UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM 10-Q





(Mark
One)





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





For
the quarterly period ended June 30, 2009





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





For
the transition period from _________ to _________





Commission
file number 001-15757





IMAGEWARE
SYSTEMS, INC.


(Exact
Name of Registrant as Specified in Its Charter)





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





10883
Thornmint Road


San
Diego, CA 92127


(Address
of Principal Executive Offices)





(858)
673-8600


(Registrant’s
Telephone Number, Including Area Code)





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





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





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





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





The
number of shares of Common Stock, with $0.01 par value, outstanding
on May 19, 2010 was 23,238,777.


IMAGEWARE
SYSTEMS, INC. INDEX





PART I.
            FINANCIAL
      INFORMATION
            3ITEM
      1.
            FINANCIAL
      STATEMENTS
            3Condensed Consolidated Balance Sheets as of June 30, 2009 (unaudited)
      and December 31, 2008
            3Condensed Consolidated Statements of Operations for the three and six
      months ended June 30, 2009 and 2008 (unaudited)
            4Condensed Consolidated Statements of Cash Flows for the six months ended
      June 30, 2009 and 2008 (unaudited)
            5Condensed Consolidated Statements of Comprehensive Loss for the three and
      six months ended June 30, 2009 and 2008 (unaudited)
            6Notes to unaudited Condensed Consolidated Financial
    Statements
            7ITEM
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results ofOperations
            20ITEM
      4T.
            Controls
      and Procedures
            32PART II.
            OTHER
      INFORMATION
            32ITEM
      1A.
            Risk
      Factors
            32ITEM
      6.
            Exhibits
            35SIGNATURES
            36


2
 PART I





FINANCIAL
INFORMATION





ITEM
1. FINANCIAL STATEMENTS





IMAGEWARE
SYSTEMS, INC.


CONDENSED
CONSOLIDATED BALANCE SHEETS


(In
Thousands, except share and per share data)





June 30,
              2009
            
            
            December 31,
              2008(Unaudited)ASSETSCurrent
      Assets:Cash
            
            $
            273
            
            
            $
            171Accounts
      receivable, net of allowance for doubtful accounts of $28 (unaudited) and
      $28 at June 30, 2009 and December 31, 2008,
      respectively
            
            
            499
            
            
            
            503Costs
      and estimated earnings in excess of billings on uncompleted
      contract
            
            
            120
            
            
            
            —Inventory
            
            
            24
            
            
            
            19Other
      current assets
            
            
            168
            
            
            
            191Total
      Current Assets
            
            
            1,084
            
            
            
            884Property
      and equipment, net
            
            
            59
            
            
            
            108Other
      assets
            
            
            42
            
            
            
            37Pension
      assets
            
            
            697
            
            
            
            682Intangible
      assets, net of accumulated amortization
            
            
            102
            
            
            
            110Goodwill
            
            
            3,416
            
            
            
            3,416Total
      Assets
            
            $
            5,400
            
            
            $
            5,237LIABILITIES
      AND SHAREHOLDERS’ EQUITYCurrent
      Liabilities:Accounts
      payable
            
            $
            2,367
            
            
            $
            2,388Deferred
      revenue
            
            
            887
            
            
            
            872Billings
      in excess of costs and estimated earnings on uncompleted
      contract
            
            
            —
            
            
            
            279Accrued
      expenses
            
            
            1,973
            
            
            
            1,530Notes
      payable to related parties
            
            
            110
            
            
            
            98Secured
      note payable, net of discount
            
            
            818
            
            
            
            —Additional
      financing obligation, net of discount
            
            
            877
            
            
            
            —Total
      Current Liabilities
            
            
            7,032
            
            
            
            5,167Pension
      obligation
            
            
            1,117
            
            
            
            1,102Total
      Liabilities
            
            
            8,149
            
            
            
            6,269Shareholders’
      equity:Preferred
      stock, authorized 4,000,000 shares:Series B
      convertible redeemable preferred stock, $0.01 par value; designated
      750,000 shares, 389,400 shares issued, and 239,400 shares outstanding
      at June 30, 2009 and December 31, 2008; liquidation
      preference $658 and $632 at June 30, 2009
      and  December 31, 2008,
    respectively
            
            
            2
            
            
            
            2Series C
      convertible non-redeemable preferred stock, $0.01 par value; designated
      3,500 shares, 2,500 shares issued, and 2,200 shares outstanding at
      June 30, 2009 and December 31, 2008; liquidation preference
      $2,691and $2,604 at June 30, 2009 and December 31, 2008,
      respectively
            
            
            —
            
            
            
            —Series D
      convertible non-redeemable preferred stock, $0.01 par value; designated
      3,000 shares, 2,198 shares issued, and 2,198 shares outstanding at
      June 30, 2009 and December 31, 2008; liquidation preference
      $2,515 and $2,428 at June 30, 2009 and December 31, 2008,
      respectively
            
            
            —
            
            
            
            —Common
      stock, $.01 par value, 50,000,000 shares authorized; 18,163,487
      (unaudited) and 18,163,487 shares issued at June 30, 2009 and
      December 31, 2008, respectively, and 18,156,783 (unaudited) and
      18,156,783 shares outstanding at June 30, 2009 and December 31,
      2008, respectively
            
            
            180
            
            
            
            180Additional
      paid in capital
            
            
            86,833
            
            
            
            86,007Treasury
      stock, at cost - 6,704 shares
            
            
            (64
            )
            
            
            (64
            )Accumulated
      other comprehensive (loss) income
            
            
            9
            
            
            
            44Accumulated
      deficit
            
            
            (89,709
            )
            
            
            (87,201
            )Total
      Shareholders’ equity (deficit)
            
            
            (2,749
            )
            
            
            (1,032
            )Total
      Liabilities and Shareholders’ Equity
            
            $
            5,400
            
            
            $
            5,237





The
accompanying notes are an integral part of these condensed consolidated
financial statements.  3
  IMAGEWARE
SYSTEMS, INC.





CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(In
Thousands, except share and per share amounts)


(Unaudited)





Three Months Ended
              June 30,
            
            
            Six Months Ended
              June 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Revenues:Product
            
            $
            999
            
            
            $
            1,020
            
            
            $
            1,674
            
            
            $
            1,797Maintenance
            
            
            646
            
            
            
            647
            
            
            
            1,285
            
            
            
            1,2531,645
            
            
            
            1,667
            
            
            
            2,959
            
            
            
            3,050Cost
      of revenues:Product
            
            
            317
            
            
            
            270
            
            
            
            601
            
            
            
            409Maintenance
            
            
            199
            
            
            
            289
            
            
            
            408
            
            
            
            604Gross
      profit
            
            
            1,129
            
            
            
            1,108
            
            
            
            1,950
            
            
            
            2,037Operating
      expenses:General
      and administrative
            
            
            595
            
            
            
            944
            
            
            
            1,204
            
            
            
            2,045Sales
      and marketing
            
            
            451
            
            
            
            548
            
            
            
            880
            
            
            
            1,214Research
      and development
            
            
            553
            
            
            
            731
            
            
            
            1,141
            
            
            
            1,628Depreciation
      and amortization
            
            
            30
            
            
            
            194
            
            
            
            63
            
            
            
            3951,629
            
            
            
            2,417
            
            
            
            3,288
            
            
            
            5,282Loss
      from operations
            
            
            (500
            )
            
            
            (1,309
            )
            
            
            (1,338
            )
            
            
            (3,245
            )Interest
      expense (income), net
            
            
            233
            
            
            
            —
            
            
            
            348
            
            
            
            (5
            )Change
      in fair value of additional financing obligation
            
            
            397
            
            
            
            —
            
            
            
            503
            
            
            
            —Loss
      on debt modification
            
            
            340
            
            
            
            —
            
            
            
            340Other
      expense (income), net
            
            
            (11
            )
            
            
            (15
            )
            
            
            (21
            )
            
            
            (43
            )Loss
      from continuing operations before income taxes
            
            
            (1,459
            )
            
            
            (1,294
            )
            
            
            (2,508
            )
            
            
            (3,197
            )Income
      tax expense (benefit)
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Loss
      from continuing operations
            
            
            (1,459
            )
            
            
            (1,294
            )
            
            
            (2,508
            )
            
            
            (3,197
            )Discontinued
      operations:Gain
      (loss) from operations of discontinued Digital Photography
      component
            
            
            —
            
            
            
            7
            
            
            
            —
            
            
            
            7Income
      tax benefit (expense)
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Gain
      (loss) on discontinued operations
            
            
            —
            
            
            
            7
            
            
            
            —
            
            
            
            7Net
      loss
            
            
            (1,459
            )
            
            
            (1,287
            )
            
            
            (2,508
            )
            
            
            (3,190
            )Preferred
      dividends
            
            
            (100
            )
            
            
            (84
            )
            
            
            (200
            )
            
            
            (169
            )Beneficial
      conversion feature on preferred stocks
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (1,794
            )Net
      loss available to common shareholders
            
            $
            (1,559
            )
            
            $
            (1,371
            )
            
            $
            (2,708
            )
            
            $
            (5,153
            )Basic
      and diluted loss per common share - see note 2Loss
      from continuing operations
            
            $
            (0.08
            )
            
            $
            (0.07
            )
            
            $
            (0.14
            )
            
            $
            (0.18
            )Discontinued
      operations
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Preferred
      dividends
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.01
            )Beneficial
      conversion feature on preferred stocks
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (0.10
            )Basic
      and diluted loss per share available to common
      shareholders
            
            $
            (0.09
            )
            
            $
            (0.08
            )
            
            $
            (0.15
            )
            
            $
            (0.29
            )Weighted-average
      shares (basic and diluted)
            
            
            18,156,783
            
            
            
            18,087,528
            
            
            
            18,156,783
            
            
            
            17,962,113








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


4
  IMAGEWARE
SYSTEMS, INC.


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(In
Thousands)


(Unaudited)





Six Months Ended
              June 30,2009
            
            
            2008Cash
      flows from operating activitiesNet
      loss
            
            $
            (2,508
            )
            
            $
            (3,190
            )Adjustments
      to reconcile net loss to net cash used in operating
      activitiesDepreciation
      and amortization
            
            
            63
            
            
            
            395Change
      in fair value of additional financing obligation
            
            
            503
            
            
            
            —Loss
      on debt modification
            
            
            340
            
            
            
            —Non
      cash interest and amortization of debt discount and debt issuance
      costs
            
            
            224
            
            
            
            —Stock
      based compensation
            
            
            265
            
            
            
            178Change
      in assets and liabilitiesAccounts
      receivable, net
            
            
            5
            
            
            
            (65
            )Inventory,
      net
            
            
            (5
            )
            
            
            (53
            )Other
      assets
            
            
            22
            
            
            
            (10
            )Pension
      assets
            
            
            (16
            )
            
            
            (65
            )Accounts
      payable
            
            
            (21
            )
            
            
            828Accrued
      expenses
            
            
            444
            
            
            
            165Deferred
      revenue
            
            
            15
            
            
            
            182Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
            
            
            (399
            )
            
            
            531Pension
      obligation
            
            
            15
            
            
            
            65Total
      adjustments
            
            
            1,455
            
            
            
            2,151Net
      cash used in operating activities
            
            
            (1,053
            )
            
            
            (1,039
            )Cash
      flows from investing activitiesPurchase
      of property and equipment
            
            
            (6
            )
            
            
            (68
            )Acquisition
      of business, net of cash acquired
            
            
            —
            
            
            
            (187
            )Net
      cash used in investing activities
            
            
            (6
            )
            
            
            (255
            )Cash
      flows from financing activitiesProceeds
      from issuance of notes payable with warrants
            
            
            1,350
            
            
            
            —Dividends
      paid
            
            
            —
            
            
            
            (25
            )Financing
      issuance costs of notes payable
            
            
            (154
            )
            
            
            —Proceeds
      from exercised stock purchase warrants
            
            
            —
            
            
            
            542Net
      cash provided by financing activities
            
            
            1,196
            
            
            
            517Effect
      of exchange rate changes on cash
            
            
            (35
            )
            
            
            (51
            )Net
      increase (decrease) in cash
            
            
            102
            
            
            
            (828
            )Cash
      at beginning of period
            
            
            171
            
            
            
            1,044Cash
      at end of period
            
            $
            273
            
            
            $
            216Supplemental
      disclosure of cash flow information:Cash
      paid for interest
            
            $
            —
            
            
            $
            —Cash
      paid for income taxes
            
            $
            —
            
            
            $
            —Summary
      of non-cash investing and financing activities:Additional
      financing obligation
            
            $
            292
            
            
            $
            —Warrants
      issued with notes payable
            
            $
            345
            
            
            $
            —Warrants
      issued pursuant to debt modification
            
            $
            209
            
            
            $
            —Beneficial
      conversion feature of Series C and D preferred stock
            
            $
            —
            
            
            $
            1,794








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


5
  IMAGEWARE
SYSTEMS, INC


CONDENSED
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS


(In
Thousands)


(Unaudited)





Three Months Ended
              June 30,
            
            
            Six Months Ended
              June 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Net
      loss
            
            $
            (1,459
            )
            
            $
            (1,287
            )
            
            $
            (2,508
            )
            
            $
            (3,190
            )Foreign
      currency translation adjustment
            
            
            (37
            )
            
            
            (12
            )
            
            
            (35
            )
            
            
            (51
            )Comprehensive
      loss
            
            $
            (1,496
            )
            
            $
            (1,299
            )
            
            $
            (2,543
            )
            
            $
            (3,241
            )








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


6
  IMAGEWARE
SYSTEMS, INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1.  DESCRIPTION OF BUSINESS AND OPERATIONS





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





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





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





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





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




7





Our
enterprise authentication software includes the IWS Desktop Security product
which is a comprehensive authentication management infrastructure solution
providing added layers of security to workstations, networks and systems through
advanced encryption and authentication technologies. IWS Desktop Security is
optimized to enhance network security and usability, and uses multi-factor
authentication methods to protect access, verify identity and help secure the
computing environment without sacrificing ease-of-use features such as quick
login. Additionally, IWS Desktop Security provides an easy integration with
various smart card-based credentials including the Common Access Card (CAC),
Homeland Security Presidential Directive 12 (HSPD-12), Personal Identity
Verification (PIV) credential, and Transportation Worker Identification
Credential (TWIC) with an organization’s access control process. IWS Desktop
Security provides the crucial end-point component of a Logical Access Control
System (LACS), and when combined with a Physical Access Control System (PACS),
organizations benefit from a complete door to desktop access control and
security model.





Basis
of Presentation





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





The
accompanying condensed consolidated balance sheet as of December 31, 2008
has been derived from the Company’s audited balance sheet included in the
2008 Annual Report on Form 10-K and the condensed consolidated unaudited
financial statements of ImageWare have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission (“SEC”)
regarding interim financial reporting. Accordingly, they do not include all of
the information and footnotes required by generally accepted accounting
principles for annual financial statements and should be read in conjunction
with the consolidated financial statements for the year ended December 31,
2008, and notes thereto included in the Company’s Annual Report on
Form 10-K, filed with the SEC on February 24, 2010. In the opinion of
management, the accompanying condensed consolidated financial statements contain
all adjustments, consisting only of adjustments of a normal recurring nature,
necessary for a fair presentation of the Company’s financial position as of
June 30, 2009, and its results of operations for the periods presented.
These condensed consolidated unaudited financial statements for the period ended
June 30, 2009 are not necessarily indicative of the results to be expected
for the entire year.





Going
Concern





As
reflected in the accompanying consolidated financial statements, the Company has
continuing losses, negative working capital and negative cash flows from
operations. These matters raise substantial doubt about the Company’s ability to
continue as a going concern.





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





Despite
securing financing arrangements in prior years and 2010, additional new
financing will be required to fund working capital and operations should the
Company be unable to generate positive cash flow from operations in the near
future. The Company is exploring the possible sale of equity securities and/or
debt financing. However, there can be no assurance that additional financing
will be available.





Insufficient
funds will require the Company to sell certain of the Company’s assets or
license the Company’s technologies to others and if the Company is unable to
obtain additional funding there is substantial doubt about the Company’s ability
to continue as a going concern.





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





The
Company operates in markets that are emerging and highly competitive. There is
no assurance that the Company will operate at a profit or generate positive cash
flows in the future.





8





Recently
Issued Accounting Standards





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





In
December 2007, the FASB issued SFAS No. 141(R), “Business
Combinations” and SFAS No. 160, “Non-controlling Interests in Consolidated
Financial Statements”. The standards are intended to improve, simplify, and
converge internationally the accounting for business combinations and the
reporting of non-controlling interests in consolidated financial statements.
SFAS No. 141(R) requires the acquiring entity in a business
combination to recognize all (and only) the assets acquired and liabilities
assumed in the transaction; establishes the acquisition-date fair value as the
measurement objective for all assets acquired and liabilities assumed; and
requires the acquirer to disclose to investors and other users all of the
information they need to evaluate and understand the nature and financial effect
of the business combination. SFAS No. 141(R) is effective for fiscal
years, and interim periods within those fiscal years, beginning on or after
December 15, 2008. SFAS No. 141(R) applies prospectively to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after
December 15, 2008. Earlier adoption is prohibited. The Company will apply
SFAS 141(R) to business combinations occurring after the effective
date.





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





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





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





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





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





9


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





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





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





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





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





In May
2009 the FASB issued SFAS No. 165, Subsequent Events, or SFAS 165. SFAS 165
establishes general standards of accounting for and disclosure of events that
occur after the balance sheet date but before financial statements are issued or
are available to be issued. SFAS 165 requires the disclosure of the date through
which an entity has evaluated subsequent events and the basis for that date,
that is, whether the date represents the date the financial statements were
issued or were available to be issued. SFAS 165 is effective in the first
interim period ending after June 15, 2009. The adoption of SFAS 165 impacted the
disclosures in our consolidated financial statements.





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





10


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





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





In August
2009, the FASB issued an amendment to the accounting standards related to the
measurement of liabilities that are recognized or disclosed at fair value on a
recurring basis. This standard clarifies how a company should measure the fair
value of liabilities and that restrictions preventing the transfer of a
liability should not be considered as a factor in the measurement of liabilities
within the scope of this standard. This standard was effective on October 1,
2009. We do not expect the impact of its adoption to be material to our
financial statements.





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





In
October 2009, the FASB issued new standards for the accounting for certain
revenue arrangements that include software elements. These new standards amend
the scope of pre-existing software revenue guidance by removing from the
guidance non-software components of tangible products and certain software
components of tangible products. These new standards are required to be adopted
in the first quarter of 2011; however, early adoption is permitted. The Company
does not expect these new standards to significantly impact the financial
statements.





In
January 2010, the FASB issued amended standards that require additional fair
value disclosures. These amended standards require disclosures about inputs and
valuation techniques used to measure fair value as well as disclosures about
significant transfers, beginning in the first quarter of 2010. Additionally,
these amended standards require presentation of disaggregated activity within
the reconciliation for fair value measurements using significant unobservable
inputs (Level 3), beginning in the first quarter of 2011. The Company does not
expect these new standards to significantly impact the financial
statements.





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





Reclassifications





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





NOTE
2.  NET LOSS PER COMMON SHARE





Basic
loss per common share is calculated by dividing net loss available to common
shareholders for the period by the weighted-average number of common shares
outstanding during the period. Diluted earnings per common share is calculated
by dividing net loss available to common shareholders for the period by the
weighted-average number of common shares outstanding during the period, adjusted
to include, if dilutive, potential dilutive shares consisting of convertible
preferred stock, stock options and warrants, calculated using the treasury stock
method. During the periods ended June 30, 2009 and 2008, the Company has
excluded the following securities from the calculation of diluted loss per
share, as their effect would have been antidilutive due to the Company’s net
loss:




11





Potential Dilutive Securities:
            
            Number of
              Common Shares
              Convertible into at
              June 30, 2009
            
            
            Number of
              Common Shares
              Convertible into at
              June 30, 2008Restricted
      stock grants
            
            
            240,000
            
            
            
            —Convertible
      notes payable
            
            
            208,745
            
            
            
            —Convertible
      preferred stock
            
            
            10,389,499
            
            
            
            3,633,384Stock
      options
            
            
            2,298,288
            
            
            
            2,103,517Warrants
            
            
            16,671,167
            
            
            
            6,721,389





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





Three Months Ended
              June 30,
            
            
            Six Months Ended
              June 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Numerator
      for basic and diluted earnings per share:Net
      income (loss) from continuing operations
            
            $
            (1,459
            )
            
            $
            (1,294
            )
            
            $
            (2,508
            )
            
            $
            (3,197
            )Preferred
      dividends
            
            
            (100
            )
            
            
            (84
            )
            
            
            (200
            )
            
            
            (169
            )Beneficial
      conversion feature on preferred stocks
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (1,794
            )Net
      loss from continuing operations available to common
      shareholders
            
            $
            (1,559
            )
            
            $
            (1,378
            )
            
            $
            (2,708
            )
            
            $
            (5,160
            )Net
      income (loss) from discontinued operations
            
            
            —
            
            
            
            7
            
            
            
            —
            
            
            
            7Net
      loss available to common shareholders
            
            
            (1,559
            )
            
            
            (1,371
            )
            
            
            (2,708
            )
            
            
            (5,153
            )Denominator
      for basic and diluted earnings per share — weighted-average shares
      outstanding
            
            
            18,156,783
            
            
            
            18,087,528
            
            
            
            18,156,783
            
            
            
            17,962,113Basic
      and diluted income (loss) per share:Loss
      from operations
            
            $
            (0.08
            )
            
            $
            (0.07
            )
            
            $
            (0.14
            )
            
            $
            (0.18
            )Discontinued
      operations
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Preferred
      dividends
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.01
            )Beneficial
      conversion feature on preferred stocks
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (0.10
            )Net
      loss available to common shareholders
            
            $
            (0.09
            )
            
            $
            (0.08
            )
            
            $
            (0.15
            )
            
            $
            (0.29
            )





Preferred
stock dividends for the three months ended June 30, 2009 and 2008 were $100,000
and $84,000, respectively.  Preferred stock dividends for the six
months ended June 30, 2009 and 2008 were $200,000 and $169,000,
respectively.  The three months ended March 31, 2008 also contains
approximately $1,794,000 in preferred dividends attributable to an embedded
beneficial conversion feature recognized in conjunction with the issuance of
common stock pursuant to the Company’s warrant financing transaction consummated
in March 2008.





NOTE
3. INVENTORY





Inventories
at June 30, 2009 were comprised of work in process of $7,000 representing direct
labor costs on in-process projects and finished goods of $17,000 net of reserves
for obsolete and slow-moving items of $93,000. Inventories at December 31,
2008 were comprised of work in process of $9,000 representing direct labor costs
on in-process projects and finished goods of $10,000 net of reserves for
obsolete and slow-moving items of $93,000. Appropriate consideration is given to
obsolescence, excessive levels, deterioration, and other factors in evaluating
net realizable value and required reserve levels.





NOTE
4. FAIR VALUE ACCOUNTING





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





12


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





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





Level
2  Level 2 applies to assets or liabilities for which there are inputs
other than quoted prices includedwithin Level 1 that are observable for the
asset or liability such as quoted prices for similar assets or liabilities in
active markets; quoted prices for identical assets or liabilities in markets
with insufficient volume or infrequent transactions (less active markets); or
model-derived valuations in which significant inputs are observable or can be
derived principally from, or corroborated by, observable market
data.





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





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





Fair
      Value at June 30, 2009($
      in thousands)
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3Assets:Pension
      assets
            
            $
            697
            
            
            $
            697
            
            
            $
            —
            
            
            $
            —Totals
            
            $
            697
            
            
            $
            697
            
            
            $
            —
            
            
            $
            —Liabilities:Secured
      promissory note
            
            $
            818
            
            
            $
            —
            
            
            $
            —
            
            
            $
            818Additional
      financing obligation
            
            $
            877
            
            
            $
            —
            
            
            $
            —
            
            
            $
            877Totals
            
            $
            1,695
            
            
            $
            —
            
            
            $
            —
            
            
            $
            1,695





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





The fair
value of the Company’s secured notes payable and additional financing obligation
are classified within Level 3 of the fair value hierarchy because they are
valued using pricing models that incorporate management assumptions that cannot
be corroborated with observable market data.  The Company uses various
pricing models that are consistent with what other market participants would
use.  The inputs and assumptions to the models include the following:
benchmark yields, issuer spreads, benchmark securities, bids, offers and other
market-related data.  The methodology uses available information
applicable such as benchmark curves, benchmarking of like securities, sector
groupings and matrix pricing.  The application of such methodologies
includes the computation of market yield, credit risk return and illiquidity
return used as inputs to the pricing models.





Other
significant assumptions used in calculating the fair value of the note and the
additional financing obligation include the application of the Black-Scholes
option pricing model used to value the warrants issued to the
Lender.  The determination of fair value of the warrants issued to the
lender using the Black-Scholes option-pricing model is affected by our stock
price as well as assumptions regarding the expected stock price volatility over
the term of the warrants. The Company calculated the expected volatility
assumption required in the Black-Scholes model based on the historical
volatility of the Company’s stock.





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





13





NOTE
5. INTANGIBLE ASSETS AND GOODWILL





The
following table presents the changes in the carrying amounts of the Company’s
acquired intangible assets for the year ended December 31, 2008 and the six
months ended June 30, 2009. All intangible assets are being amortized over their
estimated useful lives with no estimated residual values.





($
      in thousands)
            
            TotalBalance
      of intangible assets as of January 1, 2008
            
            $
            2,437Intangible
      assets acquired
            
            
            —Amortization
      of intangible assets recorded during 2008
            
            
            (525
            )Pro
      rata reduction of Sol Logic assets from purchase accounting contingency
      resolution
            
            
            (1,060
            )Impairment
      charge on Sol Logic intangible assets recorded at December 31,
      2008
            
            
            (742
            )Balance
      of intangible assets as of December 31, 2008
            
            $
            110Intangible
      assets acquired
            
            
            —Amortization
      of intangible assets recorded during six months ended June 30,
      2009
            
            
            (8
            )Impairment
      losses recorded during six months ended June 30, 2009
            
            
            —Balance
      of intangible assets as of June 30, 2009
            
            $
            102




In
December 2007, the Company completed the acquisition of substantially all
the assets of Sol Logic, Inc. resulting in acquired intangible assets of
approximately $2,311,000.  Based on fair value methodologies, the
Company recorded approximately $2,018,000 in intangibles assets for developed
technology, $93,000 in customer relationship intangible assets and $200,000 for
a non-compete agreement.




In 2008,
the Company recorded an impairment charge of approximately $742,000 related to
our intangible assets related to the acquisition of Sol Logic in
2007.  This charge reflects the amount by which the carrying value of
this asset exceeded its estimated fair value determined by the assets’ future
discounted cash flows.  The impairment charge was recorded as a
component of Operating expenses in the consolidated Statement of Operations for
2008.  We recorded no impairment losses for long-lived or intangible
assets during the three and six months ended June 30, 2009. At June 30, 2009,
the EPI trademark and trade name is the Company’s only remaining definite-lived
intangible asset.





The
changes in the carrying amount of goodwill for the year ended December 31,
2008 and the six months ended June 30, 2009 are as follows:





($
      in thousands)
            
            TotalBalance
      of Goodwill as of January 1, 2008
            
            $
            4,452Goodwill
      acquired
            
            
            —Derecognition
      of goodwill resulting from amended purchase accounting
      agreement
            
            
            (1,036
            )Balance
      of Goodwill as of December 31, 2008
            
            $
            3,416Goodwill
      acquired
            
            
            —Impairment
      losses
            
            
            —Balance
      of Goodwill as of June 30, 2009
            
            $
            3,416





14


In
December 2007, the Company completed the acquisition of substantially all
the assets of Sol Logic, Inc. resulting in goodwill acquired of
approximately $1,036,000.  On March 28, 2008, the Company entered
into Amendment No. 1 to Asset Purchase Agreement (the “Purchase Agreement
Amendment”) to amend the Purchase Agreement. The terms of the Purchase Agreement
Amendment resulted in the de-recognition of the goodwill originally recorded of
$1,036,000.





The
Company annually, or more frequently if events or circumstances indicate a need,
tests the carrying amount of goodwill for impairment. The Company performs its
annual impairment test in the fourth quarter of each year. A two-step impairment
test is used to first identify potential goodwill impairment and then measure
the amount of goodwill impairment loss, if any. These tests were conducted by
determining and comparing the fair value of our reporting units, as defined in
SFAS 142, to the reporting unit’s carrying value. In 2006, we determined that
our only reporting unit is Identity Management. Based on the results of these
impairment tests, we determined that our goodwill assets were not impaired as of
December 31, 2008.





NOTE
6. COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS





The
Company recognizes revenues and cost of revenues on long-term, fixed price
contracts involving significant amounts of customization using the percentage of
completion method based on costs incurred to date compared to total estimated
costs at completion.  Such amounts are included in the accompanying
consolidated balance sheets at June 30, 2009 under the caption “Costs and
estimated earnings in excess of billings on uncompleted contract” and at
December 31, 2008 under the caption “Billings in excess of costs and estimated
earnings on uncompleted contract”.





Costs and
estimated billings on uncompleted contracts and related amounts billed as of
June 30, 2009 and December 31, 2008 are as follows:





($ in thousands)
            
            June 30,
              2009
            
            
            December 31,
              2008Costs
      incurred on uncompleted contract
            
            $
            192
            
            
            $
            108Estimated
      earnings
            
            
            712
            
            
            
            397904
            
            
            
            505Less:
      Billings to date
            
            
            (784
            )
            
            
            (784
            )Billings
      in excess of costs and estimated earnings on uncompleted
      contract
            
            $
            —
            
            
            $
            (279
            )Costs
      and estimated earnings in excess of billings on uncompleted
      contract
            
            $
            120
            
            
            $
            —





NOTE
7. NOTES PAYABLE AND ADDITIONAL INTEREST OBLIGATION





Notes
payable consist of the following:





($
      in thousands)
            
            June
      30,
            
            
            December
      31,2009
            
            
            2008Secured
      Promissory Note9%
      Secured promissory note. Face value of note $1,350. Discount on note at
      June 30, 2009 is $532. Note due June 30, 2010.
            
            $
            818
            
            
            
            —Total
      secured notes payable
            
            
            818
            
            
            
            —Notes
      payable to related parties:7%
      Convertible promissory notes. Face value of note $110. Discount on notes
      at June 30, 2009 and December 31, 2008 is $0 and $12, respectively.
      Notes were due February 14, 2009
            
            $
            110
            
            
            $
            98Total
      notes payable to related parties
            
            
            110
            
            
            
            98Total
      notes payable
            
            $
            928
            
            
            $
            98Less
      current portion
            
            
            (928
            )
            
            
            (98
            )Long-term
      notes payable
            
            $
            —
            
            
            $
            —





15


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





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





The
Company initially recorded the convertible notes net of a discount equal to the
fair value allocated to the warrants using the relative fair value method of
approximately $13,000.  The Company estimated the fair value of the
warrants using the Black-Scholes option pricing model using the following
assumptions: term of 5 years, a risk free interest rate of 2.53%, a dividend
yield of 0%, and volatility of 96%.  The convertible notes also
contained a beneficial conversion feature, which resulted in additional debt
discount of $12,000.  The beneficial conversion amount was measured
using the accounting intrinsic value, i.e. the excess of the aggregate fair
value of the common stock into which the debt is convertible over the proceeds
allocated to the security.  The Company has accreted the beneficial
conversion feature over the life of the note.  For the three and six
month periods ended June 30, 2009, the Company recorded $0 and $12,000,
respectively, as interest expense from the amortization of the discount related
to the fair value of the warrants and from the accretion of the beneficial
conversion feature.





The
Company did not repay the Convertible Notes on the due date. In August 2009, the
Company received from the Convertible Note holders a waiver of default and
extension to January 31, 2010 of the maturity date of the Convertible
Notes.  As consideration for the waiver and note extension, the Company
issued to the Convertible Note holders an aggregate of 150,000 warrants to
purchase shares of the Company’s common stock.  The warrants have an
exercise price of $0.54 per share and expire on August 25, 2014. The Company did
not repay the notes on January 31, 2010 and is currently seeking an additional
waiver of default from the holders of the Convertible Notes.





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





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





The
Company recorded the Note and Additional Financing Obligation net of a discount
equal to the fair values allocated to the various financial instruments issued
to the Lender.  The Company estimated the fair value of the warrants
using the Black-Scholes option pricing model and the following assumptions: term
of 5 years, a risk free interest rate of 1.49%, a dividend yield of 0%, and
volatility of 96% which resulted in note discount from the issuance of the
warrants of approximately $241,000.  The Company recorded the Note and
Additional Financing Obligation net of a discount equal to the fair values of
the note instrument and the additional financing component as determined by an
independent valuation specialist resulting in additional note discount of
approximately $569,000.





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





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





16


The
Company evaluated the waiver of default under EITF 96-19, “Debtor’s Accounting
for a Modification or Exchange of Debt Instruments” to determine if the
modification was substantial.  The Company determined that because the
change in fair value of the debt instruments was greater than 10% of the
carrying value of the debt, the debt modification was substantial and therefore
the Company accounted for the modification as a debt
extinguishment.  Accordingly, the Company recorded the new debt
instruments at fair value and recorded a loss on debt extinguishment of
approximately $340,000 during the three months ended June 30,
2009.   The loss on debt extinguishment of $340,000 includes
approximately $$114,000 of unamortized deferred financing fees written off due
to the debt extinguishment. The Company recorded the new debt instruments net of
a discount equal to the fair values allocated to the various financial
instruments issued to the Lender.  The Company estimated the fair
value of the warrants using the Black-Scholes option pricing model and the
following assumptions: term of 5 years, a risk free interest rate of 2.82%, a
dividend yield of 0%, and volatility of 96% which resulted in note discount from
the issuance of the warrants of approximately $450,000.  The Company
recorded the Note and Additional Financing Obligation net of a discount equal to
the fair values of the note instrument and the additional financing component at
the June 9, 2009 modification date as determined by an independent valuation
specialist resulting in additional note discount of approximately $448,000. The
Company is accreting the note discount and the Additional Financing Obligation
discount using the effective interest rate method over the life of the
Note.





In June
2009, the Lender and the Company further amended the Note (“Amendment No.2”)
whereby the Lender advanced the Company an additional $350,000 and amended
certain terms of the Note.  As consideration for the additional advance,
the Company issued to the Lender warrants to purchase 700,000 shares of Common
Stock of the Company at an exercise price of $0.50 per share.  Such
warrants may be exercised at any time from June 22, 2009 until June 22,
2014.





The
Company recorded Amendment No. 2 net of a discount equal to the fair value
allocated to warrants.  The Company estimated the fair value of the
warrants using the Black-Scholes option pricing model and the following
assumptions: term of 5 years, a risk free interest rate of 2.71%, a dividend
yield of 0%, and volatility of 96% which resulted in note discount from the
issuance of the warrants of approximately $104,000.





During
the three and six months ended June 30, 2009, the Company recorded approximately
$110,000 and $170,000 in amortization expense from the accretion of the note
discount and additional financing obligation discount.  Such amounts
are included as a component of interest expense in the Company’s condensed
consolidated Statement of Operations under the caption “Interest expense,
net”.





NOTE
8. REGISTRATION PAYMENT ARRANGEMENTS





On
September 25, 2007, the Company sold to certain accredited investors a
total of 2,016,666 shares of the Company’s common stock, par value $0.01
per share, at a purchase price of $1.50 per share for aggregate gross proceeds
of $3,025,003 (the “Common Stock Financing”). As part of the Common Stock
Financing, the Company entered into a Registration Payment Arrangement as
defined by FASB Staff Position No. EITF 00-19-2, “Accounting for
Registration Payment Arrangements” (“EITF 00-19-2”). EITF 00-19-2 specifies that
the contingent obligation to make future payments or otherwise transfer
consideration under a registration payment arrangement should be separately
recognized and measured in accordance with SFAS No. 5 “Accounting for
Contingencies” (“SFAS No. 5”). EITF 00-19-2 is effective for registration
payment arrangements entered into after December 21, 2006 or for the fiscal
year beginning after December 15, 2006.





As part
of the September 25, 2007 Common Stock registration payment arrangement,
the Company agreed to register the shares of common stock issued in the
financing and the shares of common stock underlying the warrants issued to the
investors in the Common Stock Financing with the SEC within certain
contractually specified time periods. The Company also agreed to use its best
efforts to keep the registration statement continuously effective until the
earlier of either the second year after the date the registration statement is
declared effective by the SEC or the date when all the common stock, including
the common stock underlying the warrants have been sold or may be sold without
volume limitations. If the Company is unable to register the shares of common
stock with the SEC or keep the registration statement continuously effective in
accordance with the Securities Purchase Agreement dated September 25, 2007,
between the Company and certain accredited investors, the Company is subject to
a liquidated damages penalty equal to 1% of the aggregate purchase price paid
for each month the registration statement is not effective, provided that such
liquidated damages shall not exceed 12% of the aggregate purchase
price.





The
maximum exposure at June 30, 2009 is approximately $363,000. The Company
initially met the requirements of the Common Stock Financing registration
payment arrangement by filing the required registration statement with the SEC
within the time frame specified by the agreement. During the third quarter of
2008, the Company was faced with limited funds for operations and was compelled
to suspend SEC filings. The Company has determined that approximately $54,000
of loss contingency related to the Common Stock Financing registration
payment arrangement is required to be recorded as of June 30,
2009.  Such loss contingency is included as a component of “Accrued
expenses” in the Company’s unaudited Condensed Consolidated Balance Sheet at
June 30, 2009 and as a component of “Interest expense, net” in the Company
unaudited Condensed Consolidated Statement of Operations for the six months
ended June 30, 2009.




17





NOTE 9. COMMON STOCK AND
WARRANTS





The
following table summarizes warrant activity for the following
periods:





WarrantsBalance
      at December 31, 2008
            
            
            10,471,167Granted
            
            
            6,200,000Expired
      / Canceled
            
            
            —Exercised
            
            
            —Balance
      at June 30, 2009
            
            
            16,671,167





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





In May
2009, the Company extended the expiration date of 1,311,753 warrants from June
13, 2009 to May 27, 2010 and changed the exercise price of the warrants from
$0.50 to $0.55 as consideration for the settlement in full of a $70,000 cash
liability.  There were no other changes to the terms of the warrants.
The Company recorded this warrant modification as the difference in fair values
of the warrants using the Black-Sholes option pricing model which resulted in
additional expense of approximately $52,000. Such expense in included as a
component of general and administrative operating expenses in the Company’s
Condensed Consolidated Statements of Operations for the three and six months
ended June 30, 2009.





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





In June
2009, the Lender and the Company further amended the Note (“Amendment No.2”)
whereby the Lender advanced the Company an additional $350,000 and amended
certain terms of the Note.  As consideration for the additional advance,
the Company issued to the Lender warrants to purchase 700,000 shares of Common
Stock of the Company at an exercise price of $0.50 per share.  Such
warrants may be exercised at any time from June 22, 2009 until June 22,
2014.





In June
2009, the Company extended the expiration date of 2,857,629 warrants held by
certain accredited investors from June 13, 2009 to July 31, 2009 to allow such
warrant holders the opportunity to exercise their warrants for
cash.  There were no other changes to the terms of the warrants. The
Company recorded this warrant modification as the difference in fair values of
the warrants using the Black-Scholes option pricing model which resulted in
additional expense of approximately $7,000.  Such expense in included
as a component of general and administrative operating expenses in the Company’s
Condensed Consolidated Statements of Operations for the three and six months
ended June 30, 2009.





NOTE
10. PREFERRED STOCK





At
June 30, 2009, the Company had cumulative undeclared dividends relating to
Series B, C and D Preferred Stock of approximately $59,000, $491,000 and
$317,000 respectively.





NOTE
11. SUBSEQUENT EVENTS





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





18


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





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





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





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





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





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





In
February 2010, the Lender and the Company amended the Note (“Amendment No. 5”)
whereby the Lender extended the due date of amounts due on January 31, 2010 to
March 15, 2010.





In March
2010, a holder of existing warrants exercised 400,000 warrants.  In
conjunction with this exercise, the Company issued 200,000 shares of Common
Stock and received cash proceeds of $200,000.





In March 2010, the Lender and the
Company amended the Note (“Amendment No.6”) whereby the Lender made an
additional advance of $250,000 under the Note.  As consideration for
the advance, the Company will pay the Lender additional interest on the maturity
date or such earlier date as may be required under the terms of the Note in an
amount equal to 200,000 multiplied by the average of the Closing prices for the
Common Stock of the Company for the ten (10) trading day period immediately
preceding the date of the payment of such interest payment.  As
additional consideration for making the advance, the Company assigned to the
Lender its rights, title and interest in and to fifty percent (50%) of certain
after-cost proceeds that may be received in connection with the Borrower's
prosecution of certain commercial tort claims (including, but not limited to,
claims related to the infringement of Borrower's intellectual property). In
conjunction with Amendment No. 6, the interest rate on the Note was changed to
10% per annum, retroactive to February 2009. Also in conjunction with Amendment
No. 6, the Lender extended the due dates of amounts due on March 15, 2010 to
June 30, 2010.





19





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





This
Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. All
forward-looking statements included in this report are based on information
available to us as of the date hereof and we assume no obligation to update any
forward-looking statements. Forward-looking statements involve known or unknown
risks, uncertainties and other factors, which may cause our actual results,
performance or achievements, or industry results to be materially different from
any future results, performance or achievements expressed or implied by such
forward-looking statements. Factors that could cause or contribute to such
differences include but are not limited to those items discussed under “Risk
Factors” beginning on page 32 and elsewhere in this Quarterly
Report.





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





OVERVIEW





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





CRITICAL
ACCOUNTING ESTIMATES





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





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





Revenue
Recognition





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





·
            Long-term
      fixed-price contracts involving significant
  customization




·
            Fixed-price
      contracts involving minimal
customization




·
            Software
      licensing




·
            Sales
      of computer hardware and identification
media




·
            Post
      contract customer support (PCS)





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





20


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





Allowance
for Doubtful Accounts





Our
management must make estimates of the collectability of our accounts receivable.
Management specifically analyzes accounts receivable and analyzes historical bad
debts, customer concentrations, customer creditworthiness, current economic
trends, the age of the accounts receivable balances, and changes in our customer
payment terms when evaluating the adequacy of the allowance for doubtful
accounts. Our accounts receivable balance was approximately $527,000 and our
allowance for doubtful accounts was approximately $28,000 as of June 30,
2009.





Income
Taxes





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





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





The
Company incurred no income tax expenses during the three and six month periods
ended June 30, 2009 and 2008, respectively.




Valuation
of Goodwill and Other Intangible Assets





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





·
            Significant
      underperformance relative to historical or expected future operating
      results;·
            Significant
      changes in the manner of our use of the acquired assets or the strategy of
      our overall business;·
            Significant
      negative industry or economic
trends;





When we
determine that the carrying value of goodwill and other intangible assets may
not be recoverable based upon the existence of one or more of the above
indicators of impairment, we measure any impairment based upon fair value
methodologies. Goodwill and other net intangible assets amounted to
approximately $3,518,000 for as of June 30, 2009. During the three months
ended March 31, 2008 we amended the purchase agreement for the acquisition
of substantially all the assets of Sol Logic, Inc. originally consummated
December 19, 2007. As a result of this amendment, which reduced the
purchase price of the Sol Logic assets, we reversed previously recorded goodwill
from this acquisition of approximately $1,036,000.





21


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





With the
sale of our Digital Photography component in 2006, we reassessed the composition
of our operating segments and determined that we no longer operate in separate,
distinct market segments but rather operate in one market segment, such segment
being identity management. The Company’s determination was based on fundamental
changes in the Company’s business structure due to the consolidation of
operations, restructuring of the Company’s operations and management team, and
the integration of what where previously distinct, mutually exclusive
technologies. This has resulted in changes in the manner by which the Company’s
chief decision maker assesses performance and makes decisions concerning
resource allocation. As a result of our operation in one market segment, such
segment being identity management, our 2007 and 2008 goodwill impairment review
consisted of the comparison of the fair value of our identity management segment
as determined by the quoted market prices of our common stock to the carrying
amount of the segment. As the fair value exceeded the carrying value by a
substantial margin, we determined that our goodwill was not impaired. We
determined that as of June 30, 2009 there were no indicators of potential
impairment.





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





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





In
December 2008, we recorded an impairment charge of approximately $742,000
related to our intangible assets related to our acquisition of Sol Logic in
2007.  This loss reflects the amount by which the carrying value of
this asset exceeded its estimated fair value determined by the assets’ future
discounted cash flows.  We recorded no impairment losses for
long-lived or intangible assets during the three and six month periods ended
June 30, 2009.





Stock-Based
Compensation





Upon
adoption of SFAS 123R on January 1, 2006, we began estimating the value of
employee 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 was
estimated on the date of grant using the Black-Scholes model for the purpose of
the pro forma financial disclosure in accordance with SFAS 123. The
determination of fair value of stock-based payment awards on the date of grant
using an option-pricing model is affected by our stock price as well as
assumptions regarding a number of highly complex and subjective variables. These
variables include, but are not limited to the expected stock price volatility
over the term of the awards and the actual and projected employee stock option
exercise behaviors. The expected term of options granted is derived from
historical data on employee exercises and post-vesting employment termination
behavior. We calculated our expected volatility assumption required in the
Black-Scholes model based on the historical volatility of our stock. In addition
to the key assumptions used in the Black-Scholes model, the estimated forfeiture
rate at the time of valuation is a critical assumption. The Company has
estimated an annualized forfeiture rate of 10% for corporate officers, 4% for
members of the Company’s Board of Directors and 24% for all other employees. The
Company reviews the expected forfeiture rate annually to determine if that
percent is still reasonable based on historical experience.





Fair-Value
Measurements





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





22


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





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





Level
2     Level 2 applies to assets or liabilities for
which there are inputs other than quoted prices included within Level 1 that are
observable for the asset or liability such as quoted prices for similar assets
or liabilities in active markets; quoted prices for identical assets or
liabilities in markets with insufficient volume or infrequent transactions (less
active markets); or model-derived valuations in which significant inputs are
observable or can be derived principally from, or corroborated by, observable
market data.





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





Assessing
the significance of a particular input to the fair value measurement requires
judgment, considering factors specific to the asset or
liability.  Determining whether a fair value measurement is based on
Level 1, Level 2, or Level 3 inputs is important because certain disclosures are
applicable only to those fair value measurements that use Level 3
inputs.  The use of Level 3 inputs may include information derived
through extrapolation or interpolation which involves management
assumptions.





RESULTS
OF OPERATIONS





Three
Months Ended June 30, 2009 Compared to the Three Months Ended June 30,
2008.





Three MonthsEnded
              June 30,Net Product Revenues
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            785
            
            
            $
            586
            
            
            $
            199
            
            
            
            34
            %Percentage
      of total net product revenue
            
            
            79
            %
            
            
            57
            %Hardware
      and consumables
            
            $
            25
            
            
            $
            97
            
            
            $
            (72
            )
            
            
            (74
            )%Percentage
      of total net product revenue
            
            
            2
            %
            
            
            10
            %Services
            
            $
            189
            
            
            $
            337
            
            
            $
            (148
            )
            
            
            (44
            )%Percentage
      of total net product revenue
            
            
            19
            %
            
            
            33
            %Total
      net product revenues
            
            $
            999
            
            
            $
            1,020
            
            
            $
            (21
            )
            
            
            (2
            )%





Software
and royalty revenues increased 34% or $199,000 during the three months ended
June 30, 2009 as compared to the corresponding period in 2008. This
increase is due to higher project-oriented revenues of our Law Enforcement
software solutions of approximately $219,000 combined with higher sales of boxed
identity management software through our distribution channel of approximately
$56,000.  These increases were offset by a decrease in our
identification software royalties and license revenues of approximately $64,000
combined with lower sales of our identity management software into project
solutions of approximately $12,000.





Revenues
from the sale of hardware and consumables decreased 74% or approximately $72,000
during the three months ended June 30, 2009 as compared to the
corresponding period in 2008. The decrease reflects lower revenues from project
solutions containing hardware and consumable components.





Services
revenues are comprised primarily of software integration services, system
installation services and customer training. Such revenues decreased
approximately $148,000 during the three months ended June 30, 2009 as
compared to the corresponding period in 2008 due primarily to the completion of
the service element in certain contracts.





23
 
 
 We expect
service revenues to continue to be a significant component of our revenues
through our implementation of large-scale high-end
installations.





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





Our
backlog of product orders as of June 30, 2009, was approximately
$1,974,000.  At June 30, 2009, we also had maintenance and
support backlog of approximately $612,000 under existing maintenance
agreements.  Product revenue is typically recognized within a three to
six month period for projects not requiring significant customization. Projects
that require significant customization can range from six months to two years
depending upon the required degree of customization and customer implementation
schedules. Historically, we have experienced a very minimal risk of order
cancellation and do not anticipate order cancellations in excess of
5%.  Our revenue from maintenance agreements is generally recognized
ratably over the respective maintenance periods provided no significant
obligations remain and collectability of the related receivable is
probable.





Three MonthsEnded
              June 30,Maintenance Revenues
            
            2009
            
            
            2008
            
            
            $
      Change
            
            
            %
      Change(dollars in thousands)Maintenance
      revenues
            
            $
            646
            
            
            $
            647
            
            
            $
            (1
            )
            
            
            0
            %





Maintenance
revenues were $646,000 for three months ended June 30, 2009 as compared to
$647,000 for the corresponding period in 2008.  Identity management
maintenance revenues generated from identification software solutions were
$138,000 for the three months ended June 30, 2009 as compared to $165,000 during
the comparable period in 2008.  The decrease of 27,000 is due to lower
maintenance revenues generated from our Desktop Security product due to the
expiration of certain maintenance contracts related to this product. Law
enforcement maintenance revenues increased by $26,000 for the three month period
ended June 30, 2009 as compared to the corresponding period in 2008 due to our
expanding installed base.





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





Three MonthsEnded
              June 30,Cost of Product Revenues:
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            120
            
            
            $
            81
            
            
            $
            39
            
            
            
            48
            %Percentage
      of software and royalty product revenue
            
            
            15
            %
            
            
            14
            %Hardware
      and consumables
            
            $
            26
            
            
            $
            83
            
            
            $
            (57
            )
            
            
            (69
            )%Percentage
      of hardware and consumables product revenue
            
            
            104
            %
            
            
            86
            %Services
            
            $
            171
            
            
            $
            106
            
            
            $
            65
            
            
            
            61
            %Percentage
      of services product revenue
            
            
            90
            %
            
            
            31
            %Total
      product cost of revenues
            
            $
            317
            
            
            $
            270
            
            
            $
            47
            
            
            
            17
            %Percentage
      of total product revenues
            
            
            32
            %
            
            
            26
            %





The cost
of software and royalty product revenue increased 48% or $39,000 during the
three months ended June 30, 2009 as compared to the corresponding period in
2008 due to higher software and royalty revenues generated during the three
months ended June 30, 2009 as compared to the corresponding period in 2008.
In addition to changes in costs of software and royalty product revenue caused
by revenue level fluctuations, costs of products can vary as a percentage of
product revenue from period to period depending upon level of software
customization and third party software license content included in product sales
during a given period.





24


The
decrease in the cost of product revenues for our hardware and consumable sales
of $57,000 for the three months ended June 30, 2009 as compared to the
corresponding period in 2008 reflects the decrease in hardware and consumable
revenues for the three months ended June 30, 2009 as compared to the comparable
period in 2008 combined with lower costs incurred on hardware and consumable
procurements.





The cost
of services revenues increased $65,000 during the three months ended June 30,
2009 as compared to the corresponding period of 2008.  This increase
is due to the direct labor costs incurred in excess of revenues generated on
certain contracts during this period.





Three MonthsEnded
              June 30,Cost
      of Maintenance Revenues
            
            2009
            
            
            2008
            
            
            $
      Change
            
            
            % Change(dollars in thousands)Total
      maintenance cost of revenues
            
            $
            199
            
            
            $
            289
            
            
            $
            (90
            )
            
            
            (31
            )%Percentage
      of total maintenance revenues
            
            
            31
            %
            
            
            45
            %





Cost of
maintenance revenues as a percentage of maintenance revenues decreased to 31%
during the three months ended June 30, 2009 from 45% for the corresponding
period in 2008 due primarily to a higher percentage of the Company’s maintenance
revenues being generated from software only solutions which typically have lower
maintenance costs than those solutions containing both software and
hardware.





Three MonthsEnded
              June
      30,Product gross profit
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            665
            
            
            $
            505
            
            
            $
            160
            
            
            
            32
            %Percentage
      of software and royalty product revenue
            
            
            85
            %
            
            
            86
            %Hardware
      and consumables
            
            $
            (1
            )
            
            $
            14
            
            
            $
            (15
            )
            
            
            (107
            )%Percentage
      of hardware and consumables product revenue
            
            
            -4
            %
            
            
            14
            %Services
            
            $
            18
            
            
            $
            231
            
            
            $
            (213
            )
            
            
            (92
            )%Percentage
      of services product revenue
            
            
            10
            %
            
            
            69
            %Total
      product gross profit
            
            $
            682
            
            
            $
            750
            
            
            $
            (68
            )
            
            
            (9
            )%Percentage
      of total product revenues
            
            
            68
            %
            
            
            74
            %





Software
and royalty gross profit increased by 32% or approximately $160,000 for the
three months ended June 30, 2009 from the corresponding period in 2008 due
to higher software and royalty product revenues of approximately $199,000 in the
2009 period. Costs of software products can vary as a percentage of product
revenue from quarter to quarter depending upon product mix and third party
software licenses included in software solutions.





Hardware
and consumables gross profit decreased by $15,000 for the three month period
ended June 30, 2009 as compared to the corresponding period in 2008 due to lower
hardware and consumables revenues of approximately $72,000 in the three month
period ended June 30, 2009 as compared to the corresponding period in the 2008
year.





Services
gross profit decreased $213,000 due to higher costs of services revenues of
approximately $65,000 caused by an excess of direct labor costs incurred over
revenues generated on certain contracts during the three month period ending
June 30, 2009 as compared to the corresponding period in 2008.





Three MonthsEnded
              June 30,Maintenance gross profit
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Total
      maintenance gross profit
            
            $
            447
            
            
            $
            358
            
            
            $
            89
            
            
            
            25
            %Percentage
      of total maintenance revenues
            
            
            69
            %
            
            
            55
            %




25





Gross
margins related to maintenance revenues increased due to lower maintenance cost
of revenues due primarily to a higher percentage of the Company’s maintenance
revenues being generated from software only solutions which typically have lower
maintenance costs than those solution containing both software and
hardware.




Three Months
      Ended
              June 30,Operating expenses
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)General &
      administrative
            
            $
            595
            
            
            $
            944
            
            
            $
            (349
            )
            
            
            (37
            )%Percentage
      of total net revenue
            
            
            36
            %
            
            
            57
            %Sales
      and marketing
            
            $
            451
            
            
            $
            548
            
            
            $
            (97
            )
            
            
            (18
            )%Percentage
      of total net revenue
            
            
            27
            %
            
            
            33
            %Research &
      development
            
            $
            553
            
            
            $
            731
            
            
            $
            (178
            )
            
            
            (24
            )%Percentage
      of total net revenue
            
            
            34
            %
            
            
            44
            %Depreciation
      and amortization
            
            $
            30
            
            
            $
            194
            
            
            $
            (164
            )
            
            
            (85
            )%Percentage
      of total net revenue
            
            
            2
            %
            
            
            12
            %





General and
Administrative Expenses. General and administrative expenses are
comprised primarily of salaries and other employee-related costs for executive,
financial, and other infrastructure personnel. General legal, accounting and
consulting services, insurance, occupancy and communication costs are also
included with general and administrative expenses. The increase in such
expenses, as a percentage of total net revenues, is reflective of lower net
revenues during the three months ended June 30, 2009 as compared to the
corresponding period in 2008. The dollar decrease of $349,000 is primarily
comprised of the following major components:




·
              Decrease in stock-based
      compensation expense of approximately $46,000 due to the expiration of
      certain restricted stock grants combined with lower expenses recorded
      pursuant to SFAS 123(R) due to the expiration of vesting periods for
      certain prior year share-based payment
      issuances.
 ·
              Decrease in insurance
      related expenses of approximately
      $4,000.
 ·
              Decrease in professional
      services of approximately
  $114,000.
 ·
              Decrease in office related
      expenses of approximately
  $56,000.
 ·
              Decrease in travel related expenses
      of approximately
$24,000.


·
              Decrease in compensation and
      related fringe benefits of approximately
      $105,000.





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





Sales and
Marketing.  Sales and marketing expenses consist primarily of
the salaries, commissions, other incentive compensation, employee benefits and
travel expenses of our sales, marketing, business development and product
management functions. The dollar decrease of $97,000 during the three months
ended June 30, 2009 as compared to the corresponding period in 2008 is
comprised of the following major components:





·
            Decrease
      in compensation and related fringe benefits of approximately $69,000 due
      to headcount reductions and the consolidation of certain sales
      positions.


·
            Decrease
      in stock-based compensation expense of approximately $12,000 due to the
      expiration of certain restricted stock grants combined with lower expenses
      recorded pursuant to SFAS 123(R) due to the expiration of vesting
      periods for certain prior year share-based payment
    issuances.


·
            Decrease
      in travel related expenses of
$28,000.


·
            Decrease
      of $36,000 in amounts paid to sales
consultants


·
            Increase
      in selling expenses of approximately $48,000 related to newly hired sales
      personnel in Mexico.




26




Research and
Development.Research and
development expenses consist primarily of salaries, employee benefits and
outside contractors for new product development, product enhancements and custom
integration work. Such expenses decreased 24% or approximately $178,000 for the
three months ended June 30, 2009 as compared to the corresponding period in
2008 and is comprised of the following major components:





·
            Decrease
      in compensation and related fringe benefits of approximately $151,000 due
      to head count reductions and the consolidation of various engineering
      functions


·
            Decrease
      in contract programming expenditures of approximately
    $23,000


·
            Decrease
      in engineering supplies and travel related expenditures of approximately $
      29,000


·
            Increase
      in occupancy costs of approximately
$25,000





Our level
of expenditures in research and development reflects our belief that to maintain
our competitive position in markets characterized by rapid rates of
technological advancement, we must continue to invest significant resources in
new systems and software development as well as continue to enhance existing
products.





Depreciation and
Amortization. During the three months ended June 30, 2009,
depreciation and amortization expense decreased 85% or $164,000 as compared to
the corresponding period in 2008. The decrease in depreciation and amortization
expense reflects lower amortization of approximately $122,000 for certain
definite long-lived intangible assets acquired in the Company’s
December 2007 purchase of certain assets of Sol Logic, Inc. due to
impairment charges being recorded against these assets in December
2008.  For the three months ended June 30, 2009, the Company’s
amortization expense of $4,000 consisted solely of amortization expense incurred
on the Company’s EPI trademark and trade name intangible asset.





Interest Expense
(Income), net.For the three months
ended June 30, 2009, we recognized interest income of $0 and interest expense of
$233,000. For the three months ended June 30, 2008, we recognized interest
income of $2,000 and interest expense of $2,000.  Interest expense for
the three months ended June 30, 2009 contains the following components
approximating a total of $183,000 related to our secured notes payable issued in
February 2009: $32,000 in coupon interest and $151,000 in note discount
amortization and additional financing obligationamortization classified
and deferred financing fee amortization  classified as interest
expense.





Six
Months Ended June 30, 2009 Compared to the Six Months Ended June 30,
2008





Product
Revenues





Six MonthsEnded
              June 30,Net
      Product Revenues
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            1,175
            
            
            $
            1,245
            
            
            $
            (70
            )
            
            
            (6
            )%Percentage
      of total net product revenue
            
            
            70
            %
            
            
            69
            %Hardware
      and consumables
            
            $
            85
            
            
            $
            117
            
            
            $
            (32
            )
            
            
            (27
            )%Percentage
      of total net product revenue
            
            
            5
            %
            
            
            7
            %Services
            
            $
            414
            
            
            $
            435
            
            
            $
            (21
            )
            
            
            (5
            )%Percentage
      of total net product revenue
            
            
            25
            %
            
            
            24
            %Total
      net product revenues
            
            $
            1,674
            
            
            $
            1,797
            
            
            $
            (123
            )
            
            
            (7
            )%





Software
and royalty revenues decreased 6% or $70,000 during the six months ended June
30, 2009 as compared to the corresponding period in 2008.  The
decrease is due primarily to lower identification software royalties and license
revenues of approximately $119,000 resulting primarily from our Desktop Security
product combined with lower sales of our identity management software into
project solutions of approximately $236,000 offset by higher sales of our boxed
identity management software through our distribution channel of approximately
$46,000 and higher Law Enforcement project-oriented revenues of approximately
$239,000.





Revenues
from the sale of hardware and consumables decreased 27% or $32,000 during the
six months ended June 30, 2009 as compared to the corresponding period in
2008.  The decrease reflects lower revenues from project solutions
containing hardware and consumable components.





Services
revenues are comprised primarily of software integration services, system
installation services and customer training.  Such revenues decreased
approximately $21,000 during the six months ended June 30, 2009 as compared to
the corresponding period in 2008 due primarily to lower service revenues being
generated from software integration of our biometric engine and PIV products
into project solutions combined with a reduction in our installation of hardware
products.





27


We expect
service revenues to continue to be a significant component of our revenues
through our implementation of large-scale high-end installations.





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





Maintenance
Revenues





Six MonthsEnded
              June 30,Maintenance
      Revenues
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Maintenance
      revenues
            
            $
            1,285
            
            
            $
            1,253
            
            
            $
            32
            
            
            
            3
            %





The
increase in maintenance revenues reflects the expansion of our law enforcement
installed base resulting from the completion of significant project-oriented
work during the year ended December 31, 2008 and the first six months of
2009.





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





Cost
of Product Revenues





Six MonthsEnded
              June 30,Cost of Product Revenues:
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            165
            
            
            $
            186
            
            
            $
            (21
            )
            
            
            (11
            )%Percentage
      of software and royalty product revenue
            
            
            14
            %
            
            
            15
            %Hardware
      and consumables
            
            $
            67
            
            
            $
            110
            
            
            $
            (43
            )
            
            
            (39
            )%Percentage
      of hardware and consumables product revenue
            
            
            79
            %
            
            
            94
            %Services
            
            $
            369
            
            
            $
            113
            
            
            $
            256
            
            
            
            227
            %Percentage
      of services product revenue
            
            
            89
            %
            
            
            26
            %Total
      cost of product revenues
            
            $
            601
            
            
            $
            409
            
            
            $
            192
            
            
            
            47
            %Percentage
      of total product revenues
            
            
            36
            %
            
            
            23
            %





The cost
of software and royalty product revenue decreased 11% or $21,000 during the six
months ended June 30, 2009 as compared to the corresponding period in 2008 due
to lower software and royalty revenues during the six months ended June 30,
2009.  In addition to changes in costs of software and royalties
product revenues caused by revenue level fluctuations, costs of products can
also vary as a percentage of product revenue from period to period depending
upon level of software customization and third party software license content
included in product sales during a given period.





The
decrease in the cost of product revenues for our hardware and consumable sales
of $43,000 for the six months ended June 30, 2009 as compared to the
corresponding period in 2008 reflects the decrease in hardware and consumable
revenues for the three months ended June 30, 2009 as compared to the same period
in 2008 combined with lower costs incurred on hardware and consumable
procurements.





Cost of
service revenue increased $256,000 during the six months ended June 30, 2009 as
compared to the corresponding period in 2008 due to higher software integration
revenues of our Biometric Engine and PIV products into project solutions. This
increase is also due to the direct labor costs incurred in excess of revenues
generated on certain contracts during this period.





28


Cost
of Maintenance Revenues





Six MonthsEnded
              June 30,Cost of
      Maintenance Revenues
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Total
      maintenance cost of revenues
            
            $
            408
            
            
            $
            604
            
            
            $
            196
            
            
            
            (32
            )%Percentage
      of total maintenance revenues
            
            
            32
            %
            
            
            48
            %





Cost of
maintenance revenues decreased 32% or $196,000 during the six months ended June
30, 2009 as compared to the corresponding period in 2008 due primarily to a
higher percentage of the Company’s maintenance revenues being generated from
software only solutions which typically have lower maintenance costs than those
solution containing both software and hardware.





Product
Gross Profit





Six MonthsEnded
              June 30,Product gross profit
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Software
      and royalties
            
            $
            1,010
            
            
            $
            1,059
            
            
            $
            (49
            )
            
            
            (5
            )%Percentage
      of software and royalty product revenue
            
            
            86
            %
            
            
            85
            %Hardware
      and consumables
            
            $
            18
            
            
            $
            7
            
            
            $
            11
            
            
            
            157
            %Percentage
      of hardware and consumables product revenue
            
            
            21
            %
            
            
            6
            %Services
            
            $
            45
            
            
            $
            322
            
            
            $
            (277
            )
            
            
            (86
            )%Percentage
      of services product revenue
            
            
            11
            %
            
            
            74
            %Total
      product gross profit
            
            $
            1,073
            
            
            $
            1,388
            
            
            $
            (315
            )
            
            
            (23
            )%Percentage
      of total product revenues
            
            
            64
            %
            
            
            77
            %





Software
and royalty gross profit decreased 5% or $49,000 for the six months ended June
30, 2009 as compared to the corresponding period in 2008 due to lower software
and royalties revenues.





Hardware
and consumables gross profit increased $11,000 during the six months ended June
30, 2009 as compared to the corresponding period in 2008 due to both lower
hardware and consumables revenues of $32,000 and lower costs incurred on sales
of hardware and consumables of $43,000 during the six months ended June 30, 2009
as compared to the corresponding period in 2008. Costs of products can vary as a
percentage of product revenue from quarter to quarter depending upon product mix
and hardware content and print media consumable content included in systems
installed during a given period.





Services
gross profit decreased approximately $277,000 for the six months ended June 30,
2009 as compared to the corresponding period of 2008 due to higher integration
costs incurred for the integration of our Biometric Engine and PIV products into
project solutions caused by an excess of direct labor costs incurred over
revenues generated on certain contracts during the six month period ending
June 30, 2009 as compared to the corresponding period in 2008.





Maintenance
Gross Profit





Six MonthsEnded
              June 30,Maintenance gross profit
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)Total
      maintenance gross profit
            
            $
            877
            
            
            $
            649
            
            
            $
            228
            
            
            
            35
            %Percentage
      of total maintenance revenues
            
            
            68
            %
            
            
            52
            %





Gross
margins related to maintenance revenues increased due primarily to a higher
percentage of the Company’s maintenance revenues being generated from software
only solutions which typically have lower maintenance costs than those solution
containing both software and hardware.




29


Operating
Expenses





Six Months Ended
              June 30,Operating expenses
            
            2009
            
            
            2008
            
            
            $ Change
            
            
            % Change(dollars in thousands)General
      & administrative
            
            $
            1,204
            
            
            $
            2,045
            
            
            $
            (841
            )
            
            
            (41
            )%Percentage
      of total net revenue
            
            
            41
            %
            
            
            67
            %Sales
      and marketing
            
            $
            880
            
            
            $
            1,214
            
            
            $
            (334
            )
            
            
            (28
            )%Percentage
      of total net revenue
            
            
            30
            %
            
            
            40
            %Research
      & development
            
            $
            1,141
            
            
            $
            1,628
            
            
            $
            (487
            )
            
            
            (30
            )%Percentage
      of total net revenue
            
            
            39
            %
            
            
            53
            %Depreciation
      and amortization
            
            $
            63
            
            
            $
            395
            
            
            $
            (332
            )
            
            
            (84
            )%Percentage
      of total net revenue
            
            
            2
            %
            
            
            13
            %





General and
Administrative Expenses.  General and administrative expenses
are comprised primarily of salaries and other employee-related costs for
executive, financial, and other infrastructure personnel. General legal,
accounting and consulting services, insurance, occupancy and communication costs
are also included with general and administrative expenses.  The
dollar decrease of $841,000 is comprised of the following major
components:




·
            Decrease in stock-based
      compensation expense of approximately $95,000 due to the expiration of
      certain restricted stock grants combined with lower expenses recorded
      pursuant to SFAS 123(R) due to the expiration of vesting periods for
      certain prior year share-based payment
  issuances.


·
            Decrease in insurance
      related expenses of approximately
  $10,000.


·
            Decreasein professional
      services of approximately
$448,000.


·
            Decrease in occupancy related
      expenses and other expenses of approximately
    $83,000.


·
            Decrease in travel related expenses
      of approximately $46,000.


·
            Decrease in compensation and
      related fringe benefits of approximately $159,000 due to reductions in
      headcount and the consolidation of various administrative
      positions.





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





Sales and
Marketing.  Sales and marketing expenses consist primarily of
the salaries, commissions, other incentive compensation, employee benefits and
travel expenses of our sales, marketing, business development and product
management functions.  The dollar decrease of $334,000 during the six
months ended June 30, 2009 as compared to the corresponding period in 2008 is
comprised of the following major components:





·
            Decrease
      in compensation and related fringe benefits of approximately $183,000 due
      to reductions in headcount and the consolidation of certain sales
      positions.


·
            Decrease
      of $45,000 in expenses incurred for sales contractors and
      consultants.


·
            Decrease
      of $107,000 in travel expenses and trade show
  expenses.


·
            Decrease
      in stock-based compensation expense of approximately $25,000 due to the
      expiration of certain restricted stock grants combined with lower expenses
      recorded pursuant to SFAS 123(R) due to the expiration of vesting
      periods for certain prior year share-based payment
    issuances.


·
            Decrease
      of approximately $22,000 in occupancy costs and dues and subscription
      costs.


·
            Increase
      of $48,000 in expenses related to our Mexico City sales office opened in
      June 2009.





30




Research and
Development.  Research and development expenses consist
primarily of salaries, employee benefits and outside contractors for new product
development, product enhancements and custom integration work. Such expenses
decreased 30% or $487,000 for the six months ended June 30, 2009 as compared to
the corresponding period in 2008.  The decrease is comprised of the
following major components:





·
            Decrease
      of $329,000 in compensation and related fringe benefits due to reductions
      in headcount combined with reductions in contract programming expenditures
      of approximately $133,000.


·
            Decrease
      in stock-based compensation expense of approximately $7,000 due to the
      expiration of certain restricted stock grants combined with lower expenses
      recorded pursuant to SFAS 123(R) due to the expiration of vesting
      periods for certain prior year share-based payment
    issuances.


·
            Reductions
      in engineering supplies and small equipment of approximately $28,000
      offset by an increase in occupancy costs of approximately
      $21,000


·
            Reductions
      in engineering travel of $11,000.





Our level
of expenditures in research and development reflects our belief that to maintain
our competitive position in markets characterized by rapid rates of
technological advancement, we must continue to invest significant resources in
new systems and software as well as continue to enhance existing
products.





Depreciation and
Amortization.  During the six months ended June 30, 2009,
depreciation and amortization expense decreased 84% or $332,000 as compared to
the corresponding period in 2008.  The decrease in depreciation and
amortization expense reflects lower amortization of approximately $265,000 for
certain definite long-lived intangible assets acquired in the Company’s
December 2007 purchase of certain assets of Sol Logic, Inc. due to
impairment charges being recorded against these assets in December
2008.  For the three months ended June 30, 2009, the Company’s
amortization expense of $8,000 consisted  solely of amortization
expense incurred on the Company’s EPI trademark and trade name intangible
asset.





Interest Expense
(Income), net.  For the six months ended June 30, 2009, we
recognized interest income of $0 and interest expense of $319,000. For the six
months ended June 30, 2008, we recognized interest income of $7,000 and
interest expense of $2,000.  Interest expense for the six months ended
June 30, 2009 contains components approximating $250,000 related to our
secured notes payable: $39,000 of coupon interest and $211,000 in note discount
amortization and additional financing obligation amortization and deferred
financing fee amortization classified as interest expense.





LIQUIDITY
AND CAPITAL RESOURCES





As of
June 30, 2009, we had total current assets of $1,084,000 and total current
liabilities of $7,032,000, or negative working capital of $5,948,000. At
June 30, 2009, we had available cash of $273,000. Subsequent to June 30,
2009, we borrowed an aggregate amount of approximately $1,225,000 and
subsequently repaid $350,000 in conjunction with a line of credit arrangement
secured through the issuance of a secured promissory note. In July and August
2009, we also undertook a series of warrant financings whereby we raised
approximately $1,371,000 in cash.  Despite securing these financing
arrangements, we still have negative working capital and will need to secure
additional new financing to fund working capital and operations should we be
unable to generate positive cash flow from operations in the near
future.




N et cash
used in operating activities was $1,053,000 for the six month period ended
June 30, 2009 as compared to $1,039,000 for the corresponding period in
2008. We used cash to fund net losses of $1,113,000, excluding non-cash expenses
(depreciation, amortization, stock-based compensation, change in fair value of
additional financing obligation, amortization of debt discount and debt issuance
costs and loss on debt modification) of $1,395,000 for the six months ended
June 30, 2009. We used cash to fund net losses of $2,617,000, excluding
non-cash expenses (depreciation, amortization, and stock-based compensation) of
$573,000 for the six months ended June 30, 2008. For the six months ended
June 30, 2009, we generated cash of $6,000 through reductions in assets and
generated cash of $54,000 through increases in current liabilities and deferred
revenues, excluding debt. For the six months ended June 30, 2008, we used
cash of $193,000 to fund increases in assets and generated cash of $1,771,000
through increases in current liabilities and deferred revenues, excluding
debt.





Net cash
used in investing activities was $6,000 for the six months ended June 30,
2009. Net cash used in investing activities was $255,000 for the six months
ended June 30, 2008. For the six months ended June 30, 2009, we used
cash to fund capital expenditures of computer equipment, software and furniture
and fixtures of approximately $6,000. This level of equipment purchases resulted
primarily from the replacement of older equipment. For the six months ended
June 30, 2008, we used cash to fund capital expenditures of computer
equipment and software, furniture and fixtures and leasehold improvements of
approximately $68,000. For the six months ended June 30, 2008 we also used cash
of approximately $187,000 for our acquisition of Sol
Logic, Inc.





31


Net cash
provided by financing activities was $1,196,000 for the six month period ended
June 30, 2009 as compared to $517,000 for the corresponding period in 2008.
For the six months ended June 30, 2009, we generated cash of $1,350,000
through our issuance of a secured note payable offset by financing transaction
costs of $154,000. For the six months ended June 30, 2008, we generated
cash of $542,000 from our issuance of common stock pursuant to warrant exercises
and used cash of $25,000 for the payment of dividends on our Series B Preferred
Stock.





We
conduct operations in leased facilities under operating leases expiring at
various dates through 2013.  We also have various short-term notes
payable and capital lease obligations due at various times during
2009.





The
report of our independent accountants included with our Annual Report on
Form 10-K as filed with the Commission on February 24, 2010, contained an
explanatory paragraph regarding our ability to continue as a going
concern.  We are seeking additional financing that we believe is
necessary to fund our working capital requirements for at least the next twelve
months in conjunction with the successful implementation of our business plan.
Our business plan includes, among other things, the monitoring and controlling
of operating expenses, collection of significant trade and other accounts
receivables, and controlling of capital expenditures.  If we are
unable to secure additional financing or successfully implement our business
plan, we will be required to seek funding from alternate sources and/or
institute cost reduction measures.  We may seek to sell equity or debt
securities, secure a bank line of credit, or consider strategic
alliances.  The sale of equity or equity-related securities could
result in additional dilution to our shareholders.  There can be no
assurance that additional financing, in any form, will be available at all or,
if available, will be on terms acceptable to us.  In addition, our
ability to raise additional capital may be impacted by the markets on which our
common stock is quoted and our ability to maintain compliance with SEC filing
requirements.  In May of 2008 the AMEX removed ImageWare’s common
stock from being listed on their exchange as we failed to comply with AMEX’s
continued listing standards.  In December of 2008 our common stock was
removed from being quoted on the Over-the-Counter Bulletin Board as we failed to
make the required filings with the SEC in the required timeframe.  As
of the end of the third quarter of 2008 we were faced with limited funds for
operations and were compelled to suspend SEC filings and the associated costs
until such time as we had sufficient resources to cover ongoing operations and
the expenses of maintaining compliance with SEC filing
requirements.   There is no assurance that we will be able to
attain compliance with SEC filing requirements in the future, and if we are able
to attain compliance, there is no assurance we will be able to maintain
compliance.  If we are not able to attain and maintain compliance for
minimum required periods, we will not be eligible for re-listing on the
Over-the-Counter Bulletin board or other exchanges.





Insufficient
funds may require us to delay, scale back or eliminate some or all of our
activities, and if we are unable to obtain additional funding there is
substantial doubt about our ability to continue as a going concern.




ITEM
4T. CONTROLS AND PROCEDURES





Conclusions
Regarding the Effectiveness of Disclosure Controls and Procedures.Under the supervision
and with the participation of our management, including our principal executive
officer and principal financial officer, we conducted an evaluation of our
disclosure controls and procedures as such term is defined under
Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934,
as amended. Based on this evaluation, our principal executive officer and
principal financial officer have concluded, based upon their evaluation as of
the end of the period covered by this report, that our disclosure controls and
procedures were effective as of June 30, 2009. There has been no change in our
internal control over financial reporting that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting during the three months ended June 30, 2009. As of the end of the
third quarter of 2008, we were faced with limited funds for operations and were
compelled to suspend SEC filings. Management has determined that this late
filing situation was due to shortages in capital resources and is not related to
internal controls over financial reporting.




Changes in
Internal Control over Financial Reporting. There has been no change in
our internal control over financial reporting during the fiscal quarter ended
June 30, 2009, that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.





PART II





ITEM
1A. RISK FACTORS





Our
results of operations and financial condition are subject to numerous risks and
uncertainties described in our Annual Report on Form 10-K for our fiscal
year ended December 31, 2008, filed on February 24, 2010 and
incorporated herein by reference. You should carefully consider these risk
factors in conjunction with the other information contained in this report.
Should any of these risks materialize, our business, financial condition and
future prospects could be negatively impacted. As of June 30, 2009, there
have been no material changes to the disclosures made on the above-referenced
Form 10-K, as amended, except as follows:





32





We have a history of significant
recurring losses totaling approximately $89.7million, and these losses may
continue in the future.





As of
June 30, 2009, we had an accumulated deficit of $89.7 million, and these losses
may continue in the future. We will need to raise capital to fund our continuing
operations, and financing may not be available to us on favorable terms or at
all. In the event financing is not available in the time frame required, we will
be forced to sell certain of our assets or license our technologies to others.
We expect to continue to incur significant sales and marketing, research and
development, and general and administrative expenses. As a result, we will need
to generate significant revenues to achieve profitability and we may never
achieve profitability.





Our
operating results have fluctuated in the past and are likely to fluctuate
significantly in the future. We may experience fluctuations in our quarterly
results of operations as a result of:





·
            varying
      demand for and market acceptance of our technology and
      products;




·
            changes
      in our product or customer mix;




·
            the
      gain or loss of one or more key customers or their key customers, or
      significant changes in the financial condition of one or more of our key
      customers or their key customers;




·
            our
      ability to introduce, certify and deliver new products and technologies on
      a timely basis;




·
            the
      announcement or introduction of products and technologies by our
      competitors;




·
            competitive
      pressures on selling prices;




·
            costs
      associated with acquisitions and the integration of acquired companies,
      products and technologies;




·
            our
      ability to successfully integrate acquired companies, products and
      technologies;




·
            our
      accounting and legal expenses; and




·
            general
      economic conditions.





These
factors, some of which are not within our control, may cause the price of our
stock to fluctuate substantially. To respond to these and other factors, we may
need to make business decisions that could result in failure to meet financial
expectations. If our quarterly operating results fail to meet or exceed the
expectations of securities analysts or investors, our stock price could drop
suddenly and significantly. Most of our expenses, such as employee compensation,
inventory and debt repayment obligations, are relatively fixed in the short
term. Moreover, our expense levels are based, in part, on our expectations
regarding future revenue levels. As a result, if our revenues for a particular
period were below our expectations, we would not be able to proportionately
reduce our operating expenses for that period. Any revenue shortfall would have
a disproportionately negative effect on our operating results for the
period.





33





The holders of our preferred stock
have certain rights and privileges that are senior to our common stock, and we
may issue additional shares of preferred stock without stockholder approval that
could have a material adverse effect on the market value of the common
stock.





Our Board
of Directors (“Board”) has the authority to issue a total of up to 4,000,000
shares of preferred stock and to fix the rights, preferences, privileges, and
restrictions, including voting rights, of the preferred stock, which typically
are senior to the rights of the common stockholders, without any further vote or
action by the common stockholders. The rights of our common stockholders will be
subject to, and may be adversely affected by, the rights of the holders of the
preferred stock that have been issued, or might be issued in the future.
Preferred stock also could have the effect of making it more difficult for a
third party to acquire a majority of our outstanding voting stock. This could
delay, defer, or prevent a change in control. Furthermore, holders of preferred
stock may have other rights, including economic rights, senior to the common
stock. As a result, their existence and issuance could have a material adverse
effect on the market value of the common stock. We have in the past issued and
may from time to time in the future issue, preferred stock for financing or
other purposes with rights, preferences, or privileges senior to the common
stock. As of June 30, 2009, we had three series of preferred stock
outstanding, Series B preferred stock, Series C 8% convertible
preferred stock and Series D 8% convertible preferred stock.





The
provisions of our Series B Preferred Stock prohibit the payment of
dividends on the common stock unless the dividends on those preferred shares are
first paid. In addition, upon a liquidation, dissolution or sale of our
business, the holders of the Series B Preferred Stock will be entitled to
receive, in preference to any distribution to the holders of common stock,
initial distributions of $2.50 per share, plus all accrued but unpaid
dividends.  Pursuant to the terms of our Series B Preferred Stock we
are obligated to pay cumulative cash dividends on shares of Series B
Preferred Stock from legally available funds at the annual rate of $0.2125 per
share, payable in two semi-annual installments of $0.10625 each, which
cumulative dividends must be paid prior to payment of any dividend on our common
stock. As of June 30, 2009, we had cumulative undeclared dividends on the
Series B Preferred Stock of approximately $59,000.





The
Series C Preferred Stock has a liquidation preference equal to its stated
value, plus any accrued and unpaid dividends thereon and any other fees or
liquidated damages owing thereon. The Series C Preferred Stock accrues
cumulative dividends at the rate of 8.0% of the stated value per share per
annum.  At the option of the Company, the dividend payment may be made in
the form of cash, after the payment of cash dividends to the holders of
Series B Preferred Stock, or common stock issuable upon conversion of the
Series C Preferred Stock.  Each share of Series C Preferred Stock
is convertible at any time at the option of the holder into a number of shares
of common stock equal to the stated value (initially $1,000 per share, subject
to adjustment), plus any accrued and unpaid dividends, divided by the conversion
price (initially $1.50 per share, subsequently adjusted to $0.50 per share and
subject to further adjustment). Subject to certain limitations, the conversion
price per share shall be adjusted in the event of certain subsequent stock
dividends, splits, reclassifications, dilutive issuances, rights offerings, and
reclassifications.  Certain activities may not be undertaken by the Company
without the affirmative vote of a majority of the holders of the outstanding
shares of Series C Preferred Stock. As of June 30, 2009, we had
cumulative undeclared dividends on the Series C Preferred Stock of
approximately $491,000.





The
Series D Preferred Stock has a liquidation preference equal to its stated
value, plus any accrued and unpaid dividends thereon and any other fees or
liquidated damages owing thereon. The Series D Preferred Stock accrues
cumulative dividends at the rate of 8.0% of the stated value per share per
annum.  At the option of the Company, the dividend payment may be made in
the form of cash, after the payment of cash dividends to the holders of
Series B and Series C Preferred Stock, or common stock issuable upon
conversion of the Series D Preferred Stock.  Each share of
Series D Preferred Stock is convertible at any time at the option of the
holder into a number of shares of common stock equal to the stated value
(initially $1,000 per share, subject to adjustment), plus any accrued and unpaid
dividends, divided by the conversion price (initially $1.90 per share,
subsequently adjusted to 0.50 per share and subject to further adjustment).
Subject to certain limitations, the conversion price per share shall be adjusted
in the event of certain subsequent stock dividends, splits, reclassifications,
dilutive issuances, rights offerings, and reclassifications.  Certain
activities may not be undertaken by the Company without the affirmative vote of
a majority of the holders of the outstanding shares of Series D Preferred
Stock. As of June 30, 2009, we had cumulative undeclared dividends on the
Series D Preferred Stock of approximately $317,000.


34
  ITEM
6. EXHIBITS





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





35








SIGNATURES





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





IMAGEWARE
      SYSTEMS, INC.,a
      Delaware corporation








Date: 
      May 26, 2010
            By: /s/ Wayne G.
    WetherellWayne
      G. WetherellChief
      Financial Officer