**U.S.SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-QSB**

 

**(Mark One)**

 

**ý****          ****QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended September 30, 2005**

 

**o****          ****TRANSITION REPORT UNDER SECTION 13 OR 15(d) OFTHE EXCHANGE ACT**

 

**For the transition periodfrom         to        **

 

**Commission file number 001-15757**

 

**IMAGEWARESYSTEMS, INC.**

(Exact Name of Small Business Issuer as Specified in Its Charter)

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

 

**10883 Thornmint RoadSan Diego, CA 92127**

(Address of Principal Executive Offices)

 

**(858) 673-8600**

(Issuer’s Telephone Number, Including Area Code)

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes ý  No o

 

Indicate by check mark whether the registrant is a shell company (asdefined  in Rule 12b-2 of theExchange Act).  Yes  o No ý

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date: As of November 11, 2005, thenumber of outstanding shares of the Registrant’s common stock, par value $.01,was 13,547,662.

 

TransitionalSmall Business Disclosure Format (check one) Yes o  No ý

 

 

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**IMAGEWARE SYSTEMS, INC. INDEX**

 
| PART I.  | FINANCIAL INFORMATION |                                                                                                                                    |
|---------------|-----------------------|-----------------------------------------------------------------------------------------------------------------------------------------|
|          | ITEM 1.               | FINANCIAL STATEMENTS (UNAUDITED)                                                                                                        |   |
|          |                  | Condensed Consolidated Balance Sheets as of September 30,  2005 and December 31, 2004                                         |   |
|          |                  | Condensed Consolidated Statements of Operations for  the three and nine months ended September 30, 2005 and 2004                   |   |
|          |                  | Condensed Consolidated Statements of Cash Flows for the  nine months ended September 30, 2005 and 2004                             |   |
|          |                  | Condensed Consolidated Statements of Comprehensive  Income (Loss) for the three and nine months ended September 30, 2005 and  2004 |   |
|          |                  | Notes to Condensed Consolidated Financial Statements                                                                                    |   |
|          | ITEM 2.               | Management’s Discussion and Analysis or Plan of  Operation                                                                         |   |
|          | ITEM 3.               | Controls and Procedures                                                                                                                 |   |
|          |                  |                                                                                                                                    |   |
| PART II. | OTHER  INFORMATION    |                                                                                                                                    |
|          | ITEM 6.               | EXHIBITS AND REPORTS ON FORM 8-K                                                                                                   |   |
|          |                  |                                                                                                                                    |   |
| SIGNATURES    |                  |                                                                                                                                    |

 

2

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**PART I**

**FINANCIAL INFORMATION**

 

**ITEM 1.FINANCIAL STATEMENTS**

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS)**

 
| ** **                                                                                                                                                                                                                                                                                                                                            | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                            | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Current Assets:                                                                                                                                                                                                                                                                                                                                       |       |                         |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                                                  |       | $                            | 2,230      |                        | $          | 2,912 |   |
| Accounts receivable, net                                                                                                                                                                                                                                                                                                                              |       | 1,716                        |       | 1,797                       |       |
| Inventory                                                                                                                                                                                                                                                                                                                                             |       | 611                          |       | 1,097                       |       |
| Other current assets                                                                                                                                                                                                                                                                                                                                  |       | 244                          |       | 247                         |       |
| Total Current Assets                                                                                                                                                                                                                                                                                                                                  |       | 4,801                        |       | 6,053                       |       |
|                                                                                                                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                                                           |       | 496                          |       | 510                         |       |
| Other assets                                                                                                                                                                                                                                                                                                                                          |       | 811                          |       | 734                         |       |
| Intangible assets, net of accumulated amortization                                                                                                                                                                                                                                                                                                    |       | 541                          |       | 764                         |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                              |       | 4,661                        |       | 5,298                       |       |
| **Total  Assets**                                                                                                                                                                                                                                                                                                                                     | ** ** | **$**                        | **11,310** | ** **                  | **$**      | **13,359** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                      |       | $                            | 721        |                        | $          | 1,229 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                      |       | 1,150                        |       | 1,045                       |       |
| Billings in excess of costs and estimated  earnings on uncompleted contracts                                                                                                                                                                                                                                                                          |       | —                       |       | 424                         |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                      |       | 953                          |       | 1,565                       |       |
| Notes & advances payable to bank  and third parties                                                                                                                                                                                                                                                                                          |       | 2                            |       | 18                          |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                                                                             |       | 2,826                        |       | 4,281                       |       |
|                                                                                                                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                                                    |       | 783                          |       | 812                         |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                                     |       | 3,609                        |       | 5,093                       |       |
|                                                                                                                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Preferred stock, $.01 par value, authorized  4,000,000 shares Series B convertible redeemable preferred stock,  designated 750,000 shares, 389,400 shares issued, and 249,400 shares  outstanding at September 30, 2005 and December 31, 2004,  liquidation preference $623,500 at September 30, 2005 and December 31,  2004 |       | 2                            |       | 2                           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 13,554,366 shares issued and 13,547,662 and 11,962,385  shares outstanding at September 30, 2005 and December 31, 2004,  respectively                                                                                                                                          |       | 134                          |       | 118                         |       |
| Additional paid in capital                                                                                                                                                                                                                                                                                                                            |       | 67,650                       |       | 63,789                      |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                                                |       | (64                          | )          | (64                         | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                                                                                |       | 93                           |       | 334                         |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                   |       | (60,114                      | )          | (55,913                     | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                                                                                       |       | 7,701                        |       | 8,266                       |       |
|                                                                                                                                                                                                                                                                                                                                                  |       |                         |       |                        |       |
| **Total  Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                                                                  | ** ** | **$**                        | **11,310** | ** **                  | **$**      | **13,359** | ** ** |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)**

**(UNAUDITED)**

 
| ** **                                                                                                               | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| **Revenues:**                                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Product                                                                                                                  |       | $                                          | 1,981      |                                      | $          | 1,295 |   | $ | 5,744 |   | $ | 5,194 |   |
| Maintenance                                                                                                              |       | 524                                        |       | 495                                       |       | 1,545 |   | 1,397 |   |
|                                                                                                                     |       | 2,505                                      |       | 1,790                                     |       | 7,289 |   | 6,591 |   |
| **Cost of revenues:**                                                                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Product                                                                                                                  |       | 613                                        |       | 208                                       |       | 2,068 |   | 1,162 |   |
| Maintenance                                                                                                              |       | 255                                        |       | 236                                       |       | 750 |   | 663 |   |
| Gross profit                                                                                                             |       | 1,637                                      |       | 1,346                                     |       | 4,471 |   | 4,766 |   |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| **Operating expenses:**                                                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| General & administrative                                                                                        |       | 1,162                                      |       | 1,130                                     |       | 3,524 |   | 3,372 |   |
| Sales and marketing                                                                                                      |       | 955                                        |       | 996                                       |       | 2,719 |   | 2,510 |   |
| Research & development                                                                                          |       | 855                                        |       | 614                                       |       | 2,342 |   | 1,969 |   |
| Depreciation and amortization                                                                                            |       | 147                                        |       | 172                                       |       | 460 |   | 534 |   |
|                                                                                                                     |       | 3,119                                      |       | 2,912                                     |       | 9,045 |   | 8,385 |   |
| Loss from operations                                                                                                     |       | (1,482                                     | )          | (1,566                                    | )          | (4,574 | ) | (3,619 | ) |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense (income), net                                                                                           |       | (31                                        | )          | (1                                        | )          | (42 | ) | 5,188 |   |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Other income, net                                                                                                        |       | (86                                        | )          | (12                                       | )          | (135 | ) | (41 | ) |
| Loss from continuing operations before income taxes                                                                      |       | (1,365                                     | )          | (1,553                                    | )          | (4,397 | ) | (8,766 | ) |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Income tax expense (benefit)                                                                                             |       | —                                     |       | —                                    |       | — |   | — |   |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Loss from continuing operations                                                                                          |       | (1,365                                     | )          | (1,553                                    | )          | (4,397 | ) | (8,766 | ) |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Discontinued operations:                                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Gain (loss) from operations of discontinued  Digital Imaging Asia Component (including gain on disposal of $233 in 2005) |       | —                                     |       | 49                                        |       | 223 |   | 31 |   |
| Income tax benefit (expense)                                                                                             |       | —                                     |       | —                                    |       | — |   | — |   |
| Gain (loss) on discontinued operations                                                                                   |       | —                                     |       | 49                                        |       | 223 |   | 31 |   |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                                                                                 |       | $                                          | (1,365     | )                                         | $          | (1,504 | ) | $ | (4,174 | ) | $ | (8,735 | ) |
|                                                                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted loss per common share - see note 2                                                                     |       | $                                          | (0.10      | )                                         | $          | (0.13 | ) | $ | (0.34 | ) | $ | (0.75 | ) |
| Weighted-average shares (basic and diluted)                                                                              |       | 13,209,856                                 |       | 11,940,359                                |       | 12,456,194 |   | 11,659,626 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                                                      | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                                            |       |                                      |       |   |   |
| **Cash flows from operating activities**                                        |       |                                      |       |   |   |
| Net loss                                                                        |       | $                                         | (4,174     | ) | $ | (8,735 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities     |       |                                      |       |   |   |
| Depreciation and amortization                                                   |       | 462                                       |       | 547 |   |
| Gain on sale of subsidiary                                                      |       | (233                                      | )          | — |   |
| Non cash interest and amortization of debt  discount and debt issuance costs    |       | —                                    |       | 4,472 |   |
| Stock based compensation                                                        |       | 209                                       |       | 269 |   |
| Change in assets and liabilities                                                |       |                                      |       |   |   |
| Accounts receivable, net                                                        |       | 2                                         |       | 63 |   |
| Inventory                                                                       |       | 244                                       |       | (321 | ) |
| Other current assets                                                            |       | (15                                       | )          | (91 | ) |
| Intangible and other assets                                                     |       | 41                                        |       | (16 | ) |
| Accounts payable                                                                |       | (499                                      | )          | (202 | ) |
| Accrued expenses                                                                |       | (464                                      | )          | 96 |   |
| Deferred revenue                                                                |       | 105                                       |       | 50 |   |
| Contract costs                                                                  |       | (424                                      | )          | — |   |
| Pension obligation                                                              |       | (28                                       | )          | 83 |   |
| Total adjustments                                                               |       | (600                                      | )          | 4,950 |   |
| Net cash used by operating activities                                           |       | (4,774                                    | )          | (3,785 | ) |
|                                                                            |       |                                      |       |   |   |
| **Cash flows from investing activities**                                        |       |                                      |       |   |   |
| Purchase of property and equipment                                              |       | (244                                      | )          | (126 | ) |
| Restricted cash and cash equivalents                                            |       | —                                    |       | 48 |   |
| Proceeds from sale of subsidiary net of  cash sold and direct transaction costs |       | 1,209                                     |       | — |   |
| Payment on advances from related  stockholders                                  |       |                                      |       | (59 | ) |
| Net cash provided (used) by investing  activities                               |       | 965                                       |       | (137 | ) |
|                                                                            |       |                                      |       |   |   |
| **Cash flows from financing activities**                                        |       |                                      |       |   |   |
| Repayment of notes payable                                                      |       | (17                                       | )          | (47 | ) |
| Proceeds from issuance of common stock, net  of issuance costs                  |       | 3,234                                     |       | 6,054 |   |
| Proceeds from exercised stock options                                           |       | 63                                        |       | 483 |   |
| Dividends paid                                                                  |       | (26                                       | )          | (185 | ) |
|                                                                            |       |                                      |       |   |   |
| Net cash provided by financing activities                                       |       | 3,254                                     |       | 6,305 |   |
| Effect of exchange rate changes on cash                                         |       | (127                                      | )          | (29 | ) |
| Net increase (decrease) in cash                                                 |       | (682                                      | )          | 2,354 |   |
|                                                                            |       |                                      |       |   |   |
| Cash at beginning of period                                                     |       | 2,912                                     |       | 578 |   |
|                                                                            |       |                                      |       |   |   |
| Cash at end of period                                                           |       | $                                         | 2,230      |   | $ | 2,932 |   |
|                                                                            |       |                                      |       |   |   |
| Supplemental disclosure of cash flow information:                               |       |                                      |       |   |   |
| Summary of non-cash investing and financing  activities:                        |       |                                      |       |   |   |
| Exchange of common shares for marketable  equity securities                     |       | $                                         | 231        |   | $ | — |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

5

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME(LOSS)**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                                   | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                     |       | $                                          | (1,365     | )                                         | $          | (1,504 | ) | $ | (4,174 | ) | $ | (8,735 | ) |
| Other comprehensive income (loss):                           |       |                                       |       |                                      |       |   |   |   |   |
| Unrealized loss on securities:                               |       |                                       |       |                                      |       |   |   |   |   |
| Unrealized holding gains (losses) arising  during the period |       | 15                                         |       | —                                    |       | (113 | ) | — |   |
|                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Foreign currency translation adjustment                      |       | (1                                         | )          | 26                                        |       | (126 | ) | (28 | ) |
| Comprehensive loss                                           |       | $                                          | (1,351     | )                                         | $          | (1,478 | ) | $ | (4,413 | ) | $ | (8,763 | ) |

 

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

 

**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1.  DESCRIPTION OFBUSINESS AND OPERATIONS**

 

ImageWareSystems, Inc. (the “Company”), formerly known as ImageWare Software, Inc.,was incorporated in the State of California on February 6, 1987. TheCompany utilizes digital imaging technology to provide stand alone, networkedand web-based software solutions for secure credentials, biometrics, law enforcementand professional photography.

 

*Basis of Presentation*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting period. Actual results could differ from those estimates.

 

Theaccompanying condensed consolidated unaudited financial statements of ImageWarehave been prepared pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly,they do not include all of the information and footnotes required by generallyaccepted accounting principles for annual financial statements and should beread in conjunction with the consolidated financial statements for the yearended December 31, 2004, and notes thereto included in the Company’sAnnual Report on Form 10-KSB, filed with the SEC on March 31, 2005.In the opinion of management, the accompanying condensed consolidated financialstatements contain all adjustments, consisting only of adjustments of a normalrecurring nature, necessary for a fair presentation of the Company’s financialposition as of September 30, 2005, and its results of operations for theperiods presented. These condensed consolidated unaudited financial statementsare not necessarily indicative of the results to be expected for the entireyear.

 

Asmore fully explained in Note 5 to these condensed consolidated financialstatements, prior period financial statements for the three and nine monthsended September 30, 2004, have been restated to present the operations ofthe Company’s wholly-owned subsidiary, Digital Imaging Asia Pacific as adiscontinued operation due to this subsidiary’s sale in March 2005.

 

 

*Liquidity and Capital Resources*

 

Asreflected in the accompanying condensed consolidated financial statements, theCompany has losses and negative cash flows from operations.  The condensed consolidated financialstatements included in this report have been 

 

6

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preparedassuming that the Company will continue as a going concern.

 

Asmore fully described in Note 7 to these condensed consolidated financialstatements, in July 2005, the Company completed a private placement of itscommon stock.  The Company received netproceeds of approximately $3.3 million, however, additional financing may berequired to fund working capital and operations should the Company be unable togenerate positive cash flow from operations in the near future. The Company mayconsider the possible sale of equity securities and/or debt financing, however,there can be no assurance that financing , if required, will be available underterms and conditions that are acceptable to the Company.  In the event financing is not available inthe time frame required, the Company will be forced to reduce its rate ofgrowth, if any, reduce operating expenses, curtail sales and marketingactivities and reschedule research and development projects. In addition,the Company might be required to sell certain of its assets or license itstechnologies to others. These actions, while necessary for the continuance ofoperations during a time of cash constraints and a shortage of working capital,could adversely affect the Company’s business.

 

TheCompany operates in markets that are emerging and highly competitive. There isno assurance that the Company will operate at a profit in the future.

 

7

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*Stock-Based Compensation*

 

Stock-basedcompensation to employees has been recognized as the difference between the pershare fair value of the underlying stock and the stock option exercise price atthe initial grant date.  The cost ofstock options granted for services, other than those issued to employees, arerecorded at the fair value of the stock option.

 

Hadcompensation cost for the Company’s stock option plan been determined based onthe fair value at the grant date for awards consistent with the provisions ofStatement of Financial Accounting Standards. (“SFAS”) No. 123, Accountingfor Stock-Based Compensation, the Company’s net losses would have beenincreased to the pro forma amount indicated below for the three and nine monthsended September 30, 2005 and 2004:

 
| ** **                                                       | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                       | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Net Loss:                                                        |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                      |       | $                                          | (1,365     | )                                         | $          | (1,504 | ) | $ | (4,174 | ) | $ | (8,735 | ) |
| Stock-based compensation included in net  loss                   |       | 70                                         |       | 187                                       |       | 209 |   | 269 |   |
| Stock based employee compensation under  fair value based method |       | (196                                       | )          | (283                                      | )          | (480 | ) | (631 | ) |
| Pro forma net loss                                               |       | $                                          | (1,491     | )                                         | $          | (1,600 | ) | $ | (4,445 | ) | $ | (9,097 | ) |
|                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Basic loss per common share:                                     |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                      |       | $                                          | (0.10      | )                                         | $          | (0.13 | ) | $ | (0.34 | ) | $ | (0.76 | ) |
| Pro forma                                                        |       | $                                          | (0.11      | )                                         | $          | (0.14 | ) | $ | (0.36 | ) | $ | (0.78 | ) |

 

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

 

8

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Inaccordance with Financial Accounting Standards Board Interpretation No. 44— Accounting for Certain Transactions Involving Stock Compensation (“FIN 44”),the Company will recognize stock-based compensation expense ratably over thevesting period of the restricted stock. Such compensation expense was $70,000 and $209,000 for the three and ninemonths ended September 30, 2005, respectively, and $187,000 and $269,000for the three and nine months ended September 30, 2004, respectively.  The higher expenses in the three and ninemonths ended September 30, 2004 result from the full vesting of therestricted stock upon the termination of certain participants.

 

*Recently Issued Accounting Standards*

 

InNovember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 151, “Inventory Costs, an amendmentof ARB No. 43, Chapter 4” (“SFAS 151”), which is effective beginning January 1,2006.  SFAS 151 requires that abnormalamounts of idle facility expense, freight, handling costs and wasted materialbe recognized as current period charges. The Statement also requires that the allocation of fixed productionoverhead be based on the normal capacity of the production facilities.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.

 

InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS123R”), which is effective beginning July 1, 2005.  On April 15, 2005, the Securities andExchange Commission announced that companies may implement SFAS No 123R at thebeginning of their next fiscal year following June 15, 2005.  The Company expects to adopt the revised rules onJanuary 1, 2006.  SFAS 123R requiresall share-based payments to employees to be expensed over the requisite serviceperiod based on the grant-date fair value of the awards.  The Statement allows for either prospectiveor retrospective adoption and requires that the unvested portion of alloutstanding awards upon adoption be recognized using the same fair value and attributionmethodologies previously determined under Statement No 123, “Accounting forStock-Based Compensation.”  The Companyis currently evaluating transition alternatives and valuation methodologies forfuture grants.  As a result, pro formacompensation expense, as reflected in Note 1, may not be indicative of futureexpense to be recognized under SFAS 123R. The effect of adoption of 123R on the Company’s financial position orresults of operations has not yet been determined.

 

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

 

InApril 2005, the FASB issued Interpretation No. 47, “Accounting forConditional Asset Retirement Obligations”, which clarifies that an entity isrequired to recognize a liability for the fair value of a conditional assetretirement obligation when incurred if the liability’s fair value can bereasonably estimated. The fair value of a liability for the conditional assetretirement obligation should be recognized when incurred, which is generallyupon acquisition, construction, or development and (or) through the normal operationof the asset. Uncertainty about the timing and (or) method of settlement of aconditional asset retirement obligation should be factored into the measurementof the liability when sufficient information exists.  Interpretation No. 47 is effective nolater than the end of fiscal years beginning after December 15, 2005. Weare currently evaluating the effect of this pronouncement.

 

InJune 2005, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 154, “Accounting Changes and ErrorCorrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”(SFAS154).  This Statement replaces APBOpinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  This Statement requiresretrospective application to financial statements of prior periods for changesin accounting principle. This Statement is effective January 1, 2006.  This standard has no impact on the Company’sfinancial statements.

 

Certainreclassifications have been made to the prior period balances in order toconform to the current period presentation.

 

9

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**NOTE 2.  NET LOSS PERCOMMON SHARE**

 

Basicloss per common share is calculated by dividing net loss available to commonshareholders for the period by the weighted-average number of common sharesoutstanding during the period. Diluted earnings per common share is calculatedby dividing net loss available to common shareholders for the period by theweighted-average number of common shares outstanding during the period,adjusted to include, if dilutive, potential dilutive shares consisting ofconvertible preferred stock, stock options and warrants, calculated using thetreasury stock method. During the periods ended September 30, 2005 and2004, the Company has excluded the following securities from the calculation ofdiluted loss per share, as their effect would have been antidilutive due to theCompany’s net loss:

 
| **Potential  Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  September 30, 2005** | ** ** | **Number of  Common Shares  Convertible into at  September 30, 2004** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
|                                |       |                                                                       |       |                                                                       |       |
| Convertible preferred stock         |       | 47,280                                                                     |       | 47,280                                                                     |       |
| Stock options                       |       | 1,352,175                                                                  |       | 461,993                                                                    |       |
| Warrants                            |       | 4,469,578                                                                  |       | 6,319,650                                                                  |       |

 

Thefollowing table sets forth the computation of basic and diluted loss per sharefor the three and nine month periods ended September 30, 2005 and 2004(amounts in thousands except share and per share amounts):

 
| ** **                                                            | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator – loss from continuing operations:                     |       |                                       |       |                                      |       |   |   |   |   |
| Net loss from continuing operations                                   |       | $                                          | (1,365     | )                                         | $          | (1,553 | ) | $ | (4,397 | ) | $ | (8,766 | ) |
| Less Series B preferred dividends                                |       | (13                                        | )          | (13                                       | )          | (40 | ) | (40 | ) |
| Net loss from continuing operations  available to common shareholders |       | $                                          | (1,378     | )                                         | $          | (1,566 | ) | $ | (4,437 | ) | $ | (8,806 | ) |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Numerator – gain (loss) from discontinued operations:            |       |                                       |       |                                      |       |   |   |   |   |
| Net gain (loss) discontinued operations                               |       | —                                     |       | 49                                        |       | 223 |   | 31 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Denominator                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average shares outstanding                                   |       | 13,209,856                                 |       | 11,940,359                                |       | 12,456,194 |   | 11,659,626 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted loss per share:                                     |       |                                       |       |                                      |       |   |   |   |   |
| Loss from continuing operations                                       |       | $                                          | (0.10      | )                                         | $          | (0.13 | ) | $ | (0.36 | ) | $ | (0.76 | ) |
| Discontinued operations                                               |       | —                                     |       | —                                    |       | 0.02 |   | — |   |
| Net loss per share                                                    |       | $                                          | (0.10      | )                                         | $          | (0.13 | ) | $ | (0.34 | ) | $ | (0.76 | ) |

 

**NOTE 3.  SEGMENTINFORMATION**

 

TheCompany is comprised of three reportable segments: Law Enforcement,Identification and Digital Photography. The Law Enforcement segment develops,sells and supports a suite of modular software products and designs systemsused by law enforcement and public safety agencies to manage criminal historyrecords and investigate crime. The Identification segment develops, sells andsupports software and designs systems which utilize digital imaging in theproduction of photo identification cards, documents and identification badgingsystems. The Digital Photography segment develops digital imaging software forphotographic purposes.

 

Corporateassets are comprised primarily of cash and other assets providing benefits toall business segments.  Corporaterevenues are comprised of patent licensing fees.

 

Thereare no significant intersegment transactions.

 

10

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Thetable below summarizes information about reportable segments for the three and ninemonths ended September 30, 2005 and 2004:

 
| ** **                   | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                   | ** ** | **(in thousands)  (unaudited)**            | ** ** | **(in thousands)  (unuadited)**           | ** ** |
| Net Revenue:                 | * *   | * *                                   | * *   | * *                                  | * *   | * * | * * | * * | * * |
| Law Enforcement              |       | $                                          | 719        |                                      | $          | 809 |   | $ | 2,326 |   | $ | 3,386 |   |
| Identification               |       | 1,123                                      |       | 811                                       |       | 4,144 |   | 2,734 |   |
| Digital Photography          |       | 163                                        |       | 170                                       |       | 319 |   | 471 |   |
| Corporate                    |       | 500                                        |       | —                                    |       | 500 |   | — |   |
| Total consolidated net sales |       | $                                          | 2,505      |                                      | $          | 1,790 |   | $ | 7,289 |   | $ | 6,591 |   |
|                         |       |                                       |       |                                      |       |   |   |   |   |
| Operating income (loss):     |       |                                       |       |                                      |       |   |   |   |   |
| Law Enforcement              |       | $                                          | (971       | )                                         | $          | (359 | ) | $ | (2,547 | ) | $ | 45 |   |
| Identification               |       | (903                                       | )          | (884                                      | )          | (2,031 | ) | (2,851 | ) |
| Digital Photography          |       | (108                                       | )          | (323                                      | )          | (496 | ) | (813 | ) |
| Corporate                    |       | 500                                        |       | —                                    |       | 500 |   | — |   |
|                         |       |                                       |       |                                      |       |   |   |   |   |
| Other unallocated amounts:   |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense (income)    |       | (31                                        | )          | (1                                        | )          | (42 | ) | 5,188 |   |
| Other income                 |       | (86                                        | )          | (12                                       | )          | (135 | ) | (41 | ) |
|                         |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) before taxes   |       | $                                          | (1,365     | )                                         | $          | (1,553 | ) | $ | (4,397 | ) | $ | (8,766 | ) |

 
| ** **                           | ** ** | **September 30,  2005** | ** ** |
|--------------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**           | ** ** |
| Total Assets by Segment:             |       |                         |       |
|                                 |       |                         |       |
| Law Enforcement                      |       | $                            | 751        |   |
| Identification                       |       | 6,109                        |       |
| Digital Photography                  |       | 1,403                        |       |
| Total assets for reportable segments |       | 8,263                        |       |
| Corporate                            |       | 3,047                        |       |
| Total consolidated assets            |       | $                            | 11,310     |   |

 

**NOTE 4.  INVESTMENTS**

 

Inconjunction with the sale of the Company’s wholly-owned subsidiary, as morefully described in Note 5 to these condensed consolidated financial statements,the Company and Argus Solutions Ltd, each agreed to purchase $250,000 of eachothers common stock at a per share price equal to 108% of the closing price ofeach others’ stock as determined by the American Stock Exchange and AustralianStock Exchange, respectively.  As legalconsideration, each Company paid the other cash of $250,000.  The Company and Argus consummated thetransaction through the exchange of common shares.  The Company exchanged 71,225 shares of itscommon stock for 1,929,914 shares of common stock of Argus Solutions Ltd.,which represents approximately one percent of the voting equity of Argus.    In accordance with Statement of FinancialAccounting Standards No. 153, “Exchange of Nonmonetary Assets, anamendment of APB Opinion No. 29” (“SFAS 153), the Company has recordedthis transaction as a nonmonetary exchange based on the fair value of theshares exchanged as determined by the closing price of the Company’s shares onthe American Stock Exchange on the transaction date of $3.25 or $231,000.

 

11

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Inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 115“Accounting for Certain Investments in Debt and Equity Securities” and based onour intentions regarding these instruments, we classify marketable equitysecurities into trading or available-for-sale categories.  Marketable securities that are bought andheld principally for the purpose of selling them in the near term areclassified as trading securities and are reported at fair value, withunrealized gains and losses recognized in earnings.  Marketable securities not classified astrading are classified as available-for-sale and are carried at fair marketvalue, with the unrealized gains and losses, net of tax, included in thedetermination of comprehensive income and reported in shareholders’equity.  Marketable equity securities areincluded in other non-current assets.  AtSeptember 30, 2005, the Company had classified $118,000 asavailable-for-sale marketable securities. These securities are reported at fair value as determined through quotedmarket sources.  Unrealized gain or losson these investments is recorded as a component of accumulated othercomprehensive income, net of tax and amounted to a loss of $113,000 and $0 at September 30,2005 and 2004, respectively.

 

**NOTE 5.  SALE OFSUBSIDIARY**

 

OnMarch 3, 2005, the Company sold its wholly-owned Singapore subsidiary,Digital Imaging Asia Pacific Pte. Ltd., for cash of $1,300,000.  The Company decided to sell this subsidiaryas part of its overall strategic partnership with Argus Solutions Ltd (“Argus”),as a means of strengthening its position in the Asia-Pacific region.  In conjunction with this strategy, theCompany entered into an International Distributor Agreement with Argus pursuantto which Argus will distribute the Company’s biometric engine, law enforcementand secure credential solutions in the Asia-Pacific region, excluding Japan andKorea, for a period of three years. Argus will pay the Company a minimum license fee during the first threeyears of $1,400,000; $200,000 in year one; $400,000 in year two and $800,000 inyear three.  In accordance with theprovisions of Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”)regarding fee determination and collectibility criteria, we recognized revenuesof $50,000 and $117,000 for the three and nine month periods ended September 30,2005, respectively and recorded deferred revenues of $33,000 as of September 30,2005 related to this minimum license fee.

 

Inaccordance with SFAS 144, this subsidiary, previously included in the Company’sIdentification segment, is treated as a discontinued operation.  The net loss for this subsidiary for thethree and nine months ended September 30, 2005 and 2004 are reflected inthe Company’s condensed Consolidated Statement of Operations as loss fromdiscontinued operations.  Included in the2005 loss results is a gain on sale of subsidiary of $233,000 net of directtransaction costs of $49,000 and including the allocation of $637,000 ofgoodwill.

 

Theassets and liabilities sold as part of the transaction included the following:

 
| Cash                                           |   | $       | 41,000    |   |
|------------------------------------------------|--------|---------|-----------|--------|
| Accounts receivable                            |   | 80,000  |      |
| Inventories                                    |   | 242,000 |      |
| Prepaid expenses and other current assets      |   | 18,000  |      |
| Property and equipment, net                    |   | 17,000  |      |
| Goodwill                                       |   | 637,000 |      |
|                                           |   | $       | 1,035,000 |   |
|                                           |   |    |      |
| Accounts payable and other current liabilities |   | $       | 17,000    |   |

 

DigitalImaging Asia Pacific’s sales, reported in discontinued operations, for thethree months ended September 30, 2005 and 2004 were $0 and $217,000,respectively.  Digital Imaging AsiaPacific’s sales for the nine months ended September 30, 2005 and 2004 were$42,000 and $458,000, respectively. Digital Imaging Asia Pacific’s pretax loss, reported in discontinuedoperations, for the three months ended September 30, 2005 and 2004, were$0 and $49,000 respectively.   DigitalImaging Asia Pacific’s pretax loss, reported in discontinued operations for thenine months ended September 30, 2005 was $10,000.  Digital Imaging Asia Pacific’s pretax incomefor the nine months ended 2004, was $31,000.  Prior period financial statements for the three and nine months ended September 30,2004 have been restated to present the operations of Digital Imaging AsiaPacific as a discontinued operation.

 

12

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**NOTE 6.  RELATEDPARTIES**

 

Subsequentto the Company’s sale of its wholly-owned subsidiary, Digital Imaging AsiaPacific Pte. Ltd., to Argus Solutions Ltd (“Argus’), as more fully described inNote 5 to these condensed consolidated financial statements, the Company’sChief Executive Officer accepted an invitation to become a member of Argus’Board of Directors.  Prior to the closingof the Company’s sale transaction with Argus, the Company had no materialrelationship with Argus Solutions.

 

**NOTE 7.  COMMON STOCK**

 

DuringJuly 2005, the Company completed a Securities Purchase Agreement for thesale of 1,397,287 units to 18 accredited investors, each unit consisting of oneshare of common stock and a warrant to purchase 0.38 shares of commonstock.  The purchasers paid $2.58 perunit.  The warrants have a five-year termand exercise price of $3.45 per share. At closing, the Company issued an aggregate 1,397,287 new shares ofcommon stock plus warrants to purchase up to 530,998 shares of common stock.  The Company evaluated these warrantsaccording to the provisions of Emerging Issues Task Force (“EITF”) Issue No.00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially settled in, a Company’s Own Stock”, and determined that thewarrants meet the criteria of this Issue requiring equity classification.

 

Inconnection with these transactions, we are required to issue to the finderswarrants to purchase an additional 104,796 shares of common stock and pay afinder’s fee of approximately $281,000 in cash. The fair value of the warrants issued to the finders was approximately$170,000 as determined by the Black-Sholes option pricing model with thefollowing assumptions: risk free interest rate of 2.90%; dividend yield of 0%;volatility factor of the expected market price of the Company’s common stock of82%; and an expected life of the of warrant of 5 years.  The fair value of the warrant was charged toadditional paid in capital as a reduction of the offering proceeds.

 

Weraised approximately $3.6 million from this private placement, and afterpayment of expenses, received net proceeds of approximately $3.3 million.

 

Aspart of the Securities Purchase Agreement, the Company agreed to register theshares of common stock with the Securities and Exchange Commission (“theCommission’) within certain contractually specified time periods.  The Company also agreed to use its bestefforts to keep the registration statement continuously effective until theearlier of either the fifth year after the date the registration statement isdeclared effective by the Commission or the date when all the common stock,including the common stock underlying the warrants have been sold.

 

The Company has evaluated the provisions ofthe registration rights agreement according to Emerging Issues Task Force (“EITF”)Issue 05-04: The Effect of a Liquidated Damages Clause on a FreestandingFinancial Instrument Subject to EITF Issue No. 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially settled in, aCompany’s Own Stock”, and determined that the liquidated damage clause containedwithin the registration rights agreements meets the criteria of EITF 05-04requiring equity classification.

 

TheCompany is restricted as to the use of the net proceeds received from the saleof units under the Securities Purchase Agreement to working capital requirements.  The Company has not used any of the netproceeds for the payment of any portion of the Company’s debt (other than tradepayables and accrued expenses in the ordinary course of the Company’s business),to redeem any Company equity or equity-equivalent securities or to settle anyoutstanding litigation.

 

Duringthe three months ended September 30, 2005, the Company issued 3,125 sharesof common stock pursuant to stock option exercises.  The Company also issued 36,192 shares ofcommon stock to certain individuals pursuant to the stock option exchangeagreement more fully explained in Note 1 to these condensed consolidatedfinancial statements.

 

**NOTE 8.  PATENT LICENSINGREVENUES**

 

OnSeptember 30, 2005, the Company completed a limited, exclusive agreementwith an unaffiliated company whereby the Company granted a perpetual license toutlize the Company’s patent (number 5,577,179, entitled  “Image Editing System”) within certainspecified fields of use.  Asconsideration for the license, the Company is to receive $500,000, $50,000 uponexecution of the agreement and the remainder due by December 1, 2005.  In addition, the Company is to receive 35% ofall consideration the licensee receives the sublicense of the patent.  In connection with this transaction, theCompany has recorded $500,000 as revenue for the thee and nine months ended September 30,2005.

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOR PLAN OF OPERATION.**

 

ThisQuarterly Report on Form 10-QSB contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, and Section 21Eof the Securities Exchange Act of 1934. All forward-looking statements includedin 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 andother 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-lookingstatements. Factors that could cause or contribute to such differences includebut are not limited to those items discussed under “Risk Factors” beginning on page 26and elsewhere in this Quarterly Report.

 

Thefollowing discussion of the financial condition and results of operationsshould be read in conjunction with the condensed consolidated financialstatements included elsewhere within this quarterly report. Fluctuations inannual and quarterly results may occur as a result of factors affecting demandfor our products such as the timing of new product introductions by us and byour competitors and our customers’ political and budgetary constraints. Due tosuch fluctuations, historical results and percentage relationships are notnecessarily indicative of the operating results for any future period.

 

**OVERVIEW**

 

ImageWareSystems, Inc. utilizes its imaging technology to develop software used tocreate booking and investigative software, smart and secure identificationsystems and documents, and software for professional photographers. Oursoftware systems and associated hardware enable our customers to quicklycapture, archive, search, retrieve and share digital photographs and associatedtext records.  The following management’sdiscussion and analysis is based primarily upon our Law Enforcement,Identification and Digital Photography segments.  Results as presented for our Identificationsegment do not contain the results of our wholly-owned subsidiary, DigitalImaging Asia Pacific, due to this component of our Identification segment beingclassified as discontinued operations due to the sale of this subsidiary duringthe first fiscal quarter of 2005.

 

14

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**RESULTS OF OPERATIONS**

 

***THREE MONTHS ENDED SEPTEMBER  30,2005 AND 2004.***

 
| ** **                              | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net  Product Revenues**               | ** ** | **2005**                                    | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                    |       |                                        |       |       |       |              |       |   |   |
| **Product revenues:**                   |       |                                        |       |       |       |              |       |   |   |
| Law Enforcement                         |       | $                                           | 225        |       | $          | 328               |       | $ | (103 | ) | (31 | )% |
| Percentage of total net product revenue |       | 11                                          | %          | 25         | %          |              |       |   |   |
| Identification                          |       | $                                           | 1,106      |       | $          | 805               |       | $ | 301 |   | 37 | % |
| Percentage of total net product revenue |       | 56                                          | %          | 62         | %          |              |       |   |   |
| Digital Photography                     |       | $                                           | 150        |       | $          | 162               |       | $ | (12 | ) | (7 | )% |
| Percentage of total net product revenue |       | 8                                           | %          | 13         | %          |              |       |   |   |
| Patent Licensing                        |       | $                                           | 500        |       | $          | —            |       | $ | 500 |   | 100 | % |
| Percentage of total net product revenue |       | 25                                          | %          | 0          | %          |              |       |   |   |
| Total net product revenues              |       | $                                           | 1,981      |       | $          | 1,295             |       | $ | 686 |   | 53 | % |

 

Webelieve that the decrease in Law Enforcement product revenues is reflective ofa decrease in state and local government procurement.  We further believe that continued incidentsof terrorism has created heightened interest in the ability of law enforcementand other government agencies to be able to efficiently retrieve, analyze andshare information from their respective criminal databases.  We anticipate that these factors willincrease the overall demand for our law enforcement products and software;however, we cannot predict the timing of the shift in demand.

 

Domestically,Identification revenues increased approximately $252,000 or 40% for the threemonths ended September 30, 2005 as compared to the corresponding period in2004.  This increase in domestic revenueis reflective of an increase in project-oriented work.  Internationally, our Identification revenues increasedapproximately $49,000.  We continue to beof the opinion that government agencies and private entities will react toheightened security concerns resulting from acts of terrorism by re-evaluatingand upgrading their ability to positively identify and track their citizens,employees, consultants and visitors. We anticipate that these factors willincrease overall demand for our identification products; however, we cannotpredict the timing of the shift in demand.

 

Wefeel that we are well positioned for participation in one or more large-scaledomestic or international projects which will enable us to achieve significantproduct revenue growth in our identification segment.  In the past twelve months we have retooledour identification products to enable customization for large projectapplications, added the biometric engine for incorporation into large scalebiometric installations and reoriented our organization to direct our resourcesand capabilities toward establishing a foothold in the market for large-scalesecure identification solutions.

 

Thedecrease in Digital Photography product revenues is due to both lower customcontract programming and lower sales of boxed software during the three monthsended September 30, 2005 as compared to the comparable period of2004.  We believe this decrease is due toour customers delaying purchasing decisions until the next version of ourDigital Photography software is released. The Company has devoted substantial research and development resourcesto upgrading the Digital Photography software boxed products and released newversions of our School Days+ program midway through the thirdquarter.  We  remain optimistic that the release of theseenhanced products during the third fiscal quarter of 2005 will positivelyimpact Digital Photography product revenues.

 

Wegenerated revenues of $500,000 from sublicensing our Image Editing Systempatent within the computer video,  webconferencing and cellular phone fields of use.

 

Ourbacklog of product orders as of September 30, 2005 was approximately $1,406,000.  At September 30, 2005, we also hadmaintenance and support backlog of approximately $992,000 under existingmaintenance agreements.  Product revenueis typically recognized within a three to six month time period depending uponthe required degree of customization, if any. Historically, we have experienced a very minimal risk of ordercancellation.  Our revenue from maintenanceagreements is generally recognized ratably over the respective maintenanceperiods provided no significant obligations remain and collectibility of therelated receivable is probable.

 

15

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| ** **                                  | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2005**                                    | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                 | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                        |       |                                        |       |       |       |              |       |   |   |
| **Maintenance revenues:**                   |       |                                        |       |       |       |              |       |   |   |
| Law Enforcement                             |       | $                                           | 494        |       | $          | 481               |       | $ | 13 |   | 3 | % |
| Percentage of total net maintenance revenue |       | 94                                          | %          | 97         | %          |              |       |   |   |
| Identification                              |       | $                                           | 17         |       | $          | 6                 |       | $ | 11 |   | 183 | % |
| Percentage of total net maintenance revenue |       | 3                                           | %          | 1          | %          |              |       |   |   |
| Digital Photography                         |       | $                                           | 13         |       | $          | 8                 |       | $ | 5 |   | 56 | % |
| Percentage of total net maintenance revenue |       | 3                                           | %          | 2          | %          |              |       |   |   |
| Total net maintenance revenues              |       | $                                           | 524        |       | $          | 495               |       | $ | 29 |   | 6 | % |

 

Theincrease in Law Enforcement maintenance revenues is due to the expansion of ourinstalled base in the Law Enforcement market.

 

Theincrease in Identification maintenance revenues is due to software maintenanceon domestic identification projects.  Weshifted our strategy in late 2003 to outsource international service andmaintenance for hardware.  This shift hasenabled us to reduce costs and focus our resources on expanding ourinternational sales effort of Digital Identification, Biometric, LawEnforcement and Digital Photography solutions.

 

Ourincrease in Digital Photography maintenance revenues as compared to thecorresponding period in 2004 is reflective of software maintenance on customcontract programming projects completed subsequent to the third quarter of2004.

 
| ** **                                         | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost  of Product Revenues:**                     | ** ** | **2005**                                    | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                        | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                               |       |                                        |       |       |       |              |       |   |   |
| **Cost of Product Revenues:**                      |       |                                        |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                           | 137        |       | $          | 175               |       | $ | (38 | ) | (21 | )% |
| Percentage of Law Enforcement product  revenue     |       | 61                                          | %          | 53         | %          |              |       |   |   |
| Identification                                     |       | $                                           | 470        |       | $          | 27                |       | $ | 443 |   | 1642 | % |
| Percentage of Identification product  revenue      |       | 43                                          | %          | 3          | %          |              |       |   |   |
| Digital Photography                                |       | $                                           | 6          |       | $          | 6                 |       | $ | — |   | — |   |
| Percentage of Digital Photography product  revenue |       | 4                                           | %          | 4          | %          |              |       |   |   |
| Patent Licensing                                   |       | $                                           | —     |       | $          | —            |       | $ | — |   | — |   |
| Percentage of Patent Licensing product  revenue    |       | 0                                           | %          | 0          | %          |              |       |   |   |
| Total net product revenues                         |       | $                                           | 613        |       | $          | 208               |       | $ | 405 |   | 195 | % |
| Percentage of total product revenues               |       | 31                                          | %          | 16         | %          |              |       |   |   |

 

Overallcost of product revenues as a percentage of product revenues increasedprimarily due to higher sales of hardware and consumables (which have highercosts than software only solutions) resulting in higher costs of sales as apercentage of product revenues.

 

Theincrease in the cost of product revenues for our Law Enforcement segmentincreased as a percentage of product revenues due primarily to the smallerrevenue base to absorb fixed product costs and product mix with a higherpercentage of hardware and consumables sales for the three months ended September 30,2005 as compared to the corresponding period in 2004.  The 2004 period contained anuncharacteristically high percentage of software only solutions.  Costs of products can vary as a percentage ofproduct revenue from period to period depending upon product mix and thehardware content, print media consumable content and software content includedin systems installed during a given period.

 

16

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Thedollar increase in the cost of product revenues related to our Identificationsegment is reflective of higher domestic Identification revenues.   The percentage increase in Identificationcost of revenues as a percentage of Identification revenues from 3% for thethree months ended September 30, 2004 to 43% for the corresponding periodin 2005 is reflective primarily of higher domestic identification revenues fromproject-oriented work which included costs for equipment, third-party softwarelicenses and contract programming fees for software customization than thecomparable three months ended September 30, 2004.  Costs of products can vary as a percentage ofproduct revenue from period to period depending upon product mix and thehardware content, print media consumable content and software content includedin systems installed during a given period.

 
| ** **                                              | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  cost of revenues**                       | ** ** | **2005**                                    | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|                                                    |       |                                        |       |       |       |              |       |   |   |
| **Maintenance cost of revenues:**                       |       |                                        |       |       |       |              |       |   |   |
| Law Enforcement                                         |       | $                                           | 236        |       | $          | 214               |       | $ | 22 |   | 10 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 48                                          | %          | 44         | %          |              |       |   |   |
| Identification                                          |       | $                                           | 19         |       | $          | 22                |       | $ | (3 | ) | (14 | )% |
| Percentage of Identification maintenance  revenue       |       | 112                                         | %          | 367        | %          |              |       |   |   |
| Digital Photography                                     |       | $                                           | —     |       | $          | —            |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue  |       | —                                      | %          | —     | %          | —            |       | N/A |   |
| Total net maintenance revenues                          |       | $                                           | 255        |       | $          | 236               |       | $ | 19 |   | 8 | % |
| Percentage of total maintenance revenues                |       | 49                                          | %          | 48         | %          |              |       |   |   |

 

Thedollar increase in costs of maintenance revenues is reflective of higher costsnecessary to service our expanding installed base.

 
| ** **                                         | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product  gross profit (dollars in thousands)**   | ** ** | **2005**                                    | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|                                               |       |                                        |       |       |       |              |       |   |   |
| **Product gross profit**                           |       |                                        |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                           | 87         |       | $          | 153               |       | $ | (66 | ) | (43 | )% |
| Percentage of Law Enforcement product  revenue     |       | 39                                          | %          | 47         | %          |              |       |   |   |
| Identification                                     |       | $                                           | 637        |       | $          | 778               |       | $ | (141 | ) | (18 | )% |
| Percentage of Identification product  revenue      |       | 57                                          | %          | 97         | %          |              |       |   |   |
| Digital Photography                                |       | $                                           | 144        |       | $          | 156               |       | $ | (12 | ) | (8 | )% |
| Percentage of Digital Photography product  revenue |       | 96                                          | %          | 96         | %          |              |       |   |   |
| Patent Licensing                                   |       | $                                           | 500        |       | $          | —            |       | $ | 500 |   | 100 | % |
| Percentage of Patent Licensing product  revenue    |       | 100                                         | %          | N/A        |       |              |       |   |   |
| Total net product revenues                         |       | $                                           | 1,368      |       | $          | 1,087             |       | $ | (281 | ) | (26 | )% |
| Percentage of total product revenues               |       | 69                                          | %          | 84         | %          |              |       |   |   |

 

Totalproduct gross profit as a percentage of product revenues decreased primarilydue to lower product sales and a higher percentage of total revenues comingfrom the sales of hardware and consumables which have higher costs thansoftware only solutions.

 

17

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LawEnforcement gross profit as a percentage of Law Enforcement product revenuedecreased due primarily to our product mix containing higher percentages ofhardware (which have higher costs than software only solutions) than thecomparable period in 2004 which had an uncharacteristically high percentage ofsoftware.  Also contributing to thisdecrease is a smaller revenue base available to absorb fixed productcosts.  Costs of products can vary as apercentage of product revenue from quarter to quarter depending upon productmix and hardware content and print media consumable content included in systemsinstalled during a given period.

 

Identificationgross profit as a percentage of Identification product revenue decreased dueprimarily to our product mix containing higher percentages of hardware andconsumables (which have higher costs than software only solutions) than thecomparable period in 2004.  Costs ofproducts can vary as a percentage of product revenue from quarter to quarterdepending upon product mix and hardware content and print media consumable contentincluded in systems installed during a given period.

 

Thedecrease of $81,000 in gross profit from the Digital Photography productsegment is reflective of our lower custom contract programming in the threemonths ended September 30, 2005, as compared to the corresponding periodin 2004, combined with lower sales of boxed software.  The increase in Digital Photography grossprofit as a percentage of Digital Photography product revenues is reflective ofthe sale of certain hardware components (which have higher costs than softwareonly solutions) during the 2004 period.

 
| ** **                                             | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  gross profit**                          | ** ** | **2005**                                    | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                            | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                   |       |                                        |       |       |       |              |       |   |   |
| **Maintenance gross profit**                           |       |                                        |       |       |       |              |       |   |   |
| Law Enforcement                                        |       | $                                           | 258        |       | $          | 267               |       | $ | (9 | ) | (3 | )% |
| Percentage of Law Enforcement maintenance  revenue     |       | 52                                          | %          | 56         | %          |              |       |   |   |
| Identification                                         |       | $                                           | (2         | )          | $          | (16               | )          | $ | 14 |   | (88 | )% |
| Percentage of Identification maintenance  revenue      |       | (12                                         | )%         | (267       | )%         |              |       |   |   |
| Digital Photography                                    |       | $                                           | 13         |       | $          | 8                 |       | $ | 5 |   | 68 | % |
| Percentage of Digital Photography  maintenance revenue |       | 100                                         | %          | 100        | %          |              |       |   |   |
| Total net maintenance revenues                         |       | $                                           | 269        |       | $          | 259               |       | $ | 10 |   | 4 | % |
| Percentage of total maintenance revenues               |       | 51                                          | %          | 52         | %          |              |       |   |   |

 

Grossmargins related to maintenance revenues increased due primarily to highermaintenance revenues to absorb fixed maintenance costs.

 
| ** **                        | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating  expenses**           | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**       | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                              |       |                                       |       |       |       |              |       |   |   |
| General & administrative |       | $                                          | 1,162      |       | $          | 1,130             |       | $ | 32 |   | 3 | % |
| Percentage of total net revenue   |       | 46                                         | %          | 63         | %          |              |       |   |   |
| Sales and marketing               |       | $                                          | 955        |       | $          | 996               |       | $ | (41 | ) | (4 | )% |
| Percentage of total net revenue   |       | 38                                         | %          | 56         | %          |              |       |   |   |
| Research & development   |       | $                                          | 855        |       | $          | 614               |       | $ | 241 |   | 39 | % |
| Percentage of total net revenue   |       | 34                                         | %          | 34         | %          |              |       |   |   |
| Depreciation and amortization     |       | $                                          | 147        |       | $          | 172               |       | $ | (25 | ) | (15 | )% |
| Percentage of total net revenue   |       | 6                                          | %          | 10         | %          |              |       |   |   |

 

18

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*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses.  The decrease insuch expenses, as a percentage of total net revenues, is reflective of highertotal net revenues during the three months ended September 30, 2005 ascompared to the corresponding period in 2004. We are continuing to focus our efforts on achieving additional futureoperating efficiencies by reviewing and improving upon existing businessprocesses and evaluating our cost structure. We believe these efforts willallow us to gradually decrease our level of general and administrative expensesexpressed as a percentage of total revenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce.   The decrease in such expenses,as a percentage of total net revenues, is reflective of higher total netrevenues during the three months ended September 30, 2005 as compared tothe corresponding period in 2004.  Thedollar decrease of $41,000 is due primarily to reduced payments to salesconsultants.  We anticipate that expensesfor sales and marketing will increase through 2005 as we add personnel andresources for large project solution sales.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased due primarilyto the continued development of our Biometric Engine, the web enablement of ourCCS product, development of our IWS Desktop Security program and productenhancements to our Digital Photography software product suite utilizingcontract programming services in conjunction with internal research anddevelopment resources.   Our level ofexpenditures in research and development reflects our belief that to maintainour competitive position in markets characterized by rapid rates oftechnological advancement, we must continue to invest significant resources innew systems and software as well as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decrease is due primarily to loweramortization of intangible assets due to such assets being fully amortized.

 

*INTEREST (INCOME) EXPENSE, NET.*  Forthe three months ended September 30, 2005, we recognized interest incomeof $32,000 and interest expense of $1,000. For the three months ended September 30,2004, we recognized interest income of $4,000 and interest expense of$3,000.  Interest income for the threemonths ended September 30, 2005 was primarily due to interest earned andcollected pursuant to various software licensing agreements.

 

***NINE MONTHS ENDED SEPTEMBER  30,2005 AND 2004.***

 
| ** **                              | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net  Product Revenues**               | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**             | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                    |       |                                       |       |       |       |              |       |   |   |
| **Product revenues:**                   |       |                                       |       |       |       |              |       |   |   |
| Law Enforcement                         |       | $                                          | 855        |       | $          | 2,022             |       | $ | (1,167 | ) | (58 | )% |
| Percentage of total net product revenue |       | 15                                         | %          | 39         | %          |              |       |   |   |
| Identification                          |       | $                                          | 4,108      |       | $          | 2,710             |       | $ | 1,398 |   | 52 | % |
| Percentage of total net product revenue |       | 72                                         | %          | 52         | %          |              |       |   |   |
| Digital Photography                     |       | $                                          | 281        |       | $          | 462               |       | $ | (181 | ) | (39 | )% |
| Percentage of total net product revenue |       | 5                                          | %          | 9          | %          |              |       |   |   |
| Patent Licensing                        |       | $                                          | 500        |       | $          | —            |       | $ | 500 |   | 100 | % |
| Percentage of total net product revenue |       | 8                                          | %          | N/A        |       |              |       |   |   |
| Total net product revenues              |       | $                                          | 5,744      |       | $          | 5,194             |       | $ | 550 |   | 11 | % |

 

Webelieve that the decrease in Law Enforcement product revenues is reflective ofa decrease in state and local government procurement.  We further believe that continued incidentsof terrorism has created heightened interest in the ability of law enforcementand other government agencies to be able to efficiently retrieve, analyze andshare information from their respective criminal databases.  We anticipate that these factors willincrease the overall demand for our law enforcement products and software;however, we cannot predict the timing of the shift in demand.

 

19

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Domestically,Identification revenues increased approximately $1,429,000, or 71%.  This increase in domestic Identificationproduct revenue is reflective of sales of our Biometric Engine andidentification software products into project-oriented work and an increase inboxed software and consumables sold through distribution channels.  In June of 2004, we terminated ourmaster distributor model because it did not produce the results we anticipatedand we re-established direct sales to our distribution channel.  Internationally, our Identification revenuesdecreased approximately $31,000, or 4%.  This decrease is reflective of the repositioning of our internationalsales office in Germany to lower fixed costs and this office’s pursuit ofsignificant Identification projects utilizing the Company’s softwaretechnologies as our primary differentiator. This office had historically emphasized the resale of third partymerchandise (hardware and consumables) which generated lower gross margins thansoftware (as a percentage of revenue) and required significant fixed costs forsales, service and support.  We feel thatthe foreign markets served by this office will embrace our identification andbiometric solutions for large-scale high-end installations.  We continue to be of the opinion that governmentagencies and private entities will react to heightened security concernsresulting from acts of terrorism by re-evaluating and upgrading their abilityto positively identify and track their citizens, employees, consultants andvisitors. We anticipate that these factors will increase overall demand for ouridentification products; however, we cannot predict the timing of the shift indemand.

 

Wefeel that we are well positioned for participation in one or more large-scaledomestic or international projects which will enable the Company to achievesignificant product revenue growth in our identification segment.  In the past twelve months we have retooledour identification products to enable customization for large projectapplications, added the biometric engine for incorporation into large scalebiometric installations and reoriented our organization to direct our resourcesand capabilities toward establishing a foothold in the market for large-scalesecure identification solutions.

 

DigitalPhotography product revenues decreased due to our customers delaying purchasingdecisions until the next version of our Digital Photography software isreleased.  We have devoted substantialresearch and development resources to upgrading the Digital Photography softwareboxed products and remains optimistic that the release of these enhancedproducts during the third fiscal quarter of 2005 will positively impact DigitalPhotography product revenues.

 

Wegenerated revenues of $500,000 from sublicensing our Image Editing Systempatent within the computer video,  webconferencing and cellular phone fields of use.

 
| ** **                                  | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                        |       |                                       |       |       |       |              |       |   |   |
| **Maintenance revenues:**                   |       |                                       |       |       |       |              |       |   |   |
| Law Enforcement                             |       | $                                          | 1,471      |       | $          | 1,364             |       | $ | 107 |   | 8 | % |
| Percentage of total net maintenance revenue |       | 95                                         | %          | 97         | %          |              |       |   |   |
| Identification                              |       | $                                          | 36         |       | $          | 24                |       | $ | 12 |   | 51 | % |
| Percentage of total net maintenance revenue |       | 2                                          | %          | 2          | %          |              |       |   |   |
| Digital Photography                         |       | $                                          | 38         |       | $          | 9                 |       | $ | 29 |   | 320 | % |
| Percentage of total net maintenance revenue |       | 3                                          | %          | 1          | %          |              |       |   |   |
| Total net maintenance revenues              |       | $                                          | 1,545      |       | $          | 1,397             |       | $ | 148 |   | 11 | % |

 

Lawenforcement maintenance revenues increased due to the expansion of ourinstalled base in the Law Enforcement market.

 

Identificationmaintenance revenues increased due to software maintenance on domesticidentification projects.  We shifted ourstrategy in late 2003 to outsource international service and maintenance forhardware.  This shift has enabled us toreduce costs and focus our resources on expanding our international saleseffort of Digital Identification, Biometric, Law Enforcement and DigitalPhotography solutions.

 

20

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Ourincrease in Digital Photography maintenance revenues is reflective of softwaremaintenance on custom contract programming projects completed subsequent to thesecond quarter of 2004.

 
| ** **                                         | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost  of Product Revenues:**                     | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                        | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                               |       |                                       |       |       |       |              |       |   |   |
| **Cost of Product Revenues:**                      |       |                                       |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                          | 544        |       | $          | 515               |       | $ | 29 |   | 6 | % |
| Percentage of Law Enforcement product  revenue     |       | 64                                         | %          | 25         | %          |              |       |   |   |
| Identification                                     |       | $                                          | 1,514      |       | $          | 608               |       | $ | 906 |   | 149 | % |
| Percentage of Identification product  revenue      |       | 37                                         | %          | 22         | %          |              |       |   |   |
| Digital Photography                                |       | $                                          | 10         |       | $          | 39                |       | $ | (29 | ) | (75 | )% |
| Percentage of Digital Photography product  revenue |       | 3                                          | %          | 8          | %          |              |       |   |   |
| Patent Licensing                                   |       | $                                          | —     |       | $          | —            |       | $ | — |   |   |   |
| Percentage of Patent Licensing product revenue     |       | —                                     | %          | —     | %          |              |       |   |   |
| Total net product revenues                         |       | $                                          | 2,068      |       | $          | 1,162             |       | $ | 906 |   | 78 | % |
| Percentage of total product revenues               |       | 36                                         | %          | 22         | %          |              |       |   |   |

 

Totalcost of product revenues as a percentage of product revenues increased dueprimarily to product mix with a greater percentage of product revenues beingfrom sales of hardware and consumables (which have higher costs than softwareonly solutions) resulting in higher cost of sales as a percentage of productrevenues.

 

Costof product revenues for our Law Enforcement segment increased as a percentageof product revenues due primarily to the smaller revenue base to absorb fixedproduct costs and product mix with a higher percentage of hardware sales.  The dollar increase of $29,000 for the ninemonth period ended September 30, 2005, as compared with the correspondingperiod of 2004, despite lower law enforcement revenues for the nine month endedSeptember 30, 2005, is reflective of an uncharacteristically highpercentage of software only solutions for the nine months ended September 30,2004.   Costs of products also can varyas a percentage of product revenue from period to period depending upon productmix and the hardware content, print media consumable content and softwarecontent included in systems installed during a given period.

 

Costof product revenues related to our Identification segment increased because ofhigher domestic Identification revenues. The percentage increase in Identification cost of revenues as apercentage of Identification revenues is reflective primarily of higherdomestic Identification revenues from project-oriented work which includedcosts for equipment, third-party software licenses and contract programmingfees for software customization than the comparable nine months ended September 30,2004.    Costs of products also can varyas a percentage of product revenue from period to period depending upon productmix and the hardware content, print media consumable content and softwarecontent included in systems installed during a given period.

 

Costof product revenues related to our Digital Photography segment decreased due tolower Digital Photography sales during the nine months ended September 30,2005, as compared to the corresponding period in 2004 and to the sale ofcertain hardware components in the 2004 period as compared to software onlysales during the comparable period in 2005.

 
| ** **                                              | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  cost of revenues**                       | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                              | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Maintenance cost of revenues:**                       |       |                                       |       |       |       |              |       |   |   |
| Law Enforcement                                         |       | $                                          | 697        |       | $          | 599               |       | $ | 98 |   | 16 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 47                                         | %          | 44         | %          |              |       |   |   |
| Identification                                          |       | $                                          | 53         |       | $          | 64                |       | $ | (11 | ) | (17 | )% |
| Percentage of Identification maintenance  revenue       |       | 147                                        | %          | 267        | %          |              |       |   |   |
| Digital Photography                                     |       | $                                          | —     |       | $          | —            |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue  |       | —                                     | %          | —     | %          |              |       |   |   |
| Total net maintenance revenues                          |       | $                                          | 750        |       | $          | 663               |       | $ | 87 |   | 13 | % |
| Percentage of total maintenance revenues                |       | 49                                         | %          | 47         | %          |              |       |   |   |

 

21

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Costof maintenance revenues in Law Enforcement increased because of higher costsnecessary to service our expanding installed base.

 
| ** **                                         | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product  gross profit (dollars in thousands)**   | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Product gross profit**                           |       |                                       |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                          | 311        |       | $          | 1,507             |       | $ | (1,196 | ) | (79 | )% |
| Percentage of Law Enforcement product  revenue     |       | 36                                         | %          | 75         | %          |              |       |   |   |
| Identification                                     |       | $                                          | 2,595      |       | $          | 2,102             |       | $ | 493 |   | 23 | % |
| Percentage of Identification product  revenue      |       | 63                                         | %          | 78         | %          |              |       |   |   |
| Digital Photography                                |       | $                                          | 271        |       | $          | 423               |       | $ | (152 | ) | (36 | )% |
| Percentage of Digital Photography product  revenue |       | 97                                         | %          | 92         | %          |              |       |   |   |
| Patent Licensing                                   |       | $                                          | 500        |       | $          | —            |       | $ | 500 |   | 100 | % |
| Percentage of Patent Licensing product  revenue    |       | 100                                        | %          | N/A        |       |              |       |   |   |
| Total net product revenues                         |       | $                                          | 3,677      |       | $          | 4,032             |       | $ | (355 | ) | (9 | )% |
| Percentage of total product revenues               |       | 64                                         | %          | 78         | %          |              |       |   |   |

 

Totalproduct gross profit as a percentage of product revenues decreased primarilydue to a higher percentage of total revenues coming from the sales of hardwareand consumables (which have higher costs than software only solutions)resulting in higher cost of sales as a percentage of product revenues.

 

LawEnforcement gross profit decreased due primarily to the smaller revenue base toabsorb fixed product costs and product mix with a higher percentage of hardwaresales.  The nine month period ended September 30,2004 contained an uncharacteristically high percentage of software.  Costs of products can vary as a percentage ofproduct revenue from quarter to quarter depending upon product mix and hardwarecontent and print media consumable content included in systems installed duringa given period.

 

Identificationgross profit as a percentage of Identification product revenue decreased dueprimarily to higher domestic Identification revenues from project-oriented workwhich included costs for equipment, third party software licenses and contractprogramming fees for software customization incurred in the nine months ended September 30,2005, than the comparable nine months ended September 30, 2004.

 

Grossmargin dollars for the Digital Photography product segment decreased due tolower sales of Digital Photography software during the nine month period ended September 30,2005 as compared to the comparable period in 2004.  The percentage increase from 92% of DigitalPhotography product revenues for the nine months ended September 30, 2004to 97% of Digital Photography product revenues for the nine months ended September 30,2005 results from the sale of certain hardware components in the 2004 period ascompared to the corresponding period in 2005.

 

22

----

 
| ** **                                             | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  gross profit**                          | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                            | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                   |       |                                       |       |       |       |              |       |   |   |
| **Maintenance gross profit**                           |       |                                       |       |       |       |              |       |   |   |
| Law Enforcement                                        |       | $                                          | 773        |       | $          | 765               |       | $ | 8 |   | 1 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 53                                         | %          | 56         | %          |              |       |   |   |
| Identification                                         |       | $                                          | (17        | )          | $          | (40               | )          | $ | 23 |   | (57 | )% |
| Percentage of Identification maintenance  revenue      |       | (47                                        | )%         | (167       | )%         |              |       |   |   |
| Digital Photography                                    |       | $                                          | 38         |       | $          | 9                 |       | $ | 29 |   | 320 | % |
| Percentage of Digital Photography  maintenance revenue |       | 100                                        | %          | 100        | %          |              |       |   |   |
| Total net maintenance revenues                         |       | $                                          | 794        |       | $          | 734               |       | $ | 60 |   | 8 | % |
| Percentage of total maintenance revenues               |       | 51                                         | %          | 53         | %          |              |       |   |   |

 

Grossprofit related to maintenance revenues due primarily to higher maintenancerevenues to absorb fixed maintenance costs.

 
| ** **                        | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating  expenses**           | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**       | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                              |       |                                       |       |       |       |              |       |   |   |
| General & administrative |       | $                                          | 3,524      |       | $          | 3,372             |       | $ | 152 |   | 5 | % |
| Percentage of total net revenue   |       | 48                                         | %          | 51         | %          |              |       |   |   |
| Sales and marketing               |       | $                                          | 2,719      |       | $          | 2,510             |       | $ | 209 |   | 8 | % |
| Percentage of total net revenue   |       | 37                                         | %          | 38         | %          |              |       |   |   |
| Research & development   |       | $                                          | 2,342      |       | $          | 1,969             |       | $ | 373 |   | 19 | % |
| Percentage of total net revenue   |       | 32                                         | %          | 30         | %          |              |       |   |   |
| Depreciation and amortization     |       | $                                          | 460        |       | $          | 534               |       | $ | (74 | ) | (14 | )% |
| Percentage of total net revenue   |       | 6                                          | %          | 8          | %          |              |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses increased due primarily to fees paid forconsulting services.  Such expenses, as apercentage of total net revenues, decreased because of higher total netrevenues during the nine months ended September 30, 2005, as compared tothe corresponding period in 2004.  We arecontinuing to focus our efforts on achieving additional future operatingefficiencies by reviewing and improving upon existing business processes andevaluating our cost structure. We believe these efforts will allow us togradually decrease our level of general and administrative expenses expressedas a percentage of total revenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce. Such expenses decreased as a percentage of total net revenues, butincreased in absolute dollars due primarily to increases in headcount andpayments to sales consultants (including lobbyists).  The increase in headcount and amounts paid tosales consultants reflects required resources needed to pursue large projectsolution opportunities.  We anticipatethat this level of expenses incurred for sales and marketing during the ninemonths ended September 30, 2005 will continue as we pursue large projectsolution opportunities.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased due primarilyto the accelerated development of our new ImageWare Biometric Engine, the webenablement of our CCS product line, development of our IWS desktop securityprogram and product enhancements to our Digital Photography software productsuite utilizing contract programming services in conjunction with internalresearch and development resources.   Ourlevel of expenditures in research and development reflects our belief that tomaintain our competitive position in markets characterized by rapid rates oftechnological advancement, we must continue to invest significant resources innew systems and software as well as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased due primarily to loweramortization of intangible assets due to such assets being fully amortized.

 

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*INTEREST (INCOME) EXPENSE, NET.*  Forthe nine months ended September 30, 2005, we recognized interest income of$44,000 and interest expense of $2,000. For the nine months ended September 30,2004, we recognized interest income of $7,000 and interest expense of $5,195,000.  Interest expense for the nine months ended September 30,2004 contains approximately $4,472,000 of interest expense related to fairvalue accounting for our warrant liability due to the registration rightsagreement associated with the underlying shares of the Company’s common stockto be issued upon conversion of the warrants. During the three months ended June 30, 2004, the Company registeredthe underlying shares of common stock with the Securities and ExchangeCommission.  In accordance with EITF 00-19,there will be no further interest expense or income incurred in conjunctionwith these warrants.  Interest expensefor the nine months ended September 30, 2004 also contains $713,000 inliquidated damages, which were classified as interest expense.  The liquidated damages were incurred as theCompany did not meet certain time requirements for the registration of sharesof the Company’s common stock under the registration rights agreements for our November 2003and January 2004 private placements.

 

*LIQUIDITY AND CAPITAL RESOURCES*

 

Asof September 30, 2005, we had total current assets of $4,801,000 and totalcurrent liabilities of $2,826,000, or working capital of $1,975,000. At September 30,2005, we had available cash of $2,230,000 and $106,000 in restricted cashsecuring our performance on certain software implementation contracts.

 

Netcash used in operating activities was $4,774,000 for the nine month periodended September 30, 2005 as compared to $3,785,000 for the correspondingperiod in 2004. We used cash to fund net losses of $3,736,000, excludingnon-cash expenses (depreciation, amortization and stock-based compensation) of$671,000, offset by non-operating income (gain on sale of subsidiary) of$233,000 for the nine months ended September 30, 2005.  We used cash to fund net losses of $3,447,000,excluding non-cash expenses (depreciation, amortization, stock-basedcompensation and change in warrant liability) of $5,288,000 for thecorresponding period in 2004. For the nine months ended September 30,2005, we generated cash of $271,000 from decreases in current assets and usedcash of $1,309,000 for reductions in current liabilities and deferred revenues,excluding debt.  In the first nine monthsof 2004, we used cash of $364,000 to fund increases in current assets andgenerated cash of $26,000 from increases in current liabilities and deferredrevenues, excluding debt.

 

Netcash provided by investing activities was $965,000 for the nine months ended September 30,2005.  Net cash used by investingactivities for the nine months ended September 30, 2004 was $137,000.  For the nine months ended September 30,2005, we used cash to fund capital expenditures of computer equipment andsoftware, furniture and fixtures and leasehold improvements of approximately $244,000.The level of equipment purchases resulted primarily from the replacement ofolder equipment.  For the nine monthsended September 30, 2005, we generated cash of $1,300,000 from the sale ofour wholly-owned Singapore subsidiary, Digital imaging Asia Pacific, offset bycash sold and direct transaction costs of $91,000.  For the nine months ended September 30,2004, we used cash of approximately $59,000 to repay advances from relatedstockholders and used cash of $126,000 to fund capital expenditures of computerequipment, software, furniture and fixtures. We also generated cash of $48,000 through reductions in restricted cash.

 

Netcash provided by financing activities was $3,254,000 for the nine month periodended September 30, 2005 as compared to $6,305,000 for the correspondingperiod in 2004.  For the nine monthsended September 30, 2005, we generated cash of $3,234,000 from the sale ofour common stock in a private placement. We also generated cash of $63,000 fromthe exercise of stock options and used cash of $17,000 for the repayments ofnotes payable and $26,000 for the payment of dividends on our Series BPreferred Stock.  For the nine monthsended September 30, 2004, we generated cash of $6,054,000 from our issuanceof common stock in a private placement. We also generated cash of $483,000 from the exercise of stockoptions.   For the nine month periodended September 30, 2004, we used cash of $185,000 for the payment ofdividends on our Series B Preferred Stock and used cash of $47,000 for therepayment of notes payable.

 

Weconduct operations in leased facilities under operating leases expiring atvarious dates through 2006. In conjunction with our performance on varioussoftware installation and implementation contracts, we are contingently liableunder an irrevocable letter of credit in the amount of $106,000. The letter ofcredit expires on December 26, 2008. We also have various short-term notes payable due at various timesduring the next twelve months.

 

Additionalnew financing may be required to fund working capital and operations if we areunable to generate positive cash flow from operations in the near future.  We may be required to seek additionalfinancing that we believe is necessary to fund our working capital requirementsfor at least the next twelve months, assuming the successful implementation ofour business plan.  Our business planincludes, among other things, significant increases in revenues in futureperiods, the monitoring and controlling of operating expenses, collection ofsignificant trade accounts receivables, and controlling of capitalexpenditures.  If we are unable to secureadditional financing or successfully implement our business 

 

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plan,we will be required to seek funding from alternate sources and/or institutesignificant cost reduction plans.  We mayseek to sell equity or debt securities, secure a bank line of credit, orconsider strategic alliances. The sale of equity or equity related securitiescould result in additional dilution to our shareholders. There can be noassurance that additional financing, in any form, will be available at all or,if available, will be on terms we find acceptable.  In addition, our ability to raise additionalcapital may be dependent upon the our common stock being quoted on the AmericanStock Exchange. There can be no assurance that we will be able to satisfy thecriteria for continued listing on the American Stock Exchange. Insufficientfunds may require us to delay, scale back or eliminate some or all of ouractivities, and if we are unable to obtain additional funding, either throughgeneration of positive cash flow from operations or by obtaining additionalfunding, there is substantial doubt about our ability to continue as a goingconcern.

 

*RECENTLY ISSUED ACCOUNTING STANDARDS*

 

InNovember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 151, “Inventory Costs, an amendmentof ARB No. 43, Chapter 4” (“SFAS 151”), which is effective beginning January 1,2006.  SFAS 151 requires that abnormalamounts of idle facility expense, freight, handling costs and wasted materialbe recognized as current period charges. The Statement also requires that the allocation of fixed productionoverhead be based on the normal capacity of the production facilities.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.

 

InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123R, “Share-Based Payment (“SFAS123R”), which is effective beginning July 1, 2005.  On April 15, 2005, the Securities andExchange Commission announced that companies may implement SFAS No 123R at thebeginning of their next fiscal year begins after June 15, 2005.  The Company expects to adopt the revised rules onJanuary 1, 2006.  SFAS 123R requiresall share-based payments to employees to be expensed over the requisite serviceperiod based on the grant-date fair value of the awards.  The Statement allows for either prospectiveor retrospective adoption and requires that the unvested portion of alloutstanding awards upon adoption be recognized using the same fair value andattribution methodologies previously determined under Statement No 123, “Accountingfor Stock-Based Compensation.”  TheCompany is currently evaluating transition alternatives and valuationmethodologies for future grants.  As aresult, pro forma compensation expense, as reflected in Note 1, may not beindicative of future expense to be recognized under SFAS 123R.  The effect of adoption of 123R on the Company’sfinancial position or results of operations has not yet been determined.

 

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

 

InApril 2005, the FASB issued Interpretation No. 47, “Accounting forConditional Asset Retirement Obligations”, which clarifies that an entity isrequired to recognize a liability for the fair value of a conditional assetretirement obligation when incurred if the liability’s fair value can bereasonably estimated. The fair value of a liability for the conditional assetretirement obligation should be recognized when incurred, which is generallyupon acquisition, construction, or development and (or) through the normaloperation of the asset. Uncertainty about the timing and (or) method ofsettlement of a conditional asset retirement obligation should be factored intothe measurement of the liability when sufficient information exists.  Interpretation No. 47 is effective nolater than the end of fiscal years beginning after December 15, 2005. Weare currently evaluating the effect of this pronouncement.

 

InJune 2005, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 154, “Accounting Changes and ErrorCorrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”(SFAS154).  This Statement replaces APBOpinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  This Statement requiresretrospective application to financial statements of prior periods for changesin accounting principle. This Statement is effective January 1, 2006.  This standard has no impact on the Company’sfinancial statements.

 

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**RISK FACTORS**

 

**WE CURRENTLY HAVE LIMITED CASH RESOURCES AND WE MAY REQUIREADDITIONAL FUNDING TO FINANCE OUR WORKING CAPITAL REQUIREMENTS DURING THE NEXTTWELVE MONTHS.**

 

Wecurrently have limited cash resources and we may require financing to fund ouranticipated working capital requirements during the next twelve months. Weanticipate that our existing resources will not be sufficient to enable us tomaintain our current and planned operations for the next twelve months.  If we are not able to generate positive cashflows from operations in the near future, we will be required to seekadditional funding through public or private equity or debt financing. Therecan be no assurance that additional financing will be available on acceptableterms, or at all. If we are required to sell equity to raise additional funds,our existing shareholders may incur substantial dilution and any shares soissued may have rights, preferences and privileges superior to the rights,preferences and privileges of our outstanding Common Stock. Also, we may berequired to obtain funds through arrangements with third parties that requireus to relinquish rights to certain of our technologies or products that wewould seek to develop or commercialize ourselves. In addition, our ability toraise additional capital may be dependent upon the Company’s Common Stock beinglisted on the American Stock Exchange. We cannot guarantee that the Companywill be able to satisfy the criteria for continued listing on the AmericanStock Exchange.

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALLINGAPPROXIMATELY $60.1 MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

 

Asof September 30, 2005, we had an accumulated deficit of $60.1 million,and these losses may continue in the future. We may need to raise capital tocover these losses, and financing may not be available to us on favorableterms. We expect to continue to incur significant sales and marketing, researchand development, and general and administrative expenses. As a result, we willneed to generate significant revenues to achieve profitability and we may neverachieve profitability.

 

**THE HOLDERS OF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS ANDPRIVILEGES THAT ARE SENIOR TO THE COMMON STOCK, AND WE MAY ISSUEADDITIONAL SHARES OF PREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THAT COULDHAVE A MATERIAL ADVERSE EFFECT ON THE MARKET VALUE OF THE COMMON STOCK.**

 

OurBoard of Directors has the authority to issue a total of up to 4,000,000 sharesof preferred stock and to fix the rights, preferences, privileges, andrestrictions, including voting rights, of the preferred stock, which typicallyare senior to the rights of the common shareholders, without any further voteor action by you and the other common shareholders. Your rights will be subjectto, and may be adversely affected by, the rights of the holders of thepreferred 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 athird party to acquire a majority of the outstanding voting stock of ImageWare.This could delay, defer, or prevent a change in control. Furthermore, holdersof preferred stock may have other rights, including economic rights, senior tothe common stock. As a result, their existence and issuance could have amaterial adverse effect on the market value of the common stock. We have in thepast issued, and, may from time to time in the future issue, preferred stockfor financing or other purposes with rights, preferences, or privileges seniorto the common stock.

 

Theprovisions of our outstanding Series B Preferred Stock prohibit the paymentof dividends on the common stock unless the dividends on those preferred sharesare first paid. In addition, upon a liquidation, dissolution or sale ofImageWare’s business, the holders of the Series B Preferred Stock will beentitled to receive, in preference to any distribution to the holders of commonstock, initial distributions of $2.50 per share, plus all accrued but unpaiddividends.

 

Pursuantto the terms of our Series B Preferred Stock we are obligated to paycumulative cash dividends on shares of Series B Preferred Stock fromlegally available funds at the annual rate of $0.2125 per share, payable in twosemi-annual installments of $0.10625 each, which cumulative dividends must bepaid prior to payment of any dividend on our Common Stock.  As of September 30, 2005, the Companyhad cumulative undeclared dividends of approximately $22,000.

 

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**WE DEPEND UPON A SMALL NUMBER OF LARGE SYSTEM SALES RANGINGFROM $500,000 TO IN EXCESS OF $2,000,000, AND WE MAY FAIL TO ACHIEVE ONEOR MORE LARGE SYSTEM SALES IN THE FUTURE.**

 

Inthe past three years we have derived a substantial portion of our revenues froma small number of sales of large, relatively expensive systems, typicallyranging in price from $500,000 to $2,000,000. As a result, if we fail toreceive orders for these large systems in a given sales cycle on a consistentbasis, our business could be significantly harmed. Further, our quarterlyresults are difficult to predict because we cannot predict in which quarter, ifany, large system sales will occur in a given year. As a result, we believethat quarter-to-quarter comparisons of our results of operations are not a goodindication of our future performance. In some future quarters our operating resultsmay be below the expectations of securities analysts and investors, in whichcase the market price of our common stock may decrease significantly.

 

**OUR LENGTHY SALES CYCLE MAY CAUSE US TO EXPENDSIGNIFICANT RESOURCES FOR AS LONG AS ONE YEAR IN ANTICIPATION OF A SALE, YET WESTILL MAY FAIL TO COMPLETE THE SALE.**

 

Whenconsidering the purchase of a large computerized booking or identificationsystem, a government agency may take as long as a year to evaluate differentsystems and obtain approval for the purchase. If we fail to complete a sale, wewill have expended significant resources and received no revenue in return.Generally, agencies consider a wide range of issues before committing topurchase our products, including product benefits, ability to operate withtheir current systems, product reliability and their own budgetary constraints.While potential customers are evaluating our products and before they place anorder with us, we may incur substantial selling costs and expend significantmanagement effort to accomplish a sale.

 

**A SIGNIFICANT NUMBER OF OUR CUSTOMERS ARE GOVERNMENT AGENCIESTHAT ARE SUBJECT TO UNIQUE POLITICAL AND BUDGETARY CONSTRAINTS AND HAVE SPECIALCONTRACTING REQUIREMENTS WHICH MAY AFFECT OUR ABILITY TO OBTAIN NEWGOVERNMENT CUSTOMERS.**

 

Asignificant number of our customers are government agencies. These agenciesoften do not set their own budgets and therefore have little control over theamount of money they can spend. In addition, these agencies experiencepolitical pressure that may dictate the manner in which they spend money. Dueto political and budgetary processes and other scheduling delays that mayfrequently occur relating to the contract or bidding process, some governmentagency orders may be canceled or substantially delayed, and the receipt ofrevenues or payments may be substantially delayed. In addition, future sales togovernment agencies will depend on our ability to meet government contractingrequirements, certain of which may be onerous or impossible to meet, resultingin our inability to obtain a particular contract. Common requirements ingovernment contracts include bonding requirements, provisions permitting thepurchasing agency to modify or terminate at will the contract without penalty,and provisions permitting the agency to perform investigations or audits of ourbusiness practices.

 

**WE MAY FAIL TO CREATE NEW APPLICATIONS FOR OUR PRODUCTSAND ENTER NEW MARKETS, WHICH MAY AFFECT OUR FUTURE SUCCESS.**

 

Webelieve our future success depends in part on our ability to develop and marketour technology for applications other than booking systems for the lawenforcement market. If we fail in these goals, our business strategy andability to generate revenues and cash flow would be significantly impaired. Weintend to expend significant resources to develop new technology, but thesuccessful development of new technology cannot be predicted and we cannotguarantee we will succeed in these goals.

 

**WE OCCASIONALLY RELY ON SYSTEMS INTEGRATORS TO MANAGE OURLARGE PROJECTS, AND IF THESE COMPANIES DO NOT PERFORM ADEQUATELY, WE MAY LOSEBUSINESS.**

 

Weare occasionally a subcontractor to systems integrators who manage largeprojects that incorporate our systems, particularly in foreign countries. Wecannot control these companies, and they may decide not to promote our productsor may price their services in such a way as to make it unprofitable for us tocontinue our relationship with them. Further, they may fail to perform underagreements with their customers, in which case we might lose sales to thesecustomers. If we lose our relationships with these companies, our business maysuffer.

 

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**WE HAVE U.S. AND FOREIGN PATENT PROTECTION FOR ELEMENTS OFCERTAIN OF OUR PRODUCTS, AND HAVE PATENT APPLICATIONS IN PROCESS, HOWEVER, ACOMPETITOR MAY STILL BE ABLE TO REPLICATE OUR TECHNOLOGY.**

 

Ourbusiness is based in large part on our technology, and our success depends inpart on our ability and efforts to protect our intellectual property rights. Ifwe do not adequately protect our intellectual property through copyrights,patents and various trade secret protections afforded to us by law, ourbusiness will be seriously harmed. We have patent protection for elements ofcertain of our products and patent applications on file.

 

Welicense certain elements of our trademarks, trade dress, copyrights, patentsand other intellectual property to third parties. We attempt to ensure that ourrights in our trade names and the quality of third party uses of our names aremaintained by these third parties. However, these third parties may takeactions that could significantly impair the value of our intellectual propertyand our reputation and goodwill.

 

Inaddition, international intellectual property laws differ from country tocountry. Any foreign rights we have in our technology are limited by what hasbeen afforded to us under the applicable foreign intellectual property laws.Also, under the laws of certain foreign jurisdictions, in order to haverecognizable intellectual property rights, we may be required to fileapplications with various foreign agencies or officials to register ourintellectual property. Accordingly, our ability to operate and exploit ourtechnology overseas could be significantly hindered.

 

**WE HAVE ACQUIRED SEVERAL BUSINESSES AND FACE RISKS ASSOCIATEDWITH INTEGRATING THESE BUSINESSES AND POTENTIAL FUTURE BUSINESSES THAT WE MAY ACQUIRE.**

 

Wecompleted the acquisitions of several companies, and we plan to continue toreview potential acquisition candidates. Our business and our strategy includes building our business throughacquisitions. However, acceptable acquisition candidates may not be availablein the future or may not be available on terms and conditions acceptable to us.

 

Acquisitionsinvolve numerous risks, including among others, difficulties and expensesincurred in the consummation of acquisitions and assimilation of theoperations, personnel and services and products of the acquired companies.Additional risks associated with acquisitions include the difficulties ofoperating new businesses, the diversion of management’s attention from otherbusiness concerns and the potential loss of key employees of the acquiredcompany. If we do not successfully integrate the businesses we may acquire inthe future, our business will suffer.

 

**WE OPERATE IN FOREIGN COUNTRIES AND ARE EXPOSED TO RISKSASSOCIATED WITH FOREIGN POLITICAL, ECONOMIC AND LEGAL ENVIRONMENTS AND WITHFOREIGN CURRENCY EXCHANGE RATES.**

 

Withour acquisition of G & A, we have significant foreign operations andare accordingly exposed to risks, including among others, risks associated withforeign political, economic and legal environments and with foreign currencyexchange rates. Our results may be adversely affected by, among other things,changes in government policies with respect to laws and regulations,anti-inflation measures, currency conversions, remittance abroad and rates andmethods of taxation.

 

**ITEM3.  CONTROLS AND PROCEDURES**

 

*Evaluation of disclosure controls and procedures*.  OurChief Executive Officer and Chief Financial Officer have concluded, based upontheir evaluation as of the end of theperiod covered by this report, that our disclosure controls and procedures (asdefined in Securities Exchange Act Rule 13a - 15(e) areeffective in ensuring that information required to be disclosed in the reportsthat we file or submit under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

 

*Changes in internal controls. *There has been no change in our internal control over financialreporting during the fiscal quarter ended September 30, 2005, that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K**

 
| **(a)** | ** ** | **EXHIBITS**                                                                                                                             |
|---------|------------|------------------------------------------------------------------------------------------------------------------------------------------|
|    |       |                                                                                                                                     |
| 10.1    |       | Employment  Agreement dated September 27, 2005 by and between S. James Miller, Jr.  and ImageWare Systems, Inc.(1)        |
| 10.2    |       | Employment  Agreement dated September 27, 2005 by and between Wayne G. Wetherell and  ImageWare Systems, Inc.(1)               |
| 10.3    |       | Limited  Exclusive License Agreement dated September 30, 2005 between Boston  Equities Corporation and ImageWare Systems, Inc. |
| 10.4    |       | Securities  Purchase Agreement(2)                                                                                                        |
| 31.1    |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act                                        |
| 31.2    |       | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act                                        |
| 32.1    |       | Certification  by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act                                        |
| 32.2    |       | Certification  by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act                                        |

 

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(1)          Incorporated by reference to the Company’s Form 8-K filed on September 30,2005.

(2)          Incorporated byreference to the Company’s Form 8-K filed on July 26, 2005.

 

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**SIGNATURES**

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
|                          | IMAGEWARE  SYSTEMS, INC. |
|-------------------------------|--------------------------|
|                          |                     |   |
|                          |                     |   |
| Date:  November 21, 2005 | By:                      | /s/ Wayne Wetherell |
|                          |                     | Wayne Wetherell, Chief Financial  Officer  (on behalf of the Registrant and  as Registrant’s Principal Financial and  Accounting Officer) |

 

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