**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

 

**For thequarterly period ended September 30, 2006**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT

**For the transition periodfrom         to**

**Commission file number 001-15757**

**IMAGEWARESYSTEMS, INC.**

(Exact Name of Registrant as Specified in Its Charter)

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

 

**10883Thornmint Road**

**SanDiego, CA 92127**

(Address ofPrincipal Executive Offices)

 

**(858)673-8600**

(Registrant’sTelephone Number, Including Area Code)

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of  “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act. (Check one):

| oLarge accelerated filer |   | o  Accelerated filer |   | x  Non-accelerated filer |
|--------------------------|--------|----------------------|--------|--------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-12 of the Exchange Act).  Yes o  No x

The number of shares ofCommon Stock, with $0.01 par value, outstanding on November 17, 2006 was13,621,941.

 

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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, 2006 and  December 31, 2005                                        |   |
|       |                   | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2006 and 2005                  |   |
|       |                   | Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2006 and 2005                            |   |
|       |                   | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the three and nine  months ended September 30, 2006 and 2005 |   |
|       |                   | Notes to  Condensed Consolidated Financial Statements                                                                                   |   |
|       | ITEM 2.                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                             |   |
|       | ITEM 3.                | Quantitative  and Qualitative Disclosures About Market Risk                                                                             |   |
|       | ITEM 4.                | Controls and  Procedures                                                                                                                |   |
|       |                   |                                                                                                                                    |   |
| PART II.   | OTHER INFORMATION      |                                                                                                                                    |
|       | ITEM  1A.              | Risk  Factors                                                                                                                           |   |
|       | ITEM 6.                | Exhibits                                                                                                                                |   |
|       |                   |                                                                                                                                    |   |
| SIGNATURES |                   |

 

2

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**PART I**

**FINANCIAL INFORMATION**

**ITEM 1.FINANCIAL STATEMENTS**

**IMAGEWARE SYSTEMS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS**

**(In Thousands, except share data)**
| ** **                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                                                                                                                                                   |       |                         |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                                                                                                              |       | $                            | 276        |                        | $          | 741 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $477 (unaudited) and  $478 at September 30, 2006 and December 31, 2005, respectively                                                                                                                                                                                                                                                              |       | 967                          |       | 1,340                       |       |
| Costs and  estimated earnings in excess of billings on uncompleted contract                                                                                                                                                                                                                                                                                                                                       |       | 322                          |       | —                      |       |
| Inventory                                                                                                                                                                                                                                                                                                                                                                                                         |       | 91                           |       | 208                         |       |
| Other current  assets                                                                                                                                                                                                                                                                                                                                                                                             |       | 294                          |       | 219                         |       |
| Total Current  Assets                                                                                                                                                                                                                                                                                                                                                                                             |       | 1,950                        |       | 2,508                       |       |
|                                                                                                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Property and equipment,  net                                                                                                                                                                                                                                                                                                                                                                                      |       | 362                          |       | 424                         |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                                                      |       | 779                          |       | 738                         |       |
| Intangible assets, net  of accumulated amortization                                                                                                                                                                                                                                                                                                                                                               |       | 145                          |       | 218                         |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                                                                          |       | 3,416                        |       | 3,416                       |       |
| **Total  Assets**                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **$**                        | **6,652**  | ** **                  | **$**      | **7,304** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                                                                    | ** ** | ** **                   | ** ** | ** **                  | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                                                                  |       | $                            | 1,511      |                        | $          | 690 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                                                                                  |       | 1,635                        |       | 1,084                       |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                                                                                  |       | 1,054                        |       | 1,035                       |       |
| Notes payable to  third parties, net of discount                                                                                                                                                                                                                                                                                                                                                                  |       | 1,144                        |       | —                      |       |
| Total Current  Liabilities                                                                                                                                                                                                                                                                                                                                                                                        |       | 5,344                        |       | 2,809                       |       |
|                                                                                                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                                                                                                                |       | 1,199                        |       | 1,130                       |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                                                                                                 |       | 6,543                        |       | 3,939                       |       |
|                                                                                                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| Preferred stock,  $.01 par value, 4,000,000 shares authorized; 750,000 shares designated as  Series B convertible redeemable preferred stock, 389,400 shares issued, and  239,400 (unaudited) and 249,400 shares outstanding at September 30, 2006  and December 31, 2005, respectively; liquidation preference $598,500 (unaudited)  and $623,500 at September 30, 2006 and December 31, 2005, respectively |       | 2                            |       | 2                           |       |
| Common stock,  $.01 par value, 50,000,000 shares authorized; 13,628,645 (unaudited) and  13,554,366 shares issued at September 30, 2006 and December 31,  2005, respectively, and 13,621,941 (unaudited) and 13,547,662 shares  outstanding at September 30, 2006 and December 31, 2005,  respectively                                                                                        |       | 135                          |       | 134                         |       |
| Additional paid  in capital                                                                                                                                                                                                                                                                                                                                                                                       |       | 68,954                       |       | 67,650                      |       |
| Treasury stock,  at cost - 6,704 shares                                                                                                                                                                                                                                                                                                                                                                           |       | (64                          | )          | (64                         | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                                                                                                                                           |       | (132                         | )          | (35                         | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                                                                                              |       | (68,786                      | )          | (64,322                     | )          |
| Total  Shareholders’ equity                                                                                                                                                                                                                                                                                                                                                                                  |       | 109                          |       | 3,365                       |       |
|                                                                                                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Total Liabilities and  Shareholders’ Equity**                                                                                                                                                                                                                                                                                                                                                              | ** ** | **$**                        | **6,652**  | ** **                  | **$**      | **7,304** | ** ** |

 

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

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**IMAGEWARESYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(INTHOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)**

**(UNAUDITED)**
| ** **                                                                                                        | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Revenues:**                                                                                                     | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product                                                                                                           |       | $                                                    | 1,635      |                                                | $          | 1,981 |   | $ | 6,276 |   | $ | 5,744 |   |
| Maintenance                                                                                                       |       | 617                                                  |       | 524                                                 |       | 1,683 |   | 1,545 |   |
|                                                                                                              |       | 2,252                                                |       | 2,505                                               |       | 7,959 |   | 7,289 |   |
| **Cost of  revenues:**                                                                                            | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product                                                                                                           |       | 501                                                  |       | 613                                                 |       | 1,695 |   | 2,068 |   |
| Maintenance                                                                                                       |       | 213                                                  |       | 255                                                 |       | 718 |   | 750 |   |
| Gross profit                                                                                                      |       | 1,538                                                |       | 1,637                                               |       | 5,546 |   | 4,471 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **Operating  expenses:**                                                                                          | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| General & administrative                                                                                      |       | 1,176                                                |       | 1,162                                               |       | 3,587 |   | 3,524 |   |
| Sales and marketing                                                                                               |       | 989                                                  |       | 955                                                 |       | 3,095 |   | 2,719 |   |
| Research & development                                                                                        |       | 926                                                  |       | 855                                                 |       | 2,825 |   | 2,342 |   |
| Depreciation and amortization                                                                                     |       | 59                                                   |       | 147                                                 |       | 248 |   | 460 |   |
|                                                                                                              |       | 3,150                                                |       | 3,119                                               |       | 9,755 |   | 9,045 |   |
| Loss from  operations                                                                                             |       | (1,612                                               | )          | (1,482                                              | )          | (4,209 | ) | (4,574 | ) |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Interest expense  (income), net                                                                                   |       | 156                                                  |       | (31                                                 | )          | 339 |   | (42 | ) |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Other income,  net                                                                                                |       | (5                                                   | )          | (86                                                 | )          | (111 | ) | (135 | ) |
| Loss from continuing operations before income taxes                                                               |       | (1,763                                               | )          | (1,365                                              | )          | (4,437 | ) | (4,397 | ) |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax expense (benefit)                                                                                      |       | —                                               |       | —                                              |       | — |   | — |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Loss from continuing operations                                                                                   |       | (1,763                                               | )          | (1,365                                              | )          | (4,437 | ) | (4,397 | ) |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Discontinued operations:                                                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Gain from operations of discontinued Digital Imaging  Asia Component (including gain on disposal of $233 in 2005) |       | —                                               |       | —                                              |       | — |   | 223 |   |
| Income tax benefit (expense)                                                                                      |       | —                                               |       | —                                              |       | — |   | — |   |
| Gain on discontinued operations                                                                                   |       | —                                               |       | —                                              |       | — |   | 223 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                                                                                                          |       | $                                                    | (1,763     | )                                                   | $          | (1,365 | ) | $ | (4,437 | ) | $ | (4,174 | ) |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and  diluted loss per common share - see note 3                                                             |       | $                                                    | (0.13      | )                                                   | $          | (0.10 | ) | $ | (0.33 | ) | $ | (0.34 | ) |
| Weighted-average shares  (basic and diluted)                                                                      |       | 13,604,692                                           |       | 13,209,856                                          |       | 13,574,835 |   | 12,456,194 |   |

 

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

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**IMAGEWARESYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(INTHOUSANDS)**

**(UNAUDITED)**
| ** **                                                                      | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **Cash  flows from operating activities**                                       | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net loss                                                                        |       | $                                                   | (4,437     | ) | $ | (4,174 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities     |       |                                                |       |   |   |
| Depreciation and amortization                                                   |       | 248                                                 |       | 462 |   |
| Gain on sale of subsidiary                                                      |       | —                                              |       | (233 | ) |
| Non cash interest and amortization of debt discount  and debt issuance costs    |       | 284                                                 |       | — |   |
| Stock based compensation                                                        |       | 912                                                 |       | 209 |   |
| Provision for losses on accounts receivable                                     |       | 14                                                  |       | — |   |
| Change in assets and liabilities                                                |       |                                                |       |   |   |
| Accounts receivable, net                                                        |       | 359                                                 |       | 2 |   |
| Costs and estimated earnings in excess of billings  on uncompleted contracts    |       | (322                                                | )          | — |   |
| Inventory                                                                       |       | 117                                                 |       | 244 |   |
| Other current assets                                                            |       | (35                                                 | )          | (15 | ) |
| Intangible and other assets                                                     |       | (68                                                 | )          | 41 |   |
| Accounts payable                                                                |       | 821                                                 |       | (499 | ) |
| Accrued expenses                                                                |       | (7                                                  | )          | (464 | ) |
| Deferred revenue                                                                |       | 551                                                 |       | 105 |   |
| Contract costs                                                                  |       | —                                              |       | (424 | ) |
| Pension obligation                                                              |       | 69                                                  |       | (28 | ) |
| Total adjustments                                                               |       | 2,943                                               |       | (600 | ) |
| Net cash used in operating activities                                           |       | (1,494                                              | )          | (4,774 | ) |
|                                                                            |       |                                                |       |   |   |
| **Cash  flows from investing activities**                                       | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Purchase of property and equipment                                              |       | (113                                                | )          | (244 | ) |
| Proceeds from sale of subsidiary net of cash sold  and direct transaction costs |       | —                                              |       | 1,209 |   |
| Net cash provided by (used in) investing activities                             |       | (113                                                | )          | 965 |   |
|                                                                            |       |                                                |       |   |   |
| **Cash  flows from financing activities**                                       | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Repayment of notes payable                                                      |       | (215                                                | )          | (17 | ) |
| Proceeds from issuance of notes payable with  warrants                          |       | 1,550                                               |       | — |   |
| Debt issuance costs                                                             |       | (98                                                 | )          | — |   |
| Proceeds from issuance of common stock, net of  issuance costs                  |       |                                                |       | 3,234 |   |
| Proceeds from exercised stock options                                           |       | —                                              |       | 63 |   |
| Dividends paid                                                                  |       | (26                                                 | )          | (26 | ) |
|                                                                            |       |                                                |       |   |   |
| Net cash provided by financing activities                                       |       | 1,211                                               |       | 3,254 |   |
| Effect of exchange rate changes on cash                                         |       | (69                                                 | )          | (127 | ) |
| Net decrease in cash                                                            |       | (465                                                | )          | (682 | ) |
|                                                                            |       |                                                |       |   |   |
| Cash at  beginning of period                                                    |       | 741                                                 |       | 2,912 |   |
|                                                                            |       |                                                |       |   |   |
| Cash at end of period                                                           |       | $                                                   | 276        |   | $ | 2,230 |   |
|                                                                            |       |                                                |       |   |   |
| Supplemental  disclosure of cash flow information:                              |       |                                                |       |   |   |
| Cash paid for interest                                                          |       | $                                                   | 35         |   | $ | — |   |
| Summary of non-cash  investing and financing activities:                        |       |                                                |       |   |   |
| Exchange of  common shares for marketable equity securities                     |       | $                                                   | —     |   | $ | 231 |   |

 

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

5

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**IMAGEWARESYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVEINCOME (LOSS)**

**(INTHOUSANDS)**

**(UNAUDITED)**
| ** **                                                  | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss                                                    |       | $                                                    | (1,763     | )                                                   | $          | (1,365 | ) | $ | (4,437 | ) | $ | (4,174 | ) |
| Other  comprehensive income (loss):                         |       |                                                 |       |                                                |       |   |   |   |   |
| Unrealized loss on securities:                              |       |                                                 |       |                                                |       |   |   |   |   |
| Unrealized holding gain (losses) arising during the  period |       | (28                                                  | )          | 15                                                  |       | (28 | ) | (113 | ) |
|                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Foreign currency translation adjustment                     |       | (35                                                  | )          | (1                                                  | )          | (69 | ) | (126 | ) |
| Comprehensive loss                                          |       | $                                                    | (1,826     | )                                                   | $          | (1,351 | ) | $ | (4,534 | ) | $ | (4,413 | ) |

 

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

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**IMAGEWARE SYSTEMS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**NOTE1.  DESCRIPTION OF BUSINESS ANDOPERATIONS**

ImageWareSystems, Inc. (the “Company”), formerly known as ImageWareSoftware, Inc., utilizes identity management technology to provide standalone, networked and web-based software solutions for secure credentials,biometrics, law enforcement and 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 requiredby generally accepted accounting principles for annual financial statements andshould be read in conjunction with the consolidated financial statements forthe year ended December 31, 2005, and notes thereto included in theCompany’s Annual Report on Form 10-KSB, filed with the SEC onApril 17, 2006, as amended on May 1, 2006. In the opinion of management,the accompanying condensed consolidated financial statements contain alladjustments, consisting only of adjustments of a normal recurring nature,necessary for a fair presentation of the Company’s financial position as ofSeptember 30, 2006, and its results of operations for the periods presented.These condensed consolidated unaudited financial statements are not necessarilyindicative of the results to be expected for the entire year.

*Going Concern*

Asreflected in the accompanying condensed consolidated financial statements, theCompany has continuing losses and negative cash flows from operations. Thesematters raise doubt about the Company’s ability to continue as a going concern.

Newfinancing will be required to fund working capital and operations should theCompany be unable to generate positive cash flow from operations in the nearfuture. The Company is exploring the possible sale of equity securities and/ordebt financing, and believes that additional financing will be available underterms and conditions that are acceptable to the Company. However, there can beno assurance that additional financing will be available. In the eventfinancing is not available in the time frame required, the Company will beforced to reduce its rate of growth, if any, reduce operating expenses, curtailsales and marketing activities and reschedule research and developmentprojects. In addition, the Company might be required to sell certain of itsassets or license its technologies to others. These actions, while necessaryfor the continuance of operations during a time of cash constraints and ashortage of working capital, could adversely affect the Company’s business.

As a result of theCompany’s continuing losses and negative cash flows from operations, theCompany currently does not meet certain listing standards of the American StockExchange (AMEX) Company Guide.  As aresult, the Company may be considered for suspension or delisting from AMEX.  During May 2006, we received notification fromAMEX that we were not in compliance with certain sections of the AMEX CompanyGuide.  To maintain an AMEX listing, wewere required to submit a plan to AMEX which demonstrates our ability to regaincompliance with the continued listing standards within a maximum of 18months.  We submitted our plan to AMEXduring June 2006.  The ListingQualifications Department of AMEX evaluated our plan and in September 2006notified us that we had made a reasonable demonstration in the plan of anability to regain compliance with the continued listing standards by the end ofthe plan periods which AMEX determined to be Novembeer 15, 2006 for Section1003(a)(iv) of the AMEX Company Guide and November 30, 2007 for Sections1003(a)(i), 10033(a)(ii) and 1003(a)(iii) of the AMEX Company Guide.   Accordingly, in September 2006, AMEX notified us that they would continue the listingof the Company subject to us making a public announcement disclosing the factthat we are not in compliance with the continued listing standards of the Exchangeand that our listing is being continued pursuant to an extension and ourproviding certain supporting documentation of key elements of our plan.  We made the required public announcement andprovided the requested information.  Weare subject to periodic review to determine if we 

7

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are making progressconsistent with the plan0.  Failure tomake progress consistent with the plan or regain compliance with the continuedlisting standards by the end of the applicable extension periods could resultin the AMEX initiating delisting proceedings pursuant to Section 1009 of theAMEX Company Guide.  There is noassurance that we will make progress consistent with the plan, or that we willbe able to continue our listing on AMEX. 

Inview of the matters described in the preceding paragraphs, recoverability of amajor portion of the recorded asset amounts shown in the accompanying condensedconsolidated balance sheets is dependent upon continued operations of theCompany, which, in turn, is dependent upon the Company’s ability to continue toraise capital and generate positive cash flows from operations. The condensedconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

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

*Recently Issued Accounting Standards*

InJuly 2006, Financial Accounting Standards Board Interpretation (FIN) No. 48“Accounting for Uncertainty in Income Taxes-an Interpretation of FASB No. 109,”was issued.  FIN No. 48 prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  This interpretation alsoprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, and disclosure requirements for uncertain taxpositions.  FIN No. 48 is effective foryears beginning after December 15, 2006. The adoption of FIN No. 48 is not expected to have a material impact onthe Company’s financial position, cash flows, or results of operations.

InSeptember 2006, the FASB issued Statement of Financial Accounting Standard157 “Fair Value Measurements”(“FAS 157”). FAS 157 defines fair value, establishes a framework for measuringfair value in generally accepted accounting principles, and expands disclosuresabout fair value measurements. FAS 157 applies under other accountingpronouncements that require or permit fair value measurements. Accordingly, FAS157 does not require any new fair value measurements. However, for someentities, the application of FAS 157 will change current practice. FAS 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007, and interim periods within those fiscal years. We have notyet determined the impact of FAS 157 on our consolidated financial position,results of operations, cash flows or financial statement disclosures. 

InSeptember 2006, the FASB issued Statement of Financial Accounting Standard158 “Employers’ Accounting for DefinedBenefit Pension and Other Postretirement Plans, an amendment of FASB StatementsNo. 87, 88, 106, and 132(R)” (“FAS 158”). FAS 158 requires an employerto recognize the overfunded or underfunded status of a defined benefitpostretirement plan (other than a multiemployer plan) as an asset or liabilityin its statement of financial position and to recognize changes in the fundedstatus in the year in which the changes occur through comprehensive income. Italso requires an employer to measure the funded status of a plan as of the dateof its year-end statement of financial position, with limited exceptions. UnderFAS 158, the requirement to initially recognize the funded status of a definedbenefit postretirement plan and to provide the required disclosures iseffective for us as of the end of our first fiscal year ending after December15, 2006. The requirement to measure plan assets and benefit obligations as ofthe date of the employer’s fiscal year-end statement of financial position iseffective for us for our first fiscal year ending after December 15, 2008. Wehave not yet determined the impact of FAS 158 on our consolidated financialposition, results of operations, cash flows or financial statement disclosures.

In September 2006, the SEC staff issued StaffAccounting Bulletin, or SAB, No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements”, (“ SAB 108”). SAB 108 provides guidance on the consideration of theeffects of prior year misstatements in quantifying current year misstatementsfor the purpose of determining whether the current year’s financial statementsare materially misstated. SAB 108 is effective for fiscal years ending afterNovember 15, 2006. We will initially apply the provisions of SAB 108 inconnection with the preparation of our annual financial statements for the yearending December 31, 2006. We have evaluated the potential impact that SAB 108may have on our financial statements and do not believe the impact of theapplication of this guidance will be material.

*Reclassifications*

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

**NOTE2. STOCK BASED COMPENSATION**

At September30, 2006, the Company had three stock-based compensation plans for employeesand nonemployee directors which authorize the granting of various equity-basedincentives including stock options and restricted stock.

Priorto January 1, 2006, the Company accounted for the measurement and recognitionof stock-based compensation under the provisions of APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and related Interpretations, 

8

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permitted underStatement of Financial Accounting Standard No. 123, “Accounting for Stock-BasedCompensation” (SFAS No. 123). As a result, employee stock option basedcompensation was included as a pro forma disclosure in the Notes to theCompany’s financial statements for prior year periods.

Priorto the adoption of Statement of Financial Accounting Standards No. 123(R),“Share-Based Payment”, (SFAS No. 123(R)), the Company provided the disclosuresrequired under SFAS No. 123. The pro forma effect on net income and net incomeper share as if the fair value of stock-based compensation had been recognizedas compensation expense for the three and nine month periods ending September30, 2005 was as follows:
| ** **                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **2005**                                             | ** ** | **2005**                                            | ** ** |
|                                                               |       |                                                 |       |                                                |       |
| Net Loss:                                                          |       |                                                 |       |                                                |       |
| As reported                                                        |       | $                                                    | (1,365     | )                                                   | $          | (4,174 | ) |
| Stock-based compensation included in net loss                      |       | $                                                    | 70         |                                                | $          | 209 |   |
| Stock-based employee compensation under fair value  based method   |       | $                                                    | (196       | )                                                   | $          | (480 | ) |
| Pro forma net  loss                                                |       | $                                                    | (1,491     | )                                                   | $          | (4,445 | ) |
|                                                               |       |                                                 |       |                                                |       |
| Basic loss per  common share:                                      |       |                                                 |       |                                                |       |
| As reported                                                        |       | $                                                    | (0.10      | )                                                   | $          | (0.34 | ) |
| Pro forma                                                          |       | $                                                    | (0.11      | )                                                   | $          | (0.36 | ) |

 

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

Theeffect of recording stock-based compensation for the three and nine monthsended September 30, 2006 was as follows:
| ** **                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **2006**                                             | ** ** | **2006**                                            | ** ** |
|                                                               |       |                                                 |       |                                                |       |
| Stock-based  compensation expense by type of award:                |       |                                                 |       |                                                |       |
| Employee stock options                                             |       | $                                                    | 143        |                                                | $          | 607 |   |
| Restricted stock grants                                            |       | $                                                    | 102        |                                                | $          | 305 |   |
| Total employee  stock based compensation                           |       | $                                                    | 245        |                                                | $          | 912 |   |
| Tax effect on  stock-based compensation                            |       | —                                               |       | —                                              |       |
| Tax effect on  net income                                          |       | —                                               |       | —                                              |       |
| Stock-based  compensation included in net loss                     |       | $                                                    | 245        |                                                | $          | 912 |   |
|                                                               |       |                                                 |       |                                                |       |
| Effect on loss  per common share:                                  |       |                                                 |       |                                                |       |
| Basic                                                              |       | $                                                    | (0.02      | )                                                   | $          | (0.07 | ) |
| Diluted                                                            |       | $                                                    | (0.02      | )                                                   | $          | (0.07 | ) |

 

Priorto adopting SFAS No. 123(R), the Company presented all excess tax benefits, ifany, resulting from the exercise of stock options as operating cash flows inthe Statement of Cash Flows. SFAS No. 123(R) requires cash flows resulting fromexcess tax benefits to be classified as a financing activity. Excess taxbenefits are realized from tax deductions for exercised options in excess ofthe deferred tax asset attributable to stock compensation costs for suchoptions. The Company did not record any excess tax benefits as a result ofadopting SFAS 123(R) in the three and nine months ended 

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September 30, 2006because the Company is currently providing a full valuation on future taxbenefits realized in the United States until it can sustain a level ofprofitability that demonstrates its ability to utilize the assets.

SFASNo. 123(R) requires the use of a valuation model to calculate the fair value ofstock-based awards. For the three and nine months ended September 30, 2006, theCompany has elected to use the Black-Sholes option-pricing model, whichincorporates various assumptions including volatility, expected life, andinterest rates. The Company is required to make various assumptions in theapplication of the Black-Sholes option pricing model. The Company hasdetermined that the best measure of expected volatility is based on thehistorical weekly volatility of the Company’s common stock. Historicalvolatility factors utilized in the Company’s Black-Sholes computations rangefrom 83.5% to 98.5%. The Company has elected to estimate the expected life ofan award based upon the SEC approved “simplified method” noted under theprovisions of Staff Accounting Bulletin No. 107. Under this formula, theexpected term is equal to: ((weighted-average vesting term + originalcontractual term)/2). The expected term used by the Company as computed by thismethod range from 3.5 years to 6.1 years. The interest rate used is the riskfree interest rate and is based upon U. S. Treasury rates appropriate for theexpected term. Interest rates used in the Company’s Black-Sholes calculationsrange from 2.7% to 4.6%. Dividend yield is zero as we do not expect to declareany dividends on our common shares in the foreseeable future.

Asummary of the activity under the Company’s stock option plans for the ninemonths ended September 30, 2006 is as follows:
| ** **                     | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** |
|--------------------------------|------------|-------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|
|                           |       |        |       |                                    |       |                                                              |       |
| Balance at  December 31, 2005  |       | 1,474,093   |       | $                                       | 2.68       |                                                              | 8.20       |   |
| Granted                        |       | 363,000     |       | $                                       | 1.90       |                                                              | 9.41       |   |
| Forfeited                      |       | (181,629    | )          | $                                       | 3.08       |                                                              | 6.03       |   |
| Exercised                      |       | —      |       | $                                       | —     |                                                              | —     |   |
|                           |       |        |       |                                    |       |                                                              |       |
| Balance at September  30, 2006 |       | 1,655,464   |       | $                                       | 2.46       |                                                              | 8.03       |   |

 

Optionsexercisable at September 30, 2006 totaled 788,081 at a weighted-average priceof $2.68, with a remaining weighted average contractual term of approximately 7.1years.

Theweighted-average grant date fair value of options granted during the three andnine months ended September 30, 2006 was $1.23 and $1.38, respectively.

Thefollowing table sets forth a summary of the status and changes of the Company’sunvested shares related to its stock option plans as of and during the ninemonths ended September 30, 2006:
| ** **                     | ** ** | **Options** | ** ** | **Weighted-  Average  Grant Date  Fair Value  Per Share** | ** ** |
|--------------------------------|------------|-------------|------------|--------------------------------------------------------------------------|------------|
|                           |       |        |       |                                                                     |       |
| Balance at  December 31, 2005  |       | 849,930     |       | $                                                                        | 1.82       |   |
| Granted                        |       | 363,000     |       | $                                                                        | 1.38       |   |
| Vested                         |       | (279,209    | )          | $                                                                        | 1.78       |   |
| Forfeited                      |       | (63,445     | )          | $                                                                        | 1.95       |   |
|                           |       |        |       |                                                                     |       |
| Balance at September  30, 2006 |       | 870,276     |       | $                                                                        | 1.65       |   |

 

AtSeptember 30, 2006, the total remaining unrecognized compensation cost relatedto unvested stock options amounted to approximately $817,074, which will beamortized over the weighted-average remaining requisite service period of 1.87years.

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**NOTE3.  NET LOSS PER COMMON 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, 2006 and2005, 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, 2006** | ** ** | **Number of  Common Shares  Convertible into at  September 30, 2005** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
|                                         |       |                                                                                                |       |                                                                                                |       |
| Convertible  preferred stock                 |       | 45,384                                                                                              |       | 47,280                                                                                              |       |
| Stock options                                |       | 793,741                                                                                             |       | 589,577                                                                                             |       |
| Warrants                                     |       | 4,680,805                                                                                           |       | 4,469,578                                                                                           |       |

 

Thefollowing table sets forth the computation of basic and diluted loss per sharefor the three and nine month periods ended September 30, 2006 and 2005(amounts in thousands except share and per share amounts):
| ** **                                                            | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerator — loss  from continuing operations:                    |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss from continuing operations                                   |       | $                                                    | (1,763     | )                                                   | $          | (1,365 | ) | $ | (4,437 | ) | $ | (4,397 | ) |
| Less Series B preferred dividends                                     |       | (13                                                  | )          | (13                                                 | )          | (40 | ) | (40 | ) |
| Net loss from continuing operations available to  common shareholders |       | $                                                    | (1,776     | )                                                   | $          | (1,378 | ) | $ | (4,477 | ) | $ | (4,437 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Numerator — gain  (loss) from discontinued operations:           |       |                                                 |       |                                                |       |   |   |   |   |
| Net gain (loss) discontinued operations                               |       | —                                               |       | —                                              |       | — |   | 223 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted-average shares outstanding                                   |       | 13,604,692                                           |       | 13,209,856                                          |       | 13,574,835 |   | 12,456,194 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and  diluted loss per share:                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Loss from continuing operations                                       |       | $                                                    | (0.13      | )                                                   | $          | (0.10 | ) | $ | (0.33 | ) | $ | (0.36 | ) |
| Discontinued operations                                               |       | —                                               |       | —                                              |       | — |   | 0.02 |   |
| Net loss per  share                                                   |       | $                                                    | (0.13      | )                                                   | $          | (0.10 | ) | $ | (0.33 | ) | $ | (0.34 | ) |

 

**NOTE4.  SEGMENT INFORMATION**

TheCompany is comprised of three reportable segments: Law Enforcement,Identification and Digital Photography. The Law Enforcement segment develops,sells and supports identity management technology used to create booking andinvestigative software used by law enforcement and public safety agencies tomanage criminal history records and investigate crime. The Identificationsegment develops, sells and supports software and designs systems which utilizeidentity management technology in the production of smart and secureidentification systems and documents. The Digital Photography segment developsdigital imaging software for photographic purposes.

Corporateassets are comprised primarily of cash and other assets providing benefits toall business segments.

Thereare no significant intersegment transactions.

Thetable below summarizes information about reportable segments for the three andnine months ended September 30, 2006 and 2005:

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| ** **                    | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                    | ** ** | **(in thousands)  (unaudited)**                 | ** ** | **(in thousands)  (unuadited)**                | ** ** |
| Net Revenue:                  |       |                                                 |       |                                                |       |   |   |   |   |
| Law Enforcement               |       | $                                                    | 746        |                                                | $          | 719 |   | $ | 2,821 |   | $ | 2,326 |   |
| Identification                |       | 1,431                                                |       | 1,123                                               |       | 4,987 |   | 4,144 |   |
| Digital Photography           |       | 75                                                   |       | 163                                                 |       | 151 |   | 319 |   |
| Corporate                     |       | —                                               |       | 500                                                 |       | — |   | 500 |   |
| Total  consolidated net sales |       | $                                                    | 2,252      |                                                | $          | 2,505 |   | $ | 7,959 |   | $ | 7,289 |   |
|                          |       |                                                 |       |                                                |       |   |   |   |   |
| Operating loss:               |       |                                                 |       |                                                |       |   |   |   |   |
| Law Enforcement               |       | $                                                    | (523       | )                                                   | $          | (971 | ) | $ | (1,357 | ) | $ | (2,547 | ) |
| Identification                |       | (975                                                 | )          | (903                                                | )          | (2,506 | ) | (2,031 | ) |
| Digital Photography           |       | (114                                                 | )          | (108                                                | )          | (346 | ) | (496 | ) |
| Corporate                     |       | —                                               |       | 500                                                 |       | — |   | 500 |   |
|                          |       |                                                 |       |                                                |       |   |   |   |   |
| Other  unallocated amounts:   |       |                                                 |       |                                                |       |   |   |   |   |
| Interest expense (income)     |       | 156                                                  |       | (31                                                 | )          | 339 |   | (42 | ) |
| Other expense (income)        |       | (5                                                   | )          | (86                                                 | )          | (111 | ) | (135 | ) |
|                          |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) before  taxes   |       | $                                                    | (1,763     | )                                                   | $          | (1,365 | ) | $ | (4,437 | ) | $ | (4,397 | ) |

 
|                                       | ** ** | **September 30,  2006** | ** ** |
|---------------------------------------|------------|------------------------------|------------|
| ** **                            | ** ** | **(in thousands)**      | ** ** |
| Total Assets by  Segment:             |       |                         |       |
| Law Enforcement                       |       | $                            | 460        |   |
| Identification                        |       | 5,330                        |       |
| Digital  Photography                  |       | 40                           |       |
| Total assets for  reportable segments |       | 5,830                        |       |
| Corporate                             |       | 822                          |       |
| Total consolidated  assets            |       | $                            | 6,652      |   |

 

**NOTE5. CONTRACT COSTS**

The Company recognizessales and cost of sales on long-term, fixed price contracts involvingsignificant amounts of customization using the percentage of completion methodbased on costs incurred to date compared to total estimated costs atcompletion.  Such amounts are included inthe accompanying Balance Sheets at September 30, 2006 and December 31, 2005under the caption “Costs and estimated earnings in excess of billings onuncompleted contract.”

Costsand estimated billings on uncompleted contracts and related amounts billed asof September 30, 2006 and December 31, 2005 are as follows:
| **($ in thousands)**          | ** ** | **September 30,   2006** | ** ** | **December 31,   2005** | ** ** |
|-----------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | ** **                         | ** ** | ** **                        | ** ** |
| Costs incurred  on uncompleted contract |       | $                                  | 157        |                              | $          | — |   |
| Estimated  earnings                     |       | 165                                |       | —                            |       |
|                                    |       | 322                                |       | —                            |       |
| Less: Billings  to date                 |       | —                             |       | —                            |       |
|                                    |       | $                                  | 322        |                              | $          | — |   |

 

 

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**NOTE6. NOTES PAYABLE**

InMarch 2006, the Company completed a secured debt financing in theaggregate amount of $1,550,000, with net proceeds to Company approximating$1,452,000. The Company issued a series of secured promissory notesaggregating $1,550,000 which bear interest at 8% per annum, with interestcompounded monthly and payable quarterly. The principal balance becomes due inone year or earlier upon the occurrence of the following contractually definedevents: (i) payments received by the Company in connection with contractswith Grupo Inffinix and Argus Solutions or any affiliate thereof, or anyextension, renewal or amendment of such contracts; or (ii) payments madeagainst any new contract signed by the Company which contract amount is in excessof $1,500,000; or (iii) the receipt by the Company of proceeds from thesale of equity or equity-linked securities by the Company; or (iv) receiptof proceeds from the issuance by the Company of any type of debt instruments,including lines of credit. In addition, the Company may prepay the notesin whole or in part upon five days prior written notice.

As acondition to the loan, the Company entered into a security agreement wherebythe Company granted a security interest in all of the Company’s goods and equipment,inventory, contract rights and general intangibles, accounts or otherobligations owing to the Company, and cash deposit accounts and otherinvestment property to secure payment of the note.

As acondition to the loan, the Company also issued warrants to purchase 387,500shares of the Company’s common stock. Such warrants have a 5-year term and anexercise price $2.30 per share. Common shares underlying the warrants havepiggyback registration rights and cashless exercise after 12 months from closingdate if there is no effective registration statement covering the underlyingshares.

TheCompany recorded the secured debt financing net of a discount equal to the fairvalue allocated to the warrants using the relative fair value method ofapproximately $419,000. The Company estimated the fair value of the warrantsusing the Black-Sholes option pricing model and the following assumptions: termof 5 years, a risk free interest rate of 4.52%, a dividend yield of 0%, andvolatility of 82%.  During the three andnine months ended September 30, 2006, the Company recorded approximately$105,000 and $227,000 respectively in debt discount amortization which isincluded as a component of net interest expense in the Company’s CondensedConsolidated Statement of Operations.

**NOTE7. COMMON STOCK**

During the three months ended September 30, 2006,the Company issued 18,096 shares of its common stock pursuant to stock-basedcompensation agreements with certain employees and issued 1,895 shares of itscommon stock pursuant to the conversion of 10,000 shares of Series B PreferredStock.

**NOTE8. SUBSEQUENT EVENT**

OnNovember 14, 2006, the Company entered into a Securities Purchase Agreementwith certain accredited investors (the "Investors") pursuant to whichthe Company sold to the Investors an aggregate of 2,300 shares of the Company’sSeries C 8% Convertible Preferred Stock (the "Series C") at a statedvalue of $1,000 per share for aggregate gross proceeds of $2,300,000, andissued to the Investors warrants (the "Investor Warrants") topurchase up to an aggregate of 115,000 shares of common stock of the Companywith an exercise price of $1.575 per share (the "Financing"). Inconnection with the Financing, the Company issued to a placement agent and itsaffiliates warrants to purchase an aggregate of 40,000 shares of common stockof the Company with exercise prices of $1.575 per share (the "PlacementAgent Warrants" and, together with the Investor Warrants, the"Warrants"). In connection with the Financing, the Company alsoentered into a registration rights agreement (the "Registration RightsAgreement") with certain of the Investors, and has agreed to enter intothe Registration Rights Agreement with the remaining Investors, pursuant towhich the Company has agreed to file a registration statement with theSecurities and Exchange Commission covering the resale of certain shares ofcommon stock into which the Series C are convertible as well as the shares ofcommon stock issuable upon exercise of the Placement Agent Warrants. Thematerial terms of the Securities Purchase Agreement, the Registration RightsAgreement, the Warrants and the transactions contemplated thereby weredescribed in the Company’s Form 8-K filed on November 20, 2006 (incorporated byreference into this Report).

**ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning 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 hereofand 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 onpage 24 and 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 not necessarilyindicative of the operating results for any future period.

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**OVERVIEW**

ImageWareSystems, Inc. utilizes identity management technology to develop softwareused to create booking and investigative software, smart and secureidentification systems and documents, and software for professionalphotographers. Our software systems and associated hardware enable ourcustomers to quickly capture, archive, search, retrieve and share digitalphotographs and associated text records. The following management’s discussionand analysis is based primarily upon our Law Enforcement, Identification andDigital Photography products.

CRITICALACCOUNTING ESTIMATES

Thediscussion and analysis of our financial condition and results of operationsare based on our consolidated financial statements, which have been prepared inaccordance with accounting principals generally accepted in the United Statesof America, or U.S. GAAP. The preparation of these financial statements inaccordance with U.S. GAAP requires us to utilize accounting policies and makecertain estimates and assumptions that affect the reported amounts of assetsand liabilities, the disclosure of contingencies as of the date of thefinancial statements and the reported amounts of revenue and expenses during afiscal period. The SEC considers an accounting policy to be critical if it isimportant to a company’s financial condition and results of operations, and ifit requires significant judgment and estimates on the part of managementin its application. Although we believe that our judgments and estimates areappropriate and correct, actual results may differ from those estimates.

Thefollowing are our critical accounting policies because we believe they are bothimportant to the portrayal of our financial condition and results of operationsand require critical management judgments and estimates about matters that areuncertain. If actual results or events differ materially from thosecontemplated by us in making these estimates, our reported financial conditionand results of operations for future periods could be materially affected.

***Revenue Recognition***

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

·      Long-termfixed-price contracts involving significant customization

·      Fixed-pricecontracts involving minimal customization

·      Softwarelicensing

·      Salesof computer hardware and identification media

·      Postcontractcustomer support (PCS)

TheCompany’s revenue recognition policies are consistent with U. S. GAAP includingStatements of Position 97-2 “Software Revenue Recognition” and 98-9“Modification of SOP 97-2, Software Revenue Recognition With Respect to CertainTransactions”, Securities and Exchange Commission Staff Accounting Bulletin 104, Emerging Issues Task Force Issue 00-21 “Revenue Arrangements with MultipleDeliverables”, and Emerging Issues Task Force Issue 03-05 “Applicability ofAICPA Statement of Position 97-2 to Non-Software Deliverables in an ArrangementContaining More-Than-Incidental Software”. Accordingly, the Company recognizesrevenue when all of the following criteria are met: persuasive evidence of anarrangement exists, delivery has occurred or services have been rendered, thefee is fixed or determinable, and collectibility is reasonable assured.

Werecognize revenue and profit as work progresses on long-term, fixed-pricecontracts involving significant amount of hardware and software customizationusing the percentage of completion method based on costs incurred to datecompared to total estimated costs at completion. Revenue from contracts forwhich we cannot reliably estimate total costs or there are not significantamounts of customization are recognized upon completion. Determining when acontract should be accounted for using the percentage of completion methodinvolves judgment. Critical items that are considered in this process are thedegree of customization and related labor hours necessary to complete therequired work as well as ongoing estimates of the future labor hours needed tocomplete the contract. We also generate non-recurring revenue from thelicensing of our software. Software license revenue is recognized upon theexecution of a license agreement, upon deliverance, fees are fixed anddeterminable, collectibility is probable and when all other significantobligations have been fulfilled. We also generate 

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revenue from thesale of computer hardware and identification media. Revenue for these items isrecognized upon delivery of these products to the customer. Our revenue fromperiodic maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

***Allowance for Doubtful Accounts***

Ourmanagement must make estimates of the uncollectibility of our accountsreceivables. Management specifically analyzes accounts receivable and analyzeshistorical bad debts, customer concentrations, customer creditworthiness,current economic trends, the age of the accounts receivable balances, andchanges in our customer payment terms when evaluating the adequacy of theallowance for doubtful accounts. Our accounts receivables balance wasapproximately $1,444,000 and our allowance for doubtful accounts wasapproximately $477,000 as of September 30, 2006.

***Valuation Of Goodwill And Other Intangible Assets***

Weassess impairment of goodwill and identifiable intangible assets whenever eventsor changes in circumstances indicate that the carrying value may not berecoverable. Factors we consider important which could trigger an impairmentreview include the following:

·              Significant underperformance relative tohistorical or expected future operating results;

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

·              Significant negative industry or economictrends;

Whenwe determine that the carrying value of goodwill and other intangible assetsmay not be recoverable based upon the existence of one or more of theabove indicators of impairment, we measure any impairment based upon fair valuemethodologies. Goodwill and other net intangible assets amounted toapproximately $3,561,000 as of September 30, 2006.

In2002, Statement of Financial Accounting Standards (“SFAS”) No. 142,“Goodwill and Other Intangible Assets” became effective, and as a result weceased to amortize goodwill. In lieu of amortization, we performed an initialimpairment review of our goodwill in June 2002 and an annual impairment reviewthereafter in the fourth quarter of our fiscal year. Completion of our initialimpairment test indicated there was no goodwill impairment. We also performedour annual impairment review as of December 31, 2004 and 2005, based uponour 2005 and 2006 operating plans, respectively. This annual impairment reviewindicated there was goodwill impairment in our Digital Photography segment asof December 31, 2005, and accordingly, we have recorded an impairment lossin the 2005 Consolidated Statement of Operations. Both of these tests wereconducted by determining and comparing the fair value of our reporting units,as defined in SFAS 142, to the reporting unit’s carrying value as of that date.Our reporting units are Law Enforcement, Identification and DigitalPhotography. We determined that as of September 30, 2006 there were noindicators of potential impairment. There are many management assumptions andestimates underlying the determination of an impairment loss, and estimatesusing different, but reasonable, assumptions could produce significantlydifferent results. Significant assumptions include estimates of future levelsof revenues and operating expenses. Therefore, the timing and recognition ofimpairment losses by us in the future, if any, may be highly dependentupon our estimates and assumptions. There can be no assurance that goodwillimpairment will not occur in the future.

Weaccount for long-lived assets in accordance with the provisions of SFASNo. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets.”  This statement requires thatlong-lived assets and certain identifiable intangible assets be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be heldand used is measured by a comparison of the carrying amount of an asset tofuture net undiscounted cash flows expected to be generated by the asset. Ifsuch assets are considered to be impaired, the impairment to be recognized ismeasured by the amount which the carrying amount of the assets exceeds the fairvalue of the assets. Fair value is determined based on discounted cash flows orappraised values, depending upon the nature of the asset. Assets to be disposedof are reported at the lower of the carrying amount of fair value less costs tosell. In 2005, we recorded an impairment charge of approximately $253,000related to our intangible asset for certain trademark and tradenames carried inour Identification segment. This loss reflects the amount by which the carryingvalue of this asset exceeded its estimated fair value determined by the assets’future discounted cash flows. The impairment loss is recorded as a component of“Operating expenses” in the Statement of Operations for 2005. We determinedthat as of September 30, 2006 there were no indicators of potentialimpairment. There are many management assumptions and estimates underlying the 

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determination ofan impairment loss, and estimates using different, but reasonable, assumptionscould produce significantly different results. Significant assumptions includeestimates of future levels of revenues and operating expenses. Therefore, thetiming and recognition of impairment losses by us in the future, if any,may be highly dependent upon our estimates and assumptions. There can beno assurance that intangible asset impairment will not occur in the future.

***Stock-Based Compensation***

Uponadoption of SFAS 123R on January 1, 2006, we began estimating the value ofemployee stock options on the date of grant using the Black-Scholes model.Prior to the adoption of SFAS 123R, the value of each employee stock option wasestimated on the date of grant using the Black-Scholes model for the purpose ofthe pro forma financial disclosure in accordance with SFAS 123. Thedetermination of fair value of stock-based payment awards on the date of grantusing an option-pricing model is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited to the expected stock pricevolatility over the term of the awards and the actual and projected employeestock option exercise behaviors. The expected term of options granted isderived from historical data on employee exercises and post-vesting employmenttermination behavior. We calculated our expected volatility assumption requiredin the Black-Scholes model based on the historical volatility of our stock. Asof January 1, 2006 we have adopted the modified prospective transitionmethod and its effect is included in our three and nine month financialstatements for the period ended September 30, 2006.

**RESULTSOF OPERATIONS**

***THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005.***
| ** **                              | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net Product Revenues**      | ** ** | **2006**                                         | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**    | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                              | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Product  revenues:**                  | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                         |       | $                                                | 232        |       | $          | 225               |       | $ | 7 |   | 3 | % |
| Percentage of total net product revenue |       | 14                                               | %          | 11         | %          |              |       |   |   |
| Identification                          |       | $                                                | 1,328      |       | $          | 1,106             |       | $ | 222 |   | 20 | % |
| Percentage of total net product revenue |       | 81                                               | %          | 56         | %          |              |       |   |   |
| Digital  Photography                    |       | $                                                | 75         |       | $          | 150               |       | $ | (75 | ) | (50 | )% |
| Percentage of total net product revenue |       | 5                                                | %          | 8          | %          |              |       |   |   |
| Patent Licensing                        |       | —                                           |       | 500        |       | (500              | )          | (100 | )% |
| Percentage of total net product revenue |       | 0                                                | %          | 25         | %          |              |       |   |   |
| Total net product  revenues             |       | $                                                | 1,635      |       | $          | 1,981             |       | $ | (346 | ) | (17 | )% |

 

Theincrease in our Law Enforcement product revenues is due to the deployment ofour Crime Capture System to law enforcement agencies.  We believe that continued incidents ofterrorism has created heightened interest in the ability of law enforcement andother government agencies to be able to efficiently retrieve, analyze and shareinformation 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.

16

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Identificationrevenues generated by our San Diego and Canadian offices increasedapproximately $444,000 or 50% for the three months ended September 30,2006 as compared to the corresponding period in 2005.  This increase in revenue is reflective ofincreased sales of our Biometric Engine and Identification software products inproject-oriented work and revenues generated by our IWS Desktop Securityproducts (released in the fourth quarter of 2005), offset by decreases inproducts sold through our distribution channel. Identification revenues generated by our German sales office decreasedapproximately $222,000.  This decrease isreflective of our decision to reorganize our German sales office by closing ourexisting facility in order to reduce operating expenses.  We intend to pursue project salesopportunities in areas serviced by this office through geographically dedicatedsales personnel.  We are of the opinionthat foreign markets formerly served by this office will embrace ouridentification and biometric solutions for large-scale high-end installations.

Wecontinue to be of the opinion that government agencies and private entitieswill react to heightened security concerns resulting from acts of terrorism byre-evaluating and upgrading their ability to positively identify and track theircitizens, employees, consultants and visitors. We anticipate that these factorswill increase overall demand for our identification products; however, wecannot predict 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 our 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.

Thedecrease in Digital Photography product revenues is due to lower sales of boxedsoftware during the three months ended September 30, 2006 as compared tothe comparable period of 2005.  While wedevoted substantial research and development resources upgrading our suite ofDigital Photography product offerings in 2005 and 2006, we anticipate thatbecause of changing market dynamics and competitive pressures, product revenuesfor our Digital Photography segment will not reach 2005 levels.

Ourbacklog of product orders as of September 30, 2006 was approximately$1,047,000.  At September 30, 2006,we also had maintenance and support backlog of approximately $1,402,000 underexisting maintenance agreements.  Productrevenue is typically recognized within a three to six month time perioddepending upon the required degree of customization, if any.  Historically, we have experienced a veryminimal risk of order cancellation.  Ourrevenue from maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.
| ** **                                  | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**               | ** ** | **2006**                                         | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**        | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                        |       |                                             |       |       |       |              |       |   |   |
| **Maintenance  revenues:**                  | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                             |       | $                                                | 514        |       | $          | 494               |       | $ | 20 |   | 4 | % |
| Percentage of total net maintenance revenue |       | 83                                               | %          | 94         | %          |              |       |   |   |
| Identification                              |       | $                                                | 103        |       | $          | 17                |       | $ | 86 |   | 506 | % |
| Percentage of total net maintenance revenue |       | 17                                               | %          | 3          | %          |              |       |   |   |
| Digital  Photography                        |       | $                                                | —     |       | $          | 13                |       | $ | (13 | ) | (100 | )% |
| Percentage of total net maintenance revenue |       | 0                                                | %          | 3          | %          |              |       |   |   |
| Total net maintenance  revenues             |       | $                                                | 617        |       | $          | 524               |       | $ | 93 |   | 18 | % |

 

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.

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Ourdecrease in Digital Photography maintenance revenues as compared to thecorresponding period in 2005 is reflective of the expiration of softwaremaintenance on custom contract programming projects.
| ** **                                        | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**      | ** ** | **2006**                                         | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**              | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                              |       |                                             |       |       |       |              |       |   |   |
| **Cost of  Product Revenues:**                    | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                   |       | $                                                | 165        |       | $          | 137               |       | $ | 28 |   | 20 | % |
| Percentage of Law Enforcement product revenue     |       | 71                                               | %          | 61         | %          |              |       |   |   |
| Identification                                    |       | $                                                | 333        |       | $          | 470               |       | $ | (137 | ) | (29 | )% |
| Percentage of Identification product revenue      |       | 25                                               | %          | 43         | %          |              |       |   |   |
| Digital  Photography                              |       | $                                                | 3          |       | $          | 6                 |       | $ | (3 | ) | (50 | )% |
| Percentage of Digital Photography product revenue |       | 4                                                | %          | 4          | %          |              |       |   |   |
| Patent Licensing                                  |       | —                                           |       | —     |       |              |       |   |   |
| Percentage of Patent Licensing product revenue    |       | 0                                                | %          | 0          | %          |              |       |   |   |
| Total net  product revenues                       |       | $                                                | 501        |       | $          | 613               |       | $ | (112 | ) | (18 | )% |
| Percentage of  total product revenues             |       | 31                                               | %          | 31         | %          |              |       |   |   |

 

Theincrease in the cost of product revenues for our Law Enforcement segment as apercentage of Law Enforcement product revenues is due primarily to higher fixedcosts offset by a product mix with slightly higher percentages of software onlysolutions for the three months ended September 30, 2006 as compared to thecorresponding period in 2005.  Costs ofproducts can vary as a percentage of product revenue from period to perioddepending upon product mix and the hardware content, print media consumablecontent and software content included in systems installed during a givenperiod.

Thedecrease in the cost of product revenues for our Identification segment as apercentage of Identification product revenue is reflective of higher domesticIdentification revenues containing software only solutions.   For the three months ended September 30,2006, software and royalties comprised approximately 88% of Identificationproduct revenues as compared to approximately 77% for the corresponding periodin 2005.  Costs of products can vary as apercentage of product revenue from period to period depending upon product mixand the hardware content, print media consumable content and software contentincluded in systems installed during a given period.
| ** **                                              | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance cost of revenues**         | ** ** | **2006**                                         | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                              | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Maintenance  cost of revenues:**                      | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                         |       | $                                                | 199        |       | $          | 236               |       | $ | (37 | ) | (16 | )% |
| Percentage of Law Enforcement  maintenance revenue |       | 39                                               | %          | 48         | %          |              |       |   |   |
| Identification                                          |       | $                                                | 14         |       | $          | 19                |       | $ | (5 | ) | (26 | )% |
| Percentage of Identification maintenance revenue        |       | 14                                               | %          | 112        | %          |              |       |   |   |
| Digital  Photography                                    |       | $                                                | —     |       | $          | —            |       | $ | — |   | N/A |   |
| Percentage of Digital Photography maintenance  revenue  |       | —                                           | %          | —     | %          | —            |       |   |   |
| Total net  maintenance revenues                         |       | $                                                | 213        |       | $          | 255               |       | $ | (42 | ) | (16 | )% |
| Percentage of  total maintenance revenues               |       | 35                                               | %          | 49         | %          |              |       |   |   |

 

Costof maintenance revenues as a percentage of maintenance revenues decreased dueprimarily to higher maintenance revenues to absorb fixed maintenancecosts.  The dollar decrease during thethree months ended September 30, 2006 as compared to the corresponding periodin 2005 is reflective of a higher percentage of our maintenance revenues beinggenerated from maintenance coverage on software only solutions which typicalyhave lower maintenance costs than solution comprised on both software andhardware.

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| ** **                                        | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit**                | ** ** | **2006**                                         | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**              | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                        |       |                                             |       |       |       |              |       |   |   |
| **Product  gross profit**                         |       |                                             |       |       |       |              |       |   |   |
| Law Enforcement                                   |       | $                                                | 67         |       | $          | 87                |       | $ | (20 | ) | (23 | )% |
| Percentage of Law Enforcement product revenue     |       | 29                                               | %          | 39         | %          |              |       |   |   |
| Identification                                    |       | $                                                | 995        |       | $          | 637               |       | $ | 358 |   | 56 | % |
| Percentage of Identification product revenue      |       | 75                                               | %          | 57         | %          |              |       |   |   |
| Digital  Photography                              |       | $                                                | 72         |       | $          | 144               |       | $ | (72 | ) | (50 | )% |
| Percentage of Digital Photography product revenue |       | 96                                               | %          | 96         | %          |              |       |   |   |
| Patent Licensing                                  |       | —                                           |       | 500        |       | (500              | )          | 100 | % |
| Percentage of Patent Licensing product revenue    |       | 0                                                | %          | 100        | %          |              |       |   |   |
| Total net  product revenues                       |       | $                                                | 1,134      |       | $          | 1,368             |       | $ | (234 | ) | (17 | )% |
| Percentage of  total product revenues             |       | 69                                               | %          | 69         | %          |              |       |   |   |

 

Totalproduct gross profit decreased due primarily to the 2005 period containing$500,000 of gross profit from patent licensing revenues as compared to no suchrevenues being generated during the three months ended September 30, 2006.

LawEnforcement gross profit as a percentage of Law Enforcement product revenuedecreased due to higher fixed costs, offset by slightly higher percentages ofsoftware and royalties in our product mix than the corresponding period of2005.  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 increased dueprimarily to increased sales of identification products combined with ourproduct mix containing higher percentages of software (which has lower coststhan hardware and consumables) than the comparable period in 2005.  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.

Thedecrease of $72,000 in gross profit from the Digital Photography productsegment is reflective of lower sales of boxed product in the three months endedSeptember 30, 2006, as compared to the corresponding period in 2005.
| ** **                                             | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**                 | ** ** | **2006**                                         | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                   | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                   |       |                                             |       |       |       |              |       |   |   |
| **Maintenance  gross profit**                          |       |                                             |       |       |       |              |       |   |   |
| Law Enforcement                                        |       | $                                                | 315        |       | $          | 258               |       | $ | 57 |   | 22 | % |
| Percentage of Law Enforcement maintenance revenue      |       | 61                                               | %          | 52         | %          |              |       |   |   |
| Identification                                         |       | $                                                | 89         |       | $          | (2                | )          | $ | 91 |   | 4,528 | % |
| Percentage of Identification maintenance revenue       |       | 86                                               | %          | (12        | )%         |              |       |   |   |
| Digital  Photography                                   |       | $                                                | —     |       | $          | 13                |       | $ | (13 | ) | (100 | )% |
| Percentage of Digital Photography maintenance  revenue |       | —                                           | %          | 100        | %          |              |       |   |   |
| Total net  maintenance revenues                        |       | $                                                | 404        |       | $          | 269               |       | $ | 135 |   | 50 | % |
| Percentage of  total maintenance revenues              |       | 65                                               | %          | 51         | %          |              |       |   |   |

 

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

19

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| ** **                           | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating expenses**          | ** ** | **2006**                                             | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                 |       |                                                 |       |       |       |              |       |   |   |
| General &  administrative        |       | $                                                    | 1,176      |       | $          | 1,162             |       | $ | 14 |   | 1 | % |
| Percentage of total net revenue      |       | 52                                                   | %          | 46         | %          |              |       |   |   |
| Sales and  marketing                 |       | $                                                    | 989        |       | $          | 955               |       | $ | 34 |   | 4 | % |
| Percentage of total net revenue      |       | 44                                                   | %          | 38         | %          |              |       |   |   |
| Research &  development          |       | $                                                    | 926        |       | $          | 855               |       | $ | 71 |   | 8 | % |
| Percentage of total net revenue      |       | 41                                                   | %          | 34         | %          |              |       |   |   |
| Depreciation and  amortization       |       | $                                                    | 59         |       | $          | 147               |       | $ | (88 | ) | (60 | )% |
| Percentage of  total net revenue     |       | 3                                                    | %          | 6          | %          |              |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.*  General and administrative expenses arecomprised primarily of salaries and other employee-related costs for executive,financial, and other infrastructure personnel. General legal, accounting andconsulting services, insurance, occupancy and communication costs are alsoincluded with general and administrative expenses.  The increase in such expenses, as apercentage of total net revenues, is reflective of lower net revenues duringthe three months ended September 30, 2006 as compared to the correspondingperiod in 2005.  The dollar increase of$14,000 is due primarily to approximately $70,000 in stock-based compensationrecorded in the three months ended September 30, 2006 pursuant to theimplementation of SFAS 123(R) offset by lower personnel expenses due to reducedheadcount combined with reduced costs due to the closure of our sales office inGermany.  We are continuing to focus ourefforts on achieving additional future operating efficiencies by reviewing andimproving upon existing business processes and evaluating our cost structure.We believe these efforts will allow us to gradually decrease our level ofgeneral and administrative expenses expressed as a percentage of totalrevenues.

*SALES AND MARKETING.*  Sales and marketing expenses consistprimarily of the salaries, commissions, other incentive compensation, employeebenefits and travel expenses of our sales force.   The increase in such expenses for the threemonths ended September 30, 2006 as compared to the corresponding period in 2005is due primarily to approximately $55,000 in stock-based compensation recordedin the three months ended September 30, 2006 pursuant to the implementation ofSFAS 123(R).  We anticipate that thislevel of expenses for sales and marketing will continue through 2006 as wepursue large project solution opportunities.

*RESEARCH AND DEVELOPMENT.*  Research and development costs consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work. Suchexpenses increased due primarily to the continued development of our BiometricEngine, the development of our Personal Identity Verification (PIV) solution,the web enablement of our CCS product line, development IWS desktop securityprogram and product enhancements to our Digital Photography software productsuite utilizing contract programming services in conjunction with internalresearch and development resources.  Alsocontributing to the increase is approximately $15,000 in stock-basedcompensation recorded in the three months ended September 30, 2006 pursuant tothe implementation of SFAS 123(R).  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 decreasedprimarily due to lower amortization of intangible assets due to such assetsbeing fully amortized.

*INTEREST EXPENSE (INCOME), NET.*  For the three months ended September 30,2006, we recognized interest income of $4,000 and interest expense of $160,000.For the three months ended September 30, 2005, we recognized interestincome of $32,000 and interest expense of $1,000.  Interest expense for the three months endedSeptember 30, 2006 increased due to interest expense incurred on oursecured debt financing consummated in March 2006.

20

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***NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005.***
| ** **                               | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net Product Revenues**       | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**     | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Product revenues:**                    | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                          |       | $                                               | 1,310      |       | $          | 855               |       | $ | 455 |   | 53 | % |
| Percentage of  total net product revenue |       | 21                                              | %          | 15         | %          |              |       |   |   |
| Identification                           |       | $                                               | 4,815      |       | $          | 4,108             |       | $ | 707 |   | 17 | % |
| Percentage of  total net product revenue |       | 77                                              | %          | 72         | %          |              |       |   |   |
| Digital Photography                      |       | $                                               | 151        |       | $          | 281               |       | $ | (130 | ) | (46 | )% |
| Percentage of  total net product revenue |       | 2                                               | %          | 5          | %          |              |       |   |   |
| Patent Licensing                         |       | —                                          |       | 500        |       | (500              | )          | (100 | )% |
| Percentage of  total net product revenue |       | 0                                               | %          | 8          | %          |              |       |   |   |
| Total net product revenues               |       | $                                               | 6,276      |       | $          | 5,744             |       | $ | 532 |   | 9 | % |

 

Theincrease in our Law Enforcement product revenues is due to the deployment ofour Crime Capture System to law enforcement agencies.  We believe that continued incidents ofterrorism has created heightened interest in the ability of law enforcement andother government agencies to be able to efficiently retrieve analyze and shareinformation 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.

Identificationrevenues generated by our San Diego and Canadian offices increasedapproximately $1,164,000, or 34%.  Thisincrease in Identification product revenue is reflective of sales of ourBiometric Engine and identification software products into project-orientedwork and revenues generated by our IWS Desktop Security products (released inthe fourth quarter of 2005), offset by decreases in products sold through ourdistribution channel.  Identificationrevenues generated by our German sales office decreased approximately $457,000.   This decrease is reflective of our decisionto reorganize our German sales office by closing our existing facility in orderto reduce operating expenses.  We intendto pursue project sales opportunities in areas serviced by this office throughgeographically dedicated sales personnel. We are of the opinion that foreign markets formerly served by thisoffice will embrace our identification and biometric solutions for large-scalehigh-end installations.

Wecontinue to be of the opinion that government agencies and private entitieswill react to heightened security concerns resulting from acts of terrorism byre-evaluating and upgrading their ability to positively identify and tracktheir citizens, employees, consultants and visitors. We anticipate that these factorswill increase overall demand for our identification products; however, wecannot predict 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 our 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 project applications,added the biometric engine for incorporation into large scale biometricinstallations and reoriented our organization to direct our resources andcapabilities toward establishing a foothold in the market for large-scalesecure identification solutions.

Thedecrease in Digital Photography product revenues is due to lower sales of boxedsoftware during the nine months ended September 30, 2006 as compared tothe comparable period of 2005.  While wedevoted substantial research and development resources upgrading our suite ofDigital Photography product offerings in 2005 and 2006, we anticipate thatbecause of changing market dynamics and competitive pressures, product revenuesfor our Digital Photography segment will not reach 2005 levels.

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| ** **                                  | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**               | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**        | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Maintenance  revenues:**                  | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                             |       | $                                               | 1,511      |       | $          | 1,471             |       | $ | 40 |   | 3 | % |
| Percentage of total net maintenance revenue |       | 90                                              | %          | 95         | %          |              |       |   |   |
| Identification                              |       | $                                               | 172        |       | $          | 36                |       | $ | 136 |   | 378 | % |
| Percentage of total net maintenance revenue |       | 10                                              | %          | 2          | %          |              |       |   |   |
| Digital  Photography                        |       | $                                               | —     |       | $          | 38                |       | $ | (38 | ) | (100 | )% |
| Percentage of total net maintenance revenue |       | 0                                               | %          | 3          | %          |              |       |   |   |
| Total net maintenance  revenues             |       | $                                               | 1,683      |       | $          | 1,545             |       | $ | 138 |   | 9 | % |

 

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.

Ourdecrease in Digital Photography maintenance revenues is reflective of theexpiration of software maintenance contracts on custom contract programmingprojects.
| ** **                                        | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**      | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**              | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                              |       |                                            |       |       |       |              |       |   |   |
| **Cost of  Product Revenues:**                    | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                   |       | $                                               | 654        |       | $          | 544               |       | $ | 110 |   | 20 | % |
| Percentage of Law Enforcement product revenue     |       | 50                                              | %          | 64         | %          |              |       |   |   |
| Identification                                    |       | $                                               | 1,034      |       | $          | 1,514             |       | $ | (480 | ) | (32 | )% |
| Percentage of Identification product revenue      |       | 21                                              | %          | 37         | %          |              |       |   |   |
| Digital  Photography                              |       | $                                               | 7          |       | $          | 10                |       | $ | (3 | ) | (30 | )% |
| Percentage of Digital Photography product revenue |       | 5                                               | %          | 3          | %          |              |       |   |   |
| Patent Licensing                                  |       | —                                          |       | —     |       | —            |       |   |   |
| Percentage of Patent Licensing product revenue    |       | 0                                               | %          | 0          | %          |              |       |   |   |
| Total net  product revenues                       |       | $                                               | 1,695      |       | $          | 2,068             |       | $ | (373 | ) | (18 | )% |
| Percentage of  total product revenues             |       | 27                                              | %          | 36         | %          |              |       |   |   |

 

Totalcost of product revenues decreased in dollars and as a percentage of productrevenues due primarily to product mix with a greater percentage of productrevenues being from sales of software only solutions (which have lower coststhan sales of hardware and consumables).

Costof product revenues for our Law Enforcement segment decreased as a percentageof Law Enforcement product revenues due to a significantly larger revenue baseto absorb fixed product costs.   Costs ofproducts also can vary as a percentage of product revenue from period to perioddepending upon product mix and the hardware content, print media consumablecontent and software content included in systems installed during a givenperiod.

Domestically,cost of product revenues related to our Identification segment increased approximately$56,000 for the nine month period ended September 30, 2006 as compared with thecorresponding period in 2005 due to significantly higher sales of software onlysolutions (which have lower costs than sales of hardware and consumables).  Internationally, cost of Identificationproduct revenues decreased approximately $535,000.  This decrease is reflective of lowerinternational Identification product sales resulting from our decision toreorganize our German sales office by closing our existing facility in order toreduce operating expenses.

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Thepercentage decrease in Identification cost of revenues as a percentage ofIdentification revenues is reflective of a higher percentage of domesticIdentification revenues coming from project-oriented work in 2006 whichcontained higher percentages of software than project-oriented work during the comparableperiod of 2005.  Software and royaltycontent was approximately 86% of Identification product revenues for the ninemonths ended September 30, 2006 as compared to approximately 67% for thecorresponding period of 2005.  The 2005period included higher percentages of equipment, third-party software licensesand contract programming fees for software customization.  Costs of products also can vary as apercentage of product revenue from period to period depending upon product mixand the hardware content, print media consumable content and software contentincluded in systems installed during a given period.
| ** **                                              | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance cost of revenues**         | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                    |       |                                            |       |       |       |              |       |   |   |
| **Maintenance  cost of revenues:**                      | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                         |       | $                                               | 675        |       | $          | 697               |       | $ | (22 | ) | (3 | )% |
| Percentage of Law Enforcement  maintenance revenue |       | 45                                              | %          | 47         | %          |              |       |   |   |
| Identification                                          |       | $                                               | 43         |       | $          | 53                |       | $ | (10 | ) | (19 | )% |
| Percentage of Identification maintenance revenue        |       | 25                                              | %          | 147        | %          |              |       |   |   |
| Digital  Photography                                    |       | $                                               | —     |       | $          | —            |       | $ | — |   | N/A |   |
| Percentage of Digital Photography maintenance  revenue  |       | —                                          | %          | —     | %          |              |       |   |   |
| Total net  maintenance revenues                         |       | $                                               | 718        |       | $          | 750               |       | $ | (32 | ) | (4 | )% |
| Percentage of  total maintenance revenues               |       | 43                                              | %          | 49         | %          |              |       |   |   |

 

Costof maintenance revenues in our Law Enforcement segment decreased despite higherLaw Enforcement maintenance revenues due to a higher percentage of suchmaintenance revenues being generated on a maintenance base containing higherpercentages of software only solutions which have lower maintenance costs thansolution of both hardware and software.
| ** **                                        | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit**                | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**              | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                              |       |                                            |       |       |       |              |       |   |   |
| **Product  gross profit**                         | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                   |       | $                                               | 656        |       | $          | 311               |       | $ | 345 |   | 111 | % |
| Percentage of Law Enforcement product revenue     |       | 50                                              | %          | 36         | %          |              |       |   |   |
| Identification                                    |       | $                                               | 3,781      |       | $          | 2,595             |       | $ | 1,186 |   | 46 | % |
| Percentage of Identification product revenue      |       | 79                                              | %          | 63         | %          |              |       |   |   |
| Digital  Photography                              |       | $                                               | 144        |       | $          | 271               |       | $ | (127 | ) | (47 | )% |
| Percentage of Digital Photography product revenue |       | 96                                              | %          | 97         | %          |              |       |   |   |
| Patent Licensing                                  |       | —                                          |       | 500        |       | (500              | )          | (100 | )% |
| Percentage of Patent Licensing product revenue    |       | —                                          | %          | 100        | %          |              |       |   |   |
| Total net  product revenues                       |       | $                                               | 4,581      |       | $          | 3,677             |       | $ | 904 |   | 25 | % |
| Percentage of  total product revenues             |       | 73                                              | %          | 64         | %          |              |       |   |   |

 

Totalproduct gross profit as a percentage of product revenues increased primarilydue to a higher percentage of total revenues coming from the sale of software(which has lower costs than hardware and consumables) resulting in lower costof sales as a percentage of product revenues.

LawEnforcement gross profit increased due primarily to a significantly largerrevenue base to absorb fixed product costs. Costs of products can also vary as a percentage of product revenue fromquarter to quarter depending upon product mix and hardware content and printmedia consumable content included in systems installed during a given period.

Identificationgross profit as a percentage of Identification product revenue increased dueprimarily to higher domestic Identification revenues from project-oriented workcontaining higher percentages of software during the nine months endedSeptember 30, 2006  than comparable project-orientedwork during the nine months ended September 30, 2005.  Software and royalty content wasapproximately 86% of Identification product revenues for the nine months endedSeptember 30, 2006 as compared to approximately 67% for the correspondingperiod of 2005. Project-oriented work in the 

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2005 periodcontained higher percentages of equipment, third-party software licenses andcontract programming fees for software customization.

Grossmargins for the Digital Photography product segment decreased due to lowersales of Digital Photography software during the nine month period endedSeptember 30, 2006 as compared to the comparable period in 2005.
| ** **                                             | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**                 | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                   | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Maintenance  gross profit**                          | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                        |       | $                                               | 836        |       | $          | 773               |       | $ | 63 |   | 8 | % |
| Percentage of Law Enforcement maintenance revenue      |       | 55                                              | %          | 53         | %          |              |       |   |   |
| Identification                                         |       | $                                               | 129        |       | $          | (17               | )          | $ | 146 |   | 859 | % |
| Percentage of Identification maintenance revenue       |       | 75                                              | %          | (47        | )%         |              |       |   |   |
| Digital  Photography                                   |       | $                                               | —     |       | $          | 38                |       | $ | (38 | ) | (100 | )% |
| Percentage of Digital Photography maintenance  revenue |       | N/A                                             |       | 100        | %          |              |       |   |   |
| Total net  maintenance revenues                        |       | $                                               | 965        |       | $          | 794               |       | $ | 171 |   | 22 | % |
| Percentage of  total maintenance revenues              |       | 57                                              | %          | 51         | %          |              |       |   |   |

 

Grossprofit related to maintenance revenues increased due primarily to highermaintenance revenues to absorb fixed maintenance costs.
| ** **                           | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating expenses**          | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                           | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| General &  administrative   |       | $                                               | 3,587      |       | $          | 3,524             |       | $ | 63 |   | 2 | % |
| Percentage of total net revenue      |       | 45                                              | %          | 48         | %          |              |       |   |   |
| Sales and  marketing                 |       | $                                               | 3,095      |       | $          | 2,719             |       | $ | 376 |   | 14 | % |
| Percentage of total net revenue      |       | 39                                              | %          | 37         | %          |              |       |   |   |
| Research &  development     |       | $                                               | 2,825      |       | $          | 2,342             |       | $ | 483 |   | 21 | % |
| Percentage of total net revenue      |       | 35                                              | %          | 32         | %          |              |       |   |   |
| Depreciation and  amortization       |       | $                                               | 248        |       | $          | 460               |       | $ | (212 | ) | (46 | )% |
| Percentage of  total net revenue     |       | 3                                               | %          | 6          | %          |              |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.*  General and administrative expenses arecomprised primarily of salaries and other employee-related costs for executive,financial, and other infrastructure personnel. General legal, accounting andconsulting services, insurance, occupancy and communication costs are alsoincluded with general and administrative expenses.  The decrease in such expenses, as apercentage of total net revenues, is reflective of higher total net revenuesduring the nine months ended September 30, 2006 as compared to thecorresponding period in 2005.  The dollarincrease of $63,000 is due primarily to approximately $296,000 in stock-basedcompensation expense recorded in the nine months ended September 30, 2006pursuant to the implementation of SFAS 123(R) offset by reduced costs due tothe closure of our sales office in Germany and lower personnel expenses due toreduced headcount.  We are continuing tofocus our efforts on achieving additional future operating efficiencies byreviewing and improving upon existing business processes and evaluating ourcost structure. We believe these efforts will allow us to gradually decreaseour level of general and administrative expenses expressed as a percentage oftotal revenues.

*SALES AND MARKETING.*  Sales and marketing expenses consistprimarily of the salaries, commissions, other incentive compensation, employeebenefits and travel expenses of our sales force. Such expenses increased as apercentage of total net revenues due primarily to increases in headcount offsetby reductions in payments to sales consultants and reduced trade show expenses.  Also contributing to the increase is approximately$233,000 in stock-based compensation recorded in the nine months ended September30, 2006 pursuant to the implementation of SFAS 123(R).  The increase in headcount reflects requiredresources needed to pursue large project solution opportunities.  We anticipate that this level of expensesincurred for sales and marketing during the nine months endedSeptember 30, 2006 will continue as we pursue large project solutionopportunities.

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*RESEARCH AND DEVELOPMENT.*  Research and development costs consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work. Suchexpenses increased due primarily to the continued development of our BiometricEngine, the development of our Personal Identity Verification (PIV) solution, theweb enablement of our CCS product line, development IWS desktop securityprogram and product enhancements to our Digital Photography software productsuite utilizing contract programming services in conjunction with internalresearch and development resources.  Alsocontributing to the increase is approximately $62,000 in stock-basedcompensation recorded in the nine months ended September 30, 2006 pursuant tothe implementation of SFAS 123(R).  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 dueprimarily to lower amortization of intangible assets due to such assets beingfully amortized.

*INTEREST EXPENSE (INCOME), NET.*  For the nine months ended September 30,2006, we recognized interest income of $13,000 and interest expense of $352,000.For the nine months ended September 30, 2005, we recognized interestincome of $44,000 and interest expense of $2,000.  The increase in interest expense for the ninemonths ended September 30, 2006 was primarily due to interest expense incurredon our secured debt financing consummated in March 2006.

*LIQUIDITYAND CAPITAL RESOURCES*

As ofSeptember 30, 2006, we had total current assets of $1,950,000 and totalcurrent liabilities of $5,344,000, or negative working capital of $3,394,000.  At September 30, 2006, we had availablecash of $276,000 and $106,000 in restricted cash securing our performance oncertain software implementation contracts.

Netcash used in operating activities was $1,494,000 for the nine month periodended September 30, 2006 as compared to $4,774,000 for the correspondingperiod in 2005. We used cash to fund net losses of $2,980,000, excludingnon-cash expenses (depreciation, amortization and stock-based compensation) of$1,457,000 for the nine months ended September 30, 2006.  We used cash to fund net losses of $3,736,000,excluding non-cash expenses (depreciation, amortization, and stock-basedcompensation) of $671,000 offset by non-operating income (gain on sale ofsubsidiary) of $233,000 for the nine months ended September 30, 2005.  For the nine months ended September 30,2006, we generated cash of $50,000 through reduction in current assets andgenerated cash of $1,436,000 through increases in current liabilities anddeferred revenues, excluding debt.  For thenine months ended September 30, 2005, we generated cash of $271,000 fromdecreases in current assets and used cash of $1,309,000 for reductions in currentliabilities and deferred revenues, excluding debt.

Netcash used in investing activities was $113,000 for the nine months endedSeptember 30, 2006.  Net cashprovided by investing activities was $965,000 for the nine months endedSeptember 30, 2005.  For the ninemonths ended September 30, 2006, we used cash to fund capital expenditures ofcomputer equipment, software and furniture and fixtures of approximately $113,000.  The level of equipment purchases resultedprimarily from the replacement of older equipment. For the nine months endedSeptember 30, 2005, we used cash to fund capital expenditures of computerequipment and software, furniture and fixtures and leasehold improvements ofapproximately $224,000.  For the ninemonths ended September 30, 2005, we generated cash of $1,300,000 from thesale of our wholly-owned Singapore subsidiary, Digital Imaging Asia Pacific,offset by cash sold and direct transaction costs of $91,000.

Netcash provided by financing activities was $1,211,000 for the nine month periodended September 30, 2006 as compared to $3,254,000 for the correspondingperiod in 2005.  For the nine monthsended September 30, 2006, we generated cash of $1,550,000 from theissuance of secured notes payable and incurred debt issuance costs of98,000.  For the nine months endedSeptember 30, 2006, we used cash of $215,000 for the repayment of our securednotes payable and used cash of $26,000 for the payment of dividends on ourSeries B Preferred Stock.   For thenine months ended September 30, 2005, we generated cash of $3,234,000 fromthe sale of our common stock in a private placement.  We also generated cash of $63,000 from theexercise of stock options and used cash of $17,000 for the repayments of notespayable and $26,000 for the payment of dividends on our Series B PreferredStock.  

Weconduct operations in leased facilities under operating leases expiring atvarious dates through 2009. 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 secured notes payable due during the next twelve months ofapproximately $1,335,000.

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Thereport of our independent accountants included with our Annual Report as filedwith the Commission on April 17, 2006, contained an explanatory paragraphregarding our ability to continue as a going concern.  We are seeking additional financing that webelieve is necessary to fund our working capital requirements for at least thenext twelve months in conjunction with the successful implementation of ourbusiness plan. Our business plan includes, among other things, the monitoringand controlling of operating expenses, collection of significant trade andother accounts receivables, and controlling of capital expenditures. If we areunable to secure additional financing or successfully implement our businessplan, we will be required to seek funding from alternate sources and/orinstitute cost reduction measures. We may seek to sell equity or debtsecurities, secure a bank line of credit, or consider strategic alliances. Thesale of equity or equity-related securities could result in additional dilutionto our shareholders. There can be no assurance that additional financing, inany form, will be available at all or, if available, will be on termsacceptable to us. In addition, our ability to raise additional capitalmay be dependent upon our common stock continuing to be quoted on theAmerican Stock Exchange. There can be no assurance that we will be able tosatisfy the criteria for continued listing on the American Stock Exchange.Insufficient funds may require us to delay, scale back or eliminate someor all of our activities, and if we are unable to obtain additional fundingthere is substantial doubt about our ability to continue as a going concern.

**ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

*ForeignCurrency Exchange Risk*

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

**ITEM 4. CONTROLS AND PROCEDURES**

*Evaluation of disclosure controls and procedures*.  Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we conducted an evaluation of our disclosurecontrols and procedures as such term is defined under Rule 13a-15(e)promulgated under the Securities Exchange Act of 1934, as amended.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded, based upon their evaluationas of the end of the period covered by this report, that our disclosurecontrols and procedures are effective in ensuring that information required tobe disclosed in the reports that we file or submit under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’srules and forms.

*Changes in internal controls. *There has been no change inour internal control over financial reporting during the fiscal quarter endedSeptember 30, 2006, that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

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**PART II**

**ITEM1A.  RISK FACTORS**

Ourresults of operations and financial condition are subject to numerous risks anduncertainties described in our Annual Report on Form 10-KSB for our fiscal yearended December 31, 2005, filed on April 17, 2006 and as amended on May 1, 2006,and incorporated herein by reference. You should carefully consider these risk factors in conjunction with theother information contained in this report. Should any of these risks materialize, our business, financial conditionand future prospects could be negatively impacted.  As of September 30, 2006, there have been nomaterial changes to the disclosures made on the above-referenced Form 10-KSB,as amended, except as follows:

**WEHAVE HAD NET LOSSES IN OUR FIVE MOST RECENT FISCAL YEARS AND CURRENTLY HAVESTOCKHOLDER’S EQUITY OF LESS THAN $6,000,000, AND AS A RESULT, AMEXMAY CONSIDER SUSPENDING OR DELISTING OUR SECURITIES FROM THE EXCHANGE.**

TheAMEX Company Guide provides that AMEX will normally consider suspendingdealings in, or removing from the list, securities of a company which sustainsnet losses in its five most recent fiscal years and has  stockholders’ equity of less than $6,000,000,unless the company has total market capitalization of at least $50,000,000, ortotal assets and revenue of $50,000,000. We have sustained net losses duringour five most recent fiscal years, and as of the year ended December 31,2005, our stockholders’ equity dropped to $3,365,602, from $8,266,219 for theyear ended December 31, 2004. We do not meet the alternative minimummarket capitalization or total asset and revenue requirements. As a result, wemay be considered for suspension or delisting from AMEX. During May 2006,we received notification from AMEX that we were not in compliance with certainsections of the AMEX Company Guide.  Tomaintain an AMEX listing, we were required to submit a plan to AMEX whichdemonstrates our ability to regain compliance with the continued listingstandards within a maximum of 18 months. We submitted our plan to AMEX during June 2006.  The Listing Qualifications Department of AMEXevaluated our plan and in September 2006 notified us that we had made areasonable demonstration in the plan of an ability to regain compliance withthe continued listing standards by the end of the plan periods which AMEXdetermined to be Novembeer 15, 2006 for Section 1003(a)(iv) of the AMEX CompanyGuide and November 30, 2007 for Sections 1003(a)(i), 10033(a)(ii) and1003(a)(iii) of the AMEX Company Guide.  Accordingly,  in September 2006, AMEXnotified us that they would continue the listing of the Company subject to usmaking a public announcement disclosing the fact that we are not in compliancewith the continued listing standards of the Exchange and that our listing isbeing continued pursuant to an extension and our providing certain supportingdocumentation of key elements of our plan. We made the required public announcement and provided the requestedinformation.  We are subject to periodicreview to determine if we are making progress consistent with the plan.  Failure to make progress consistent with theplan or regain compliance with the continued listing standards by the end ofthe applicable extension periods could result in the AMEX initiating delistingproceedings pursuant to Section 1009 of the AMEX Company Guide.  There is no assurance that we will makeprogress consistent with the plan , or that we will be able to continue ourlisting on AMEX.  

**WEHAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALING APPROXIMATELY $67.0MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

As ofSeptember 30, 2006, we had an accumulated deficit of $68.8 million,and these losses may continue in the future. We may need to raisecapital to cover these losses, and financing may not be available to us onfavorable terms. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and we may never achieve profitability.

**THEHOLDERS OF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS AND PRIVILEGES THAT ARESENIOR TO THE COMMON STOCK, AND WE MAY ISSUE ADDITIONAL SHARES OFPREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THAT COULD HAVE A MATERIAL ADVERSEEFFECT 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 to the common stock. As a 

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result, theirexistence and issuance could have a material adverse effect on the market valueof the common stock. We have in the past issued, and, may from time totime in the future issue, preferred stock for financing or other purposes withrights, preferences, or privileges senior to the common stock.The provisions ofour outstanding Series B Preferred Stock prohibit the payment of dividendson the common stock unless the dividends on those preferred shares are firstpaid. In addition, upon a liquidation, dissolution or sale of ImageWare’sbusiness, the holders of the Series B Preferred Stock will be entitled toreceive, in preference to any distribution to the holders of common stock,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 ofSeptember 30, 2006, the Company had cumulative undeclared dividends ofapproximately $22,000.

**ITEM 6. EXHIBITS**
| (a)    | ** ** | **EXHIBITS**                                                                                                                                                         |
|--------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                                 |
| 10.1   |       | Commercial Lease between Union Bank of California as  Trustee for Quest Group Trust VII and ImageWare Systems, Inc. dated September  7, 2006                         |
| 31.1   |       | Certifications of Chief Executive Officer pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                            |
| 31.2   |       | Certifications of Chief Financial Officer pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                            |
| 32.1   |       | Certification of the Chief Executive Officer  provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2   |       | Certification of the Chief Financial Officer  provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                               |   | IMAGEWARE SYSTEMS, INC. |
|-------------------------------|--------|-------------------------|
|                          |   |                    |
|                          |   |                    |
| Date:  November 20, 2006 |   | 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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