income tax rate.  Since management of
the Company cannot determine if it is more likely than not that the Company will
realize the benefit of its net deferred tax asset, a valuation allowance equal
to the full amount of the net deferred tax asset at June 30, 2009 and 2008 has
been established.


F-22


At June
30, 2009, the Company had tax basis net operating loss carryforwards of
approximately $26.9 million available to offset future regular taxable
income.  These net operating loss carryforwards expire through
2029.





15.
            401(k)
      and Profit Sharing Plan





The
Company has a 401(k) plan, which commenced in fiscal year 2007, covering all
eligible full-time employees of the Company.  Contributions to the
401(k) plan are made by the participants to their individual accounts through
payroll withholding.  The 401(k) plan also allows the Company to make
contributions at the discretion of management.  To date, the Company
has not made any contributions to the 401(k) plan.





16.
            UralDial,
      LLC





On
January 23, 2008, the Company, through its subsidiary IsoRay International LLC,
became a thirty percent (30%) owner in a Russian limited liability company,
UralDial, LLC (UralDial), a new company based in Yekaterinburg,
Russia.  In December 2008, the Company entered into an agreement to
sell its thirty percent (30%) interest in UralDial for a nominal
amount.  UralDial did not have any material assets or liabilities at
the time of the Company’s disposition of its ownership interest.





Also in
December 2008, the Company finalized a contract to purchase Cs-131 from
UralDial.  Under the contract, the Company will purchase Cs-131 from
UralDial rather than purchasing Cs-131 directly from its two existing suppliers
in Russia.  UralDial will provide Cs-131 from at least two Russian
facilities subject to scheduled maintenance shutdowns of the facilities from
time to time.  The contract stabilizes supply arrangements for the 12
months beginning on December 15, 2008 and ending on December 31,
2009.





The
Company has an existing distribution agreement with UralDial that allows
UralDial to distribute Proxcelan Cs-131 brachytherapy seeds in
Russia.  The Company, through UralDial, has regulatory approval to
sell Cs-131 seeds in Russia.  However, the economic downturn in Russia
has slowed the Company’s market penetration efforts.





17.
            Distribution
      Agreement





On
February 18, 2009, the Company entered into an exclusive distribution agreement
with BrachySciences, a division of Biocompatibles International
plc.  The agreement allows BrachySciences to sell the Company’s
Proxcelan Cs-131 brachytherapy seeds throughout the United
States.  The Company did not have any sales under this agreement in
fiscal year 2009.





18.
            Commitments
      and Contingencies





Royalty Agreement for
Invention and Patent Application





A
shareholder of the Company previously assigned his rights, title and interest in
an invention to IsoRay Products LLC (a predecessor company) in exchange for a
royalty equal to 1% of the Gross Profit, as defined, from the sale of “seeds”
incorporating the technology.  The patent and associated royalty
obligations were transferred to the Company in connection with the merger
transaction.





The
Company must also pay a royalty of 2% of Gross Sales, as defined, for any
sub-assignments of the aforesaid patented process to any third
parties.  The royalty agreement will remain in force until the
expiration of the patents on the assigned technology, unless earlier terminated
in accordance with the terms of the underlying agreement.


F-23


During
fiscal years 2009 and 2008, the Company recorded royalty expenses of $20,063 and
$21,219, respectively.





Patent and Know-How Royalty
License Agreement





The
Company is the holder of an exclusive license to use certain “know-how”
developed by one of the founders of a predecessor to the Company and licensed to
the Company by the Lawrence Family Trust, a Company shareholder.  The
terms of this license agreement require the payment of a royalty based on the
Net Factory Sales Price, as defined in the agreement, of licensed product
sales.  Because the licensor’s patent application was ultimately
abandoned, only a 1% “know-how” royalty based on Net Factory Sales Price, as
defined in the agreement, remains applicable.  To date, management
believes that there have been no product sales incorporating the “know-how” and
therefore no royalty is due pursuant to the terms of the
agreement.  Management believes that ultimately no royalties should be
paid under this agreement as there is no intent to use this “know-how” in the
future.





The
licensor of the “know-how” has disputed management’s contention that it is not
using this “know-how”.  On September 25, 2007 and again on October 31,
2007, the Company participated in nonbinding mediation regarding this matter;
however, no settlement was reached with the Lawrence Family
Trust.  After additional settlement discussions, which ended in April
2008, the parties failed to reach a settlement.  The parties may
demand binding arbitration at any time.





Operating Lease
Agreements





The
Company leases office and laboratory space and production and office equipment
under noncancelable operating leases.  The lease agreements require
monthly lease payments and expire on various dates through April 2016 (including
renewal dates).  The Company’s significant lease is described
below.





On May 2,
2007, Medical entered into a lease for its new production facility with Energy
Northwest, the owner of the Applied Process Engineering Laboratory (the APEL
lease).  The new lease originally provided the Company with 19,328
square feet of manufacturing and office space and the Company has moved all
manufacturing operations to this new leased space as of September 2007 and
vacated its leased space at the PEcoS-IsoRay Radioisotope Laboratory
(PIRL).  The APEL lease has a three year term expiring on April 30,
2010, plus options to renew for two additional three-year terms, and monthly
rent of approximately $26,700, subject to annual increases based on the Consumer
Price Index, plus monthly janitorial expenses of approximately
$700.  Due to the severe economic penalty associated with not
exercising the two lease renewal options, the Company currently intends to
exercise both of the three-year renewal options at the appropriate time in the
lease.  Subsequent to the initial signing of this lease, the Company
reconfigured its space requirements and returned some lab space to Energy
Northwest.  This has reduced the Company’s rent to approximately
$23,500 per month plus janitorial expenses of approximately $460 per
month.





Future
minimum lease payments under operating leases including the two three-year
renewals of the APEL lease, which the Company intends to exercise, are as
follows:





Year ending June 30,2010
                    
                    $
                    305,9082011
                    
                    
                    302,2352012
                    
                    
                    290,9932013
                    
                    
                    288,4672014
                    
                    
                    288,467Thereafter
                    
                    
                    528,857$
                    2,004,927


F-24





Rental
expense amounted to $325,496 and $354,202 for the years ended June 30, 2009 and
2008, respectively.





License Agreement with
IBt





In
February 2006, the Company signed a license agreement with International
Brachytherapy SA (IBt), a Belgian company, covering North America and providing
the Company with access to IBt’s Ink Jet production process and its proprietary
polymer seed technology for use in brachytherapy procedures using
Cs-131.  Under the original agreement royalty payments were to be paid
on net sales revenue incorporating the technology.





On
October 12, 2007, the Company entered into Amendment No. 1 (the Amendment) to
its License Agreement dated February 2, 2006 with IBt.  The Company
paid license fees of $275,000 (under the original agreement) and $225,000 (under
the Amendment) during fiscal years 2006 and 2008, respectively.  The
Amendment eliminates the previously required royalty payments based on net sales
revenue, and the parties intend to negotiate terms for future payments by the
Company for polymer seed components to be purchased at IBt's cost plus a
to-be-determined profit percentage.  No agreement has been reached on
these terms and there is no assurance that the parties will consummate an
agreement pursuant to such terms.  The Company does not currently
intend to use this technology and recorded an impairment charge on the remaining
book value of the license in fiscal year 2009.





19.
            Concentrations
      of Credit and Other Risks





Financial
Instruments





The
Company’s financial instruments that are exposed to concentrations of credit
risk consist primarily of cash and cash equivalents, short-term investments, and
accounts receivable.





The
Company’s cash and cash equivalents are maintained with high-quality financial
institutions.  The accounts are guaranteed by the Federal Deposit
Insurance Corporation (FDIC) up to
$250,000.  At      June 30, 2009, cash
balances uninsured by the FDIC totaled approximately $2.5 million.  A
portion of this amount (approximately $2.3 million) is held in a money market
account that is protected by the US Treasury Department’s Temporary Guarantee
Program for Money Market Funds.





Short-term
investments are held by a major, high-quality financial
institution.  Generally, these securities are traded in a highly
liquid market and may be redeemed upon demand and bear minimal
risk.  Management regularly monitors the composition and maturities of
these investments and the Company has not experienced any material realized
losses on its investments.





The
Company’s accounts receivable result from credit sales to
customers.  The Company had two customers whose sales were greater
than 10% for each of the years ended June 30, 2009 and 2008,
respectively.  These customers represented a combined 35.0% and 34.3%
of the Company’s total revenues for the years ended June 30, 2009 and 2008,
respectively.  These same customers accounted for a combined 39.6% and
38.4% of the Company’s net accounts receivable balance at June 30, 2009 and
2008, respectively.





The loss
of any of these significant customers would have a temporary adverse effect on
the Company’s revenues, which would continue until the Company located new
customers to replace them.





The
Company routinely assesses the financial strength of its customers and provides
an allowance for doubtful accounts as necessary.


F-25





Inventories





Most
components used in the Company’s product are purchased from outside
sources.  Certain components are purchased from single
suppliers.  The failure of any such supplier to meet its commitment on
schedule could have a material adverse effect on the Company’s business,
operating results and financial condition.  If a sole-source supplier
or a supplier of Cs-131 or irradiated barium were to go out of business or
otherwise become unable to meet its supply commitments, the process of locating
and qualifying alternate sources could require up to several months, during
which time the Company’s production could be delayed.  Such delays
could have a material adverse effect on the Company’s business, operating
results and financial condition.


F-26


SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.





Dated:  September
23, 2009





ISORAY,
      INC., a Minnesota corporationBy
                    /s/
    Dwight  BabcockDwight
      Babcock, Chief Executive Officer and ChairmanBy
                    /s/ Jonathan R. HuntJonathan
      R. Hunt, Chief Financial Officer and Principal Accounting
  Officer





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.





Dated:  September
23, 2009





/s/
    Dwight  BabcockDwight
      Babcock, Chief Executive Officer and Chairman/s/ Jonathan R. HuntJonathan
      R. Hunt, Chief Financial Officer and Principal Accounting
  Officer/s/ Robert KauffmanRobert
      Kauffman, Director and Vice-Chairman/s/ Thomas LaVoyThomas
      LaVoy, Director/s/ Albert SmithAlbert
      Smith,
Director





61