UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM 10-Q





(Mark
One)





x
            QUARTERLY REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
the quarterly period ended September 30, 2008





o
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE EXCHANGE
    ACT





For
the transition period from to   .





Commission
file number 001-15757





IMAGEWARE
SYSTEMS, INC.


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
            
            33-0224167(State
      or Other Jurisdiction of
              Incorporation
      or Organization)
            
            (IRS
      Employer
              Identification
      No.)





10883
Thornmint Road


San
Diego, CA 92127


(Address
of Principal Executive Offices)





(858)
673-8600


(Registrant’s
Telephone Number, Including Area Code)





Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (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 o  No x





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
definitions of “large accelerated filer,” “accelerated filer,” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check
one):





Large
      accelerated filer o
            
            Accelerated
      filer oNon-accelerated
      filer o
            
            Smaller
      reporting company x(Do
      not check if a smaller reporting company)





Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-12 of the Exchange Act).  Yes o  No x





The
number of shares of Common Stock, with $0.01 par value, outstanding
on January 28, 2010 was 22,104,483.




1




IMAGEWARE
SYSTEMS, INC. INDEX





PART I.
            
            FINANCIAL
      INFORMATION
            3ITEM
      1.
            
            FINANCIAL
      STATEMENTS
            3Condensed
      Consolidated Balance Sheets as of September 30, 2008 (unaudited) and
      December 31, 2007
            3Condensed
      Consolidated Statements of Operations for the three and nine months ended
      September 30, 2008 and 2007 (unaudited)
            4Condensed
      Consolidated Statements of Cash Flows for the nine months ended
      September 30, 2008 and 2007 (unaudited)
            5Condensed
      Consolidated Statements of Comprehensive Loss for the three and nine
      months ended September 30, 2008 and 2007 (unaudited)
            6Notes
      to unaudited Condensed Consolidated Financial Statements
            7ITEM
      2.
            
            Management’s
      Discussion and Analysis of Financial Condition and Results ofOperations
            19ITEM
      4.
            
            Controls
      and
      Procedures
            3131PART II.
            
            OTHER
      INFORMATION
            31ITEM
      1A.
            
            Risk
      Factors
            31ITEM
      6.
            
            Exhibits
            33SIGNATURES
            36





2


PART I





FINANCIAL
INFORMATION





ITEM
1. FINANCIAL STATEMENTS





IMAGEWARE
SYSTEMS, INC.


CONDENSED
CONSOLIDATED BALANCE SHEETS


(In
Thousands, except share and per share data)





September 30,

                2008
              
              
              December 31,

                2007(Unaudited)ASSETSCurrent
      AssetsCash
      and cash equivalents
              
              $
              427
              
              
              $
              1,044Accounts
      receivable, net of allowance for doubtful accounts of $28
      (unaudited)and
      $0 at September 30, 2008 and December 31, 2007,
      respectively
              
              
              394
              
              
              
              425Inventory
              
              
              126
              
              
              
              130Other
      current assets
              
              
              220
              
              
              
              441Total
      Current Assets
              
              
              1,167
              
              
              
              2,040Property
      and equipment, net
              
              
              168
              
              
              
              288Other
      assets
              
              
              39
              
              
              
              24Pension
      assets
              
              
              684
              
              
              
              694Intangible
      assets, net of accumulated amortization
              
              
              2,038
              
              
              
              2,437Goodwill
              
              
              3,416
              
              
              
              4,452Total
      Assets
              
              $
              7,512
              
              
              $
              9,935LIABILITIES
      AND SHAREHOLDERS’ EQUITY (Deficit)Current
      Liabilities:Accounts
      payable
              
              $
              2,340
              
              
              $
              1,415Deferred
      revenue
              
              
              1,331
              
              
              
              1,011Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
              
              
              572
              
              
              
              —Accrued
      expenses
              
              
              1,307
              
              
              
              1,341Acquisition
      related obligation
              
              
              1,060
              
              
              
              1,502Total
      Current Liabilities
              
              
              6,610
              
              
              
              5,269Pension
      obligation
              
              
              1,128
              
              
              
              1,139Total
      Liabilities
              
              
              7,738
              
              
              
              6,408Shareholders’
      equity (deficit):Preferred
      stock, authorized 4,000,000 shares:Series B
      convertible preferred stock, $0.01 par value; designated 750,000shares, 389,400
      shares issued, and 239,400 shares outstanding at September 30,
      2008and December 31,
      2007; liquidation preference $620 at September 30, 2008 and
      $607at
      December 31, 2007
              
              
              2
              
              
              
              2Series C
      convertible preferred stock, $0.01 par value; designated3,500
      shares, 2,500 shares issued, and 2,200 shares outstanding at
      September 30, 2008and
      December 31, 2007; liquidation preference $2,559 at
      September 30, 2008 and $2,434at
      December 31, 2007
              
              
              —
              
              
              
              —Series D
      convertible preferred stock, $0.01 par value; designated
    3,000shares,
      2,310 shares issued, and 2,198 shares outstanding at September 30,
      2008 andDecember 31,
      2007; liquidation preference $2,384 at September 30, 2008 and $1,486
      atDecember 31,
      2007
              
              
              —
              
              
              
              —Common
      stock, $.01 par value, 50,000,000 shares authorized; 18,149,963
      (unaudited)and
      17,797,826 shares issued at September 30, 2008 and December 31,
      2007, respectively,and
      18,143,259 (unaudited) and 17,791,122 shares outstanding at
      September 30, 2008 andDecember 31,
      2007, respectively
              
              
              180
              
              
              
              177Additional
      paid in capital
              
              
              85,850
              
              
              
              79,294Treasury
      stock, at cost - 6,704 shares
              
              
              (64
              )
              
              
              (64
              )Accumulated
      other comprehensive (loss) income
              
              
              (19
              )
              
              
              7Accumulated
      deficit
              
              
              (86,175
              )
              
              
              (75,889
              )Total
      Shareholders’ equity (deficit)
              
              
              (226
              )
              
              
              3,527Total
      Liabilities and Shareholders’ Equity
              
              $
              7,512
              
              
              $
              9,935





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




3
 IMAGEWARE
SYSTEMS, INC.





CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(in
thousands, except share and per share amounts)


(unaudited)





Three Months Ended
              September 30,
            
            
            Nine Months Ended
              September 30,2008
            
            
            2007
            
            
            2008
            
            
            2007Revenues:Product
            
            $
            705
            
            
            $
            2,832
            
            
            $
            2,502
            
            
            $
            4,698Maintenance
            
            
            639
            
            
            
            678
            
            
            
            1,892
            
            
            
            1,9261,344
            
            
            
            3,510
            
            
            
            4,394
            
            
            
            6,624Cost
      of revenues:Product
            
            
            323
            
            
            
            510
            
            
            
            732
            
            
            
            992Maintenance
            
            
            305
            
            
            
            281
            
            
            
            909
            
            
            
            871Gross
      profit
            
            
            716
            
            
            
            2,719
            
            
            
            2,753
            
            
            
            4,761Operating
      expenses:General
      and administrative
            
            
            840
            
            
            
            889
            
            
            
            2,885
            
            
            
            2,989Sales
      and marketing
            
            
            464
            
            
            
            607
            
            
            
            1,678
            
            
            
            1,974Research  and
      development
            
            
            785
            
            
            
            752
            
            
            
            2,413
            
            
            
            2,741Depreciation
      and amortization
            
            
            194
            
            
            
            60
            
            
            
            588
            
            
            
            1992,283
            
            
            
            2,308
            
            
            
            7,564
            
            
            
            7,903Income
      (loss) from operations
            
            
            (1,567
            )
            
            
            411
            
            
            
            (4,811
            )
            
            
            (3,142
            )Interest
      expense (income), net
            
            
            5
            
            
            
            (2
            )
            
            
            1
            
            
            
            236Other
      expense (income), net
            
            
            (63
            )
            
            
            (6
            )
            
            
            (106
            )
            
            
            38Income
      (loss) from continuing operations before income
taxes
            
            
            (1,509
            )
            
            
            419
            
            
            
            (4,706
            )
            
            
            (3,416
            )Income
      tax expense (benefit)
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Income
      (loss) from continuing operations
            
            
            (1,509
            )
            
            
            419
            
            
            
            (4,706
            )
            
            
            (3,416
            )Discontinued
      operations:Gain
      from operations of discontinued Digital Photography
      component
            
            
            6
            
            
            
            6
            
            
            
            13
            
            
            
            17Income
      tax benefit (expense)
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Gain
      on discontinued operations
            
            
            6
            
            
            
            6
            
            
            
            13
            
            
            
            17Net
      income (loss)
            
            
            (1,503
            )
            
            
            425
            
            
            
            (4,693
            )
            
            
            (3,399
            )Preferred
      dividends
            
            
            (90
            )
            
            
            (85
            )
            
            
            (259
            )
            
            
            (243
            )Amortization
      of beneficial conversion feature on preferred stocks
            
            
            (3,774
            )
            
            
            (470
            )
            
            
            (5,568
            )
            
            
            (814
            )Net
      loss available to common shareholders
            
            $
            (5,367
            )
            
            $
            (130
            )
            
            $
            (10,520
            )
            
            $
            (4,456
            )Basic
      and diluted loss per common share - see Note 2Income
      (loss) from continuing operations
            
            $
            (0.08
            )
            
            $
            0.03
            
            
            $
            (0.26
            )
            
            $
            (0.24
            )Discontinued
      operations
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Preferred
      dividends
            
            
            —
            
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.02
            )Beneficial
      conversion feature on preferred stocks
            
            
            (0.21
            )
            
            
            (0.03
            )
            
            
            (0.31
            )
            
            
            (0.06
            )Basic
      and diluted loss per share available to common
      shareholders
            
            $
            (0.29
            )
            
            $
            (0.01
            )
            
            $
            (0.58
            )
            
            $
            (0.32
            )Weighted-average
      shares (basic and diluted)
            
            
            18,143,259
            
            
            
            14,891,641
            
            
            
            18,022,936
            
            
            
            14,086,249





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




4


IMAGEWARE
SYSTEMS, INC.


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(IN
THOUSANDS)


(UNAUDITED)





Nine Months Ended
              September 30,2008
            
            
            2007Cash
      flows from operating activitiesNet
      loss
            
            $
            (4,693
            )
            
            $
            (3,399
            )Adjustments
      to reconcile net loss to net cash used in operating
      activitiesDepreciation
      and amortization
            
            
            588
            
            
            
            199Provision
      for losses in investment in equity securities
            
            
            —
            
            
            
            85Increase
      (decrease) in inventory obsolescence reserve
            
            
            75
            
            
            
            (32
            )Reduction
      in exit activities reserve
            
            
            (51
            )
            
            
            —Non
      cash interest and amortization of debt discount and debt issuance
      costs
            
            
            —
            
            
            
            229Stock
      based compensation
            
            
            390
            
            
            
            513Allowance
      for doubtful accounts
            
            
            —
            
            
            
            25Prepaid
      royalty impairment
            
            
            100
            
            
            
            —Change
      in assets and liabilitiesAccounts
      receivable
            
            
            3
            
            
            
            1,306Inventory
            
            
            (70
            )
            
            
            (44
            )Other
      assets
            
            
            (26)
            
            
            
            (203
            )Pension
      assets
            
            
            10
            
            
            
            (61
            )Accounts
      payable
            
            
            925
            
            
            
            (225
            )Accrued
      expenses
            
            
            109
            
            
            
            204Deferred
      revenue
            
            
            320
            
            
            
            239Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
            
            
            572
            
            
            
            —Pension
      obligation
            
            
            (11
            )
            
            
            84Total
      adjustments
            
            
            2,934
            
            
            
            2,319Net
      cash used in operating activities
            
            
            (1,759
            )
            
            
            (1,080
            )Cash
      flows from investing activitiesPurchase
      of property and equipment
            
            
            (69
            )
            
            
            (68
            )Change
      in restricted cash
            
            
            132Acquisition
      of business, net of cash acquired of $0
            
            
            (187
            )
            
            
            —Net
      cash used by  investing activities
            
            
            (124
            )
            
            
            (68
            )Cash
      flows from financing activitiesRepayment
      of notes payable
            
            
            —
            
            
            
            (1,310
            )Proceeds
      from issuance of preferred stock, net of issuance costs of  $33
      and $173 respectively
            
            
            776
            
            
            
            1,327Proceeds
      from issuance of common stock, net of issuance costs of  $0 and
      $404, respectively
            
            
            
            
            
            
            2,621Other
      financing issuance costs
            
            
            —
            
            
            
            (54
            )Dividends
      paid
            
            
            (25
            )
            
            
            (25
            )Proceeds
      from exercised stock purchase warrants
            
            
            542
            
            
            
            1,121Net
      cash provided by financing activities
            
            
            1,293
            
            
            
            3,680Effect
      of exchange rate changes on cash and cash
equivalents
            
            
            (27
            )
            
            
            (33
            )Net
      increase (decrease) in cash and cash equivalents
            
            
            (617
            )
            
            
            2,499Cash
      and cash equivalents at beginning of period
            
            
            1,044
            
            
            
            939Cash
      and cash equivalents at end of period
            
            $
            427
            
            
            $
            3,438Supplemental
      disclosure of cash flow information:Cash
      paid for interest
            
            $
            —
            
            
            $
            46Adjustment
      to provision for losses on doubtful accounts
    receivable
            
            $
            28
            
            
            $
            —Summary
      of non-cash investing and financing activities:Beneficial
      conversion feature of series C and D preferred stock
            
            $
            5,568
            
            
            $
            814Conversion
      of preferred stock to common
            
            $
            —
            
            
            $
            2





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




5


IMAGEWARE
SYSTEMS, INC.


CONDENSED
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS


(IN
THOUSANDS)


(UNAUDITED)





Three Months Ended
              September 30,
            
            
            Nine Months Ended
              September 30,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
      income (loss)
            
            $
            (1,503
            )
            
            $
            425
            
            
            $
            (4,693
            )
            
            $
            (3,399
            )Foreign
      currency translation adjustment
            
            
            24
            
            
            
            (8
            )
            
            
            (27
            )
            
            
            (33
            )Comprehensive
      income (loss)
            
            $
            (1,479
            )
            
            $
            417
            
            
            $
            (4,720
            )
            
            $
            (3,432
            )





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




6


IMAGEWARE
SYSTEMS, INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1.  DESCRIPTION OF BUSINESS AND OPERATIONS





ImageWare
Systems, Inc. (the “Company” or “ImageWare”) is a leader in the emerging
market for software-based identity management solutions, providing biometric,
secure credential, law enforcement and enterprise authorization.  Our
“flagship” product is the IWS Biometric Engine.  Scalable for small city
business or worldwide deployment, our biometric engine is a multi-biometric
platform that is hardware and algorithm independent, enabling the enrollment and
management of unlimited population sizes.  Our identification products are
used to manage and issue secure credentials, including national IDs, passports,
driver licenses, smart cards and access control credentials. Our law enforcement
products provide law enforcement with integrated mug shot, fingerprint LiveScan
and investigative capabilities. The Company also provides comprehensive
authentication security software, as well as real-time voice recognition,
multilingual speech translation and voice analytics technologies. 
Biometric technology is now an integral part of all markets the Company
addresses, and all of our products are integrated into the Biometric Engine
Platform.  Elements of the IWS Biometric Engine can be used as
investigative tools for law enforcement utilizing multiple biometrics and
forensic data elements, and to enhance security and authenticity of public and
private sector credentials.





Our
biometric technology is a core software component of an organization’s security
infrastructure and includes a multi-biometric identity management solution for
enrolling, managing, identifying and verifying the identities of people by the
physical characteristics of the human body. The Company develops, sells and
supports various identity management capabilities within government (federal,
state and local), law enforcement, commercial enterprises, and transportation
and aviation markets for identification and verification purposes. Our IWS
Biometric Engine is a biometric identity management platform for multi-biometric
enrollment, management and authentication, managing population databases of
virtually unlimited sizes. It is also offered as a Software Development Kit
(SDK) based search engine, enabling developers and system integrators to
implement a biometric solution or integrate biometric capabilities into existing
applications without having to derive biometric functionality from pre-existing
applications.  The IWS Biometric Engine combined with our secure credential
platform, IWS EPI Builder, provides a comprehensive, integrated biometric and
secure credential solution that can be leveraged for high-end applications such
as passports, driver licenses, national IDs, and other secure documents. It can
also be utilized within our law enforcement systems to incorporate any number of
various multiple biometrics into one system.





The
Company recently added next generation voice recognition, multilingual speech
translation and voice analytics capabilities to our suite of biometric identity
management solutions, enabling users to facilitate and improve communication
across major language groups globally. The ImageWare Mediator products are
offered stand-alone or integrated with our Biometric Engine platform providing
an advanced multilingual communications capability. Government, intelligence,
defense, public safety and border control customers are able to realize language
translation and voice recognition capabilities whereby an English-speaking user
can understand and be understood in numerous languages including Spanish,
German, French, Korean, Arabic and Polish, among others. ImageWare Mediator
products support speech to speech translation, multilingual collaboration,
conversational environments, which are represented for both voice and text and
include biometric functionality for speaker identification and voice
analytics.





Our law
enforcement solutions enable agencies to quickly capture, archive, search,
retrieve, and share digital images, fingerprints and criminal history records on
a stand-alone, networked, wireless or Web-based platform. The Company develops,
sells and supports a suite of modular software products used by law enforcement
and public safety agencies to create and manage criminal history records and to
investigate crime. Our IWS Law Enforcement solution consists of six software
modules: a Capture and Investigative module, which provides a criminal booking
system and related database; a Facial Recognition module, which uses biometric
facial recognition to identify suspects; a Suspect ID module, which facilitates
the creation of full-color, photo-realistic suspect composites; a wireless
module, which provides access to centrally stored records over the Internet in a
connected or wireless fashion; a PDA add-on module, which enables access to
centrally stored records while in the field on a handheld Pocket PC compatible
device combined with central repository services which allows for inter-agency
data sharing on a local, regional, and/or national level; and a LiveScan module,
which incorporates LiveScan capabilities into IWS Law Enforcement providing
integrated fingerprint and palm print biometric management for civil and law
enforcement use.





Our
Secure Credential ID solutions empower customers to create secure and smart
digital identification documents with complete ID systems. We develop, sell and
support software and design systems which utilize digital imaging in the
production of photo identification cards and credentials and identification
systems. Our products in this market consist of IWS EPI Suite, IWS EPI Builder
(SDK), Identifier for Windows and ID Card Maker.  These products allow for
the production of digital identification cards and related databases and records
and can be used by, among others, schools, airports, hospitals, corporations or
governments.  The Company has recently added the ability to incorporate
multiple biometrics into the ID systems the Company offers with the addition of
our new IWS Biometric Engine to our product line.




7


Basis
of Presentation





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenue and expenses during
the reporting period. Actual results could differ from those
estimates.





The
accompanying condensed consolidated balance sheet as of December 31, 2007
has been derived from the Company’s audited balance sheet included in the
2007 Annual Report on Form 10-K and the condensed consolidated unaudited
financial statements of ImageWare have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission (“SEC”)
regarding interim financial reporting. Accordingly, they do not include all of
the information and footnotes required by generally accepted accounting
principles for annual financial statements and should be read in conjunction
with the consolidated financial statements for the year ended December 31,
2007, and notes thereto included in the Company’s Annual Report on
Form 10-K, filed with the SEC on April 15, 2008, as amended on
April 29, 2008. In the opinion of management, the accompanying condensed
consolidated financial statements contain all adjustments, consisting only of
adjustments of a normal recurring nature, necessary for a fair presentation of
the Company’s financial position as of September 30, 2008, and its results
of operations for the periods presented. These unaudited condensed consolidated
financial statements for the period ended September 30, 2008 are not
necessarily indicative of the results to be expected for the entire
year.





Going
Concern





As
reflected in the accompanying condensed consolidated financial statements, the
Company has continuing losses, negative working capital and negative cash flows
from operations for both the three and nine month periods ended September 30,
2008.  These matters raise substantial doubt about the Company’s
ability to continue as a going concern.





In May
2008, the AMEX removed the Company’s common stock from being listed on their
exchange as the Company failed to comply with AMEX’s continued listing
standards.  In December of 2008 our common stock was removed from
being quoted on the Over-the-Counter Bulletin Board as the Company failed to
make the required filings with the SEC in the required timeframe.  As
of the end of the third quarter of 2008, the Company was faced with limited
funds for operations and was compelled to suspend SEC filings and the associated
costs until such time as the Company had sufficient resources to cover ongoing
operations and the expenses of maintaining compliance with SEC filing
requirements.   There is no assurance that the Company will be
able to attain compliance with SEC filing requirements in the future, and if the
Company is able to attain compliance, there is no assurance it will be able to
maintain compliance.  If it is not able to attain and maintain
compliance for minimum required periods, the Company will not be eligible for
re-listing on the Over-the-Counter Bulletin Board or other
exchanges.





Despite
financing arrangements secured in 2008, additional new financing will be
required to fund working capital and operations should the Company be unable to
generate positive cash flow from operations in the near future. The Company is
exploring the possible sale of equity securities and/or debt financing. However,
there can be no assurance that additional financing will be available. In the
event financing is not available in the time frame required, the Company will be
forced to sell certain of its assets or license its technologies to others.
These actions, while necessary for the continuance of operations during a time
of cash constraints and a shortage of working capital, could adversely affect
the Company’s business.





In view
of the matters described in the preceding paragraphs, recoverability of a major
portion of the recorded asset amounts shown in the accompanying condensed
consolidated balance sheets is dependent upon continued operations of the
Company, which, in turn, is dependent upon the Company’s ability to continue to
raise capital and generate positive cash flows from operations. The condensed
consolidated financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or amounts and
classifications of liabilities that might be necessary should the Company be
unable to continue its existence.




Recently
Issued Accounting Standards




In December2007, the FASB issued SFAS
No. 141(R), “Business Combinations” and SFAS No. 160, “Non-controlling
Interests in Consolidated Financial Statements”. The standards are intended to
improve, simplify, and converge internationally the accounting for business
combinations and the reporting of non-controlling interests in consolidated
financial statements. SFAS No. 141(R) requires the acquiring entity in
a business combination to recognize all (and only) the assets acquired and
liabilities assumed in the transaction; establishes the acquisition-date fair
value as the measurement objective for all assets acquired and liabilities
assumed; and requires the acquirer to disclose to investors and other users all
of the information they need to evaluate and understand the nature and financial
effect of the business combination. SFAS No. 141(R) is effective for
fiscal years, and interim periods within those fiscal years, beginning on or
after December 15, 2008. SFAS No. 141(R) applies prospectively to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after
December 15, 2008. Earlier adoption is prohibited. SFAS No. 141(R) will be
applied to business combinations occurring after the effective
date.




8


In
December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in
Consolidated Financial Statements, an Amendment of ARB 51 (“SFAS
No. 160”), which requires non-controlling interests (previously
referred to as minority interests) to be treated as a separate component of
equity. SFAS No. 160 is effective for periods beginning on or after
December 15, 2008. Earlier application is prohibited. In addition, SFAS
No. 160 shall be applied prospectively as of the beginning of the fiscal
year in which it is initially applied, except for the presentation and
disclosure requirements. The presentation and disclosure requirements shall be
applied retrospectively for all periods presented. The Company does not have an
outstanding non-controlling interest in one or more subsidiaries and therefore,
SFAS No. 160 is not applicable to the Company at this time.





In
December 2007, the FASB ratified the consensus reached by the EITF on Issue
No. 07-1 (“EITF 07-1”), Accounting for Collaborative
Arrangements. EITF 07-1 is effective for the Company beginning
January 1, 2009 and will be applied retrospectively to all prior periods
presented for all collaborative arrangements existing as of the effective date.
EITF 07-1 defines collaborative arrangements and establishes reporting
requirements for transactions between participants in a collaborative
arrangement and between participants in the arrangement and third parties. The
Company does not expect the provisions of EITF 07-1 to have an impact on our
financial position and results of operations.





In
February 2008, the FASB issued FASB Staff Position FAS 157-2, Partial Deferral of the Effective
Date of Statement 157(“FSP FAS 157-2”). FSP
FAS 157-2 delays the effective date of SFAS No. 157 for nonfinancial assets
and nonfinancial liabilities, except for items that are recognized or disclosed
at fair value in the financial statements on a recurring basis (at least
annually) to fiscal years beginning after November 15, 2008.  The
Company does not expect the provisions of FSP FAS 157-2 to have an impact on our
results of operations or financial position.





In
March 2008, the FASB issued Statement No. 161, Disclosures about Derivative
Instruments and Hedging Activities(“FAS 161”), which is effective
January 1, 2009. FAS 161 requires enhanced disclosures about derivative
instruments and hedging activities to allow for a better understanding of their
effects on an entity’s financial position, financial performance, and cash
flows. Among other things, FAS 161 requires disclosure of the fair values of
derivative instruments and associated gains and losses in a tabular format.
Since FAS 161 affects only disclosure requirements, there will be no effect on
our results of operations or financial position.





In
April 2008, the FASB issued Staff Position FSP FAS 142-3, “Determination of
the Useful Life of Intangible Assets” (“FSP FAS 142-3”). The FSP amends the
factors that should be considered in developing renewal or extension assumptions
used to determine the useful life of a recognized intangible asset under SFAS
No. 142, “Goodwill and Other Intangible Assets”. The intent of the FSP is
to improve the consistency between the useful life of a recognized intangible
asset under SFAS No. 142 and the period of expected cash flows used to
measure the fair value of the asset under other accounting principles generally
accepted in the United States of America. The FSP is effective for financial
statements issued for fiscal years beginning after December 15, 2008, and
interim periods within those fiscal years. Early adoption is prohibited. The
guidance for determining the useful life of a recognized intangible asset shall
be applied prospectively to intangible assets acquired after the effective date.
Certain disclosure requirements shall be applied prospectively to all intangible
assets recognized as of, and subsequent to, the effective date. FSP FAS 142-3
will be applied to intangible assets acquired after the effective
date.





In
May 2008, the FASB issued FASB Statement No. 162, The Hierarchy of Generally Accepted
Accounting Principles. The new standard is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. generally accepted accounting principles
(GAAP) for nongovernmental entities. FAS No. 162 is effective for financial
statements issued for interim and annual periods ending after September 15,
2009.  Previous references to GAAP accounting standards will no longer
be used in our disclosures for financial statements ending after the effective
date. The adoption of SFAS No. 162 will not have an impact on our consolidated
financial position or results of operations.





In
May 2008, the FASB issued FASB Staff Position (FSP) No. APB 14-1,
Accounting for Convertible
Debt Instruments That May Be Settled in Cash upon Conversion (Including
Partial Cash Settlement)(“FSP APB 14-1”).  FSP APB 14-1
clarifies that convertible debt instruments that may be settled in cash upon
conversion (including partial cash settlement) are not addressed by paragraph 12
of APB Opinion No. 14, Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants. Additionally, this FSP
specifies that issuers of such instruments should separately account for the
liability and equity components in a manner that will reflect the entity’s
nonconvertible debt borrowing rate when interest cost is recognized in
subsequent periods. This FSP is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within
those fiscal years. Early adoption is not permitted. The Company is assessing
the impact of adoption of FSP No EITF 03-6-1 on its financial position and
results of operations.




9


In June
2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities,” (FSP
EITF 03-6-1). FSP EITF 03-6-1 states that unvested share-based payment awards
that contain nonforfeitable rights to dividends or dividend equivalents (whether
paid or unpaid) are participating securities and shall be included in the
computation of earnings per share pursuant to the two-class method. FSP EITF
03-6-1 becomes effective for the Company on January 1, 2009. The Company
does not expect the provisions of FSP No. EITF 03-6-1to have a material impact
on our results of operations or financial position.




In
January 2009, the FASB issued FSP EITF 99-20-1, "Amendments to the Impairment
Guidance of EITF Issue No. 99 - Recognition of Interest Income and Impairment on
Purchased and Retained Beneficial Interests in Securitized Financial Assets".
FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be
more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1
achieves this by amending the impairment model in EITF 99-20 to remove its
exclusive reliance on "market participant" estimates of future cash flows used
in determining fair value. Changing the cash flows used to analyze
other-than-temporary impairment from the "market participant" view to a holder's
estimate of whether there has been a "probable" adverse change in estimated cash
flows allows companies to apply reasonable judgment in assessing whether
another-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1
is not expected to have a material impact on our results of operations,
financial position or liquidity.




In April
2009 the FASB issued FSP No. 141R-1 Accounting for Assets Acquired and
Liabilities Assumed in a Business Combination That Arise from Contingencies, or
FSP 141R-1. FSP 141R-1 amends the provisions in SFAS No. 141R for the initial
recognition and measurement, subsequent measurement and accounting, and
disclosures for assets and liabilities arising from contingencies in business
combinations. The FSP eliminates the distinction between contractual and
non-contractual contingencies, including the initial recognition and measurement
criteria in SFAS No. 141R and instead carries forward most of the provisions in
SFAS No. 141 for acquired contingencies. FSP 141R-1 is effective for contingent
assets and contingent liabilities acquired in business combinations for which
the acquisition date is on or after the beginning of the first annual reporting
period beginning on or after December 15, 2008. The adoption of FSP No. 141R-1
is not expected to have a material impact on our results of operations,
financial position or liquidity.




In April
2009 the FASB issued three related Staff Positions: (i) FSP No. 157-4,
Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability have Significantly Decreased and Identifying Transactions That Are Not
Orderly, or FSP 157-4, (ii) FSP 115-2 and FSP No. 124-2, Recognition and
Presentation of Other-Than-Temporary Impairments , or FSP 115-2 and FSP 124-2,
and (iii) FSP 107-1 and APB No. 28-1, Interim Disclosures about Fair Value of
Financial Instruments, or FSP 107 and APB 28-1, which are effective for interim
and annual periods ending after June 15, 2009. FSP 157-4 provides guidance on
how to determine the fair value of assets and liabilities under SFAS No. 157 in
the current economic environment and reemphasizes that the objective of a fair
value measurement remains an exit price. If the Company was to conclude that
there has been a significant decrease in the volume and level of activity of the
asset or liability in relation to normal market activities, quoted market values
may not be representative of fair value and the Company may conclude that a
change in valuation technique or the use of multiple valuation techniques may be
appropriate. FSP 115-2 and FSP 124-2 modify the requirements for recognizing
other-than-temporarily impaired debt securities and revise the existing
impairment model for such securities, by modifying the current intent and
ability indicator in determining whether a debt security is
other-than-temporarily impaired. FSP 107 and APB 28-1 enhance the disclosure of
instruments under the scope of SFAS No. 157 for both interim and annual
periods. The Company does not expect the adoption of these standards to
have a material effect on its financial position of results of
operations.




In May
2009 the FASB issued SFAS No. 165, Subsequent Events, or SFAS 165. SFAS 165
establishes general standards of accounting for and disclosure of events that
occur after the balance sheet date but before financial statements are issued or
are available to be issued. SFAS 165 requires the disclosure of the date through
which an entity has evaluated subsequent events and the basis for that date,
that is, whether the date represents the date the financial statements were
issued or were available to be issued. SFAS 165 is effective in the first
interim period ending after June 15, 2009. The Company expects that SFAS 165
will have an impact on disclosures in our consolidated financial statements, but
the nature and magnitude of the specific effects will depend upon the nature,
terms and value of any subsequent events occurring after adoption.




In June
2009 the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R),
or SFAS 167, that will change how the Company determines when an entity that is
insufficiently capitalized or is not controlled through voting (or similar
rights) should be consolidated. Under SFAS No. 167, determining whether a
company is required to consolidate an entity will be based on, among other
things, an entity's purpose and design and a company's ability to direct the
activities of the entity that most significantly impact the entity's economic
performance. SFAS 167 is effective for financial statements after January 1,
2010. The Company is currently evaluating the requirements of SFAS 167 and the
impact of adoption on their consolidated financial statements, if
any.




In June
2009 the FASB issued SFAS No. 168, The FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting. SFAS No. 168 represents the
last numbered standard to be issued by FASB under the old (pre-Codification)
numbering system, and amends the GAAP hierarchy established under SFAS No. 162.
On July 1, 2009 the FASB launched FASB's new Codification entitled The FASB
Accounting Standards Codification, or FASB ASC.




The
Codification will supersede all existing non-SEC accounting and reporting
standards. SFAS No. 168 is effective in the first interim and annual periods
ending after September 15, 2009. This pronouncement will have no effect on the
Company’s consolidated financial statements upon adoption other than current
references to GAAP which will be replaced with references to the applicable
codification paragraphs.




10


A variety
of proposed or otherwise potential accounting standards are currently under
study by standard setting organizations and various regulatory agencies. Due to
the tentative and preliminary nature of those proposed standards, management has
not determined whether implementation of such proposed standards would be
material to the consolidated financial statements.




In
October 2009, the Financial Accounting Standards Board (“FASB”) issued new
revenue recognition standards for arrangements with multiple deliverables, where
certain of those deliverables are non-software related. The new standards permit
entities to initially use management’s best estimate of selling price to value
individual deliverables when those deliverables do not have VSOE of fair value
or when third-party evidence is not available. Additionally, these new standards
modify the manner in which the transaction consideration is allocated across the
separately identified deliverables by no longer permitting the residual method
of allocating arrangement consideration. These new standards are effective for
annual periods ending after June 15, 2010 and are effective for the Company
beginning in the first quarter of fiscal 2011, however early adoption is
permitted. The Company is currently evaluating the impact of adopting these new
standards on its consolidated financial position, results of operations and cash
flows, including possible early adoption.





Reclassifications





Certain
reclassifications have been made to the prior period balances in order to
conform to the current period presentation.





NOTE
2.  NET LOSS PER COMMON SHARE





Basic
loss per common share is calculated by dividing net loss available to common
shareholders for the period by the weighted-average number of common shares
outstanding during the period. Diluted earnings per common share is calculated
by dividing net loss available to common shareholders for the period by the
weighted-average number of common shares outstanding during the period, adjusted
to include, if dilutive, potential dilutive shares consisting of convertible
preferred stock, stock options and warrants, calculated using the treasury stock
method. During the three and nine month periods ended September 30, 2008
and 2007, the Company has excluded the following securities from the calculation
of diluted loss per share, as their effect would have been antidilutive due to
the Company’s net loss:





Potential Dilutive Securities:
            
            Number of
              Common Shares
              Convertible into at
              September 30, 2008
            
            
            Number of
              Common Shares
              Convertible into at
              September 30, 2007Convertible
      preferred stock
            
            
            9,850,369
            
            
            
            2,512,052Stock
      options
            
            
            1,766,421
            
            
            
            1,671,839Warrants
            
            
            11,516,152
            
            
            
            6,020,778





The table
below presents the computation of basic and diluted earnings (loss) per
share:





(Amounts in thousands,
      except share and per share amounts)
            
            Three Months Ended
              September 30,
            
            
            Nine Months Ended
              September 30,2008
            
            
            2007
            
            
            2008
            
            
            2007Numerator
      for basic and diluted earnings per share:Net
      income (loss) from continuing operations
            
            $
            (1,509
            )
            
            $
            419
            
            
            $
            (4,706
            )
            
            $
            (3,416
            )Preferred
      dividends
            
            
            (90
            )
            
            
            (85
            )
            
            
            (259
            )
            
            
            (243
            )Amortization
      of beneficial conversion feature on preferred stocks
            
            
            (3,774
            )
            
            
            (470
            )
            
            
            (5,568
            )
            
            
            (814
            )Net
      loss from continuing operations available to common
      shareholders
            
            $
            (5,373
            )
            
            $
            (136
            )
            
            $
            (10,519
            )
            
            $
            (4,473
            )Net
      income from discontinued operations
            
            
            6
            
            
            
            6
            
            
            
            13
            
            
            
            17Net
      loss available to common shareholders
            
            
            (5,367
            )
            
            
            (130
            )
            
            
            (10,520
            )
            
            
            (4,456
            )Denominator
      for basic and diluted earnings per share — weighted-average shares
      outstanding
            
            
            18,143,259
            
            
            
            14,891,641
            
            
            
            18,022,936
            
            
            
            14,086,249Basic
      and diluted income (loss) per share:Continuing
      operations
            
            $
            (0.08
            )
            
            $
            0.03
            
            
            $
            (0.26
            )
            
            $
            (0.24
            )Discontinued
      operations
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Preferred
      dividends
            
            
            —
            
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.02
            )Beneficial
      conversion feature on preferred stocks
            
            
            (0.21
            )
            
            
            (0.03
            )
            
            
            (0.31
            )
            
            
            (0.06
            )Net
      loss available to common shareholders
            
            $
            (0.29
            )
            
            $
            (0.01
            )
            
            $
            (0.58
            )
            
            $
            (0.32
            )





11


As more
fully explained in Note 7 to these condensed consolidated financial statements,
preferred stock dividends for the three and nine months ended September 30,
2008 contains approximately $3,774,000 and $5,568,000, respectively, in
preferred dividends attributable to an embedded beneficial conversion feature
recognized in conjunction with the issuance of equity securities pursuant to the
Company’s warrant financing transaction consummated in March 2008 and
Series D Preferred Stock financing consummated in September 2008. Preferred
dividends for the three and nine months ended September 30, 2007 contains
approximately $470,000 and $814,000, respectively, in preferred stock dividends
attributable to an embedded beneficial conversion feature.





NOTE
3. FAIR VALUE ACCOUNTING





In
September 2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Statement No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines
fair value, establishes a framework for measuring fair value in generally
accepted accounting-principles, and expands disclosures about fair value
measurements. The provisions of FAS 157 were adopted January 1, 2008. In
February 2008, the FASB staff issued Staff Position No. 157-2 “Effective
Date of FASB Statement No. 157” (“FSP FAS 157-2”). FSP FAS 157-2 delayed
the effective date of FAS 157 for nonfinancial assets and nonfinancial
liabilities, except for items that are recognized or disclosed at fair value in
the financial statements on a recurring basis (at least annually). The
provisions of FSP FAS 157-2 are effective for the Company’s fiscal year
beginning January 1, 2009.





FAS 157
establishes a fair value hierarchy that prioritizes the inputs to valuation
techniques used to measure fair value. The hierarchy gives the highest priority
to unadjusted quoted prices in active markets for identical assets or
liabilities (Level 1 measurements) and the lowest priority to unobservable
inputs (Level 3 measurements). The three levels of the fair value hierarchy
under FAS 157 are described below:





Level 1
            Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or
  liabilities;





Level 2
            Quoted
      prices in markets that are not active, or inputs that are observable,
      either directly or indirectly, for substantially the full term of the
      asset or liability;





Level 3
            Prices
      or valuation techniques that require inputs that are both significant to
      the fair value measurement and unobservable (supported by little or no
      market activity).





The
following table sets forth the Company’s financial assets and liabilities
measured at fair value by level within the fair value hierarchy. As required by
FAS 157, assets and liabilities are classified in their entirety based on the
lowest level of input that is significant to the fair value
measurement.





Fair
      Value at September 30, 2008($
      in thousands)
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3Assets:Pension
      assets
            
            $
            684
            
            
            $
            684
            
            
            $
            —
            
            
            $
            —Totals
            
            $
            684
            
            
            $
            684
            
            
            $
            —
            
            
            $
            —Liabilities:None
            
            $
            —
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —





The Company’s Pension assets are
classified within Level 1 of the fair value hierarchy because they are valued
using market prices. The Pension assets are valued based on market prices in
active markets and are primarily comprised of the cash surrender value of
insurance contracts.All
plan assets are managed in a policyholder pool in Germany by outside investment
managers.  The investment objectives for the plan are the preservation
of capital, current income and long-term growth of capital.





The
Company had no financial assets or liabilities which were being measured at
Level 2 or 3.





In
February 2007, the FASB issued FASB Statement No. 159, “The Fair Value
Option for Financial Assets and Financial Liabilities” (“FAS 159”). FAS 159
permits entities to choose to measure many financial instruments and certain
other items at fair value, with the objective of improving financial reporting
by mitigating volatility in reported earnings caused by measuring related assets
and liabilities differently without having to apply complex hedge accounting
provisions. The provisions of FAS 159 were adopted January 1, 2008. The
Company did not elect the Fair Value Option for any of its financial assets or
liabilities, and therefore, the adoption of FAS 159 had no impact on the
Company’s consolidated financial position, results of operations or cash
flows.




12


NOTE
4. INVENTORY





Inventories
at September 30, 2008 were comprised of work in process of $94,000 representing
direct labor costs on in-process projects and finished goods of $32,000 net of
reserves for obsolete and slow-moving items of $91,000.  Inventories
at December 31, 2007 were comprised of work in process of $29,000 representing
direct labor costs on in-process projects and finished goods of $101,000 net of
reserves for obsolete and slow-moving items of $16,000.  Appropriate
consideration is given to obsolescence, excessive levels, deterioration, and
other factors in evaluating net realizable value and required reserve
levels.





NOTE
5. ACQUISITION





In
December 2007, the Company entered into an agreement for the purchase of
certain assets of Sol Logic, Inc. (“Sol Logic”) pursuant to an Asset
Purchase Agreement (the “Asset Purchase Agreement”).  The assets acquired
include certain customer contracts, software licenses and intellectual property
(collectively, the “Acquired Assets”).  As a result of this asset
acquisition, the Company integrated real-time voice recognition, multiple
language translation and voice analytic capabilities into its biometric
offerings. The Asset Purchase Agreement contained various customary
representations and warranties on behalf of Sol Logic.





In
consideration for the acquisition of the Acquired Assets, the Company:
(1) issued to Sol Logic on December 19, 2007 (the “Closing”) 935,089
shares of restricted common stock of the Company (the “Initial Shares”), and
(2) on June 19, 2008 (the “Additional Issuance Date”) was required to
issue to Sol Logic that number of shares of restricted common stock (the
“Additional Shares” and collectively with the Initial Shares, the “Shares”)
equal to the quotient obtained by dividing $1,502,000 by the greater of
(A) $1.633 and (B) the volume weighted average closing price of the
Company’s common stock over the 20 trading-day period ending on June 18,
2008, as reported on the Over-the-Counter Bullet Board (“OTCBB”).  Fifty
percent of the Initial Shares and ten percent of the Additional Shares were held
in escrow until the one-year anniversary of the Closing. The Company recorded
the obligation to issue the required number of shares on the Additional Issuance
Date as a current liability in the accompanying Consolidated Balance Sheet as of
December 31, 2007 under the caption “Acquisition related
obligation”.





On
March 28, 2008, the Company entered into Amendment No. 1 to Asset
Purchase Agreement (the “Purchase Agreement Amendment”) to amend the Purchase
Agreement.  The Purchase Agreement Amendment provided that in consideration
for the Acquired Assets, the Company issues to Sol Logic an aggregate of 677,940
shares of restricted Common Stock (the “Initial Shares”). Of these shares,
467,545 were issued to Sol Logic on December 19, 2007, the date of the
Purchase Agreement. The remaining 210,395 shares were issued to Sol Logic upon
execution of the Purchase Agreement Amendment.  In conjunction with these
issuances, the Company simultaneously rescinded the issuance of 257,149 common
shares originally placed into escrow on December 19, 2007.





In the
event the Company’s revenues on certain specified products set forth in the
Purchase Agreement Amendment either equal or exceed $3,000,000 for the six-month
period commencing on March 6, 2008 and ending on September 6, 2008 or
equal or exceed $5,000,000 for the eighteen-month period commencing on
March 6, 2008 and ending on September 6, 2009, the Company was
obligated to issue that number of additional shares of Common Stock (the
“Additional Shares” and together with the Initial Shares, the “Shares”) obtained
by dividing $1,921,924 by the greater of $1.10 or the volume weighted average
closing price of the Company’s common stock over the 20 trading-day period
immediately prior to the date the Additional Shares are issued, subject to the
terms of the escrow described below.  Pursuant to the Purchase Agreement
Amendment, the maximum number of Additional Shares that may be issued are
1,747,204. The Company did not attain the specified revenue levels required
pursuant to the terms of the Purchase Agreement Amendment and on September 6,
2009, the contingent consideration provision contained in the Purchase Agreement
Amendment expired with no additional consideration due.





Concurrently
with the execution of the Purchase Agreement Amendment, the Company entered into
Amendment No. 1 to Registration Rights Agreement (the “Rights Agreement
Amendment”) to amend the Rights Agreement.  Under the terms of the Rights
Agreement Amendment, the Company was required to register an additional 371,755
of the Initial Shares, for a total of 677,940 shares of Common Stock, for resale
by Sol Logic.





As a
result of recording the terms of the Purchase Agreement Amendment, the aggregate
purchase price, not including direct transaction costs of approximately $274,000
was approximately $1,019,000. The value of the 677,940 common shares issued was
determined based on the average market price of the Company’s common stock over
the 2-day period before and after the terms of the Purchase Agreement Amendment
were consummated on March 6, 2008 in accordance with EITF 99-12,
“Determination of the Measurement Date for the Market Price of Acquirer
Securities Issued in a Purchase Business Combination’. As of September 30, 2008,
the Company had incurred approximately $131,000 in expenses related to the
issuance and registration of the Company’s equity securities issued pursuant to
the Sol Logic asset purchase. Such issuance and registration costs have been
recognized as a reduction of the fair value of the Company’s common stock in
accordance with FASB Statement of Financial Accounting Standards No 141,
“Business Combinations” (“FAS 141”).




13


In
connection with the Purchase Agreement Amendment, the Company agreed to pay
additional consideration in future periods, based upon the attainment of certain
revenue levels on certain specified products. FAS 141 requires, in situations
involving a contingent consideration agreement that might result in the
recognition of an additional element of cost when the contingency is resolved,
the recognition of a purchase accounting liability in an amount equal to the
lesser of the maximum amount of contingent consideration or the excess (the
amount by which the amounts assigned to the assets acquired exceeds the cost of
the acquired entity). Accordingly, the Company, upon execution of the Purchase
Agreement Amendment, recorded a purchase accounting liability of approximately
$1,060,000 as a current liability. When the contingency is resolved and the
consideration is issued or becomes issuable, any excess of the fair value of the
contingent consideration issued or issuable over the amount that was recognized
as a liability shall be recognized as an additional cost of the acquisition. Any
such additional cost would result in increases in goodwill. If the amount
initially recognized as a liability exceeds the fair value of the consideration
issued or issuable, that excess shall be allocated as a pro rata reduction of
the amounts assigned to the acquired assets.





As more
fully described in Note 4 to these consolidated financial statements, the
Company determined that the intangible assets acquired in the December 2007
purchase of certain assets of Sol Logic, Inc. were impaired at December 31, 2008
as the carrying value of these assets exceeded their estimated fair value
determined by the assets’ future discounted cash flows.  The Company
did not attain the specified revenue levels required pursuant to the terms of
the Purchase Agreement Amendment and on September 6, 2009, the contingent
consideration provision contained in the Purchase Agreement Amendment expired
with no additional consideration due. The Company has recorded the resolution of
the purchase accounting contingency as a recognized subsequent event and has
allocated the excess of the contingent liability of $1,060,000 as a pro rata
reduction of the amounts assigned to the acquired assets prior to the recording
of an impairment charge of approximately $742,000 in the fourth quarter of
2008.The following table presents the allocation of the acquisition cost,
including professional fees and other related acquisition costs, to the assets
acquired and liabilities assumed, based on their fair values:




(Amounts in thousands,
      except share amounts)
              
              As
      recorded
                per
      Dec. 19, 2007
                Asset
      Purchase
                Agreement
              
              
              As adjusted
                per
      Mar. 6, 2008
                Purchase
                Agreement
                AmendmentFixed
      assets, net
              
              $
              42
              
              
              $
              42Covenant
      not to compete
              
              
              200
              
              
              
              200Customer
      base
              
              
              93
              
              
              
              93Developed
      technology
              
              
              2,018
              
              
              
              2,0182Goodwill
              
              
              1,036
              
              
              
              —Total
      assets acquired
              
              $
              3,389
              
              
              $
              2,353Cash
      and direct transaction costs
              
              $
              (410
              )
              
              $
              (466
              )Acquisition
      liability
              
              
              (1,502
              )
              
              
              (1,060
              )Common
      stock
              
              
              (9
              )
              
              
              (7
              )Additional
      paid in capital
              
              
              (1,468
              )
              
              
              (820
              )Total
      consideration issued and liabilities incurred
              
              $
              (3,389
              )
              
              $
              (2,353
              )Number
      of shares issued
              
              
              935,089
              
              
              
              677,940




The
following (unaudited) pro forma consolidated results of operations have been
prepared as if the acquisition of Sol Logic, Inc. had occurred at
January 1, 2007:





($ in thousands)
            
            Three
      Months Ended September 30, 2007
            
            
            Nine
      Months Ended September 30, 2007(unaudited)
            
            
            (unaudited)Sales
            
            $
            3,595
            
            
            $
            6,928Net
      loss available to common shareholders
            
            $
            (431
            )
            
            $
            (5,309
            )Net
      loss per share available to common shareholders
            
            $
            (0.03
            )
            
            $
            (0.36
            )





The pro
forma information is presented for informational purposes only and is not
necessarily indicative of the results of operations that actually would have
been achieved had the acquisition been consummated as of that time, nor is it
intended to be a projection of future results.




14


NOTE
6. COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS





The
Company recognizes revenues and cost of revenues on long-term, fixed price
contracts involving significant amounts of customization using the percentage of
completion method based on costs incurred to date compared to total estimated
costs at completion.  Such amounts are included in the accompanying
consolidated balance sheets at September 30, 2008 and December 31, 2007 under
the caption “Billings in excess of costs and estimated earnings on uncompleted
contract”.





Costs and
estimated billings on uncompleted contracts and related amounts billed as of
September 30, 2008 and December 31, 2007 are as follows:




($ in thousands)
            
            September 30,
              2008
            
            
            December 31,
              2007Costs
      incurred on uncompleted contract
            
            $
            73
            
            
            $
            —Estimated
      earnings
            
            
            139
            
            
            
            —212
            
            
            
            —Less:
      Billings to date
            
            
            (784
            )
            
            
            —Billings
      in excess of costs and estimated earnings on uncompleted
      contract
            
            $
            (572
            )
            
            $
            —





15


NOTE
7. COMMON STOCK AND WARRANTS





On
March 12, 2008, the Company received $541,666 from the exercise of
541,666 warrants to purchase shares of the Company’s common stock, par value
$0.01 per share (the “Warrant Financing”). The warrants were originally issued
in connection with a private placement of Common Stock to certain accredited
investors (the “Investors”). The Financing was previously reported in a Current
Report on Form 8-K filed on September 26, 2007. The Company agreed to
reprice all warrants issued in the Financing, which originally had an exercise
price of $1.67 per share, to an exercise price of $1.00 per share, in
consideration for their immediate exercise (the “Warrant Repricing”) by the
Investors who participated in the Warrant Repricing or their transferees, as
applicable (the “Participating Investors”).





In
connection with the Warrant Repricing, the Company also issued to the
Participating Investors new warrants (the “Warrants”) to purchase up to an
aggregate of 270,833 shares of Common Stock with an exercise price of $1.20 per
share. The Warrants may be exercised at any time from March 12, 2008 until
March 12, 2013. In addition, if the shares of Common Stock issuable upon
exercise of the Warrants are not registered for resale with the Securities and
Exchange Commission on or before the later of September 12, 2008 or the end
of the applicable holding period for resales of securities by non-affiliates
under Rule 144 of the Securities Act, but in any event no later than
March 12, 2009, the Warrants may be exercised by the Participating
Investors by “cashless” exercise.





As more
fully disclosed in Note 4 to these condensed consolidated financial statements,
in March 2008 the Company amended the Asset Purchase Agreement relating to
the purchase of certain assets of Sol Logic, Inc. As a result of amending
the Asset Purchase Agreement, the Company rescinded the issuance of 257,149
shares of common stock originally issued to Sol Logic and placed into escrow on
December 19, 2007.





In June
and July 2008, the Company issued 54,096 and 13,524 shares of common stock,
respectively, pursuant to stock-based compensation agreements with certain
employees.





The issuance of common stock and
warrants in March 2008 pursuant to the Warrant Financing triggered certain
antidilution clauses in the Company’s Series C and Series D Preferred
Stock agreements. As a result of these antidilution clauses, the Company was
required to adjust the conversion price of the Series C and Series D
Preferred Stock from $1.50 per share to $1.00 per share. This antidilution
feature will cause an additional 733,335 common shares to be issued upon
conversion of the Series C Preferred Stock into common stock and an
additional 462,669 common shares to be issued upon conversion of the
Series D Preferred Stock into common stock. In accordance with EITF Issue
00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments”,
this antidilution feature resulted in the additional recognition of a discount
attributable to an embedded beneficial conversion feature of approximately
$1,100,000 related to Series C Preferred Stock and $694,000 related to
Series D Preferred Stock. This discount was amortized over the minimum
period from the date of the conversion price adjustment to the date at which the
preferred shareholders are permitted to convert as a dividend to the
Series C and Series D Preferred Stock shareholders.




On
November 14, 2008, we entered in to a series of convertible promissory notes
(the” Convertible Notes”), aggregating $110,000 with certain officers and
members of the Company’s Board of Directors. The Convertible Notes bear interest
at 7.0% per annum and were originally due February 14, 2009 for which a
forbearance waiver was obtained as more fully described in Note 10. The
principal amount of the Convertible Notes plus accrued but unpaid interest is
convertible at the option of the holder into Common Stock of the Company. The
number of shares into which the Convertible Notes are convertible shall be
calculated by dividing the outstanding principle and accrued but unpaid interest
by $0.55 (the “Conversion Price”).In conjunction with the
issuance of the Convertible Notes, the Company issued an aggregate of 149,996
warrants to the note holders to purchase Common Stock of the Company. The
warrants have an exercise price $0.55 per share and may be exercised at any time
from November 14, 2008 until November 14, 2013.




As more
fully explained in Note 9 to these unaudited condensed consolidated financial
statements, subsequent to September 30, 2009, the Company entered into a series
of financing arrangements involving the issuance of common stock, convertible
debt instruments and warrants.




NOTE
8. PREFERRED STOCK





In March 2007, the Company’s Articles
of Incorporation were amended to authorize 2,000 shares of Series D 8%
Convertible Preferred Stock (“Series D Preferred Stock”).  In August
2008, the Company’s Articles of Incorporation were further amended to increase
the number of authorized shares of Series D Preferred Stock from 2,000 to
3,000.  Each share of Series D Preferred Stock has a par value of
$0.01, a stated value of $1,000 and is convertible into the Company’s common
stock at an initial conversion price of $0.50 per share.  The Series D
Preferred Stock does not have voting rights.




16


Commencing in August 2008 and ending in
September 2008, (the”2008 Series D Preferred Stock Financing”), the Company
issued to certain investors 810 shares of Series D Preferred Stock for aggregate
gross proceeds of $810,000.  In conjunction with the 2008 Series D
Preferred Stock Financing, the Company issued warrants to the investors of the
Series D Preferred Stock to purchase 1,620,000 shares of the Company’s common
stock at $0.50 per share.  These warrants have been classified as
equity instruments on the Company’s Consolidated Balance Sheet at September 30,
2008. The proceeds from the 2008 Series D Preferred Stock Financing were
allocated to the warrants and the Series D Preferred Stock based on the relative
fair value of each on the date of issuance.  This allocation process
resulted in the initial recognition of a discount attributable to an embedded
beneficial conversion feature of approximately $186,000.  This
discount was amortized over the minimum period from date of issuance to the date
at which the preferred shareholders are permitted to convert as a dividend to
the Series D Preferred Stock shareholders.





The issuance of the Series D Preferred
Stock and warrants pursuant to the 2008 Series D Preferred Stock Financing
triggered certain antidilution clauses in the Company’s Series C and previously
issued Series D Preferred Stock agreements.  As a result of these
antidilution clauses, the Company was required to adjust the conversion price of
the Series C and Series D Preferred Stocks from $1.00 to $0.50 per
share.  This antidilution feature will cause an additional 3,588,000
common shares to be issued upon conversion of the Series C and Series D
Preferred Stocks into common stock.  In accordance with EITF Issue
00-27,”Application of Issue 98-5 to Certain Convertible Instruments”, this
antidilution feature resulted in the additional recognition of a discount
attributable to an embedded beneficial conversion feature of approximately
$3,588,000.  This discount was amortized over the minimum period from
date of issuance to the date at which the preferred shareholders are permitted
to convert as a dividend to the Series D Preferred Stock
shareholders.





As compensation to the placement agent
for the 2008 Series D Preferred Stock Financing, the Company agreed to pay
approximately $33,000 in cash.  The cash payment has been recorded as
an adjustment to additional paid in capital as a reduction of net
proceeds.





At
September 30, 2008, the Company had cumulative undeclared dividends
relating to Series B, C and D Preferred Stock of approximately $21,000,
$359,000 and $186,000 respectively.




NOTE 9. SUBSEQUENT
EVENTS




On
November 14, 2008, the Company entered in to a series of convertible promissory
notes (the” Convertible Notes”), aggregating $110,000 with certain officers and
members of the Company’s Board of Directors. The Convertible Notes bear interest
at 7.0% per annum and are due February 14, 2009. The principal amount of the
Convertible Notes plus accrued but unpaid interest is convertible at the option
of the holder into Common Stock of the Company. The number of shares into which
the Convertible Notes are convertible shall be calculated by dividing the
outstanding principle and accrued but unpaid interest by $0.55 (the “Conversion
Price”).




In
conjunction with the issuance of the Convertible Notes, the Company issued an
aggregate of 149,996 warrants to the note holders to purchase Common Stock of
the Company. The warrants have an exercise price $0.55 per share and may be
exercised at any time from November 14, 2008 until November 14,
2013.




In
February 2009, the Company entered in to a secured promissory note (the ‘Note”),
for Five Million Dollars ($5,000,000) with a third-party lender (“the Lender”).
The Note secures a credit facility for a total of up to Five Million Dollars
($5,000,000). The initial advance under the Note was One Million Dollars
($1,000,000). Subsequent advances shall be in increments of $1,000,000 and are
subject to the discretion of the Lender. The Note shall bear interest at 5.0%
per annum on the outstanding principal. Principal and interest was originally
due June 30, 2010. The Company will also pay the Lender additional interest on
the maturity date or such earlier date as may be required under the terms of the
Note equal to the greater of Four Hundred Thousand Dollars ($400,000) or an
amount equal to 2,000,000 multiplied by the average of the Closing prices for
the Common Stock of the Company for the ten (10) trading day period immediately
preceding the date of the payment of such interest payment.




The
Note is secured by all of the assets of the Company. Under the terms of the
Note, the entire outstanding balance together with all accrued interest shall be
payable on (i) the maturity date (June 30, 2010), (ii) a change of control
transaction, (iii) receipt by the Company of proceeds from the sale of equity or
equity linked securities of the Company in excess of $2,500,000, (iv) receipt by
the Company of proceeds from the issuance by the Company of any type of
additional debt instruments, or upon the occurrence of an event of default under
the terms of the Note. The Company intends to use the proceeds from the
Note for general working capital purposes.




17


In
conjunction with the issuance of the Note, the Company issued a warrant to
purchase 4,500,000 shares of Common Stock of the Company. The warrant has an
exercise price $0.50 per share and may be exercised at any time from February
12, 2009 until February 12, 2014. Additionally, the Company entered into a
Registration Rights Agreement requiring the Company to provide certain
registration rights to the Lender relative to the 4,500,000 shares of Common
Stock of the Company issuable pursuant to the warrant.




On May
19, 2009, ImageWare Systems, Inc. formed a wholly owned subsidiary in Mexico in
order to support the Company’s efforts to develop new business and service
existing contracts to provide products and service in Mexico.  The
Mexican subsidiary, ImageWare Mexico, S. DE R.L., is located in Mexico City and
has one employee.




In
June 2009, the Lender and the Company agreed to amend the Note (“Amendment
No.1”) whereby the Company received a waiver of default and extension of certain
date sensitive covenants contained in the Note.  As consideration for the
waiver and extension, the Company issued to the Lender warrants to purchase
1,000,000 shares of Common Stock of the Company at an exercise price of $0.50
per share.  Such warrants may be exercised at any time from June 9, 2009
until June 9, 2014.  In conjunction with the June 2009 waiver and
extension, the interest rate on the Note was changed to 9% per annum,
retroactive to February 2009.




In
June 2009, the Lender and the Company further amended the Note (“Amendment
No.2”) whereby the Lender advanced the Company an additional $300,000 and
amended certain terms of the Note.  As consideration for the additional
advance, the Company issued to the Lender warrants to purchase 700,000 shares of
Common Stock of the Company at an exercise price of $0.50 per share.  Such
warrants may be exercised at any time from June 22, 2009 until June 22,
2014.




In
July and August 2009, the Company undertook a series of warrant financings
whereby the Company issued 2,401,075 warrants with an exercise price of $0.50
per share to incentivize certain warrant holders to exercise their existing
warrant of cash.  Pursuant to this series of warrant financings, the
Company issued an aggregate of 2,741,075 shares of common stock and raised
approximately $1,371,000 in cash.




In
July and August 2009, holders of existing warrants exercised 929,395 of their
warrants pursuant to cashless exercise provisions and received 353,702 shares of
common stock.




In August
2009, the Company received from the Convertible Note holders a waiver of default
and extension to January 31, 2010 of the maturity date of the Convertible
Notes.  As consideration for the waiver and note extension, the Company
issued to the Convertible Note holders an aggregate of 150,000 warrants to
purchase shares of the Company’s common stock.  The warrants have an
exercise price of $0.54 per share and expire on August 25, 2014. The
Company is currently seeking an additional waiver of default from the holders of
the Convertible Notes.




In
October 2009, the Lender and the Company amended the Note (“Amendment No. 3”)
whereby the Lender agreed to make additional advances in an aggregate amount up
to One Million Dollars ($1,000,000) to only be used for the purpose of
compromising certain of the Company’s outstanding vendor payables or for paying
the audit of the Company’s financial statements.  The amendment calls for
the Company to repay the lender in full the amount of any and all Third
Amendment Advances, together with all accrued and unpaid interest thereon, on or
before January 31, 2010.  On October 5, 2009, the Lender made an advance of
$300,000 to the Company pursuant to these provisions.  As consideration for
the additional advance, the Company issued to the Lender warrants to purchase
200,000 shares of Common Stock of the Company at an exercise price of $0.60 per
share.  Such warrants may be exercised at any time from October 5, 2009
until October 5, 2014.  As additional consideration, the Company assigned
certain patents related to discontinued product lines to the Lender with the
condition that the Company would participate in future proceeds generated from
efforts by the Lender to monetize the patents.




On
November 4, 2009, the Lender and the Company amended the Note (“Amendment No.
4”) whereby the Lender made an additional $350,000 advance (the “Additional
Advance”) under the Note.  As consideration for the Additional Advance, the
Company executed an assignment of all accounts receivable (the “Assignment of
Receivables”) whereby the Company assigned to the Lender all of the Company’s
rights, title and interest in all accounts receivable as of the date of
Amendment No. 4.  In December 2009, the Company paid back the $350,000
advance plus accrued interest.




In
December 2009, the Lender advanced an additional $325,000 under Amendment
No.3.




In
January of 2010, holders of existing warrants exercised 13,120 of their warrants
pursuant to cashless exercise provisions and received 5,665 shares of common
stock.




In
January of 2010, the Company issued 847,258 shares of restricted stock to
members of management and the Board.  These shares will vest quarterly
over a three year period.  The restricted shares were issued as
compensation for the cancellation of 1,412,096 warrants held by members of
management and the Board.




18
 ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.





This
Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. All
forward-looking statements included in this report are based on information
available to us as of the date hereof and we assume no obligation to update any
forward-looking statements. Forward-looking statements involve known or unknown
risks, uncertainties and other factors, which may cause our actual results,
performance or achievements, or industry results to be materially different from
any future results, performance or achievements expressed or implied by such
forward-looking statements. Factors that could cause or contribute to such
differences include but are not limited to those items discussed under “Risk
Factors” beginning on page 29 and elsewhere in this Quarterly
Report.





The
following discussion of the financial condition and results of operations should
be read in conjunction with the condensed consolidated financial statements
included elsewhere within this Quarterly Report. Fluctuations in annual and
quarterly results may occur as a result of factors affecting demand for our
products such as the timing of new product introductions by us and by our
competitors and our customers’ political and budgetary constraints. Due to such
fluctuations, historical results and percentage relationships are not
necessarily indicative of the operating results for any future
period.





OVERVIEW





ImageWare
Systems, Inc. is a leader in the emerging market for software-based
identity management solutions, providing biometric, secure credential and law
enforcement technologies. Our “flagship” product is the IWS Biometric EngineTM.
Scalable for small city business or worldwide deployment, our biometric engine
is a multi-biometric platform that is hardware and algorithm independent,
enabling the enrollment and management of unlimited population sizes. Our
identification products are used to manage and issue secure credentials
including national IDs, passports, driver licenses, smart cards and access
control credentials. Our law enforcement products provide law enforcement with
integrated mug shot, fingerprint Livescan and investigative capabilities. The
biometric technology is now an integral part of all markets we address, and all
of our products are integrated into the Biometric Engine Platform. 
Elements of the biometric engine can be used as investigative tools to law
enforcement potentially utilizing multiple biometrics and forensic data
elements, and to enhance security and authenticity of public and private sector
credentials.





CRITICAL
ACCOUNTING ESTIMATES





The
discussion and analysis of our financial condition and results of operations are
based on our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America, or U.S. GAAP. The preparation of these financial statements in
accordance with U.S. GAAP requires us to utilize accounting policies and make
certain estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingencies as of the date of the financial
statements and the reported amounts of revenue and expenses during a fiscal
period. The SEC considers an accounting policy to be critical if it is important
to a company’s financial condition and results of operations, and if it requires
significant judgment and estimates on the part of management in its
application. Although we believe that our judgments and estimates are
appropriate and correct, actual results may differ from those
estimates.





The
following are our critical accounting policies because we believe they are both
important to the portrayal of our financial condition and results of operations
and require critical management judgments and estimates about matters that are
uncertain. If actual results or events differ materially from those contemplated
by us in making these estimates, our reported financial condition and results of
operations for future periods could be materially affected.





Revenue
Recognition





Our
revenue recognition policy is significant because our revenue is a key component
of our consolidated results of operations. We recognize revenue from the
following major revenue sources:





·
            Long-term fixed-price contracts
      involving significant
customization





·
            Fixed-price contracts involving
      minimal customization





·
            Software
      licensing





·
            Sales of computer hardware and
      identification media





·
            Postcontract customer support
      (PCS)





19


The
Company follows the provisions of Statements of Position 97-2 “Software Revenue
Recognition” and 98-9 “Modification of SOP 97-2, Software Revenue Recognition
With Respect to Certain Transactions”, Statement of Position 81-1 “Accounting
for Performance of Construction-Type and Certain Production-Type Contracts”,
Securities and Exchange Commission Staff Accounting Bulletin 104 , Emerging
Issues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”,
and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement of
Position 97-2 to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software”. Accordingly, the Company recognizes revenue when
all of the following criteria are met: persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered, the fee is fixed
or determinable, and collectibility is reasonably assured.




We
recognize revenue and profit as work progresses on long-term, fixed-price
contracts involving significant amounts of hardware and software customization
using the percentage of completion method based on costs incurred to date
compared to total estimated costs at completion.The
primary components of costs incurred are third party software and direct labor
cost including fringe benefits. Revenue
from contracts for which we cannot reliably estimate total costs or which do not
involve significant amounts of customization are recognized upon completion.
Determining when a contract should be accounted for using the percentage of
completion method involves judgment. Critical items that are considered in this
process are the degree of customization and related labor hours necessary to
complete the required work as well as ongoing estimates of the future labor
hours needed to complete the contract. We also generate non-recurring revenue
from the licensing of our software. Software license revenue is recognized upon
the execution of a license agreement, upon deliverance, fees are fixed and
determinable, collectibility is probable and when all other significant
obligations have been fulfilled. We also generate revenue from the sale of
computer hardware and identification media. Revenue for these items is
recognized upon delivery of these products to the customer. Our revenue from
periodic maintenance agreements is generally recognized ratably over the
respective maintenance periods provided no significant obligations remain and
collectibility of the related receivable is
probable.





Allowance
for Doubtful Accounts





Our
management must make estimates of the uncollectibility of our accounts
receivable. Management specifically analyzes accounts receivable and analyzes
historical bad debts, customer concentrations, customer creditworthiness,
current economic trends, the age of the accounts receivable balances, and
changes in our customer payment terms when evaluating the adequacy of the
allowance for doubtful accounts. Our gross accounts receivable balance was
approximately $422,000 and our allowance for doubtful accounts was approximately
$28,000 as of September 30, 2008.





Income
Taxes




The
Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes”
and FIN No. 48, “Accounting for Uncertainty in Income
Taxes”. Deferred income taxes are recognized for the tax consequences
related to temporary differences between the carrying amount of assets and
liabilities for financial reporting purposes and the amounts used for tax
purposes at each year-end, based on enacted tax laws and statutory tax rates
applicable to the periods in which the differences are expected to affect
taxable income. A valuation allowance is established when necessary based on the
weight of available evidence, if it is considered more likely than not that all
or some portion of the deferred tax assets will not be realized. Income tax
expense is the sum of current income tax plus the change in deferred tax assets
and liabilities.




FIN
No. 48 requires a company to first determine whether it is
more-likely-than-not (defined as a likelihood of more than fifty percent) that a
tax position will be sustained based on its technical merits as of the reporting
date, assuming that taxing authorities will examine the position and have full
knowledge of all relevant information. A tax position that meets this
more-likely-than-not threshold is then measured and recognized at the largest
amount of benefit that is greater than fifty percent likely to be realized upon
effective settlement with a taxing authority.





The
Company incurred no income tax expenses during the three and nine months ended
September 30, 2008 and 2007.




Valuation
of Goodwill and Other Intangible Assets





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





·
            Significant underperformance
      relative to historical or expected future operating
      results;





·
            Significant changes in the manner
      of our use of the acquired assets or the strategy of our overall
      business;





·
            Significant negative industry or
      economic trends;


20


When we
determine that the carrying value of goodwill and other intangible assets may
not be recoverable based upon the existence of one or more of the above
indicators of impairment, we measure any impairment based upon fair value
methodologies. Goodwill and other net intangible assets amounted to
approximately $5,454,000 as of September 30, 2008. During the three months
ended March 31, 2008 we amended the purchase agreement for the acquisition
of substantially all the assets of Sol Logic, Inc. originally consummated
December 19, 2007. As a result of this amendment, which reduced the
purchase price of the Sol Logic assets, we reversed previously recorded goodwill
from this acquisition of approximately $1,036,000 as originally reflected in the
2007 consolidated financial statements.





In 2002,
Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and
Other Intangible Assets” became effective, and as a result we ceased to amortize
goodwill. In lieu of amortization, we performed an initial impairment review of
our goodwill in June, 2002 and will perform an annual impairment review
thereafter in the fourth quarter of our fiscal year.





With the
sale of our Digital Photography component in 2006, we reassessed the composition
of our operating segments and determined that we no longer operate in separate,
distinct market segments but rather operate in one market segment, such segment
being identity management. The Company’s determination was based on fundamental
changes in the Company’s business structure due to the consolidation of
operations, restructuring of the Company’s operations and management team, and
the integration of what where previously distinct, mutually exclusive
technologies. This has resulted in changes in the manner by which the Company’s
chief decision maker assesses performance and makes decisions concerning
resource allocation. As a result of our operation in one market segment, such
segment being identity management, our 2006 and 2007 goodwill impairment review
consisted of the comparison of the fair value of our identity management segment
as determined by the quoted market prices of our common stock to the carrying
amount of the segment. As the fair value exceeded the carrying value by a
substantial margin, we determined that our goodwill was not impaired. Using the
same methodologies, we determined that as of September 30, 2008 there were
no indicators of potential impairment.





There are
many management assumptions and estimates underlying the determination of an
impairment loss, and estimates using different, but reasonable, assumptions
could produce significantly different results. Significant assumptions include
estimates of future levels of revenues and operating expenses. Therefore, the
timing and recognition of impairment losses by us in the future, if any, may be
highly dependent upon our estimates and assumptions. There can be no assurance
that goodwill impairment will not occur in the future.





We
account for long-lived assets in accordance with the provisions of SFAS
No. 144, “Accounting for the Impairment or Disposal of Long-Lived
Assets.”  This statement requires that long-lived assets and certain
identifiable intangible assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net undiscounted cash
flows expected to be generated by the asset. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount which the
carrying amount of the assets exceeds the fair value of the assets. Fair value
is determined based on discounted cash flows or appraised values, depending upon
the nature of the asset. Assets to be disposed of are reported at the lower of
the carrying amount of fair value less costs to sell. During the twelve months
ended December 31, 2007 we completed the acquisition of substantially all
the assets of Sol Logic, Inc. In March 2008, we amended the purchase
price of this asset acquisition. Pursuant to this acquisition, we recorded
approximately $2,311,000 in identifiable intangible assets. The assets acquired
were a covenant not to compete valued at approximately $200,000, customer base
valued at approximately $93,000 and developed technology valued at approximately
$2,018,000. The allocation of the purchase price was based on fair value
methodologies.





As of
September 30, 2008, the Company had incurred no impairment charges and
accordingly we recorded no impairment losses for long-lived or intangible assets
during the nine months ended September 30, 2008. There are many management
assumptions and estimates underlying the determination of an impairment loss,
and estimates using different, but reasonable, assumptions could produce
significantly different results. Significant assumptions include estimates of
future levels of revenues and operating expenses. Therefore, the timing and
recognition of impairment losses by us in the future, if any, may be highly
dependent upon our estimates and assumptions.





The
Company determined that the intangible assets acquired in the December 2007
purchase of certain assets of Sol Logic, Inc. were impaired at December 31, 2008
as the carrying value of these assets exceeded their estimated fair value
determined by the assets’ future discounted cash flows.  The Company
did not attain the specified revenue levels required pursuant to the terms of
the Purchase Agreement Amendment and on September 6, 2009, the contingent
consideration provision contained in the Purchase Agreement Amendment expired
with no additional consideration due. The Company recorded an impairment charge
of approximately $742,000 in the fourth quarter of 2008.




21


Stock-Based
Compensation





Upon
adoption of SFAS No. 123R “Accounting for Stock Based Compensation” on
January 1, 2006, we began estimating the value of employee stock options on
the grant date using the Black-Scholes model. Prior to the adoption of SFAS No.
123R, the value of each employee stock option was estimated on the grant date
using the Black-Scholes model for the purpose of the pro forma financial
disclosure in accordance with SFAS No. 123R. The determination of fair value of
stock-based payment awards on the grant date using an option-pricing model is
affected by our stock price as well as assumptions regarding a number of highly
complex and subjective variables. These variables include, but are not limited
to the expected stock price volatility over the term of the awards and the
actual and projected employee stock option exercise behaviors. The expected term
of options granted is derived from historical data on employee exercises and
post-vesting employment termination behavior. We calculated our expected
volatility assumption required in the Black-Scholes model based on the
historical volatility of our stock. In addition to the key assumptions used in
the Black-Scholes model, the estimated forfeiture rate at the time of valuation
is a critical assumption. The Company has estimated an annualized forfeiture
rate of 10% for corporate officers, 4% for members of the Company’s Board of
Directors and 24% for all other employees. The Company reviews the expected
forfeiture rate annually to determine if that percent is still reasonable based
on historical experience.





As of
January 1, 2006 we have adopted the modified prospective transition method
and its effect is included in our Condensed Consolidated Statements of
Operations for the three and nine months ended September 30, 2008 and
2007.




RESULTS
OF OPERATIONS




Three
Months Ended September 30, 2008 Compared to the Three Months Ended September 30,
2007.





Three Months
              Ended
              September 30,Net Product Revenues
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            408
            
            
            $
            2,768
            
            
            $
            (2,360
            )
            
            
            (85
            )%Percentage
      of total net product revenue
            
            
            58
            %
            
            
            98
            %Hardware
      and consumables
            
            $
            28
            
            
            $
            37
            
            
            $
            (9
            )
            
            
            (24
            )%Percentage
      of total net product revenue
            
            
            4
            %
            
            
            1
            %Services
            
            $
            269
            
            
            $
            27
            
            
            $
            242
            
            
            
            896
            %Percentage
      of total net product revenue
            
            
            38
            %
            
            
            1
            %Total
      net product revenues
            
            $
            705
            
            
            $
            2,832
            
            
            $
            (2,127
            )
            
            
            (75
            )%





Software
and royalty revenues decreased 85% or $2,360,000 during the three months ended
September 30, 2008 as compared to the corresponding period in 2007. This
decrease is due to lower project-oriented revenues of our Personal Identity
Verification (“PIV”) and Biometric Engine software solutions of approximately
$2,156,000.  Revenues generated from Law Enforcement software
solutions also decreased approximately $104,000 combined with lower
identification software royalties and license revenues of approximately
$100,000.





Revenues
from the sale of hardware and consumables decreased 24% or approximately $9,000
during the three months ended September 30, 2008 as compared to the
corresponding period in 2007. The decrease reflects the lower revenues from
project solutions containing hardware and consumable components.




Services
revenues are comprised primarily of software integration services, system
installation services and customer training. Such revenues increased
approximately $242,000 during the three months ended September 30, 2008 as
compared to the corresponding period in 2007 due primarily to a higher
percentage of overall revenues being generated from project work. We expect
service revenues to continue to be a significant component of our
revenues through increased implementations of large-scale high-end
solutions.





We
believe that the decrease in identity management software revenue in
project-oriented solutions is largely due to delays in government procurement
with respect to the various programs we are pursuing. Based on management’s
current visibility into the timing of potential government procurements, we
believe that we will see an increase in government procurement and
implementations with respect to identity management initiatives however we
cannot predict the timing of any such initiatives..




22
 
 Our
backlog of product orders as of September 30, 2008 was approximately
$2,379,000. At September 30, 2008, we also had maintenance and support backlog
of approximately $1,205,000 under existing maintenance agreements. Product
revenue is typically recognized within a three to six month time period for
projects not requiring significant customization.  Projects that
require significant customization can range from six months to two years
depending upon the required degree of customization and customer implementation
schedules. Historically, we have experienced a very minimal risk of order
cancellation. Our revenue from maintenance agreements is generally recognized
ratably over the respective maintenance periods provided no significant
obligations remain and collectibility of the related receivable is
probable.




Three Months
              Ended
              September 30,Maintenance Revenues
            
            2008
            
            
            2007
            
            
            $
      Change
            
            
            %
      Change(dollars in thousands)Maintenance
      revenues
            
            $
            639
            
            
            $
            678
            
            
            $
            (39
            )
            
            
            (6
            )%




We
anticipate the growth of our maintenance revenues through the retention of
existing customers combined with the expansion of installed base combined
resulting from the completion of project-oriented work, however, we cannot
predict the timing of this anticipated growth.





Three Months
              Ended
              September 30,Cost of Product Revenues:
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            186
            
            
            $
            472
            
            
            $
            (286
            )
            
            
            (61
            )%Percentage
      of software and royalty product revenue
            
            
            46
            %
            
            
            17
            %Hardware
      and consumables
            
            $
            23
            
            
            $
            33
            
            
            $
            (10
            )
            
            
            (30
            )%Percentage
      of hardware and consumables product revenue
            
            
            82
            %
            
            
            89
            %Services
            
            $
            114
            
            
            $
            5
            
            
            $
            109
            
            
            
            2180
            %Percentage
      of services product revenue
            
            
            42
            %
            
            
            19
            %Total
      product cost of revenues
            
            $
            323
            
            
            $
            510
            
            
            $
            (187
            )
            
            
            (37
            )%Percentage
      of total product revenues
            
            
            46
            %
            
            
            18
            %





The cost
of software and royalty product revenue decreased 61% or $286,000 during the
three months ended September 30, 2008 as compared to the corresponding
period in 2007 due to lower software and royalty revenues generated during the
three months ended September 30, 2008 as compared to the corresponding
period in 2007. The three month period ended September 30, 2008 contains
approximately $75,000 related to the write down of certain third party software
which was written down to estimated net realizable value. In addition to changes
in costs of software and royalty product revenue caused by revenue level
fluctuations, costs of products can vary as a percentage of product revenue from
period to period depending upon level of software customization and third party
software license content included in product sales during a given
period.





The
decrease in the cost of product revenues for our hardware and consumable sales
of $10,000 for the three months ended September 30, 2008 as compared to the
corresponding period in 2007 reflects the decrease in hardware and consumable
revenues for the three months ended September 30, 2008 as compared to the
comparable period in 2007 combined with lower costs incurred on hardware and
consumable procurements.





The
increase in the cost of services product revenue of $109,000 for the three
months ended September 30, 2008 as compared to the corresponding period of 2007
reflects an increase in software integration services and system installation
services generated from project work.





Three Months
              Ended
              September 30,Cost
      of Maintenance Revenues
            
            2008
            
            
            2007
            
            
            $
      Change
            
            
            % Change(dollars in thousands)Total
      maintenance cost of revenues
            
            $
            305
            
            
            $
            281
            
            
            $
            24
            
            
            
            9
            %Percentage
      of total maintenance revenues
            
            
            48
            %
            
            
            41
            %





23


Cost of
maintenance revenues decreased approximately $24,000 or 9% during the three
months ended September 30, 2008 as compared to the corresponding period in
2007 and is reflective of lower hardware costs incurred for replacement
equipment during the 2008 period offset by increased personnel costs required to
service our expanding installed base.




Three Months
              Ended
              September
      30,Product gross profit
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            222
            
            
            $
            2,296
            
            
            $
            (2,074
            )
            
            
            (90
            )%Percentage
      of software and royalty product revenue
            
            
            54
            %
            
            
            83
            %Hardware
      and consumables
            
            $
            5
            
            
            $
            4
            
            
            $
            1
            
            
            
            25
            %Percentage
      of hardware and consumables product revenue
            
            
            18
            %
            
            
            11
            %Services
            
            $
            155
            
            
            $
            22
            
            
            $
            133
            
            
            
            605
            %Percentage
      of services product revenue
            
            
            58
            %
            
            
            81
            %Total
      product gross profit
            
            $
            382
            
            
            $
            2,322
            
            
            $
            (1,940
            )
            
            
            (84
            )%Percentage
      of total product revenues
            
            
            54
            %
            
            
            82
            %





Total
product gross profit decreased due to lower product revenues during the three
months ended September 30, 2008 as compared to the corresponding period in
2007.





Software
and royalty gross profit decreased by 90% or approximately $2,074,000 for the
three months ended September 30, 2008 from the corresponding period in 2007
due to lower software and royalty product revenues of approximately $2,360,000
in the 2008 period. Costs of software products can also vary as a percentage of
product revenue from quarter to quarter depending upon product mix and third
party software licenses included in software solutions.





Services
gross profit increased due to higher services revenues of approximately $242,000
generated through project sales for the three month period ending
September 30, 2008 as compared to the corresponding period in
2007.





Three Months
              Ended
              September 30,Maintenance gross profit
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Total
      maintenance gross profit
            
            $
            334
            
            
            $
            397
            
            
            $
            (63
            )
            
            
            (16
            )%Percentage
      of total maintenance revenues
            
            
            52
            %
            
            
            59
            %





Gross
margins related to maintenance revenues decreased due primarily to lower
maintenance revenues generated during the three months ended September 30, 2008
as compared to the corresponding period in 2007 combined with higher personnel
costs.





Three Months
      Ended
              September 30,Operating expenses
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)General &
      administrative
            
            $
            840
            
            
            $
            889
            
            
            $
            (49
            )
            
            
            (6
            )%Percentage
      of total net revenue
            
            
            63
            %
            
            
            25
            %Sales
      and marketing
            
            $
            464
            
            
            $
            607
            
            
            $
            (143
            )
            
            
            (24
            )%Percentage
      of total net revenue
            
            
            35
            %
            
            
            17
            %Research &
      development
            
            $
            785
            
            
            $
            752
            
            
            $
            33
            
            
            
            4
            %Percentage
      of total net revenue
            
            
            58
            %
            
            
            21
            %Depreciation
      and amortization
            
            $
            194
            
            
            $
            60
            
            
            $
            134
            
            
            
            223
            %Percentage
      of total net revenue
            
            
            14
            %
            
            
            2
            %




24


General and
Administrative Expenses.General and administrative
expenses are comprised primarily of salaries and other employee-related costs
for executive, financial, and other infrastructure personnel. General legal,
accounting and consulting services, insurance, occupancy and communication costs
are also included with general and administrative expenses. The increase in such
expenses, as a percentage of total net revenues, is reflective of lower net
revenues during the three months ended September 30, 2008 as compared to
the corresponding period in 2007. The dollar decrease of $49,000 is primarily
comprised of the following major components:





·
            Decrease in stock-based
      compensation expense of approximately $20,000 due to the vesting of
      certain restricted stock grants combined with lower expenses recorded
      pursuant to SFAS No. 123(R) due to the expiration of vesting periods
      for certain prior year share-based payment
    issuances.





·
            Decrease in insurance
      related expenses of approximately
  $8,000.





·
            Decrease in professional
      services of approximately
$121,000.





·
            Decrease in travel related
      expenses of approximately
$33,000.





·
            Increase
      in compensation and related fringe benefits of approximately
      $33,000.


·
              Increase
      in royalty and license expense of $100,000 due to the write down of
      certain prepaid royalties to estimatednet realizable
      value.
 
 We are
continuing to focus our efforts on achieving additional future operating
efficiencies by reviewing and improving upon existing business processes and
evaluating our cost structure. We believe these efforts will allow us to
gradually decrease our level of general and administrative expenses expressed as
a percentage of total revenues.


Sales and
Marketing.Sales
and marketing expenses consist primarily of the salaries, commissions, other
incentive compensation, employee benefits and travel expenses of our sales,
marketing, business development and product management functions. The dollar
decrease of $143,000 during the three months ended September 30, 2008 as
compared to the corresponding period in 2007 reflects headcount reductions due
to the elimination and consolidation of various sales positions combined with
reduced advertising, trade show, travel and professional services
expenditures.





Research and
Development.Research and development expenses consist primarily of salaries, employee
benefits and outside contractors for new product development, product
enhancements and custom integration work. Such expenses increased 4% or
approximately $33,000 for the three months ended September 30, 2008 as
compared to the corresponding period in 2007. This increase is comprised of
reductions in contract programming expenditures of approximately $114,000 offset
by increases in salaries and employee benefits of approximately
$69,000.  Other major components of the overall increase were
increased expenditures of $90,000 for engineering facilities related
expenditures offset by lower travel and other expenses of approximately $12,000.
The reduction in contract programming reflects the absorption of the majority of
these functions by internal engineering resources. The increase in salaries and
employee benefits is due primarily to increased headcount in the three month
period ending September 30, 2008 as compared to the corresponding prior
year period needed to facilitate the transition from contract programming to
internal resources. Our level of expenditures in research and development
reflects our belief that to maintain our competitive position in markets
characterized by rapid rates of technological advancement, we must continue to
invest significant resources in new systems and software as well as continue to
enhance existing products.





Depreciation and
Amortization.During the three months ended September 30, 2008, depreciation and
amortization expense increased 223% or $134,000 as compared to the corresponding
period in 2007. The increase in depreciation and amortization expense reflects
higher amortization of approximately $122,000 for certain definite long-lived
intangible assets acquired in the Company’s December 2007 purchase of
certain assets of Sol Logic, Inc. offset by reduced depreciation expense
due to fully depreciated fixed assets.





Interest Expense
(Income), Net.For the three months ended September 30, 2008, we recognized interest
income of $4,000 and interest expense of $9,000. For the three months ended
September 30, 2007, we recognized interest income of $9,000 and interest
expense of $7,000.




25


Nine
Months Ended September 30, 2008 Compared to the Nine Months Ended September 30,
2007





Product
Revenues





Nine Months
              Ended
              September 30,Net
      Product Revenues
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            1,653
            
            
            $
            4,178
            
            
            $
            (2,525
            )
            
            
            (60
            )%Percentage
      of total net product revenue
            
            
            66
            %
            
            
            89
            %Hardware
      and consumables
            
            $
            145
            
            
            $
            227
            
            
            $
            (82
            )
            
            
            (36
            )%Percentage
      of total net product revenue
            
            
            6
            %
            
            
            5
            %Services
            
            $
            704
            
            
            $
            293
            
            
            $
            411
            
            
            
            140
            %Percentage
      of total net product revenue
            
            
            28
            %
            
            
            6
            %Total
      net product revenues
            
            $
            2,502
            
            
            $
            4,698
            
            
            $
            (2,196
            )
            
            
            (47
            )%





Software
and royalty revenues decreased 60% or $2,525,000 during the nine months ended
September 30, 2008 as compared to the corresponding period in
2007.  The decrease is due primarily to lower project-oriented
revenues of our Personal Identity Verification (“PIV”) and Biometric Engine
software solutions of approximately $1,681,000, lower identification software
royalties and license revenues of approximately $402,000 resulting primarily
from our Desktop Security product, lower sales of our boxed identity management
software through our distribution channel of approximately $173,000 and lower
Law Enforcement project-oriented revenues of approximately
$269,000.





Revenues
from the sale of hardware and consumables decreased 36% or $82,000 during the
nine months ended September 30, 2008 as compared to the corresponding period in
2007.  The decrease reflects lower revenues from project solutions
containing hardware and consumable components.





Services
revenues are comprised primarily of software integration services, system
installation services and customer training.  Such revenues increased
approximately $411,000 during the nine months ended September 30, 2008 as
compared to the corresponding period in 2007 due primarily to higher service
revenues being generated from software integration of our biometric engine and
PIV products into project solutions offset by a decrease in our installation of
hardware products.  We expect service revenues to continue to be a
significant component of our revenues through increased implementations of
large-scale high-end solutions.
 
 We
believe that the decrease in identity management software revenue in
project-oriented solutions is largely due to delays in government procurement
with respect to the various programs we are pursuing. Based on management’s
current visibility into the timing of potential government procurements, we
believe that we will see an increase in government procurement and
implementations with respect to identity management initiatives however we
cannot predict the timing of such initiatives.





Maintenance
Revenues





Nine Months
              Ended
              September 30,Maintenance
      Revenues
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Maintenance
      revenues
            
            $
            1,892
            
            
            $
            1,926
            
            
            $
            (34
            )
            
            
            (2
            )%





The
decrease in maintenance revenues reflects lower revenues generated from the
expiration of maintenance contracts on certain identification software solutions
combined with lower maintenance revenues generated from our Desktop Security
product due to the expiration of certain maintenance contracts related to this
product.




26


We
anticipate continued growth of our maintenance revenues through the retention of
existing customers combined with the expansion of installed base combined
resulting from the completion of project-oriented work, however, we cannot
predict the timing of this anticipated growth.





Cost
of Product Revenues





Nine Months
              Ended
              September 30,Cost of Product Revenues:
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            373
            
            
            $
            682
            
            
            $
            (309
            )
            
            
            (45
            )%Percentage
      of software and royalty product revenue
            
            
            23
            %
            
            
            16
            %Hardware
      and consumables
            
            $
            132
            
            
            $
            236
            
            
            $
            (104
            )
            
            
            (44
            )%Percentage
      of hardware and consumables product revenue
            
            
            91
            %
            
            
            104
            %Services
            
            $
            227
            
            
            $
            74
            
            
            $
            153
            
            
            
            207
            %Percentage
      of services product revenue
            
            
            32
            %
            
            
            25
            %Total
      cost of product revenues
            
            $
            732
            
            
            $
            992
            
            
            $
            (260
            )
            
            
            (26
            )%Percentage
      of total product revenues
            
            
            29
            %
            
            
            21
            %





The cost
of software and royalty product revenue decreased 45% or $309,000 during the
nine months ended September 30, 2008 as compared to the corresponding period in
2007 due to lower software and royalty revenues during the nine months ended
September 30, 2008.  In addition to changes in costs of software and
royalties product revenues caused by revenue level fluctuations, costs of
products can also vary as a percentage of product revenue from period to period
depending upon level of software customization and third party software license
content included in product sales during a given period.





The
decrease in the cost of product revenues for our hardware and consumable sales
of $104,000 for the nine months ended September 30, 2008 as compared to the
corresponding period in 2007 reflects the decrease in hardware and consumable
revenues for the nine months ended September 30, 2008 as compared to the
comparable period in 2007 combined with lower costs incurred on hardware and
consumable procurements.





Cost of
service revenue increased $153,000 during the nine months ended September 30,
2008 as compared to the corresponding period in 2007 due to higher software
integration revenues of our Biometric Engine and PIV products into project
solutions.  Such revenues increased approximately $411,000 during the
nine months ended September 30, 2008 as compared to the corresponding period in
2007.





Cost
of Maintenance Revenues





Nine Months
              Ended
              September 30,Cost of
      Maintenance Revenues
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Total
      maintenance cost of revenues
            
            $
            909
            
            
            $
            871
            
            
            $
            38
            
            
            
            4
            %Percentage
      of total maintenance revenues
            
            
            48
            %
            
            
            45
            %





Cost of
maintenance revenues increased 4% or $38,000 during the nine months ended
September 30, 2008 as compared to the corresponding period in 2007 and reflects
higher personnel costs incurred to service our installed base during this
period.




27


Product
Gross Profit





Nine Months
              Ended
              September 30,Product gross profit
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            1,280
            
            
            $
            3,496
            
            
            $
            (2,216
            )
            
            
            (63
            )%Percentage
      of software and royalty product revenue
            
            
            77
            %
            
            
            84
            %Hardware
      and consumables
            
            $
            13
            
            
            $
            (9
            )
            
            $
            22
            
            
            
            244
            %Percentage
      of hardware and consumables product revenue
            
            
            9
            %
            
            
            (4
            )%Services
            
            $
            477
            
            
            $
            219
            
            
            $
            258
            
            
            
            118
            %Percentage
      of services product revenue
            
            
            68
            %
            
            
            75
            %Total
      product gross profit
            
            $
            1,770
            
            
            $
            3,706
            
            
            $
            (1,936
            )
            
            
            (52
            )%Percentage
      of total product revenues
            
            
            71
            %
            
            
            79
            %





Software
and royalty gross profit decreased 63% or $2,216,000 for the nine months ended
September 30, 2008 as compared to the corresponding period in 2007 due to lower
software and royalties revenues.  This decrease reflects lower
software and royalty revenues of approximately $2,500,000 for the nine months
ended September 30, 2008 as compared to the corresponding period of
2007.





Hardware
and consumables gross profit increased $22,000 during the nine months ended June
30, 2008 as compared to the corresponding period in 2007 due to lower costs
incurred on sales of hardware and consumables of $104,000 during the nine months
ended September 30, 2008 as compared to the corresponding period in 2007.
Hardware and consumables gross profit as a percentage of hardware and
consumables product revenue increased to 9% from (4%) and reflects the 2007
period containing expenses charged to cost of sales for restocking fees. Costs
of products can vary as a percentage of product revenue from quarter to quarter
depending upon product mix and hardware content and print media consumable
content included in systems installed during a given period.





Services
gross profit increased approximately $258,000 for the nine months ended
September 30, 2008 as compared to the corresponding period of 2007 due to higher
project revenues for the integration and customization of our Biometric Engine
and PIV products into project solutions.





Maintenance
Gross Profit





Nine Months
              Ended
              September 30,Maintenance gross profit
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)Total
      maintenance gross profit
            
            $
            983
            
            
            $
            1,055
            
            
            $
            (72
            )
            
            
            (7
            )%Percentage
      of total maintenance revenues
            
            
            52
            %
            
            
            55
            %





Gross
margins related to maintenance revenues decreased due primarily to lower
maintenance revenues generated during the nine months ended September 30, 2008
as compared to the corresponding period in 2007 combined with higher personnel
costs needed to service our installed base.




28


Operating
Expenses





Nine Months Ended
              September 30,Operating expenses
            
            2008
            
            
            2007
            
            
            $ Change
            
            
            % Change(dollars in thousands)General
      & administrative
            
            $
            2,885
            
            
            $
            2,989
            
            
            $
            (104
            )
            
            
            (3
            )%Percentage
      of total net revenue
            
            
            66
            %
            
            
            45
            %Sales
      and marketing
            
            $
            1,678
            
            
            $
            1,974
            
            
            $
            (296
            )
            
            
            (15
            )%Percentage
      of total net revenue
            
            
            38
            %
            
            
            30
            %Research
      & development
            
            $
            2,413
            
            
            $
            2,741
            
            
            $
            (328
            )
            
            
            (12
            )%Percentage
      of total net revenue
            
            
            55
            %
            
            
            41
            %Depreciation
      and amortization
            
            $
            588
            
            
            $
            199
            
            
            $
            389
            
            
            
            195
            %Percentage
      of total net revenue
            
            
            13
            %
            
            
            3
            %





General and
Administrative Expenses.  General and administrative expenses
are comprised primarily of salaries and other employee-related costs for
executive, financial, and other infrastructure personnel. General legal,
accounting and consulting services, insurance, occupancy and communication costs
are also included with general and administrative expenses.  The
dollar decrease of $104,000 is comprised of the following major
components:





·
            Decrease in stock-based
      compensation expense of approximately $112,000 due to the expiration of
      certain restricted stock grants combined with lower expenses recorded
      pursuant to SFAS No. 123(R) due to the expiration of vesting periods
      for certain prior year share-based payment
    issuances.





·
            Decrease in insurance
      related expenses of approximately
  $22,000.





·
            Decrease in professional
      services of approximately
$86,000.





·
            Decrease in bad debt expenses of
      approximately $25,000.





·
            Decrease in supplies and other
      office related expenses of approximately
  $21,000.





·
            Increase
      in compensation and related fringe benefits of approximately
      $62,000.


·
              Increase
      in royalty and license expense of $100,000 due to the write down of
      certain prepaid royalties to estimatednet realizable
      value.





We are
continuing to focus our efforts on achieving additional future operating
efficiencies by reviewing and improving upon existing business processes and
evaluating our cost structure. We believe these efforts will allow us to
gradually decrease our level of general and administrative expenses expressed as
a percentage of total revenues.





Sales and
Marketing.  Sales and marketing expenses consist primarily of
the salaries, commissions, other incentive compensation, employee benefits and
travel expenses of our sales, marketing, business development and product
management functions.  The dollar decrease of $296,000 during the nine
months ended September 30, 2008 as compared to the corresponding period in 2007
reflects headcount reductions due to the elimination and consolidation of
various sales positions resulting in lower personnel related expenses of
approximately $128,000, lower advertising and trade show expenses of
approximately $74,000, lower travel expenses of approximately $44,000, lower
stock-based compensation expense of approximately $32,000 and lower other office
related expenses of approximately $18,000.





Research
and Development.Research and development
expenses consist primarily of salaries, employee benefits and outside
contractors for new product development, product enhancements and custom
integration work. Such expenses decreased 12% or $328,000 for the nine months
ended September 30, 2008 as compared to the corresponding period in
2007.  The decrease reflects reductions in contract programming
expenditures of approximately $535,000 offset by increases in facilities related
expenditures and supplies of approximately $110,000 and increases in salaries
and employee benefits of approximately $97,000 due primarily to increased
headcount necessary for the continued development of our Biometric Engine, the
development of our Personal Identity Verification (PIV) solution, the web
enablement of our CCS product line, and the development of our IWS desktop
security solution.  Our level of expenditures in research and
development reflects our belief that to maintain our competitive position in
markets characterized by rapid rates of technological advancement, we must
continue to invest significant resources in new systems and software as well as
continue to enhance existing products.




29


Depreciation and
Amortization.  During the nine months ended September 30, 2008,
depreciation and amortization expense increased 195% or $389,000 as compared to
the corresponding period in 2007.  The increase in depreciation and
amortization expense reflects higher amortization of approximately $387,000 for
certain definite long-lived intangible assets acquired in the Company’s
December 2007 purchase of certain assets of Sol Logic, Inc. offset by
reduced depreciation expense due to fully depreciated fixed assets.





Interest Expense
(Income), net.  For the nine months ended September 30,
2008, we recognized interest income of $10,000 and interest expense of $11,000.
For the nine months ended September 30, 2007, we recognized interest income
of $23,000 and interest expense of $259,000.  Interest expense for the
nine months ended September 30, 2007 contains three components
approximating $248,000 related to our secured notes payable which were paid in
full in March 2007: $19,000 of coupon interest, $213,000 in note discount
amortization and $16,000 in deferred financing fee amortization classified as
interest expense.





LIQUIDITY
AND CAPITAL RESOURCES




As of
September 30, 2008, we had total current assets of $1,167,000 and total
current liabilities of $6,610,000, or negative working capital of $5,443,000. At
September 30, 2008, we had available cash of $427,000. In 2009, we secured
a line of credit facility through the issuance of a secured promissory note
whereby we borrowed an aggregate amount of approximately $2,325,000 and
subsequently repaid $350,000. In 2009, we also undertook a series of warrant
financings whereby we raised approximately $1,371,000 in
cash.  Despite securing these financing arrangements, we still have
negative working capital and will need to secure additional new financing to
fund working capital and operations should we be unable to generate positive
cash flow from operations in the near future.





Net cash
used in operating activities was $1,759,000 for the nine month period ended
September 30, 2008 as compared to $1,080,000 for the corresponding period
in 2007. We used cash to fund net losses of $3,691,000, excluding non-cash
expenses (depreciation, amortization, prepaid royalty impairment, reduction in
exit activities reserve, and stock-based compensation) of $1,102,000 for the
nine months ended September 30, 2008. We used cash to fund net losses of
$2,381,000, excluding non-cash expenses (depreciation, amortization, debt
issuance costs, debt discount, stock-based compensation and provision for losses
on accounts receivable and investment in marketable securities less reductions
in inventory obsolescence reserves) of $1,018,000 for the nine months ended
September 30, 2007. For the nine months ended September 30, 2008, we
used cash of $83,000 through reductions in current assets and generated cash of
$1,915,000 through increases in current liabilities and deferred revenues,
excluding debt. For the nine months ended September 30, 2007, we generated
cash of $998,000 through reductions in current assets and generated cash of
$303,000 through increases in current liabilities and deferred revenues,
excluding debt.





Net cash
used in investing activities was $124,000 for the nine months ended
September 30, 2008. Net cash used in investing activities was $68,000 for
the nine months ended September 30, 2007. For the nine months ended
September 30, 2008, we used cash to fund capital expenditures of computer
equipment, software and furniture and fixtures of approximately $69,000. This
level of equipment purchases resulted primarily from the replacement of older
equipment. We also used cash of approximately $187,000 for our acquisition of
Sol Logic, Inc. For the nine months ended September 30, 2008, we generated
cash of $132,000 from the release of a collateral requirement on an irrevocable
standby letter of credit which was secured by a certificate of
deposit.  For the nine months ended September 30, 2007, we used
cash to fund capital expenditures of computer equipment and software, furniture
and fixtures and leasehold improvements of approximately $68,000.





Net cash
provided by financing activities was $1,293,000 for the nine month period ended
September 30, 2008 as compared to $3,680,000 for the corresponding period
in 2007. For the nine months ended September 30, 2008, we generated cash of
$542,000 from our issuance of common stock pursuant to warrant exercises and
used cash of $25,000 for the payment of dividends on our Series B Preferred
Stock. We also generated cash of $776,000 from our issuance of Series D
Preferred Stock net of direct transaction costs of approximately
$34,000.  For the nine months ended September 30, 2007, we
generated cash of $1,327,000 from our issuance of preferred stock in a private
placement net of direct transaction costs of $173,000. We also generated cash of
$1,121,000 from our issuance of common stock pursuant to warrant exercises and
$2,621,000 from our issuance of common stock in a private placement net of
direct transaction costs of $404,000. For the nine months ended
September 30, 2007, we used cash of $1,310,000 for the repayment of our
secured notes payable and used cash of $54,000 from the incurrence of financing
related expenses.  We also used cash of $25,000 for the payment of
dividends on our Series B Preferred Stock.





The report of our independent
accountants included with our Annual Report on Form 10-K as filed with the
Commission on April 15, 2008, contained an explanatory paragraph regarding
the substantial doubt of our ability to continue as a going concern. We are
seeking additional financing that we believe is necessary to fund our working
capital requirements for at least the next twelve months in conjunction with the
successful implementation of our business plan. Our business plan includes,
among other things, the monitoring and controlling of operating expenses,
collection of significant trade and other accounts receivable, and controlling
of capital expenditures. We may seek to sell equity or debt securities,
secure a bank line of credit, or consider strategic alliances. The sale of
equity or equity-related securities could result in additional dilution to our
shareholders. There can be no assurance that additional financing, in any form,
will be available at all or, if available, will be on terms acceptable to
us.




30


On
May 5, 2008 the Company’s common stock was delisted from AMEX. In May of
2008, the AMEX removed the Company’s common stock from being listed on their
exchange as we failed to comply with AMEX’s continued listing
standards.  In December of 2008 our common stock was removed from
being quoted on the Over-the-Counter Bulletin Board as we failed to make the
required filings with the SEC in the required timeframe.  As of the
end of the third quarter of 2008, we were faced with limited funds for
operations and were compelled to suspend SEC filings and the associated costs
until such time as the Company had sufficient resources to cover ongoing
operations and the expenses of maintaining compliance with SEC filing
requirements.   There is no assurance that we will be able to
attain compliance with SEC filing requirements in the future, and if we are able
to attain compliance, there is no assurance we will be able to maintain
compliance.  If we are not able to attain and maintain compliance for
minimum required periods, we will not be eligible for re-listing on the
Over-the-Counter Bulletin Board or other exchanges.





The delisting could adversely affect
the public price of our common stock and limit the Company’s stockholders’
ability to dispose of, or to obtain accurate quotations as to the prices of the
Company’s common stock. Moreover, the Company’s ability to obtain financing on
favorable terms, or at all, may be adversely affected by the delisting because
certain institutional investors that have policies against investments in
companies that are not traded on a national securities exchange and other
investors may refrain from purchasing the Company’s common stock because of the
delisting. The Company’s ability to obtain financing may also be more limited in
numerous states because the Company will no longer benefit from state exemptions
from registration which are dependent upon the listing of the Company’s common
stock on AMEX. Insufficient funds will require us to sell certain of our
assets or license or technologies to others and if we are unable to obtain
additional funding there is substantial doubt about our ability to continue as a
going concern.





ITEM
4T. CONTROLS AND PROCEDURES





Conclusions
Regarding the Effectiveness of 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 our
disclosure controls and procedures as such term is defined under
Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934,
as amended. Based on this evaluation, our principal executive officer and
principal financial officer have concluded, based upon their evaluation as of
the end of the period covered by this report, that our disclosure controls and
procedures were effective as of September 30, 2008. There has been no
change in our internal control over financial reporting that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting during the three months ended September 30, 2008.
As of the end of the third quarter of 2008, we were faced with limited funds for
operations and were compelled to suspend SEC filings. Management has determined
that this late filing situation was due to shortages in capital resources and is
not related to internal controls over financial reporting.




Changes in
Internal Control over Financial Reporting.There has been no change in
our internal control over financial reporting during the fiscal quarter ended
September 30, 2008, that has materially affected, or is reasonably likely
to materially affect, our internal control over financial
reporting.





PART II





ITEM
1A. RISK FACTORS





Our
results of operations and financial condition are subject to numerous risks and
uncertainties described in our Annual Report on Form 10-K for our fiscal
year ended December 31, 2007, filed on April 15, 2008 and as amended
on April 30, 2008 and incorporated herein by reference. You should
carefully consider these risk factors in conjunction with the other information
contained in this report. Should any of these risks materialize, our business,
financial condition and future prospects could be negatively impacted. As of
September 30, 2008, there have been no material changes to the disclosures
made on the above-referenced Form 10-K, as amended, except as
follows:





OUR
COMMON STOCK IS NO LONGER LISTED ON THE AMEX OR THE OVER-THE-COUNTER BULLETIN
BOARD AND IS NOW TRADED ON THE PINK SHEETS.





In May of 2008 the AMEX removed
ImageWare’s common stock from being listed on their exchange as we failed to
comply with AMEX’s continued listing standards.  In December of 2008
our common stock was removed from being quoted on the Over-the-Counter Bulletin
Board as we failed to make the required filings with the SEC in the required
timeframe.  As of the end of the third quarter of 2008 we were faced
with limited funds for operations and were compelled to suspend SEC filings and
the associated costs until such time as we had sufficient resources to cover
ongoing operations and the expenses of maintaining compliance with SEC filing
requirements.   There is no assurance that we will be able to
attain compliance with SEC filing requirements in the future, and if we are able
to attain compliance, there is no assurance we will be able to maintain
compliance.  If we are not able to attain and maintain compliance for
minimum required periods, we will not be eligible for re-listing on the
Over-the-Counter Bulletin board or other exchanges.




31


WE
HAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALING APPROXIMATELY $86.2
MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.





As of
September 30, 2008, we had an accumulated deficit of $86.2 million,
and these losses may continue in the future. We will need to raise
capital to cover these losses, and financing may not be available to us on
favorable terms. In the event financing is not available, in the time frame
required, we will be forced to sell certain of our assets or license our
technologies to others. We expect to continue to incur significant sales and
marketing, research and development, and general and administrative expenses. As
a result, we will need to generate significant revenues to achieve profitability
and we may never achieve profitability.





WE
HAVE HAD AND CONTINUE TO HAVE NEGATIVE WORKING CAPITAL BALANCES WHICH INCLUDE
SIGNIFICANT CREDITOR BALANCES THAT ARE PAST DUE.





As of
September 30, 2008 we had accounts payable of $2.3 million, much of which were
past due.  There is no assurance that the company’s creditors will continue
to work with the Company and allow us to pursue our business plan to achieve
positive working capital balances and bring our creditor accounts
current.





THE
HOLDERS OF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS AND PRIVILEGES THAT ARE
SENIOR TO THE COMMON STOCK, AND WE MAY ISSUE ADDITIONAL SHARES OF PREFERRED
STOCK WITHOUT SHAREHOLDER APPROVAL THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON
THE MARKET VALUE OF THE COMMON STOCK.





Our Board
of Directors has the authority to issue a total of up to 4,000,000 shares of
preferred stock and to fix the rights, preferences, privileges, and
restrictions, including voting rights, of the preferred stock, which typically
are senior to the rights of the common stockholders, without any further vote or
action by the common stockholders. The rights of our common shareholders will be
subject to, and may be adversely affected by, the rights of the holders of the
preferred stock that have been issued, or might be issued in the future.
Preferred stock also could have the effect of making it more difficult for a
third party to acquire a majority of the outstanding voting stock of ImageWare.
This could delay, defer, or prevent a change in control. Furthermore, holders of
preferred stock may have other rights, including economic rights, senior to the
common stock. As a result, their existence and issuance could have a material
adverse effect on the market value of the common stock. We have in the past
issued and may from time to time in the future issue, preferred stock for
financing or other purposes with rights, preferences, or privileges senior to
the common stock. At September 30, 2008 we had three series of preferred
stock outstanding, Series B preferred stock, Series C 8% convertible
preferred stock and Series D 8% convertible preferred stock.





The
provisions of our Series B Preferred Stock prohibit the payment of
dividends on the common stock unless the dividends on those preferred shares are
first paid. In addition, upon liquidation, dissolution or sale of ImageWare’s
business, the holders of the Series B Preferred Stock will be entitled to
receive, in preference to any distribution to the holders of common stock,
initial distributions of $2.50 per share, plus all accrued but unpaid
dividends.  Pursuant to the terms of our Series B Preferred Stock we
are obligated to pay cumulative cash dividends on shares of Series B
Preferred Stock from legally available funds at the annual rate of $0.2125 per
share, payable in two semi-annual installments of $0.10625 each, which
cumulative dividends must be paid prior to payment of any dividend on our common
stock. As of September 30, 2008, the Company had cumulative undeclared dividends
on the Series B Preferred Stock of approximately $21,000.





The
Series C Preferred Stock has a liquidation preference equal to its stated
value, plus any accrued and unpaid dividends thereon and any other fees or
liquidated damages owing thereon. The Series C Preferred Stock accrues
cumulative dividends at the rate of 8.0% of the stated value per share per
annum.  At the option of the Company, the dividend payment may be made in
the form of cash, after the payment of cash dividends to the holders of
Series B Preferred Stock, or common stock issuable upon conversion of the
Series C Preferred Stock.  Each share of Series C Preferred Stock
is convertible at any time at the option of the holder into a number of shares
of common stock equal to the stated value (initially $1,000 per share, subject
to adjustment), plus any accrued and unpaid dividends, divided by the conversion
price (initially $1.50 per share, subsequently adjusted to $0.50 and subject to
further adjustment). Subject to certain limitations, the conversion price per
share shall be adjusted in the event of certain subsequent stock dividends,
splits, reclassifications, dilutive issuances, rights offerings, and
reclassifications.  The Series C Preferred Stock generally does not
have voting rights except as required by law, however, certain activities may
not be undertaken by the Company without the affirmative vote of a majority of
the holders of the outstanding shares of Series C Preferred Stock. As of
September 30, 2008, the Company had cumulative undeclared dividends on the
Series C Preferred Stock of approximately $359,000.





The
Series D Preferred Stock has a liquidation preference equal to its stated
value, plus any accrued and unpaid dividends thereon and any other fees or
liquidated damages owing thereon. The Series D Preferred Stock accrues
cumulative dividends at the rate of 8.0% of the stated value per share per
annum.  At the option of the Company, the dividend payment may be made in
the form of cash, after the payment of cash dividends to the holders of
Series B and Series C Preferred Stock, or common stock issuable upon
conversion of the Series D Preferred Stock.  Each share of
Series D Preferred Stock is convertible at any time at the option of the
holder into a number of shares of common stock equal to the stated value
(initially $1,000 per share, subject to adjustment), plus any accrued and unpaid
dividends, divided by the conversion price (initially $1.90 per share,
subsequently adjusted to $0.50 per share and subject to further adjustment).
Subject to certain limitations, the conversion price per share shall be adjusted
in the event of certain subsequent stock dividends, splits, reclassifications,
dilutive issuances, rights offerings, and reclassifications.  The
Series D Preferred Stock generally does not have voting rights except as
required by law, however, certain activities may not be undertaken by the
Company without the affirmative vote of a majority of the holders of the
outstanding shares of Series C Preferred Stock. As of September 30,
2008, the Company had cumulative undeclared dividends on the Series D
Preferred Stock of approximately $186,000.




32


ITEM
6. EXHIBITS





(a)
            
            EXHIBITS31.1
            
            Certification
      of the Principal Executive Officer pursuant to
      Rule 13a-14(a) and 15d-14(a)31.2
            
            Certification
      of the Principal Financial and Accounting Officer pursuant to
      Rule 13a-14(a) and 15d-14(a)32.1
            
            Certification
      by the Principal Executive Officer and Principal Financial and Accounting
      Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906
      of the Sarbanes-Oxley Act of 2002











SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned hereunto
duly authorized.





IMAGEWARE
      SYSTEMS, INC.,

                a
      Delaware corporationDate: 
      February 24, 2010
              By:
              /s/ Wayne
      G. WetherellWayne
      G. Wetherell
                Chief
      Financial Officer